|
Item 1.
|
Financial Statements
|
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
($ in thousands except share data)
|
|
March 31,
2014
|
|
|
December 31,
2013
|
|
|
|
(Unaudited)
|
|
|
|
|
ASSETS
|
|
|
|
|
|
|
|
|
Current assets:
|
|
|
|
|
|
|
|
|
Cash and cash equivalents
|
|
$
|
8,379
|
|
|
$
|
3,881
|
|
Receivable from sale of licensing rights
|
|
|
9
|
|
|
|
18
|
|
Note receivable-short term
|
|
|
69
|
|
|
|
66
|
|
Inventories, net
|
|
|
3,348
|
|
|
|
3,473
|
|
Prepaid expenses and other current assets
|
|
|
1,164
|
|
|
|
1,575
|
|
Total current assets
|
|
|
12,969
|
|
|
|
9,013
|
|
Property, plant and equipment, net
|
|
|
373
|
|
|
|
399
|
|
Intangible assets, net of accumulated amortization
|
|
|
454
|
|
|
|
472
|
|
Note receivable long-term
|
|
|
500
|
|
|
|
517
|
|
MSA escrow funds
|
|
|
482
|
|
|
|
482
|
|
Assets held for sale of discontinued operations
|
|
|
69
|
|
|
|
69
|
|
Total assets
|
|
$
|
14,847
|
|
|
$
|
10,952
|
|
|
|
|
|
|
|
|
|
|
LIABILITIES AND STOCKHOLDERS’ EQUITY
|
|
|
|
|
|
|
|
|
Current liabilities:
|
|
|
|
|
|
|
|
|
Accounts payable, trade
|
|
$
|
1,725
|
|
|
$
|
2,082
|
|
Accrued expenses
|
|
|
3,093
|
|
|
|
1,812
|
|
Due to stockholder
|
|
|
50
|
|
|
|
50
|
|
Current liabilities of discontinued operations
|
|
|
4
|
|
|
|
29
|
|
Total current liabilities
|
|
|
4,872
|
|
|
|
3,973
|
|
Total liabilities
|
|
|
4,872
|
|
|
|
3,973
|
|
Commitments and contingencies (note 6)
|
|
|
-
|
|
|
|
-
|
|
Stockholders’ equity:
|
|
|
|
|
|
|
|
|
Common stock (A)
|
|
|
18
|
|
|
|
17
|
|
Additional paid-in capital
|
|
|
284,152
|
|
|
|
271,327
|
|
Accumulated deficit
|
|
|
(274,195
|
)
|
|
|
(264,365
|
)
|
Total stockholders’ equity (B)
|
|
|
9,975
|
|
|
|
6,979
|
|
Total liabilities and stockholders’ equity
|
|
$
|
14,847
|
|
|
$
|
10,952
|
|
____________
|
(A)
|
$0.0001 par value per share, 213,500,000 shares authorized, 181,859,940 and 172,384,178 shares issued and outstanding as of
March 31, 2014 and December 31, 2013, respectively.
|
|
(B)
|
Class A, convertible, $.01 par value, 4,000 shares authorized, no shares issued or outstanding; Series B, convertible;
$.01 par value 15,000 shares authorized, no shares issued or outstanding.
|
See notes to condensed
consolidated financial statements.
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS
($ in thousands except share and per
share data)
|
|
Three Months Ended March 31,
|
|
|
|
2014
|
|
|
2013
|
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
Net sales
|
|
$
|
1,123
|
|
|
$
|
2,507
|
|
Less:
|
|
|
|
|
|
|
|
|
Product cost of goods sold
|
|
|
457
|
|
|
|
1,385
|
|
Gross profit
|
|
|
666
|
|
|
|
1,122
|
|
Operating expenses:
|
|
|
|
|
|
|
|
|
Sales and marketing
|
|
|
825
|
|
|
|
3,149
|
|
General and administrative
|
|
|
8,949
|
|
|
|
4,797
|
|
Research and development
|
|
|
715
|
|
|
|
1,397
|
|
Total operating expenses
|
|
|
10,489
|
|
|
|
9,343
|
|
Operating loss from operations
|
|
|
(9,823
|
)
|
|
|
(8,221
|
)
|
Other income (expense), net
|
|
|
(7
|
)
|
|
|
(2
|
)
|
Loss from operations before income taxes
|
|
|
(9,830
|
)
|
|
|
(8,223
|
)
|
Income tax benefit (expense)
|
|
|
-
|
|
|
|
-
|
|
Net loss
|
|
$
|
(9,830
|
)
|
|
$
|
(8,223
|
)
|
Net loss (basic and diluted) per common share
|
|
$
|
(0.06
|
)
|
|
$
|
(0.05
|
)
|
Weighted average shares outstanding, basic and diluted
|
|
|
174,317,653
|
|
|
|
166,485,724
|
|
See notes to condensed
consolidated financial statements.
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’
EQUITY
FOR THE THREE MONTHS ENDED MARCH 31,
2014 (UNAUDITED)
($ and share data in thousands)
|
|
Common stock
|
|
|
Additional
Paid-In
|
|
|
Accumulated
|
|
|
|
|
|
|
Shares (A)
|
|
|
Amount
|
|
|
Capital
|
|
|
Deficit
|
|
|
Total
|
|
Balances, December 31, 2013
|
|
|
172,369
|
|
|
$
|
17
|
|
|
$
|
271,327
|
|
|
$
|
(264,365
|
)
|
|
$
|
6,979
|
|
Stock issuance
|
|
|
5,100
|
|
|
|
1
|
|
|
|
5,112
|
|
|
|
-
|
|
|
|
5,113
|
|
Warrant and option exercise
|
|
|
4,168
|
|
|
|
-
|
|
|
|
4,168
|
|
|
|
-
|
|
|
|
4,168
|
|
Stock-based compensation
|
|
|
223
|
|
|
|
-
|
|
|
|
3,545
|
|
|
|
-
|
|
|
|
3,545
|
|
Net Loss
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
(9,830
|
)
|
|
|
(9,830
|
)
|
Balances, March 31, 2014 (unaudited)
|
|
|
181,860
|
|
|
$
|
18
|
|
|
$
|
284,152
|
|
|
$
|
(274,195
|
)
|
|
$
|
9,975
|
|
|
(A)
|
In January 2014, an immaterial number of shares (15,230 shares) were reclassified from outstanding to available for
issuance. The outstanding shares at December 31, 2013 were revised to account for the share reclass
|
See notes to condensed consolidated financial
statements.
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS
($ in thousands)
|
|
Three Months Ended March 31,
|
|
|
|
2014
|
|
|
2013
|
|
|
|
(Unaudited)
|
|
|
(Unaudited)
|
|
Operating activities:
|
|
|
|
|
|
|
|
|
Net loss
|
|
$
|
(9,830
|
)
|
|
$
|
(8,223
|
)
|
Adjustments to reconcile net loss to net cash flows from operating activities:
|
|
|
|
|
|
|
|
|
Depreciation and amortization
|
|
|
43
|
|
|
|
83
|
|
Provision for inventory obsolescence
|
|
|
(1
|
)
|
|
|
5
|
|
Stock-based compensation
|
|
|
5,232
|
|
|
|
1,003
|
|
Increase (decrease) in cash resulting from changes in:
|
|
|
|
|
|
|
|
|
Current assets
|
|
|
552
|
|
|
|
134
|
|
Current liabilities
|
|
|
(763
|
)
|
|
|
992
|
|
Net cash flows used in operating activities
|
|
|
(4,767
|
)
|
|
|
(6,006
|
)
|
Investing activities:
|
|
|
|
|
|
|
|
|
Proceeds from sale of licensing rights
|
|
|
9
|
|
|
|
8
|
|
Net cash flows from (used in) investing activities
|
|
|
9
|
|
|
|
8
|
|
Financing activities:
|
|
|
|
|
|
|
|
|
Proceeds from issuance of common stock
|
|
|
5,113
|
|
|
|
-
|
|
Proceeds from stock option and warrant exercise
|
|
|
4,168
|
|
|
|
30
|
|
Payments on long-term debt
|
|
|
-
|
|
|
|
(5
|
)
|
Net cash flows from financing activities
|
|
|
9,281
|
|
|
|
25
|
|
Increase (decrease) in cash and cash equivalents from continuing operations
|
|
|
4,523
|
|
|
|
(5,973
|
)
|
Cash flows used in discontinued operations:
|
|
|
|
|
|
|
|
|
Net cash flows used in operating activities
|
|
|
(25
|
)
|
|
|
(1,038
|
)
|
Net cash flows used in investing activities
|
|
|
-
|
|
|
|
-
|
|
Net cash flows from financing activities
|
|
|
-
|
|
|
|
-
|
|
Net cash flows from discontinued operations
|
|
|
(25
|
)
|
|
|
(1,038
|
)
|
Increase (decrease) in cash and cash equivalents
|
|
|
4,498
|
|
|
|
(7,011
|
)
|
Cash and cash equivalents, beginning of period
|
|
|
3,881
|
|
|
|
23,121
|
|
Cash and cash equivalents, end of period
|
|
$
|
8,379
|
|
|
$
|
16,110
|
|
See notes to condensed consolidated financial
statements.
