We are a bit late to the party on this one, yet Shortzilla believes there is significant reason to go short Star Scientific here (CGIX), even at $2.83/share (our entry price on Friday. There’s a lot of back history, much of which covered in depth by the folks over at Street Sweeper who offered an impressive two part write-up on the company last year.
I could probably write for days on this one, but I’ll try and keep this report condensed, while providing some further color over the coming days. Star Scientific, once strictly a cigarette company, exited the business in 2007 to focus on its low TSNA smokeless tobacco products and nutraceutical business. The company is separated into two divisions: Rock Creek Pharmaceuticals and its remaining smokeless tobacco segment.
Rock Creek which has become the primary focus for the company (and accounted for ~72% of sales in 2011) currently produces two products: CigRx, a lozenge that essentially tricks the brain into thinking you are smoking, and Antabloc, also a lozenge which aims to reduce inflammation. Both product’s main ingredient is anatabine, which is an alkaloid found in a number of plants including green tomatoes, peppers as well as tobacco.
According to Martin Shrkeli, noted biotech investor, the chemical structure of anatabine is a demethylated nicotine. Shrkeli notes that “it is highly unlikely anatabine and nicotine have beneficial properties beyond those already known”.
The good news is that Star recently signed an agreement in February 2012 with GNC for the re-sale of Antabloc, and also signed an endorsement deal with legendary golfer Fred Couples as a spokesman for the Antabloc product. The bad news is that there are so many warning signs with this company, that it is impossible to accept that any signs of positive news as anything less than a spin job.
The company, based on its market capitalization at Friday’s close is worth $412 million. Must at least be some postitive sales results and/or solid profits, right? Think again. At year end 2011, the company had reported sales of $1.7 million, resulting in a price to sales valuation of 242x sales. Okay okay…must be making money then, right? Sorry, in 2011, the company posted a net loss of $38 million, its ninth consecutive year of operating losses.
And from a liquidity perspective it doesn’t look any better. As of year end 2011, the company had $10 million in cash. Over the past four quarters, the average cash burn has been $5 million, meaning that the company has likely two quarters left of cash before something has to give. Management even acknowledges that “the recurring losses generated by our operations continue to impose significant demands on our liquidity”.
So how is this company worth so much? After examining past financials, company statements, and other research, we at Shortzilla have concluded that there is some shady business going on here at Star Scientific.
Usually, when there are throngs of bullish investors littering the Yahoo Message Boards or Seeking Alpha posts/comments for a company which obviously has no chance of a profitable future, we get skeptical. And then we take a look at the past dealings of managment and reach our conclusion: Star is worth only a fraction of where it stands today.
First, about those bullish investors. The most notable hype artist behind the stock is a gentleman named Dr. John Faessel. Mr. Faessel, an alleged Dentist (not even sure about that claim) seems to have quite a vested interest in the successes of Star. One glance at Faessel’s Seeking Alpha profile shows you all you need to know about his optimism regarding CIGX. On his SA profile, Faessel denies any association with Star, claiming that he ”no other affiliation with the company other than as a shareholder.”
Yet, Shortzilla smells funny business with Faessel. Aside from his dentist practice, Faessel also runs a company called Faessel Publishing. I pulled this from a Google Search:
“Faessel Publishing is a firm that specializes in assisting emerging growth companies with public relations, capital markets experience, brand building and brand awareness and developing and initiating strategies to strengthen relations and communications between companies or individuals associated with the firm. Faessel Publishing will assist the company in gaining increased exposure to investors through the dissemination of corporate information to a network of on-line venues, brokerage firms, financial institutions and private investors.”
Faessel also has a history writing for a website called Small Cap Insights, which in essence is a paid pumper site; Faessel and the authors recieve compensation- often in the form of stock and cash in order to write positive articles about the company in question. I couldn’t find CIGX on their website, but given Faessel’s past business relations, and his extreme optimism surrounding the prospects for Star, I’m nearly convinced he is being comped by Star somehow.
Now all of this connecting of the dots might seem like a stretch, if it weren’t for the past of Star CEO Jonnie Williams. See, Mr. Williams has a past that might give Bernie Madoff a bad name. His long questionable track record goes a little something like this: take company public, pump it up, sell stock and drift off into the sunset with cash in hand, ready to make more millions at the expense of the poor duped investors.
Star was founded by Jonnie Williams and Frank O’Donnell, who met while attending John Hopkins back in the late 1970′s. Williams is a former car salesman who in the words of fellow Fredericksburg residents was “one of the best salesmen ever to hit” his hometown. O’Donnell is studying optometry at Hopkins- and according to an old Boston Globe article –he was described as “tanned, handsome, equipped with a photographic memory and brilliant.”
Here’s a timeline of the two’s relations before founding Star (with a little help with a Boston Globe article from 1988)”
1978 – At age 22, Johnnie Williams opens Colonial Opticians. A local court fined him for fitting contact lenses without a license. O’Donnell starts to work for Williams as an eye doctor at the store (a violation of a Johns Hopkins policy for students working on the side).
December 1980 – Jonnie Williams disappears and according to the Globe leaves behind “tens of thousands of dollars of debts and countless unclaimed eyeglasses.” Store is auctioned off by the SBA to collect on its debt.
