THIRD QUARTER 2005 CONFERENCE CALL
October 27, 2005
Welcome to Nanophase’s third quarter conference call from “Sweet Home Chicago”, the home of the world champion Chicago White Sox. Nanophase reported the highest third quarter revenues in the Company’s history and record first nine month’s revenues. The Company had a strong quarter and first nine months and we are pleased that you are taking the time to be here today. Jess Jankowski, Nanophase’s CFO, and I will be hosting this session.
As we normally do to begin our discussion, Jess will summarize the financial highlights of the quarter and the first nine months. Jess….
Jess Jankowski, Acting CFO and Controller
As I review the financial performance of the Company for the third quarter and nine-month periods, I‘ll continue to do so at a strategic level. More details are included in the financials that accompanied our press release earlier this afternoon.
All numbers will be in approximate terms for ease of discussion.
Total revenues for the third quarter of 2005 were up $297K, or 22%, compared to the third quarter of 2004. For the nine-month period, total revenues were up $1.2M, or 28%, compared to the same period in 2004.
For the nine months of 2005, Product Revenue was up 46%, to $5.1M, another new Nanophase record. This increase was largely composed of sales of sunscreen materials and growth in sales of personal care materials to BASF, plus the $375K in material that was shipped to a new customer in the medical diagnostics market. We also saw Rohm & Haas Electronics Materials taking product in keeping with their commitment for 2005.
For the nine month periods presented, Other Revenue was down $447K. This decrease in Other Revenue, when compared to the same period of last year, related to the Company recognizing the first three quarterly payments of $150K, or $450K in aggregate, in technology development funding from Rohm & Haas during 2004. This funding was part of its $600,000 commitment to support Nanophase’s efforts in jointly developing slurry products for current and future semiconductor technologies during 2004.
Rohm & Haas’ commitment to Nanophase for 2005 will ultimately be greater, and be in the form of product sales. As discussed previously, we began shipping to this product commitment in Q2 of this year.
We have generated a positive gross margin of $867K for the 2005 nine month period. About $640K of this was margin purely related to product sales. We view this as an ongoing validation of our business plan and our financial modeling. As we continue to discuss, our margins have been impeded by not having enough revenue to absorb the manufacturing overhead that’s required to work with the customers we have and the new ones we expect to have. The additional product revenue this quarter showed that, as volume grows and manufacturing overhead is absorbed, our solid variable margins have an appreciable impact on gross margins.
Moving down the P&L....
Nine-month period to period R&D Expenses were up $67K. This was largely due to increases in compensation expense. In SG&A, which was up 6% over the same period, we saw increases in auditing and SOX-404-related expenses and compensation, offset by reductions in legal fees, business insurance costs, and other items.
Now I would like to take a moment to explain a non-cash charge we took in Q3 relating to recognition of straight-lined rent expense, referred to as a “Lease accounting adjustment,” in the amount of $280K, as a separate line item in the operating expense section of our P&L. In 2005, the SEC published guidance regarding the observance of the convention of amortizing rent expense over the same term as any underlying leasehold improvements. Beginning in the year 2000, we had amortized rent expense only over the first six-year term of our then current lease, while opting to amortize leasehold improvements over sixteen years, a term that included the two available five-year option periods in that same lease.
This $280K item represents the portion of 2006 through 2016 escalated rent that we would have recognized over the past five years, at about $13K per quarter, had we calculated straight-line rent expense over the longer term initially.
In a related issue, the lease amendment that we renegotiated and announced effective October 1st will result in a savings of almost $600K over the life of the original lease. This savings, as well as the $280K accrued liability we created to take the non-cash charge this quarter, will be recognized quarterly in rent expense reductions over the next twenty years.
In total, the Company lost $0.23/share for the first nine months of ‘05 versus $0.27/share for the same period last year.
Note that depreciation and amortization amounted to about five & 1/2 cents per share, or $980K of the Company’s loss for the first nine months of 2005. The non-cash rent expense charge accounted for 1.6 cents of this loss also.
