Second Quarter 2002 Conference Call Transcript

SECOND QUARTER 2002 CONFERENCE CALL

Joseph Cross - President and CEO

Good morning and welcome to our conference call to discuss the second quarter and first half of 2002. As always, we appreciate your continuing support and interest. The Nanophase attendees for this session are: Dr. Don Freed, Vice President, Business Development; Jess Jankowski, Vice President - Controller; Dr. Gina Kritchevsky, Chief Technology Officer; and Bob Haines, Vice President of Operations.

To begin our discussion, Jess Jankowski will review the financial results for the second quarter and first half of 2002, during which I believe that the company performed exceptionally well, especially in view of the general US economic and manufacturing conditions. After the financial review, I will offer an overview of the company's progress during the fist half of 2002. Dr. Gina Kritchevsky will then provide an update on our technology progress. Bob Haines will follow and provide details and examples of the company's definitive progress in operations and manufacturing. Dr. Don Freed will then provide an overview of the company's new business development initiatives in multiple market areas. I will return once again to comment on sales for the first half and the view to the second half. After our prepared remarks, we will accept questions. Jess….

Jess Jankowski - Vice President-Controller

Good morning and thank you for being here.

Please keep in mind, all numbers are approximate. For the second quarter of 2002, our revenues were $1,662,000 versus $1,049,000 for the same quarter last year, a 58% increase. The majority of our revenues continue to come from products.

The Company had $260,000 in gross margin for the second quarter of this year. This positive gross margin was achieved through a combination of favorable product mix, increased volume, which allows for greater absorption of overhead, and the fact that many of the Company's manufacturing cost-saving measures are having an impact. Additionally, the Company received nonrecurring other revenue in the amount of $65,000 that had no associated period costs. Some of these gains were offset by an additional $96,000 in depreciation relating to the placement in service of most of our large capital projects. These projects I'm referring to are the roughly $8million in capital used to enhance the Burr Ridge facility, build infrastructure in the Romeoville facility, and build our pilot manufacturing and blending lines, both contained within the Romeoville facility. These projects began in the latter half of 2000 and ran through the first quarter of 2002. Given our visibility, quarter-to-quarter variability in various margin drivers, such as product mix, are difficult to predict at this time.

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 Q2 of 2001, R&D expenses are up by $120,000, mainly due to payroll coming back on line that was being capitalized for construction projects during 2001. R&D expenses should stabilize in the current range.

SG&A expenses are down $80,000, with some further reductions expected. Finally, a major difference relating to the bottom line was the decline in interest income of $140,000. This was largely a function of fewer funds available for investment, coupled with lower interest rates.

On the bottom line, we lost 9 cents per share for both the second quarter of this year and the second quarter of 2001.

For the six months ended June 30, 2002, revenues were approximately $3.1million versus $2.1million for the same period in 2001. This represents an increase of 45% year over year. With respect to earnings per share, Nanophase lost 20 cents per share for the six months ended June 30, 2002 versus 18 cents per share for the same period in 2001. Again, the reduction in interest income in 2002 had a significant impact on the bottom line, amounting to $255,000 or $0.02 of the loss. As discussed, increased R&D expenses also contributed to the loss. These items were somewhat offset by increases in gross margin and decreases in SG&A expenses.

For the year ended 2001, the Company had an average gross margin percentage of negative 21%, versus a positive 12% for the six months ended June 30th 2002. We expect margins to continue to improve.

I would now like to spend some time walking you through the major categories on the June 30, 2002 balance sheet:

Again, all numbers are approximate….

We issued 1.37 million shares of additional common stock at $5.00 per share. This resulted in an effective 3% discount to market. Gross proceeds from this transaction amounted to $6.85 million, yielding approximately $6.2 million after commissions, legal, accounting, and other costs.

No warrants or other rights were granted as part of this transaction. Management believes that the terms and results of this transaction were quite competitive.

In terms of expected cash burn in 2002 relative to that in 2001…. In 2001, we used $5million for operations and $5.5million for capital expenditures to increase capacity and add capability, as we have previously discussed. This was offset in 2001 by proceeds from the previously discussed loan from our largest customer. Netting these items, cash outflows for 2001 were $10.2million. On a quarterly basis, this brought our total cash burn to a little over $2.5million, approximately half, or $1.25million, of which related to operations. For the first six months of 2002, we used $1.3million in our operations, resulting in an average cash burn from operations of approximately $650,000 per quarter. We also spent about $1.5million on capital, the majority of which related to the final payouts on projects begun in 2000 and 2001. Again, in terms of cash flow, 2002 will not be a repeat of 2001.

