Finding a long that doesn't make sense is fairly straightforward and if you've done your homework averaging down is simply part of the process. On the flip side, shorting brings a whole new level of fun. ZIRP is making it expensive to short and there's the obvious factor of margin calls. I'm sure there has never been an "easy" time to short, but I would imagine today is especially onerous. Regardless, today I present Star Scientific.
Background
I found this idea on VIC (I'll briefly brag that I'm now a member) and the short case has been made by numerous other analysts (see here and here). I think the idea is better now than it was in the past, despite a much lower share price.
Here is the short thesis in a nutshell: the only thing that Star Scientific can sell is their stock. This isn't unusual for Jonnie Williams and team, they've been running sca....unprofitable, shareholder leaching, management-centric "businesses" for several decades. It took some time, but those other ventures eventually went to zero. (Oh yeah, he also can fit you with contact lenses on the cheap, no license needed!)
Anyways, the best piece of news to sell stock was when STSI sued RJ Reynolds for patent infringement. While they successfully received compensation from RJR, it is hard to argue that the $8.4M received was in the best interest of shareholders. We can see the original language in their license agreement from March 16, 2001. (SSI refers to Star and RCT refers to Regent Court Technologies).
8.2 SSI shall promptly notify RCT of any potential infringement of any of the Patent Rights. In the event that a third party infringes on any of the Patent Rights, SSI shall have the right but not an obligation to bring legal action to enforce any such patent, including the right to bring suit in the name of Star Scientific, Inc. If SSI exercises such right, SSI shall select legal counsel and pay all legal fees and costs of prosecution of such action. In the event that SSI shall choose not to take such action, RCT shall have the right, at its option and at it own expense, to prosecute any action to enjoin such infringement or to prosecute any claim for damages. The party prosecuting any such action shall be entitled to retain any funds received as a result of settlement or judgment of such action. The Parties may also agree to jointly pursue infringers. After deduction and payment to the Parties of their respective costs and fees (including without limitation reasonable attorneys' fees) incurred in prosecuting any such actions, the net funds obtained as a result of settlement or of judgment of any such jointly prosecuted action shall be divided in the following manner: 25% of all net funds shall be divided equally by the Parties and 75% of all the net funds shall be divided between the Parties in the proportion to the amount of legal fees and costs incurred by the Parties in the prosecution of such actions.
STSI got to foot the bill and pay Regent Court Technologies a bunch of money. For Williams and company this has proven very lucrative.
After "winning" this lawsuit, management decided that safe cigarettes weren't going anywhere. Eight out of 16 patents STSI holds will be expiring by the end of 2016 (pg 12 2012 10K), suing other tobacco companies and waiting a decade won't help them much. Thus, management has decided to shift their strategy again and market anatabine to consumers.
Anatabine
Anatabine is a minor alkaloid of tobacco. From a chemistry perspective it is simple and a synthetic process of isolating the compound has been known as far back as 1965. This was improved upon in 2005 (isolating optically pure substance in a method that should scale well). STSI came along and determined an even better way to synthesize the product. And guess what?
They could make kilos of the stuff and I doubt anyone would care. It has been known for decades that tobacco alkaloids are have some sort of pharmacological effect. These have been studied by other companies, some decades old.
So what does STSI think anatabine will cure in the future? Right now, ANYTHING dealing with inflammation.
Based on the overwhelming lack of evidence from reputable scientific sources I'd say that the company has a very low chance of success. I say this not because I'm an expert in pharmaceuticals, but because I believe, like investing, science is very hard. If it was easy, it's likely that it would have been discovered.
A search at PubMed for anatabine brings back 59 articles. There was only one article that gave details on the anti-inflammatory nature of anatabine. This was written by Daniel Paris from the Roskamp institute. The other articles not written by Roskamp associates were mostly analytical studies. It seems odd that no one, anywhere, has researched this small molecule. Unless of course it had no promise.
It's no secret that small molecule drug makers are finding few sources of new revenue. I would say that anatabine has been tested several times in various library assays for drug potential. Other companies probably think the chance of success is low and now so does STSI. This is despite the recent press releases that talk about medical studies on colitis (IR would not tell me who is actually running the study at UVA) the company seems to think the best chance for success lies elsewhere.
