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By Melissa Davis

* Editor's Note: This story is the first in a two-part investigative series, with the second article scheduled to run after the Fourth of July holiday.

Over the years, regulatory filings show, Star Scientific (CIGX) has often changed its pretty story -- with the former cigarette maker now spinning tobacco as the key to breakthrough medical cures – but the company has rarely changed its ugly numbers.

Star posted its highest revenue as a discount cigarette maker more than a decade ago, records show, and has generated dismal sales (and absolutely no profits) ever since shedding that traditional tobacco business. Last year, for example, Star posted total revenue of just $848,000 – or less than 1% of the $223 million in record 2000 sales it achieved as a profitable cigarette company – while recording an annual loss (a number that keeps growing) for the eighth straight year in a row.

Star nevertheless boasts a market value of almost $600 million, some 35% higher than its peak market value during the year the company achieved its strongest financial results on record, and currently trades at an astounding 720 times its prior-year sales. If investors assigned Star the same multiple now as they did back then, the company would sport a market value of just $1.68 million – with its $4.50 stock fetching barely a penny a share – instead.

For years, corporate filings reveal, Star has enjoyed far more success selling its story (and the stock it keeps issuing in order to stay afloat) than it has at actually selling its unpopular products. Star executed the latest in a series of private placements during the first quarter of this year, with enough warrants and stock options now outstanding – at average exercise prices of around $2 a share – to increase the company's swelling share count, which totaled less than 60 million back in 2000, by another 33% to almost 180 million shares. The restrictions on the last of that cheap stock should expire this September, records indicate, with the shares facing a potential slide toward $3 unless the company's handsome market value further expands to absorb that looming dilution hit.

Of course, that price assumes that investors continue to value Star based on its ambitious plans and keep ignoring the company's miserable results. Without the speculative hype provided by its long-shot dreams, which alternate between beating Big Tobacco for massive damage awards and beating Big Pharma for blockbuster miracle cures, Star would arguably lose all of the appeal that makes it one of the most active (and volatile) small-cap stocks on the Nasdaq exchange.

Take a look at the company's latest quarterly results, just for starters. Star posted total revenue of $156,000 during the first quarter, corporate filings show, with dwindling sales of its most-established product – tobacco-based "Hard Snuff" lozenges now competing with well-branded rivals – plummeting 26% to $110,000 "due to higher returned goods and promotion costs." Star generated the rest of its meager revenue from its newer CigRx offering, a nutritional supplement designed to curb nicotine cravings, but that product – introduced a full year earlier – still mustered less than half the revenue posted by the company's shrinking hard snuff business despite the celebrated launch of a national marketing campaign.

Nevertheless, one of the most vocal stock promoters touting Star these days recently portrayed CigRx as a looming blockbuster hit.

"Its market potential is staggering, and its eminent regional and national rollout gets closer by the day," declared John Faessel, a longtime company bull who previously touted NXT Nutritionals (OTCPK:NXTH) – a dubious microcap company exposed by TheStreetSweeper before it later collapsed – in two "research reports" published by a promotional website that caters to the penny-stock crowd. "Star and inVentive Health (the company's big marketing partner) are preparing for a major push with new, state-of-the-art call centers to handle the volume of sales that they anticipate.

"So you get the picture: inVentive Health has the muscle and know-how, sees a big – if not huge – revenue stream and has the money to push CigRx out to a nationwide public … Therein lies the moon-shoot potential."

Star launched that national roll-out a full month before the first quarter came to an end, however, and still sold only $46,000 worth of CigRx – while losing $1.41 million on the product -- during that three-month period. Nevertheless, even after Star released those figures, Faessel began suggesting that CigRx could soon achieve annual sales of $100 million and eventually see that number explode to $800 million down the road. He pegged the value of Star's stock at $6 using the first sales figure and at $40 to $60 using the second.

That math, while intended to dazzle investors with explosive growth projections, actually illustrates the huge distortion already present in Star's current share price. According to an equation set forth by one of Star's most relentless bulls, sales of CigRx need to skyrocket from a current run-rate of about $200,000 to $100 million – or roughly 50,000% -- in order to justify a stock price that's just $1.50 above present levels.