Relative to 2001, we expect to see a decrease in cash used from operations for the balance of this year. Regarding capital expenditures, we are currently planning for less than $1million in additional spending for the balance of 2002. This will include a second NanoArc Synthesis reactor and additions to support our expanding CMP (an acronym for Chemical Mechanical Planarization, or wafer polishing) business through at least 2003.

If other opportunities come before us that provide a compelling business case, but require a significant capital outlay, we plan to finance them via other means than depleting our current operating cash.

Getting back to the balance sheet…..

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. These monies are not due until April of 2003. 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 currently makes up 14% of our A/R balance.

Also, receivables from the Company's largest customer amounted to 70% of the total. This amount reflects some of their quarterly volume that shipped in June and was not due and owing until after the second quarter closed.

Another thing I would like to address on the balance sheet is the Company's roughly $1.3million dollars in long and short-term debt, and capital leases. In accordance with GAAP and SEC requirements, this total is broken into four line items on the Balance sheet.

For purposes of this analysis, I have added them together to more clearly define the Company's obligations. 88% of this, which is currently classified as both current and long-term, reflects funds received against the previously discussed loan from our largest customer. The remaining 12% reflects leased equipment and prepaid insurance premiums that management elected to finance.

Lastly, we have also had a reduction of $650,000 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 improvement plan.

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

Thanks, Jess. While Jess has covered the financial overview of the company's performance during the first half thoroughly, let me dwell briefly on revenue. This past quarter's revenue represents the highest quarterly revenue attained in the company's history, and, as a comparison for all the long-time followers of Nanophase, this quarter's revenue was greater than the entire revenue for all of 1999, by about 17% actually. And, as noted in the earnings release, revenue for the second quarter represents a 58% increase over the equivalent period in 2001. Secondly, let me point out that based on the 4th quarter of 2002, Nanophase has experienced sequential quarterly revenue growth of 14% and 18%, respectively in the last two quarters.

During the first half of 2002, product sales continue to be derived mainly from sunscreens and personal care markets, abrasion-resistant coating for flooring, environmental catalysts, CMP for photo masks and semiconductors - the company's newest market initiatives, and other miscellaneous applications.

Nanophase is also demonstrating continued improvement in gross margin on manufactured products with a fourfold year-over-year increase comparing the second quarters. I think an even more telling statistic is the positive 12% gross margin year-to-date for 2002 versus the NEGATIVE gross margin of 21% average for 2001. It is also encouraging that gross margin improved sequentially, comparing the second quarter to the first quarter of 2002, by doubling.

This is a direct effect of manufacturing improvements and the capital investment that the company has made over the last two years to increase productivity and reactor output rates to reduce cost and raise gross margin. Without a doubt, I believe, positive gross margin also demonstrably validates and reinforces the fact that Nanophase's technology is commercially scalable.

We expect this trend to continue and actually grow well into 2003-2004, as manufacturing cost will continue to reduce with increasing volume and increased output and, correspondingly, gross margins will continue to grow. Except for any additional depreciation caused by additional capital investment that may be required to meet customer volume demands, this will occur because the fixed cost for manufacturing is in place and will essentially not significantly increase with increasing volume and revenue. Positive growth margin growth is obviously one of the key predictors along the path to profitability.

Relative to intellectual property and nanomaterials technology accumulation, which is a key strategic goal for Nanophase, we have continued to demonstrate leadership in nanomaterials by increasing patent coverage along the entire spectrum of our family of integrated nanotechnologies that are focused towards solution applications. Especially over the last two years, Nanophase has created an integrated family of nanomaterial technologies from nanoparticle manufacturing, for which we now have two technologies, to nanocoating to dispersion of nanoparticles in various liquid media. We believe that this is an industry-leading suite of nanomaterial technologies and provides a real competitive advantage for Nanophase in multiple market applications. Dr. Gina Kritchevsky will provide more details on this later in the conversation.

Continuing the new technology theme, the first half of 2002 was also rather momentous for Nanophase in that we essentially began commercializing the first volume products from our NanoArc Synthesisä technology in CMP applications for photomask polishing and semiconductors. In the latter area, we have partnered with Rodel, as announced. We believe that both market areas represent significant revenue growth opportunities for the company.

Relative to operations and manufacturing, the company continues to become increasingly skilled with practice. We have, and are, implementing practices only normally found in leading high-technology companies to increase inventory turns to reduce working capital, strengthen supply chain management, increase process robustness to the six-sigma level, and continue to reduce costs and improve gross margins. Progressively more, operations is becoming a core competency and is a rather significant differentiator between Nanophase and potential competitors going forward. Bob Haines will elaborate on the company's progress later in our discussion.

