First Quarter 2002 Conference Call Transcript

FIRST QUARTER 2002 CONFERENCE CALL

Joseph Cross, President and CEO

Welcome to our conference call to discuss the first quarter 2002. The Nanophase attendees for this session are: Dan Bilicki, VP Sales and Marketing; Dr. Don Freed, VP Business Development; Dr. Richard Brotzman, VP R&D; Jess Jankowski, Vice president - Controller; Dr. Gina Kritchevsky, Chief Technology Officer; and Bob Haines, VP of Operations.

To begin, Jess Jankowski will review the financial results for the first quarter. I will then summarize the company's progress in the first quarter. After which, Dr. Don Freed will provide an overview of the company's new business development initiatives in multiple markets. Dan Bilicki will address progress in the company's marketing and sales efforts, and expectations for the second quarter. Dr. Gina Kritchevsky will provide an update on our technology progress. Following our prepared comments, we will accept questions that you may have. Jess…..

Jess Jankowski, Vice President-Controller

Good morning and thank you for your continuing attention and support.

Please keep in mind, all numbers are approximate. For the first quarter of 2002, our revenues were $1,408,000 versus $1,072,000 for the same quarter last year, a 31% increase. The majority of our revenues continue to come from products.

We had $113,000 in gross margin for the first quarter of this year. This positive gross margin was achieved through a combination of favorable product mix and the fact that we are starting to see many of our manufacturing cost-saving measures coming through. We now feel that gross margins, for the year taken as a whole, should be positive. Given our visibility, quarter-to-quarter variability in various margin drivers, such as product mix, are difficult to predict. The extent to which we remain positive, as a percentage of revenue, will be dependent upon revenue mix, revenue volume, and our ability to continue to cut costs.

Relative to Q1 of 2001, a major difference relating to the bottom line was the decline in interest income of $220,000. This was largely a function of fewer funds available for investment, coupled with lower interest rates. On the bottom line, we lost 11 cents per share for the first quarter of this year versus 8 cents per share for the first quarter of 2001.

I would now like to spend a little time walking you through the major categories on the March 31, 2002 balance sheet:

Again, all numbers are approximate….

At March 31st, we had $5.5million in cash and investments…. This might be a good point to take a step back and discuss the rate of expected cash burn in 2002 relative to that in 2001. In 2001, we used $5million in our operations and used $5.5million for capital expenditures to increase capacity and add capability, as we have previously discussed. This was offset in 2001 by $300,000 in loan proceeds, net of principal payments. If we net these three items, cash outflows for 2001 were $10.2million. On a quarterly basis, this brought our total cash burn to a little over $2.5million. For the first quarter of 2002, we used $900,000 in our operations and spent about $1.1million on capital, 75-80% of which related to the finalization of projects begun in 2000 and 2001. What I would like you to take away from this is that, in terms of cash flow, 2002 will not be a repeat of 2001.

Our overall cash burn rate for 2001, and the first quarter of 2002, was heavily influenced by spending on capital. Aside from any expanded working capital required to support a potential revenue spike, which, by the way, I am not forecasting here, we expect to see a decrease in cash used from operations for the balance of this year.

If opportunities come before us that make business sense, but require a significant capital outlay, we will finance them via other means than depleting our current operating cash.

Back to the balance sheet…..

At March 31, 2002, Accounts Receivable amounted to $1.1million. 85% of our receivables were current, with only 3% being over 60 days. We expect all of our receivables to be fully collectible. Two reasons that our receivables appear large in relation to sales are that:

We have an accrued receivable relating to a minimum royalty due us from a licensee, which amounts to $300,000/year and is accrued at a rate of $75,000 per quarter. Most of these monies are not due until the middle of this quarter. As the quarters go by, this builds our A/R and may lead people unfamiliar with this relationship to assume that we are not collecting on a timely basis. This receivable makes up 32% of our A/R balance.

Also, receivables from the Company's largest customer amounted to 47% of the total. This amount reflects the percentage of their quarterly volume that shipped in March and was not due and owing until after the first quarter closed.

