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A professional investment process is similar to peeling an onion. We peel the garbage layers of skin to arrive at a substantive core. The short opportunities are those companies that have virtually nothing after stripping away irrelevant news releases and overhyped promotional campaigns. TherapeuticsMD (NYSEMKT:TXMD) and Star Scientific (STSI) epitomize this type of short opportunity.

Name

Ticker

Price

Ent Val

Revs

EV/Revs

Net Loss

Star Scientific

STSI

$3.17

$454M

$5.4M

84x

-$33.1M

TherapeuticsMD

TXMD.OB

$2.93

$298M

$3.1M

95x

-$39.0M

Normally, stocks valued in the $250M-to-$500M range have hundreds of millions in revenues, and tens of millions in net profits. But both TherapeuticsMD and Star Scientific have revenues under $6M with net losses in excess of -$30M. So, these stocks need to have amazing realizable future value to justify their current prices. So let's start peeling the onion, and see what valuations are fundamentally justified.

Star Scientific

Star Scientific produces tobacco-plant derived dietary supplements (94% of revenues), and dissolvable smokeless tobacco products that are low in TSNAs or tobacco-specific nitrosamines (6%) which will be discontinued after 2012. The dietary supplements (or "neutraceuticals") are Anatabloc for anti-inflammatory support and CigRx - a tobacco alternative to reduce the urge to smoke. Anatabine is the active ingredient in both Anatabloc and CigRx, which is derived from the company's tobacco plants. A cosmetic facial cream was introduced in September 2012. Anatabine's potential in treating Alzheimer's disease and other anti-inflammatory conditions is also being explored.

STSI, Three-Month ChartSTSI, Three Month Chart

Star Scientific has a very active marketing program of both its products and its shares. The hype ratio measures how much selling support dollars are needed to generate one dollar of revenues. Most companies selling support costs are a small fraction of revenues generated, even consumer companies. But in the latest quarter, Star Scientific required $1.03 of marketing and distribution costs to generate just $1 of revenue, which is slightly above the $0.99 ratio for the nine months ended September 2012. On Yahoo message boards, Amazon.com, etc. are a common thread of ecstatic reviews of Anatabloc and STSI shares. But Amazon reviews were not all positive, and there was one review that was particularly insightful:

I was about to plunk down $100 on a bottle of this stuff after reading the 5 star reviews, when I read the 1 star reviews. A 1 star reviewer who said it did nothing for her pointed out that the only thing most of the 5 star reviewers reviewed was this product or other products from this vendor. I checked, and sure enough it's the only thing most have reviewed.

Most of the positive reviews of this product are obviously from the vendor of the product.

They almost got my $100. Thanks for the review by Lindann Hamilton!

This is not the first time I've seen fraudulent reviews on Amazon. That's why it's important to read ALL of the reviews and look at the history of what other products a reviewer has reviewed. There are some real crooks out there.

Star Scientific bulls may cite ramping neutraceutical revenues. First of all, they have no choice, because revenues will have to skyrocket by an astronomical amount to justify the current $464M market cap. Secondly, the marketing product claims do not gel with independent consumer feedback, putting into question the sustainability of future revenues. And this may already be occurring. Sequential revenue growth slowed in Q3, despite the higher marketing costs. While Q3 10% sequential revenue growth is better than most other companies, it does not even get close to supporting a market value that is 86x last twelve months' revenues.

Furthermore, Star Scientific is losing money hand over fist. For the first nine months of 2012, total revenues of $4.5M required SG&A support costs of $17.2M. Total operating loss was -$19.8M.

Star Scientific has been a moving target of increasingly incredible stories to justify upside to its bloated valuation. First, there was the tobacco curing patent lawsuit against Reynolds American (NYSE:RAI) with settlement amounts promoted from $500M to the billions of dollars a few years ago. The companies finally settled in Q3 (but management only reported in November) that the net settlement amount was $7M. But even before the demise of the lawsuit, management and its band of supporters were saying the big upside was in Anatabloc for treating inflammation, citing golfer Fred Couples as their poster child. Most recent stock promotional efforts are increasingly focused on the huge potential of Anatabine as a treatment for Alzheimer's disease.

