FIRST QUARTER 2006 CONFERENCE CALL Transcript

FIRST QUARTER 2006 CONFERENCE CALL

Joseph Cross, President and CEO

Welcome to Nanophase’s conference call to review the first quarter of 2006. From a revenue view, we had a strong first quarter with 24% year-over-year revenue growth and achieved the highest first quarter revenue in the Company’s history. Jess Jankowski, Nanophase’s CFO, and I will be hosting this session.
To begin our discussion, Jess will summarize the financial highlights of the quarter. Jess….

Jess Jankowski, CFO and Controller

As I review the financial performance of the Company, I intend to only address significant areas comparing Q1 2006 to Q1 2005. All numbers will be in approximate terms for ease of discussion. Details are included in the financials accompanying today’s press release.
Revenues for the first quarter were up 24% to 2.0 million dollars this year, versus a million-six last year. Again, the lion’s share of the growth was from product sales, a full ninety-six percent of Nanophase’s Q1 revenue. The first quarter of 2006 also proved to be the biggest first quarter in Nanophase’s history.
Gross margin continues to grow out of proportion to product revenue growth. This is a sign of our business model, as we discussed in depth in March’s call, delivering as promised. Recall that our fixed manufacturing cost structure, the minimum that’s required to be in the game, does not need to grow until we achieve a multiple of 2005 revenue. This is a key component of our path to cash flow breakeven, then profitability.
In that same vein, some of you have expressed concerns as to how demand for our product will remain strong, how pricing power will stay solid, and how Nanophase’s material will avoid commoditization…..
Well, we’re not selling materials that can be comparison-shopped by any measure. We have a strategic platform of materials development capabilities that is UNIQUE. Each nanoparticle we make, from zinc oxide for sunscreens to ceria for CMP polishing, looks and performs differently than other materials of similar composition in the marketplace. It starts with the particle and the controlled way we make it. That’s the first differentiator. Then, and this is another key competitive advantage, we take our unique particle and adjust the surface chemistry, either in-process or through a surface treatment.
Through these complimentary technologies, we have developed the ability to disperse these materials in various media, from water to organics. To our knowledge, no one else has these capabilities. We simply aren’t seeing them in the marketplace. Our material, by definition, CANNOT be commoditized. We can’t stress this enough. BASF, Rohm & Haas, and Altana rely on the leverage provided by our capabilities in concert to gain competitive advantages in their respective markets. We’ve staked out and protected our market position well. In a nutshell, regardless of the spin applied by others, all nanos are NOT created equal. Our customers understand this very well, and it’s critical that the investment community consider this also.
Moving on, I also want to ensure that you understand that we are continuing to make bottom line progress as we grow. This is not necessarily apparent comparing the relative losses from Q1 of ’06 to Q1 of ’05. Our loss appears to have grown by $130K year over year.
Two anomalous things took place this quarter that have negatively affected comparative GAAP earnings:
1) First, we abandoned two patent applications, along with their foreign counterparts. We expect this neither to have an impact on our business, nor the protections afforded it relative to our competition. One patent applies to particle separation technology that we’ve outgrown, while the other, in the view of the patent office, is redundant when viewed against Nanophase patents already in place. We wrote these off in Q1 in the amount of $111K. If it cost nothing to continue these patents along the path to grant, we would have kept going down that path. Every bit of IP protection we can get adds to the formidable barrier to entry that surrounds this business. Occasionally, as in these cases, costs of continuing on the path to grant outweighs management’s estimates of value gained.
2) The second, and more pervasive, issue is the advent of FAS123(R), the requirement that we begin expensing stock options in 2006. To put this in perspective, in the first quarter of 2005, we had less than $15K in equity compensation expense. This quarter, we had $195K of equity compensation expense, of which $115K relates to this new standard. The balance was composed of expenses relating to a change in board director compensation which added a stock component, and past issuances of restricted and performance share grants whose expense swelled this quarter due to growth in our stock’s value.
In total, the Company lost $0.09/share this year, of which $0.02 relates to the two items just discussed, versus $0.08/share last year. Note that Q106 depreciation and amortization amounted to about $300K, equity compensation expense about $200K, and the non-recurring patent expense amounted to $111K of the Company’s $1.5 million loss for the quarter.
Net of these expenses, the loss would have been $900K, or $0.05/share, versus $1.1M, or $0.06/share, in the same quarter last year, when adjusted for these same factors. Taking another view, these Q106 non-cash and patent items amounted to 40% of the Company’s operating loss.
In other words, we’re continuing to see progress where it matters on our path to becoming cash flow positive.

