Second Quarter 2003 Conference Call Transcript

SECOND QUARTER 2003 CONFERENCE CALL

Joseph Cross, President and CEO

Welcome to the Nanophase conference call to discuss the second quarter and first half of 2003. The Nanophase attendee for this session, besides me, is Jess Jankowski, VP and Corporate Controller. The other Nanophase officers are not available for the conference call.
The agenda for today’s discussion is, first, Jess will review the financial results for the quarter and first half. I will then return to summarize the Company’s progress during the first half, review our sales target markets, and update business development initiatives. After our prepared comments, we will be available for questions.
Jess, would you please review the financial results for the first half?

Jess Jankowski, CFO and Controller

Good morning and thank you for your continuing attention and support.
Keep in mind, all numbers are approximate. For the second quarter of 2003, our revenues were $1,308,000 versus $1,662,000 for the same quarter last year. For the six-month period ended June 30, ‘03, our revenues were $2,972,000 versus $3,070,000 for the same period last year, a 3 percent decrease. For purposes of this discussion today, given the quarter-to-quarter variability of the business, I will speak mainly in terms of six month numbers which are more representative of the financial condition of the business.
Lower product sales to our largest customer, combined with no volume from two of our smaller-but-consistent customers for the first half of 2003, has resulted in a reduction in product revenue of $570,000 for the period. This reduction was partially offset by sales volume from Rodel, which we expect to be our second largest customer in 2003.
Of the $401,000 in Other Revenue thus far in 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 total revenues continue to come from products. We had $190,000 in gross margin for the first half of this year versus a $373,000 positive gross margin for the same period in ‘02. If we dig a little deeper, we see that the decrease in margin has been driven by the increase in depreciation along with the relative size of our fixed manufacturing overhead. Our direct labor and direct material costs, as a percentage of product revenue, have gone down by 50% between these two periods. This decrease in variable costs reinforces management’s view that incremental increases in product revenue will prove to strongly enhance gross margin given that costs relating to added revenue will amount mainly to variable costs. Based on Q203 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. We continue to aggressively attack variable product costs.
Moving down, research and development expense is down about $35,000 from the first half of last year to the first half of 2003. This reduction is due mainly to bonuses accrued in 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.
SG&A increased by $89,000 in the first half of 2003 compared to the same period in 2002. There were a few 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 $300,000.
On the bottom line, we lost 20 cents per share for the first half of this year versus 20 cents per share for the first half of 2002.
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 $375,000, or 2.5 cents per share, from the annualized number at June 30th of last year. Without this additional depreciation, the loss per share for the six months ended June 30th, 2003 would have been 17.5 cents per share.
As I said last time, management has not let up in terms of cost containment. 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 through the major categories on the June 30, 2003 balance sheet:

At June 30th, we had $5.4million in cash and investments.
Accounts Receivable amounted to $830,000. 97% of this balance is current and management expects all of it to be fully collectible.

Moving down, Inventory has decreased by $144,000 between the end of 2002 and June 30th 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 half year ended June 30, ‘03, inventory turns amount to SEVEN times annualized total sales. Keep in mind that this number was five turns at December 31st of 2002. Nanophase is 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.
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. Through June 30th, the Company spent $156,000 on CapEx. For comparative purposes, the company spent more than $550,000 on CapEx during the first six months of ‘02 and a total of $1.7million during the whole of 2002.
Another thing I would like to address on the June 30th balance sheet is the Company’s roughly $1.2 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. As you may recall, 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.

The balance of the $1.2 million in debt reflects insurance premiums and leased equipment that management elected to finance.

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

Joseph Cross, President and CEO

Thank you, Jess.
As we have stated previously, most recently at the June stockholder meeting, the Company remains focused on four integrated, key strategic goals: Technology accumulation and leadership; Solution delivery capability relative to target markets and lead potential customers; Operational excellence; and, lastly, but most importantly, revenue growth and financial performance. Relative to the first half, I would like to summarize the Company’s progress toward each of these.
Nanophase continues to add to its intellectual property. The Company now has 22 U.S patents and patent applications; 24 foreign patents and patent applications; and has amassed considerable proprietary technology. We have additional patents and patent ideas in the pipeline and expect to continue enlarging our intellectual property estate both in nanotechnology and applications for nanomaterials.
Toward the Company’s solution delivery goal, we believe that the goal, which we established during 1999, has been largely fulfilled relative to our current target markets, but further refinement and improvement will continue.