Moving to the balance sheet, Nanophase ended the third quarter with $8.5 million in cash and investments compared to about $11.6 million at the end of 2004.
Looking at cash burn, we used $2.8M for operations and about $405K for capital improvements thus far in 2005.
The Company also reduced debt by $355K in this nine-month period. Management expects the note to BASF, currently at $236K, to be paid off in mid-to-late 2006.
Thank you for your attention, now I'd like to turn things back over to Joe Cross, our CEO.
Joseph Cross, President and CEO
Thank you, Jess
Today, I intend to focus my comments solely on revenue growth since this is our highest priority at Nanophase and, I am sure, at least one of your top concerns as investors and shareholders. Before entering specifics, I would like to discuss the critical factors that, we believe, directly have and continue to influence the Company’s ability to grow revenue and the rate of growth. Based on several recent conferences and discussions, it seems to us that many in the investment community have an uncertain appreciation of the market situation. From an understanding perspective, we think it is worthwhile to communicate our views on revenue growth and the revenue growth rate.
So, starting with the 10,000 foot view, consider this: nanotechnology is and remains a NEW science and emerging technology. Despite the promise of nanotechnology and all of the hype, this still is an emerging science and technology that should continue to grow at least over the next two decades and likely considerably longer. We firmly believe the adoption rate is increasing and the rate of revenue growth will increase accordingly.
For discussion simplicity, I am separating the critical factors to revenue growth into roughly three piles: those where we have major or direct control, those where we have some control, and those where we have limited or indirect control. Let me speak to each of those and try to provide a qualitative assessment as they affect Nanophase and how we are managing these factors:
Under the ‘major control pile’, at one time in history, revenue growth for Nanophase was hindered due to our limited ability to advance the nanomaterial to a readily usable format for the market or customer. We have, rather uniquely in the global industry, I believe, eradicated that hindrance with our technology advances that have resulted in our current and growing platform of integrated nanomaterial technologies where we provide nanoparticles, surface-treated nanoparticles using a variety of patented and proprietary materials, and nanoparticle or surface-treated nanoparticle dispersions in a variety of media featuring high stability and non-agglomeration of nanoparticles. While this platform of technologies may not be well understood or appreciated, we firmly believe that building a large, sustainable nanomaterials business requires a combination of all of these technologies to address market applications and be successful. We have taken a new science, created integrated technologies, commercialized these technologies, and continued to advance our expertise in these vital areas over the past two years or so. Again, we believe Nanophase is uniquely positioned. In our assessment, most of our potential global competitors still have much of this basic hindrance.
Under the ‘some control pile’ is application development. This is THE current focus area for Nanophase because it is largely research in many targeted application areas, such as coatings, where the market pay-off is potentially significant. The difficulty involved in application development and testing (a non-trivial task in and of itself), product development, market introduction, and subsequent growth is the major reason that Nanophase has chosen to align itself with premier market partners – BASF, Rohm & Haas, and Altana Chemie – as well as other customer partners that we may not discuss, but where valuable development is underway and our partner brings vital application expertise coupled with detailed market knowledge. Appreciated or not, this a major advantage for Nanophase and the reason that in many corners we continue to be told that we are doing it right. However, understand that this is a critical, research, and time-consuming area with both a timeframe and success level that is difficult, if not impossible, to predict. Application development, or an optimal nanoengineered solution, remains a critical factor to revenue growth rate, but one where we have been fortunate to secure solid partners, increase the Company’s knowledge base – and let me emphasize how critical this is in an emerging technology company, and gather momentum over the past few years.
