First Quarter 2003 Conference Call Transcript

FIRST QUARTER 2003 CONFERENCE CALL

Joseph Cross, President and CEO

Welcome to the Nanophase conference call to discuss the first quarter of 2003. The Nanophase attendees for this session beside myself are Jess Jankowski, VP and Corporate Controller; and Bob Haines, VP of Operations and Engineering. Dan Bilicki, VP Sales and Marketing, is traveling and with customers and is not able to be here today. Dr. Richard Brotzman, vice president of R&D, is presenting a paper and attending the Material Research Society’s Spring Meeting and is unavailable.

The agenda for today’s discussion is, first, Jess will review the financial results for the quarter; I will return to summarize the Company’s progress during the first quarter, review our sales target markets, and update business development initiatives. Bob Haines will cover the continuing progress in our operations and discuss the innovative new NanoArc Synthesisä materials being introduced to several specific market areas. I will then return for final comments and questions.

Jess, would you please review the financial results for the first quarter?

Jess Jankowski, CFO and 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 2003, our revenues were $1,664,000 versus $1,408,000 for the same quarter last year, an 18% increase. Of the $314,000 in Other Revenue in Q1 of 2003, approximately $240,000 related to the sale of a PVS reactor to C.I. Kasei, our Japanese licensee, to support demand from their customers. The majority of our revenues continue to come from products.

We had $117,000 in gross margin for the first quarter of this year. This positive gross margin was achieved through the contributions from Other Revenue and the fact that we have seen many of our manufacturing cost-saving measures coming through. These gains have been offset somewhat by increases of approximately $90,000, in depreciation expense as new assets have been brought online, as well as the fact that inventory was depleted in Q1 of 2003 offering the Company limited opportunities to absorb fixed overhead costs. Based on Q103 data, annualized depreciation expense recognizable as part of the fixed cost of manufacturing currently amounts to $1.1 million. Management expects that gross margins, taken for the year as a whole, should be positive. Given our visibility, quarter-to-quarter variability in various margin drivers, such as product mix and volume, 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.

Research and development expense is down about $60,000 from the first quarter of last year to the first quarter of 2003. This reduction is due mainly to bonuses accrued in Q1 of 2002 being higher than bonuses accrued in the same period in 2003. As an aside, no bonuses were paid either for 2002 or 2003 in this period. We also reduced engineering staff by one member between the same two periods which contributed to this cost reduction.

While SG&A appeared relatively flat period to period, there were a lot of compensating changes within the category that will impact future costs. Director compensation appeared to go down by $130,000, given that it was recorded in lump sum in Q1 of 2002 and began to be accrued monthly in 2002 also. This resulted in twice as much total director compensation being recognized in 2002, the year of the change in recording convention, than in 2003. An offset to this favorable variance was that business insurance costs and legal fees relating to our current securities litigation increased by almost $200,000.

It should be noted that, on an annualized basis, the Company will now recognize approximately $1.5 million, or 10 cents per share, in depreciation and amortization expense. This total is up $390,000, or 3 cents per share, from the annualized number at March 31st of last year.

On the bottom line, we lost 9 cents per share for the first quarter of this year versus 11 cents per share for the first quarter of 2002.

In terms of cost containment, as it pertains to not only manufacturing cost but also R&D and SG&A, management has not let up. We have been driving discretionary costs out of the business as opportunities arise. Part of the cost escalations, or apparent lack of substantial cost-reduction progress, you’re seeing relates to those costs that we can’t control. Insurance and legal costs continue to be difficult to manage. Audit fees, along with securities-related legal fees, continue to climb with the advent of all the new shareholder protection legislation that has been passed in 2002 and continues to be expanded in 2003.

I would now like to spend a little time walking you through the major categories on the March 31, 2003 balance sheet:

Again, all numbers are approximate...

At March 31st, we had $6.2 million in cash and investments.

