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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

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)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨

As of November 3, 2004, there were 66,185,948 shares outstanding of the Registrant’s common stock, par value $.0001 per share.

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PART I—FINANCIAL INFORMATION

STAR SCIENTIFIC, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

AS OF SEPTEMBER 30, 2004 AND DECEMBER 31, 2003

See notes to condensed consolidated financial statements.

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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE MONTHS AND NINE MONTHS

ENDED SEPTEMBER 30, 2004 AND 2003 (UNAUDITED)

See notes to condensed consolidated financial statements.

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CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 (UNAUDITED)

See notes to condensed consolidated financial statements.

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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

As compensation for the $9,000,000 convertible debenture issuance, the Company issued 173,611 common shares (compensation of $717,013 at an issuance price of $4.13 per share). Additionally, the Company issued options to purchase 100,000 shares with a Black-Scholes value of $195,240, for total non-cash loan issuance costs of $912,236.

Subsequent thereto, the Company repriced the warrants issued in connection with the aforementioned debentures from $4.476 to $4.00 in exchange for elimination of certain acceleration provision of the debenture. Compensation costs of $239,276 has been recognized in connection therewith.

During 2004, the Company converted accounts payable of approximately $420,000 into debt.

See notes to condensed consolidated financial statements.

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The condensed consolidated financial statements of Star Scientific, Inc. and its subsidiary, collectively (“Star Scientific”, “Star” or the “Company”), and notes thereto should be read in conjunction with the financial statements and notes for the year ended December 31, 2003.

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, 2004 and 2003 are not necessarily indicative of the results for a full year.

The Company had net losses during the three and nine months ended September 30, 2004 and 2003. Potential common shares outstanding are excluded from the calculation of diluted loss per share if their effect is anti-dilutive. Dilutive loss per share is the same as basic loss per share as the effect of all options outstanding is anti-dilutive.

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).

In November 1998, 46 states, the District of Columbia (the “Settling States”) and several U.S. territories entered into the Tobacco Master Settlement Agreement (the “MSA” or “Master Settlement Agreement”) 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 non-participating manufacturer, the Company is required to satisfy certain escrow obligations under statutes that 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, or “qualifying statutes”, require non-participating 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 non-participating tobacco manufacturers. Under these statutes the Company is obligated to escrow certain defined amounts for sales of cigarettes occurring in the prior year in each such state. These amounts are adjusted annually by statute and to reflect inflation adjustments (at the higher of 3% or the Consumer Price Index), using 1999 as a base year for the calculation. The base amount for 2003 through 2006 is $3.35 per carton, as adjusted for inflation. Specifically for 2003, the amount was $3.89 per carton. The base amount for 2007 and thereafter, is $3.77 per carton, as adjusted for inflation since 1999. Such escrowed funds will be available to satisfy tobacco-related judgments or settlements, if any, in the Settling 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. In addition to the escrow deposits associated with the Company’s direct customer sales, the Company has 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”). 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. Star’s sale of smokeless tobacco products are not subject to the MSA escrow obligations.

On June 18, 2003, the Company and all of the MSA states executed a comprehensive settlement agreement under which Star remains a non-participating manufacturer under the MSA and which resolved all issues as to the funding of the escrow accounts for the period 1999-2002. Under the Settlement Agreement, Star accepted responsibility for cigarettes manufactured during this period at its Petersburg, Virginia facility only. Brown and Williamson Tobacco Corporation (“B&W”) entered into a separate settlement agreement with the MSA states under which it agreed to make MSA payments based on the cigarettes that it contract manufactured for Star during the period 1999-2002. As a result of the settlement, Star’s total escrow obligation for the period 1999–2002 was $27,024,333, based on the number of cigarettes produced at its Petersburg, Virginia, facility and later sold in MSA states. Following the settlement, Star is responsible for making escrow payments on all Star cigarettes sold in any MSA state, regardless of where such products are manufactured.

Star currently has approximately $33.3 million in escrow, which includes an initial deposit of approximately $6.2 million made in April 2004 for its 2003 escrow obligation, and additional net deposits of $46,679 made in the third quarter of 2004 to satisfy a portion of its 2004 escrow obligations. These funds will remain in escrow pursuant to the terms of the qualifying statutes, and will be available to satisfy state judgments for the type of claims asserted against the major tobacco manufacturers in the suits that resulted in the negotiation of the MSA.

In addition to the “level playing field” statutes, most of the MSA states have enacted statutes that require non-participating 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 its ability to sell cigarettes in the MSA states, notwithstanding its substantial payments into escrow,

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since the states generally prohibit the sales of cigarettes by companies that are not certified as being MSA-compliant. Also, a number of states recently have amended their qualifying statutes to limit the extent to which escrow payments for a particular year could be capped and to allow regulations that would require escrow payments to be made quarterly or on some other intermittent schedule. The requirement for quarterly payments would exacerbate the impact of the MSA escrow obligations on the Company’s liquidity, and the elimination of the caps on payments would increase the amounts required to be deposited into escrow by requiring a payment on each cigarette sold, regardless of the state’s proportionate receipt of MSA settlement funds. Currently, the Company is required to make quarterly payments in Wyoming, Louisiana and New Mexico. As initially drafted, the state qualifying statutes permitted a non-participating manufacturer to obtain a refund on escrow payments once those payments equaled the amount that an MSA state would have received from that non-participating manufacturer under the allocation formula in the MSA (which is based on the state population as a percentage of the overall US population). Depending on the number of cigarettes sold in a particular state, the difference between the capped amount and the amount calculated on a per-cigarette basis could be material.

On December 15, 2000 and June 12, 2001, the Company filed lawsuits in the United States District Courts for the Eastern District of Virginia and the Southern District of Indiana, respectively, challenging the MSA and the qualifying statutes on a number of constitutional bases. On March 26, 2001, the District Court for the Eastern District of Virginia dismissed the Company’s complaint, but in its opinion, the court did note that Star “must now suffer as a result of the bad faith of previous market entrants.” The 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 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 court’s ruling. On appeal, the United States Court of Appeals for the Fourth Circuit affirmed the decision of the District Court and on October 7, 2002, the Supreme Court denied the Company’s Petition for a Writ of Certiorari filed with the Supreme Court on May 20, 2002. The action by the Supreme Court effectively ended the Company’s constitutional challenge to the MSA. Based on the Supreme Court denial of the Company’s petition for a writ of certiorari, the Company dismissed its Indiana lawsuit.

$25.0 million sale of common stock

On August 9, 2004, the Company filed with the SEC a registration statement on Form S-3 (File No. 333-118054), as amended by Amendment No. 1 filed on August 20, 2004 (collectively, the “Registration Statement”), relating to the registration under the Securities Act of 1933, as amended, of shares of $0.0001 par value Common Stock of the Company with an aggregate offering price of $25.0 million; that Registration Statement was declared effective on August 20, 2004.

Subsequently, on August 31, 2004, the Company completed an offering of 1,510,000 shares of common stock under the Registration Statement with an aggregate purchase price of $6,795,000 ($4.50 per share). On September 25, 2004, the Company entered into a Stock Purchase Agreement with certain purchasers in connection with the offering of 3,640,000 shares of common stock under the Registration Statement with an aggregate offering price of $18,200,000 ($5.00 per share). This offering was completed on September 28, 2004.

Management Acquisitions of Our Stock

In our quarterly report on Form 10-Q filed for the quarter ended June 30, 2004, which was filed on August 9, 2004, we disclosed that Jonnie Williams, our Chief Executive Officer and largest stockholder, and other members of management had expressed an intent to purchase up to 1 million shares of the Company’s common stock in transactions that may include purchases on the open market, private acquisitions from third parties and purchases directly from the Company. Between August 9, 2004 and the date of this report, Mr. Williams and David Dean, our Vice President of Sales and Marketing, purchased an aggregate of 300,000 shares in private acquisitions from a third party. While Mr. Williams and other members of management may purchase additional shares, they have no specific plans at this time.

Increase in Independent Director Compensation

In light of the increasing demands on our three independent directors due to the Sarbanes-Oxley Act and related developments, we have increased their compensation. On August 31, 2004, we issued to each of our three independent directors a stock option to purchase up to 150,000 shares of our common stock. Each such option vested immediately upon issuance and has an exercise price equal to $4.95, the closing price of our common stock on the business day prior to the issuance. In addition, subject to the approval of our stockholders at our next annual meeting, each independent director’s annual retainer option grant will increase from 25,000 to 50,000 shares. On October 28, 2004, the Board approved a further, one-time grant of 50,000 shares of the Company’s common stock to Mr. Kelley for his services as Chair of the Audit Committee. Each director will now receive $4,500 for each board and committee meeting attended personally and $3,500 for participation in such meetings telephonically. This represents an increase from $2,500 and $1,500, respectively. Fees for meeting attendance will now be capped at $6,000, compared to the current daily caps of $4,000 for

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in-person meetings and $2,500 for telephonic meetings. In addition, the audit committee chairman will receive an additional fee of $20,000 per year.

RJR Litigation

On September 1, 2004 a pre-trial conference was held with the Honorable Marvin J. Garbis to whom Star’s patent infringement lawsuit against R.J. Reynolds Tobacco Company (“RJR”) had been transferred in August 2004. Following the conference, on September 3, 2004, Judge Garbis issued a “First Procedural Order”. In that Order, Judge Garbis set a firm trial date for the patent infringement lawsuit to begin on Monday, January 24, 2005. The procedural order also established interim dates for the filing of various pretrial motions and other pretrial matters.

On July 30, 2004, RJR, Brown & Williamson Tobacco Corporation (“B&W”) and certain of their affiliated tobacco businesses combined operations under the new publicly traded holding company, Reynolds American Inc., which is 42% owned by British American Tobacco PLC, the former parent of B&W. RJR has recently taken the position that the new operating entity established as a result of this transaction has assumed all of the rights and obligations under the agreements previously entered into between Star and B&W. As a result, RJR has claimed that under the agreements Star is not in a position to continue its lawsuits against RJR. Star believes that both of these positions are without merit and is contesting those assertions vigorously.

Removal of Redemption Provision for the $9 million subordinated debt

On September 15, 2004, the Company completed an agreement with Manchester Securities to remove the redemption provisions for the $9 million subordinated debt principal amount and any accrued and unpaid interest. This transaction was announced in an 8-K filed on September 15, 2004, and changed the exercise price for 502,681 warrants held by Manchester Securities from $4.476 per share to $4.00 per share. The resulting cost recognized by the Company was approximately $240,000.

Subsequent Events

Sales and Use Tax Assessment with respect to the Company’s curing barns in the Commonwealth of Virginia

In a letter dated October 7, 2004, the Company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to the Company and that the sales and use tax assessment plus penalties and interest together now total approximately $988,000. The Company continues to challenge this assessment and has filed a request for reconsideration with the Commissioner of Taxation, and is prepared to file a judicial action if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue. The Company and its representatives believe that the assessment is incorrect. Accordingly, the Company does not believe that the payment of this obligation is probable at September 30, 2004 and, as such, the liability has not been accrued.

Changes in Composition of the Board of Directors

In order to comply with the recent changes in the NASDAQ rules, which require a majority of the Board members to be independent, Christopher G. Miller resigned from the Board on October 28, 2004. Mr. Miller continues to serve as the Company’s CFO.

Repayment of Principal and Interest to Jonnie R. Williams

On October 28, 2004, the Company determined to repay the outstanding advance of $4.5 million to Mr. Williams, together with the accrued interest, in order to reduce the Company’s borrowing costs. Subsequently, the Company repaid the outstanding balance to Mr. Williams. Mr. Williams remains obligated under the Loan Agreement to make advances to the Company if required for the Company’s liquidity at any time prior to March 31, 2005, in an amount not to exceed $10 million.

Registration of Stock Option Plans

On October 28, 2004, the Board and the Company agreed that the Company will register its 1998 Stock Option Plan and its 2000 Equity Incentive Plan under the Securities Act of 1933 on Form S-8 by no later than December 31, 2004. The Directors have agreed that they will enter into lock-up arrangements with the Company that they will not exercise their options or sell the shares upon any exercise of options granted under the Plans prior to March 31, 2005, and the Company will seek similar agreements from other persons holding option grants under the Plans.

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Overview

During the third quarter of 2004, the Company raised $25.0 million through the sale of common shares. As of September 30, 2004, the Company has a working capital surplus of approximately $2.9 million. Future cash needs over the near term include:

In addition, there exist certain contingencies which could require the Company to make significant cash payments, including:

On October 28, 2004, the Company determined to repay the outstanding advance of $4.5 million to Mr. Williams, together with the accrued interest, in order to reduce the Company’s borrowing costs. Subsequently, the Company repaid the outstanding balance to Mr. Williams. Mr. Williams remains obligated under the Loan Agreement to make advances to the Company if required for the Company’s liquidity at any time prior to March 31, 2005, in an amount not to exceed $10 million.

With the proceeds of the recent stock sale and the improving margins in the cigarette business, the Company anticipates that it will have sufficient funds to support its operations in the near term. However, absent the successful completion of its patent infringement litigation, a substantial improvement in revenues and/or royalties from its smokeless tobacco products, or a significant improvement of the volume of sales of cigarettes, it is expected that the Company will need to pursue additional sources of funds during the second half of 2005. However, there are significant limitations on the Company’s ability to raise new debt financing, including its agreements with Manchester Securities and B&W. The Company’s ability to raise future financings on terms acceptable to the Company will depend on a number of factors, including the performance of the Company’s stock price and its operational performance. Any equity financing will be dilutive to the Company’s existing shareholders.

