Star hitches its wagon to patent case

For every $1.80 pack of Ariva or Stonewall cigalets it sells, Star Scientific Inc. spends $8.44 making the powdered tobacco tablets, its only product.

It spends more than $14 marketing it.

And it spends another $60.75 on corporate overhead, including paying each of its top two executives more than $1 million a year and spending $1.4 million last year for use of a plane owned by one of them.

The Petersburg-based tobacco company has been losing money for years as it pushes its vision of safer tobacco. But it has pulled in nearly $100 million from investors, including some professional fund managers who specialize in small, thinly traded stocks, during the past five years on a gamble the company will win big -- very big -- in a federal patent-infringement case.

Star's potential is in the patent it holds for a leaf-curing technique that reduces some toxins in tobacco used for cigarettes, snuff or smoking-cessation products. At one time, hundreds of tobacco growers had signed up to adopt the process.

It is a dream that has faded across Virginia's Southside. Star canceled contracts to buy leaf cured by its patented process years ago and stopped making cigarettes from the leaf in 2007. A big cigarette-maker ended its experiments with Star's leaf in 2003.

"We are deeply committed to following a harm-reduction strategy," said Paul Perito, Star's president and chief operating officer.

In response to questions about the million-dollar salaries he and chairman and CEO Jonnie R. Williams earn, Perito said, "The company has a very small senior management group -- each of us wears several hats at any given time."

Perito said Star's use of the airplane owned by Williams has been helpful in generating capital, adding: "The population of potential investors for Star is broadly national in scope, and it has been important to meet personally with both existing and potential investors."

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The idea of safer tobacco beguiles investors.

"What you see on the balance sheet and the [profit and loss statement] doesn't tell you anything," said Robert W. Scannell, whose Tradewinds Investment Management partnership in Sausalito, Calif., owns 14.3 million shares, a 14.3 percent stake. Founder Williams is the only stockholder who owns more, a 17.1 percent stake.

After warning through last year that it had enough cash to make it through March, Star raised $14 million this month when some of its hedge-fund backers bought more newly issued stock.

The funds had options and warrants giving them the right to buy those shares. They paid an average of about $1.84, Star's financial filings show.

Star's shares were trading at around $2.65 to $2.70 when the funds bought their shares.

That money brought hedge-fund investment in Star -- whose only product is the $450,000 worth of money-losing tablets it sells a year -- to $97 million since 2004.

On March 9, a week after the last of the new share sales, the U.S. Supreme Court declined to hear an appeal of a procedural ruling in Star's long-running patent lawsuit against cigarette giant R.J. Reynolds, the nation's second-largest tobacco company, based in Winston-Salem, N.C. That news sent Star's stock price above $4.

Last August, the 4th U.S. Circuit Court of Appeals rejected Reynolds' bid to throw out Star's lawsuit because Star never disclosed to patent officials a letter from one of its consultants that said the technology on which it eventually won a patent was in use in China and had been standard in the United States until the 1960s.

That decision, and the Supreme Court's lack of action on Reynolds' request for a review, clears the way for trial in May.

Scannell said Star holds much potential.

"I'm very positive," he said. "It's not just the lawsuit. There's more to the story."

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Star has been battling Reynolds since 2001, alleging that the tobacco giant infringed on its patents for curing tobacco.

Those patents involve using radiant heat from enclosed burners, instead of heat from open flames, to dry the leaf in curing barns. Growers began using open-flame heaters, instead of indirect radiant heat, in the 1960s.

By the mid-1990s, Reynolds, like Star founder Williams, was looking at whether the open-flame technique was generating toxic chemicals called nitrosamines in cured leaf. In late 1997 or early 1998, Reynolds disclosed findings of a link to a scientist who later became a consultant to Star, court records show.

Star filed a provisional application to patent radiant-heat barns in September 1998 and began supplying hundreds of farmers with barns in return for their agreement to sell Star low-nitrosamine leaf. Star filed a full application the following year and won the patent in 2001.

Reynolds filed a patent for converting barns using open flames to radiant heaters in April 1999. The company, meanwhile, contracted with farmers to use the converted barns in the summer of 1999.

The trial will turn on whether Reynolds' use of radiant-heat-cured barns is a patent infringement. Meanwhile, the U.S. Patent Office said it will re-examine Star's patents.

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David McClary, general partner of Willowbrook Fund, a Franklin, Tenn., investment firm that owns more than 100,000 shares of Star, is confident that its patents will stand and that the lawsuit will pay off in damages that could exceed $1 billion.

With that, and a pharmaceutical division that last year had a research budget of $300,000 that he believes is poised to launch a major new approach to getting smokers to quit, McClary sees Star's shares likely to increase in value nearly tenfold.

"I'm a strong believer," he said. "They've accomplished for the tobacco industry making a safer product, for which they were shunned and then overwhelmed."

Contact David Ress at (804) 649-6051 or dress@timesdispatch.com.

Staff writer John Reid Blackwell contributed to this report.