Fourth Quarter 2001 Conference Call Transcript

FOURTH QUARTER 2001 CONFERENCE CALL

Joseph Cross, President and CEO

Welcome to our conference call to discuss 2001 results and the company's position and expectations for 2002. The Nanophase attendees for this session are: Dan Bilicki, VP Sales and Marketing; Dr. Don Freed, VP Business Development; Dr. Richard Brotzman, VP R&D; Jess Jankowski, CFO and Corporate Controller; Dr. Gina Kritchevsky, chief technology officer; and Bob Haines, VP of Operations.

To begin, Jess Jankowski will review the financial results for the fourth quarter and fiscal 2001. After which, I would like to comment on the company's solid progress during the year and provide a summary of the company's position entering 2002. Following my comments, Dr. Don Freed will provide an overview of the company's new business development initiatives in multiple markets. After which, Dan Bilicki will address the marketing and sales efforts and expected growth from existing customers during the coming year. Then, I will return to comment on activities and expectations for 2002. Jess…..

Jess Jankowski, CFO and Controller

Good morning and thanks for your continuing interest in Nanophase.

All numbers are approximate. For the fourth quarter of 2001, our revenues were $1,239,000 dollars versus $1,194,000 for the same period in 2000. The majority of our revenues continue to come from products. On the bottom line, we lost 14 cents per share for the fourth quarter of this year versus 8 cents per share for the fourth quarter of 2000.

For the year ended December 31, 2001, our revenues were $4,039,000 dollars versus $4,273,000 for the same period in 2000. With respect to earnings per share, we lost 42 cents per share for the year ended December 31, 2001 versus 34 cents per share for the same period in 2000.

The largest contributing factors to the decrease in earnings per share for both the fourth quarter and year ended December 31st were non-recurring inventory adjustments and a reduction in invested funds coupled with decreased interest rates.

The Company added to its allowance for excess inventory in the amount of $550,000 resulting in a 4th quarter charge to cost of goods sold in the same amount. $260,000 of this charge related to raw materials purchased to support the Company's catalyst business.

The magnitude of this adjustment was directly related to the Company's previously disclosed memorandum of understanding with a UK company that demanded large volumes of long lead time material be available for delivery in 2001. Late in the fourth quarter, the Company determined that, given breakthroughs in our NanoArc Synthesis process, and a breach of this customer's previous contract requirements, we would no longer manufacture this material via the PVS process. This decision rendered the raw materials obsolete. An additional $270,000 of this charge related to excess catalyst finished goods inventory. Management felt that, although we have a customer for this material, the volumes currently required, and limited future predictability of demand by this existing customer, warranted a conservative approach. Again, due to the breach by the aforementioned UK customer, the Company built more inventory than it normally would have given current customer needs, outside of that scenario. Although we have several business development and sales programs revolving around the various catalyst markets, management viewed a conservative valuation approach as most prudent at this point.

These non-recurring inventory adjustments had an impact of a negative $0.04 per share for both the fourth quarter of 2001 and calendar 2001.

SG&A was up $410,000 for 2001, largely due to the addition of two staff members and related relocation expenses, increases in business insurance premiums, and increased expenses relating to the Company's new facility in Romeoville, Illinois. These expenses were offset somewhat by a reduction in bad debt expense and by reductions in discretionary spending. Aside from potential augmentation of the Company's marketing, sales, and business development organization, management expects these expenses to flatten over 2002.

The reduction in interest income relating to fewer invested funds and lower interest rates had a negative impact of $0.02 and $0.05 per share for the three and twelve months ended 12/31/01, respectively.

Investments in productivity and cost-savings, the non-recurring inventory adjustments, the decrease in interest income, and softer than expected industrial demand globally for 2001, have somewhat tempered the positive impact the Company expected reductions in production costs to have on net loss per share.

The Company expects ongoing manufacturing cost-cutting efforts to be enhanced throughout 2002 and will continue to focus on selling the products that it makes most efficiently and with the best margins. One of the issues that the Company had to contend with this year, as did much of the industrial growth sector, was the lack of predictable sales volumes and product mixes resulting in the inability to absorb fixed manufacturing overhead with regularity. Nanophase has painstakingly built a manufacturing organization that is ready and able to support a much larger revenue level than the Company experienced in 2001. With planned growth, Nanophase should be well positioned to reap the benefits of an efficient overhead structure, keeping in mind that visibility is limited. As Nanophase grows and achieves a stronger position in the marketplace, we expect to achieve better and better margins through a combination of internal cost management and upward market pressure reflected in the growing demand for our products.

