Marcial: Pros Gazing at Star Scientific

With its technology for eliminating key toxins in tobacco, the outfit has huge potential, especially if it wins a court fight against R.J. Reynolds

Investors will be watching intently as a big tobacco industry patent-infringement case goes to trial in mid-May: a David-and-Goliath court battle pitting the second-largest U.S. cigarette maker, R.J. Reynolds Tobacco, a unit of Reynolds American (RAI), against the tiny and little-known Star Scientific (STSI).

Shares of Star Scientific, which has developed tobacco-curing technology that prevents the formation of certain carcinogenic toxins in tobacco, have started to attract some big investors. They're betting that if it wins a lawsuit it has filed against Reynolds, seeking damages of about $1 billion, the potential rewards to the small-cap company would be huge. The stock has been on the rise, climbing from a low of 1.48 a share on Nov. 20, 2008, to 4.84 on Apr. 9, 2009. Reynolds stock has also gone up recently, from 31 on Mar. 6 to 39 on Apr. 9.

Wall Street analysts haven't had much to say about the lawsuit. Of the 11 analysts tracking Reynolds, four of them rate it a buy, including MatrixUSA, which tags it a strong buy. But no analysts cover Star. While the disparity in size between the two companies is huge, investors in Star are upbeat. "Despite Reynolds' legal efforts to derail and delay the patent-infringement suit, Star Scientific succeeded in getting a trial date," says Neal Goldman, president of Goldman Capital Management, which holds a 4% stake in Star. That indicates Star has a chance of winning, "and we believe it will," says Goldman. The stock, he adds, is very undervalued, based on its technology, products, and likelihood of winning the patent fight.

Goldman notes that if Star emerges victorious, the loss to Reynolds would be huge. So he figures Reynolds may agree to an-out-of court settlement. At the same time, however, he doesn't discount the possibility that Star may be bought out before the case is resolved in court. A large tobacco company, he argues, could make a bid to acquire Star. Goldman puts Star's worth at 20 a share.

Reexamining the Patent

At issue in the litigation: Star's patents covering a technology invented by CEO Jonnie Williams, the company's largest shareholder with a 15% stake. Williams began work on the project in 1996. The result: He developed novel methods to inhibit the "microbial nitrate-reductase" activity in tobacco that leads to the formation of nitrosamines. Williams says those are among the most active cancer-causing agents in tobacco and have been identified in animal and clinical tests as contributing to a variety of cancers, inducing tumors of the lung, oral cavity, esophagus, pancreas, and liver. Star was issued a patent for the technology on Mar. 20, 2001.

The legal battle started on May 23, 2001, when Star sued R.J. Reynolds Tobacco, accusing it of using and selling tobacco made by a process that infringed on Star's patent. Reynolds adamantly denies the charge and also questions the patent's merit.

David Howard, a spokesman for R.J. Reynolds, says the U.S. Patent & Trademark Office has granted Reynolds' request to reexamine Star's patent because of questions about its validity. The reexamination could take six to eight months, he says. "We are confident of winning the case," says Howard.

But on Mar. 9, 2009, the U.S. Supreme Court dealt Reynolds a severe blow by refusing to hear its appeal on the case. And on Mar. 31, Reynolds suffered another setback when U.S. District Court Judge Marvin Garbis denied its request to suspend a jury trial while the U.S. Patent & Trademark Office was reexamining Star's patent. The jury trial is scheduled to begin on May 18.

Lots of Legal Firepower

The difference in the size and capitalization of Reynolds and Star Scientific is huge. Reynolds American, the result of the merger of R.J. Reynolds Tobacco and Brown & Williamson Tobacco, another large tobacco producer, has a market capitalization of $11.4 billion. Reynolds manufactures about 3 out of 10 cigarettes produced in the U.S. and produces five of the nation's best-selling brands: Camel, Winston, Kool, Salem, and Doral.

Star Scientific, based in Petersburg, Va., has a market cap of just $450 million. Apart from its toxin-reduction technology for tobacco, Star is also producing other products, including dissolvable smokeless tobacco aimed at relieving cigarette withdrawal symptoms, which would compete with over-the-counter nicotine replacement products already in the market.

Scott Peters, general partner at Tradewinds Investment, the second-largest shareholder in Star with a 10% stake, says he believes Star is likely to win its lawsuit "because of the clear-cut and preponderance of evidence that we have looked at." Tradewinds first started investing in Star four years ago but increased its stake a year and a half ago because of its suit against Reynolds.

The company is tiny, Peters says, but its legal firepower is enormous, spearheaded by Star Chairman Paul L. Perito, who was a prominent Washington (D.C.) lawyer as a senior partner in the law firm Paul, Hastings, Janofsky & Walker before joining Star in 1999. In the 1970s he was deputy director of the White House Special Action Office on Drug Abuse Prevention. "Despite Reynolds' deep pockets, Perito's legal team can meet the challenge and win," contends Peters.

"Dramatic." Potential Market Value

David McClary, general partner at Willowbrook Capital Management, which also owns shares, says Star's lawsuit could lead to other lawsuits against other major tobacco companies. And should RJR lose, he says. additional royalties would be owed Star for patent infringement from 2001 through the patents' 2016 expiration.

McClary says the potential market value of Star based on executing on its patented business through royalty and partnership agreements is "dramatic." He puts its value at 32 a share, assuming, he says, that the tobacco industry is compelled to honor its patents on its tobacco curing process.

That possibility may be the key to a deal, which could either result in a licensing agreement or in Reynolds or another tobacco giant acquiring Star. Either way, investors in Star could win.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

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