Summary of Balances and Recent Sources and Uses

As of September 30, 2004, the Company held approximately $18.7 million in cash and cash equivalents and $5.0 million of accounts receivable, compared to approximately $0 in cash and cash equivalents, and $5.6 million in accounts receivable, as of December 31, 2003.

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Net Cash Provided By (Used In) Operating Activities. In the first nine months of 2004, $8.8 million of cash was used in operating activities. This compared to $8.7 million of cash generated by operating activities during the first nine months of 2003. This decrease in cash generated by operations during the first nine months of 2004 was primarily due to losses as a result of a decrease in the price per carton sold in the first six months of 2004, while volumes for the comparable nine month periods remained constant, offset by a decrease in the cost of goods sold and receipt of income tax refunds aggregating approximately $1.3 million. In both periods, the Company had significant net operating losses.

Net Cash Provided By (Used In) Financing Activities. During the first nine months of 2004, $33.3 million of cash was generated by financing activities versus $6.1 million of cash used in financing activities in the same period in 2003. The funds generated during the first nine months of 2004 were from the $9 million convertible debenture financing, from the $4.0 million in proceeds from common stock sold in a private placement, from $0.8 million of cash provided by the working capital loan from the Company’s CEO and from $25.0 million in proceeds from the sale of common stock pursuant to the shelf registration. During the first nine months of 2004, approximately $4.7 million of cash was used in the repayment of notes payable and capital leases while during the first nine months of 2003, approximately $6.1 million of cash was used for the repayment of notes payable and capital leases.

Net Cash Provided by (Used In) Investing Activities. During the first nine months of 2004, $0.5 million of cash was generated by investing activities versus $0.8 million of cash generated by investment activities in the first nine months in 2003. The cash generated during 2003 was from the repayment of a note from an officer of the Company, while the cash generated during 2004 was due to the release of a portion of a deposit on an operating lease.

Net Cash Used in MSA Escrow Payments. During the first nine months of 2004, the Company deposited approximately $6.2 million for its 2003 escrow obligation for 2003 sales in MSA states, as well as net quarterly deposits of $46,679 required during 2004 for 2004 sales in certain MSA states, versus approximately $3.4 million deposited during the first nine months of 2003. This lower amount deposited in 2003 was a direct result of the settlement agreement with the MSA states described herein.

Cash Demands on Operations

While the Company obtained $9.0 million, $4.0 million, and $25.0 million in funding in March 2004, April 2004 and September 2004, respectively, it was required to deposit approximately $6.2 million into its MSA escrow accounts for 2003 sales in April 2004 and had a net loss of approximately $11.8 million for the first nine months of the year.

The Company continues to experience negative cash flow from operations despite increasing prices for its cigarettes for the third quarter of 2004 compared with both the same period last year as well as the second quarter of 2004. Cigarette sales volumes for the third quarter of 2004 are up significantly compared to the same period last year, but are down slightly from sales during the second quarter of 2004. Sales of the Company’s smokeless products as well as royalty income continue to be de minimis. The Company has in the past and continues to spend a significant amount of money in connection with the development and protection of its intellectual property portfolio, principally in connection with its patent infringement litigation against RJR. As of September 30, 2004, the Company had a working capital surplus of $2.9 million, compared with a working capital deficit of $10.2 million as of June 30, 2004.

The Company’s working capital surplus as of September 30, 2004 does not reflect its obligation to make MSA escrow deposits for 2004 sales, which it must make in April 2005. Certain MSA states require quarterly escrow payments, and the Company makes those payments for ongoing sales. In the third quarter of 2004, the Company made additional net deposits of $46,679 into its MSA escrow accounts. In addition, 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, which are scheduled for trial beginning on January 24, 2005. Further, given anticipated levels of revenues and cash flows from operations, substantial capital will be needed for sales, marketing and promotion of ARIVA^® and STONEWALL Hard Snuff^®. The Company’s liquidity needs for the next 12-24 months are difficult to predict. However, the Company has raised capital during both the second and third quarters of 2004 which will be sufficient to support its operations for the near term. Depending on its results of operations, including its patent infringement litigation against RJR and sales of smokeless tobacco products, the Company may need to raise additional funds to support its operations in the second half of 2005.

Contingent Liabilities and Cash Demands

B&W Agreements. Under the Restated Master Agreement, as amended by letter agreements dated December 4, 2002 and August 14, 2003, between B&W and the Company, the Company owes B&W approximately $20 million of long-term debt, with no interest accruing, or principal payments required through December 31, 2005. Beginning January 1, 2006, interest accrues at prime plus 1% and interest and principal are payable in 96 monthly installments. The debt is secured by tobacco leaf inventory, the tobacco curing barns, and a first priority security interest in the Company’s intellectual property. Once the outstanding loan balance is reduced to $10 million, the collateral will be released by B&W. Star also has a current obligation of $7,899,647 payable to B&W. The principal on this obligation has been deferred to at least January 2005.

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In the second quarter of 2004, Star entered into an agreement with another tobacco manufacturer for the licensing of low-TSNA hard tobacco. Under that agreement, the manufacturer has conducted an initial assessment of a hard tobacco product and the agreement anticipates that this will be followed up with a subsequent test market. The Company does not anticipate receiving any royalties under that agreement for the foreseeable future. To enable Star to pursue this agreement, and potentially other licensing of hard tobacco products, B&W agreed to waive its ten-year right to be the exclusive purchaser of hard tobacco from Star (subject to Star’s own rights) in return for concessions on the April 21, 2001 Hard Tobacco Agreement and a 3-month extension of the date on which it would begin once again to pay royalties under the April 25, 2001 Other Low-TSNA Tobacco Royalty Agreement, once a royalty rate is established with one of the other three largest tobacco manufacturers.

Pursuant to the Hard Tobacco Agreement entered into with B&W in April 2001, B&W will forgive one-half of Star’s then-outstanding indebtedness to B&W if B&W determines that its test market of a hard tobacco products is successful, and all of the remaining debt if and when it introduces a hard tobacco product into distribution in retail locations in 15 states. On December 15, 2003, B&W began to test market in Louisville, Kentucky a hard tobacco product named Interval^® which the Company manufactured at its facility in Chase City, Virginia. While B&W has not ordered further amounts of Interval^®, it indicated its intent to initiate a further large-scale test market of a similar dissolvable low-TSNA smokeless tobacco product and product for that test market was shipped to B&W by Star this summer. However, there can be no assurances that B&W’s test market will be deemed successful or extended into additional states. The Company has had de minimis revenues from royalties on the sale of smokeless tobacco products by B&W.

Master Settlement Agreement. In April 2004, the Company deposited $6.2 million into its MSA escrow accounts for sales of cigarettes in MSA states in 2003, and a net amount of $46,679 during the third quarter of 2004 which includes quarterly escrow payment for certain MSA states. Star currently has approximately $33.3 million in escrow. These funds will remain in escrow pursuant to the terms of the qualifying statutes, and will be available to satisfy state judgments for the type of claims asserted against the major tobacco manufacturers in the suits that resulted in the negotiation of the MSA. The MSA escrow deposit for 2004 sales is due on or before April 15, 2005, except for any quarterly payments that may be required under recent changes to the qualifying statutes in a number of MSA states. Given the Company’s focus on sales in the non-MSA states, its cigarette volume to date in 2004, and the fact that the base payments in 2004 are comparable to 2003, it is anticipated that the escrow obligations for 2004 sales would be somewhat less than the $6.2 million paid in April 2004.

Litigation Costs. The Company has entered into fee arrangements with counsel in several litigation and related matters under which certain costs related to the litigation are being advanced by counsel on behalf of the Company. 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 this contingent liability. The Company has paid or accrued all existing obligations. Also, as part of its fee arrangements in certain of 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 in return for a cap on fee payments during the litigation.

The Company has never been sued by a consumer of its tobacco products on a claim for product liability and is not named as a defendant in any litigation relating to the manufacture of tobacco products. The Company believes that it has conducted its business in a manner which decreases the risk of liability in a lawsuit relating to product liability because it:

Over the past several years, the Company has asserted several challenges to the MSA and qualifying statutes. These constitutional challenges were not successful and the Company is not currently engaged in any litigation challenging the constitutionality of the MSA and qualifying statutes. Also, the Company completed a comprehensive settlement relating to its obligation as a nonparticipating manufacturer under the MSA in June 2003. As a result, the Company does not anticipate incurring significant costs related to litigation arising out of the MSA in the future.

The Company is currently prosecuting patent infringement claims against RJR in a consolidated action in the United States District Court for the District of Maryland and in 2002 was successful in having a declaratory judgment action brought by Philip Morris dismissed on the basis that no actionable controversy existed between the companies. In the coming months, the Company anticipates increases in its general and administrative costs in connection with the continued prosecution of its patent infringement lawsuits which have been scheduled for trial beginning on January 24, 2005.

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Changes in Operations. During the first nine months of 2004, the Company committed to additional cost savings measures. These included, initially, projected decreases of approximately $1 million in executive salaries in 2004, either through deferrals or reductions. Deferrals are expensed but not paid, and reductions are neither expensed nor paid. Additionally, during portions of 2004, use of an aircraft owned by Starwood Industries, Inc. (a company in which Jonnie R. Williams, Star’s CEO and largest shareholder, is a principal) was discontinued in an effort to reduce costs. After the close of the third quarter of 2004, deferrals of $694,423 were paid to the Executives, and their previous salaries were reinstated. During the third quarter, aircraft use was reinstated and $230,000 of aircraft expenses were charged to the Company for usage of the above mentioned aircraft. While the Company has continued to reduce certain of its operating costs and has increased its gross margin, the Company expects to continue to experience negative cash flows from operations for the year and intermediate future.

Request for a Private Letter Ruling and Virginia Tax Assessment. The Company has recently been notified that its 2001 federal income tax return has been selected for examination by the Internal Revenue Service. No action has currently taken place with regard to this audit. Except for the item discussed below, the impact of the IRS examination on the Company’s financial condition, results of operations and cash flow, if any, cannot be ascertained at this time.

During 2002, the Company submitted to the IRS a Request for a Private Letter Ruling asking that the IRS rule on the deductibility of funds placed in escrow under the MSA. The Company has taken the position on its 2001 and later federal and state income tax returns that the payment to the escrow account under the terms of the MSA is a current expense. Additionally, the Company filed claims for refunds of taxes paid in prior years based upon the deductibility of these escrow payments. During 2002 and 2003, the Company received a total of $12.6 million in federal and state refunds relating to such claims. During the first quarter of 2004, the Company received an additional $1.3 million in state refunds relating to such claims.

The Company is continuing to seek a favorable ruling from the IRS on its Request. If the IRS determines that it will not grant the Company’s Request, the Company anticipates that it will withdraw the Request. Further, if upon examination, the IRS rules against the Company with respect to the claimed deductions, the Company expects that it will challenge any such determination through the Appeals process up to and including the US Tax Court to seek a final determination with respect to this issue. While the Company believes that its position is reasonable and supported by the statute and IRS Regulations, the outcome of these proceedings cannot be predicted. Ultimate resolution of this matter, should the IRS rule adversely, is not anticipated until late 2005, at the earliest.

If it is ultimately determined that the Company’s treatment of the payments into escrow is not a current deduction for tax purposes, it is expected that the Company’s existing carryback claims net of operating loss deductions will be sufficient to offset any additional tax due for the years in question, given the extent of the Company’s recent losses. Further, the Company would be subject to interest and possibly certain penalties. However, those amounts would also be subject to being offset by the Company’s existing carryback claims to the extent available.

In a letter dated October 7, 2004, the Company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to the Company and that the sales and use tax assessment plus penalties and interest together now total approximately $988,000. The Company continues to challenge this assessment and has filed a request for reconsideration with the Commissioner of Taxation, and is prepared to file a judicial action if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue.

Funding from the CEO

In early October 2003, Jonnie R. Williams, Star’s CEO and largest shareholder, loaned Star $2 million in funds for corporate purposes. In a letter dated November 7, 2003, Mr. Williams advised the Company that he would personally extend an additional $8 million (and with the funds previously loaned in October, a total of $10 million) to the Company on an as-needed basis until the Company returns to profitability. Since October, Mr. Williams has from time to time as needed by the Company advanced amounts up to approximately $5 million to the Company.

In late December 2003, the Company used funds advanced from Mr. Williams to pay down the then-outstanding balance of approximately $2.2 million under its $7.5 million line of credit from Guaranty Bank. This line of credit was terminated as of December 31, 2003 consistent with the letter agreement the Company and Guaranty Bank entered into on August 14, 2003. As of December 31, 2003, the Company had borrowings of $3.7 million outstanding from Mr. Williams. As of September 30, 2004, the advances to the Company were $4.5 million. Further, Mr. Williams pledged to provide such funds as may be necessary to the Company to cover cash flow shortfalls in 2004 and through March 31, 2005.