Moving to the balance sheet…….

The Company's accounts receivable were 95% current at 12/31/01, with the balance being 31-60 days old. In evaluating this statement, it is essential to understand that the Company shipped large quantities of material to its largest customer in December, and that $300K of the $1.1million in accounts receivable represents license fees that are accrued quarterly, then received once a year in April.

Moving down, Nanophase has added $6.4 million to property, plant, & equipment in 2001. These investments were largely for infrastructure needs in its Romeoville facility, additional manufacturing capacity in both its Burr Ridge and Romeoville facilities, and to implement cost-saving measures in the Burr Ridge facility. These investments have lead to further expansion of production capacity in Romeoville, including a coating line and pilot manufacturing facility, and material handling equipment and capacity enhancements in Burr Ridge.

The Company had approximately $1.5million in debt at year-end. $1.3million of this represents a loan from a customer used to support construction of the Company's coating facility.

Also note that Nanophase had $7.4 million in cash and investments at the end of 2001.

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

Joseph Cross, President and CEO

Thank you, Jess. At this time, I would like to provide a summary overview of the company's major accomplishments during 2001 and discuss how we believe that the company is positioned entering 2002.

During last year, Nanophase had several major initiatives that were targeted to position the company for future revenue growth and increasingly improving financials. I would like to cover these in some detail, because given last year's events, these are almost stealth improvements and, perhaps, not well understood.

As part of a significant $7M capital expansion and infrastructure improvement, we have invested in both the Burr Ridge nanopowder and the new Romeoville facility. The investment goals were: 1) to implement the infrastructure necessary for future revenue growth by providing vital technical and manufacturing capability: 2) and improve manufacturing processes to provide a robust platform for long-term improvements, including continued reduced manufacturing cost and improved process controls. We believe that these capabilities are absolutely vital as we work with Fortune 100 companies to penetrate new vertical and horizontal markets.

The Romeoville upfit included three laboratory facilities focused on nanocrystalline research and multi-market application technology; a production area and equipment for the nanoparticle coating technology that is now in production on 2-shift operations for sunscreen and personal care products; and, the new multi-purpose pilot area to make large-scale dispersions and formulations, which is also now in use for specific market applications and we expect to add operational shifts throughout the year.

Burr Ridge improvements were focused on improving the quality of nanopowders, increasing reactor output rates, improving material handling systems to reduce handling cost and labor, and automating process control systems. The results of this continuing improvement effort in our core nanocrystalline materials manufacturing facility has been a total variable manufacturing cost reduction of 40-65%, including a 25% permanent reduction in manufacturing staff, and increased output per reactor of 100% to over 200%. These efforts have also allowed us to move from a one-sigma level in process control to approximately a five-sigma level on our journey to six-sigma process control discipline.

All of these capital projects were major undertakings and consumed considerable organizational resources during the year, but, again, they are absolutely vital to the company's future growth and development.

Nanophase also made very significant progress extending its technologies from nanocrystalline materials manufacturing to application technologies - that is taking the nanoparticles we create and making them work in applications. In parallel, our new nanocrystalline materials process, which we are now formally calling NanoArc SynthesisÔ, but many of you will recall as Audrey, completed all of its initial material testing and began producing materials for customer evaluations during the last quarter. We have high expectations of this technology going forward

These synergistic developments have opened new markets in product and process applications that we believe will appreciably add to revenues in 2002 and later years. New patent activity from these advances has also been strong with 4 patent applications filed in 2001 and three already filed in 2002. While these patents, referring to our recent announcements, may be difficult to understand, they are critical to markets that we are even now penetrating and the underlying technology clearly maintains, or even extends, the company's technology leadership position in this field. Nanophase now has 38 patents, patent applications, or licenses protecting its platform of nanotechnologies.

Perhaps a critical point to understand is that over the past two years Nanophase has developed a fully integrated series of nanotechnologies, from nanocrystalline manufacturing to application engineering that allows the company to address an increased variety of markets. This platform of technologies is much broader than the company's initial PVS technology, which itself has been tremendously improved, and will be a vital factor in the company's future growth.

