Nanophase Technologies Corp. Q2 2008 Earnings Call Transcript

Jul.22.08 | About: Nanophase Technologies (NANX)

Nanophase Technologies Corp. (NASDAQ:NANX)

Q2 2008 Earnings Call

July 22 2008 5:00 pm ET

Executives

Joseph Cross - CEO

Jess Jankowski - CFO

Analysts

Michael Lu

Jim Lieberman

Operator

Ladies and gentlemen, thank you for standing by. And welcome to the Second Quarter 2008 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session. (Operators Instructions).

The words expect, anticipate, plans, forecasts and similar expressions are intended to identify forward-looking statements. Statements contained in this news release that are not historical facts are forward-looking statements that are made pursuant to the Safe Harbor provisions that are filed with the Securities Litigation Reform Act of 1995. These statements reflect the company's current beliefs and a number of important factors could cause actual results for future periods to differ materially from those expressed in the news release. These important factors includes, without limitation a decision of the customer to cancel a purchase order or supply agreement, demand for and acceptance of the company's nanocrystalline materials, changes in development and distribution relationships, the impact of competitive products and technologies, possible disruption in commercial activities occasioned by terrorist activity and armed conflicts, and other risks indicated in the company's filings with the Securities and Exchange Commission. Nanophase undertakes no obligation to update or revise these forward-looking statements to reflect new events or uncertainties.

Thank you. I would now like to turn the conference over to Joseph Cross, President and CEO. Mr. Cross, you may begin your conference.

Joseph Cross

Thank you. Welcome to Nanophase's conference call to review the second quarter of 2008. Especially given current economic conditions, Nanophase had a solid quarter, and we are pleased that you are taking the time to be with us today.

Jess Jankowski, Nanophase's CFO, and I will be hosting this session. To begin discussion, Jess will comment on second quarter financial reporting..

Jess Jankowski

Good afternoon. And thank you for your continuing support of Nanophase. This second quarter has been a good one. We've seen the rewards of being vigilant in reducing and controlling costs. We had relatively flat revenue from Q1 as we expected, though we had strong margins that have grown for the three and six months period, even though last year's second quarter's spike resulted in lower revenue overall in 2008's first half.

This reduction in comparative revenue was largely created by last year's Q2 volume being inflated ironically by demand spiked from our architectural coatings customer that was achieved just prior to the much publicized slowdowns in the housing and mortgage markets, which added to this pressure. I am about to walk you through some of the good and telling things we've seen this year. Let's get into some of the details.

As always, I'll discuss the financial results in approximate terms. For more details, please see the financial statements along with the supplementary non-cash items schedule accompanying today's press release. Second quarter 2008 revenue amounted to 2.9 million, which is relatively flat to Q1's revenue, but lower than last year's Q2. Six months 2008 revenue was 6 million, down about 15% from the same period last year due to the revenue spike that I mentioned in Q2 of 2007.

Due to the irregular revenue patterns we are analyzing, I'll focus most of my attention in the six months comparison along with a few notable changes from the preceding quarter and discuss some great progress in managing costs.

For the six months of 2008 versus 2007 on the revenue side, we saw reductions of 880,000 from BASF, 570,000 ALTANA and architectural coatings customer, offset by a $640,000 increase from Rohm and Hass. This resulted in a net revenue decrease of just over a $1 million year-over-year.

What this tells us about is the strengths of these underlying businesses is not obvious. We entered 2008 with a view toward year-over-year unit sales growth with our partners BASF and ALTANA; peppered by the fact that commodity pricing was receding and we expected dollar revenue might flatten, particularly for BASF in the form of commodity surcharge reductions. As a matter of fact 15 to 20% of the reduction in BASF 2008 revenue is due to lower commodity raw material pricing.

For the balance of the reductions, we now believe that BASF and ALTANA left 2007 with significant inventory levels, which has met their previous views of their growth. These two partners along with their large architectural coatings customer also seem to be experiencing the impact of consumer sentiment and ongoing concerns about the economy on the industrial side as it impacts demand for their downstream products.

Rohm and Hass, while delivering on the growth we expected this year is also purchasing material more evenly in 2008 than it did in 2007, which was backloaded. We don't believe that BASF or ALTANA have seen large downturns from what they have been selling, as much as they purchased less to offset previous inventory builds. Our large architectural coatings customers had solid business that is doing well, but may along with the two partners, be impacted by the economy in the second half.