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS
The accompanying unaudited condensed
consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United
States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.
In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation
of the results of operations for the periods presented have been included. Operating results for the three months ended March 31,
2014 and 2013 are not necessarily indicative of the results that may be expected for the fiscal year. The balance sheet at December
31, 2013 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes
required by GAAP for complete financial statements.
You should read these condensed
consolidated financial statements together with the historical consolidated financial statements of the Company for the years ended
December 31, 2013, 2012, and 2011 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013,
filed with the Securities and Exchange Commission, or SEC, on March 17, 2014 (the “Annual Report”).
2.
|
Liquidity and managements’ plans:
|
|
The Company has been operating at a loss for the
past eleven years. Star Scientific’s future prospects will depend on its ability to transition into the area of drug development,
and the distribution and consumer acceptance of its products and line extensions of those products. In the long term, the Company
expects that its revenues will shift to be more dependent on the ability to successfully implement its drug development program,
but it has no drug products in advance development as of this date. The Company has considerable intellectual property related
to the low-TSNA (as defined below) curing methodology and dissolvable tobacco products, which it intends to pursue through licensing
agreements in exchange for royalties or other payments.
Star Scientific introduced Anatabloc
®
,
its dietary supplement for anti-inflammatory support, in August 2011 through an interactive website and a customer service
center. Since the introduction of Anatabloc
®
, the Company’s revenues
have been derived almost exclusively from the sale of this product. Future sales of the Company’s dietary supplements will
be dependent on it resolving issues with the Federal Drug Administration “FDA” relating to the status of its Anatabloc
®
and CigRx
®
products and any other developments with respect
to the status of those products, given the fact that the Company has limited the marketing and advertising of its dietary supplements
following receipt of the FDA warning letter in December 2013.
On March 12, 2014, the Company entered into a series
of equity and financing transactions that resulted in gross cash proceeds to it of approximately $9.3 million and cash availability
under a credit facility of approximately $5.8 million, for total available funds of $15.1 million. Under one of its transactions,
holders of previously held warrants with strike prices ranging from $1.50 to $2.00 agreed to immediately exercise an aggregate
of 4.2 million warrants at a reduced strike price of $1.00 per share. The investors also were issued new warrants for an equal
number of shares that have a term of seven years and a strike price of $1.00 per share. This transaction resulted in proceeds of
approximately $4.2 million. Under another transaction the Company sold 5.1 million shares with matching warrants to purchase another
5.1 million shares to other investors at a purchase price of $1.00 for each share and its matching warrant. This transaction resulted
in proceeds to us of $5.1 million. Finally, the Company entered into a credit facility with another investor under which that investor
agreed to loan it up to $5.8 million. The credit facility provides for an interest rate of 3% on any funds drawn by the Company.
It also provides the lender with the option to convert any loan amount to a unit consisting of a share of the Company’s common
stock and a matching seven-year warrant at a conversion price of $1.00 per unit.
While the Company may seek to obtain funds in the
future through other financing arrangements, there is no guarantee that these efforts would be successful or commercially feasible
given its continued operating losses. Moreover, the Company’s ability to raise future funds on terms acceptable to it (including
through the exercise of outstanding warrants) will depend on a number of factors, including the performance of the Company’s
stock price and its operational performance. Any equity financing will be dilutive to the Company’s existing shareholders.
The Company believes it has sufficient funds to operate
through the first quarter of 2015. Depending upon market conditions and the price of its common stock, the Company may decide to
seek additional funds before that time. There can be no assurance that the Company will be successful in obtaining such funding
at commercially reasonable terms.
3.
|
Discontinued Operations:
|
|
Since the 1990s, the Company has sought to develop
processes that significantly prevent the formation of one of the most abundant and significant groups of carcinogens, tobacco specific
nitrosamines, or TSNAs, found in tobacco and tobacco smoke. The Company utilized this technology in producing low-TSNA tobacco
and related low-TSNA dissolvable smokeless tobacco products as less harmful alternatives to cigarettes and traditional smokeless
tobacco products and as a platform to provide a base of financial support for its intellectual property, licensing and development
initiatives.
On December 14, 2012, the Company’s Board of
Directors (the “Board”) voted unanimously to discontinue the manufacturing, distribution and sale of the Company’s
dissolvable smokeless tobacco products, Ariva
®
and Stonewall Hard Snuff
®
as of December 31, 2012. The Board was motivated to take this action in light of the continued losses and low
sales for its dissolvable tobacco products over the several years preceding this decision. It was also motivated by the fact that
restrictions under the Family Smoking Prevention and Tobacco Control Act which prohibit a company from making any statements about
the comparative safety of various types of tobacco products made it extremely difficult to effectively market its dissolvable tobacco
products, notwithstanding that they represented a meaningful alternative to cigarettes and traditional smokeless tobacco products.
The Board’s action was further influenced by the fact that continuing to manufacture dissolvable tobacco products had a negative
impact on its ability to interest leading research centers in undertaking clinical research related to its anatabine compound and
its potential for providing support in managing excessive inflammation.
At the time it discontinued its smokeless tobacco
operations, the Company noted that it would continue to look for licensing opportunities for its patented tobacco curing technology
and related low-TSNA smokeless tobacco products. On October 2, 2013, the Company entered into a series of transactions with
Starion LLC, or Starion, a tobacco manufacturer, under which, among other things, it sold equipment and inventory previously utilized
in its discontinued smokeless tobacco business and licensed certain trademarks and patents to Starion for use in the manufacture
and sale of low-TSNA dissolvable smokeless tobacco products. The Company continues to look for licensing opportunities related
to its dissolvable tobacco products and related technology.
The Company incurred severance costs in the form
of salary continuation payments and continued health benefit costs under COBRA of approximately $829,000, for employees transitioning
from Star Tobacco (the subsidiary that was responsible for the Company’s smokeless tobacco operations). In addition, the
Company issued stock awards under the Company’s 2008 Incentive Award Plan in the aggregate amount of 330,000 shares to those
employees transitioning from Star Tobacco, in recognition of their long-time service to the Company. The stock awards had a total
fair value of approximately $1.1 million as well as a gross up charge for taxes of approximately $0.8 million. The total cost in
connection with the discontinuance of the Company’s dissolvable tobacco business was approximately $3.1 million consisting
of cash and non-cash items and was recorded in the fourth quarter of 2012.
|
|
Assets and liabilities of the discontinued operations consisted of the following as of:
|
$ thousand
|
|
March 31,
2014
|
|
|
December 31,
2013
|
|
Current assets:
|
|
|
|
|
|
|
|
|
Accounts receivable, trade
|
|
$
|
-
|
|
|
$
|
-
|
|
Assets held for sale
|
|
|
69
|
|
|
|
69
|
|
Total assets
|
|
$
|
69
|
|
|
$
|
69
|
|
|
|
|
|
|
|
|
|
|
Current liabilities:
|
|
|
|
|
|
|
|
|
Accrued expenses
|
|
$
|
4
|
|
|
$
|
29
|
|
Total current liabilities
|
|
$
|
4
|
|
|
$
|
29
|
|
The Company owns the manufacturing equipment located
at its dissolvable tobacco manufacturing facility in Chase City, Virginia which is being held for sale as a result of the Company’s
decision to exit the dissolvable tobacco business as of December 31, 2012.