Let's take a deeper look at the Alzheimer's disease therapeutic landscape. More than 150 companies are working in the Alzheimer's space, including about 15 large multinationals - some of which are in Phase III human clinical trials. There is no cure for Alzheimer's yet. John Sterling, Editor of Genetic Engineering & Biotechnology News, summed up the current state of affairs:

Despite all the research on amyloid plaques and neurofibrillary tangles there is still a debate on whether these biological phenomena are causative or symptomatic of Alzheimer's. Once scientists can clearly and unequivocally define key factors related to the actual biology of the disease itself, therapeutic advances could take place much more quickly.

In layman's terms, it is not clear if the build-up of amyloid beta proteins that have been related to brain cell death is a cause or a symptom of Alzheimer's disease. Thus, the real innovation in Alzheimer's is finding the biological pathway that causes the disease (see here as an example) for which a cure can then be targeted, as opposed to just treating the symptoms.

The current market of Alzheimer's drugs is between $4B and $8B, depending on the data source. For the Alzheimer's therapeutic market to really break-out will require a cure. Most of the human clinical trials today are focused on treating the symptoms (mainly these amyloid-related plaques), and slowing the progression of the disease. Thus, there is already a lot of competition for Alzheimer's treatments that address amyloid beta protein build-up, which is what Anatabine, at best, hopes that it can do. Furthermore, anti-amyloid beta protein drugs like MK-8931 from Merck (NYSE:MRK) are well-patented, require extensive, multi-year clinical trials that Star Scientific cannot afford, and are already several years ahead of Star Scientific's animal/upcoming human studies. In other words, Star Scientific will have to raise tens of millions of dollars for the miniscule chance of achieving FDA approval in about five years. Proving efficacy (and avoiding toxicity) against a standard set by Merck and other large competitors addressing amyloid plaques makes Anatabine's case especially challenging. In the 1% chance that Anatabine is approved five years from now, it will be entering an overcrowded market that will require high marketing and distribution costs and a completely different skill set.

Even worse, Star Scientific has a weak patent position, with two old patents from 2001 and 2002 that are more about tobacco curing than therapeutic medicine. Anatabine is a natural substance that cannot be patented. The processing of the tobacco leaf to obtain the Anatabine can easily be engineered around, if it was ever worthwhile for anyone to do. Moreover, those patents will expire in 2018-2019. So, even in the miraculous scenario that Anatabine makes it to the market five years from now as an FDA-approved therapeutic treatment, and is commercially successful, it has little patent protection to protect revenues and those patents will be expiring anyway.

Star Scientific's Alzheimer's venture is a folly. If management wants to avoid even larger cash outflows and share dilution in the future, they should shut this project down. But management needs to extend the myth, not end it. The lawsuit story is over. Anatabloc as an anti-inflammatory is losing momentum. Investors need an even grander story to keep the promotional train chugging along, and to support the company's horrific cash burn.

So, count on upcoming vaporware news releases on initial human Anatabine results to excite investors; just realize that it is meaningless in terms of adding fundamental value to the stock. In spite of the sensational news releases and large trading volume, not one blue-chip institutional research firm has picked up coverage on STSI.

Here is an interesting fact. Intellect Neurosciences (OTCPK:ILNS) is currently trading at $0.01 with a market cap of $1M. Yet in March 2012, this company was granted a patent for Antisenilin, an Alzheimer's drug therapy that targets amyloid beta proteins, and is now in Phase III trials. On the other hand, overly hyped Star Scientific with a market cap of $464M, has no direct patent coverage, not even a Phase I clinical trial, and even worse, has not even the authorization from the FDA to begin clinical trials.

The operative word for Star Scientific is promotion. It is in their genetic code. The founder and CEO, Jonnie Williams is a case in point. Mr. Williams has a long history of stock promotion that led to SEC sanctions (see here for more details). Fortunately for Mr. Williams, his investors have short memories.