The Company has entered into a loan agreement with Mr. Williams under which he has agreed to make funding available to the Company with the understanding that Mr. Williams could not demand payment of the principal or interest before March 31, 2005. The loan agreement provides that interest on the outstanding advances by Mr. Williams would be at a rate of 8% per annum on the outstanding balance. After March 31, 2005, subject to restrictions in any other lending documents, the outstanding balance would be

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repaid to Mr. Williams based on his determination of the Company’s ability to repay such advances. In connection with the transactions with Manchester Securities, Mr. Williams entered into a subordination agreement with Manchester Securities, subordinating his claims under the loan agreement to the rights of Manchester Securities under the debenture and related agreements.

On October 28, 2004, the Company determined to repay the outstanding advance of $4.5 million to Mr. Williams, together with the accrued interest, in order to reduce the Company’s borrowing costs. Subsequently, the Company repaid the outstanding balance to Mr. Williams. Mr. Williams remains obligated under the Loan Agreement to make advances to the Company if required for the Company’s liquidity at any time prior to March 31, 2005, in an amount not to exceed $10 million.

Prospects for Company Operations

Since 2000, the Company’s discount cigarette business has continued to experience a significant decline in sales, partly caused by intensified pricing competition from foreign manufacturers. In addition, a substantial portion of the Company’s gross profits on cigarette sales must be paid into escrow in April of each year to meet the Company’s obligations under the MSA. ST’s cigarettes are sold through approximately 177 tobacco distributors throughout the United States, although the Company has sought to focus sales efforts in the states of Florida, Minnesota, Mississippi and Texas, where it does not incur escrow obligations under the MSA.

During the third quarter of 2004, the number of cigarettes sold as well as the price of cigarettes increased substantially compared with the third quarter of 2003. The termination of the proposed sale of the cigarette business to North Atlantic Trading Company, Inc. (“NATC”) in July 2003 resulted in a significant disruption of the Company’s cigarette business in the third quarter of 2003, particularly in Texas where a number of senior sales managers left the Company shortly after the termination of the NATC transaction was announced. Since the termination of the NATC purchase agreement, the Company has taken a number of steps to address these negative trends, including the implementation of a promotional program at the retail level and a separate wholesale pricing promotion, which were terminated in June 2004, as well as the successful restructuring of the senior sales management team in Texas.

Shipments in the third quarter of 2004 totaled approximately 63.9 truckloads of cigarettes. This compares to 51.6 truckloads in the third quarter of 2003 and 66.5 truckloads in the second quarter of 2004. The truckload sales continue to reflect pricing competition in the non-MSA states and pressures on the cigarette industry in general. The Company achieved substantially higher pricing for its cigarettes in the third quarter due to an increase in sales price and a discontinuation of a sales promotion. As a result, the average carton price increased from $6.68 in the second quarter of 2004 to $7.56 in the third quarter of 2004.

The increase in truckload sales and higher carton sales prices resulted in substantially increased cigarette revenues and gross margins for the third quarter of 2004. Over the past year, the Company has been successful in its efforts to reduce its cost-of-goods sold. Also, in the second quarter as the Company discontinued its retail and wholesale promotional discounts and, as prices firmed up in the latter half of the second quarter of 2004, the gross profit per month increased correspondingly. Gross profits were $534,540 in April, $941,419 in May and $1,178,897 in June. During the third quarter of 2004, gross profits totaled $4.6 million, as compared to gross profits of $0.1 million in the third quarter of 2003 and $2.7 million in the second quarter of 2004. Sales of Star’s smokeless products continue to be de minimis and it will take significantly greater sales of smokeless products for this business segment to operate at breakeven levels. STONEWALL Hard Snuff^® now represents a majority of Star’s hard tobacco sales.

Since January 1, 2003, the Company has been manufacturing all of its cigarettes at its Petersburg, Virginia manufacturing facility. The Company anticipates that the manufacturing capacity in Petersburg should be sufficient to satisfy the manufacturing needs for the foreseeable future. However, management has undertaken to make arrangements for contract manufacturing of cigarettes in the event that sales increase beyond the capacity of the Petersburg facility.

Conclusion

The Company’s cigarette sales and associated gross profits have continued to decline, particularly when consideration is given to the Company’s MSA escrow requirements. Increasing regulatory requirements in both MSA and non-MSA states, as well as increased pricing competition, have also impacted the sales of discount cigarettes. Further, there are significant impediments to generating significant revenues from royalties or sales of its smokeless tobacco products in the near future. Accordingly, depending on the success of its future operations, including its patent litigation against RJR and sales of smokeless tobacco products, the Company may need to raise funds to support its operations beyond the $25.0 million raised under the shelf registration in August and September 2004, although management believes these funds will support its activities for the near term. While Jonnie Williams, the CEO and largest stockholder, has pledged to fund the Company’s working capital needs through March 2005, the Company in the future may need to seek additional funds from sources other than Mr. Williams.

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The following table shows the raw materials and finished good inventories for both cigarettes and smokeless products.

Notes/capital leases payable at September 30, 2004 consist of the following:

The annual maturities of notes payable and capital leases, without regard to potential royalty or forgiveness reductions, are as follows:

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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), which claims a process for substantially preventing the formation of TSNAs in tobacco. 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, and on August 27, 2002 the two suits were consolidated.

In April 2003, the parties filed dispositive motions for Summary Judgment. Star Scientific filed a Motion for Summary Judgment on Claim Construction and Definiteness, and RJR filed six Motions for Summary Judgment asserting various defenses. Pursuant to an Order dated September 15, 2003, the Court appointed a Special Master to prepare Reports and Recommendations (“R&Rs”) for the Court on Star Scientific’s Motion for Summary Judgment and five of RJR’s six Motions for Summary Judgment. The Special Master issued R&Rs on all six of the Summary Judgment Motions and on March 31, 2004, the Court issued final rulings on five of the six Summary Judgment Motions. In its rulings, the Court adopted without modification the Special Master’s R&Rs, which recommended that the Court deny RJR’s Summary Judgment Motions, and that Star Scientific’s motion for Summary Judgment on claim construction and definiteness be granted in part and denied in part. The Court also issued an order denying RJR’s motion for Summary Judgment seeking to limit Star’s damages claim. On June 24, 2004, the Court issued a final order on the last RJR Summary Judgment Motion and adopted without modification the Special Master’s R&R, which recommended that the Court deny the Summary Judgment Motion.

On August 17, 2004, the Company was informed that the case was transferred from Judge Alexander Williams to Judge Marvin J. Garbis and that a pre-trial conference would be held on September 1, 2004. Following the conference, on September 3, 2004, Judge Garbis issued a “First Procedural Order”. In that Order, Judge Garbis set a firm trial date for the patent infringement lawsuit to begin on Monday, January 24, 2005. The procedural order also established interim dates for the filing of various pretrial motions and other pretrial matters.

On July 30, 2004, RJR, Brown & Williamson Tobacco Corporation (“B&W”) and certain of their affiliated tobacco businesses combined operations under the new publicly traded holding company, Reynolds American Inc., which is 42% owned by British American Tobacco PLC, the former parent of B&W. RJR has recently taken the position that the new operating entity established as a result of this transaction has assumed all of the rights and obligations under the agreements previously entered into between Star and B&W. As a result, RJR has claimed that under the agreements Star is not in a position to continue its lawsuits against RJR. Star believes that both of these positions are without merit and is contesting those assertions vigorously.

Following the introduction of ARIVA^®, three citizen petitions were filed with the United States Food and Drug Administration (the “FDA”) seeking to have ARIVA^® 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. The Company’s legal team was headed by former U.S. Solicitor General Charles Fried, Esquire. In the responses counsel concluded that the petitions were factually flawed and without merit, because ARIVA^® does not fit the definition of a food or a drug under the Federal Food, Drug and Cosmetic Act and the FDA lacks jurisdiction to regulate ARIVA^® based on the March 21, 2000 decision of the Supreme Court in FDA v. Brown & Williamson Tobacco Corporation, 529 U.S. 120 (2000). On August 29, 2003, the FDA issued a letter opinion denying the multiple Citizen Petitions. In its ruling, the FDA concluded that it lacked jurisdiction to regulate ARIVA^® since it is a customarily marketed tobacco product. Petitioners have not challenged that decision.

In 2002, the Virginia Department of Taxation 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. The Company 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. In a letter dated October 7, 2004, the Company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to the Company and that the sales and use tax assessment plus penalties and interest together now total approximately $988,000. The Company continues to challenge this assessment and has filed a request for reconsideration with the Commissioner of Taxation, and is prepared to file a judicial action if the administrative

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action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue.

There is other minor litigation in the ordinary course of business which the Company is vigorously defending or pursuing.

The Company has entered into fee arrangements with counsel in several litigation and related matters under which certain costs related to the litigation are being advanced by counsel on behalf of the Company. It is estimated that at the time these litigation and related matters are concluded, which likely will not be before the end of the first quarter of 2005, the Company’s portion of these costs could be in excess of one million dollars. One-half of these costs advanced by counsel would be payable by the Company if it does not prevail in these litigation matters. 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 this contingent liability. The Company has paid or accrued all existing obligations. Also, as part of its fee arrangements in certain of 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 in return for a cap on fee payments during the litigation.

The Financial Accounting Standards Board has issued an Exposure Draft, Share-Based Payment - an Amendment of FASB Statements No. 123 and 95, and is expected to issue a final Statement by December 31, 2004. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB 25, and generally would require instead that such transactions be accounted for using a fair-value-based method. We have previously adopted the fair-value-based method of accounting for share-based compensation arrangements and as such, the pronouncement will have no impact on the Company’s financial position or operating results.

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Overview

The following discussion provides an assessment of the Company’s consolidated results of operations, capital resources, and liquidity and should be read together with the financial statements and related notes included elsewhere in this report and in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

The Company’s prospects are dependent, in the near term, on its ability to improve the performance of its discount cigarette business and raise additional funds; and, in the longer term, on the distribution and consumer acceptance of its low-TSNA smokeless tobacco products as well as the continued development of new low-TSNA smokeless tobacco products, independently and through alliances with other tobacco manufacturers, and on its ability to begin generating significant revenues through royalties on its patented tobacco curing process, including through success in its pending patent litigation against RJR.

During the third quarter of 2004, the Company raised $25.0 million through the sale of shares of common stock. As of September 30, 2004, the Company has a working capital surplus of approximately $2.9 million.

With the proceeds of the recent stock sale and the improving margins in the cigarette business, the Company anticipates that it will have sufficient funds to support its operations in the near term. However, absent the successful completion of its patent infringement litigation, a substantial improvement in revenues and/or royalties from its smokeless tobacco products, or a significant improvement of the volume of sales of cigarettes, it is expected that the Company will need to pursue additional sources of funds during the second half of 2005. However, there are significant limitations on the Company’s ability to raise new debt financing, including its agreements with Manchester Securities and B&W. The Company’s ability to raise future financings on terms acceptable to the Company will depend on a number of factors, including the performance of the Company’s stock price and its operational performance. Any equity financing will be dilutive to the Company’s existing shareholders.

The Company’s inability to improve its operations or to raise funds over the next 12-24 months could have a material adverse effect on its ability to meet its working capital needs and continue operations.

Company Mission

Star Scientific, Inc. (“Star”) and its wholly-owned subsidiary, Star Tobacco, Inc. (“ST”, and together with Star, the “Company”) are technology-oriented tobacco companies with a mission to reduce toxins in tobacco leaf and tobacco smoke. The Company is engaged in:

(1) the development, implementation and licensing of scientific technology for the curing of tobacco so as to substantially prevent the formation of carcinogenic toxins present in tobacco and tobacco smoke, primarily the tobacco-specific nitrosamines (“TSNAs”);

(2) the manufacturing, sales, marketing and development of very low-nitrosamine smokeless tobacco products that also carry enhanced warnings beyond those required by the Surgeon General, including Stonewall^®dry snuff, ARIVA^® compressed powdered tobacco cigalett^® pieces, and STONEWALL Hard Snuff^®. The Company also manufacturers very low-nitrosamine smokeless tobacco products for B&W which are currently in test market; and

(3) the manufacture and sale of four discount cigarette brands, SPORT^®, MAINSTREET^®, VEGAS^® and G-SMOKE^®, which have historically generated the vast majority of the Company’s revenues.

The Company has previously purchased very low-TSNA flue-cured tobacco, cured by farmers using the StarCured^® tobacco curing process, and resold this leaf tobacco to B&W. The Company has suspended these purchases and sales through at least the end of 2004.

Star Scientific’s long-term focus continues to be the research, development and sale of products, particularly very low-TSNA smokeless tobacco products, that expose adult tobacco users to lower levels of toxins. The Company’s overall objective is to ultimately reduce the range of serious health hazards associated with the use of smoked and smokeless tobacco products. The Company fully accepts the evidence that links smoking tobacco with a variety of diseases and premature death and believes that it is highly unlikely that the health risks of smoked tobacco can be completely eliminated. Star believes it was the first company to state unequivocally that “there is no such thing as a safe cigarette”, and to affix to the back of the package of its first premium low-TSNA product, Advance^®, a package “onsert” which contained not only scientifically verified comparative content data, but also additional health warnings. Nevertheless, in a world where an estimated 1.2 billion people smoke and use other conventional tobacco products, there is an urgent need to reduce the toxicity of tobacco products to the maximum extent possible, given available technology. Accordingly, the Company believes that it has a corporate responsibility to continue its research and development efforts to

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manufacture tobacco products in the least hazardous manner possible, given available technology, particularly through the StarCured^® tobacco curing process. While the Company has deferred certain research projects because of cost-cutting efforts necessitated by its lack of available working capital, it expects to renew those efforts after the completion of the trial in its patent infringement lawsuits which are scheduled to begin on January 24, 2005.