Inventories consisted of the
following as of:
$ thousands
|
|
March 31,
2014
|
|
|
December 31,
2013
|
|
Raw materials
|
|
$
|
1,619
|
|
|
$
|
1,457
|
|
Packaging materials
|
|
|
1,372
|
|
|
|
1,374
|
|
Work in process
|
|
|
67
|
|
|
|
67
|
|
Finished goods
|
|
|
1,697
|
|
|
|
1,983
|
|
|
|
|
4,755
|
|
|
|
4,881
|
|
Obsolescence allowance
|
|
|
(1,407
|
)
|
|
|
(1,408
|
)
|
|
|
$
|
3,348
|
|
|
$
|
3,473
|
|
Stock Option Plans:
Prior to 2008 the Company adopted a 1998 Stock Option
Plan, and a 2000 Equity Incentive Plan, and in September 2008 it adopted a 2008 Incentive Award Plan (collectively the “Plans”).
The Plans provide for grants of options to those officers, key employees, directors and consultants whose substantial contributions
are essential to the continued growth and success of the Company. In the aggregate the Plans provide for grants of both qualified
and non-qualified stock options to purchase up to 43,200,000 shares at a purchase price equal to the fair market value on the date
of grant in the case of qualified options granted to employees.
On January 2, 2014, the Company issued 3,000,000
stock options with an exercise price of $1.16 to Dr. Michael J. Mullan, the Company’s Chairman and CEO, pursuant to his employment
contract. On January 3, 2014, the Company granted awards of 223,052 shares that vested immediately with a share price of $1.02
per share to two of its brand ambassadors pursuant to their agreements with the Company to promote its dietary supplement and cosmetic
products. On February 2, 2014, the Company issued 100,000 and 150,000 stock options with an exercise price of $1.30 and $2.00,
respectively, and issued 50,000 shares of stock to the Company’s Vice President of Corporate Development and Strategy
at the time he joined the Company.
At March 31, 2014, there were
25,335,000 options issued and outstanding with a weighted average exercise price of $2.14 per share.
A summary of the status of the
Company’s unvested stock options at March 31, 2014, and changes during the quarter then ended, is presented below.
Non-Vested Stock Options
|
|
Shares
|
|
|
Weighted
Average
Grant-Date Fair
Value
|
|
Non-Vested at December 31, 2013
|
|
|
4,710,000
|
|
|
$
|
0.95
|
|
Granted
|
|
|
3,250,000
|
|
|
|
0.85
|
|
Vested
|
|
|
-
|
|
|
|
-
|
|
Forfeited
|
|
|
(60,000
|
)
|
|
|
(1.41
|
)
|
Non-Vested at March 31, 2014
|
|
|
7,900,000
|
|
|
$
|
0.90
|
|
As of March 31, 2014, there
was $6.0 million of unrecognized compensation cost related to unvested share-based compensation arrangements under the Plans.
During the three months ended
March 31, 2014, no stock options were exercised.
The outstanding stock options
as of March 31, 2014 had no intrinsic value.
Warrant activity:
During the three months ended
March 31, 2014, 4.2 million warrants were exercised resulting in gross proceeds to the Company of $4.2 million. There was no aggregate
intrinsic value of the warrants exercised.
During the three months ended
March 31, 2014, 9.2 million warrants with a strike price of $1.00 were issued as a part of the financing described in Note 2.
As of March 31, 2014, the Company
had 15,587,580 warrants outstanding with a weighted average exercise price of $1.29 per share. The intrinsic value of the exercisable
warrants at March 31, 2014 was zero.
Net Loss Basic and Diluted
Per Common Share:
Due to the Company’s net
losses, basic and diluted loss per share was $(0.06) and $(0.05) for the three months ended March 31, 2014 and 2013, respectively.
An aggregate of 40,922,580 at March 31, 2014 and 34,012,501 at March 31, 2013 of stock options and warrants outstanding were excluded
from this computation because they would have had an anti-dilutive effect.
6.
|
Commitments, Contingencies and Other Matters:
|
Class Action Lawsuits
Three individuals, Francis J. Reuter, Charles Boravian
and Marty Cole, filed separate similar purported class actions on behalf of putative classes of persons or entities collectively
encompassing those who purchased or otherwise acquired shares of the Company’s common stock between October 31, 2011 and
March 18, 2013. The first action was filed on or about March 25, 2013 in the United States District Court for the Eastern District
of Virginia, Francis J. Reuter v. Star Scientific, Inc. et al., E.D. Va. Richmond Division, 13-00183-JAG (the “Reuter Action”).
The Reuter Action named as defendants the Company, its subsidiary, Rock Creek Pharmaceuticals, Inc., and certain of the Company’s
current or former officers and/or employees. The second action was filed on or about March 26, 2013 in the United States District
Court for the District of Massachusetts, Boravian v. Star Scientific, Inc. et al. D. Mass. 13-1-695-DJC (the “Boravian Action”).
The Boravian Action named as defendants the Company and Jonnie R. Williams, Sr. and was voluntarily dismissed by the plaintiff.
The third action was filed on or about May 7, 2013 in the United States District Court for the Eastern District of Virginia, Cole
v. Star Scientific, Inc. et al., E.D. Va. Richmond Division, 13-00287-JAG (the “Cole Action”). The Cole Action
named as defendants, the Company, its subsidiary, Rock Creek Pharmaceuticals, Inc., and certain of its officers and employees.
In general, the complaints collectively allege that the Company and the individual defendants violated Section 10(b) under the
Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder as related to statements made regarding its past and future
prospects and certain scientific data relating to its products, as well as related to unspecified private placements and related
party transactions engaged in since 2006. The Reuter Action and the Cole Action have been consolidated and a lead plaintiff
was appointed by the Court in the consolidated cases on June 21, 2013. Pursuant to a joint scheduling order in place in these cases,
plaintiff filed a consolidated operative complaint on September 5, 2013 and defendants filed a motion to dismiss the consolidated
operative complaint on October 25, 2013. Following full briefing and argument on January 7, 2014, the Court indicated that
it would not grant the motion at that time and would allow the case to proceed to discovery, but ordered additional briefing.
Also the Court entered a scheduling order for discovery and an order directing the parties to participate in mediation before a
Magistrate Judge. Defendants thereafter filed answers. Subsequently, the United States on January 28, 2014 moved to stay
discovery in the case pending the completion or other disposition of the criminal trial of former Governor McDonnell and his wife.
That motion was granted by the Court on January 28, 2014. On February 12, 2014, the Court granted a joint motion by the parties
to stay all deadlines other than a court sponsored mediation session and the issuance of the Court's opinion on the motion to dismiss.
On March 11, 2014, Defendants filed a motion for leave to submit new authority in support of their motion to dismiss. On March
13, 2014, the Court granted Defendants’ motion and ordered the submission of additional supplemental briefs by the parties.
Those briefs were filed on March 19, 2014 and March 26, 2014. The Company intends to continue to defend vigorously these claims.
However, at this time, it cannot predict the probable outcome of these claims. Accordingly, no amounts have been accrued in
the consolidated financial statements.