This variability drives home the reason for our migration from the partnership model to more of a direct sales approach. We've had limited success pushing our partners to sell on more (inaudible) fashion, because their business models are build that way. Our partnership brought us to a good spot, giving us the legs to stand on, now we need to take the next step.

When we secured the large architectural coatings customer, it took an innovative, collaborative process that brought us to comparable revenue stream that relies on the strength of both of our materials and our applications development expertise. This was a single event in our history that told us we could sell our materials effectively into new markets that we are seeking advantages unavailable elsewhere and at good margins.

It also taught us that we needed to touch end use customer directly in order to have greater success. This knowledge is what precipitated the changes to our sales and marketing focus that we believe will propel us to a positive cash flow position of profitability. We're building a pipeline and we expect we'll begin bear fruit next year.

We'd hope to show earlier signs of progress to be a greater revenue volume this year, but what we have seen is the additional several alpha customers in target markets -- new markets that we expect to grow and to help us to gain additional customers. We continue to invest in applications development in order to accelerate this process. Joe will address this more completely in his comments.

In terms of our revenue for the recent six months ended, BASF had made up to 37%, our architectural coatings customer 32%, Rohm and Hass 13%, and BYK Chemie accounted for 8% of total revenue.

Now, let's talk about the bright spot shown via margin performance for the second quarter and the first half of 2008. Gross margins for Q2 amounted to 38% of revenue versus 37% for Q2 of '07. Gross margins for the six months ended June 30, amounted to 36% this year versus 32% for the same period last year. Why are a few percentage points so remarkable, because in Q2 of 2007, we had a record high degree of capacity utilization having produced a record of materials, from our sense to grow in 2008, and significantly reduced revenue. That's a strong indication that our organization is running leaner and more effectively.

Let me put it more concretely; our revenue was down about $1 million, while our gross margin was already down $65,000, and we built more finished goods inventory in the first six months of 2007 than we did in 2008, which can inflate margins. What we're seeing here is that as we transition towards the direct sales model, we should be able to maintain a leaner manufacturing infrastructure given that applications development and the actual powder products produce will be more focused. We are moving in the right direction. Product mix also contributed to the higher margins realized, but lion share is due to the factors I just discussed.

Moving down, R&D expenses were down 8% quarter-over-quarter and down 12% for the six months period. The bulk of these decreases were due to reductions in compensation expense that has been possible due to the migration of the business model for being more focused on application development than on broad new material development.

We believe we are now doing more respective applications development with fewer better focused resources. SG&A expenses were up 12 and 16% respectively when comparing to three and six months periods in 2008 to those in 2007. Several anomalies and non0-recurring items have created this disparity, which amounted to 450,000 for the six month period.

The company's annual option grants were made in Q2 of this year versus in the second half of last year, resulting in non-cash equity compensation expense that contributed a $100,000 for the difference. This should balance itself out in the second half.

The Q1 2008 patent abandonment also contributed to 150,000 as a variant. And per due SEC guidance, audit fees were all expense than Q1 has earned versus being accrued evenly throughout 2007. This contributed 90,000 of the variants and should also be on the top half of the second half.

Further we incurred 40,000 in recruiting cost for our new Director of Sales. Some of the other increases were due to added compensation mainly related to changes in the sales and marketing group, offset by reductions in consulting speech for 2008, given the extensive 2007 market study we commissioned. We also had some similar back and forth accrual timing issues at a smaller scale.

Most of the increases in SG&A are easily explainable and not expected to recur for the rest of the year. On a GAAP basis, as reported, Nanophase lost $0.04 per share in Q2 of 2008 versus $0.01 per share in Q2 of 2007 with six month losses holding at $0.08 per share for 2007 and 2008.

Analyzing the non-cash components of the six month '08 loss, we have depreciation and amortization of about 645,000 which is a regular component of our GAAP bottom line and amounted to about $0.03 per share of the $0.08 loss. Equity compensation also a non-cash expense amounted to 430,000 and contributed another $0.02 per share to the loss. In total, depreciation and equity compensation expense amounted to about 60% of the most recent 6 months loss.

Moving to the balance sheet highlights, Nanophase ended Q2 with $15.8 million in cash and investments. Q3 inventories are up to 1.6 million, about 39% higher than last quarter. This increase largely relates to material for which we have orders and solid forecast, as well as the significant amount of raw material some of which comes via China that we ordered in advance for the summer Olympics to avoid logistics problems. Equipment and leasehold improvements amounted to about 300,000 for the first half of this year. And until our view of 2009 and beyond solidifies, we plan on limiting CapEx to a bear minimum.