"Initially, marketing of Anatabloc ® was directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who regularly deal with issues relating to inflammation." pg 6 2012 10K
So the company now believes it will make money from an overpriced, over-marketed, GNC product. There are 3 active ingredients in Anatabloc: vitamin A, vitamin D, and anatabine. Since it's been well established that vitamin A and vitamin D combat inflammation, where's the proof that Anatabloc is any better than multivitamin?
Discussions with physical therapists lead me to believe that in the past year the company was sending copious amounts of marketing material to medical professionals. Nobody bought the product except for one massage therapist who was referenced in a puff piece on STSI's press release page.
He got all of his information about the science from the company (he claimed to understand it but didn't know anything about the molecule when I questioned him). He heard about the company through a client...who was an investor in STSI.
Cash Burn
So what does it take to run a pharmaceutical lab investigating one of the greatest small molecules in the world?
In 2012 spent $4.5M on R&D. All that research obviously required a lot of publicity, which is why STSI spent $6.1M on marketing. Having worked at a venture backed company (chemical based) those numbers do not paint a pretty picture for innovation.
Regardless, the company burned through $17.4M of cash (FCF before working capital) in 2012, roughly in line with my estimated cash burn in 2011 and 2010. Currently there is $23.1M of cash in the bank. Keeping a staff of scientists and their equipment hunting for the next breakthrough will be tough, especially with all that marketing spend and management incentives.
With a current burn rate of $1.4M ($17.5M/12 months) per month it seems likely that the company will have to:
A. Cut staff. This would drain resources from creating/selling product. Plus this is a very top heavy firm with set contracts and exit agreements. Every $40K tech they fire will only pay for 2 weeks of Williams salary.
B. Cut marketing. This would also drain resources from selling the product. The extra marketing spend (an increase of $3.6M from 2011 to 2012) was likely the only reason they increased sales to $6.188M in 2012 from $1.244M in 2011. I would imagine a lot of this is set too just to remain in GNC fliers.
C. Dilute shareholders.
Based on managements past, (C) seems most likely. Since 2010 share count has risen from 118.3M to 146.99M(8% growth per year). Further dilution is almost guaranteed unless Anatabloc catches fire. I guess there is a chance of this happening even though Anatabloc has been in GNC stores for more than a year now. Tom Dowd, a GNC executive, recently stated that "sales of Anatabloc continue to surpass expectations."
With sales of $6.188M in more than 4,000 GNC locations, GNC must have expected sales to be less than $1,547 per store per year, or 20 bottles/store per year($1,547 divided by $79.99 per bottle). Since one bottle is only a months supply, there are 1.66 people per store buying Anatabloc(20 bottles/12 months in a year).
I'm being quite generous by saying all sales in 2012 took place in GNC, so the actual sales per store was probably lower. Even if my numbers were off (the wholesale price per bottle is ~$66 for a minimum of six bottles) it doesn't change the fact that barely anyone is buying this product despite endorsements, a national chain roll-out, and all the advertising that they can buy.
Conclusion
Star Scientific is a terrible company that doesn't make any sense. Now that the RJR lawsuit is out of the way it seems unlikely, if not impossible, that the company can grow their profits to match their ridiculous $190M market cap. With only $23M in the bank the company will have to exponentially increase sales to operate at breakeven operating margins.
Since they are already established in GNC I believe we are already seeing the best that they can do. In my opinion, the company is worth, at most, 2X book value(let's pretend that there is some value to the IP). With 146.99M shares outstanding and a book value of $24.98M(12/31/2012) this gives a per share value of $0.33/share compared to the current price of $1.33.
Even if some miraculous medical discovery happens, it will take years before the company is actually able to monetize anything. I believe that the large retail base and abhorrent management team makes this a timely and compelling short.
We are short STSI. This can change at any time.
They could make kilos of the stuff and I doubt anyone would care. It has been known for decades that tobacco alkaloids are have some sort of pharmacological effect. These have been studied by other companies, some decades old.
So what does STSI think anatabine will cure in the future? Right now, ANYTHING dealing with inflammation.
Based on the overwhelming lack of evidence from reputable scientific sources I'd say that the company has a very low chance of success. I say this not because I'm an expert in pharmaceuticals, but because I believe, like investing, science is very hard. If it was easy, it's likely that it would have been discovered.