Mr. Williams recently purchased 1M shares of STSI in November at an exercise price of $1.50, as part of a larger financing to avert a cash liquidity squeeze. At that time, Mr. Williams also stated that he will cut-out his salary until the company becomes profitable. While this is commendable, it does not change the money-losing direction of the company. In fact, there has been no fundamental change in the company's prospects (besides averting bankruptcy) since last month, but the stock has doubled. In the past week, however, nervous lenders of STSI stock increased the borrow rate to 96%. Sky-high stock loan rates are usually a sign of a coming stock crash.

Whether STSI shares implode tomorrow or next year, they will go down. Promotional activity ultimately has limits, as share dilution, profit-taking on cheap insider options, and cash hemorrhaging take their toll. Investors will eventually realize that there is no fundamental value in this company. No billion dollar lawsuits. No anti-inflammatory payday that costs $3 in SG&A support for every $1 in sales for a questionable product. No discernible value as a cure for Alzheimer's disease. STSI is worthless in my view.

TherapeuticsMD

Through a reverse takeover (RTO) of VitaMed in 2H 2011, TherapeuticsMD provides vitamins and nutritional supplements for women. VitaMed itself only launched its first product in 2009, and has a long way to go before getting even close to revenue break-even. The VitaMed RTO is the latest of a string of three failed business ventures that this company has undertaken in only the last 3½ years.

TXMD.OB, Three-Month ChartTXMD.OB, Three-Month Chart

TherapeuticsMD currently is in a low-margin business of distributing generic nutritional supplements. Life's DHA, one of its main products, is sourced by DSM's Martek Bioscience division, which is where the value-creation resides (even if it is now going off patent). Similar to Star Scientific, TherapeuticsMD has a dysfunctional business model where $3 to $4 of SG&A expenses is required to generate $1 in revenue. Distribution is in a minority of states, and management is in the midst of expanding regional coverage and sales people, which is burning even more cash. Even if the company sticks to the business plan this time and somehow succeeds in its expensive mandate to achieve much wider geographical coverage, distribution companies normally trade at single-digit P/E multiples and at a fraction of revenues. So, how can TherapeuticsMD support a market cap of $292M, trading at 95x revenues while losing $39M in the last twelve months!

Facing the dilemma of a money-losing, low-market-valuation distributor business model, management and insiders changed the company's stripes again, and suddenly made VitaMed a pharmaceutical company (hence the new name TherapeuticsMD). As opposed to Star Scientific, they at least filed IND (Investigational New Drug) applications with the FDA, and according to the company, received approval to begin clinical trials on certain compounds.

An IND application entails a pharmaceutical company requesting permission to ship an experimental drug across state lines (usually to clinical investigators) before a marketing application for the drug has been approved. The FDA reviews the IND application for safety to assure that research subjects will not be subjected to unreasonable risk. If the application is cleared, the candidate drug usually enters a Phase I clinical trial.

Management's plan-du-jour is to build out a nationwide distribution network and fill that network with proprietary drugs that address women's health, in particular controversial hormone replacement therapy {HRT} products for menopause. In theory, this makes sense. In reality, this is a train wreck.

First, distribution companies cannot overnight transform themselves into being viable competitors against multinational drug companies with exponentially more resources and experience. Is management prepared for the three-to-five-year ordeal of FDA clinical trials for each drug candidate? Relatedly, should management have promised investors that it expects FDA approval of these products "as early as 2013 and as late as 2015", before clinical trials had even begun? Why is management claiming to go directly to Phase III trials? Standard procedure is to start at Phase I.

Secondly, HRT products were literally banned after a 2002 Women's Health Initiative trial that cited increased incidences of breast cancer and stroke for women on HRT. Since that time, there have been studies that show HRT may work for a small subset of women under certain conditions under very low dosages. Not only will TherapeuticsMD need to prove efficacy in absolute terms, but also efficacy against the current standard of care of existing HRT drugs, while at the same time reversing the past history of life-threatening side effects. Thus, it will be extremely challenging for TherapeuticsMD to obtain FDA approval, despite company news releases and presentations to the contrary.

