Fourth Quarter 2002 Conference Call Transcript

FOURTH QUARTER 2002 CONFERENCE CALL

Joseph Cross, President and CEO

Welcome to the Nanophase conference call to discuss 2002 results, the Company’s position entering 2003, and expectations for the New Year. 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, VP and Corporate Controller; and Bob Haines, VP of Operations.

To begin our discussion, Jess Jankowski will review the financial results for the fourth quarter and fiscal 2002. I will return to comment on the company’s solid progress during the year and provide a view of the company’s position entering 2003. 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 2003. Jess....

Jess Jankowski, CFO and Controller

Good morning and thanks for your continuing interest in Nanophase.

As I review the financials, please remember that all numbers are approximate. More exact details are included in the financials accompanying our press release.

For the fourth quarter of 2002, our revenues were $1,078,000 dollars versus $1,239,000 for the same period in 2001. The majority of our revenues continue to come from product sales. On the bottom line, we lost 9 cents per share for the fourth quarter of this year versus 14 cents per share for the fourth quarter of 2001. Our quarterly numbers continue to display a level of variability that one would associate with a company at our stage. Given our current visibility, which is still not much better than 60 days, and our reliance on one very large and several other smaller customers for the lion’s share of our volume, quarter to quarter comparisons don’t always yield meaningful information. I will build upon this more as we discuss year over year results.

For the year ended December 31, 2002, revenues were $5,401,000 dollars versus $4,055,000 for the same period in 2001. With respect to earnings per share, the Company lost 35 cents per share for the year ended December 31, 2002 versus 42 cents per share for the same period in 2001.

Rather than merely going on to highlight changes in the period to period statements that you can all plainly see, I would like to analyze a few of the differences between results for 2001 and 2002 at a high level and share what they mean to me, from a business perspective. The difference in earnings in the statements before you, a $0.07 pick-up per share in 2002 versus 2001, merits further discussion. If we analyze this difference and normalize for non-operating changes year to year, such as the decrease in interest income due to declining rates and lower invested balances, at $433,000, and additional interest expense of $92,000, the resulting number amounts to more than $0.03 per share in additional increases in operating earnings from 2001 to 2002. Adding this number to the $0.07 per share we just discussed, we arrive at a $0.10 per share (normalized) increase in earnings between 2001 and 2002.

Viewing this from the top down, given that sales increased $1.4million, or $0.09 per share, and we dropped $0.10 per share to the bottom line, $0.01 more than the $0.09 per share in additional sales we gained, we are able to draw some interesting conclusions. This indicates that our variable margins have definitely increased and that, even given increased insurance and compliance costs, we were still able to shave several cents per share from our discretionary expenses. This performance speaks very well to our ability to hold costs in check and the fact that we are poised for further profitable growth.

The Company expects ongoing manufacturing cost-cutting efforts to continue throughout 2003 and will continue to focus on selling the products that it makes most efficiently and with the best margins. Nanophase has painstakingly built a lean manufacturing organization that is capable of supporting a larger revenue volume than the Company experienced in 2002. As we have stated before, this infrastructure is required to have both cGMP and ISO 9001 systems. Both of these are a requirement in attracting Fortune 500 customers. With planned growth, Nanophase should be well positioned to reap the benefits of an efficient overhead structure; again keeping in mind that visibility is limited.

Technology and SG&A expenses were relatively flat year over year. Aside from the addition of more gray hair, we don’t fully know what further impacts the current regulatory environment will have on our audit, legal, and insurance costs for 2003.

Moving to the balance sheet.

Note that inventories appear to be flat year over year. Considering all materials, turns have improved from 4 to 5 per year from 2001 to 2002. Planned inventory turns were affected by poor visibility for our unfolding CMP business with Rodel and a 4th quarter reduction in personal care orders.

The bright spot here is that inventory turns relating to materials for our largest customer are at 9 per year. Without the 4th quarter volume reduction, turns for this same material would be approaching 12.

The good news, with both A/R and inventory, is that at higher volume production levels we have demonstrated our ability to manage the Company’s assets quite efficiently.