In closing I'd like to draw your attention to another operational metric. Given that cash burn from operations was less than 700,000 for the first 6 months of 2008 versus 1.6 million for the same period in 2007, we are confident that Nanophase is in a very stable financial position. We remain on the right track. We also invite to review our upcoming 10-Q, which we expect to be filed by August 11.

Thanks for your attention. Now I'd like to turn things over to our President and CEO, Joseph Cross.

Joseph Cross

Thank you, Jess. Let me start by reviewing the company's operational progress for the first half of 2008, after which I would like to discuss our business development and sales initiatives.

See the first six months Nanophase achieved a customer complaint rate of zero and a customer service level worth 99.9%. This is generally regarded as world class product and service quality, an attribute that clearly differentiates Nanophase in the market. As we have repeatedly demonstrated since 1999, we continue to improve product cost which is clearly demonstrated in our increasing gross margins by improving up on our current assets and improving product quality. Based on our Lean Six Sigma manufacturing methodology, we have now improved product quality to Six Sigma for our largest volume products. This represents quality level of 99.9999% essentially zero defects. Simultaneously, we have increased product yields by 6% further reducing costs and improving gross margins.

Again, during the first half, the company has recertified its meeting the standards of ISO 9001 International Quality Management Standard and ISO 14001 International Environmental Management Standard. Exiting the second quarter Nanophase has now accumulated almost 900,000 hours without loss time accident. It sure makes an exemplary record for a company of our size. Well perhaps not as exciting to the investment community. This progress and continuing achievement demonstrates the company's expectation and drive for excellence.

Moving to business development and sales. Let me first discuss prudent updates for our market partners and major customers, followed by new sales initiatives. Being with BASF in sunscreens and personal care, they have recently learnt that they appear to have an excess inventory situation, but it does not appear to be sales related issue, but due to over order in 2007. We believe this is a short-term situation that will likely impact two quarters but given BASF's volume and revenue with the company, the impact would be material in the second half. Still, BASF business continued to grow year-over-year. We are also working with BASF on some new product initiatives to increase business further overtime.

Rohm and Haas' CMP Technologies, and I'll refer to them as RHEM going forward, continues to make progress in the market. The isuues about our current cerium based polishing product is meeting the forecast at annual purchase order placed with Nanophase. We have some indications that the volume appears to be growing over original projections, which seems encouraging for future orders

RHEM has stated that it is in the final stages of closing new business for our alumina based slurry, which is a new product for our partnership. And as such, would represent a new revenue stream for Nanophase. We are unable to speculate on the timing of this, but we are optimistic that it may occur in the near term, but obviously until an order is received, it is still speculative.

RHEM is also starting field trials of a new Nanophase cerium-based slurry in the next 30 to 60 days with a major semiconductor manufacturer, which is a positive development for the new product. We are optimistic for success and we will support RHEM, however needed. In summary, RHEM is moving forward and we are optimistic for continuing revenue growth in the CMP area.

BYK-Chemie appears to be seeing some impact of challenging economic conditions, especially in US, and their demand level from Nanophase during 2008 is disappointing. BYK's inventory rates are deemed high at this time and we now expect weak demand from BYK during the second half. Based on our recent 8-K filing, you may be aware that we have restructured our relationship with ALTANA, BYK-Chemie to allow Nanophase more direct marketing and sales access, and through the field of exclusivity, we have several market initiatives in this area.

Our largest architectural paint customer is seeing continued success with our nanomaterial based formulation and have stated they are pleased with market adoption, customer acceptance and growth. One year after market introduction, the new product launch has been successful and we are optimistic about continuing growth in the future. We are also involved in a specific new product development with this customer that appears promising at this time and if successful would represent a new revenue source for Nanophase.

As you maybe aware, architectural coating companies have public announced as recently as last week, revenue and financial impacts from the housing market and the consumer slowdown in US. While our customers forecast for the second half of 2008 is essentially to our expectation entering the year. We remain cautious given current market conditions and uncertainties in the second half of 2008.