Accounts Receivable amounted to $1.1million. 99% of our receivables were current. We expect all of them to be fully collectible. Two reasons that our receivables appear large in relation to sales are that:

Moving down, Inventory has decreased by $260,000 between the end of 2002 and March 31st of this year. 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. For the quarter ended March 31, 2003, inventory turns amount to NINE times on annualized total sales. Keep in mind that this number was five turns at December 31st of 2002. Nanophase is still often subject to rapid changes in its customers’ demand for product on a quarter-by-quarter basis. Given our current visibility, which is still not much better than 60 days, and our reliance on one very large customer, one growing customer, and several other smaller customers for the lion’s share of our volume, quarter to quarter comparisons don’t always yield meaningful information. We continue to manage inventory levels closely.

You will note that net equipment and leasehold improvements have decreased by $260,000. This is a function of increased depreciation being recognized as our large capital projects have become operational, offset by light capital spending for the quarter. Nanophase anticipates spending approximately $325,000 in capital for new projects in 2003 along with some smaller expenditures to close capital projects that began last year.

Another thing I would like to address on the March 31st balance sheet is the Company’s roughly $1.5 million dollars in long and short-term debt. The majority 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 which is being paid back on a per unit of product shipped basis. This loan was used to build a coating facility at Nanophase’s Romeoville 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. In the same spirit of cooperation and partnership, in March this customer agreed to change some of the covenants in the loan agreement in order to ease any potential financial pressure on Nanophase.

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

Across each of our tactical focus areas, Nanophase continued to make notable progress during the first quarter of 2003.

Relative to sales, first quarter 2003 revenue represents 18% year-over-year growth compared to the first quarter of 2002, and 54% sequential quarterly growth compared to the fourth quarter of 2002. We were also able to actually exceed the higher end of the revenue guidance that we provided in February. In fact, this past quarter represents the highest revenue quarter in the Company’s history. It is an encouraging beginning to the fiscal year.

From a business development perspective, we are quite pleased that Dr. Ed Ludwig joined Nanophase this past quarter as vice president of business development. Dr. Ludwig has a Ph.D. in Chemistry from the University of Michigan and a Master of Business Administration from the University of Iowa. Dr. Ludwig has over eighteen years of domestic and international application and business development experience with Rohm and Haas Company, Lighting Technologies International, and Penford Products. He was also a key inventor on four US patents. We believe that Ed will be a definite factor and driver in our revenue growth plans going forward.

In general, Nanophase’s business development activities continue to be robust and we have several high quality application opportunities in process for both new and existing market areas. We are continuing to focus in market areas that we have discussed: a wide variety of polishing applications for semiconductors, displays, disk drives, read heads, and optics; antimicrobial applications for filters, textiles, surface cleaning products, wood treatment, and coatings; electronic applications; wear resistant coatings for flooring, automotive, inks and printing applications; and several other coating applications. We have over 60 opportunities in process at this point.

Additionally, we are adding vertical and horizontal market opportunities through new, innovative nanomaterials derived from the Company’s novel NanoArcä Synthesis process, and complemented for applications by the Company’s patented nanocoating technology, and unique dispersion technology (patent applications pending). These materials are specifically targeted for defined markets: catalysis; advanced sunscreens; electronic packaging; catalytic converters; polishing applications for semiconductors, photomask, photonics, optics, and metals; biocides; and fuel cells. Nanophase has identified and is working with potential lead customers in these markets to test these materials relative to application performance and market introduction.

From a financial view, we believe that reducing the BASF contractual limit of cash and liquid investments from $4 million to $2 million is an obvious benefit for the Company. Separately, as you may recall, BASF loaned Nanophase approximately $1.3 million to scale-up coatings for sunscreen products, which Nanophase repays through a discount on purchased materials. We are pleased that BASF has revised and extended their loan terms to move a potential balloon payment from June 2004 until June 2005. By this time, we believe, the loan should be essentially fully paid through product deliveries under our current discount on sunscreen product.

