General
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 Companies are engaged in: (1) the development and implementation of scientific technology for the curing of StarCured(TM) tobacco so as to retard or significantly reduce the formation of carcinogenic toxins present in tobacco and tobacco smoke, primarily the tobacco specific nitrosamines ("TSNAs"); (2) the sales, marketing and development of tobacco products that expose adult tobacco users to substantially lower levels of carcinogenic toxins, namely TSNAs, that are sold with enhanced health warnings and comparative content information so that adult tobacco consumers will have the option to make informed choices about the use of tobacco products which pose a range of serious health risks (the TSNA levels in the Company's tobacco products will continue to be reduced to very low levels, measured in parts per billion, using the StarCured(TM) tobacco curing process); (3) the sales, marketing and development of very low-nitrosamine smokeless tobacco products which also carry enhanced warnings beyond those required by the Surgeon General (in 2001, the Company introduced three new smokeless products, Stonewall(TM) moist and dry snuffs, and ARIVA(TM) compressed powdered tobacco cigalett(TM) pieces); (4) the manufacture and sale of four discount cigarette brands which currently contain 24% very low-TSNA StarCured(TM) tobacco; and (5) in the future continued focus on developing smoking cessation products if the Company can secure a joint venture partner or corporate pharmaceutical partner with a significant regulatory infrastructure.
In the first quarter of 2002, the Company's revenues were generated principally through the sale of discount cigarettes by ST, which currently manufactures and sells four brands of discount cigarettes, SPORT(R), MAINSTREET(R), VEGAS(R) and G-SMOKE(R), through approximately 260 tobacco distributors throughout the United States and by the sales of its smokeless tobacco products. The Company continues to focus sales efforts in the states of Florida, Minnesota, Mississippi and Texas. Note that there are no sales of tobacco leaf during the first quarter 2002 as tobacco leaf sales are seasonal in nature and occur in the 3rd and 4th quarters of a year.
Over the past two years, the Company has been engaged in the development of smokeless tobacco products that could provide adult tobacco users with a viable alternative to cigarettes in situations and environments when they can't smoke or when they would prefer not to smoke. This effort was encouraged by the Company's Scientific Advisory Board and other independent scientific, medical, and public health advisors who encouraged Star to accelerate the development of smokeless products whose tobacco is 100% StarCured(TM) low-TSNA tobacco, because smokeless products have far fewer toxins than conventional cigarettes. Cigarette smoke contains more than 4,000 chemical compounds, 43 of which are known to be carcinogenic. A number of respected scientists and researchers believe that the only major or significant toxins in smokeless tobacco are the TSNAs, particularly the NNNs and NNKs. Accordingly, the Company expects that in the future its focus will continue to be on smokeless tobacco products.
On September 28, 2001, the Company introduced its first two very low-TSNA snuff products (a moist and a dry snuff) under the brand name Stonewall(TM). On November 14, 2001, Star introduced its flagship hard tobacco cigalett(TM) pieces (ARIVA(TM)). ARIVA(TM) is a compressed powdered tobacco product designed to dissolve completely in the mouth without leaving any residue. Sales of Star's smokeless products were de minimus in 2001. During January 2002, ARIVA(TM) was launched nationally in the United States. ARIVA(TM) and Stonewall(TM) are being marketed nationwide by ST through its network of established tobacco distributors and through new distributors with whom ST has not previously had a relationship. In addition, the Company has sought to introduce ARIVA(TM) and Stonewall(TM) through direct arrangements with several national retail chains and through national distributors experienced with consumer products. Following the successful limited test market of its smokeless products, Star decided it was appropriate to expand distribution. Accordingly, by March 2002, the Company's smokeless products had been placed in more than 12,000 convenience and retail store locations. In the first quarter the sales of smokeless tobacco products represented a small portion of the Company's total sales, consistent with the introduction of those products into test markets beginning the fall of 2001. The Company anticipates expanding the number of stores in which its smokeless tobacco products will be available during 2002, but cannot be sure that its smokeless tobacco products will be accepted into the national marketplace.
Since the introduction of ARIVA(TM), three citizen petitions have been filed with the Food and Drug Administration ("FDA") seeking to have ARIVA(TM) regulated as a food and/or a drug product. On May 1, 2002 the Company, through counsel, filed responses to two of these petitions. The Company's legal team is headed by former U.S. Solicitor General Charles Fried, Esquire and by FDA attorneys from McDermott, Will & Emery; Paul, Hastings, Janofsky & Walker LLP and Bergeson & Campbell, P.C. In the responses counsel concluded that the petitions are factually flawed and without merit, because ARIVA(TM) does not fit the definition of a food or a drug under the Federal Food, Drug and Cosmetic Act. Furthermore, because ARIVA(TM) is a smokeless tobacco product that is intended to provide tobacco satisfaction, the FDA lacks authority to regulate ARIVA(TM) based on the March 21, 2000 decision of the Supreme Court in FDA v. Brown & Williamson Tobacco Corporation, 529 U.S. 120 (2000). The Company will respond to the third petition filed on May 6, 2002 in a timely fashion.