Lastly, let’s consider the pile where we have ‘limited or indirect control’, which leads to revenue growth. While much is written about nanotechnology, especially related to universities and national labs that have received huge funding and write exciting, almost fictional, articles about future advances, the real measure of success for nanotechnology is industrial adoption and the rate thereof. Make no mistake about that. We influence the adoption rate through conferences, company capability presentations, articles, and similar measures, but the cycle for industrial acceptance and adoption is real for nanotechnology as it is and has been for all new technologies. Again, our market partners are an asset in this area since they push nanomaterial adoption in a wide variety of markets and create new nanomaterial-based products. The positive news is that we are seeing global acceleration in industrial interest across a broad variety of markets based on development of new or improved products, not a centralized R&D effort, which we have painfully learned is the ‘valley of lingering death’ for new technologies. From the amount of increasing effort, we perceive a growing industrial mass heading toward adoption of nanomaterials as part of their new product toolbox and fully expect this tend to gain further momentum.
We are discussing this topic because we realize waiting is difficult and the plethora of publicity is confusing and tends to cause expectations. The factors just outlined are real – for Nanophase and everyone else in nanotechnology. But as industrial interest and adoption gains momentum, and it clearly is, Nanophase is uniquely positioned to exploit opportunities. Our assessment leads us to believe the rate of growth should continue to increase for nanomaterials over the next 5 years. This assessment is buttressed by a recent study by the Freedonia Group which forecasts nanomaterials to be about a $90B world market by 2020. Moving closer, Freedonia forecasts that metal oxides will comprise about 58% of the total market in 2008 with a reported value over $2B growing to about $6.5B in 2013. In summary, the factors that we believe influence revenue growth and the rate thereof have and are positively improving. It is this assessment that leads management to be quite positive about the 2-5 year horizon.
Delving down into greater specificity, let me provide a summary update on our primary market partners.
Beginning with BASF, we continue to make progress building and expanding the base business with our initial product, Z-Cote, in both personal and sun care applications. Based on current forecasts, we now believe that this business will have increased approximately 20% in 2005 versus 2004. According to BASF, they are still adding customers for this product, most recently in Asia and Canada, and we expect moderate growth in this line during 2006.
The new formulation for sun and personal care products, Z-Cote Max, which is based on our patented and patent-pending coating technology, is in the market introduction phase and, according to BASF, is receiving positive response. We expect this volume to begin ramping during 2006 and continue to build in 2007-2008. BASF has stated that they envision growth in this product to eventually equate to a level comparable to that of our current product.
As announced, we developed a robust process to manufacture a 35 nm ZnO particle at the request of BASF, as well as BYK Chemie, which is now in the application development cycle. Again, to re-emphasize a point I made on previous conference calls, this is one of the values in having market partners; focused new product development and market introduction. BASF intends to introduce this product for high-end sun care and personal care applications during 2006. In parallel, BASF and Nanophase are collaborating on a second new product for introduction during 2006 that I am unable to discuss.
Additionally, in another new product area, we are having success in oral care application development. Through BASF, our nanomaterials are currently used in oral care products, but we would like to increase and broaden the usage. BASF is working very closely with a major consumer products company in a joint development to incorporate nanomaterials in oral care products. In parallel, Nanophase is in co-development with another major consumer products company for similar products. While it is impossible to forecast revenues at this time, we have been told by both companies that they expect new consumer product introduction to begin in 2006.
Finally, we have a new product development initiative with BASF outside of personal care in both thermoplastics and films. This initial effort has been underway for about three months and has demonstrated very positive results related to market needs. Going forward, we will be partnering with BYK Chemie, which already has a close relationship with BASF, to drive the product development into the market and revenues. Based on information from BASF, we believe this is a significant opportunity with a relatively short time-to-market and anticipate initial market introduction may occur as early as 2006.
Moving to Rohm & Haas Electronic Materials, CMP Technologies, which I will refer to as RHEM, considerable progress has been made in market penetration. RHEM is beginning to see the predicted market synergies from their dominance in the pad and pad conditioner market extend to the slurry market. Rohm & Haas has stated that they have made a corporate strategic, long-term commitment to this market and intend to be a major player over time. RHEM’s current view is that they should have between 4-6 separate semiconductor fabs in various stages of ramping up actual production during the fourth quarter of ’05 and the first quarter of ’06. RHEM believes they are building market momentum that should lead to several customer wins over the next few years. We continue to believe that fine polishing applications, including semiconductors, represent a considerable revenue growth opportunity for Nanophase over the next 2-3 years.