From a manufacturing, quality, and engineering vantage, the quarter saw significant achievements. Our operations team continues to reduce variable manufacturing cost by increasing machine utilization and improving yields. During this past quarter, despite higher energy costs, we again reduced variable manufacturing cost by 4-8 percent on our higher volume products.

At this point in time, I would like to ask Bob Haines to provide a summary update on operations and engineering. Bob….

Bob Haines, VP Operations

Good morning and thank you for your interest in Nanophase.

We continue to improve processes and reduce manufacturing costs while developing and introducing a number of new commercial nanomaterials. I would like to first address our continuing improvements in manufacturing and finish with a discussion on recent development of new materials focused on catalysis, fuel cells, polishing, and antimicrobial applications.

During this quarter, the Company successfully completed the ISO9001: 1994 transition audit to the new ISO9001: 2000 standards. After an extensive audit on both of our manufacturing facilities in Romeoville and Burr Ridge, Illinois, SGS International Certification Services certified that Nanophase’s Quality Management System meets the requirements of the new ISO standards.

This recent external revalidation of our integrated quality management system is one of several Nanophase initiatives to be highly focused on our product quality, our customers, and the company’s total commitment to lean manufacturing and continuous improvement. Having an internationally recognized quality system and operating our manufacturing facilities under FDA’s current good manufacturing practices (cGMP) definitely provides the Company with a distinct competitive advantage as a manufacturer of nanomaterials. This also gives the company substantial credibility from a product assurance standpoint as we attract new customers and markets.

Lean Manufacturing by our definition is a highly focused effort on removing nonvalue added activities from every aspect of our commercial manufacturing, as well as process development for new products. We drive these efforts using cross functional Process Improvement Teams with participation from operators to our most senior scientists and sales and marketing folks. Some highlighted improvement activities for this quarter include:

On volume products, we currently are able to produce the same volume of finished materials on a two shift, five day per week operation as we did a year ago on a three shift operation. This results in approximately 25% less direct labor and significantly improved output and capacity for our capital assets.

VMC on volume products has been reduced during Q1 2003 in a range of 4% to 8% through improved yields and efficiency. This is during a period we have experienced significant increases in energy costs and to a somewhat lesser extent, increases in the cost of raw materials.

NTC has developed and manages a global supply chain for raw material sources, including Asia. This allows us to better control the cost and availability of our precursors while managing inventory costs.

As good corporate citizens, we continue to operate all of our facilities with an outstanding environmental and safety record. As an example, we have worked over a half million hours without a lost time accident.

In summary, we have a highly developed and cost effective commercial manufacturing capability that allows rapid response to new and developing business opportunities while maintaining unquestionable quality.

I would like to now change the focus of our discussion to development of new materials

We have experienced a rapid acceleration in the development of new nanomaterials, largely in part by commercialization of NTC’s proprietary NanoArc Synthesis technology. During the last quarter of 2002, we started construction of a new development NAS reactor, which was commissioned early in January of this year. Since the beginning of this year, we have developed on the average a new material every two weeks that have strong potential commercial applications. These materials are all customer / market driven with a twelve to eighteen month market horizon and are in direct response to customer requests. NAS, with its advanced process control system, has certainly opened up an extensive list of new nanometal oxides in terms of composition, particle size, and surface chemistry. We are currently sampling to the market a number of new NAS materials for evaluation in the areas of catalysis, ultra fine polishing, and fuel cells.

Available for the first time in commercial quality and quantities, these unique nanostructured powders are single or multi-element rare earth oxides that are combined in a single-phase crystal. Ratios of mixed rare earth oxides may be easily adjusted based on a customer particular application. These new homogenous single-phase, multi-component, high surface area nanomaterials are available in discrete ranges of average particle sizes from 7 to 35 nanometers, again depending on the customer’s requirements.

