Tobacco: The Negative Cash Flow Crop

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What do early American colonists, the Marlboro Man, and Joe Camel have in common? Tobacco earned them massive amounts of cash, just as it should for shareholders. Large tobacco companies like Philip Morris International (NYS: PM) and Reynolds American (NYS: RAI) rake in so much cash that they oftentimes reward shareholders with dividend yields greater than 4%. Then there is the black sheep of the tobacco community, smokeless cigarette manufacturer Star Scientific (NAS: CIGX) , which continues to burn through cash at an alarming rate. While Star is more reliant on developing new products than other tobacco companies that by contrast can rely on cigarette repurchases, Star Scientific's spending habit still sends off smoke signals of a bleak future.

A contrarian tobacco company
Star Scientific, creator of smokeless tobacco alternatives, has operated at a loss for the past nine years. For a smaller business concentrating on product development and marketing, operating at a loss for several years can be excusable. However, Star Scientific's smokeless products compete against industry giants whose cash is bolstered by traditional cigarette sales, and who can invest in similar smokeless products. For example, Altria (NYS: MO) sells a smokeless variety under the popular Marlboro brand. To promote its products and steal the giants' market share, Star Scientific needs an overflowing cash box to market and develop its products.

The problem? Star Scientific lacks both the cash box and the revenue from traditional cigarette sales to compete. Here is its cash balance and its net operating cash flows, or how much it spends each year manufacturing and selling its products, both in millions:

 

2005

2006

2007

2008

2009

2010

Cash Balance4.3011.538.886.4712.3613.19
OCF(14.02)(10.66)(14.9)(17.8)(19.03)(23.66)

Source: Star Scientific's annual 10-K SEC filings.

Remember: This is operating cash flow -- normally the category that should be pumping cash into a business. Again, it's competing against giant Altria, which made $6.3 billion from operating activities last year and sits on a war chest of $2.3 billion in cash -- showing the massive resources that can be spent on further marketing Marlboro and squashing any competitors.

Where is Star Scientific spending this money? Let's look at the most recent quarterly report's income statement. While this doesn't show the actual cash expenses because of the accrual-based system, it can give us a general idea of where the company is focusing its capital. The $17.5 million operating loss in the past nine months is made up of:

  • $1.7 million gross loss (revenue minus the cost of goods)
  • $2.2 million spent on marketing and distribution
  • $2.2 million spent on research and development
  • $11.4 million spent on general and administrative expenses

While spending on marketing and research is a good sign, Star Scientific will have to increase current sales of $819,000 by over 1,300% just to cover the $11.4 million in general expenses.

Can it achieve this outstanding growth? On one hand, early sales of its new tobacco-derived dietary supplement Anatabloc sold more in one month than the company's two other dissolvable tobacco products combined for the entire quarter. But these products only recorded an 11% sales growth last year, compared to nearly 60% the year before. Additionally, there may be a misplaced incentive to market products, because if one of its smokeless products is sold or licensed to another company, management is generously rewarded with vested options. Ultimately, I believe this target is too lofty for it to hit.

Snuffing out shareholder value
How does Star Scientific get the cash to continue operating? A major way is by issuing more shares of stock, diluting the value of each share and making whatever shares you own worth less and less. From 2008 to 2010, available shares ballooned from 81 million to 127 million! And due to its negative operating cash flow, I believe the company will keep issuing shares until each share truly is worthless.

Cash is king
While tobacco is a cash crop, Star Scientific has yet to translate its crops into cash. The company is too short on cash for comfort, and consistently dilutes shareholder value to keep adding cash to its unprofitable operations. While I believe this stock has no value to shareholders, it does remind you to keep an eye on cash flow for any of your investments. While profits are important, a business cannot operate day to day without cash.

Follow what I think will be Star Scientific's demise by adding it to My Watchlist, or keep track of Big Tobacco's big dividend players by adding Reynolds American and Philip Morris International to My Watchlist.

At the time this article was published Fool contributor Dan Newman does not own any shares of the companies mentioned above. The Motley Fool owns shares of Philip Morris International. Motley Fool newsletter services have recommended buying shares of Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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