*Moving down, Inventory has decreased by $150,000 between the end of 2001 and March 31st. We have made every effort to keep inventories at the minimum levels that we can and still be able to service the needs of our existing customers. We continue to manage this situation closely.

Another thing I would like to address on the March 31st balance sheet is the Company's roughly $1.4million dollars in long and short-term debt. 86% of this, which is currently classified as both current and long-term, reflects funds received against the previously discussed $1.3million loan from our largest customer. This loan was used to build a coating facility at Nanophase's Romeoville, Illinois location that has allowed the Company to both strengthen its relationship with its largest customer and to further extend our products in that customer's supply chain. The other 14% reflects insurance premiums and leased equipment that management elected to finance.

Lastly, we have also had a reduction of $390,000 in our accounts payable from the end of last year to the end of this quarter. This is mainly a result of making final vendor payouts on our 2000-2001 capital-spending plan.

Generally speaking, in terms of our balance sheet strength, the Company is aware of its cash position, its business needs, and its contractual obligations. We have no further comment on that at this time.

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

Joseph Cross, President and CEO

Thank you, Jess

The first quarter, we believe, was an excellent start to fiscal 2002 with revenue 30% above the comparable period last year and increasing 14% sequentially quarterly. Business development activity remains strong, as Don will discuss shortly, and growth in our existing customer base has been good as expected. We continue to expect existing products and customer revenue to provide approximately $5M in revenue in 2002, as well as provide an increasing revenue platform for 2003. As Dan will detail shortly, we continue to forecast approximately $3.0M in revenue during the first half of 2002, which is a 40% increase over the same period last year.

The NanoArc Synthesis process technology has progressed well and we are beginning to commercialize our first product in the ultrafine polishing market where the nanomaterial has enjoyed early initial success. Going forward, we continue to have significant expectations for this market and for the growth of new products from NanoArc Synthesis technology, which we perceive as break-through technology and well ahead of competitive technology.

Our application development for new markets and new opportunities also made good progress. This is manifested in the three new patent applications to-date during 2002. Gina will provide additional details in this area later in the conversation.

From an operational perspective, we continue to perform excellently - operations, that is manufacturing commercial quantity and quality nanomaterial solutions - has definitely become a core strength of this company and a key differentiator in the emerging nanotechnology industry and the markets we can address. During the first quarter, we continued to reduce manufacturing cost, which continues to increase gross profit, and we expect this activity to be equally as successful during the remainder of the year. We also completed operational implementation of the nanocoating area and equipment that is now in production on a two-shift basis five days a week, primarily for sunscreens and personal care products. Equally as important to penetrating our target markets and revenue growth plans over the next 18 - 21 months, we completed installation of the new nanoparticle dispersion equipment and began trial deliveries of nanoparticle dispersions and formulations to potential customers. Coupled with the application developments mentioned earlier, this is a significant capability for the company and directly addresses the needs of potential customers who prefer nanoparticle solutions in a liquid matrix that is easier to handle in their production environments.

In summary, as I have stated previously, Nanophase entered 2002 with significantly improved market application capability and delivery tools than we entered 2001. We believe that the company has created an integrated series of nanomaterial technologies from nanoparticle manufacturing to nanocoating to dispersion of nanoparticles in various liquid media. We believe this is an industry-leading suite of technologies that allows the company to address significantly more markets while increasing the probability of success in potential applications.

We continue to believe that the company's technology advances, significant improvement in operations over the past 18-24 months, and momentum in business development and sales clearly differentiate Nanophase versus potential competitors in nanomaterials.

First, before I hand the conversation over to Don, let me address yesterday's ill-timed press release regarding litigation against the company, which by the way is old news, since I know I will get a question and it seems to have caused undue concern with some of our stockholders. The timing, we think, was irregular, and, perhaps, not coincidental given that the action occurred 4-6 weeks ago. The release, we think, left out some important details. First, the suit was amended, as the release noted, since the company had filed for dismissal to their original filing. The release also failed to note that the company has already filed for dismissal, again, in response to the amended suit.

