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FOURTH QUARTER 2005 CONFERENCE CALL
Joseph Cross, President and CEO
- Welcome to Nanophase’s conference call to review the fourth quarter and fiscal year 2005. Nanophase set year-over-year revenue records for each quarter last year and for the year as a whole. The Company had a strong year and we are pleased that you are taking the time to be with us today. Jess Jankowski, Nanophase’s CFO, and I will be hosting this session. This is typically our longest conference call of the year because we discuss 2005 and then try to provide a sense of direction for 2006; it is a lot of ground to cover. But, we believe there is some important information in our comments and encourage your attentiveness.
- To begin our discussion, Jess will summarize the financial highlights of the quarter and the fiscal year. Jess....
Jess Jankowski, CFO and Controller
Good afternoon and thank you for your continuing support of Nanophase. 2005 was a good year for Nanophase, our shareholders, and our stakeholders. It has also served as a good stepping-off point for 2006.
- As I review the financial performance of the Company, I intend to only address significant financial areas comparing 2005 to 2004. All numbers will be in approximate terms for ease of discussion. More details are included in the financials accompanying today’s press release.
- Revenues for the fourth quarter were up 44% to 1.4 million dollars this year, versus about a million last year. 2005 revenues came in at $6.8 million versus $5.2 million for 2004, a 31% increase in total revenue, and a 52% increase in product revenue. A full ninety-five percent of Nanophase’s 2005 revenue, or $6.4 million, was generated through the sale of products.
I’m also glad to tell you that each quarter’s 2005 product revenue totals, the driver and most critical success metric of this business right now, set a new record compared to their corresponding quarters from all previous years.
For the year, 66% of our revenue came from BASF and 12% came from Rohm & Haas. All of the Rohm & Haas revenue came from products. We also saw the continuation of a small revenue flow from Altana, our newest strategic partner. As our partnerships mature with Rohm & Haas and Altana, and product revenue volumes increase, we expect the revenue breakdown to reflect at least several larger customers composing the majority of our revenue volume.
This will eventually lead to a more balanced distribution. This rebalancing should help to reduce quarter-to-quarter variations in demand, while enhancing management’s admittedly limited visibility.
- I think, before going any further, it would be useful to quickly walk some of our newer shareholders through our profit model. From a quick scan of the P&L, it’s not always apparent how we’ll be able to achieve break-even.
Nanophase has a fixed manufacturing infrastructure that will support a multiple of current revenue. We could probably triple 2005 revenue without adding significantly to fixed overhead.
So, the natural question that follows is: “Why have we maintained this type of structure for a $7million revenue company?” Well, we’ve built the company this way because this structure is sized at the minimum we think we can operate with, given the size and sophistication of the companies that we target as customers. We know that it’s been a key factor in making us an attractive partner to the large companies that we currently do business with and those that we expect to develop significant business with in the future.
Much of this infrastructure supports compliance with FDA and USP standards for sunscreen and personal care materials, as well as the exacting performance requirements of the electronic chemicals industry for CMP, and now the medical diagnostics and coatings industries.
We receive positive feedback regularly on this part of the business from both customers and competitors. As an aside, there have been signals that our infrastructure advantage may prove a key barrier to entry for some of our nascent competition.
In a nutshell, what this all means is that as volume continues to grow, we expect our strong variable margins, which we continually focus on, to lead to overall gross margin growth, and then profitability. Let’s look at the numbers.
On 2005’s record sales, we had almost a million dollars in gross margin, versus $83K in 2004. This represents more than 10X margin growth driven by a 31% increase in revenue. Clearly, this disproportionate margin growth validates our business model and assumptions regarding variable contribution.
During each quarter in 2005, we not only had a positive gross margin, but margin growth related directly to volume. The margin analyses we’ve done show that fixed cost increases are not required to drive expected near-term increases in revenue.