Shareholder Derivative Lawsuits
Four individuals, David C. Inloes, William Skillman,
Harold Z. Levine and Louis Lim, filed separate, but similar derivative actions naming all or most of the Company’s then current
Directors, several Officers of the Company and, in one case, one former Director as defendants. Two of the actions were filed in
the United States District Court for the Eastern District of Virginia, Alexandria Division (the “Alexandria Actions”).
The first Alexandria Action, William Skillman v. Jonnie R. Williams et al., was filed on May 2, 2013. The second Alexandria Action,
David C. Inloes v. Jonnie R. Williams et. al. was filed on May 3, 2013. The Alexandria Actions have been consolidated and
co-lead counsel appointed by the Court. Pursuant to a court order plaintiffs filed a consolidated amended complaint on January
13, 2014 and a motion to dismiss was filed on February 3, 2014 on behalf of all of the defendants. Also, on February 3, 2014
the Company, as nominal defendant, moved to stay or dismiss this action pending a resolution of the securities class action litigation
pending in Federal Court in Richmond, Virginia. Separately, on January 29, 2014, the United States moved to stay discovery in the
case pending the completion or other disposition of the criminal trial of former Governor McDonnell and his wife. That motion
was granted by the Court on January 30, 2014. On February, 28, 2014, the Court granted the Company’s motion to stay
the case, ruling that the case would be stayed for all purposes pending further order of the Court and ordering the Company, within
ten days of the dismissal or resolution of the Richmond securities class action or the trial court's verdict in the McDonnell case,
whichever occurs first, to file a report indicating what action, if any, it intends to take with regard to this case, including
specifically, without limitation, whether it intends to pursue or seek dismissal of the claims asserted against each of the named
individual defendants.
The third derivative action, Harold Z. Levine v.
Jonnie R. Williams, et. al., was filed on July 8, 2013, in the Circuit Court for the City of Richmond and the fourth case, Louis
Lim v. Christopher C. Chapman, et. al., was filed in the Circuit Court for Henrico County on July 11, 2013. In general, the
complaints collectively allege that the Company’s Directors and Officers breached their fiduciary duties by causing the Company
to issue false and misleading statements regarding its past and future prospects and certain scientific data relating to its products,
as well as engaging in certain unspecified private placements and related party transactions since 2006. On July 1, 2013
and August 1, 2013, stipulations were filed in each of the state court actions which would stay the period for defendants to respond
to the complaints until a date established in an agreed upon schedule is in place or until forty days after the parties advise
the court that they are unable to reach an agreement on such a schedule. The Company intends to vigorously defend against
these claims. However, at this time, it cannot predict the probable outcome of these claims. Accordingly, no amounts
have been accrued in the consolidated financial statements.
Demands for Inspection of Books and
Records and for Investigation
Two individuals, Bruce A. Welker and Michael Weber,
have written to the Company requesting that it produce various books and records pursuant to Delaware Code Section 220. Mr.
Welker’s letter was dated May 31, 2013 and the letter sent on behalf of Mr. Weber was dated June 5, 2013. The Company
has responded by letter to these demands, has been in subsequent communication with counsel regarding the demands, and has produced
certain documents to the shareholders. One individual, Steven Segall, has written to the Company’s Board of Directors
and demanded that the Board investigate certain claims and take appropriate remedial action in response to alleged wrongdoing that
took place between 2010 and 2013. The Company advised Mr. Segall that the Board of Directors would review the issues raised
in his demand letter and further respond once that review was complete. Following a full review by a Committee of Independent
Directors, assisted by separate outside counsel, the Board upon recommendation of the Committee determined that Mr. Segall’s
demand should be refused pending the outcome of related securities litigation and directed that this decision be communicated to
counsel for Mr. Segall.
FDA Warning Letter
On December 24, 2013, the Company received a Warning
Letter, from the FDA regarding its CigRx
®
and Anatabloc
®
dietary supplements. In the letter
the FDA asserted that CigRx
®
and Anatabloc
®
were not properly marketed as dietary supplements, since
the Company had not filed a New Dietary Ingredient Notification for anatabine as a dietary ingredient prior to the introduction
of its dietary supplements. The FDA also claimed that certain materials on the Company’s websites, including published
research articles, contained drug claims for Anatabloc
®
. The Company responded to the Letter on January 31,
2014, contesting the FDA’s position with respect to the status of the Company’s dietary supplements and noting that
it had voluntarily removed from its websites, materials objected to by the FDA. The Company is currently communicating with
the FDA in an effort to reach an amicable resolution of the issues asserted in the Warning Letter.
Consumer Class Action
On January 27, 2014, Howard T. Baldwin filed a purported
class action naming the Company, Rock Creek and GNC Holding, Inc., or GNC, as defendants. The case was filed in the
United States District Court for the Northern District of Illinois. Generally, the complaint alleges that claims made for
the Company’s Anatabloc
®
product have not been proven and that individuals purchased the product based on
alleged misstatements regarding characteristics, uses, benefits, quality and intended purposes of the product. The complaint
purports to allege claims for violation of state consumer protection laws, breach of express and implied warranties and unjust
enrichment. The Company has agreed to indemnify and defend GNC pursuant to the terms of the purchasing agreement between
Rock Creek and GNC. Consistent with that commitment, the Company has agreed to assume the defense of this matter on its own behalf
as well as on behalf of GNC. The defendants filed a motion to dismiss the complaint on March 24, 2014 and plaintiff filed his
response in opposition on April 21, 2014. The defendants have until May 12, 2014 to file their reply memorandum in support of their
motion. The Court has scheduled the motion for oral argument on May 15, 2014. The Company intends to vigorously defend against
these claims. However, at the present time, it cannot predict the possible outcome of these claims. Accordingly, no
amount has been accrued in the consolidated financial statements.
Commitments
The Company had purchase order
and other operating supply commitments totaling $1.3 million as of March 31, 2014.
Item
2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
In preparing the discussion
and analysis contained in this Item 2, we presume that persons reviewing this Item have read or have access to the discussion and
analysis contained in our Annual Report on Form 10-K for the year ended December 31, 2013, which was filed with the Securities
and Exchange Commission (or SEC) on March 17, 2014 and which was amended by the filing of Amendment No. 1 to that Form 10-K on
April 30, 2014 (collectively, our “2013 10-K”). In addition, persons reviewing this Report should read the discussion
and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and
related notes included elsewhere in this Report. The following results of operations include a discussion of the three months ended
March 31, 2014 as compared to the three months ended March 31, 2013.
Overview
Corporate Transition, Leadership
and Operational Changes
Prior to the corporate transition in December
2013, our business strategy focused on:
|
1)
|
selling nutraceutical dietary supplements that provide anti-inflammatory support and decrease the urge to smoke
|
|
2)
|
selling a line of cosmetic products
|
|
3)
|
pursuing ongoing research and development by Rock Creek of related dietary supplements and pharmaceutical products, and
|
|
4)
|
to a much lesser degree seeking to license our low-TSNA curing technology and related products.
|
In late 2013, our senior management and
Board of Directors determined to undertake certain significant corporate changes in order to better take advantage of the potential
opportunities in the area of pharmaceutical products, including the development of products approved by the U.S. Food and Drug
Administration (the “FDA”). In December 2013, our stockholders approved various matters necessary to effect the
corporate transition. As part of the corporate transition, Michael J. Mullan, MBBS (MD), PhD was appointed to serve as our
Chief Executive Officer and as Chairman of our Board of Directors, and Christopher C. Chapman, MD was appointed to serve as our
President. In addition to these significant management changes, our stockholders elected a new Board of Directors consisting
of five new directors (including Dr. Mullan) and one existing director (Dr. Chapman).
The corporate transition was driven, in
large part, by our belief that our company has evolved such that, from an operational standpoint, it is in our best interest to
focus more on pharmaceutical products because there is potential for greater revenue growth through pharmaceutical product sales
(for various reasons, including market acceptance of FDA-approved pharmaceutical products, the ability to market such products
on a broader scale and recent Anatabloc
®
research in support of the feasibility of pursuing FDA applications).