1980-1982- Williams goes back to selling cars. O’Donnell earns instant success at the University of St Louis- helping to launch a $10 million eye institute at Bethesda General Hospital. O’Donnell also starts a non-profit group which aims to help educate medical professionals through the use of instructional videos. O’Donnell taps heavyweight institutions such as Johns Hopkins and Beth Israel for contributors and at the same time gains “access to their schools’ power to grant academic credit for watching his taped courses”.
July 1983 – O’Donnell has second thoughts about the non-profit venture, so Williams and O’Donnell hook up again -organizing their first company, CME-SAT Inc., and selling $2.2 million worth of stock in it to the public. According to the Globe –”Their repeated stock purchases kept the company afloat despite almost continuous losses. Those purchases also paid O’Donnell and Williams’ substantial salaries for the few years they remained with the firm.”
July 1983- O’Donnell is forced out as department chairman and medical director of the Bethesda Eye Institute, which he had helped create. “O’Donnell’s decision to take a salary from the company violated university rules against full-time faculty holding paid outside positions, and he was told to choose one job or the other.”
1984- Professors which had agreed to provide educational videos under the guise that the operation is a non-profit become enraged. O’Donnell and Williams continue drawing their salaries and bonuses: more than $150,000 in the last half of 1983, almost $275,000 in 1984 and another $180,000 in the first half of 1985. Both men are also driving extravagant cars on the company dime–a brand new Mercedes for O’Donnell and Williams amassing over $150K in travel expenses in only a ten month period.
1985 – Starting in early 1985, the pair and close associates sold off all of their CME-SAT stock for at least $1.2 million, according to SEC documents. And by that summer they had quit. The firm eventually lands in bankruptcy in 1989.
Spring 1985 – In the spring of ‘85, O’Donnell gets an invite from former medical mentor A. Edward Maumenee along to form Spectra. Williams also joins. Most of their plans centered on discovery that a vitamin A ointment could cure several different eye diseases. Maumennee along with other researchers document their study of the ointment in a medical journal-yet the study is conducted on only 22 patients. Williams and O’Donnell are provided with roughly 10% ownership of the company.
Spring 1985 Williams and O’Donnell also get involved in starting a company called Eye Technology
December 1985 – Spectra goes public in late ‘85, climbing from $2 to $8/share.
1986 -Williams pays Florida financial newsletter publisher Robert E. Baker at least $5,000 to produce a glowing report about Spectra, which was then mailed to thousands of doctors by a company owned by O’Donnell and Williams. “Among other things, the report claims that a new market had been discovered for Spectra’s eye drug: as a substitute for a popular skin cream.”–touting the university connections.
1987 – March 16th- Spectra issues a press release announcing that the ointment “had not produced encouraging results based on preliminary indications.” Stock price tumbles on the news, yet the price soon recovers by the summer.
1987 – Summer of ‘87 — O’Donnell, Williams and their associates sell out most their shares in the summer of 1987 for more than $1 million.
Late 1987- C.A. Blockers (a new O’Donnell, Williams venture) files with the SEC for an initial offering of 1.5 million common shares. C.A. Blockers is out of business in 1990 after marketing what it said was a `safer’ cigarette.
July 1990 – Spectra files for bankruptcy.
Jan 1994- Jonnie Williams is fined $300,000 by the SEC for activities related to promoting paid equity research as independent research. (see the 1986 timeline regarding the Robert Baker newsletter)
We should also mention the exorbidant salaries being paid to Williams, who earned $1.1 million in 2011, despite the ninth consecutive year of losses for his company. He amazingly was also awarded 4.9 million options in 2011. For what? Great question. There are some serious question marks here.
The only reason I can assume that the stock is still trading at current levels is for a lingering legal battle between RJ Reynolds and Star. Long investors are praying on a wing and a prayer to collect some sort of royalties from RJR. I have my doubts.
The dispute dates back to 2001, when Star filed the first of two patent infringement suits over a method of curing tobacco that helps prevent the formation of TSNA’s (or tobacco-specific nitrosamines), a toxin.
The case had been bouncing around for years until a 2009 jury verdict invalidated Star’s patents. The appeals court then overturned the finding in August 2011, but also came out saying that Reynolds had not infringed on Star’s patents.
Reynolds’ is now back again, seeking to invalidate Star’s patents. The problem with Star’s patents is that they list only a “controlled environment” to prevent the growth of the toxic nitrosamines, which Reynolds said provides insufficient detail and could lead to inadvertent infringement. I don’t know what will come of this trial, but there is one important note that the longs seem to be missing. Star Scientific does not even own the patents in question related to the Reynolds trial. These tobacco curing patents are owned by Regent Court Technologies, of which Jonnie R. Williams, Star’s CEO, and Frank O’Donnell are the owners. Therefore, even if there is a ruling that Star somewhow gains royalties (a BIG IF) from RJR and others, it remains to be seen how Star might benefit.
This a high risk short, due to the fact that there are pumpers galore (Faessel et al) doing their best to keep this stock afloat with overhyped dreams of grandeur. The nutraceuticals business might be worth maybe $5 million or so. That’s generious, considering that sales for 2011 were only $1.2 million. Let’s say those patents are worth a few bucks too, even $50 million (that’s generous as well). Really no cash to speak of here. So we have a company worth $55 million trading at a cap of $410 million. This results in a target for $CIGX of $0.35. Short interest is right around 18% of float; a concern but I’d be more worried about the pumpers than anything else. Stop set at $3.15.