Nanophase now has two distinct, but synergistic, processes to create rather novel nanoparticles: the PVS process that was the Company’s original technology and the recent NanoArc? synthesis technology. To this, we have added and continue to refine our surface modification technologies. This technology spans in situ technology, which modifies the nanoparticle surface as it is created, to various coatings designed to meet specific applications. Further, the Company is able to take this these nanoproducts and supply them in dispersions, formulations, and coatings – dependent on market or customer need. So, Nanophase current markets and delivers nanoparticles in the form of nanopowders; coated nanoparticles, an example of which is sunscreen nanomaterials; and nanoparticle dispersions, primarily for the several polishing markets we are entering.

This platform of integrated nanotechnologies has greatly enhanced the Company’s ability to penetrate markets and succeed in applications.

Toward our goal of operational excellence, Nanophase has an integrated engineering and operations function that delivers current products to customer orders, creates new nanomaterials, and refines and improves processes. As we demonstrated at the stockholder meeting, this group continues to deliver impressive results developing new nanomaterials and improving, that is reducing, variable manufacturing cost. Since we began this effort in 1999 in the PVS process, which included recruiting the engineering talent to fulfill the mission, reactor output has increased over four times; direct labor has been reduced by 75%; material handling, which once required three people/shift, has been eliminated; and process control has been improved from the one sigma level to now over five sigma control.

This continuing effort is still producing remarkable results during 2003. For example, comparing the first half of 2003 to the same period in 2002, Nanophase is producing the same volume on two shifts that previously required three shifts. During this evolving, continual improvement during 2003, we have been able to reduce labor by 20% and improve output per hour worked by over 15%. In our relatively new NanoArc? synthesis manufacturing area, we have improved process utilization by about 30%, meaning more production per dollar of asset. Looking forward, we expect to increase PVS reactor output by another 25-30% by mid-’04 and continue reducing variable product cost to increase gross margins.

In parallel, the Company’s highly integrated Quality infrastructure is delivering impressive results. Both of our facilities were certified to the new ISO 9001: 2000 standards during April. ISO certification is a critical company attribute to our current and potential customers. Nanophase continues to experience ZERO customer product returns and a customer service rate over 99 percent.

The Company takes this same mentality of excellence with environmental health and safety regulations. From an employee health and safety perspective, Nanophase has now over 500,000 man-hours worked without a lost time accident. Environmentally, the Company is a solid corporate citizen and has enjoyed excellent relations with federal and state regulations. Moreover, Nanophase has reduced waste nanomaterials and air emissions over 80% during the past year.

In summary, Nanophase‘s operations and processes continue to be very demonstrably scalable and highly controllable. The Company has instituted management and manufacturing practices normally found in more sophisticated, larger companies. The results of these efforts are clearly appreciable and will help drive the Company’s future success.

Toward our remaining, and most crucial, goal, that is revenue growth leading to financial performance, let me review the Company’s business and market development and sales initiatives. Clearly, increasing revenue is the Company’s first priority and drives the financial performance desired. First, Nanophase remains highly focused on specific markets and, within those markets, target customer co-development. It is important, I think, that investors understand the rationale for this. While Nanophase has rather unmatched expertise in nanomaterials, we do not have the expertise, personnel, nor equipment to empirically test nanomaterials in most specific applications relative to performance requirements. Understand that application performance is not always well quantified; equally true is that there are not always tests available to simulate performance. Nanomaterial performance has to actually be evaluated in the application. For that reason, a potential customer is required to co-develop nanomaterial solutions and generate the performance data to demonstrate success.
Secondly, many of these market partners also offer a global sales distribution capability and an established market presence and customer base, which Nanophase could not hope to match at its size. In some markets, an example of which is semiconductor polishing, our market partner, in this case Rodel, also has complementary product offerings and a global customer technical service capability that it vital to success in this market.
Relative to markets, we have differentiated market opportunities as current and near-term, mid-term, and mid-to-longer term based on our perception and estimates of probable time-to-market. However, the Company has now evolved to the point that a time spectrum of potential opportunities is being managed to create a corollary spectrum of revenue growth opportunities.
Relative to current and near-term markets, we believe that a major growth area continues to be personal care, including sunscreens. In the later area, our nanomaterials are currently being used by consumers in both daily wear applications, and beachwear sunscreen products in the U.S. and Asia. An example of beachwear, is Coppertone’s new Spectra 3 line that contains our nanozinc oxide, while daily wear products are perhaps best noted by the Olay product line. Additionally, with our partner, we are developing a generation two nanocoated material for sunscreens that is primarily directed towards the European market and has a targeted market introduction by mid-2004.

Additionally, our nanomaterials are now being used in personal care products such as foot powder and skin care products. We are targeting additional applications in the personal care market working with several companies that are in various stages of the business development cycle. We are not at liberty to discuss specific applications.

