Third Quarter 2002 Conference Call Transcript

THIRD QUARTER 2002 CONFERENCE CALL

Joseph Cross, President and CEO

Good morning and welcome to our conference call to discuss the third quarter and first nine months 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; Bob Haines, vice president of Operations, Dr. Richard Brotzman, vice president of R&D, and Dan Bilicki, vice president of Marketing and Sales.

To begin our discussion, Jess Jankowski will review the financial results for the third quarter and first nine months of 2002, during which I believe that the company performed exceptionally well, especially in view of general US economic and manufacturing conditions. After the financial review, I will offer comments on the company's progress. Dr. Don Freed will provide an overview and update of business development initiatives and markets. Then, Dan Bilicki will summarize the company's progress in its current and short-term market efforts. I will return once again to comment on sales for the fourth quarter. After our prepared remarks, we will accept questions. Jess….

Jess Jankowski, CFO and Controller

Good morning and thank you for being here.

Please keep in mind, all numbers are approximate. For the third quarter of 2002, our revenues were $1,253,000 versus $680,000, for the same quarter last year. You may recall that Nanophase had a $401,000 downward adjustment to revenue in the third quarter of 2001 that has been previously discussed. The majority of our revenues continue to come from products.

Gross margin for the third quarter of this year was $169,000. This positive gross margin was tempered by the last minute reduction of Q3 revenue that was discussed in our initial Q3 press release as well as the addition of $135,000 in depreciation over the third quarter of 2001 relating to the placement in service of most of our large capital projects. The 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. These effects, the reduced revenue and added depreciation, were partially offset by the fact that Nanophase added $300,000 to its inventory between Q2 and Q3 of this year, which allows for greater absorption of overhead. Given our limited 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 volume, revenue mix, and our ability to continue to cut costs. Even given these uncertainties, we fully expect 2002 to be the Company's first entire year showing positive gross margins.

Relative to Q3 of 2001, R&D expenses are down slightly in the current quarter.

SG&A expenses for Q3 of 2002 appear to have increased by $159,000 when compared to Q3 of 2001. This is mainly due to the comparison of an anomalous third quarter of 2001, where the Company reversed $175,000 in bad debt expense, in effect creating a negative expense with no offsets, being compared to Q3 of 2002 where no bad debt expense, or bad debt expense of zero, was recognized. Without an explanation, it appears that SG&A has grown when, in effect, the prior years SG&A expense benefited from a non-cash adjustment to an estimate. This discrepancy normalizes over the nine-month periods.

On the bottom line, we lost 7 cents per share the third quarter of this year versus a 9 cent loss per share for the third quarter of 2001.

For the nine months ended September 30, 2002, revenues were $4.3million versus $2.8million for the same period in 2001. This represents an increase of 54% year over year. With respect to earnings per share, Nanophase lost 26 cents per share for the nine months ended September 30, 2002 versus 28 cents per share for the same period in 2001.

Again, the reduction in interest income during 2002 has had a significant impact on the bottom line, amounting to $416,000 or $0.03 of the loss, making comparisons to 2001 difficult.

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

Again, all numbers are approximate….

At September 30th, we had $9.4 million in cash and investments.

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 $1.3million 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 nine months of 2002, we used $2.3million in our operations, resulting in an average cash burn of approximately $780,000 per quarter. We also spent about $1.8million on capital, the majority of which related to the final payouts on projects begun in 2000 and 2001. To summarize, for the nine months ended September 30th, cash outflows from operations are down approximately $1.5million compared to the same period in 2001. Cash flows relating to the acquisition of equipment and leasehold improvements are down $3.6million between the same periods.

Getting back to the balance sheet…..

At September 30th, Accounts Receivable amounted to about $608,000. 90% of our receivables were current, with the balance being 1 - 30 days overdue. We expect all of our receivables to be fully collectible. Our receivable balances relative to sales would appear even stronger were it not for the $225,000 in accrued license fees (that's $75,000 per quarter) that are not payable to Nanophase 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.

Moving down, you may have noticed that Inventory has increased by about $300,000 between June 30th and September 30th. This is a result of a customer reducing second quarter shipments at the last minute as well as our shoring up inventory in anticipation of fourth quarter volumes required during the holiday season. We will continue to make 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 expect inventory levels to decrease at year-end. Nanophase has moved from roughly 4 inventory turns to more than five turns in the first nine months of 2002. Management is focused on this metric as one of several that reduce our working capital requirements. Keep in mind that this is somewhat dependent upon product mix for the balance of this quarter and the first half of next quarter conforming to expected levels.