A search at PubMed for anatabine brings back 59 articles. There was only one article that gave details on the anti-inflammatory nature of anatabine. This was written by Daniel Paris from the Roskamp institute. The other articles not written by Roskamp associates were mostly analytical studies. It seems odd that no one, anywhere, has researched this small molecule. Unless of course it had no promise.
It's no secret that small molecule drug makers are finding few sources of new revenue. I would say that anatabine has been tested several times in various library assays for drug potential. Other companies probably think the chance of success is low and now so does STSI. This is despite the recent press releases that talk about medical studies on colitis (IR would not tell me who is actually running the study at UVA) the company seems to think the best chance for success lies elsewhere.
"Initially, marketing of Anatabloc ® was directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who regularly deal with issues relating to inflammation." pg 6 2012 10K
So the company now believes it will make money from an overpriced, over-marketed, GNC product. There are 3 active ingredients in Anatabloc: vitamin A, vitamin D, and anatabine. Since it's been well established that vitamin A and vitamin D combat inflammation, where's the proof that Anatabloc is any better than multivitamin?
Discussions with physical therapists lead me to believe that in the past year the company was sending copious amounts of marketing material to medical professionals. Nobody bought the product except for one massage therapist who was referenced in a puff piece on STSI's press release page.
He got all of his information about the science from the company (he claimed to understand it but didn't know anything about the molecule when I questioned him). He heard about the company through a client...who was an investor in STSI.
Cash Burn
So what does it take to run a pharmaceutical lab investigating one of the greatest small molecules in the world?
In 2012 spent $4.5M on R&D. All that research obviously required a lot of publicity, which is why STSI spent $6.1M on marketing. Having worked at a venture backed company (chemical based) those numbers do not paint a pretty picture for innovation.
Regardless, the company burned through $17.4M of cash (FCF before working capital) in 2012, roughly in line with my estimated cash burn in 2011 and 2010. Currently there is $23.1M of cash in the bank. Keeping a staff of scientists and their equipment hunting for the next breakthrough will be tough, especially with all that marketing spend and management incentives.
With a current burn rate of $1.4M ($17.5M/12 months) per month it seems likely that the company will have to:
A. Cut staff. This would drain resources from creating/selling product. Plus this is a very top heavy firm with set contracts and exit agreements. Every $40K tech they fire will only pay for 2 weeks of Williams salary.
B. Cut marketing. This would also drain resources from selling the product. The extra marketing spend (an increase of $3.6M from 2011 to 2012) was likely the only reason they increased sales to $6.188M in 2012 from $1.244M in 2011. I would imagine a lot of this is set too just to remain in GNC fliers.
C. Dilute shareholders.
Based on managements past, (C) seems most likely. Since 2010 share count has risen from 118.3M to 146.99M(8% growth per year). Further dilution is almost guaranteed unless Anatabloc catches fire. I guess there is a chance of this happening even though Anatabloc has been in GNC stores for more than a year now. Tom Dowd, a GNC executive, recently stated that "sales of Anatabloc continue to surpass expectations."
With sales of $6.188M in more than 4,000 GNC locations, GNC must have expected sales to be less than $1,547 per store per year, or 20 bottles/store per year($1,547 divided by $79.99 per bottle). Since one bottle is only a months supply, there are 1.66 people per store buying Anatabloc(20 bottles/12 months in a year).
I'm being quite generous by saying all sales in 2012 took place in GNC, so the actual sales per store was probably lower. Even if my numbers were off (the wholesale price per bottle is ~$66 for a minimum of six bottles) it doesn't change the fact that barely anyone is buying this product despite endorsements, a national chain roll-out, and all the advertising that they can buy.
Conclusion
Star Scientific is a terrible company that doesn't make any sense. Now that the RJR lawsuit is out of the way it seems unlikely, if not impossible, that the company can grow their profits to match their ridiculous $190M market cap. With only $23M in the bank the company will have to exponentially increase sales to operate at breakeven operating margins.
Since they are already established in GNC I believe we are already seeing the best that they can do. In my opinion, the company is worth, at most, 2X book value(let's pretend that there is some value to the IP). With 146.99M shares outstanding and a book value of $24.98M(12/31/2012) this gives a per share value of $0.33/share compared to the current price of $1.33.
Even if some miraculous medical discovery happens, it will take years before the company is actually able to monetize anything. I believe that the large retail base and abhorrent management team makes this a timely and compelling short.
We are short STSI. This can change at any time.