Gina, would you provide a summary overview of the company's technology progress?

Gina Kritchevsky - Chief Technology Officer

Good morning and welcome to our second quarter conference call. I would like to provide an update on Nanophase's recent progress in expanding our growing intellectual property portfolio and developments in the technology arena.

Over the course of the past two years, Nanophase has demonstrated substantial growth in our technology targeted at our "solution provider" business model. We believe that our interrelated suite of nanotechnologies provides us with a competitive advantage in many application areas and enhances the value of the company. We have been and continue to be proactive in protecting all aspects of our technology and expertise through patent applications.

During the first half of 2002, we have filed four new patent applications, filed one provisional application detailing non-aqueous dispersion technology as a US utility patent and as an international application. Additionally, and our application covering transparent conductive coatings has issued as a US patent.

The new applications will expand our coverage of our intellectual property to include not only our novel nanoparticles, nanoparticle production methodology and equipment, but continue to extend protection to cover our entire spectrum of integrated nanotechnologies, ranging from particles to surface treatments, dispersion technology and applications of our technology aimed at solving customer needs.

The first of the new applications details a novel method and equipment to remove supramicron particles from nanoparticle streams allowing us to tailor the particle size distributions for all of our products. This technology was developed based upon computational fluid dynamic studies of our proprietary reactors and is applicable to both our PVS and our NanoArc Synthesisä processes.

The second new application illustrates improved technology allowing us to create stable dispersions of nanoparticles in aqueous solutions. This technology allows Nanophase to manufacture nanoparticle dispersions and to adjust the pH to match a customer's application requirements while maintaining dispersions that are stable for extended time periods. This technology is critical for several applications in multiple markets, for example CMP.

The third new application teaches a novel composite nanoparticle structure with a core-shell morphology that demonstrates improved properties compared with single constituent nanoparticles in a wide range of applications ranging from catalysis to electromagnetic materials to chemically passivated materials. This patent application extends our ability to provide surface modification and coatings of our particles. This development allows us to engineer a composite structure where certain properties, such as density can be determined by the particle core and others, such as refractive index or chemistry can be controlled by the particle shell.

The fourth new patent application is entitled, "Process for Preparing Nanostructured Materials of Controlled Surface Chemistry" and details a novel approach to control and modify the surface chemistry of the particles produced in our plasma processes. The technology applies to both our PVS technology and to NanoArc Synthesisä and will have direct application in glass polishing, rigid memory disk polishing and Chemical Mechanical Planarization of semiconductor wafers as well as catalytic wash coat formulations, cosmetic and personal care applications and catalytic fuel additives.

We believe that this approach - that is, protecting not only the materials and production processes, but the technology required for these materials to provide value in our numerous of applications - provides Nanophase with a tangible competitive advantage in the marketplace.

Going forward in the second half of 2002, our focus will be in three primary areas. In the area of technology improvements, we will continue to develop additional materials to be produced using NanoArc Synthesisä for a variety of applications, continue our progress in improving the transparency and properties of both UV curable and thermosetting coatings containing our particles, and developing enhanced surface treatments for the particles to provide superior application performance.

Now, I would like to turn the conversation over to Bob Haines who will summarize our continuous improvement in operations during the first half.

Bob Haines - Vice President, Operations

Nanophase continues to grow as the industry leader in producing commercial quantities of nanomaterials, with current annual capacity of manufacturing well over a half million kilograms of nanopowders. During the last six months, we have also significantly expanded our manufacturing capacity and capabilities for surface treating nanopowders as well as manufacturing various stable dispersions of nanopowders. All of these capabilities allow Nanophase to offer our customers a complete solution in a form that is compatible with their existing manufacturing processes.

Beyond expanded facilities and production capabilities, I believe that our approach to Lean Manufacturing has and continues to significantly differentiate us from others in this field; specifically,

Robust and capable manufacturing processes that continue to be very scalable for commercial quantities.

The ability to focus on reduction of waste and manufacturing inefficiencies while producing quality products through continuous process improvements, active involvement of employees at all levels with these improvements, and cost reduction activities in every process.

Using a "Pull" or Kanban system to drive manufacturing, meeting high customer service demands while significantly reducing raw and finished goods inventories and the costs for these inventories.

Global management of the supply chain from procurement of the raw material precursors to customer delivery and support.

Being both an ISO9000 registered company since 1997, as well as manufacturing under FDA's cGMP (current Good Manufacturing Practices).