The Company believes it has the technology to reduce exposure to carcinogenic TSNAs, particularly the subgroups of nitrosamines commonly referred to as NNNs and NNKs, to the lowest possible levels and has demonstrated that its method for curing tobacco using the StarCured^® tobacco curing process can be scaled up to meet broad commercial needs in the United States and abroad. Given the fact that tobacco smoke contains over 4,000 constituents, 43 of which are known carcinogens, the Company’s focus over the last several years has centered on the development and commercialization of very low-TSNA, non-fermented smokeless tobacco products that can be used as an alternative to cigarettes in situations where adult tobacco users either cannot or choose not to smoke. The Company expects that in the future its focus will continue to be on the development and sale of very low-TSNA non-fermented smokeless tobacco products, as well as on encouraging other tobacco manufacturers to sublicense the StarCured^® tobacco curing technology to produce very low-TSNA tobacco (with carcinogenic NNKs and NNNs that measure 200 parts per billion and below). The Company currently markets three very low-TSNA smokeless products: (1) ARIVA^®, a compressed powdered tobacco “cigalett”; (2) a dry snuff under the brand name Stonewall^®; and (3) STONEWALL Hard Snuff^®, a new, non-fermented, spit-free^® “hard tobacco” product for moist snuff users. The tobacco in each of the Company’s smokeless products is 100% StarCured^® very low-TSNA tobacco. Previously, the Company had manufactured a low-TSNA moist snuff (Stonewall^® moist snuff). With the introduction of STONEWALL Hard Snuff^®, the Company has discontinued the manufacture of Stonewall^® moist snuff. To date, the Company’s smokeless products have not generated significant revenues.

Over the last several years, the Company has expended significant effort and money on the development of its very low-TSNA tobacco and smokeless tobacco products, its patent infringement lawsuits against RJR, and sales of smokeless products. While product licensing royalties and smokeless tobacco sales were de minimis during 2003 and the first nine months of 2004, the Company will continue its development and sales of smokeless tobacco products and product licensing efforts. The Company continues to seek additional sales outlets for its smokeless products.

Prospects for Company Operations

Discount Cigarettes. Since 2000, the Company’s discount cigarette business has experienced a significant decline in sales, partly caused by intensified pricing competition from foreign manufacturers. In addition, a substantial portion of the Company’s gross profits on cigarette sales must be paid into escrow to meet the Company’s obligations under the MSA. ST’s cigarettes are sold through approximately 177 tobacco distributors throughout the United States, although the Company has sought to focus sales efforts in the states of Florida, Minnesota, Mississippi and Texas, where it does not incur escrow obligations under the MSA.

During the third quarter of 2004, the number of cigarettes sold as well as the price of cigarettes increased substantially compared with the third quarter of 2003. The termination of the proposed sale of the cigarette business to North Atlantic Trading Company, Inc. (“NATC”) in July 2003 resulted in a significant disruption of the Company’s cigarette business, particularly in Texas where a number of senior sales managers left the Company shortly after the termination of the NATC transaction was announced. Since the termination of the NATC purchase agreement, the Company has taken a number of steps to address these negative trends, including the implementation of a promotional program at the retail level and a separate wholesale pricing promotion, which were terminated in June 2004, as well as the successful restructuring of the senior sales management team in Texas. The Company has also sought to offset lower sales by manufacturing its cigarettes at its own facility and using less expensive tobacco and filters in its discount cigarettes.

While the Company’s shipments of cigarettes increased compared to the third quarter of 2003, cigarette sales and associated gross profits have continued to generally trend downward over the last several years, particularly when consideration is given to the Company’s MSA escrow requirements. Increasing regulatory requirements in both MSA and non-MSA states, as well as increased pricing competition, have also impacted on the sales of discount cigarettes. Moreover, there continues to be significant competition in the non-MSA states and pressures on the cigarette industry in general. As a result, while the increase in truckload sales and higher carton sales prices resulted in substantially increased cigarette revenues for the third quarter of 2004, the Company continued to operate at a loss for the quarter.

While the volume of cigarette sales has declined compared to the second quarter of 2004, gross margins have increased substantially compared to the third quarter of 2003 as well as compared to the second quarter of 2004. The Company’s gross margin was $4.6 million during the third quarter of 2004, versus $0.1 million in the third quarter of 2003 and $2.7 million in the second quarter of 2004. This was primarily due to achieving a higher price per carton of $7.56 during the third quarter of 2004, versus $7.00 per carton during the third quarter of 2003 and $6.68 per carton during the second quarter of 2004.

In the third quarter of 2004, the Company shipped 63.9 truckloads of cigarettes. This compares to 51.6 truckloads in the third quarter of 2003 and 66.5 truckloads in the second quarter of 2004. The truckload sales continue to reflect pricing competition in the non-MSA states and pressures on the cigarette industry in general. The increase in truckload sales and higher carton sales prices

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resulted in substantially increased cigarette revenues for the third quarter of 2004 compared to the third quarter of 2003. Additionally, over the past year the Company has been reducing its cost-of-goods sold. Further, the Company reduced its retail and wholesale promotional discounts in the second quarter of 2004. As prices firmed up in the latter half of the second quarter of 2004, the gross profit per month increased correspondingly. Gross profits were $534,540 in April, $941,419 in May and $1,178,897 in June, and during the third quarter of 2004, totaled $4.6 million.

Notwithstanding the increased pricing pressures in the discount cigarette business, the Company will continue to focus its principal efforts on the sale of discount cigarettes in the four non-MSA states for the foreseeable future. At the same time, the Company will continue to evaluate the prospects for its cigarette business in general and, in particular, sales in MSA states given the additional regulatory and MSA burdens of operating in those states.

Smokeless Tobacco. Sales of Star’s smokeless products continue to be de minimis and it will take significantly greater sales of smokeless products for this business segment to operate at breakeven levels. STONEWALL Hard Snuff^® now represents a majority of Star’s hard tobacco sales. The Company continues to seek to increase the distribution and consumer acceptance of low-TSNA smokeless tobacco products as well as the continued development of other smokeless tobacco products, independently and through alliances with other tobacco manufacturers. The Company’s marketing of its smokeless products has been curtailed due to its working capital constraints, and the Company does not expect to increase its efforts to broadly market smokeless products in the near term.

Licensing. The Company has an exclusive, worldwide license from Regent Court Technologies, LLC under eleven patents issued and patents pending relating to methods to substantially prevent the formation of TSNAs in tobacco including the StarCured^® tobacco curing process and the production of very low-TSNA tobacco products. The StarCured^® tobacco curing process, as discussed herein, involves the control of certain conditions in tobacco curing barns, and in certain applications, uses microwave and/or electronic beam technology. The StarCured^® process substantially prevents the formation in the tobacco leaf of the carcinogenic TSNAs, which are widely believed by medical and scientific experts to be among the most abundant and powerful cancer-causing toxins present in tobacco and in tobacco smoke. The Company continues to pursue means of collecting royalties with respect to this curing technology, including through arrangements described below and its patent infringement lawsuits against RJR, as described in greater detail in Part II, Item 1 “Legal Proceedings” below.

Pursuant to the Hard Tobacco Agreement entered into with B&W in April 2001, B&W will forgive one-half of Star’s then-outstanding indebtedness to B&W if B&W determines that its test market of a hard tobacco products is successful, and all of the remaining debt if and when it introduces a hard tobacco product into distribution in retail locations in 15 states. On December 15, 2003, B&W began to test market in Louisville, Kentucky a hard tobacco product named Interval^® which the Company manufactured at its facility in Chase City, Virginia. While B&W has not ordered further amounts of Interval^®, it indicated its intent to initiate a further large-scale test market of a similar dissolvable low-TSNA smokeless tobacco product and product for that test market was shipped to B&W by Star this summer. However, there can be no assurances that B&W’s test market will be deemed successful or extended into additional states. The Company has had de minimis revenues from royalties on the sale of smokeless tobacco products by B&W.

In the second quarter of 2004, Star entered into an agreement with another tobacco manufacturer for the licensing of low-TSNA hard tobacco. Under that agreement, the manufacturer has conducted an initial assessment of a hard tobacco product and the agreement anticipates that this will be followed up with a subsequent test market. The Company does not anticipate receiving any royalties under that agreement for the foreseeable future. To enable Star to pursue this agreement, and potentially other licensing of hard tobacco products, B&W agreed to waive its ten-year right to be the exclusive purchaser of hard tobacco from Star (subject to Star’s own rights) in return for concessions on the April 21, 2001 Hard Tobacco Agreement and a 3-month extension of the date on which it would begin once again to pay royalties under the April 25, 2001 Other Low-TSNA Tobacco Royalty Agreement, once a royalty rate is established with one of the other three largest tobacco manufacturers.

Impact of the MSA. The Company continues to experience negative cash flow from operations, particularly when its significant escrow obligations arising under the MSA are taken into account. The Company has deposited into escrow a net amount of approximately $33.3 million for sales of cigarettes in MSA states during the period 1999-2003, including approximately $6.2 million which the Company initially deposited into these accounts in April 2004 based on 2003 sales and made net deposits of $46,679 during the third quarter of 2004 pursuant to quarterly payments now required for 2004 sales in certain MSA states. To minimize the impact of these MSA obligations on the Company’s liquidity, the Company has attempted to focus its cigarette sales primarily in the four non-MSA states where it is not required to make deposits into escrow and has enhanced its efforts to prevent its cigarettes intended for the non-MSA states from being diverted into MSA states. However, as described in “Liquidity and Capital Resources” below, in the near term the Company will continue to be required to make substantial MSA escrow deposits. Given the Company’s focus on sales in the non-MSA states, its comparable cigarette volume to date in 2004, and the fact that the per carton obligation in 2004 is comparable to 2003, it is anticipated that the escrow obligations for 2004 sales would be somewhat less than the $6.2 million paid in April 2004.

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Recent State Legislation Impacting Sales of Discount Cigarettes

Minnesota, one of the four non-MSA states in which Star increasingly has focused its sales of discount cigarettes, passed a statute which took effect on July 1, 2003, requiring distributors in the state to pay an additional $0.35 per-pack fee on cigarettes purchased from manufacturers like Star that have not entered into a separate settlement with the state. Because the statute impacts on all non-participating manufacturers, its effect has tended to be uniform among these manufacturers. The statute has provided an advantage to Vector Group, whose subsidiary Liggett Group manufactures and sells several discount brands that compete with brands of non-participating manufacturers, including those sold by Star. Vector had previously settled with the State of Minnesota, and after passage of the statute reached a separate agreement on payments that it would have to make each year under its prior settlement.

In Florida and Mississippi, two of the other non-MSA states, bills were introduced in the 2004 legislative sessions that would have imposed an additional user fee on non-participating manufacturers at a rate of $0.50 and $0.40 per pack, respectively, on cigarettes sold by companies that have not entered into separate settlement agreements with those states. Neither Florida nor Mississippi enacted such legislation during their respective 2004 legislative sessions, which have concluded. In Texas, a special thirty-day session of the legislature was convened in April to address deficits in statewide school funding. One proposal that has been offered as part of a funding formula is a $0.50 per-pack fee on cigarettes sold by manufacturers that had not previously settled with Texas. The special session was concluded without any resolution of the funding dispute, and the matter was then considered in a series of meetings by working groups of state legislators. It is unclear whether a further special session will be convened to address these issues. The next regular legislative session will be convened in January 2005.

Passage of statutes in the non-MSA states that impose fees on manufacturers would be expected to impact on all such manufactures equally, but would make discount cigarettes more expensive and lessen the competitive price advantage they currently enjoy compared to generic and premium brand cigarettes. In addition, there are numerous recently enacted statutes and legislative initiatives in MSA states that could further impact the Company’s ability to compete in these states. The Company has determined to cease sales in certain states in response to some of these developments.

Michigan, an MSA state, passed a fee statute in January 2004 that requires the payment of a $0.35 per-pack fee on cigarettes sold by non-participating manufacturers, which must be paid in advance, and is based on an estimate of projected sales by the state’s Department of Revenue. This fee is in addition to the MSA requirement that non-participating manufacturers deposit funds into escrow for each cigarette sold in an MSA state. Given the cost burden of making both the escrow payments and fee payments, Star has advised the Department of Revenue that it will not sell its cigarette brands in Michigan in the future. In March 2004, Utah, another MSA state, also passed legislation assessing a $.35 per-pack fee on cigarettes sold by non-participating manufacturers. However, this statute has little impact on Star since the company has had virtually no sales in Utah during the past several years. Similarly, in Alaska, another state in which the Company has virtually no sales, a bill has been signed by the Governor that would impose an additional per-pack fee on cigarette sales by non-participating manufacturers.

Similar legislation imposing a fee on cigarettes sold by non-participating manufacturers has been introduced and is pending in the state legislatures in California, Kentucky, Illinois, Kansas, Louisiana, Missouri, New Hampshire and Tennessee, and it is anticipated that other MSA states will introduce similar legislation. Similar legislation was introduced but not enacted in Indiana this year. The impact of these new statutes in the MSA states would be expected to negatively impact on sales in these states by all non-participating manufacturers, including Star. However, as previously noted, Star has sought to focus its cigarette sales in recent years in the four non-MSA states.