Drs. Mullan and Chapman have extensive experience in the commercial aspects of the development, approval process and marketing
of pharmaceutical products. Additionally, in connection with this corporate transition, we will be required to generate the
appropriate preclinical and clinical data needed for Investigational New Drug (“IND”) applications related to pharmaceutical
products. Drs. Mullan and Chapman are highly experienced in this area as well. Dr. Chapman has extensive experience with the IND
process that will be invaluable in implementing part of the Company’s strategy going forward. Further, Dr. Mullan has strong
scientific credentials that will be necessary to generate the information for the IND process as well as experience interacting
with applicable scientific consultants and others with respect to the IND process.
As part of our corporate transition we
are consolidating offices and moving functions to a new corporate headquarters in Sarasota, Florida. Our company’s Compensation
Committee has approved a severance plan for employees whose positions will not be continued as a result of this transition.
Also as part of our transition, our former Chief Executive Officer, Jonnie R. Williams, Sr. and our former President and Chief
Operating Officer, Paul L. Perito, resigned from their prior positions with the Company and assumed the role of a non-executive
employee, in the case of Mr. Williams, and the role of Vice President and Senior Counsel, Legal and Regulatory Affairs, in
the case of Mr. Perito. We anticipate that, as part of our transition, our company will enter into separate severance arrangements
with Messrs. Perito and Williams.
Our Company and Products
In recent years, we have engaged primarily
in the sale of nutraceutical dietary supplements and related cosmetic products, and pursuing ongoing research and development by
our subsidiary, Rock Creek, of related dietary supplements and pharmaceutical products. We continue to operate our nutraceutical
supplement and cosmetic lines of business and have been evaluating this aspect of our business in light of our corporate transition
and the matters raised in a warning letter we recently received from the FDA regarding our CigRx
®
and Anatabloc
®
dietary supplements (discussed below). However, we also expect that, by leveraging the underlying science and clinical data accumulated
by us in relation to our existing products, we will focus our operations on the research and development of drug candidates.
We expect much of these research and development efforts will initially focus on developing our anatabine compound as a potential
drug candidate.
We historically have focused on utilizing
certain alkaloids found in the Solanacea family of plants, which includes potatoes, tomatoes, and eggplants, initially to address
issues related to the desire to smoke or use other traditional tobacco products. More recently, we have concentrated on the anti-inflammatory
aspects of one of those alkaloids, anatabine. Currently, Rock Creek manufactures and sells two nutraceutical dietary
supplements: Anatabloc
®
, for anti-inflammatory support, and CigRx
®
, for assistance in fighting the
urge to smoke cigarettes. Rock Creek also has been involved in the development of a cosmetic line of products that utilizes our
anatabine compound to improve the appearance of the skin. We introduced Anatabloc
®
Facial Crème in September
2012 and related line extensions in 2013. Since the introduction of Anatabloc
®
, our revenues have been derived
almost exclusively from the sale of our anatabine based nutraceutical products and, more particularly, Anatabloc
®
.
We do not expect to recognize any revenues related to our drug development initiatives for the foreseeable future.
Prospects for Our Operations
General Overview of Operations and Current
Financial Condition
The recurring losses generated by our business
continue to impose significant demands on our liquidity. Our future prospects will be highly dependent on our ability to successfully
implement our current strategy to better take advantage of the potential opportunities in the area of pharmaceutical products,
including the development of products approved by the FDA. Our ability to appropriately scale our sales and marketing expenses
for these products, manage overall operating expenses, as well as raise additional capital necessary to support our operations,
will be key to future operations and financial condition (particularly given the capital intensive nature of drug development).
Sales of Anatabloc
®
were responsible for virtually all of our dietary supplement
revenue during the three months ended March 31, 2014 and 2013. We do not expect to generate revenue from the sale of pharmaceutical
products in the near term, given the long timeframe for approval of these products. We have and will continue to seek to
generate revenues through royalties from the patented tobacco curing process with respect to which we are the exclusive licensee
and for our related products, but royalty revenues have been insignificant to date.
We recognized net revenue of approximately
$1.1 million for three months ended March 31, 2014 and a loss from continuing operations of approximately $(9.8) million. The recurring
losses generated by our operations continue to impose significant demands on our company’s liquidity. As of March 31,
2014, we had approximately $8.1 million of working capital, of which approximately $8.4 million was cash and cash equivalents.
On March 12, 2014, we entered into a series of equity and financing transactions that resulted in gross cash proceeds to us of
approximately $9.3 million and a credit facility of $5.8 million, for total funds available of $15.1 million. For a discussion
of this financing transaction, see Note 2 “Liquidity and Managements’ Plans” of the condensed consolidated financial
statements included in this Report. We currently believe that, after giving effect to this transaction, we have sufficient
funding to support our operations through the first quarter of 2015. However, there are factors that could make it necessary
for us to seek to raise additional capital before that time, and there is no assurance that we will be successful in obtaining
funding on commercially favorable terms, if at all. For a discussion of these factors, see “Liquidity and Capital Resources,”
below.
Regulatory Hurdles; IND Process
The drug development business is highly
regulated, and will require us to file an IND application related to any new pharmaceutical products we intend to introduce.
While we intend to file an IND application during the second quarter of 2014, the filing of the IND could be delayed if there is
difficulty in assembling scientific data necessary to support the IND application. In addition, there can be no assurance
that, once we file, an IND application the FDA will not impose a regulatory hold on the initiation of clinical trials, if it believes
that the data supporting the IND is insufficient.
In addition, we intend to file
a Clinical Trial application (“CTA”) by the end of the second quarter of 2014 in the United Kingdom.
Capital Intensive Nature of Drug Development
The drug development business is very capital
intensive, particularly for early stage companies that do not have significant off-setting revenues. Even if we are successful
in filing an IND, our product development initiatives will be substantially dependent on our ability to continue our research initiatives
and to obtain the funding necessary to support these initiatives. Our inability to continue these initiatives and initiate
new research and development efforts could result in a failure to develop new products or to improve upon existing products.
FDA Warning Letter
On December 24, 2013, we received a Warning
Letter from the FDA regarding our CigRx
®
and Anatabloc
®
dietary supplements. In the letter,
the FDA asserted that CigRx® and Anatabloc® were not properly marketed as dietary supplements, since our company had not
filed a New Dietary Ingredient Notification for anatabine as a dietary ingredient prior to the introduction of our dietary supplements.
The FDA also claimed that certain materials on our websites, including published research articles, contained drug claims
for Anatabloc
®
. We responded to the FDA’s letter on January 31, 2014 contesting the FDA’s position
with respect to the status of our dietary supplements and noting that we had voluntarily removed website and other materials objected
to by the FDA. We are currently communicating with the FDA in an effort to reach an amicable resolution of the issues asserted
in the warning letter.
Investigations and Other Litigation
In late January and February 2013 our company,
directors and others received subpoenas from the United States Attorney’s Office, or USAO, for the Eastern District of Virginia
seeking documents. We believe we have responded to substantially all of the issues being reviewed by the USAO. In addition,
the international law firm of Chadbourne & Parke LLP conducted an internal investigation of these matters and that investigation
was substantially completed in late June 2013. As previously reported, based on the results of the internal investigation,
the cooperation with the USAO, and discussions and communications between our outside counsel and the USAO, we do not believe our
company will be prosecuted for any of the matters that the USAO has been investigating.
We incurred substantial legal expenses
in connection with the government and internal investigations discussed above in 2013, although those expenses declined significantly
later in 2013 as the USAO investigation with respect to our company neared completion. However, we expect to continue to
incur additional legal expenses in 2014 in connection with the USAO investigation which has resulted in the indictment against
former Governor Robert McDonnell and his wife, Maureen McDonnell. We also expect to continue to incur legal expenses (and related
cash demands) in connection with the civil actions and other matters discussed under “Part II- Legal Proceedings” of
this Report and such expenses and cash demands relating to those matters may be material. We expect that much of the cost
related to the ongoing securities class action and derivative actions discussed in Part II of this report will be covered by insurance,
but cannot provide any assurances with respect to the outcome of the pending actions, or action yet to arise, including that such
claims will not exceed the limits of our insurance policies.