The best way to demonstrate the effectiveness of our Lean Manufacturing approach is review some high level performance indicators, comparing the 2002 Q1 through Q2 with the same period in 2001:

Product output per manufacturing employee has improved by 50% over the same period in 2001. This significant improvement is due to process output and cycle time improvements, reduction in labor required to operate the processes, elimination of most intermediate material handling steps, and reduction of setup and process change over times.

Reduction of variable manufacturing costs on the average of 12% over 2001 year end average cost as well as much improved absorption of manufacturing overhead as demonstrated by the continuous improvement of positive gross margin.

Through practical application of Kanban or "Pull" system techniques, we have increased annual inventory dollar turn by 200% while improving our customer service level to greater than 99.5%, which is a measurement of our on time customer delivery.

With a total company commitment to unquestionable product quality driven through continuous improvement, our volume nanopowder manufacturing and coating processes critical quality parameters are approaching a six sigma quality level, which means a predicted defect level approaching one part per million or a 99.9999% acceptance level. This is primarily a result of our Process Improvement Team focusing at a very detailed process level and never being satisfied with where we are.

Our manufacturing capability uniquely differentiates Nanophase from potential competitors and continues to develop as a core competency. Lean Manufacturing drives our focus on elimination of activities that do not bring value to either Nanophase or our customers.

PVS and NanoArch are complimentary nanomaterials synthesis routes and we are actively developing improvements in the range of materials and efficiencies for both processes. Currently under development, key activities in improving the output of PVS for existing high volume products and development of a broad pallet of new materials for the NanoArch synthesis are as follows:

Work is underway on PVS to improve reactor rates by a minimum of 20%, which will allow capacity to meet some additional forecasted future business without addition of more reactors.

Further commercialization of a high rate PVS process for alumina.

The first large-scale commercialization of our NanoArch synthesis reactor and associated dispersion process for a broad range of CMP applications is well underway.

Construction of the second NAS reactor and development over the next six to eight months of new homogenous mixed nano metal oxides through NanoArch synthesis. Potential applications include new catalysts and a new generation of CMP materials.

Further process commercialization of both aqueous and organic dispersions of nanomaterials, which is possible due to the unique surface chemistry of our particles.

While notable improvements have been made in manufacturing over the last two years, we are certainly not satisfied with where we are. Moving forward, we will continue to work on optimization of our entire supply chain process, fast track the development and commercialization of new products to market, and improve gross margins through continued elimination of waste and unnecessary costs throughout our operation.

I will now turn it over to Dr. Don Freed.

Dr. Don Freed - Vice President, Business Development

Good morning - and thanks for your participation and interest. Because many of you were not able to attend our annual meeting last month, I'd like to provide you with a summary of the Company's current, short term and mid term market opportunities.

Current Market Opportunities - Our existing business is based on personal and health care, environmental catalysts, wear-resistant flooring products and an exciting new area of ultrafine polishing with new products becoming qualified by industry leaders in semiconductor wafer planarization and semiconductor photo mask polishing. These opportunities have developed as a direct result of our new NanoArc™ Synthesis process, coupled with our new dispersion line lets us provide highly uniform dispersions of nanoparticles a, key requirement for our customers, who are reporting to us that they are achieving significant reductions in the number of defects produced during wafer polishing and vastly improved selectivity as compared to competitive materials. You may have seen our recent announcement on our long term arrangement with Rodel - part of the electronics materials business of Rohm & Haas - and we believe that polishing of semiconductors, photomasks and optics can become one of the most significant applications for Nanophase products. Joe Cross will also provide more detail on this and other current opportunities in a few minutes.

We are seeing sequential yearly growth in the sunscreen and personal care portion of our business with a growing number of products using our nanocrystalline materials and we are also experiencing growth in the wear resisting flooring business. Automotive emissions control catalysts continue to meet expectations and we are developing additional new customers in the diesel engine segment of this market.

All told, we expect that these application areas will contribute about 80% to this year's revenue and about 67% to year 2003 revenue and we see current market opportunity for Nanophase products in the above areas of between $20 million and $30 million.

However we cannot just depend on sequential growth from existing customers so to position the Company for the future we're developing additional Short-Term Market Opportunities that is, those with a time-to-market of between 0 and 18 months. These include antimicrobial applications for personal and health care and general industrial use. These take advantage of the bacteriostatic and antifungal properties of two of our proprietary nanocrystalline materials. We believe that this is due to the large surface area of our materials, which makes them effective against microorganisms, and we have increased the scope of these efforts to product development programs with four companies.

We continue to make progress in the area of textile nanotechnology and particularly in development of wear, UV-resistant and antimicrobial nylon fibers for industrial carpeting - here we're producing 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.