On June 28, 2004, regulations went into effect in New York requiring that cigarettes sold in that state meet certain fire safety standards. The Company decided it would not be economically feasible to develop a separate type of cigarette for sale in New York and has not attempted to become certified under the new regulations. As a result, the Company is not now selling cigarettes in New York State and does not anticipate having sales of cigarettes in New York State in the future. Bills relating to fire safety standards have been introduced in several other states and in Congress. The Company will monitor these legislative initiatives as they move forward and reassess its position on this issue as appropriate.

During the past two years, bills have been introduced in both the House of Representatives and the Senate that would effect a buyout of the federal tobacco quota system. The buyout would end the federal price-support program in existence since the Depression, under which the government gave farmers “quotas” that essentially granted the right to grow tobacco. Each year, the Department of Agriculture has set the amount of tobacco that growers could bring to annual markets.

An amendment was attached to the FSC/ETI comprehensive tax bill in September with a provision to end the federal tobacco program. A conference committee of members of both houses of Congress met and issued a report during the last days of the Congressional session that provided for a $10 billion buyout of the tobacco quota system. Both the House and the Senate voted to pass the FSC/ETI bill with the tobacco buyout amendment, and President Bush signed the legislation on October 22. The buyout will be paid for by all tobacco manufacturers over a ten-year period based on each company’s percentage of sales and manufacturers are

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likely to raise cigarette prices to fund those payments. The apportionment of responsibility for payments to quota holders will be 96% to cigarette manufacturers, and the remaining 4% will be divided among other tobacco product manufacturers, based on market share.

The Department of Agriculture will be responsible for structuring the payment program to tobacco growers, but it is likely to take up to a year to establish that framework. One cigarette manufacturer has announced its intent to increase the price of its cigarettes to compensate for tobacco buyout payments, and it is likely that other companies may make the same decision as the effect of those payments are calculated. However, it is not possible for the Company to predict at this time the exact financial impact, if any, the future payment structure will have on Star. Further, it is likely to take more than one year to assess the affect the buyout may have on tobacco cultivation and sales, although the elimination of price supports and limits on tobacco cultivation is expected to result in lower prices for tobacco leaf.

RJR 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), which claims a process for substantially preventing the formation of TSNAs in tobacco. 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, and on August 27, 2002 the two suits were consolidated.

In April 2003, after the conclusion of discovery, the parties filed a number of dispositive Motions for Summary Judgment. On March 31, 2004 and June 24, 2004, the Court issued rulings denying all of RJR’s Summary Judgment Motions and granted in part, and denied in part, Star’s motion for Summary Judgment.

On August 17, 2004, the Company was informed that the case was transferred from Judge Alexander Williams to Judge Marvin J. Garbis and that a pre-trial conference would be held on September 1, 2004. Following the conference, on September 3, 2004, Judge Garbis issued a “First Procedural Order”. In that Order, Judge Garbis set a firm trial date for the patent infringement lawsuits to begin on Monday, January 24, 2005. The procedural order also established interim dates for the filing of various pretrial motions and other pretrial matters.

RJR has recently taken the position that the new operating entity established as a result of the business combination described below has assumed all of the rights and obligations under the agreements between Star and B&W. As a result, RJR has claimed that under the agreements Star is not in a position to continue its lawsuits against RJR. Star believes that both of these positions are without merit and is contesting those assertions vigorously.

The lawsuit against RJR is consistent with Star Scientific’s announced policy of protecting the intellectual property to which it is the exclusive licensee under its license arrangement with Regent Court Technologies.

Merger of B&W and RJR

B&W and certain of her affiliated tobacco businesses combined operations under the new publicly traded holding company, Reynolds American Inc., which is 42% owned by British American Tobacco PLC, the former parent of B&W. We have a variety of agreements with B&W. Given our pending patent infringement lawsuits against RJR, it is difficult to evaluate the precise impact which the transaction between B&W and RJR will have on Star and its operations. However, the fact that B&W and RJR have combined their operations could have a negative impact on the range of existing agreements which Star has entered into with B&W, including future royalties under its agreements relating to the Advance^® low-TSNA cigarette, hard tobacco products, potential royalties on B&W’s purchase of StarCured^® tobacco and other low-TSNA tobacco, and the forgiveness of one-half of the then-outstanding indebtedness to B&W if B&W declares as successful the test marketing of a hard tobacco product and the remainder once B&W distributes a hard tobacco product in 15 states. For instance, as described above, RJR has recently asserted that the agreements with B&W were transferred to RJR as part of the business combination. While the Company believes this claim is without merit, it is not clear what impact, if any, this assertion will have on these agreements.

In recent years, B&W has granted the Company a number of concessions under our agreements, including deferred interest and principal payments, consenting to our incurrence of additional indebtedness and agreeing to modify the Hard Tobacco Agreement to allow us to pursue similar licensing arrangements with third parties. B&W’s failure to grant similar concessions in the future could have a number of adverse consequences, including restricting the pursuit of business opportunities with B&W or third parties, limiting the Company’s ability to raise funds through debt financing and requiring payment of our obligations to B&W.

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Results of Operations

The Company’s unaudited condensed consolidated results for the periods ended September 30, 2004 and 2003 are summarized in the following table:

Third Quarter 2004 Compared with Third Quarter 2003

Net Sales. During the third quarter of 2004, the Company’s cigarette sales increased approximately $5.7 million or 52.3% to $16.7 million from $10.9 million for the third quarter of 2003, due primarily to higher volume and a higher sales price. The number of cigarettes sold increased despite the Company’s efforts to continue to operate in very competitive and price-sensitive geographic regions, namely Texas, Florida, Mississippi and Minnesota. The Company sold approximately 442 million cigarettes during the third quarter of 2004, compared with sales of approximately 357 million cigarettes during the third quarter of 2003, representing an increase of approximately 23.8%. In the third quarter of 2003, sales were adversely affected by the termination of the proposed sale of the cigarette business to North Atlantic Trading Company (NATC). The average sales price per carton increased approximately 8.0% from approximately $7.00 per carton during the third quarter of 2003 to $7.56 per carton during the third quarter of 2004. This sales price also reflects favorably with the second quarter 2004 sales price of $6.68 per carton. Prices increased due to the effect of focusing on retail and wholesale service, rather than promotions to combat competitive pricing pressures. The Company in the second quarter of 2004 discontinued its promotional discounts and did not incur those costs during the third quarter. Further, the Company sold approximately 442 million cigarettes during the third qtuarter of 2004, compared with sales of approximately 357 million cigarettes during the third quarter of 2003, representing an increase of approximately 23.8%.

Cigarette shipments in the third quarter of 2004 totaled 63.9 truckloads. This compares to 51.6 truckloads in the third quarter of 2003 and 66.5 truckloads in the second quarter of 2004. Gross margin increased to $4.6 million during the third quarter of 2004, versus $0.1 million in the third quarter of 2003 and $2.7 million in the second quarter of 2004. This was primarily due to achieving higher pricing at an average carton price of $7.56 during the third quarter of 2004, versus $7.00 per carton during the third quarter of 2003 and $6.88 per carton during the second quarter of 2004.

While the Company’s shipments of cigarettes increased compared to the third quarter of 2003, cigarette sales and associated gross profits have continued to generally trend downward over the last several years, particularly when consideration is given to the Company’s MSA escrow requirements. Increasing regulatory requirements in both MSA and non-MSA states, as well as increased pricing competition, have also impacted on the sales of discount cigarettes. Moreover, there continues to be significant competition in the non-MSA states and pressures on the cigarette industry in general. As a result, while the increase in truckload sales and higher carton sales prices resulted in substantially increased cigarette revenues for the third quarter of 2004, the Company continued to operate at a loss for the quarter.

During the third quarter of 2004, Star continued to market two very low-TSNA smokeless tobacco products – ARIVA^® and STONEWALL Hard Snuff^®. The sales of smokeless products has decreased from the third quarter of 2003 by 0.4%. The sales of smokeless tobacco products continues to be de minimis and it will take significantly greater sales of smokeless products for this business segment to operate at breakeven levels. For the third quarter of 2004, the sale of smokeless products totaled $70,021.

Sales of STONEWALL Hard Snuff^® decreased by 7% during the third quarter of 2004 as compared to the third quarter of 2003, when Stonewall Hard Snuff^® was first introduced into the market. By the beginning of the second quarter of 2004, STONEWALL Hard Snuff^® had been introduced into approximately 7,000 locations and that number has remained fairly constant since that time. STONEWALL Hard Snuff^® now represents a majority of Star’s hard tobacco sales.

The Company’s net sales of ARIVA^® continued to be de minimis in the third quarter. Acceptance of ARIVA^® as an alternative to cigarettes has continued to be adversely impacted by a number of factors, including, among others: (1) lack of consumer familiarity with ARIVA^®, (2) the fact that ARIVA^® requires a change in habit by smokers, i.e. using a smokeless product rather than a smoked product; (3) publicly stated opposition to ARIVA^® by certain Attorneys General and certain public health advocacy groups which has

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appeared in various newspapers and FDA filings; (4) ARIVA^® requires smokeless warning labels that may be unfamiliar to and/or misunderstood by cigarette smokers; (5) the need to develop name brand recognition with consumers; and (6) difficulty in obtaining capital required for large-scale consumer education and marketing directed to adult tobacco users. Sales of STONEWALL Hard Snuff^® and ARIVA^® have continued to be impacted by the Company’s working capital constraints which have limited its expenditures for marketing and product placement.

Beginning in 2002, ARIVA^® was broadly distributed in retail outlets throughout the United States. Based on the continued, de minimis sales of ARIVA^® and the passage of time from the initial placement of the product, management believes the number of locations actively selling ARIVA^® as of the end of the third quarter of 2004 continues to be less than 5,000 stores.

During the first nine months of 2004, as during the third quarter of 2003, the Company earned de minimis royalties paid by B&W on sales of its ADVANCE^® low-TSNA cigarette, which B&W has been test marketing in Indianapolis, Indiana. In June 2004, B&W expanded its test market of ADVANCE^® to include Phoenix, Arizona.

In the third quarter of 2004, there were no royalties paid by B&W on purchases of smokeless hard tobacco. B&W began test marketing Interval^® in Louisville, Kentucky in December 2003 and purchased sufficient product for that test market in the first quarter of 2004. In the second quarter, B&W purchased additional hard tobacco for a further large scale test market of another hard tobacco product and that product was shipped to B&W during the summer.

Gross Profits. Gross profit increased approximately $4.5 million in the third quarter of 2004 to $4.6 million from $0.1 million in the third quarter of 2003. The increase was due primarily to the higher sales price and higher volume for the Company’s cigarette products, as well as by the Company’s reduction in cost of goods sold. The Federal excise taxes have remained constant at $3.90 per carton for both periods. Thus, the increase in sales price has a larger impact on gross profit because the fixed costs of Federal excise taxes are based on volume and not sales price.

For discount cigarette sales during the third quarter of 2004, the Company reduced its cost-of-goods sold by approximately 24.2%, to approximately $1.55 per carton, compared with an average cost of $2.04 per carton during the third quarter of 2003.

Consistent with the practice over the last few quarters, during the third quarter of 2004, excess production costs for the Company’s ARIVA^® and STONEWALL Hard Snuff^® manufacturing lines were recognized as general and administrative expenses as reflected below. Due to the underutilization of the packaging equipment for smokeless products, the Company’s gross profit for smokeless products was zero during both periods when sales were netted against the cost of manufacturing.

Total Operating Expenses. Total operating expenses increased to $9.1 million for the third quarter of 2004 from $8.4 million for the third quarter of 2003. Marketing and distribution expenses, as well as research and development costs have remained approximately the same in both periods. General and administrative costs have risen by approximately $0.1 million, and depreciation costs have risen by approximately $0.6 million.

Marketing and Distribution Expenses. Marketing and distribution expenses totaled $2.3 million for the third quarter of 2004, approximately the same as the comparable 2003 period expense of $2.3 million. This was achieved despite higher shipping costs primarily due to increases in fuel costs and higher commissions paid.

General and Administrative Expenses. General and administrative expenses totaled $4.8 million for the third quarter of 2004, an increase of $0.1 million compared with $4.7 million for the third quarter of 2003. This increase was due, in part, to the one-time non-cash charge of $0.9 million for the issuance of 450,000 options to the Company’s independent Board members, and $0.2 million non-cash cost for the reduction of the strike price of the Manchester warrants from $4.76 to $4.00 in return for the elimination of the redemption right with respect to Manchester’s convertible debenture. There was also an under-utilization cost of $0.1 million for the packaging equipment for smokeless tobacco products. The Company wrote off $0.8 million in smokeless tobacco inventory in 2003. Legal costs were approximately $1.4 million during the 3^rd quarter of 2004 compared with $0.7 million during the third quarter of 2003 due to additional accruals in 2004 relating primarily to the RJR litigation. The Company anticipates increases in its general and administrative costs in excess of $1 million in connection with the upcoming trial of its patent infringement litigation which is scheduled to begin in January 2005.

Depreciation. Depreciation Expenses totaled $2.0 million during the third quarter of 2004 compared with $1.4 million during the third quarter of 2003.

