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Trade of the Day: Star Scientific (STSI)

Political scandal, shoddy science and deteriorating technicals all point to a short trade

   

I will admit that I am fairly skeptical of the entire nutraceutical industry. The whole business seems to exist within a legal technicality (the DSHE Act of 1994) created by one of my home state’s senators. I am not committed enough to pull an “Ackman” and short Herbalife (HLF) but there is some attractive downside available elsewhere in the industry for bears looking to take advantage of a struggling vitamin-pill maker.

Star Scientific (STSI) came to my attention because the CEO has been giving very extravagant “gifts” to Virginia Gov. Bob McDonnell…I assume with no expectation of reciprocity whatsoever. The case is under investigation and McDonnell has returned all gifts, but I would suggest that if it quacks like a duck and walks like a duck, it’s a duck.

The question traders should be asking themselves is why the CEO had to be so brash in gaining the governor’s favor. Political graft is very dangerous business and allegations should not be taken lightly. If true, there must be some desperate reasons for taking those kinds of risks. Based on an analysis of STSI’s financial statements and technicals, desperation may be an understatement.

STSI has big dreams to turn a chemical compound derived from tobacco into a wonder-drug for inflammation-related illnesses. They are marketing this under the name Anatabloc and are paying an incredible amount of money for sports celebrities like Fred Couples and John Isner to shill for them. The claims, like most nutraceuticals, have no real evidence of effectiveness in humans and have not been evaluated by the FDA.

Cash is King

Vitamin makers have a tough time taking a product to market. The barrier to entry is low, there is limited evidence that their products work, and in STSI’s case the cash burn rate doesn’t give them a lot of time to build a viable model. Some companies in the industry like HLF and Nu Skin Enterprises (NUS) really sell the business opportunity of becoming a network marketer. STSI has no such plans as far as we can tell.

STSI was originally in the tobacco business but has now left. Their dealings with Bob McDonnell appear to have been an attempt to access some of the money available from the state (funded by a settlement with tobacco companies) to sponsor businesses that can help stimulate the economy. The problem with STSI switching horses in midstream like this is that they still have a bloated operation that is bleeding cash.

The company has recently been able to raise some cash through some long-time investors who were willing to exercise $4 million in warrants at a very favorable price. Based on their most recent 10-Q, the company has enough cash to support themselves into 2014 but sales trends don’t indicate they will be able to fund themselves from operations by then. That doesn’t mean they are going out of business immediately. They should be able to continue raising some capital, at least temporarily, before they will have to start slashing operations.

In this market, cash in king and unless you really do have a wonder drug in the works, you will probably not survive. STSI looks a lot like a struggling biotech but without the promise of a scientifically valid medication, treatment or device. Keep in mind that even legitimate development-stage biotechs have a very high failure rate.

No Evidence of Antabloc’s Effectiveness

The bottom line is that there are no direct, peer-reviewed studies of its effectiveness for anything in humans. Even then, a peer-reviewed study is not the same thing as a study for clinical efficacy. Those take a long time and involve the FDA. STSI is not even close to doing something like that.

It hasn’t stopped them from implying Antabloc’s effectiveness from a pretty poor mice study. However, it’s important to note that they didn’t even test their supplement in that study. They used a chemical called Anatabine that is supposedly included in the supplement…but since it’s not evaluated by the FDA, we don’t know how much Anatabine is actually in Antabloc pills. Investors should be asking themselves if a study in mice of a chemical that comprises an unknown quantity of the company’s supplement means anything at all.

Technicals: Shooting Star

STSI has also triggered an interesting technical pattern this week as the stock was picked up by a few bullish and bearish analysts. On Oct. 14, the stock rallied above $2.50 per share before closing just below its open. The candle for that day has a small body and a tall upper shadow, which is known as a “shooting star”. This bearish signal was confirmed on Oct. 15, with a big decline back towards $2.00 per share. This is the same kind of pattern JCPenney (JCP) formed on September 19, 2012 before losing  two thirds of its value.

 10 15 13 stsi Trade of the Day: Star Scientific (STSI)

The stock likely has some support from long-time investors around $1.90 per share. That is our first target but that kind of support tends to be very fragile. We recommend adding to a short position if the first target is breached in anticipation of the stock hitting longer-term support near $1.20 per share.

Recommendation

There isn’t a great need to dig into the financials of a firm like this. Once in a while companies get into a feedback loop of bad financing deals and burning cash. Quite often, a company in this situation doesn’t survive. There are certain industries where these face-plants are a little more common than others. Nutraceuticals, oil and gas, mining, solar, and biotechnology are prone to these kinds of problems and bears like to keep their eyes on these groups for new opportunities.

However, the CEO at STSI is a creative fellow and a very good salesman. There is a high likelihood that he can do a lot to promote the stock before its final death throes. Those efforts may lead to a great deal of volatility.

We recommend opening a short position but we would emphasize that there is a high level of risk in the trade. This kind of opportunity falls within the “play money” side of your portfolio, where a large loss isn’t going to be detrimental because the winners can also be very, very large.

Sell short STSI at current levels with an initial price target of $2.00 per share. Add to that short position on a break of support and set a secondary target at $1.20 per share.

InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news.  Get in on the next trade and get 1 free month today by clicking here.

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Article printed from InvestorPlace Media, http://investorplace.com/2013/10/trade-day-star-scientific-stsi/.

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