Secondly, to the best of our knowledge, there is essentially only one legal firm with a Chicago connection involved in this suit. Again, to the best of our knowledge, this suit is filed by one individual who purchased 200 shares of stock two weeks before the end of the defined period and well after the information concerning relations with the European customer was publicly disclosed, and after all of alleged misrepresentations had been absorbed by the market. No class has been certified in this case.

We believe that the suit is entirely without merit and are awaiting the court's ruling on our dismissal filing. Let me also remind you, irrespective of this suit, that the company maintains sufficient D&O insurance. Beyond this, the company has no additional comments on the matter, other than to state that this event is thoroughly discussed in the company's 10K filing.

Don, would you now please summarize the company's activities in business development?

Dr. Don Freed - Vice President, Business Development

Good morning - and thanks for your participation and interest. I'm pleased to report that customer interest in Nanophase' capabilities and products remains high, particularly in new market areas. I'll also remind you that our competition routinely listens to our conference calls so that we are unable to provide a lot of detail.

Before I begin, I'd like to mention that we've just added to our business development resources a new Director of Business Development, Greg Palagi, who comes to Nanophase with close to 10 years business development experience in several multinational companies and a BS in Chemistry and an MBA. Greg will initially focus on creating additional opportunities in the ultrafine polishing, antimicrobial and wear and UV resistant coatings market segments.

The opportunities that we are working on fall naturally into three groups - current business, which I will not cover since that is normally not in the province of business development but about which Dan Bilicki will be providing more information in a few minutes. Business development is really about positioning the company for future growth and the programs that we are pursuing consist of short term opportunities, i.e., those that we expect to mature to commercial scale in twelve to eighteen months and mid-term opportunities - those which have a time horizon of eighteen to thirty-six months or more.

The advances in technology that we've been making plus the significant capital investment in coating and dispersion facilities made during the past eighteen months are enabling access to significant new opportunities. For example, within the short term opportunity space, the technology advances in our new NanoArc™ Synthesis process, coupled with our new dispersion line are allowing us to provide highly uniform dispersions of nanoparticles for use in ULTRAFINE POLISHING of semiconductor wafers, rigid memory disks, glass photo masks, and optical lenses, new market areas for Nanophase. Customers are reporting to us that they are achieving significant reductions in the number of defects produced during wafer polishing and vastly improved selectivity with the Company's nanocrystalline particles as compared to competitive materials.

We continue to make progress in another very exciting short-term market opportunity, ANTIMICROBIAL applications. We believe that this is due to the large surface area of our materials, which makes them effective against microorganisms, and their insolubility in water, which provides a degree of permanence. The first of our customers to use our nanocrystalline materials for water purification products is we believe, nearing production and we are seeing strong interest in evaluating our nanocrystalline particles for antimicrobial protection for hard surfaces.

In the textile nanotechnology, we noted during our last call that we were working with industry leaders in the nylon, polyester and polypropylene fibers markets - we're developing surface engineered nanoparticles that can be incorporated directly into fibers to develop better wear and UV resistance properties. Our surface treatment and dispersing technology, covered by our recent patent application filings, is important here because that is the enabling technology that makes our nanocrystalline materials compatible with the polymer fibers. I should mention however, that this application probably falls into the mid-term market category in terms of timing.

In addition to the above, we continue to develop applications in the areas of LIGHTING, MICROELECTRONICS (in the latter area we are co-developing applications with a number of lead customers for photo printing, specialty products for digital printing, varistors and photocopying to name a few) and NANOCOATINGS.

All told, we are quite optimistic about our prospects and within the markets referred to above, we're currently pursuing between $20 million and $30 million of opportunity. I need to remind you also that the decision to use our products is often a binary decision - and that, coupled with limited visibility makes it difficult to predict just when a particular application will result in production orders.

Now, I'd like to turn it over to Dan Bilicki - Dan…

Dan Bilicki, VP Sales & Marketing

Good morning and thank you for your interest in Nanophase.

As reported, total revenue for Q1 was $1.4 million with $1.29 million or 91% being derived from sales of products. The product sales revenue represents a 31% increase over Q1 of last year and an 11% increase over last quarter.