Moving to business development and new opportunities. We're excited about the progress we have made in 2008 creating new opportunities to our sales pipeline and moving those forward. As we have noticed, previous opportunities have now transitioned to initial revenues streams. New consumer and industrial glass polishing application, electrostatic discharge protection for electronics application, and a more hygiene products. We're optimistic that each of these will continue to grow going forward.

Relative to the new business we are actively involved with several opportunities in various markets, examples includes, solar energy, animal hygiene, current electronics, lighting, natural rubber, latex products, SPF clothing, liquid cooling, (inaudible) exterior wood products and several others.

We're managing this closely with our stage gate sales process and aggressively moving each along towards revenue generation. As you know, we have now re-skilled about 70% of our sales team in the last 18 months and are searching for yet another skilled professionals to add to the effort. We've also realigned R&D and internal resources solely along new business and product development. This approach is making progress and having success.

Entering 2008, we understood that the company's revenues had to grow enough to equal the one-time inventory ordering we experienced in 2007 that is on a year-to-year comparison basis. Before we could show revenue growth in 2008, we're optimistic entering 2008, as the year has developed, situations with two market partners have evolved and now made that goal unattainable. As we noted in the earnings release, excess inventory situations, two our market partners, and the challenging economic environment have impacted our earlier expectations for the last half of the year. This situation with our market partners, we believe, validates our tactical to move increasingly to a direct sales model and progressively reduce our reliance on market partners. We have made some progress in business development and building the pipeline.

Material revenue erosion from market partners is difficult to replace at the current time. As such, we now expect the third and fourth quarters to be relatively flat with the second. While we continue to pursue our opportunities, we're optimistic that we'll close some of these situations in the second half. Timing is unpredictable at this point.

Given the market partner impact to our earlier estimate, we now unfortunately believe that on the year-over-year basis 2008 revenue will likely be down 10 to 15% in comparison to 2007. Much of that being due to inventory ordering by BYK and BASF during 2007. While we are frustrated with the situation, we're working hard to mill our way through revenue effects, the timing is difficult to overcome.

This concludes our prepared remarks and we are available for your questions at this time.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from [Michael Lu].

Michael Lu

Hi Jess.

Joseph Cross

Hey Michael.

Michael Lu

You've hired from these new market opportunities or rather three new customers, can you provide like I know its tough with the timeframe of when do you think you could possibly see revenue contribution or more significant contributions from these customers.

Joseph Cross

Michael this is Joe. On the last polishing product, we just got our second order. So that is starting to scale up. We have met with this customer as recently as last week, and they have an exciting product, but we are under non-disclosure so I can't discuss it a lot. And it's a commercial product that seems to have a very significant market and they are taking us to the market now.

So this could be a seven figure opportunity as well as we can tell, if they are successful in the market place. The ESD Protection we've received several orders for that. We have a team out there actually with the customer today, and that's expected to grow in 2009. I can't say a lot about this application because of non-disclosure, but I can tell you coming from the electronics field that if this application really takes off, I think it's really exciting. Because essentially what it does is in the event of a surge to a device think of a laptop or cell phone. Instead of frying the components, the layer that's in there close to nanomaterials instantaneously at a molecular level changes from an insulator to a conductor and dissipates this charge saving the component and device. So it's a really exciting application.

That too assuming growth, that's a significant opportunity for us. The animal hygiene product, I'd rather not speculate. It's a market we're just getting in to, we've got our first customer, we're working with two other customers also in that industry, and while we've got some estimates or size, Michael, I'm just not real comfortable guessing right this minute.

Michael Lu

And also you'd mentioned that, obviously you want to shift towards more of a direct sales model, what percentage of revenues are currently direct right now?

Joseph Cross

I don't have that number off the top of my head.

Joseph Cross

Well currently the revenue from BASF and BYK and Rhom and Haas, we would not define as direct sold revenue where as the revenue from their hedge funds putting customer is. So right now that's -- almost 60% is partner revenue not direct revenue. So there's a lot of room to grow there.

Michael Lu

Okay. And the other question I had is you had mentioned that you expect revenues to be flat in the second half of this year or in 3Q and 4Q relative to the second quarter. But if we look on an annualized basis, that only amounts to like a single digit type of decline on a full year-over-year comp, and you have also indicated being more like 10 to 15% decline. Could you just clarify that?

Joseph Cross

I think it will be bigger than that, I think it will be a decline in the -- depending we don't know exactly what the quarter mix is going to be, but I think its 10 to 15 (inaudible) year-over-year is accurate.