The area of disappointment was obviously revenue growth, which remained essentially flat with 2000. 2001 was a very difficult year for Nanophase with the economic recession especially severe in our primary customer base - manufacturing companies who use our products in their processes or products. It was also difficult to obtain interest in our new technologies with companies who were especially defensive and focused internally on their own issues and downsizing. Obviously, the events of 9/11 only exacerbated an already difficult situation and made customer contact and involvement especially difficult in the following two months at least.

At this time, I think that it is appropriate that Dr. Don Freed, vice president of business development, elaborate on our business development strategies and multiple major market initiatives.

Dr. Don Freed - Vice President, Business Development

Good morning - and thanks for your participation and interest. I'm pleased to report that customer interest in Nanophase capabilities and products is accelerating in several new market areas. Nonetheless, I'd remind you that the decision to use our products is often a binary decision and that we also have limited visibility on just when these programs will make it to the finish line. I would like to also say that although I will be discussing a number of new opportunities and markets, but keeping in mind these calls are public, and that our competition listens to our conference calls it's wouldn't be smart to provide to much detail.

The primary focus of business development is to develop new opportunities for the future, so before talking about markets, I'd like to briefly discuss our approach to position the company for future growth. Practically speaking, our opportunities occur in two time groups, typically less than 18 months, and longer although there is a continuum of opportunities -that is, we're always trying to keep the top of the opportunity funnel full.

In the less than 18-month time frame, and at the top-of-the mountain of our business development activities, are a number of strategic initiatives based on developing relationships with multinational industry leaders where our capabilities are enabling for the development of uniquely engineered products or processes for multiple business units within a broad umbrella relationship.

Another facet of our less than 18 month strategy is to develop broad market initiatives with lead customers - both in our major markets of PERSONAL CARE, MICROELECTRONICS and NANOCOATINGS and using our improved capabilities targeted opportunities in four exciting new market areas - ULTRAFINE POLISHING, NANOFIBERS, LIGHTING and ANTIMICROBIALS.

While it would be imprudent to focus all of our resource on developing applications for markets that are farther out, nonetheless we must not ignore these but our approach here is somewhat more opportunistic.

For example, we've adopted a program designed to make people more aware of Nanophase - this includes an increase in product- and patent related press releases and increased in company-authored technical publications - and the Company is being invited to chair, present and discuss our kind of solution provider business model at an increasing number of nanotechnology forums - resulting in an increase in the number of opportunities that we're evaluating. Dan Bilicki will also discuss some other approaches.

Before I close, I'd like to share some of the results of our activities. As I do this, I'd like you to keep in mind that many of these opportunities were not accessible to us as recently as six months ago - but the technology advances in our core PVS process, commercialization of our new NanoArc™ Synthesis (that you know as Audrey) process, the recent completion of our new pilot line facilities are allowing us to evaluate more emerging opportunities.

In the area of ULTRAFINE POLISHING, a new market area for Nanophase, we've engineered NanoTek® metal oxides to have extremely low levels of larger sized particles - these are designed specifically for polishing applications, including semiconductors, rigid memory disks, glass photo masks, and optical lenses. This is a demanding application in high-tech electronics that requires a significant level of nanoengineering and testing before market acceptance. It is also an application where larger materials would not be able to produce the low level of defects and ultrafine surface finish required. We are vigorously pursuing a broad variety of applications for this capability.

In another new area that we call NANOFIBERS -we're developing surface engineered nanoparticles that can be incorporated directly into fibers to develop better wear properties. You may recall that earlier we were attempting to improve fabric wear with particle-based coatings, and that while these did offer improvements the coating was not permanent - this new approach should result in a wear-resistant fiber with a high level of permanence - we're co-developing these products with companies in the "big three" of fibers - nylon, polyester and polypropylene.

In yet another area, our improved technology for preparation of nanoparticle dispersions with long-term stability and very narrow particle size distribution is enabling us to explore the development of unique products for the LIGHTING industry

All told, within the markets referred to above, we're currently pursuing between $20 million and $30 million of opportunity in the less than eighteen-month time frame and a roughly equal amount in the longer time frame. Please remember, as I stated earlier, that the decision to use our products is often a binary decision - that coupled with limited visibility makes it difficult to predict just when a particular application will result in production orders.

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

Dan Bilicki, VP Sales & Marketing

Good morning and thank you for your interest in Nanophase.