Q1 product sales into the personal care business were 2% ahead of plan. Projections for the first half of 2002 put personal care sales volume at 8% above our forecast. The personal care business is the largest market segment for Nanophase, and new application opportunities for our products are rapidly developing. It is expected that product revenue for the personal care market segment for 2002 will exceed 2001 by over 30%.

Product sales into our flooring applications for Q1 were 17% ahead of our annual plan as one of our customers launched a new product line, resulting in increased product sales from filling the pipeline. The first half outlook for these applications is projected to be 9% ahead of plan.

Sales revenue from environmental catalysts customers in Q1 was 32% of our annual forecast due to heavy demand from a major customer. Product sales into this market segment for the first half of 02 are expected to be slightly ahead of plan.

As reported during our last conference call technical advances made on the manufacturing of nano crystalline particles via the NanoArc Synthesis process or, Audrey as it was previously called, have opened up significant opportunities in the ultrafine polishing market. Applications in this market segment include ultrafine polishing of semi conductor wafers, rigid memory disks, read/write heads, glass photo masks, and optical lenses. As a result, sales revenue generated in ultrafine polishing applications increased from a low base in Q4 of last year by 76% in Q1. Revenue generated from Q2 sales in this market segment is expected to increase over Q1 by 5 fold.

With product shipments to date, purchase orders, and annual supply agreements in-hand, the company has a current shipped and order backlog of approximately $5.0 million for 2002, which is 24% ahead of the total revenue generated in 2001. The second quarter sales revenue for 2002 will be in the range of $1.6 million, resulting in revenue for the first half of 2002 of $3 million, or a 40% increase for the same period in 2001.

Now I'd like to turn the conference call back to Joe Cross.

Joseph Cross, President and CEO

Dr. Gina Kritchevsky will now provide an update on the company's technology progress.

Gina Kritchevsky, Chief Technology Officer

Good morning. I would like to take this opportunity to provide an update on several development efforts, progress in the protection of our intellectual property and some of our recent endeavors to broaden our awareness of nanotechnology advancements (in the business and potential government funding arenas as well as technology) and lastly, to increase the visibility of Nanophase within these forums.

We have been developing and supplying to customers new and improved nanoparticle dispersions for use as abrasives in various polishing applications such as photomask blanks and semiconductor wafers. These products demonstrate further commercialization progress of our NanoArc Synthesis™ produced nanomaterials.

We are also developing zinc oxide and dispersions of zinc oxide for several applications requiring antimicrobial characteristics. Formulation development for abrasion resistant coatings also continues to be an active area. In total, we have over 150 samples under evaluation at customers and potential customers.

We continue to build in the area of intellectual property, with patent applications filed this quarter covering aqueous nanoparticle dispersions at various pH ranges for multiple applications, composite catalyst systems and an application covering extensions and improvements of our core nanoparticle synthesis technologies. The US patent office has allowed our patent on transparent, conductive coatings containing nanoparticles.

The emerging fields of nanoscale science, engineering and technology are continuing to attract more and more interest and attention and, of course, funding. We see this reflected in the increasing number of university research programs in the nano area, and the resultant spin off companies, in the government funded nanoprograms, both in the US and in countries such as Japan and Germany, the UK and others. There are also an increasing number of nanotech consortia and most technical organizations have included at least one nanotechnology symposia at their annual meeting. I think that one could easily attend a nanotech meeting every week of the year if interested. Over the next several years, I believe that there will be a rationalization and the stronger players will emerge.

Certainly, improvements in product costs and broadening of our intellectual property portfolio and our customer base are helping to establish Nanophase as one of the strongest players in the nanomaterials segment. However, in order to better position ourselves for this shake-out we are increasing our effort evaluating emerging nanomaterial technology for potential acquisition, or licensing. We are expanding our presence at a number of industry and nanotechnology meetings in order to ensure that Nanophase remains at the forefront of nanotechnology and the leading producer of nanomaterials and more importantly, nanomaterial solutions.

Joseph Cross, President and CEO

That concludes our prepared remarks at this time.