Our Product and Product Development
Initiatives
Dietary Supplements and Development
of Pharmaceutical Products.
Anatabloc
®
, which is intended
to provide anti-inflammatory support, is currently being sold through our interactive website and our customer service center.
Also, Anatabloc
®
is available on a pay-on-scan basis through GNC, a retailer of dietary supplements, through
its online store as well as through its more than 4,000 company-owned stores and franchised retail locations. The Company’s
initial marketing of Anatabloc
®
had been primarily directed toward physicians
and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups
of individuals who are frequently seeking to maintain healthy levels of inflammation. In 2013, our company sought to further align our
marketing and distribution efforts with GNC as our primary strategic partner for growth. Following this realignment
we experienced a decline in sales volumes in our company’s internet sales and although sales volumes at GNC increased, our
overall sales volume and revenue declined given the lower wholesale pricing to GNC as compared to our retail pricing for product
sold through the Company’s website. We have been evaluating our dietary supplement business in light of our corporate
transition and in light of the FDA warning letter that we received in December 2013.
In 2009, Rock Creek developed a non-nicotine,
non-tobacco nutraceutical, CigRx
®
, that is intended to temporarily reduce
the desire to smoke. We continue to market this product on our interactive website and through limited retail distribution. Consistent
with the transition of our company’s focus, we anticipate concentrating more of our effort in the future on the development
of pharmaceutical products with clinical claims, as well as pharmaceutical products for the treatment of a range of conditions,
including Alzheimer’s disease, Parkinson’s disease, multiple sclerosis, schizophrenia, depression and Hashimoto's
autoimmune thyroiditis.
Cosmetics
.
We introduced
our anatabine-based cosmetic products, Anatabloc
®
Facial Crème
in September 2012 and Anatabloc
®
Revitalizing Facial Serum in March 2013. Our
Anatabloc
®
Clarifying Facial Cleanser, which does not contain anatabine, was
introduced in August 2013. These products, which are intended to improve the appearance of the skin, are currently sold on our
interactive website and customer service center. Also, GNC began carrying our Anatabloc
®
Facial Crème on its website in February 2013 and in April 2013 began carrying our Anatabloc
®
Revitalizing Facial Serum. Our Anatabloc
®
Facial Crème
and Anatabloc
®
Revitalizing Facial Serum also are available at select GNC
franchise locations.
Research Related to Our Dietary
Supplements and Cosmetic Products.
Since 2011, Rock Creek, the Roskamp Institute and researchers at Johns
Hopkins University, have completed and reported on a number of studies designed to assess the ability of our anatabine
compound to lower chronic inflammation in a variety of pre-clinical (non-human) and clinical (human) settings. For a
description of our relationship with the Roskamp Institute, see “Item 1. Business - Our Current Product Development
Initiatives-Our Relationship with the Roskamp Institute” in our 2013 10-K. One study conducted by the Roskamp Institute
and reported in
The European Journal of Pharmacology
showed that anatabine lowered levels of amyloid production
both in the test tube and when administered to mice vulnerable to accumulation of amyloid which, at excessive levels, damages
brain tissue. A second manuscript written by the same researchers and published online in
The European Journal of
Pharmacology
in 2012 and in manuscript form in January 2013, further characterized the anti-inflammatory effects of
anatabine in several types of animal tissues, in human cells, and in human whole blood. The Roskamp Institute also presented
results of pre-clinical studies of anatabine in mouse models of multiple sclerosis, traumatic brain injury, and
Alzheimer’s disease at the Neuroscience 2012 conference held in New Orleans in October 2012. In January 2013,
the results of the animal multiple sclerosis study were published in PLoS One under the title “Amelioration of
Experimental Autoimmune Encephalomyelitis by Anatabine.” Further, a pre-clinical investigator-initiated and
independently funded study from Johns Hopkins that examined the effect of anatabine supplementation in a mouse model of
autoimmune thyroiditis was published in September 2012 in an article entitled, “Anatabine Ameliorates
Experimental Autoimmune Thyroiditis” in the Endocrine Society’s journal,
Endocrinology
(Endocrinology. 2012 Sep; 153(9):4580-7).
In 2013, Rock Creek received positive results
from a study conducted by researchers at the University of Virginia Medical School investigating the effects of anatabine in an
animal model of ulcerative colitis. Rock Creek also received functional binding data from a study it sponsored that offers an explanation
and a possible mechanism of action for some of the observed effects of anatabine.
Rock Creek also has been involved in human
(clinical) trials evaluating the impact of supplementation with anatabine citrate on an inflammatory marker, C-reactive protein,
or CRP, (which is believed to be an indicator of coronary heart disease), on Hashimoto’s autoimmune thyroiditis, in individuals
with mild to moderate Alzheimer’s disease and in a multi-site study of Anatabloc
®
Facial Crème. In February 2012, Rock Creek reported research on the first clinical trial demonstrating that Anatabloc
®
lowers chronic inflammation measured by CRP levels in the blood. The reported results were obtained in connection
with an in-house study undertaken by Rock Creek that involved a group of smokers who had been using Anatabloc
®
on an extended basis. In October 2012 Rock Creek reported further results, based on an interim look at
the results of a second CRP study that was conducted by the Roskamp Institute as the study sponsor. That interim look showed
that 61% of diabetic subjects (11 of 18) taking metformin (the most common drug prescribed to diabetics) had a CRP reduction,
as did 38% of the general trial population not taking metformin (31 of 81). Overall, 42 of 99 subjects (42%) had a decrease in
CRP after one month of anatabine supplementation. After further, extensive review of the interim data from this CRP study,
Rock Creek and the Roskamp Institute completed the study report, which confirmed the interim findings reported in October 2012. The
report further confirmed that the supplement was safe and well tolerated, but that given the cyclical nature of CRP levels further
enrollment in the study would not be productive.
On January 7, 2013, Rock Creek reported
initial results for its Thyroid Health Study. Those results suggest that dietary supplementation with anatabine ameliorates
the immune system’s targeting of the thyroid gland in cases of autoimmune thyroiditis. On October 31, 2013, the results
of the Thyroid Health Study were published on-line in
The Journal of Clinical Endocrinology & Metabolism
in a peer-reviewed
brief report entitled “Anatabine supplementation decreases thyroglobulin antibodies in patients with chronic lymphocytic
autoimmune (Hashimoto’s) thyroiditis”. Also in October 2013, a peer-reviewed article titled, “Effects of
Dietary Supplementation with the Solanacea Plant Alkaloid Anatabine on Joint Pain and Stiffness: Results from an Internet-Based
Survey Study", was published in
Clinical Medicine Insights: Arthritis and Musculoskeletal Disorders.
The Alzheimer’s study that is being
sponsored by Rock Creek and conducted and paid for by the Roskamp Institute began enrolling subjects at the end of August 2012.
As of May 1, 2014, 83 subjects had been screened, 62 subjects had been enrolled in the study and 53 subjects had completed
the study. This study has now been suspended pending filing of an IND, but an interim analysis is anticipated which may influence
the decision to proceed with this study. Both the double-blind and open-label portion of the Anatabloc
®
Facial Crème study were completed at the end of August 2013. A total of 109 of the 117 subjects
enrolled in the study completed the double-blind portion of the study and 85 of 88 subjects completed the open-label extension.
The study report is in preparation, but a first look at the data shows that both the active and placebo treatments produced marked
improvements in both investigator and subject-related measures of appearance and severity of conditions.