Beyond a certain volume, each new revenue dollar drops its variable margin, or variable contribution if you like, right to the bottom line.
Moving down,
- R&D Expenses were flat while SG&A Expenses expanded marginally year over year. In SG&A, the largest category increases were in salaries and benefits, and fees for the GAAP audit and ongoing costs relating to SOX-404. These were somewhat offset by decreases in D&O and package insurances, and legal fees. I’ll discuss these decreases and the strategy around them further in a moment.
- As you may remember, the $280K “Lease accounting adjustment” was a third quarter non-cash charge relating to changes in the amortization periods of our previously existing Romeoville lease, to remain consistent, within GAAP accounting requirements.
- In a related, yet far more exciting issue, the lease amendment that we renegotiated and announced effective October 1st will result in cash savings of almost $600K over the life of the original lease. This savings, as well as the $280K accrued liability we created to take the non-cash charge in Q3, will be recognized quarterly in rent expense reductions over the life of the lease.
- Nanophase also began 2006 under a new type of health insurance regime. This change will save the Company $200K per year, when compared with the quoted increases, under the existing form of coverage from 2005.
- We also expect our directors and officers insurance, which has seen total cost reductions of more than 55% in the past three policy years, to be further reduced. Thus far, the cumulative savings have topped more than $800K. This has been done through the aggressive marketing of Nanophase’s management and board practices to a series of D&O insurance underwriters.
The underwriters have been impressed that Nanophase has been operating under the spirit of Sarbanes-Oxley, without the unfortunate added bureaucratic load we now labor under, since we’ve been a public company.
As you can see, controlling expenses remains a priority of Nanophase management.
- In total, the Company lost $0.30/share this year versus $0.37/share last year. Note that depreciation and amortization amounted to about $0.07/share or $1.2 million of the Company’s $5.4 million loss for the year.
Taking another view, these non-cash items amounted to 22% of the Company’s 2005 operating loss. We’re beginning to see the progress I spoke of in the margin analysis.
Moving to the balance sheet highlights;
- Nanophase ended 2005 with $8.5 million in cash and investments.
- In terms of accounts receivable, 82% of this balance is made up of receivables from BASF, Rohm and Haas, Altana, and the C.I. Kasei license fees. These same customers accounted for a cumulative total of approximately 85% of our 2005 revenue.
- Equipment and leasehold improvements netted to $6.6 million in total, which included $290K for capital additions in 2005. Capital requirements for 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 are all truly excited about the possibilities that this funding will bring to our strategic marketing attack.
- On the liabilities side, the Company now has about $1.8million in total debt.
$200K 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 by mid-year.
The balance of this debt reflects the previously mentioned $1.6million loan from BYK Chemie. The debt discount and offsetting deferred revenue referenced on the balance sheet relate to the required accounting treatment under APB 21 of this loan and have no cash impact. Given that the terms are favorable to Nanophase, including interest-free periods and a low interest rate, we were required under GAAP to adopt this treatment.
There will be a more substantial discussion of this issue in our upcoming 10-K, to be filed next week.
- 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
- I would like to review Nanophase’s progress during 2005 both from the perspective of year-over-year improvement, as well as the continuing foundation the Company is building for future revenue growth, as we continue to be a recognized leader in the global, growing nanomaterials business.
- Beginning with operational improvement, which is a continuous effort at Nanophase, we again made significant progress in 2005. We believe that operations, which include manufacturing, quality, and associated engineering, are a core competency and a major Company advantage in the global marketplace. Reviewing selected achievements, we
- Developed five new nanomaterials targeted for applications in personal care, coatings, fuel catalyst, and medical diagnostics.
- Implemented Generation Two of our patented NanoArc® synthesis technology which increases production rates 3-5X and allows volume commercial production across a broad material palette of sub-25 nanometer particles with appreciably tighter distribution. Gen Two will allow the Company to produce nanoparticles for focus markets, both with our market partners and new markets that Nanophase is targeting. I anticipate that this technology should lead to some interesting new nanomaterials during 2006 based on our planned development schedule.
