Star Scientific: Widely Shorted for Good Reason

| About: Rock Creek (RCPI)

Star Scientific (CIGX) is a tobacco/healthcare hybrid company trading at 5.26 per share. There are 134 million shares, resulting in a $700+ million market cap. It is my opinion that the fair value for all of CIGX shares is $5 to $10 million, 90%+ less than current prices.

Star has a few lines of businesses. They sell a line of “snuff” products which generate less than $1 million in annual sales and have done so for years. These products are sold at negative gross margin. I suspect the company has failed to generate meaningful revenue for these products due to intense competition with Big Tobacco. The value of this product is perhaps $1 million.

Star’s second line of business is a “smoking alternative dietary supplement” designed to help smokers quit. The product sold $63,000 in 2010. It is important to note the failure of this business because it will help you judge management’s new endeavors. This is a worthless product.

Star’s next line of business was prosecuting a safer tobacco production patent. Star sued RJR and lost in 2009. An appeal decision is coming shortly and may be a catalyst for the stock. Even if you assume there is a small % chance of victory, the present value of this asset is small, perhaps a few million value "lotto ticket".

Star is developing a new nutraceutical based on anatabine, which is found in tobacco and food. Claims of efficacy for Alzheimer’s disease are the new story which has Star’s stock at 52 week highs. I will address anatabine in detail shortly.

Unlike similar small-cap shorts we are active in, management is very unique at Star Scientific. The CEO, Jonnie Williams, earns $1,000,000 per year in base salary. Williams has been at Star for over a decade (1999). Williams routinely participates in secondary offerings of Star stock and owns about 15% of the shares outstanding. Williams and Francis O’Donnell own an airplane company that Star is a major customer (only customer?) of. You might recognize Francis O’Donnell, who is a Florida based biotech executive, formerly CEO of BioVest, a successful MSMB short (MSMB is the fund company I manage). The duo also receives a royalty on the sale of any Star products. In a remarkable display of self-dealing, Star pays the entity Williams owns and controls ~1.5 million per year for at least the last three years.

Star has a diehard allegiance of retail investors who are attracted to the sub-$5 share price and seemingly large tobacco and Alzheimer’s markets. A sub-$5 share price is not the key to financial success. This optical illusion results in illogical investor losses--one is better off buying shares of undervalued companies like Biomarin (NASDAQ:BMRN) or Onyx (NASDAQ:ONXX). Always think in terms of market cap, not share price. Ask yourself: Is CIGX worth $700 million? Cover up the market cap and try to figure out what you think it is worth, independent of the stock market. If you guessed $2 billion, buy the stock. If you came up with less than $50m like I did, stay away or short.

I hope I’ve established why the current snuff business appears worthless; the facts around the RJR case will be detailed in an appendix, but in general it’s a long shot for an appeal of a patent case to be heard or to be a valuable exercise. It is apparent the nutraceutical business is not worth anything, and Star management team is of a questionable nature, not only with respect to their execution, but also their ethical practices.

The final piece of analysis is—are anatabine nutraceutical and pharmaceuticals worth anything?

My opinion is a conclusive no. The chemical structure of anatabine is a demethylated nicotine.

It is highly unlikely that nicotine and anatabine have different properties. Nicotine has interesting properties in vitro and in vivo, but the millions, if not billions of users of nicotine know exactly what its properties are. It is highly unlikely anatabine and nicotine have beneficial properties beyond those already known. It is known that these agents are ligands for nicotine receptors, which have been implicated in Alzheimer’s. Nevertheless, clinical trials by Comentis, Memory/Roche and Targacept have revealed these products to not be meaningful pharmaceutical agents. Star’s lack of success in nutraceuticals bodes poorly for their new endeavor. Their complete lack of experience in pharmaceuticals makes it unlikely the company will succeed there.

Star is out of cash. Star is actually always out of cash, and finances ‘hand to mouth’, usually from their CEO and PIPE players.

What will make the stock go down? I don’t know, in short. I have succeeded in shorting stocks like this by initiating front-end weighted VWAP entries and exits. Timing can be difficult for shorts like this. I suspect the stock may remain overvalued for some time. Continued meager sales and financings may be useful. Weak product launches or failure to progress in clinical trials may also be catalysts for Star’s price to fall. I’m not so concerned with when it will happen, as I’m pretty sure it will.

Disclosure: My firm is short CIGX. My firm and I may cover our CIGX position at any time without updating Seeking Alpha.