Moving down, Nanophase has added $1.7 million to property, plant, & equipment in 2002. These investments represented the finalization of the Company’s major capacity and infrastructure build-outs for its Burr Ridge and Romeoville facilities, and the addition of a second NAS reactor at the Company’s Romeoville facility. Joe will discuss this in greater detail later in the call.

The Company expects to incur less than $525,000 in capital spending in 2003. $200,000 of this will relate to assets delivered in 2002 and paid for in 2003 with the balance relating to the current 2003 capital plan.

The Company had approximately $1.7million in debt at year-end. $1.1million of this represents a loan from a customer used to support construction of the Company’s coating facility.

Also note that Nanophase had $7.5 million in cash and investments at the end of 2002.

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 comment on the company’s major accomplishments during 2002 and discuss how we believe that the company is positioned entering 2003.

During the past year, Nanophase accomplished several major initiatives that were targeted to position the company for future revenue growth and increasingly improving financial performance.

As part of a now-completed $7M capital expansion and infrastructure improvement, which were started during 2001 and finished during 2002, we invested in both the Burr Ridge nanopowder and the new Romeoville facility. As we stated in the 2001 conference call, the Company’s investment goals were: First, to implement the infrastructure necessary for future revenue growth by providing vital technical and manufacturing capability; and, secondly, improve manufacturing processes to provide a robust platform for long-term improvements, including continued reduction of manufacturing cost and improved process controls. We believed then, as we do now, that these capabilities are absolutely vital as we work with Fortune 500 companies to penetrate new vertical and horizontal markets.

As a direct result of this investment in capability and capacity, coupled with the development of the Company’s NanoArc?Synthesis technology, we believe that we have achieved a break-through relative to CMP applications. This, we believe, is demonstrated, in the Rodel agreement, which Dan discussed, completed during 2002 that is expected to result in approximately $12 million in annual revues during 2003-2005 at the minimum annual supply quantities specified in the agreement. This is also manifest in Nanophase securing its first photomask-polishing customer during 2002. Both of these applications are demanding and require high material performance.

In the Romeoville facility during 2002, the Company implemented the facilities and equipment for the nanoparticle coating technology that is now in production on a 2-shift operation for sunscreen and personal care products; commercialized and automated our initial NanoArc? Synthesis reactor primarily for CMP materials relative to the Rodel agreement and photomask polishing; installed a second NanoArc? Synthesis reactor to develop innovative materials for new vertical market initiatives; and completed the new multi-purpose manufacturing area to make large-scale dispersions and formulations, which is also now in use for CMP dispersions for both semiconductors and photomask polishing.

Operations – which refers to the manufacturing, quality, production control, distribution, and engineering functions that report to Bob Haines – continued to improved processes and reduce cost. As you may recall, as part of the investment in the Burr Ridge facility to provide the robust manufacturing structure I previously outlined, during 2001, we were able to decrease variable manufacturing cost by 40-65%, including a 25% permanent reduction in manufacturing staff. During 2002, continuing to build on the 2001 efforts, the Operations team was able to again reduce variable manufacturing cost by 10-30% depending on the specific nanomaterial, while achieving 100% product acceptance by customers and shipping 99+% of customer orders on time. The results of this effort are evident in the positive gross margin that the Company is now achieving on product shipments. 2002 was the first full year of positive gross margins for the Company, which we believe is a critical and demonstrable first step toward profitability.

A continuing key strategy for the Company is to constantly expand its intellectual property position in the still emerging nanomaterials technology industry. During 2002, the Company submitted six additional US patent applications, five of which were related to nanoparticle or nanoparticle dispersion applications. Nanophase Technologies currently owns or licenses 25 United States patents and patent applications, consisting of 8 owned United States patents, 9 owned United States patent applications, and 8 licensed United States patents. The Company also has 20 foreign patents and patent applications, consisting of 7 owned foreign patents and 13 owned foreign patent applications.