BYK Chemie continues to make progress in their NanoBYK product line area. We have made excellent progress improving scratch resistance for UV-curable coatings where we have improved abrasion resistance of the neat film by 10X with the addition of nanoparticles. We are currently working with solvent-based and aqueous-based systems and anticipate similar success over the next 3-6 months. Again, the primary market application focus at this time is scratch resistance and UV protection for industrial coatings and films. BYK Chemie is currently working on approximately 20 direct application opportunities with their customers in the US, Asia and Europe and continues to grow the effort on a weekly basis. We believe that penetration of this estimated ~$60B global market is a critical effort for Nanophase relative to revenue growth over the next five years.
This market commitment and confidence in Nanophase’s capabilities is shared by Altana Chemie and BYK Chemie as evidenced by the $1.6 million loan to Nanophase announced earlier today to enhance Nanophase’s development and manufacturing capability. This is in addition to the $10 million equity funding from Altana Chemie in March 2004. This new funding will be used to purchase and install a dedicated NanoArc™ reactor to develop specific new nanomaterials for targeted markets and installation of a commercial dispersion line to manufacture high volume nanoparticle dispersions. We anticipate the equipment should be on-line and available around mid-2006. Note that this loan is interest free to Nanophase until approximately December 2006.
In addition to our market partners, we continue to experience robust business development opportunities. We enlarged our business development efforts to include both tactical market attacks and specific customer application opportunities.
From a tactical market penetration basis, we have plans in place for two markets where we believe nanoparticles and nanomaterial solutions bring application value in process or product improvement. We have developed highly targeted plans to develop and introduce products, directly and with our market partners, into a new catalysts market and antimicrobial market, which includes both industrial and personal care. We believe these are significant market opportunities, as was also noted in the Freedonia industry study on World Nanomaterials, where our integrated technologies bring a distinct competitive edge and value. We are in the process of implementing our plans and initial results definitely show impressive performance improvement on application testing. We plan to begin market penetration leading to initial revenues during 2006 and believe that both areas could be major contributors to revenue growth over the next five years.
Another application area that has received considerable interest in recent months is fuel-borne catalysts in heavy fuel applications, diesel applications, and in fuel additives. We introduced and announced a new nanomaterial directed for specific applications in this area during the last quarter and will continue application development for at least the next 6-9 months with 3-4 different companies.
Relative to company and application specific product development, we are currently engaged with over 100 different opportunities in a variety of markets. While this may seem like a large number, there are application synergies which allow us to progress with our current resources. Application development is progressing and we are optimistic relative to revenue growth.
One such application that we have discussed before has moved during the last quarter. As you may recall this involved the potential of securing a major new customer with two distinct products for the consumer and DIY market that is sold through a big box retailer. The initial product is now on the shelves, noted as a nano product, and was recently featured in advertising at least in Chicago. The second product release in the big box, which has the large volume and revenue potential to Nanophase, appears to be early 2006. Again, relative to the timing of the big box, we have no control, but are positive it will happen sometime around this timeframe. Our direct customer has already scaled their production in three of their manufacturing facilities and is awaiting word from the box. Based on customer information, we anticipate this should result in a new annual revenue stream of approximately $1-2 million annually.
Lastly, Nanophase has decided to broaden its focus relative to multi-faceted nanomaterial technologies that are synergistic with our business model, current technologies, and market partners. Our recent announcement regarding our exclusive arrangement with Competitive Technologies is part of this strategy. CTT has relationships with over 200 universities and national labs and will actively seek new nanomaterial related technologies that may be of interest to Nanophase. CTT provides a direct window into the research that is occurring throughout the US and some areas of Europe, which is a capability that Nanophase needs. We expect to continue pursing strategic initiatives to maximize the Company’s value to its shareholders and build a substantial, sustainable business.
That concludes our prepared remarks; we are open to your questions.
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