- Again this year, we increased reactor rates on our PVS technology by 35% and improved output per labor hour by 43%. These ongoing year after year improvements are continually reducing the cost of manufacturing, which directly increases gross margin, while essentially adding additional capacity for no material capital cost. With aggregate improvements since about 2000, we have more than quadrupled capacity with existing reactors.
- During 2005, Nanophase’s facilities were certified to ISO 14001:2004, the internationally recognized environmental management standard, and recertified to ISO 9001:2000, the internationally recognized standard of manufacturing and quality excellence. Clearly, this is consistent with our global leadership position in nanomaterials.
- Lastly, for the fourth consecutive year, Nanophase achieved essentially 100% customer service levels with zero customer complaints. Again, it is this service and quality that allows Nanophase to obtain and grow global partnerships with world-class companies. One further point, at the end of 2005, Nanophase exceeded 500,000 hours worked without a lost time accident in manufacturing. This is an exceptional record for a company of our size and demonstrates the Company’s sophistication and excellence in workplace safety and manufacturing.
- Moving to revenue growth in 2005, despite the end of $600,000 in development funding in 2004, or about 11% of that year’s revenues, we were able to grow total revenue 31% year-over-year in 2005. Most importantly and what investors should really note, I believe, Nanophase grew product revenue 52% year-over-year, which is the kind of growth rate the Company needs at this stage to reach future financial goals. Also, as Jess covered, the revenue growth experienced in 2005 validates our business and financial models which demonstrate that increasing volume and associated revenue disproportionately increases gross margins or profit. To that point, 2005 gross margin increased 1078% year-over-year. Moving to more specifics in regard to revenue composition,
- Revenues from sunscreens and personal care products through BASF increased 24% year-over-year comprised of a 21% growth in the original Z-Cote product line and 3% in new products. BASF launched a new sunscreen product line, Z-Cote MAX during mid-2005 based on a unique coating developed by Nanophase for formulations in the European and Asian markets. This coating and its manufacturing is patent-pending. I will be speaking more to new products later in the discussion.
- Rohm & Haas Electronic Materials CMP Technologies, or RHEM, continued to gain market acceptance and adoption during 2005. RHEM revenues grew 26% during 2005. Nanophase was also honored to receive RHEM’s “Excellence in Partnership Award” for 2005 for our proactive support in RHEM’s market penetration efforts and new product development. As a side, but important note, partnering ability is a core strength in Nanophase which, we believe, is evident from the quality of our market partners and the continuing growth with each.
- Revenues from polishing for other applications, including optics, increased significantly during 2005 growing over 600% as we added five new customers during the year.
- Lastly, Nanophase added a new market partner forming a mutually exclusive relationship with Alfa Aesar, the research chemicals unit of Johnson Matthey, to globally distribute research quantities of Nanophase-branded nanomaterials. Alfa Aesar distributes research quantities on every continent printing 12 million catalogs and offering web sites for on-line purchase. We anticipate that this will significantly extend Nanophase’s reach into global research and product development efforts and become a factor in the Company’s future revenue growth.
- In summary, 2005 was a strong year for Nanophase. We achieved the product revenue growth rate necessary to significantly grow the business and continued to build a platform of capability and products for future revenue growth.
- Looking forward, we believe that the global adoption rate for nanomaterials is increasing based on recent market forecasts from Freedonia Group, SEMI, and our own observations. For instance, Freedonia is forecasting nanomaterials market growth to $3.7 billion by 2008 and then to $90 billion by 2020. More specifically, Freedonia forecasts a global market over $3 billion for nanoparticles, particularly oxides and metals which Nanophase is able to manufacture, by 2008. SEMI forecasts rapid growth in nanomaterials for electronics and a compounded annual growth rate of 39% through 2010. We believe that Nanophase is uniquely positioned to take advantage of increased market and customer adoption, growth in existing markets and penetration of emerging markets.