There are three factors that impact the generation of revenues in an emerging market. The first is that for each potential customer the time to market is influenced by our ability to provide a solution to the customer's problem, secondly the customers sense of urgency in testing and proving the product performance, and thirdly the cost of the material supplied must be attractive on a systems cost basis. Poor revenue performance for 2001 was the result of an extended time to market caused by a significant slow down of potential customers testing and proving the performance, as well as failure of a customer to generate the necessary capital to be a viable business resulting in the default of a valid purchase order.

However, 2001 did have some bright spots including a small increase in our ZnO personal care business versus 2000. Sales to our vinyl flooring and environmental catalysts customers met expectations.

As indicated during the October 2001 conference call we discussed what Nanophase was doing to drive revenue generation. I would like to spend a few moments to review our progress on these initiatives. As you may recall the major elements of the plan are as follows:

Extend contacts at existing customers as well as expand dialogue at potential new customers, by focusing the entire company.

Increase our exposure by publishing technical papers and making presentations at nano related conferences.

Develop partnerships, strategic alliances, and look for joint venture opportunities.

Focus significant attention on those customers that are still in the performance testing stage to push these projects into product sales.

The result of these initiatives has been encouraging. Expanding contacts with current potential customers and opening dialogue with new potentials allows Nanophase to assess the level commercialization interest helping us to better allocate our resources.

Don Freed mentioned our efforts to make potential customers aware of the current capabilities at Nanophase through technical presentations and papers. A recently published technical paper generated over new 40 leads in the transparent functional coatings area.

Nanophase has opened discussions with several large multi national companies that have existing nano technology efforts to explore opportunities for cooperation. These initiatives are directed toward building partnerships or strategic alliances that have the potential to quickly grow our business.

Nanophase continues to focus on developing revenues in the transparent functional coatings, thermal spray and catalysts markets.

Technical advances made during 2001 on the manufacturing of nano crystalline particles via the Nano Arc Synthesis process or, Audrey as it was previously called, have opened up significant opportunities in the ultra fine polishing market. As a result, a new customer in Germany has approved nano crystalline particles made by the Nano Arc Synthesis process. The press release covering this development was sent out this morning.

From a revenue and sales view, based on existing customers only and annual orders received to-date, the company is currently seeing a 20 to 30% increase in demand and believes that revenues from established customers will approach a $5 million revenue base. We also believe that there may be upside potential to that revenue base. With product shipments to date, purchase orders, and annual supply agreements in-hand, the company already has a current shipped and order backlog of approximately $4.5 million for 2002. The first quarter sales revenue for 2002 will be in the range of $1.3 million and our current projections for the second quarter are in the area of $1.5 million.

Joseph Cross, President and CEO

Thanks, Dan.

On the cost side, to ensure that we maximize margins and match cost to sales, we have aggressively reduced overhead costs throughout the organization during the last six months of 2001. We continue that focus and expect to see a reduced overhead run rate during the first quarter and subsequent quarters of 2002. We are still reducing variable manufacturing cost and fixed manufacturing overhead. Obviously, as we increase manufacturing product volume, fixed manufacturing overhead will be better utilized and absorbed.

Let me address revenue growth expectation for 2002. Understand that we view and gauge revenue growth in two distinct areas. The first area is growth in our existing customer base and/or new products with current customers. The second area of growth is new customers and/or products for new customers or markets - that is new business development. Forecasting the former is quite a bit easier than predicting the latter.

In the first area, as Dan stated, we are seeing appreciable growth within our existing customer base, including increased demand from customer new product introductions, and are very comfortable with the company's current level of shipped and order backlog at $4.5 million this early in 2002, which is already 13% greater than 2001 revenues. Again, we believe that revenues from existing customers should approach $5 million this year, or about 25% over 2001.

Regarding the second area, new business development, as Don stated, the company's business development activity is exceptionally strong and we believe that Nanophase has higher quality and quantity of opportunities than at any time in its history. While we have several efforts close, some of which may be significant, our visibility on timing is limited at this time. We expect to have increasing visibility as the first half of 2002 progresses.

At this point in the year, we are unable to predict or forecast total 2002 revenues with any degree of accuracy and expect to be able to only provide quarterly guidance. However, we are clearly cautiously optimistic about 2002-revenue growth, barring any additional economic weakening or U.S. environment impacts, and expect to have significantly increased revenue growth during the second half of 2002 and throughout 2003.

This concludes our prepared remarks. As a reminder, our prepared comments will be posted on our web site by mid-next week. At this time we are ready for any questions you may have.