The Company's central focus continues to be the research, development and commercialization of products that reduce the range of serious health hazards associated with the use of tobacco products. The Company fully accepts the evidence showing links between smoking tobacco and a variety of diseases and premature death and believes that it is unlikely that the health risks of smoked tobacco can be completely eliminated. Nevertheless, in a world where an estimated 1.2 billion people smoke and use other tobacco products, there is an urgent need to reduce the toxicity of tobacco products to the maximum extent possible using available technology. The Company believes that it has a corporate responsibility to continue to expand its research and development efforts to manufacture tobacco products that contain the lowest levels of toxins as technologically possible, although given the present limited state of the research efforts of the Company and others in this area, the Company in discussing its low-TSNA products has shared with adult consumers the fact that there is not now sufficient evidence to demonstrate that reduced toxin delivery can be quantified in terms of reduced health risk.
Results of Operations
The Company's unaudited condensed consolidated results for the periods ended March 31, 2002 and 2001 are summarized in the following table:
Three Months Ended March 31,
2002 2001
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Net sales $33,549,218 $37,374,606
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Cost of goods sold 10,189,188 11,043,087
Excise taxes on products 14,736,078 16,400,212
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Gross profit 8,623,952 9,931,307
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Total operating expenses 7,455,399 5,877,034
Operating income 1,168,554 4,054,273
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Net income $ 578,042 $2,418,493
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Basic income per common share:
Net income $0.01 $0.04
Diluted income per common share:
Net income $0.01 $0.04
Weighted average shares outstanding 59,741,481 59,741,460
Diluted weighted average shares outstanding 60,291,438 61,769,523
FIRST QUARTER 2002 COMPARED WITH FIRST QUARTER 2001
During the first quarter of 2002, the Company's consolidated net sales decreased $3.8 million or 10.2% to $33.5 million, from $37.4 million, for the first quarter of 2001. The decrease in sales was primarily due to a reduction in sales volume created by concentrating sales and marketing efforts into a smaller geographic region, namely Texas, Florida, Mississippi and Minnesota, and the Company's focus on the introduction of its smokeless tobacco products which were introduced in the fall of 2001. The Company sold approximately 150 million fewer cigarettes during the first quarter of 2001, representing a decrease of approximately 16% from sales during the first quarter of 2001. The decrease in sales volume was offset in part by an increase in the sales price charged by the Company and by the sale of its smokeless tobacco products.
Gross profit in the first quarter of 2002 was $8.6 million, approximately 13% lower than the $9.9 million gross profit in the first quarter of 2001. Sales price increases were partially offset by an increase in manufacturing costs. The Company's federal excise tax expense for first quarter 2002 was $14.7 million, down from $16.4 million for first quarter of 2001, despite a 12.8% increase in the federal excise tax from $3.40 per carton to $3.90 per carton which became effective on January 1, 2002.
Total operating expenses increased to $7.5 million for the first quarter of 2002 from $5.9 million for the first quarter of 2001 principally due to the sales and marketing efforts associated with the market introduction of ARIVA(TM) and STONEWALL(TM). Approximately $1.2 million of this amount is related to the promotion and introduction of ARIVA(TM) in Florida, Minnesota, Mississippi and Texas where the Company's sales force is concentrated. Marketing and distribution expenses, on a consolidated basis, totaled $3.5 million for the first quarter of 2002, an increase of $1.2 million over the comparable 2001 period. This reflects a larger sales force of approximately 90 employees and increased distribution expenses resulting from the introduction of new smokeless products. Additionally, the sales cycle for selling smokeless products to major chain stores takes approximately 90-150 days, which means that substantial costs must be expensed in anticipation of having smokeless products available at the chain store level.
Research and development costs in the first quarter of 2002 were approximately $219,000 compared to $588,000 during the first quarter of 2001. These decreased costs reflect the Company's decreased product development costs related to its two new smokeless tobacco products, ARIVA(TM) and STONEWALL(TM), which were released into test markets during late 2001, and were both in national distribution in early 2002. The Company continues its focus on the research and development of products that have reduced levels of toxins and that potentially may reduce the range of serious health hazards associated with the use of smoked and smokeless tobacco products. Further, the Company has initiated and is in the process of designing several additional scientific studies to determine, among other things, whether a reduction in TSNAs can be equated with a reduction in health risk. The Company conducts these studies through independent laboratories and universities.