In other words, that math suggests, Star should already be selling $75 million worth of CigRx a year to warrant the stock price it currently enjoys. But for now, that math indicates, current sales of CigRx warrant a stock price of just one penny – about the same price rendered when assigning past valuation multiples to the company – instead.

This exercise clearly underscores an obvious point. With current sales of Star's hard snuff actually fading and explosive sales of CigRx largely baked into its share price already, investors are not buying the stock based on high hopes for the company's unpopular products. Rather, they are counting on jackpot-size payouts – measured in the billions – from a couple of apparent long-shot gambles regularly hyped by the enthusiastic bulls who keep touting the company's speculative shares.

Star failed to respond to requests by TheStreetSweeper seeking input for this story.

Up in Smoke

For the past decade, filings show, Star has been pursuing massive damages against tobacco giant R.J. Reynolds (NYSE:RAI) for allegedly infringing on its patented curing process for reducing the deadly toxins in tobacco to create less harmful cigarettes.

Star has already suffered major setbacks in the case, records show, with both a federal judge and a federal jury ruling against the company – by declaring that its "invention" was not new – and siding with RJR instead. The company's stock plummeted below $1 after each of those decisions, records show, but staged a big comeback when the U.S. Patent & Trademark Office (PTO) took the opposite stand by confirming the validity of those contested patents earlier this year.

The stock, which fetched less than $2 when select investors (including Star CEO Jonnie Williams) purchased millions of shares through a private placement the week before that ruling, rocketed toward $4 within days of that favorable development. Lifted by escalating hopes for long-sought damages, combined with powerful hype about the company's pursuit of tobacco-based medical breakthroughs, the stock continued to rally in the weeks that followed and ultimately broke past $5 this April for the first time in years. With the stock finally closing above the crucial $5 mark in late May, records indicate, Star executives are now free to exercise millions of cheap stock options granted under new employment agreements – signed days after the favorable PTO decision – that linked fully half of those awards to a single-day closing price of $5 or more.

Meanwhile, despite the celebrated PTO ruling, Star still faces the inherently daunting challenge of reversing earlier decisions through the courtroom-appeals process. For its part, corporate filings show, RJR has portrayed the PTO ruling as an irrelevant development in a distinctly separate case.

"For several reasons," the tobacco giant stated in its latest quarterly report, "RJR Tobacco believes that the PTO's re-examination decision – which is not binding on the Federal Circuit – should not materially affect the Federal Circuit's review of the district court's final judgment, because the jury found non-infringement in any case and invalidity in RJR Tobacco's favor on grounds not considered by the PTO."

In fairness, like any party embroiled in a legal war, RJR likely holds a biased view favoring its own shot at victory. At the same time, however, Star General Counsel Robert Pokusa – the insider arguably best equipped to weigh the company's chances in the case – has sent some potentially negative signals to the market in recent months as well.

In late March, with Star climbing above $4 on the favorable PTO ruling four weeks earlier, Pokusa executed the first insider sale by a company executive in years. He exercised 50,000 options set to expire, filings show, and then sold the underlying stock at $3.66 a share (a price well below the reported low for the day) instead of holding onto it for potentially bigger gains on down the road. Two months after that, records show, Pokusa followed up by selling twice as much stock – this time cashing in options expiring a full year later – as the stock raced toward a new multi-year high before losing some of its steam once again.

Pokusa exercised almost one-third of his stock options through those two transactions, records indicate, and directly owns just 1,200 shares in the company (or less than 1% of the total number he sold) at the present time.

Pokusa can still score a big windfall if Star actually manages to beat the formidable RJR down the road, corporate filings indicate, since the company has promised a portion of any damages it receives in exchange for a cap on related legal fees. By cashing in a big chunk of his stock options (exercised at prices roughly 60% to 75% below the prices that he received) in the meantime, however, Pokusa has also scaled back his exposure to any looming courtroom setbacks like those that have decimated the shares – and seemed to threaten the very survival of the company – over the course of the past few years.

Down to Dreams?

If Star weathers yet another devastating blow in that legal war, as bearish investors have widely come to expect, then the company could need to pull off nothing short of a miracle – besting Big Pharma with an effective treatment for Alzheimer's disease – in order to support, and ultimately boost, its current share price.

