Star Scientific's Shares Set for a Major Pullback

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Star Scientific (CIGX) shares have more than doubled since March 7th, leading the stock to trade at its highest level since 2009. The shares have surged on two factors. The first is that the company has appeared to gain the upper hand in a patent dispute that could perhaps bring the company more than a billion dollars in damages. Second, SA contributor James Altucher claimed that Star Scientific has stumbled upon a potential cure for Alzheimer's.

However, neither of these reasons can justify anything close to the current run-up in Star Scientific's shares. The lawsuit opportunity is still nowhere near being close to being monetized. Star Scientific sued Reynolds in 2001 -- 10 years ago -- and the trial is still multiple appeals away from being finished. Benzinga reported that:

Machir (a Star Scientific Investor Relations spokesperson) said on Monday that while the notices from the patent and trademark office were good news for Star, the champagne is on ice. “The patents were upheld and we're awaiting the decision from the federal circuit,” said Machir. “All arguments were heard in January, and we're awaiting the decision on the appeal. If they overturn the verdict, there will be a new trial and a new judge. That won't be before summer 2011, and Reynolds will appeal if the verdict goes in our favor. The appeal will then be heard by a three-judge panel. If we win, it won't be sent back before late fall 2011. Taking all of that into account, it will be at least 12 months before the dispute reaches its conclusion.”

Star Scientific had risen to more than $5 a share in 2009 when it appeared to be on the cusp of victory in its patent dispute. Star Scientific shares then plunged 80 percent in one frantic after-hours session after the company had a legal setback that year. Since legal proceedings are still far away from any resolution, recent legal victories are insufficient to justify Star Scientific's current upswing. Star Scientific's eventual legal outcome is undetermined and the company may recover much less than it is suing for, or nothing at all. One can't rationally justify Star's more than $400 million market cap solely on hopes of a positive legal outcome.

Of course, Star Scientific's investors have also been excited by James Altucher's article suggesting that the company had found a cure for Alzheimer's. But it's way too early to be claiming victory on that front. Zzlangerhans -- Motley Fool's resident biotech expert who is an emergency room physician and who graduated magna cum laude from Harvard with a degree in Biochemistry -- had this to say about Altucher's article:

The author touts a test in a Petri dish as conclusive proof of a cure for Alzheimer's, and probably any other disease that involves inflammation[...]

[T]he company has dredged up a tobacco alkaloid called anatabine as a potential cure for Alzheimer's. Presto, the tobacco candy pusher has become a drug developer. A proposed clinical trial, far from demonstrating a cure for Alzheimer's, is only designed to show a reduction in levels of an inflammation marker called CRP in test subjects who don't even have Alzheimer's. Even if the study is a resounding success, the clinical implications are dubious at best. And of course, moving into clinical trials costs a lot of money.

While the recently accounced news is a good first step for anatabine, the company is still far from having cured Alzhemier's (or any other inflammation-related disease). Unlike Altucher's promotional piece, the company did not rush to tout the discovery, wisely offering a much more measured response to the research. Investors should take the same stance. Even in the unlikely case that anatabine ends up leading to a successful Alzheimer's drug, it's doubtful that Star Scientific will be the company developing it.

Star Scientific has only a couple of quarters of cash left on its balance sheet, its main operation -- selling tobacco -- generates less than a million dollars a year of revenue, and the company has been consistently losing money for many years. It's book value is now 0.01 per share. Star Scientific cannot possibly afford the lengthy and expensive process that it would take to move anatabine through the lengthy drug development cycle.

The most likely outcome of the recent surge in Star Scientific's share price is that the company will do a major dilution to ensure that the lights aren't turned off. Star Scientific shares have spent most of the past four years under $2/share, and if you are interested in investing in either anatabine or in the never-ending legal fight against Reynolds, you will get the opportunity to buy under $2 again in the near future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.