Another thing I would like to address on the balance sheet is the Company's roughly $1.2million 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. 89% 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 11% reflects the long and short-term capital leases on equipment.

Lastly, we have also had a reduction of $740,000 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.

To recap, Nanophase has shown significant progress in a few areas on the P&L and balance sheet that I would like to draw your attention to:

For the year ended 2001, the Company had an average gross margin percentage of negative 21%, versus a positive 13% for the first nine months of 2002. We expect margins to continue to improve. This is the first step towards EBITDA break-even, then GAAP profitability.

Net loss has improved by each quarter through 2002. Nanophase lost $0.11 per share in Q1, improved to $0.09 per share in Q2, and further improved in Q3 to a loss per share of $0.07.

We have augmented our cash position by adding a net $6.2million via the May 2002 equity funding transaction.

9/30 inventory represents just over 67 days sales. This works out to be 5+ turns per year. At 12/31 of 2001, this number was just over 4 turns per year. We expect to see continued improvement over the next several quarters.

If we eliminate the $225,000 in license fees from our 9/30/02 A/R balance, third quarter A/R on products represents about 30 days of sales. This number was at 73 days of sales at 12/31 of 2001, and 47 days of sales last quarter.

As you can see, we are aggressively managing our working capital in order to limit the impacts of rapid growth on our cash position. This has been, and will continue to be, one of the issues that management is focused on.

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 third quarter and first nine months of 2002, let me dwell briefly on revenue growth. As noted in the earnings release, revenue for the third quarter represents an 84% increase over the equivalent period in 2001. Year-to-date versus 2001, the Company has increased revenues 54%.

Revenue increases for 2002, and we believe for future years, is a direct result of two major strategic initiatives on which the company has focused since late-1999. First, improving our nanomaterial technologies and, in parallel, extending those technologies toward applications and then, secondly, but equally as important, implementing a solution delivery business model based on the expanded technology platform.

Concerning technology, Nanophase has made rather dramatic progress in improving its core nanomaterials processes and extending the Company's patented and proprietary technologies toward nanomaterial incorporation into target market applications. Over the last two years, Nanophase has created an integrated family of nanomaterial technologies from nanoparticle manufacturing, for which we now have two distinct and synergistic technologies; to coating nanomaterials with multiple coating materials; to dispersion of nanoparticles in various liquid media, including resins and polymers. This technology extension has been responsible for 11 Nanophase patent applications since January 2000 and 3 patent applications that have issued. We believe that this is an industry-leading suite of nanomaterial technologies and provides a real competitive advantage for Nanophase in multiple market applications. The total, integrated platform of technologies is allowing the Company to successfully address applications, which, in prior years, would have been difficult or improbable.

Relative to a solution delivery capability, the Company has invested approximately $8 million to implement its solution delivery strategy and business model that the company developed in late 1999 and early 2000. This plan began in June 2000 with the signing of the lease for the Romeoville facility, physically occupying the facility in September 2000 and beginning construction, and was essentially completed during the first half of 2002. Coupled with our expanded base of core technologies, Nanophase has the capability to incorporate nanomaterials in the format needed by potential customers, which is not always nanopowder, to shorten development time and drive revenue growth. The Company is now generally able to do this in lab quantities, pilot plant quantities, and then full manufacturing volume. We believed in 1999, and are even more positive today, that this is a vital capability for revenue growth. For example, this capability was vital, and will continue to be so, for our expansion into CMP applications.

Nanophase is also demonstrating continued improvement in gross margin on revenue. I think a key statistic is the positive 12.5% average gross margin year-to-date for 2002 versus the NEGATIVE gross margin of 21% average for 2001, or a current improvement of over 30%. It is also encouraging that gross margin improved sequentially, comparing the second quarter to the first quarter of 2002, by doubling. And, continued to improve in the third quarter by an additional 1.5%.

Gross margin growth is a direct result of manufacturing improvements and, again, the capital investment that the company has made over the last two years to significantly improve its manufacturing operations. 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.

For example, compared to Q4 2001, to date in 2002, the company has achieved a 10% reduction in variable manufacturing cost in its nanopowders operations and a 37% reduction in direct labor costs in its nanocoating operations. Every year since 1999, the company has improved its technology and operations and reduced cost. We fully expect this to continue in the future.

As I have stated previously, manufacturing operations is becoming a core company competency and is a rather significant differentiator between Nanophase and potential competitors going forward.

We expect gross margin growth to continue into 2003-2004. Fixed manufacturing cost will be absorbed with increasing volume and increased output and, correspondingly, gross margins will continue to grow. Except for any incremental 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 early key predictors along the path to profitability.