In summary, 2002 was a solid revenue and operational growth year for Nanophase despite a worsening economy and increasingly turbulent geopolitical situation. We have now established a solid customer base in at least four growth markets – personal care, sunscreens, abrasion – resistant coatings, and CMP. These markets alone should grow at a pace that will allow the Company to become profitable in the near-term. Additionally, we believe that we have established the delivery and technology capability over the last 18 months to add additional customers and markets that will be accretive to this revenue stream.

At this point in time, let me turn the conversation over to Dan Bilicki to discuss 2002 and the business development/sales market focus for 2003.

Dan Bilicki, VP Sales & Marketing

Good morning and thank you for your interest in Nanophase.

As reported, sales revenue for 2002 increased over 2001 by 34%. We believe that 2002 was a break through year for the company and I would like to spend a few minutes covering the major accomplishments and their impact on future revenue growth for Nanophase.

The most significant development for 2002 was the new partnership with Rodel, a division of Rohm & Haas. The long-term mutually exclusive arrangement is focused on chemical mechanical planerization of semiconductor wafers. In short, a slurry containing particles is used to provide both mechanical action and a chemical reaction to polish semiconductor wafers.

The market for slurries containing particles used in semiconductor polishing is currently estimated at $420 million with an expected growth to $540 million by the end of 2005. Silica is the most widely used particle accounting for approximately 72% of the current market, while alumina particles account for 19%, and the balance are ceria particles. By 2005 it is estimated that ceria particles will account for 14% of the $540 million market or approximately $75 million annually.

The development of the NanoArc Synthesis™ process as well as dispersion technology has resulted in producing ceria and alumina particles that provide unique performance capabilities. After testing our particles, major slurry providers to the semiconductor wafer polishing market wanted to develop an exclusive relationship with Nanophase. Our decision to go with Rodel was based on their business model of providing integrated solutions to customers and their interest in a close working relationship with Nanophase. The combination of Rodel and Nanophase is committed to capturing a major share of the developing semiconductor polishing market.

However, under the agreement with Rodel, Nanophase is free to sell our ceria and alumina particles outside of the semiconductor polishing market. Significant opportunities exist in polishing disk drives, photomasks, and specialized optics.

During 2002 Nanophase utilizing its unique particle technology developed its first photomask customer - Schott Lithotec part of Schott Glass an industry leaders. Schott Lithotec and Nanophase will be presenting a joint paper at the upcoming Opti-Fab trade show in May. The photomask polishing market for particles used in final stage polishing is currently estimated at $3 million and is expected to grow to $5 million by 2005.

Particles produced by Nanophase are currently being tested in polishing read/ write heads, and disk drives, these two markets are expected to grow from their current level of $12 million to $18 million by 2005. We are also working to define the exact opportunities and market value for polishing specialized optics such as mirrors and lenses.

Given our unique NanoArc Synthesis™ technology, the partnership with Rodel, and the opportunities in the horizontal markets of photomask, disk drives, and specialized optics, Nanophase is well positioned to grow market share in this important market segment.

Another accomplishment in 2002 was that sales revenue to BASF into the sunscreen and personal care applications grew by 26% versus 2001. Additionally, further development of the partnership was evidenced by the signing of a technology agreement in Q1 of 2002 to allow a much closer technical working relationship and joint development efforts on opportunities in sunscreen and personal care applications. During the year Nanophase also began 3 new projects within BASF Corporation focused on products for polymers, catalysts, and antimicrobial applications.

During 2002 Nanophase worked closely with our Japanese licensee C. I. Kasei to expand production capacity and improve the product mix offered for sale. C. I Kasei and Nanophase are jointly exploring significant market opportunities for product sales in polishing of photomasks, flat panel displays, and optics as well as particles and dispersions for catalytic converters.

The NanoArc Synthesis™ technology has also opened other opportunities in the Catalysts market. The capability of making mixtures of nano structured particles has sparked an interest by manufacturers of catalytic converter for both gasoline and diesel applications. Nanophase particles and dispersions are currently being tested in Europe, and the US.