The compositions directed at the catalyst markets are unique in many ways, particularly in terms of maintaining high surface area at elevated temperatures, narrow nanoparticle distribution, high oxygen storage capacity, and ease of dispersion in both aqueous and organic systems. The engineered surface chemistry results from the active plasma zone of the NAS reactor and yields high zeta potential, hydrolytically stable particles. The large pallets of catalytic materials being offered include very high surface area ceria (7 nm) and ceria doped with various concentrations of other rare earth oxides including prseseodymium and neodymium, and with various other important catalytic dopants such as yttrium, lanthanum, and zirconium.

Why are we excited about the potential of these nanocatalytic materials? In summary, we believe that these materials;

Address an existing, established market with new and unmet needs for performance and cost,

High dispersability allows these materials improved and more controlled application on various substrates. Many of our NAS catalytic materials can be dispersed at up to 50 weight percent solution, which is essentially unheard of for catalytic materials,

Minimal sintering and maintenance of high oxygen storage capacity at elevated operating temperatures, and

NAS technology allows NTC to highly customize the composition, purity, and particle size to meet a variety of customer requirements with minimum development time to commercial quantities and quality.

Other promising NAS material developments include:

Samarium doped ceria for application as a solid phase electrolyte layer in fuel cells. We have just made available for industry sampling a 15% mole percent composition nanopowder and can produce a range of other samarium concentrations. This is a single phase nanomaterial with very high purity and dispersability. We are also exploring vapor phase deposition of samarium doped ceria directly on substrates

We have also produced a new, very small cerium oxide with an average particle size of 7 nm and will be testing this material in ultra fine polishing applications during Q2/Q3 of this year

Future NAS development projects include various doped cerium oxides for other CMP polishing applications

Our NAS technology platform is proving to be a very viable and cost effective route for rapid development and commercialization of a variety of new nanometal oxides. Stay tuned for more in the future.
In an effort to develop new horizontal markets for zinc oxide in the areas of personal care and antimicrobial applications, we are extending our existing PVS process to include various dopants such as copper, silver, and aluminum. Initial sample quantities are currently being screened for antimicrobial / antifungal activity using copper and silver doped zinc oxide. We believe that the combination of these materials has potential as a cost effective antimicrobial with both immediate and long term bacteria kill without the environmental concerns associated with some current organics. These are single phase crystalline nanomaterials and are produced using existing capital assets and with our current commercial capacity. While it is still very early in determining actual commercial viability of the doped zinc oxides, we are hopeful that these unique materials will allow NTC to enter additional markets in the future.
That concludes my comments on operations and new materials development. I will turn it back over to Joe Cross for his concluding remarks.

Joseph Cross, President and CEO

Thanks, Bob

Going forward, Nanophase has encouraging momentum entering 2003 and several rather exciting opportunities in process. We are also optimistic on the market potential for the new NanoArcä nanomaterials and testing the new PVS doped materials. However, we are also concerned with the general state of the economy and the geopolitical situation. We have observed weakening in abrasion-resistant coatings for flooring and in catalytic converters due to the economy. We have also seen unpredictable, and somewhat unmanageable, slowing or lateral movement in some of the application development underway. We are concerned that these factors are causing uncertainty in our established customer base and, perhaps, lengthening development cycles.

However, as we have stated before, Nanophase has already established a solid customer base in at least four growth markets – personal care, sunscreens, abrasion resistant coatings, and CMP. Each sector has had some impact from macroeconomic events. While economic conditions may affect the timing of growth and cause starts and stops, we believe that these markets alone should grow at a pace that will allow the Company to become profitable in the near-term.

Our visibility, however, is not good. For that reason, we are not providing guidance until we have received adequate information from our customers to give us clarity. We have several fluid situations at the current time that potentially may affect revenue timing during subsequent quarters. We plan to issue guidance when we believe it is reasonably accurate. At this time, we expect revenues for the first half of 2003 to be roughly comparable to the same period in 2002, but are unable to quantify the situation any better at this time.

This concludes our prepared comments. Let me remind you that our comments will be posted on the Company’s website, www.nanophase.com on or before April 29, 2003. We are available to respond to your questions at this time