Relative to business development, Nanophase continues to see robust opportunities and progress in a number of target markets. At this time, Don Freed will provide an update.

Dr. Don Freed - Vice President, Business Development

Good morning - and thanks for your participation and interest. Today, I want to discuss two topics - first, I want to bring you up-to-date on our current business development opportunities, and second, I'd like to provide you with a more in-depth understanding of how we intend to bring our advanced solutions in ultra fine polishing to the marketplace.

First, much of our current business development activity is focused on extending our opportunities in personal care, wear and UV-resistant coatings, environmental catalysts, microelectronics and antimicrobial applications so that we can use our already developed know-how and technology -these programs also fit our target time-to-market of 12 to 18 months.

We continue to work in the area of textile nanotechnology in the development of UV-resistant and antimicrobial nylon fibers - here we're producing surface engineered nanoparticles that can be incorporated directly into fibers. These initiatives are closely related to our developments in nanocoatings where we're working with several coatings manufacturers to develop wear and UV-resistant clear coats for automotive and other uses - both utilize the surface treatment and dispersing technology covered by our recent patent application filings as the enabling technology to make our nanocrystalline materials compatible with the organic polymers.

An important component of our short-term market focus is to complement our existing sunscreen and personal care with second-generation products.

In the electronics area our work to incorporate surface-treated nanoparticles into photocopying applications is also progressing well.

Finally, in the antimicrobial market segment, we have just completed a comparison of our products with current industry standard products - this study, performed by a leading biological test laboratory demonstrates that our nanocrystalline materials perform better than those in current use and at much lower concentrations. It is well established by both the published literature and our own tests at an independent outside laboratory, that smaller particles are as much as eight times more effective at killing bacteria and mold. For example, at the parts-per-million level, our nanoparticulate zinc oxide can kill more than 99% of s. aureus bacteria within 24 hours, and furthermore, prevent their re-occurrence. Because of this, we have increased the scope of our efforts to product development programs with more companies in water purification, textiles and food handling applications.

I might stop here to explain the relatively sudden focus on polishing of semiconductors, photomasks and optics. You may remember that some years ago Nanophase had a brief and not entirely successful foray into this industry. So what's different now? It is only recently that the Company has been able to bring together a family of integrated technologies to bear on a particular set of customer requirements, namely the need for highly uniform and stable dispersions of nanoparticles with the selectivity and removal rate needed to be competitive in ultra fine polishing. It is only since mid-2000 that Nanophase has had a high quality aluminum oxide capable of meeting the stringent polishing requirements. Nor did we have a cerium dioxide suitable for polishing semiconductors and photo masks until the development and commercialization of NanoArc™ synthesis in the early part of this year. In our former attempts to enter the polishing market we did not have the capability to provide our particles in dispersed form and it is only recently that we have developed the technology, now patent-pending, needed to disperse at controlled pH and classify these nanoparticles. We now have, for the first time, the ability to provide nanoparticles dispersions of aluminum oxide, cerium dioxide and shortly, mixed rare-earth oxides to meet very specific and exacting requirements. Although there will be significant testing by end-users before adoption, we remain optimistic that our products will demonstrate the performance benefit that we expect.

As to what we're doing about this, we've targeted the leading companies in photomasks, color displays, glass and optics polishing and computer memory disk manufacture, all of whom use ultra fine polishing materials and we are aggressively pursuing this opportunity by meeting with them, making presentations so that they understand our capabilities and providing evaluation materials for their testing. And we're doing this on a global basis with companies in the US, Europe and Asia.

In doing so, we are also working very closely with our Japanese affiliate, C. I. Kasei to develop the Asian market for our polishing products. During a recent trip to Japan, we made presentations and held discussions with the more than half-a-dozen glass manufacturers including the number one photo mask manufacturer in the world and the leader in flat-panel displays, both of whom are now testing our polishing products. All told, we now have 11 different companies in the US, Japan and Europe in the process of testing our polishing products.

We are also working in Asia on antimicrobial applications and environmental catalysts - during my trip we met with representatives of one Japan's largest catalytic converter companies and their customer, one of the five largest auto companies in the world. Our capability for the manufacture of mixed rare-earth oxides via NanoArc™ synthesis has generated significant interest and we are developing additional new potential customers in the diesel engine segment of this market.

In summary, by focusing on the areas of ultrafine polishing, antimicrobial products, and environmental catalyst applications, which we estimate to be relatively quick-to-market, and our initiatives in expanding our opportunities for coatings and environmental catalysts, we believe that we are positioning Nanophase to achieve our goals for 2003/2004. And now, I'd like to turn the call over to Dan Bilicki, Dan….