The Company currently expects appreciable revenue growth in this market area during 2004-2006. While I am not making a forecast here, annual revenues for these products have the potential to at least double over the next 2-3 years.

A somewhat over-lapping market area, antimicrobial applications includes some personal care items, fibers, filters, and textiles, plus others. The Company believes that nanomaterials offer increased coverage and persistence in applications. Nanophase has several potential customer-specific initiatives in each of these general areas.
Continuing with current and near-term markets, we continue to believe that polishing applications for semiconductors, photomasks, optics, and disk drives are potentially strong revenue opportunities for the Company. To understand the size of this opportunity somewhat, let me provide the following information. Total polishing slurry value, that is not our material value or expected revenues, for polishing is estimated to be over $900 million by 2005 by independent sources such as Kline & Co. and Gartner Dataquest. Approximately 72% of this will be semiconductor polishing.

Key market drivers going forward for semiconductors are new technology nodes that include smaller circuit line width, larger wafers, new materials, and increased number of polishing steps. In all of these, we believe that nanoparticle dispersions may play a significant role.

The current Nanophase/Rodel nanoparticle slurry is directed at STI and SON technologies. STI is approximately $50 million in slurry value and growing at a CAGR (compounded annual growth rate) of 15-20% by several estimates. We do not have reliable figures on the SON portion of the market, but we currently believe that it may become 2-3 times the size of STI and appears to be growing rapidly. This product is now being introduced to the market focusing on the 10-12 top tier semiconductor manufacturers and early results have been very encouraging. Production trials have reported improved planarization and significantly improved defect levels, up to a 75% improvement, relative to materials currently on the market. However, the speed of market acceptance and adoption is not predictable at this time.

Additionally, Nanophase is developing new nanoparticle dispersions that are in early stage testing for other technology segments for semiconductors. Nanophase’s NanoArc? synthesis and dispersion technologies are a critical advantage in this market. They allow the company to provide an evolving platform of nanomaterials, including single-crystal mixed elements, in highly stable dispersions to address current and future technology nodes for semiconductor manufacturing in a manner that we believe is unique. In total, the Company’s development efforts are currently directed to provide nanomaterials dispersions, including the newer mixed element nanoparticles, which we believe should potentially address well over 50% of the semiconductor slurry market by 2006.

Disk drives are expected to account for about 20% of the polishing market, or about $180 million in slurry value (again, that is not our material value or perceived revenues). Technology drivers that we believe may be addressed by nanoparticle dispersions are a shift in substrate material to glass and ceramic compositions, and increased surface finish requirements. In initial testing, our nanomaterial dispersions appear to provide improved planarity, high selectivity, and a very low angstrom surface finish. One major disk drive manufacturer has indicated to the Company that it plans to use our nanoparticle dispersion for its 2004 product line launch. Nanophase currently has expanding customer-focused development in this area.

Precision optics, a relatively new initiative for the Company, is predicted to be about 8% of the polishing market in 2005, or about $70 million – again that is slurry value. We believe that nanoparticle dispersions potentially address lower surface roughness requirements for laser applications and high-end imaging applications. We have initiated customer testing for specific applications and expect to enlarge our testing efforts.

Lastly, photomasks, where we currently have a commercial product, is expected to be around a $10 million market in slurry value on 2006. Our materials have demonstrated improved planarity, surface finish, and the ability to polish some of the newer ceramic materials coming into the market. A paper presenting photomask-polishing improvements due to Nanophase’s nanoparticle dispersion is being presented at a major photomask conference in mid–September by one of our co development partners. Nanophase is currently working with photomask manufacturers to expand its market penetration and product line.

Continuing with current and near-term markets, the Company is still focused on transparent functional coatings for various markets. Examples include flooring, where we have a current customer, auto finishes, plastics, wood finishes, and overprint varnishes.
In the mid-term and long-term markets, that is again relative to expected time-to-market, Nanophase has efforts in biocides for marine antifouling and wood treatment; catalysts, including catalytic converters; thermal spray; and fuel cells.
Finally, Nanophase has several specific development initiatives that do not fit neatly into any of these categories, but nonetheless represent significant future potential revenue opportunities.
In summary, the Company is focused on five major market areas: anti-microbial applications for personal and industrial products; personal care, including sunscreens; abrasion and scratch resistant coatings; catalysts; and polishing markets. The Company’s business development and marketing efforts have been significantly improved and expanded during the first half of 2003. We believe that our efforts are well directed and robust. We fully expect these markets, and the additional opportunities I mentioned previously, to drive the Company’s revenues.
That concludes our prepared remarks. We are available for questions.