Research and Development Expenses. There were no research and development costs in the third quarter of 2004 compared to de minimis costs of approximately $36,000 during the third quarter of 2003. During the third quarter of 2003, research and development costs were connected principally to scientific studies related to low-TSNA products, and the Company’s development of a spit-free^® STONEWALL Hard Snuff^® tobacco product for smokeless tobacco users. Consistent with its efforts to cut costs, the Company deferred certain research projects in the last half of 2003 and the first nine months of 2004. The Company expects to

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maintain its spending on research during the remainder of 2004 at a de minimus level, while it continues to concentrate on the preparation for the January 2005 trial of its patent infringement litigation. Presently, the Company’s research focus is directed to assessing the impact that products with reduced toxin levels may have on the range of serious health hazards associated with the use of conventional smoked and smokeless tobacco products. While its research work has been deferred necessitated by its lack of available working capital, the Company is continuing to design several additional scientific studies to determine, among other things, whether a reduction in TSNAs can be equated with a reduction in health risk, to assess biomarker differences that can be equated to levels of various toxins in smoked versus smokeless tobacco, and to measure the impact of the decline in TSNA exposure in low-TSNA smokeless tobacco compared to traditional cigarette products. These studies are conducted by independent laboratories and universities.

Interest Expense. The Company had interest expense of $617,111 and interest income of $102,784, for a net interest expense of $514,327 in the third quarter of 2004. This compares to interest expense of $442,840 and interest income of $72,695 for a net interest expense of $350,145 in the third quarter of 2003. The higher interest expense in the third quarter of 2004 resulted primarily from interest charges on the $4.5 million borrowed from the Company’s CEO, interest on the Manchester Securities debenture and interest on the B&W restructured account payable. This interest expense was partially offset by interest income generated by the Company’s MSA escrow fund; however, the escrow fund interest rates are very low due to the conservative investment options permitted by the escrow agreements. 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.

Income Tax Benefit. The Company had no income tax benefit for the third quarter of 2004 as compared to an income tax benefit of $3.9 million for the third quarter of 2003. The tax benefits in 2003 was attributable to the loss experienced that year. In 2004, there was no tax benefit due to a valuation allowance.

Net Loss. The Company had a net loss of $5.0 million for third quarter 2004 compared with a net loss of $7.2 million reported in the comparable 2003 period. The net loss in 2004 primarily reflects the impact of higher general and administrative expenses, offset by higher margins on increased cigarette sales, as well as higher interest expenses and no tax benefit due to the valuation allowance. In 2003, $4.4 million of the loss reported in the third quarter related to the Company’s contractual settlement with B&W in connection with disposing of its tobacco inventory which was partially offset by $2.0 million of income from the termination of the NATC transaction.

In the third quarter 2004, the Company had a basic and diluted loss per share of $(.08) compared to a basic and diluted loss per share of $(0.12) in the same period in 2003.

First Nine Months of 2004 Compared with First Nine Months of 2003

Net Sales. During the first nine months of 2004, the Company’s cigarette sales decreased approximately $6.3 million or 12.7% to $49.2 million from $55.5 million for the first nine months of 2003, due primarily to a lower sales price in 2004. The Company sold approximately 1.4 billion cigarettes during the first nine months of both 2003 and 2004. While unit sales for the nine months remained approximately the same, the average price charged by the Company for its cigarettes decreased from approximately $7.74 per carton during the first nine months of 2003 to $6.97 during the first nine months of 2004. A reversal in the downward pricing occurred in the third quarter of 2004 and the average carton price was $7.56.

During the first nine months of both 2003 and 2004, the Company’s net sales for ARIVA^® were comparable. Sales of STONEWALL Hard Snuff^® began in the last half of 2003. By the beginning of the second quarter of 2004, STONEWALL Hard Snuff^® had been introduced into approximately 7,000 locations and that number has remained fairly constant since that time.

Beginning in 2002, ARIVA^® was broadly distributed in retail outlets throughout the United States. Based on the continued de minimis sales of ARIVA^® and the passage of time from the initial placement of the product, management believes the number of locations actively carrying ARIVA^® as of the end of the third quarter of 2004 continues to be less than 5,000 stores.

During the first nine months of 2004, as during the first nine months of 2003, the Company earned de minimis royalties paid by B&W on sales of its ADVANCE^® low-TSNA cigarette, which B&W has been test marketing in Indianapolis, Indiana. In June 2004, B&W expanded its test market of ADVANCE^® to include Phoenix, Arizona.

B&W began test marketing Interval^® in Louisville, Kentucky in December 2003 and purchased sufficient product for that test market in the first quarter of 2004. In the second quarter, B&W purchased additional hard tobacco for a further large scale test market of another hard tobacco product and that product was shipped to B&W during the summer.

Gross Profits. Gross profit decreased approximately $3.6 million or approximately 35.3% in the first nine months of 2004 to $10.2 million from $13.8 million in the first nine months of 2003. The decline was due primarily to the lower sales price for the

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Company’s cigarette products while selling approximately 1.4 billion cigarettes during both the first nine months of 2004 and the first nine months of 2003.

For discount cigarette sales during the first nine months of 2004, the Company reduced its average cost-of-goods sold by approximately 22.5%, to a blended average of approximately $1.55 per carton, compared with a blended average cost of $2.00 per carton during the first nine months of 2003. However, this reduction was offset by the fact that, principally due to competitive pressures and retail promotions that continued into early June 2004, the average sales price per carton decreased approximately 10.0% from approximately $7.74 per carton during the first nine months of 2003 to $6.97 per carton during the first nine months of 2004. Federal excise tax remained at $3.90 per carton during both 2003 and 2004. Thus, the decrease in prices has a larger impact on gross profit because the fixed costs of Federal excise taxes results in a much lower margin for cigarette sales.

Consistent with the practice over the last few quarters, during the first nine months of 2004, excess production costs for the Company’s ARIVA^® and STONEWALL Hard Snuff^® manufacturing lines were recognized as general and administrative expenses as reflected below. Due to the under-utilization of the packaging equipment for smokeless products, the Company’s gross profit for smokeless products was zero during both periods.

Total Operating Expenses. Total operating expenses decreased to $22.0 million for the first nine months of 2004 from $23.2 million for the first nine months of 2003. Depreciation costs rose by approximately $1.1 million, primarily due to a one-time adjustment of approximately $0.5 million in the useful life of certain fixed assets in Chase City and Chester, VA during the first quarter of 2004 and an increase of $0.6 million in the third quarter of 2004. General and Administrative costs decreased by approximately $1.2 million, research and development costs decreased by approximately $0.6 million and marketing and distribution costs decreased by approximately $0.3 million.

Marketing and Distribution Expenses. Marketing and distribution expenses totaled $7.3 million for the first nine months of 2004, a decrease of $0.3 million over the comparable 2003 period expense of $7.6 million. This decrease was caused by approximately $0.4 million of higher ARIVA^® sampling and event promotion costs and approximately $0.2 million of higher commissions paid during the first nine months of 2003. Offsetting these decreases was an approximate increase of $0.1 million in shipping costs primarily due to increases in fuel costs.

General and Administrative Expenses. General and administrative expenses totaled $12.0 million for the first nine months of 2004, a decrease of $1.2 million compared to the first nine months of 2003. During the third quarter of 2004, there was a one-time charge of $0.9 million for the award of 450,000 options to the Company’s independent Board members, and a charge for the under-utilization cost of $0.2 million for the packaging equipment for smokeless tobacco products which were offset by lower aircraft expenses ($0.7 million in the first nine months of 2003 versus $0.2 million in the first nine months of 2004), and administrative salaries were down $0.3 million. The Company wrote off $0.8 million in smokeless tobacco products inventory in 2003. As the trial date for the patent infringement suit approaches on January 24, 2005, the Company anticipates that the additional cash requirements for legal costs related to the trial will be in excess of $1 million.

Depreciation. Depreciation totaled $2.8 million for the first nine months of 2004, compared with $1.7 million in the first nine months of 2003. This increase was due to a one-time adjustment of approximately $0.5 million in the useful life of certain fixed assets at the Chase City and Chester, Virginia locations during the first quarter of 2004 and an increase of $0.6 million in the third quarter of 2004.

Research and Development Expenses. There were de minimis research and development costs in the first nine months of 2004 and $0.7 million during the first nine months of 2003. During 2003, research and development costs were connected principally to scientific studies related to low-TSNA products, and the Company’s development of a spit-free^® STONEWALL Hard Snuff^® tobacco product for smokeless tobacco users. Consistent with its efforts to cut costs, the Company deferred certain research projects in the last half of 2003 and the first nine months of 2004. The Company expects to maintain its spending on research during the fourth quarter of 2004 at a de minimis level, while it continues to concentrate on the preparation for the January 2005 trial of its patent infringement litigation. Presently, the Company’s research focus is directed to assessing the impact that products with reduced toxin levels may have on the range of serious health hazards associated with the use of conventional smoked and smokeless tobacco products. While its research work has been deferred necessitated by its lack of available working capital, the Company is continuing to design several additional scientific studies to determine, among other things, whether a reduction in TSNAs can be equated with a reduction in health risk, to assess biomarker differences that can be equated to levels of various toxins in smoked versus smokeless tobacco, and to measure the impact of the decline in TSNA exposure in low-TSNA smokeless tobacco compared to traditional cigarette products. These studies are conducted by independent laboratories and universities.

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Interest Expense. The Company had interest expense of $1,971,616 and interest income of $201,409, for a net interest expense of $1,770,207 in the first nine months of 2004. This compares to interest expense of $1,092,425 and interest income of $162,078 for a net interest expense of $930,347 in the first nine months of 2003. The higher interest expense in the first nine months of 2004 resulted primarily from interest charges on the $4.5 million borrowed from the Company’s CEO, interest on the Manchester Securities debenture and interest on the B&W restructured account payable. This interest expense was partially offset by interest income generated by the Company’s MSA Escrow Fund; however, the escrow fund interest rates are very low due to the conservative investment options permitted by the escrow agreements. 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.

Income Tax Benefit. The Company had an income tax benefit of $1.8 million for the first nine months of 2004 as compared to an income tax benefit of $8.6 million for the first nine months of 2003. The tax benefits are directly attributable to the losses experienced in both periods; however, in 2004 the tax benefits were reduced due to a valuation allowance.

Net Loss. The Company had a net loss of $11.8 million for the first nine months of 2004 compared with a net loss of $14.0 million reported in the comparable 2003 period. The net loss in 2004 primarily reflects the impact of lower margins on cigarette sales, certain higher overhead expenses, as well as higher interest expenses and the impact of the reduced tax benefit due to the valuation allowance. In 2003, a significant portion of the loss reported to the first nine months of the year related to the Company’s comprehensive settlement with all of the MSA states and the payment of part of its escrow fund to B&W in connection with the settlement.

In the first nine months of 2004, the Company had a basic and diluted loss per share of $(.19) compared to a basic and diluted loss per share of $(0.23) in the same period in 2003.

Liquidity and Capital Resources

Overview

During the third quarter of 2004, the Company raised $25.0 million through the sale of common shares. As of September 30, 2004, the Company has a working capital surplus of approximately $2.9 million. Future cash needs over the near term include:

In addition, there exist certain contingencies which could require the Company to make significant cash payments, including:

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On October 28, 2004, the Company determined to repay the outstanding advance of $4.5 million to Mr. Williams, together with the accrued interest, in order to reduce the Company’s borrowing costs. Subsequently, the Company repaid the outstanding balance to Mr. Williams. Mr. Williams remains obligated under the Loan Agreement to make advances to the Company if required for the Company’s liquidity at any time prior to March 31, 2005, in an amount not to exceed $10 million.

With the proceeds of the recent stock sale and the improving margins in the cigarette business, the Company anticipates that it will have sufficient funds to support its operations in the near term. However, absent the successful completion of its patent infringement litigation, a substantial improvement in revenues and/or royalties from its smokeless tobacco products, or a significant improvement of the volume of sales of cigarettes, it is expected that the Company will need to pursue additional sources of funds during the second half of 2005. However, there are significant limitations on the Company’s ability to raise new debt financing, including its agreements with Manchester Securities and B&W. The Company’s ability to raise future financings on terms acceptable to the Company will depend on a number of factors, including the performance of the Company’s stock price and its operational performance. Any equity financing will be dilutive to the Company’s existing shareholders.

Summary of Balances and Recent Sources and Uses

As of September 30, 2004, the Company held approximately $18.7 million in cash and cash equivalents and $5.0 million of accounts receivable, compared to approximately $0 in cash and cash equivalents, and $5.6 million in accounts receivable, as of December 31, 2003.

Net Cash Provided By (Used In) Operating Activities. In the first nine months of 2004, $8.8 million of cash was used in operating activities. This compared to $8.7 million of cash generated by operating activities during the first nine months of 2003. This decrease in cash generated by operations during the first nine months of 2004 was primarily due to a decrease in the price per carton of cigarettes sold offset somewhat by a decrease in the cost of goods sold and receipt of income tax refunds aggregating approximately $1.3 million.