Moving to the balance sheet highlights;

Nanophase ended Q1 with $7.6 million in cash and investments.
In terms of accounts receivable, 90% of this balance is made up of receivables from BASF, Rohm and Haas, and the C.I. Kasei license fees. These same customers also accounted for a cumulative total of approximately 90% of our Q1 revenue.
Equipment and leasehold improvements netted to $7 million in total, which included $280K for capital additions in Q1. Capital requirements for the balance of 2006 will be mainly composed of the build-out of the equipment outlined in the November 2005 loan of $1.6million from BYK Chemie, a subsidiary of Altana.
We continue to be excited about the possibilities that this funding will bring to our strategic marketing attack.
On the liabilities side, the Company now has about $1.7million in total debt.
$60K of this represents the note in favor of BASF that was used to finance equipment to produce sunscreen nanomaterials. Management expects to retire this loan in Q2. The balance of this debt reflects the previously mentioned $1.6million loan from BYK Chemie. The debt discount, and offsetting deferred other revenue referenced on the balance sheet, relate to the required accounting treatment under APB 21 of this loan and have no cash impact.
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
As we have stated previously, revenue growth is management’s first priority. We achieved 52% product revenue growth during 2005 and recognize that such a growth rate is necessary for the Company to achieve its financial goals. The first quarter is a solid start to fiscal 2006 and one the Company hopes to build on.
Since we had a lengthy conference call about one month ago and covered the Company fairly broadly, today I would like to confine my comments to revenue growth and first quarter events related to that. If you were not able to attend the previous conference call, I would encourage you to read the transcript that is on our website under investor relations.
To be clear in this discussion, Nanophase has what we term market partners as well as customers. Market partners include Altana Chemie, BASF, Rohm & Haas Electronic Materials CMP Technologies, and Alfa Aesar. With market partners, we have long-term exclusive relationships for specific markets, or fields of application, where we provide nanomaterial products and the market partner offers application development, global sales and distribution, as well as focused new product development for their respective markets based on their intimate knowledge of customer or market needs. Customers are typically obtained through the Company’s business development initiatives, have little or no exclusivity, and order nanomaterial products from Nanophase.
To begin, I would like to cover progress with our market partners and then discuss new customers. As we have stated before, we believe that market partner revenue growth alone will drive Nanophase to profitability. Beginning with BASF, the Company’s longest-term market partner, our relationship and business continues to grow. After growing about 24% in 2005, the original sunscreen product, which BASF brands as Z-Cote, continues to show strength during the first quarter increasing year-over-year.
On a separate, but parallel, track, the new product introduced last year, which BASF brands as Z-Cote MAX, is on target with the new product launch plan and we anticipate revenue growth during late 2006 well into 2009. Again, this product utilizes a special nanoparticle coating that was developed by Nanophase to provide high loading levels and formulation compatibility with European and Asian cosmetic formulations. BASF anticipates that this brand will grow to level approximately equal to the current brand.
BASF also plans to introduce two additional products in the Z-Cote MAX line around September 2006 based on nanomaterial products from Nanophase. We cannot discuss the details of these, but expect positive material revenue impact during late 2006 and into 2007. In total, exiting 2006, we should have four distinct products marketed globally by BASF, versus the original one sunscreen product, which provides Nanophase a solid base of existing and growing revenue from current products, and significant revenue growth opportunities going forward in new products.
Moving to Altana Chemie, we are continuing focused, vigorous product development both in Germany and in the US. During the first quarter, Altana released three new nanomaterial-based products, which they brand as NanoBYK, targeted to UV protection for industrial coatings. They plan to announce an additional three new nanomaterial based products in the near future targeted to abrasion or scratch resistance and UV protection for solvent based coatings. This will equate to ten nanomaterial based products for various market applications with several more planned to follow.
As you may recall, Altana Chemie loaned Nanophase $1.6 million to purchase and install dedicated production equipment for their expected volume. Implementation is on plan and the equipment should be operational by the May/June timeframe to support an anticipated material scale-up in order rate during the second half.
Altana Chemie continues to move forward penetrating markets and creating nanomaterial-based additives for coatings and plastics. We continue to anticipate, based on their current forecast, significant revenue growth during 2006.
Rohm & Haas Electronic Materials CMP Technologies is making significant strides gaining business in chemical mechanical polishing slurries for semiconductors. I provided considerable details on this activity during our March 9 conference call and I would refer you to those comments. But the scaling by semiconductor manufacturers continues vigorously and we are highly optimistic about business and revenue growth going forward.
Alpha Aesar, a new market partner we added in late 2005, is scaling and now delivering 21 Nanophase-branded nanomaterial products to research and development communities globally. In the near future, they plan to make a mass marketing push with a specific brochure dedicated to Nanophase nanomaterial products. Again, we believe that this relationship will help the Company reach the global research and development community and help drive future revenue growth as our nanomaterials are incorporated into commercial applications.
Late in the first quarter, actually the beginning of this quarter, we received orders from two different customers for new applications. The first is for a cleaning product that utilizes nanomaterials to provide residual antimicrobial and UV protection. It’s an interesting application in a new field and should grow to be a nice account for the Company.
The second represents several initial orders for an exterior architectural coating application that we have discussed before. This product is scheduled to begin hitting the big box store between Memorial Day and June 1 followed by a sequenced national rollout. We are shipping initial orders this quarter, which will be material to second quarter revenue, and have been told to expect a multiple volume increase in the third quarter. At this point, we do not know the exact details of the rollout and the timing, but have been led to believe the full roll out is in the near future. Based on the volume estimates from our customer, we believe that this application will add $1-2 million in revenues per year when the rollout is complete.
As an aside, architectural coatings are a focus market for Altana Chemie and Nanophase going forward. According to a recent analysis by the Freedonia Group, this is a $39B global market that offers many opportunities for nanomaterial-based products.
In summary, we remain aggressively optimistic about achieving material revenue growth during 2006. Market partner growth, new customer additions and growth, and business development opportunities remain robust. This concludes our prepared remarks and we are available for questions at this time.