The Company had net interest income of $178,000 in the first quarter of 2002, as compared to net interest expense of $53,966 during the first quarter of 2001. The interest expense in the first quarter of 2001 resulted from the credit facility from B&W, which was used for the purchase of tobacco curing barns and working capital requirements. This interest expense was partially offset by interest income generated by the Company's deposits into its MSA Escrow Fund. The Company receives the current interest on the escrow for its own account.
The Company's income tax expense for the first quarter of 2002 was $0.4 million as compared to $1.6 million for the first quarter of 2001. This decrease was due to the Company's lower pre-tax income during the first quarter of 2002.
Consolidated net income of $0.6 million for first quarter 2002 was a decrease of 76% from the $2.4 million reported in the comparable 2001 period, as a result of decreased cigarette sales plus the costs associated with the introduction of the Company's smokeless tobacco products. In the first quarter 2002, the Company had basic and diluted earnings per share of $0.01 compared to comparable period basic and diluted per share earnings of $0.04 in 2001. This decrease in earnings per share reflects the decrease in net income for the first quarter of 2002.
Liquidity and Capital Resources
In the first quarter of 2002, $1.8 million of cash was used in operating activities, as compared to $142,000 during the first quarter of 2001. This increase in cash used in operations in 2002 was primarily due to an increase of $3.6 million in accounts receivable from customers during first quarter. This increase in accounts receivable resulted primarily from a timing difference in sales during the 1st quarter of 2002 which occurred later in the quarter when compared with the 1st quarter of 2001.
During the first quarter of 2002, the Company had deposits of approximately $1.1 million for equipment required to manufacture the new smokeless tobacco products. The cumulative total for deposits through March 31, 2002 was $2.4 million. The Company intends to close leasing facilites in the 2nd and 3rd quarters of 2002 for this equipment. At that time, these deposits would be reimbursed and the leases would commence.
The Company and ST each have granted B&W a first priority security interest under the B&W credit facility in their respective
intellectual property as collateral, and have each guaranteed the payment of the other's obligations. Also, the B&W credit facility is collateralized by the Company's curing barns and leaf tobacco inventory.
The Company has a working capital line of credit, which is collateralized by accounts receivable from its cigarette business, in the amount of $7.5 million. The Company had $3.5 million of borrowings under this credit facility at March 31, 2002 at an interest rate of Prime plus 0.5% which was an effective rate of approximately 5.25% during the first quarter of 2002.
As of April 30, 2002, the Company, on behalf of ST, has deposited into escrow approximately $33.5 million to fund ST's net purported escrow obligations under the MSA for sales in 1999, 2000 and 2001. Based on the increased escrow amount per carton, and ST's sales in MSA states in future years, the Company will have to pay significant sums into these escrow accounts to meet the Master Settlement Agreement requirements. If not used to satisfy judgments or settlements, the funds will be returned to the Company 25 years after the applicable date of deposit on a rolling basis. In addition to the escrow deposits associated with the Company's direct sales, the Company has, under protest, been required to make additional escrow deposits related to sales of the Company's cigarettes subsequently made by the Company's direct customers into other states ("indirect sales"). In 2001 and in the first quarter of 2002, the Company made approximately $3,800,000 in escrow payments in connection with indirect sales that occurred in 1999 and 2000. The Company has received demands for additional escrow payments after making its escrow payment for 2001 and expects that it will continue to be subject to additional escrow obligations related to indirect sales which occurred from 1999-2001.
The Company believes that its existing working capital, together with anticipated earnings from its existing operations and new products, will be sufficient to meet its liquidity and capital requirements in the foreseeable future. However, if the Company is required to deposit into escrow the amounts being demanded by MSA states as additional escrow payments, such amounts could be material and could require the Company to raise additional funds to meet its purported escrow obligations under the Master Settlement Agreement. Accordingly, the Company's need, if any, to raise additional funds to meet its working capital and capital requirements will depend upon numerous factors, including the results of its marketing and sales activities, the amount of any escrow obligations it may be required to deposit to comply with the Master Settlement Agreement, the success of the Company's anticipated very low-nitrosamine smokeless tobacco products and the other factors described under "Factors That May Affect Future Results" in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2001.
The foregoing discussion of the results of operations and financial condition of the Company should be read in conjunction with the Company's condensed consolidated financial statements and related notes included elsewhere in this Report.
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