Net Cash Provided By (Used In) Financing Activities. During the first nine months of 2004, $33.3 million of cash was generated by financing activities versus $6.1 million of cash used for repayment of notes payable and capital leases in the same period in 2003. The funds generated during the first nine months of 2004 were from the $25 million sales of common shares during the third quarter, the $9 million convertible debenture financing, the $4.0 million in proceeds from common stock sold in a private placement and the $0.8 million of cash provided by the working capital loan from the Company’s CEO. During the first nine months of 2004, approximately $4.7 million of cash was used in the repayment of notes payable and capital leases.

Net Cash Provided by (Used In) Investing Activities. During the first nine months of 2004, $0.5 million of cash was generated by investing activities versus $0.8 million of cash generated by investment activities in the first nine months in 2003. The cash generated during 2003 was from the repayment of a note from an officer of the Company, while the cash generated during 2004 was due to the release of a portion of a deposit on an operating lease.

Net Cash Used in MSA Escrow Payments. During the first nine months of 2004, the Company deposited approximately $6.2 million for its 2003 escrow obligation for 2003 sales in MSA states plus additional net deposits of $46,679 for quarterly payments during the third quarter of 2004 versus a net amount of approximately $3.4 million following the MSA settlement in 2003. This lower amount deposited in 2003 was a direct result of the settlement agreement with the MSA states described herein.

Cash Demands on Operations

While the Company obtained $25.0 million in funding in August and September 2004, $9.0 million in March 2004 and $4.0 million in April 2004, it was required to deposit approximately $6.2 million into its MSA escrow accounts for 2003 sales in April 2004 and had a net loss of approximately $11.8 million for the first nine months of the year.

The Company continues to experience negative cash flow from operations. Sales of its discount cigarettes have declined in price but stabilized in volume during the first nine months of 2004 as compared to the first nine months of 2003. Recent trends during the third quarter of 2004 indicate that increased pricing is holding firm in the market. Sales of the Company’s smokeless products as well as royalty income continue to be de minimis. The Company has in the past and continues to spend a significant amount of money in connection with the development and protection of its intellectual property portfolio, principally in connection with its patent infringement litigation against RJR.

As of September 30, 2004, the Company had a working capital surplus of $2.9 million. The Company’s working capital surplus does not reflect its obligation to make MSA escrow deposits for 2004 sales, which it must make in April 2005. In addition, 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. Further, given anticipated levels of revenues and cash flows from operations, substantial capital will be needed for sales, marketing and promotion of ARIVA^® and STONEWALL Hard Snuff^®. While the Company has

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already raised significant amounts of capital during 2004, it may need to raise additional funding from its CEO and principal shareholder, Jonnie R. Williams or outside sources in the future depending on the results of its operations and the outcome of its patent infringement litigation against RJR.

Contingent Liabilities and Cash Demands

B&W Agreements. Under the Restated Master Agreement, as amended by letter agreements dated December 4, 2002 and August 14, 2003, between B&W and the Company, the Company owes B&W approximately $20 million of long-term debt, with no interest accruing, or principal payments required through December 31, 2005. Beginning January 1, 2006, interest accrues at prime plus 1% and interest and principal are payable in 96 monthly installments. The debt is secured by tobacco leaf inventory, the tobacco curing barns, and a first priority security interest in the Company’s intellectual property. Once the outstanding loan balance is reduced to $10 million, the collateral will be released by B&W. Star also has a current obligation of $7,899,647 payable to B&W. The principal on this obligation has been deferred to at least January 2005.

Pursuant to the Hard Tobacco Agreement entered into with B&W in April 2001, B&W will forgive one-half of Star’s then-outstanding indebtedness to B&W if B&W determines that its test market of a hard tobacco products is successful, and all of the remaining debt if and when it introduces a hard tobacco product into distribution in retail locations in 15 states. On December 15, 2003, B&W began to test market in Louisville, Kentucky a hard tobacco product named Interval^® which the Company manufactured at its facility in Chase City, Virginia. While B&W has not ordered further amounts of Interval^®, it indicated its intent to initiate a further large-scale test market of a similar dissolvable low-TSNA smokeless tobacco product and product for that test market was shipped to B&W by Star this summer. However, there can be no assurances that B&W’s test market will be deemed successful or extended into additional states. The Company has had de minimis revenues from royalties on the sale of smokeless tobacco products by B&W. Forgiveness of debt would trigger a taxable event for the Company, and the Company would be required to pay that tax in cash, offset by any losses the Company might have for tax purposes.

In the second quarter of 2004, Star entered into an agreement with another tobacco manufacturer for the licensing of low-TSNA hard tobacco. Under that agreement, the manufacturer has conducted an initial assessment of a hard tobacco product and the agreement anticipates that this will be followed up with a subsequent test market. The Company does not anticipate receiving any royalties under that agreement for the foreseeable future. To enable Star to pursue this agreement, and potentially other licensing of hard tobacco products, B&W agreed to waive its ten-year right to be the exclusive purchaser of hard tobacco from Star (subject to Star’s own rights) in return for concessions on the April 21, 2001 Hard Tobacco Agreement and a 3-month extension of the date on which it would begin once again to pay royalties under the April 25, 2001 Other Low-TSNA Tobacco Royalty Agreement, once a royalty rate is established with one of the other three largest tobacco manufacturers.

Master Settlement Agreement. In April 2004, the Company deposited $6.2 million into its MSA escrow accounts for sales of cigarettes in MSA states in 2003. Star currently has approximately $33.3 million in escrow. These funds will remain in escrow pursuant to the terms of the qualifying statutes, and will be available to satisfy state judgments for the type of claims asserted against the major tobacco manufacturers in the suits that resulted in the negotiation of the MSA. The MSA escrow deposit for 2004 sales is due on or before April 15, 2005, except for any quarterly payments that may be required under recent changes to the qualifying statutes in a number of MSA states. Given the Company’s focus on sales in the non-MSA states, its comparable cigarette volume to date in 2004, and the fact that the per carton obligation in 2004 is comparable to 2003, it is anticipated that the escrow obligations for 2004 sales would be somewhat less than the $6.2 million paid in April 2004 sales.

Litigation Costs. The Company has entered into fee arrangements with counsel in several litigation and related matters under which certain costs related to the litigation are being advanced by counsel on behalf of the Company. 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 this contingent liability. The Company has paid or accrued all existing obligations. Also, as part of its fee arrangements in certain of 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 in return for a cap on fee payments during the litigation.

The Company has never been sued by a consumer of its tobacco products on a claim for product liability and is not named as a defendant in any litigation relating to the manufacture of tobacco products. The Company believes that it has conducted its business in a manner which decreases the risk of liability in a lawsuit relating to product liability because it:

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Over the past several years, the Company has asserted several challenges to the MSA and qualifying statutes. These constitutional challenges were not successful and the Company is not currently engaged in any litigation challenging the constitutionality of the MSA and qualifying statutes. Also, the Company completed a comprehensive settlement relating to its obligation as a nonparticipating manufacturer under the MSA in June 2003. As a result, the Company does not anticipate incurring significant costs related to litigation arising out of the MSA in the future.

The Company is currently prosecuting patent infringement claims against RJR in a consolidated action in the United States District Court for the District of Maryland and in 2002 was successful in having a declaratory judgment action brought by Philip Morris dismissed on the basis that no actionable controversy existed between the companies. In the coming months, the Company anticipates increases in its general and administrative costs in connection with the continued prosecution of its patent infringement lawsuits. As the January 24, 2005 trial date for the patent infringement lawsuit approaches, the Company anticipates that the additional cash requirements related to the trial will be in excess of $1 million.

Changes in Operations. During the first nine months of 2004, the Company committed to additional cost savings measures. These included, initially, projected decreases of approximately $1 million in executive salaries in 2004, either through deferrals or reductions. Deferrals are expensed but not paid, and reductions are neither expensed nor paid. Additionally, during portions of 2004, use of an aircraft owned by Starwood Industries, Inc. (a company in which Jonnie R. Williams, Star’s CEO and largest shareholder, is a principal) was discontinued in an effort to reduce costs. After the close of the third quarter of 2004, deferrals of $694,423 were paid to the Executives, and their previous salaries were reinstated. During the third quarter, aircraft use was reinstated and $230,000 of aircraft expenses were charged to the Company for usage of the above mentioned aircraft. While the Company has continued to reduce certain of its operating costs and has increased its gross margin, the Company expects to continue to experience negative cash flows from operations for the year and intermediate future.

Since January 1, 2003, the Company has been manufacturing all of its cigarettes at its Petersburg, Virginia manufacturing facility. The Company anticipates that the manufacturing capacity in Petersburg should be sufficient to satisfy the manufacturing needs for the foreseeable future. However, management has undertaken to make arrangements for contract manufacturing of cigarettes in the event that sales increase beyond the capacity of the Petersburg facility.

In the past the Company has maintained product liability insurance only with respect to claims that tobacco products manufactured by or for the Company contain any foreign object, i.e. any object that is not intended to be included in the manufactured product. The Company currently does not maintain such insurance and as a result is self-insured for this risk. The product liability insurance that the Company previously maintained did not cover health-related claims such as those that have been made against the major manufacturers of tobacco products. The Company does not believe that such insurance currently can be obtained. The Company has not, nor has ever been, named as a defendant in any legal proceedings involving claims arising out of the sale, distribution, manufacture, development, advertising, marketing and claimed health effects relating to the use of its tobacco products. While the Company believes that the risk of being named a defendant in such a lawsuit is relatively low given its efforts to thoroughly disclose the risks associated with the use of tobacco products, the Company may be named as a defendant in the future.

Request for a Private Letter Ruling. The Company has recently been notified that its 2001 federal income tax return has been selected for examination by the Internal Revenue Service. No action has currently taken place with regard to this audit. Except for the item discussed below, the impact of the IRS examination on the Company’s financial condition, results of operations and cash flow, if any, cannot be ascertained at this time.

During 2002, the Company submitted to the IRS a Request for a Private Letter Ruling asking that the IRS rule on the deductibility of funds placed in escrow under the MSA. The Company has taken the position on its 2001 and later federal and state income tax returns that the payment to the escrow account under the terms of the MSA is a current expense. Additionally, the Company filed claims for refunds of taxes paid in prior years based upon the deductibility of these escrow payments. During 2002 and 2003, the Company received a total of $12.6 million in federal and state refunds relating to such claims. During the first quarter of 2004, the Company received an additional $1.3 million in state refunds relating to such claims.

The Company is continuing to seek a favorable ruling from the IRS on its Request. If the IRS determines that it will not grant the Company’s Request, the Company anticipates that it will withdraw the Request. Further, if upon examination, the IRS rules against the Company with respect to the claimed deductions, the Company expects that it will challenge any such determination through the Appeals process up to and including the US Tax Court to seek a final determination with respect to this issue. While the Company believes that its position is reasonable and supported by the statute and IRS Regulations, the outcome of these proceedings cannot be predicted. Ultimate resolution of this matter, should the IRS rule adversely, is not anticipated until late 2005, at the earliest.

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If it is ultimately determined that the Company’s treatment of the payments into escrow is not a current deduction for tax purposes, it is expected that the Company’s existing carryback claims net of operating loss deductions will be sufficient to offset any additional tax due for the years in question, given the extent of the Company’s recent losses. Further, the Company would be subject to interest and possibly certain penalties. However, those amounts would also be subject to being offset by the Company’s existing carryback claims to the extent available.

In a letter dated October 7, 2004, the Company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to the Company and that the sales and use tax assessment plus penalties and interest together now total approximately $988,000. The Company continues to challenge this assessment and has filed a request for reconsideration with the Commissioner of Taxation, and is prepared to file a judicial action if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue.

Funding from the CEO

In early October 2003, Jonnie R. Williams, Star’s CEO and largest shareholder, loaned Star $2 million in funds for corporate purposes. In a letter dated November 7, 2003, Mr. Williams advised the Company that he would personally extend an additional $8 million (and with the funds previously loaned in October, a total of $10 million) to the Company on an as-needed basis until the Company returns to profitability. Since October 2003, Mr. Williams has from time to time as needed by the Company advanced amounts up to approximately $5 million to the Company.

In late December 2003, the Company used funds advanced from Mr. Williams to pay down the then-outstanding balance of approximately $2.2 million under its $7.5 million line of credit from Guaranty Bank. This line of credit was terminated as of December 31, 2003 consistent with the letter agreement the Company and Guaranty Bank entered into on August 14, 2003. As of December 31, 2003, the Company had borrowings of $3.7 million outstanding from Mr. Williams. As of September 30, 2004, the advances to the Company were $4.5 million. Further, Mr. Williams has pledged to provide such funds as may be necessary to the Company to cover cash flow shortfalls in 2004 and through March 31, 2005.

The Company has entered into a loan agreement with Mr. Williams under which he has agreed to make funding available to the Company with the understanding that Mr. Williams could not make demand for principal or interest before March 31, 2005. The loan agreement provides that interest on the outstanding advances by Mr. Williams would be at a rate of 8% per annum on the outstanding balance. After March 31, 2005, subject to restrictions in any other lending documents, the outstanding balance will be repaid to Mr. Williams based on his determination of the Company’s ability to repay such advances. In connection with the transactions with Manchester Securities, Mr. Williams entered into a subordination agreement with Manchester Securities, subordinating his claims under the loan agreement to the rights of Manchester Securities under the debenture and related agreements.