Federal Regulations of Dietary Supplements,
Drug Products and Cosmetics
Under the Food, Drug and Cosmetic Act,
the FDA, has authority for reviewing and approving any new drug product prior to its introduction into commerce. The FDA approval
process involves, among other things, successfully completing clinical trials under an IND Application and obtaining a premarket
approval after filing a New Drug Application (“NDA”). The NDA process requires a company to prove the safety and efficacy
of a new drug product to the FDA’s satisfaction. The Dietary Supplement Health and Education Act (the “DSHEA”),
provides the FDA with authority over the production and marketing of dietary supplements. In certain cases the DSHEA also requires
notification to the FDA before a company begins to market a dietary supplement. The DSHEA does not require prior approval by the
FDA for the introduction of dietary supplements into the market, but does require that such products comply with the requirements
of the DSHEA prior to and after their introduction into commerce. The FDA also has jurisdiction over cosmetic products and claims
made for such products. While premarket approval is not required prior to the marketing of cosmetic products, the ingredients in
such products must be recognized as being safe and appropriate for use in cosmetics and the FDA has authority with respect to the
labeling, packaging and promotion of such products.
Licensing and Intellectual Property
.
Since 2010 we have filed United States
patent applications relating to the active ingredient of our dietary supplement products, uses of the products and product formulations.
These included two applications for therapeutic methods involving the administrations of anatabine, its isomers and derivatives
thereof for treating chronic inflammation that may be associated with disorders such as thyroiditis, cancer, arthritis, Alzheimer’s
disease, and multiple sclerosis, an application for a beverage product containing anatabine or a derivative or salt thereof, an
application for our CigRx
®
formulation and our Anatabloc
®
formulation as well as an application for the synthesis of anatabine and an application for a relapse prevention
product. It also includes two applications that we filed in 2013 for our Anatabloc
®
Facial Crème formulation and for an anatabine based inhaler for smoking cessation. We also filed an application for a design
patent relating to the 20-piece container used for our CigRx
®
and Anatabloc
®
products and a divisional application for food grade salts of anatabine. On October 15, 2013, the United States Patent and Trademark
Office (the “PTO”) issued a patent (Patent No. 8,557,999) to Rock Creek covering anatabine citrate, the active
component in our company’s Anatabloc
®
and CigRx
®
products. In June 2012, the PTO issued a patent to Rock Creek for an improved method of synthesizing anatabine that facilitates
large scale commercial production of high purity anatabine. Also, in August 2012, the PTO issued a patent to Rock Creek for an
anatabine and yerba mate composition and uses thereof in assisting weight loss and curbing the urge for tobacco. In 2011, the PTO
issued a design patent to Rock Creek for the 20-piece dispenser used for our CigRx
®
and Anatabloc
®
products. In 2014 Rock Creek filed a divisional application
with method claims in connection with its prior application for the Anatabloc
®
formulation and in lieu of the previously filed application. We also have several international applications pending that
relate to inflammation-mediated disorders, our anatabine and yerba mate composition, our Anatabloc
®
formulation, a relapse prevention product and the administration of anatabine, its isomers and derivatives thereof generally,
and also for autism and seizure indications.
We are the exclusive licensee under a License
Agreement with Regent Court Technologies, LLC which grants us exclusive worldwide rights to and a right of sublicense for the StarCured
®
process, related patents covering the production of low-TSNA dissolvable smokeless tobacco products and the use of certain MAO
inhibitors in treating neurological conditions. This technology essentially arrests or eliminates microbial activity that
normally occurs during curing, thereby preventing the formation of TSNAs.
Off-Balance Sheet Arrangements
None.
Results of Operations
Our company’s unaudited condensed
consolidated results for the three month periods ended March 31, 2014 and 2013 are summarized in the following table:
|
|
Three Months Ended March 31,
|
|
$ in thousands (except share and per share data)
|
|
2014
|
|
|
2013
|
|
Net sales
|
|
$
|
1,123
|
|
|
$
|
2,507
|
|
Cost of goods sold
|
|
|
457
|
|
|
|
1,385
|
|
Gross profit
|
|
|
666
|
|
|
|
1,122
|
|
Total operating expenses
|
|
|
10,489
|
|
|
|
9,343
|
|
Operating loss from operations
|
|
|
(9,823
|
)
|
|
|
(8,221
|
)
|
Other income (expense), net
|
|
|
(7
|
)
|
|
|
(2
|
)
|
Net loss
|
|
$
|
(9,830
|
)
|
|
$
|
(8,223
|
)
|
Basic and diluted loss per common share
|
|
$
|
(0.06
|
)
|
|
$
|
(0.05
|
)
|
Weighted average shares outstanding
|
|
|
174,317,653
|
|
|
|
166,485,724
|
|
Three Months Ended March 31, 2014 Compared to Three Months
Ended March 31, 2013
Net Sales
. For
the three months ended March 31, 2014, net sales (gross sales less cash discounts, product discounts and product return allowance)
were $1.1 million compared to $2.5 million during same period in 2013. The decrease of 56% was attributable exclusively to decreased
Anatabloc
®
sales volume. The Company significantly reduced marketing related to Anatabloc
®
in response
to the FDA warning letter received in December 2013.
Gross Profit.
We had a gross profit of $0.7 million for the three months ended March 31, 2014 compared to a gross profit of $1.1 million for
the same period in 2013. The decreased gross profit is attributable exclusively to the decreased Anatabloc® sales volume discussed
above.
Total Operating
Expenses.
Total operating expenses (comprised of Sales and Marketing, General and Administrative and Research and Development
expenses) were approximately $10.5 million for the three months ended March 31, 2014, an increase of approximately $1.2 million,
or 12.3%, from approximately $9.3 million for the same period in 2013. General and administrative expenses increased by approximately
$4.2 million, and marketing and distribution costs decreased by approximately $2.3 million. Research and development costs decreased
by approximately $0.7 million.
Sales and Marketing
Expenses.
Sales and Marketing expenses were approximately $0.8 million for the three months ended March 31, 2014, a decrease
of approximately $2.3 million, or 74.2%, from approximately $3.1 million for the same period in 2013. The decrease in marketing
expense was attributable to the reduced promotion of our Anatabloc
®
dietary
supplement in response to the FDA warning letter received in December 2013. We expect our sales and marketing expenses to remain
at these lower levels in the near-term, as we await further discussions of this matter with the FDA.
General and Administrative
Expenses.
General and administrative expenses were approximately $9.0 million for the three months ended March 31, 2014, an
increase of approximately $4.2 million, or 86.6%, from approximately $4.8 million for the same period in 2013. For the three months
ended March 31, 2014, we had decreased legal expenses of $1.0 million primarily related to our response to subpoenas in the government
investigation and our related internal investigation; an increase for non-cash charges of $4.5 million related to stock options
issued and the modification of the time to exercise previously issued stock options. We had increases in executive salaries of
$0.4 million and increases in administrative salaries of $0.2 due to adding two executives, Dr. Mullan as Chairman and CEO and
Dr. Chapman as President. Also the company entered into severance agreements with certain of its employees as part of the office
consolidation plan in connection with our corporate transition. In the near term, we expect decreased expenses as we implement
our office consolidation plan and other measures to reallocate resources to our drug development plans.
Research and Development
Expenses
. We expended approximately $0.7 million on research and development in the three months ended March 31, 2014, compared
to approximately $1.4 million in the comparable period in 2013. The research and development costs in the three months ended March
31, 2014 were directed principally toward the ongoing product development of Anatabloc
®
and the IND submission to
the FDA. In the three months ended March 31, 2014, we incurred $53 thousand of expense based on the Research and Royalty Agreement
with an affiliate of the Roskamp Institute under which we are obligated to pay a royalty of 5% on all Anatabloc
®
sales. See Item 1. Business-Our Current Product Development Initiatives-Our Relationship with the Roskamp Institute”
in our 2013 10-K for more information relating to the Roskamp Institute.
Other Income and Expense, net
. We
had interest income of $8 thousand and miscellaneous expense of $15 thousand for the three months ended March 31, 2014, for a net
other expense of $7 thousand during the period. For the same period in 2013, we had interest income of $3 thousand and miscellaneous
expense of $5 thousand, for a net other expense of $2 thousand.