An important component of our short-term market focus is to complement our existing sunscreen and personal care with second-generation products and we are working closely with our customers to develop additional and color cosmetic applications. In the electronics area we've partnered with a major photocopying company to assist them in increasing the service life of their products and in the antimicrobial market segment, in addition to the products mentioned before, we are also developing materials for the food handling, food processing, and water purification industries.

We estimate that the short-term segment provides a market potential of more than $30 million for the Company's products and we are targeting a substantial portion of 2003/2004 revenue from applications in this segment.

It would not be prudent to ignore Mid-term Opportunities - those with a time to market of between 18 and 36 months and although we devote a smaller amount of our resource to these areas, they are important for longer term future growth. These include unique new Thermal Spray technology - the subject of a new patent filing, Lighting Applications, Nanocoating Applications and New NanoArc™ Materials for the Chemical Process Catalyst industry.

All told, we are cautiously optimistic about our prospects and within the markets referred to above, we're currently pursuing between $20 million and $30 million of opportunity with the potential of an additional $20 million to $30 million within the short term opportunity group of applications. However, I will 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. Joe…

Joseph Cross - President and CEO

Thanks, Don. Looking forward specifically to the second half of 2002, but also with a focus to 2003, the company has specific targets and goals to achieve. Relative to business development and sales, we expect to see increased activity in sunscreen and personal care products, transparent functional coatings, catalysts, antimicrobial applications, and CMP for photo masks, semiconductors, and optics. New material development and commercialization, primarily directed toward NanoArc Synthesisä technology, is principally directed at these markets, but also considers markets Don mentioned under the short and mid-term market horizons. Our business development focus continues to be on both new vertical markets and expansion of developed products into horizontal market applications.

Relative to operations and technology, we have defined several specific goals: to increase output/reactor in major products; augment our dispersion capability focused on CMP market applications and the scale-up in deliveries that are expected during the fourth quarter of 2002 and into the first quarter of 2003; and add an additional NanoArc Synthesisä reactor that will be dedicated for development of new materials beginning during late third quarter for current and new markets. We expect new materials development to be a significant driver in revenue growth for several specific market applications during 2003-2004.

Relative to CMP for semiconductors, we have rather high expectations for this market - even though competition is admittedly intense and applications are highly demanding. We believe that nanoparticles with the proper attributes have the potential to offer significantly increased performance and yield gains to semiconductor manufacturers. In regard to revenue growth potential, we believe that this market has the potential to be equal to or greater in size than sunscreens and personal care, which is our current largest revenue source.

From both nanoparticle manufacturing to our technologies associated with producing highly stable dispersions at various pH ranges, we believe that Nanophase has the technological base to grow revenue from this market. In addition to the current initiative, we plan on expanding the nanomaterials offered to the market for current and future technology nodes.

Revenue growth predictions for CMP relative to semiconductors are difficult to make, especially at this early stage. However, based only on the minimum annual purchases that are required by the agreement with Rodel to maintain exclusivity, we currently believe that revenues from this market have the potential to add approximately $12 million over the next three years. Obviously, from this estimate, there is definitely the potential that the revenue growth could be significantly greater. More precise numbers should be possible after we begin to penetrate the market and obtain end customer feedback and forecasts. Relative to growth, there will be a scale-up beginning in 2003 with fairly rapid growth forecast for 2004 and 2005.

We are frankly quite pleased with our agreement and relationship with Rodel, who is a global leader in precision surface technologies employing almost 1,000 personnel worldwide. Rodel is part of Rohm & Haas Electronics Materials Group, which also includes the Shipley Company, with an estimated $1.2 billion in sales for 2000 in electronic materials. We believe that Rodel is an excellent partner for Nanophase and are quite pleased with the cooperative working relationship that the companies have developed.

From a sales view, the company has received orders for $5.3 million for 2002 YTD, representing about 75%of our 2002 revenue target. Excluding shipments, Nanophase enters the third quarter with a sales backlog of $2.2 million. Based on information from current and prospective customers, we currently believe that additional potential orders should be received in July through September toward our annual revenue target.

Based on customer information and the current status of orders and contracts, we continue to expect revenue of approximately $1.7 million during the third quarter, which would represent an anticipated revenue growth of 150% versus the equivalent quarter of 2001.

While we still have some work to do, remain somewhat concerned about the continuing state of the economic situation in the manufacturing sector, and are watchful as to the extent of the normal summer slowdown in our current and potential customer base, we are maintaining our annual revenue target of $7.0 million. Again, this target would represent an anticipated growth rate of approximately 75% over 2001.

That concludes our prepared remarks. For your information, our prepared remarks will be available through our Internet site on or about Tuesday, July 30, 2002. We will be pleased to accept questions at this time.