Four years ago, with the company's stock hammered below $1 on its original courtroom defeat, Star suddenly announced plans to expand into the biotech arena by seeking potential tobacco-based treatments for Alzheimer's disease. Star abandoned the discount cigarette business – the past source of most of its revenue and all of its profits – that same year, records show, leaving the company almost entirely dependent upon proceeds from stock sales to address its constant need for cash.

Star won a surprising legal victory in the meantime, records show, when it convinced an appeals court to return its case back to the lower court for further review that would include an actual jury trial. With its shot at a huge damage award seemingly revived, records show, Star resumed its status as a hot litigation stock – its biotech story now fading into the background – until a jury, like the federal judge before it, ruled against the company in mid-2009.

After spending the rest of that year in survival mode, its stock spiraling well below $1 a share, Star once again embraced biotech as a key focus for the company. Star soon won over a growing crowd of bulls, records show, with even a former contributor to TheStreet.comJames Altucher – trumpeting the company's chances of proving that a tobacco-based "nutraceutical" could effectively treat Alzheimer's disease. In April of 2010, just one day after Star announced that a research institute would begin testing the compound (later identified as anatabine), Altucher boldly predicted that the company could introduce a new Alzheimer's treatment within a few months and see its stock rapidly skyrocket to $15 or $20 a share as a result.

When almost a year passed without that potential cure and Altucher returned with an even bolder forecast – this one carrying a headline suggesting that Star had already cured Alzheimer's disease – he sparked a strong rebuttal from a former colleague widely viewed as the best financial journalist covering the biotech space.

"He knows full well there is no scientific evidence yet to back up a claim that anatabine cures Alzheimer's," Adam Feurestein, a veteran columnist for TheStreet.com, declared. "His column, despite the enticing headline, doesn't offer any proof, either…

"It's highly unlikely that any nutraceutical or nutritional supplement, including anatabine, is going to be selective enough to cure a disease like Alzheimer's," Feurestein continued. "I know some people swear by the efficacy of nutraceuticals, but I'm not one of them. I prefer a bit more scientific rigor with my medical claims."

That science costs plenty, of course, with the pharmaceutical industry often spending billions pursuing miracle cures that they sometimes fail to find. Meanwhile, corporate filings show, Star itself spent just $650,000 on research and development during its most recent quarter -- or roughly half the modest sum it spent the previous year -- even as it further bolstered its public image as a viable biotech company within reach of a possible Alzheimer's cure.

In a damaging report earlier this month, however, New York hedge fund manager Martin Shkreli proclaimed that at least three drug companies have already conducted clinical trials of similar tobacco-based agents and found no evidence supporting their use as effective treatments for Alzheimer's disease. He expressed serious doubts that Star, with its "lack of success" in the nutraceuticals field and its "complete lack of experience" in the pharmaceuticals space, could somehow manage to succeed where more established health-related companies had already failed.

His firm placed a bet against the company by shorting its heavily promoted stock, pegging the true value of Star – including its shrinking hard snuff business, its unpopular CigRx offering, its potentially long-shot legal awards and its proposed treatment for Alzheimer's disease – at well below $1 a share.

"What will make the stock go down?" Shkreli mused at the time. "I don't know … (But) I'm not so concerned with when it will happen, as I'm pretty sure it will."

Disclosure: Through its members, TheStreetSweeper began establishing a financial position in CIGX on June 22 and will profit on future declines in the share price. It currently holds the following positions in the stock: 800 contracts for the July $5.50 puts purchased at an average price of $1.18 apiece; 350 contracts for the July $6 puts purchased at an average price of $1.54 apiece; and a total of 44,300 shares of CIGX stock sold short at an average price of $4.83 a share. TheStreetSweeper will sell the CIGX puts it acquired and cover its short position in the stock at a future date. It will update this disclosure when those transactions occur.

As a matter of policy, Melissa Davis – the editor of TheStreetSweeper and the author of this story – never takes a financial position in any of the stocks that she covers. To contact Ms. Davis, please send an email to editor@thestreetsweeper.org.

Source: Star Scientific: A Tobacco Stock Buoyed by Dubious Forecasts