Net Loss.
We
had a net loss of approximately $9.8 million for the three months ended March 31, 2014 compared to a net loss of approximately
$8.2 million for the same period in 2013. The increased net loss for the three months ended March 31, 2014 was primarily due to
increases in stock based compensation costs offset by lower sales and marketing expenses.
At March 31, 2014,
we had a basic and diluted loss per share of $(0.06) compared to a basic and diluted loss per share of $(0.05) at March 31, 2013.
Liquidity and Capital Resources
We have been operating at a loss for the
past eleven years, which imposes significant cash demands on our business. These conditions were exacerbated by the
expenses we incurred in 2013 in connection with the USAO investigation, which we believe has now been substantially completed as
to our Company, as well as costs associated with the corporate transition. Our future prospects will be dependent on our
ability to transition into the area of drug development, the distribution and consumer acceptance of our products and related line
extensions of those products, our ability to appropriately scale our sales and marketing expenses for these products and manage
our overall operating expenses, and our ability to obtain additional capital necessary to support our operations (particularly
research and development and related expenses in connection with our drug development operations). In the long-term, we expect
that our revenues will shift to be more dependent on our ability to successfully implement our drug development program.
Since the introduction of Anatabloc
®
,
our revenues have been derived almost entirely from the sales of our anatabine based nutraceutical products and, more particularly,
Anatabloc
®
. Future sales of our dietary supplements will be dependent
on our resolving issues with the FDA relating to the status of our Anatabloc
®
and CigRx
®
products and any other developments with respect to the status of
these products, given the fact that we have limited the marketing and advertising of our dietary supplements following our receipt
of the FDA warning letter in December 2013. Our future prospects also will be dependent on our ability to develop pharmaceuticals,
particularly given our intent to concentrate more effort and focus on this area as part of our ongoing corporate transition, and
on our ability to begin generating income through royalties from the patented tobacco curing process with respect to which we are
the exclusive licensee. We continue to market our CigRx
®
non-tobacco
nutraceutical dietary supplement to reduce the desire to smoke, but sales of CigRx
®
have been and continue to be insignificant.
On March 12, 2014, we entered into a series
of equity and financing transactions that resulted in gross proceeds to our company of approximately $9.3 million and cash availability
under a credit facility of $5.8 million, for total funds available of $15.1 million. Under one of the transactions, holders
of previously held warrants with strike prices ranging from $1.50 to $2.00 agreed to immediately exercise an aggregate of 4.2 million
warrants at a reduced strike price of $1.00 per share. The investors also were issued new warrants for an equal number of
shares that have a term of seven years and a strike price of $1.00 per share. This transaction resulted in proceeds of approximately
$4.2 million. Under another transaction we sold 5.1 million shares with matching warrants to purchase another 5.1
million shares to other investors at a purchase price of $1.00 for each share and its matching warrant. This transaction
resulted in proceeds to us of $5.1 million. Finally, we entered into a credit facility with another investor under which that investor
agreed to loan us up to $5.8 million. The credit facility provides for an annual interest rate of 3% on any funds drawn by
us. It also provides the lender with the option to convert any loan amount to a unit consisting of a share of our common
stock and a matching seven-year warrant at a conversion price of $1.00 per unit
.
We currently believe that, after giving
effect to these equity and financing transactions, we have sufficient funding to support our operations through the first quarter
of 2015. However, depending upon, among other factors, product sales levels, the results of ongoing product development initiatives
and trials, market conditions, increased expenses beyond what we currently budgeted for 2014 (in particular, our operating expenses
or increased expenses related to the corporate transition matters), increased costs beyond our forecast, costs associated with
the ongoing investigation and civil litigation matters to the extent not covered by insurance, and the price of our common stock,
it may be necessary for us to seek additional capital before that time, including through debt financing and additional equity
offerings. There can be no assurance that we will be successful in obtaining such funding at commercially favorable terms,
if at all. If we are unable to raise additional capital (including through the exercise of outstanding warrants and stock options
and through private placements of our securities, each of which has been a primary source of our financing in the past), our liquidity
may be materially adversely affected. Any equity financing will be dilutive to our existing shareholders.
Corporate Transition Matters
As discussed above, as part of our ongoing
corporate transition, we are shifting the focus of our operations to concentrate more on the development of pharmaceutical products,
in addition to the maintenance of our nutraceutical and cosmetic lines of business. The costs and expenses related to the
drug development industry may vary significantly from those associated with our nutraceutical supplement and cosmetic lines of
business, including costs and expenses related to clinical trials, regulatory compliance and generally bringing to market drug
candidates. These factors, among others, may require us to seek additional capital resources as we move forward with our
drug development program on a more expedited basis.
Summary of Balances and Recent Sources and Uses
As of March 31, 2014,
we had a working capital surplus of approximately $8.1 million, which included cash of approximately $8.4 million in current assets.
We had cash and cash equivalents of approximately $3.9 million at December 31, 2013.
Net Cash From Operating Activities.
During the three months ended March 31, 2014, approximately $4.8 million of cash was used in operating activities compared to approximately
$6.0 million of cash used in operating activities during the same period in 2013. Cash used in operations was approximately $1.2
million lower during the three months ended March 31, 2014 as compared to the same period in 2013, due primarily to decreases in
sales and marketing expenses.
Net Cash From Investing
Activities.
During the three months ended March 31, 2014, we generated $9 thousand from investing activities, as we continue
to receive payments from the sale of licensing rights related to the sale of our cigarette business in 2007.
Net Cash From Financing Activities.
During the three months ended March 31, 2014, we generated net cash from financing activities of $9.3 million through the exercise
of warrants for $4.2 million and the sale of common stock for gross proceeds of $5.1 million. During the same period in 2013, we
generated net cash from financing activities of approximately $25 thousand through the exercise of warrants for $30 thousand partially
offset by $5 thousand for long term debt payments.
Net Cash Used in MSA Escrow Payments
. Given the fact
that we discontinued the sale of cigarettes in June 2007, we do not have any ongoing obligation to make any deposits into escrow.
During the three months ended March 31, 2014 and March 31, 2013 we did not make any deposits for the sale of cigarettes in the
MSA states.
Cash Demands on Operations
During the three months
ended March 31, 2014, we had losses from continuing operations that totaled $(9.8) million. See “Overview” and “Results
of Operations” above for a discussion of our increased operating expenses that resulted in increased use of cash during the
first quarter of 2014.
Contingent Liabilities and Cash Demands
Prior to the introduction
of our dietary supplements and cosmetics, we obtained product liability insurance for each of our products. This insurance covers
claims arising from product defects or claims arising out of the sale, distribution and marketing of these products. There have
been no claims asserted with respect to the manufacture, sale or use of our dietary supplements or cosmetics to date. If any such
claims are asserted in the future and ultimately result in liability that exceeds the limits of our insurance coverage, we would
be liable for any such excess amount. In the past, we maintained product liability insurance only with respect to claims that tobacco
products manufactured by or for us contained any foreign object (i.e., any object that is not intended to be included in the manufactured
product). The product liability insurance previously maintained did not cover health-related claims such as those that have been
made against the major manufacturers of tobacco products. We do not believe that insurance for health-related claims can currently
be obtained. Although we ceased selling cigarettes in 2007 and exited from the tobacco business as of December 31, 2012, we may
be named as a defendant in such cases in the future. However, we believe that we have conducted our business in a manner that decreases
the risk of liability in a lawsuit of the type described above, because we have attempted to consistently present to the public
the most current information regarding the health risks of long-term smoking and tobacco use generally, have always acknowledged
the addictive nature of nicotine and have never targeted adolescent or young persons as customers.
Government Investigation
.
See the information above under “Investigations and Other Litigation” and in our 2013 10-K under “Risk Factors”
related to the ongoing government investigation and our related internal investigation.