In conclusion, the development of a major partnership with Rodel focused on the fast growing semiconductor wafer polishing market further validates the Nanophase technology, provides a strong vertical market with excellent horizontal market opportunities, and significantly strengthens the company.

Joseph Cross, President and CEO

Thanks, Dan

Entering 2003, we believe that the company is stronger and better positioned than at any time in its history. We have established the vital delivery capabilities to succeed with our enlarged platform of nanoengineering technologies and delivery capability investments, our market attack is broader and at the same time better focused, the infrastructure is ready to deliver, our processes continue to be demonstrably scalable and robust, and we have strengthened the company’s supply chain.

On the cost side,

We have been diligent and prudent with spending and equally creative finding opportunities to reduce discretionary spending and improve cost both in operations and throughout the Company. We continue to focus in this manner. For example, the company recently installed a new health benefit plan to reduce current costs and avoid an expected 15-20% increase during 2003. However, at the same time, we have seen other insurance costs that are rather uncontrollable, increase much the same as reported by other companies.

Relative to staffing, we have continued to maintain staffing levels between 2001-2002 and increase productivity. Average headcount for both years was essentially identical despite 35% higher revenue during 2002. The Company entered this year with about 52 employees and does not intend to increase staffing except in the direct labor area as increases in output volume require.

Lastly, we have significantly improved our business modeling relative to forecasting financial performance and highlighting areas of concentration. Relative to improving financial performance, volume growth is the most critical factor. It is rather obvious that volume growth will absorb the fixed manufacturing overhead in place and gross margins will quickly, and rather dramatically we think, increase and the Company will demonstrate quite improved financial performance.

From a cash position, we are relatively comfortable with our cash status entering 2003 and for the visible future. As I stated, we continue to monitor and control spending. The Company will also continue to monitor its cash position as it encounters new opportunities to grow revenue that may require capital investment. Having completed the infrastructure investments in our two facilities over the past two years, our current planned capital expenditures for 2003 are about $325,000, equating to less than 15% of the capital spending during 2002.

Relative to vertical and horizontal market expansion, during 2003 Nanophase expects business development and sales efforts to focus in the following major areas:

Expansion activities in the sunscreen and personal care business;

Horizontal market expansion and introduction of CMP materials for the applications Dan mentioned;

Specific electronic applications that are underway;

Introduction of new, and we believe potentially novel, mixed metal oxides into catalysts and catalytic converter applications;

Several new coatings applications, as well as others that are at various stages of development;

Continued development of nanoparticle fiber-related applications;

Continued development of a nanoparticle thermal spray process; and

Initial exploration and development of specific materials related to fuel cell technology for which we believe that the NanoArc Synthesis? process may have unique capability.

And other market areas that we would rather not discuss at this time.

Our business development activities remain focused on time-to-market relative to revenue growth, but also encompass a 24-month horizon, meaning that we are focusing on business development for revenue growth opportunities for both 2003 and 2004.

Relative to sales for 2003, as we noted in the earnings release, our visibility is limited, especially regarding the timing of new opportunities. We are entering 2003 with a sales or order backlog of approximately $5.2 million based on annual orders received and customer forecasts to annual orders, which is up about $700,000 or about 14%, from the Company’s position at the same time last year. However, we remain concerned about the direction of the economy, the uncertainty of the geopolitical situation, and the potential for U.S. terrorist activity, since any or all may affect current customers and developments in process.

Our current expectation is that revenues for the first half of 2003 will probably exceed the comparable period in 2002. We also have fairly solid reasons to believe that revenues for the second half of 2003 will be greater than the first half. We are not in a position, however, to provide quantitative guidance on full year numbers and will only provide guidance on a quarterly outlook. However, we are optimistic regarding revenue growth for 2003.

Our current expectation for the first quarter ending March 30, 2003, is that revenues will be in the range of $1.5-1.6 million. This would equate to a 7-14% improvement over the comparable period of 2002, and an approximate 40% sequential increase over the fourth quarter of 2002. We intend to provide second quarter guidance as soon as we are comfortable doing so.

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.