Dan Bilicki, VP Sales & Marketing

Good morning and thank you for your interest in Nanophase.

Let me review the revenue for the year, once again, and then focus on the third quarter and the fiscal year ending in December. Revenue for the first 9 months of 2002 was $4.3 million versus $2.8 million for the same period in 2001. Year to date revenue have exceeded the entire 2001 revenues by 7%.

Third quarter revenue of $1.3 million was impacted by slower than anticipated development of Zinc Oxide personal care applications. On a global basis, BASF has experienced delays in generating new Zinc Oxide customers for sunscreen products. Relative to personal care applications, Zinc Oxide in non-sunscreen products have shown good growth albeit from a small base. However, the large volume growth anticipated by BASF throughout the first half of 2002 for new, non- sunscreen applications is still in the formulation, development and testing stage. While the opportunities here are still perceived as quite significant, they are moving slower than our customer anticipated.

The impact of these delays will reduce Nanophase's previously targeted revenue of $7.0 million for 2002 by $460,000. An additional negative variance to this target from other Zinc Oxide customers will be approximately $150,000. The majority of this latter variance can be attributed to scale up problems experienced by a customer following product approval in pilot scale equipment.

Despite the delays I have just cited, sales of Zinc Oxide from 1999 through 2002 have grown significantly and have increased at a compounded annual growth rate of 254%. Put another way, Zinc Oxide sales have increased over 200 fold since 1999.

As announced earlier this year, Nanophase's innovative NanoArc Synthesisä technology, coupled with state of the art dispersion capabilities, led to the signing of a mutually exclusive long-term agreement with Rodel to supply Cerium Dioxide dispersions to polish semiconductor wafers.

The product adoption cycle for semiconductor wafers first requires our partner to develop suitable chemistry and do extensive testing prior to taking the product to their customers. Initial testing by Rodel has shown very positive results. However, the semiconductor wafer fabricator will first need to perform in-house testing and, if acceptable, begin a gradual transition from current material to the Rodel/Nanophase product.

The Cerium Dioxide forecast included in our initial target of $7 million for 2002 reflected a faster completion of the product adoption cycle than we are actually experiencing. This delay results in an additional negative variance from the $7.0 million target of approximately $400,000.

The encouraging initial performance of the NanoArc Synthesisä Cerium Dioxide dispersions in polishing semiconductor wafers, coupled with Nanophase's relatively recent capabilities to consistently manufacture world-class quality dispersions will eventually result in significant revenue generation that will exceed our BASF growth rates. 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.

Once Nanophase successfully develops a vertical market, such as semiconductor wafer polishing, we then look to exploit the new technology by developing horizontal applications. As indicated in Don's presentation, Nanophase is actively pursuing polishing applications outside the semiconductor area on a global basis. The customer requirements for these polishing applications are not as stringent as semiconductor wafers making the product adoption cycle shorter by 6 to 9 months. Nanophase already has an on-going photomask customer as well as several prospective customers in ultra fine polishing of color filters, flat panel displays, and specialized optics. Having existing products with unique performance characteristics in the ultra fine polishing market offers many exciting opportunities to significantly grow revenues.

Concerning the 4th Quarter Nanophase is involved in detailed discussions with our current partners focused on sales volume for the remainder of this year and their outlook for 2003. These discussions will be completed in the first half of November. We are also having meetings with current and prospective customers to agree volume and timing for purchasing Nanophase products during 2003. Our current visibility for Q4 is a range of $1.3 to $1.7 million.

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

Joseph Cross, President and CEO

Thanks, Dan.

Relative to the fourth quarter, as Dan indicated, the Company is involved in several discussions, two or three of which are key, that may affect fourth quarter revenue. We do not expect, based on continuing customer discussions, to have these quantified until mid-November. As we stated in the earnings release, our current, best estimate is that fourth quarter revenues will be in the range of $1.3 - 1.7 million. As these situations are clarified, we will provide additional guidance.

Concerning 2003, the Company currently expects appreciable revenue growth during the next fiscal year. We will be defining 2003 demands from existing customers over the next 4-6 weeks and attempting to quantify timing and demand from potential customers. However, this is a continuous process and does not always fit neatly into fiscal time periods. In general, we expect the company to continue revenue growth in personal care and sunscreen applications, CMP applications primarily in semiconductors and photomasks, antimicrobial applications, various coating applications, and electronic applications. Quantifying the timing and revenue realization in these is always difficult. We expect to issue quarterly guidance for 2003, much as we have in 2002.

At this time we plan to issue first quarter 2003 guidance no later than early January 2003 and will provide guidance for subsequent quarters when we believe that we have adequate visibility to do so.

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