Michael Lu

Okay.

Joseph Cross

So, probably 20 or 30% down potentially in one of those quarters, but we don't know yet exactly where the fill is going to be.

Michael Lu

Okay. Great, thank you.

Operator

Your next question comes from [Jim Lieberman].

Jim Lieberman

The promising opportunities and the improving environment regarding Rohm and Haas. And is it possible that…

Joseph Cross

Jim we missed the first part of what you were saying.

Jim Lieberman

Oh, yes. Well this is really more of a comment and a question combined. It's that I am focusing more on the promising new opportunities, the improving scenario and the environment with Rohm and Haas, and the polishing technologies. So that's where I am sort of thinking about it. If you could -- is it possible that the Rohm and Haas could actually be the pleasant surprise on the outside and diminish some of your concerns and conservatisms going forward? And then also is there anything else you would like to elaborate regarding the BYK Chemie relationship or have you already discussed every aspect of that?

Joseph Cross

Let me comment on both. Rohm and Haas has over the last 18 months. In fact there was an announcement and I think it was like two or three months ago again, it has moved their CMP technology business primarily to Asia where the customers are. And it appears to us from talking to management at Rohm and Haas that they are actually getting increased market traction because they are where their customers are. And that make sense if you've ever sold in Asia, it's much easier to do business when you are in Asia then selling from the US, okay.

And then talking to the management I'm under the impression that they will continue to migrate more and more of that business Asia. So I think from a commitment standpoint, from putting the resources in place organizationally, Rohm and Haas is making the right moves, and it seems to be making progress. So I think they've made a lot progress technically with this new generation of cerium slurry product. I think the trials that's coming up with a large semiconductor manufacturing frankly is looked at as a technology leader in the industry. Meaning that if they should adopt, it will bring appropriate sales is very important for us. So we're pleased with the progress of Rohm and Haas at this time.

Relative to BYK, the new agreement we have, allows us to sell much more directly into that marketplace under certain conditions which are documented in 8-K, and I won't go through all those. But essentially what it does is always work with customers and formulate our materials directly into their formulation. That's been our experience especially over the last 12 months, and one of the things we've learned is that, if we work directly with customers, especially coating customers or paint customers or plastic customers. And we work directly with them on their formulation, we have a higher probability of success, than giving them a sample and just letting them go, okay. So from building an opportunity pipeline, increasing the odds of success, we consider this to be a significant situation for Nanophase. So that's my comments.

Jim Lieberman

Okay, I appreciate that. Now, since you're moving more toward the direct sales model, are you -- will you be able to talk more about some of the applications for those or will you still be under non-disclosure agreements?

Joseph Cross

Jim, I imagine that we will be able to talk a little bit more truly about some of them and then some we won't be able to talk about. You know it's like a large architectural coating customer. That's a customer, we sell them directly in house all the time and we work with them very closely, they just don't want us to talk about them, and the customers' kind of always right at that. So and some of the others are out, there's a couple -- one -- two of the new customers we currently have, we are talking to them about being able to reveal who they are, okay. And if we get permission to do that, we will definitely like to do that. But until we get permission we can't. So I think it's going to be a mix bag. Again I think investor need to understand that in every case where we have a market partner or a customer, we are soul source for them. They don't buy from anybody else. And a lot of this material frankly they can't get from anywhere else --.

Jim Lieberman

And I have one more questions. Could you mention that the UV exterior wood based products, you missed the clear cuttings. Is that something, do you have any clear picture of when it may hit the market?

Joseph Cross

Yeah, we are in testing now with a couple of larger manufacturers of that product. There are two types of outdoor preservation products; one is a deep -- one (inaudible) is a deep penetrating product, one is a (inaudible) product. The different manufactures have different avenues to get there. We are working in both -- the real criteria are the value proposition that marketplace seems to be, if you can extend the clear coating life one year and then its kind of a win. And so far the test for us are very promising. We have test internally, we have stakes in the ground whether in Florida, so we're are pretty optimistic about that market. We think we can play in that market.

Jim Lieberman

Thank you very much.

Joseph Cross

Thank you.

Operator

(Operator Instructions). At this time there are no further questions. Mr. Cross do you have any closing remarks.

Joseph Cross

We thank you for you attention and we look forward to talking to you next quarter. Thank you.

Operator

Thank you for attending today's conference call, you may now disconnect.

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