Third, TherapeuticsMD out-of-the-blue "drug pipeline" of three compounds has no issued patents, and patent applications were just filed this year. The odds are against patent approval given the extensive prior art in the HRT field.

Fourth, the cash outlays for this bold transformation are in the tens if not hundreds of millions of dollars. Unfortunately, TherapeuticsMD is not a private company with deep-pocketed, patient investors that can wait out the huge losses for five-to-ten years for this dream to come true. TherapeuticsMD is a quoted stock on the OTCBB market with quarterly reporting. There is a huge disconnect between OTCBB retail investor expectations and the financial realities of this business model. The $8.5M capital raise in September, some of which was used to pay-off debt, is a temporary Band-Aid that will not last long. Management will be in virtual fundraising mode for the foreseeable future. This translates into tremendous share dilution or debilitating debt. But the company already has too much debt and an extremely high valuation already. Thus, there is only one place for TXMD's stock price to go from here - down.

HRT for menopause is a $1.5B market opportunity. Premarin from Wyeth-Ayerst, the market leader, has about $1B in revenues. The Alzheimer's market opportunity is even larger for Star Scientific. But this is faulty logic. Zero percent of $1B or $8B is still zero. Many internet and biotech companies have fooled investors with enormous addressable markets to justify bubble-like valuations, with disappointing results.

More worrying than TherapeuticsMD's outlandish valuation or money-losing business is the extreme two-tier pricing between insider prices and the quoted price retail investors pay. According to the SC 13D filed July 20th, Steven Johnson (President of CareView Communications (OTCQB:CRVW)) through his 100%-owned investment vehicle, converted a $105k promissory note into 10M shares gross ($0.0105 per share), converted part of another promissory note at $0.038 per share. Furthermore, as part of a debt extinguishment agreement which cost the company $10M in Q1, Mr. Johnson converted debt into millions of shares at $0.38 per share. Thus, certain investors pay $0.01 to $0.38, while retail investors had to pay $2.15 in the September placement and between $1 and $3.40 (mostly weighted towards the $3.40) since the latest RTO became effective in Q4 2011.

The icing on the cake is that after Mr. Johnson extracted his ton of flesh out of the company, management was desperate enough to borrow another $1M (6% interest) from him in June, with a cashless warrant exercise at $2 for 3M shares (plus another 0.5M shares at $3). Thus, Mr. Johnson can demand that the company pay him the difference between the market price and the warrant exercise price, which today would be a whopping $2.8M on a $1M loan. Even worse, the company approved the cashless exercise for all holders of the company's options. What a great source of future cash outflows from the company's coffers.

In 2012, Tommy Thompson (Chairman of CareView, and now Chairman of TherapeuticsMD) and Samuel Greco (CEO of CareView, and now Director of TherapeuticsMD) joined Mr. Johnson as inside investors of TherapeuticsMD (for more information about CareView see here and here). Insiders, including management and the CareView entourage, own 53% of outstanding shares. The huge price differentials between insider shares and outsider shares, the cashless exercise of options for insiders, Mr. Johnson's past government Cease and Desist Order for overpromoting his previous company to investors (see here), and certain Board members' questionable benefits from revocation of subscription rights while at CareView, raise red flags for outside minority investors. The bottom line is if TherapeuticsMD or CareView Communications by some miracle do create any fundamental value, it is unlikely this value will be equally shared with outside investors.

In summary, TherapeuticsMD is grossly overvalued, will be losing tens of millions of dollars for the foreseeable future on both its dysfunctional drug distribution business and its therapeutic pipedream, and insiders are gouging the other investors in the company. TXMD is worthless in my view.

Source: Star Scientific And TherapeuticsMD: 2 Overvalued Pseudo-Pharmaceuticals