On October 28, 2004, the Company determined to repay the outstanding advance of $4.5 million to Mr. Williams, together with the accrued interest, in order to reduce the Company’s borrowing costs. Subsequently, the Company repaid the outstanding balance to Mr. Williams. Mr. Williams remains obligated under the Loan Agreement to make advances to the Company if required for the Company’s liquidity at any time prior to March 31, 2005, in an amount not to exceed $10 million.

Convertible Debentures and Warrants

On March 25, 2004, the Company entered into a series of agreements with Manchester Securities. Under the agreements, Manchester Securities purchased from the Company a $9 million convertible 8% debenture due March 25, 2006 and warrants for 502,681 shares of the Company’s common stock. The proceeds from this transaction have been used for general corporate purposes, including funding of the Company’s MSA escrow obligations.

The Debenture is secured by ST’s inventory and receivables to the extent not subject to B&W’s prior security interests. Interest on the debenture is to be paid quarterly beginning in June 2004, and principal payments together with interest are to be made in four quarterly installments on each quarterly anniversary date of the debenture, beginning in March 2005. The debenture can be converted into Star’s common stock at a price of $3.73 per share, which represents the closing price of the Company’s common stock on the day preceding the date of the debenture. The warrants entitle Manchester Securities, at any time during the next five years, to acquire 502,681 shares of common stock at an exercise price of $4.00. In connection with the transaction, the Company and Manchester Securities also entered into a Securities Purchase Agreement, a Security Agreement and a Registration Rights Agreement. ST also executed the Security Agreement, as well as a Guaranty with respect to Star’s obligations under the debenture.

The Manchester Securities agreements include a number of provisions that would result in default interest rates and redemption rights. If the Company fails to comply with its obligations under the Registration Rights Agreement, it could incur additional fees of 1% of the principal, or currently $90,000, per month.

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In the case of other defaults, including violations of representations and breaches of the covenants restricting debt and equity financing, the interest rate could increase from 8% to 12% per annum. In such events, Manchester Securities would be entitled to accelerate the debenture, in which case the Company would have to pay 110% of the outstanding principal plus accrued and unpaid interest. Furthermore, in the event of certain defaults related to the conversion of the debenture into common stock and the resale of the underlying shares, the Company would be obligated to pay Manchester Securities the higher of the 110% amount described in the preceding sentence and the value (based on a 20-day trailing average) of the shares of common stock into which the debenture would then be convertible.

Manchester Securities may also require the Company to redeem the debenture for the original principal amount of $9 million plus all accrued but unpaid interest and any default payments owed under certain transaction documents related to the debenture if the Company’s recovery under a settlement or final judgment in the RJR litigation is less than $50 million.

Recent Raising of Capital

During the third quarter of 2004, the Company raised a total of $25.0 million from the sale of common shares pursuant to a shelf registration offering. The first sale occurred on August 31, 2004 for 1,510,000 common shares at a price of $4.50 per share for an aggregate issuance price of approximately $6.8 million. The second sale was completed on September 28, 2004 and included the sale of 3,640,000 shares of common stock at a price of $5.00 per share for an aggregate issuance price of $18.2 million. A portion of these funds were used to reduce accounts payable, which were decreased from approximately $5.3 million at the end of the second quarter of 2004 to $3.7 million at the end of the third quarter. The remainder of the proceeds from the sale of common shares will be used to fund current operations in light of continued operating losses, provide funding for litigation costs which are expected to increase as the Company approaches trial in the RJR case, for MSA escrow deposits, for working capital and for interest and principal payments on existing obligations. Additionally, the Company’s annual deposits into its MSA escrow accounts for 2004 sales will be due in April 2005.

New Financing Opportunities

Mr. Williams has pledged to provide the Company with such funds as it may require to fund its cash needs through March 2005. As of September 30, 2004, the Company had a working capital surplus of $2.9 million.

With the proceeds of the recent stock sale, the Company anticipates that it will have sufficient funds to support its operations in the near term. However, absent the successful completion of its patent infringement litigation, a substantial improvement in revenues and/or royalties from its smokeless tobacco products, or a further improvement of the sales of cigarettes, it is expected that the Company will need to pursue additional sources of funds during the second half of 2005. The Company’s ability to obtain additional funds through additional debt is subject to significant restrictions under the Manchester Securities agreements, including outright prohibitions on raising funds through additional secured debt or other debt that is not subordinated to the debenture. Also, other assets of the Company have already been pledged for existing borrowings, including the B&W loans and the Company’s leases and debt relating to its tobacco curing barns. Accordingly, if the Company required additional cash in the future, the focus on the potential for raising funds would be through the issuance of new common stock. The Company’s ability to raise equity financing on terms acceptable to the Company will depend on a number of factors, including the performance of the Company’s stock price in the coming months. The equity financing will be dilutive to the existing shareholders. In addition, if the Company elects to raise equity, Manchester Securities would have its conversion option reset to the extent the issuance price for the equity is below its present conversion price of $3.73 per share, further diluting shareholders.

Conclusion

The Company’s cigarette sales and associated gross profits have continued to decline, particularly when consideration is given to the Company’s MSA escrow requirements. Increasing regulatory requirements in both MSA and non-MSA states, as well as increased pricing competition, have also impacted on the sales of discount cigarettes. Further, there are significant impediments to generating significant revenues from royalties or sales of its smokeless tobacco products in the near future. Accordingly, depending on the success of its future operations, including its patent litigation against RJR and sales of smokeless tobacco products, the Company may need to raise funds to support its operations beyond the $25.0 million raised under the shelf registration in August and September 2004 which will support its activities for the near term. While Jonnie Williams, the CEO and largest stockholder, has pledged to fund the Company’s working capital needs through March 2005, the Company in the future may need to seek additional funds from sources other than Mr. Williams.

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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 some of the Company’s leases, are at variable rates and, as a result, the Company is subject to interest rate exposure. There is no interest payable on a majority of the debt due to B&W until the beginning of 2006, at that time the debt will bear an interest rate of prime plus 1%.

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 MAINTAIN 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 SMOKELESS TOBACCO PRODUCTS, COMPETITION FROM COMPANIES WITH GREATER RESOURCES THAN THE COMPANY, THE COMPANY’S DECISION NOT TO JOIN THE MSA, THE EFFECT OF STATE STATUTES ADOPTED UNDER THE MSA AND ANY SUBSEQUENT MODIFICATION OF THE MSA, AND THE COMPANY’S DEPENDENCE ON KEY EMPLOYEES AND ON ITS STRATEGIC RELATIONSHIPS WITH BROWN & WILLIAMSON TOBACCO CORPORATION IN LIGHT OF ITS MERGER WITH RJR TOBACCO COMPANY. 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 REGISTRATION STATEMENT ON FORM S-3, AS AMENDED BY AMENDMENT NO. 1 TO FORM S-3 FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON AUGUST 20, 2004, 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 REPORT OR TO REFLECT THE OCCURRENCE OF UNANTICIPATED EVENTS.

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 Securities and Exchange Commission’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 for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes 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 is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), 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

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effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level.

In order to comply with the requirements of the Sarbanes Oxley Act, the Company by the end of the third quarter established a telephone hotline for the reporting of accounting irregularities and updated and expanded its accounting policies and procedures to strengthen its internal controls.

PART II—OTHER INFORMATION

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), which claims a process for substantially preventing the formation of TSNAs in tobacco. 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, and on August 27, 2002 the two suits were consolidated.

In April 2003, the parties filed dispositive motions for Summary Judgment. Star Scientific filed a Motion for Summary Judgment on Claim Construction and Definiteness, and RJR filed six Motions for Summary Judgment asserting various defenses. Pursuant to an Order dated September 15, 2003, the Court appointed a Special Master to prepare Reports and Recommendations (“R&Rs”) for the Court on Star Scientific’s Motion for Summary Judgment and five of RJR’s six Motions for Summary Judgment. The Special Master has issued R&Rs on all six of the Summary Judgment Motions and on March 31, 2004, the Court issued final rulings on five of the six Summary Judgment Motions. In its rulings, the Court adopted without modification the Special Master’s R&Rs which recommended that the Court deny RJR’s Summary Judgment Motions and that Star Scientific’s Motion for Summary Judgment on claim construction and definiteness be granted in part and denied in part. The Court also issued an order denying RJR’s Motion for Summary Judgment seeking to limit Star’s damages claim. On June 24, 2004, the Court issued a final order on the last RJR Summary Judgment Motion and adopted without modification the Special Master’s R&R, which recommended that the Court deny the Summary Judgment Motion.

On August 17, 2004, the Company was informed that the case was transferred from Judge Alexander Williams to Judge Marvin J. Garbis and that a pre-trial conference would be held on September 1, 2004. Following the conference, on September 3, 2004, Judge Garbis issued a “First Procedural Order”. In that Order, Judge Garbis set a firm trial date for the patent infringement lawsuit to begin on Monday, January 24, 2005. The procedural order also established interim dates for the filing of various pretrial motions and other pretrial matters.

On July 30, 2004, RJR, Brown & Williamson Tobacco Corporation (“B&W”) and certain of their affiliated tobacco businesses combined operations under the new publicly traded holding company, Reynolds American Inc., which is 42% owned by British American Tobacco PLC, the former parent of B&W. RJR has recently taken the position that the new operating entity established as a result of this transaction has assumed all of the rights and obligations under the agreements with B&W. As a result, RJR has claimed that under the agreements Star is not in a position to continue its lawsuits against RJR. Star believes that this position is without merit and is contesting this assertion vigorously.

In June 2001, RJR filed a complaint against the Company for declaratory judgment in the United States District Court for the Middle District of North Carolina. In that case, RJR sought a judgment declaring that the ‘649 Patent had not been infringed and that the patent was invalid. The Company filed a motion to stay, dismiss or transfer the North Carolina action, given the earlier filing in the Maryland District Court. The Court on October 3, 2001 granted the Company’s motion in part and the North Carolina case is now stayed.

Following the introduction of ARIVA^®, three citizen petitions were filed with the United States Food and Drug Administration (the “FDA”) seeking to have ARIVA^® 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. The Company’s legal team was headed by former U.S. Solicitor General Charles Fried, Esquire. In the responses counsel concluded that the petitions were factually flawed and without merit, because ARIVA^® does not fit the definition of a food or a drug under the Federal Food, Drug and Cosmetic Act and the FDA lacks jurisdiction to regulate ARIVA^® based on the March 21, 2000 decision of the Supreme Court in FDA v. Brown & Williamson Tobacco Corporation, 529 U.S. 120 (2000). On August 29, 2003, the FDA issued a letter opinion denying the multiple Citizen Petitions. In its ruling, the FDA concluded that it lacked jurisdiction to regulate ARIVA^® since it is a customarily marketed tobacco product. Petitioners have not challenged that decision.

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In 2002, the Virginia Department of Taxation 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. The Company 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. In a letter dated October 7, 2004, the Company received notification from the Commonwealth of Virginia that an adverse decision had been made by the Commissioner of Taxation with respect to the sales and use tax assessment previously issued to the Company and that the sales and use tax assessment plus penalties and interest together now total approximately $988,000. The Company continues to challenge this assessment and has filed a request for reconsideration with the Commissioner of Taxation, and is prepared to file a judicial action if the administrative action is not favorable. The filing of the request for reconsideration stays any collection of the tax assessment, although interest continues to accrue.

In the third quarter of 2003, 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. 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.

(a) Exhibits

(b) Reports on Form 8-K

On August 18, 2004, the Company filed a Current Report on Form 8-K stating that the Company was informed that the patent infringement case was transferred from Judge Alexander Williams to Judge Marvin J. Garbis and that a pretrial conference was scheduled to be held on September 1, 2004.

On August 31, 2004, the Company filed a Current Report on Form 8-K stating relating to the Company’s pending sale of 1,510,000 shares of Common Stock under the Registration Statement with an aggregate offering price of $6,795,000.

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On September 2, 2004, the Company filed a Current Report on Form 8-K stating that the sale of 1,510,000 shares with an aggregate offering price of $6,795,000 had been completed.

On September 15, 2004, the Company filed a Current Report on Form 8-K relating to an Amendment Agreement with Manchester Securities (“Manchester”) that amended and restated the $9 million convertible 8% debenture due March 25, 2006 and a warrant for 502,681 shares of the Company’s common stock.

On September 27, 2004, the Company filed a Current Report on Form 8-K stating that the Company had entered into Agreements to sell 3,640,000 shares of Common Stock under the Registration Statement with an aggregate offering price of $18,200,000.

On September 29, 2004, the Company filed a Current Report on Form 8-K stating the sale of 3,640,000 shares with an aggregate offering price of $18,200,000 had been completed. This report also noted that between August 9, 2004 and September 29, 2004, Mr. Williams and David Dean, Vice President of Sales and Marketing, purchased an aggregate of 300,000 shares in private acquisitions from a third party. Additionally, the report detailed increases in Independent Director Compensation, provided an update on the Company’s patent infringement litigation, the combination between B&W and RJR and the potential impact of that combination on various agreements that the Company has with B&W.

On November 3, 2004, the Company filed a Current Report on Form 8-K noting the resignation of Christopher G. Miller as a Director of the Company. This registration was required in order to meet NASDAQ compliance rules that require a majority of the directors to be independent. Prior to Mr. Miller’s resignation, the number of independent and inside Directors were equal. Mr. Miller continues to serve as Chief Financial Officer of the Company.

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SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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