- Looking forward into 2006 and peering into 2007, we continue to anticipate material revenue growth in 2006 from multiple sources and we plan to continue evolving our technology and improving operations. Dealing first with revenue,
- We believe that revenues from the original Z-Cote product sold through BASF for sunscreens and personal care will grow moderately during 2006 based on new customer adoption. We anticipate initial growth in the new Z-Cote MAX product line launched last year as adoption begins in Asia and Europe and begins to accelerate into 2007. BASF has stated that it believes this new product line will grow to a revenue level approximately equivalent to the current product line without cannibalizing the initial Z-Cote product since the formulation chemistries are different. Keep in mind that Z-Cote and Z-Cote MAX are different products for distinctly different formulation chemistries.
- BASF also plans to launch two new additional Z-Cote MAX products this year. One product is based on a nanoparticle we developed and commercially launched last year. BASF is optimistic about rapid market acceptance and adoption of these two products which may positively impact Nanophase’s revenues in the fourth quarter of 2006 and into 2007, although the timing of the initial product launches is not solidly fixed at this time and may move. In summary, by the end of 2006, we anticipate that we will have four unique products with BASF for sun and personal care versus the one initial product.
- Additionally, and quite significantly we believe we have expanded our relationship with BASF into polymers and plastics working a three way development effort with BASF, BYK Chemie and Nanophase. Polymer chemistry is about 30% of BASF’s revenues so it represents significant markets for nanomaterials, especially with BASF’s increasing focus on nanotechnology. In that regard, underscoring BASF's commitment to nanotechnology R&D, Dr. Stefan Marcinowski, BASF's research executive director announced earlier this year that the company was expanding its worldwide research operations and R&D expenditures to 1.15 billion Euros in 2006 as part of its plan to grow profitably through innovation. Of BASF's total R&D investment, approximately two-thirds involve nanoscale applications and development. As a designated ‘strategic development partner’ for BASF, which is a classification BASF takes quite seriously, Nanophase is obviously in a position to benefit from BASF’s focus on innovation through nanomaterial technologies. There is also obvious synergy with BASF’s proficiency in organic nanomaterials and Nanophase’s expertise in inorganic nanomaterials.
- Initial development in both of these areas has been positive and we believe that revenues associated with this effort may begin during late 2006 and grow, perhaps materially, into 2007.
- Turning to Rohm & Haas Electronic Materials CMP Technologies, which again I will refer to as RHEM, they have made just tremendous progress in market acceptance and penetration. Understand that I cannot go into all of the details out of respect for our partner. RHEM now has two slurry products on the market using our nanomaterial dispersions. The first product has seen market adoption and is being used in semiconductor manufacturing and continuing adoption is underway.
The second slurry product is a no ammonia slurry formulation, which is unique in the industry, and has recently been adopted in mass by a major semiconductor manufacturer in two large operations that are in production now, quickly scaling manufacturing, and will be major customers of the product by the second half of 2006 or before. This manufacturer also has two significant technology partners that are also adopting: one is scaling now and the other has stated that it plans to begin scaling to 60,000 wafer starts per month by June or July and be fully ramped by the end of the year. This particular manufacturer is also building a second adjacent semiconductor facility with planned use of the RHEM/Nanophase slurry anticipated in the first quarter of 2007 at another 60,000 wafer starts a month. The growth in this slurry product should be significant during 2006 and 2007 relative to both RHEM and Nanophase.
Additionally, RHEM is now introducing a third product based on Nanophase’s nanoparticle dispersions and RHEM’s novel chemistry formulation that, we have been told, is leapfrog technology. Until now, slurries either tend to be highly selective or physically stop polishing at a certain layer or point; both chemistry types have advantages and disadvantages. RHEM’s new slurry actually offers both – high selectivity and stopping – and combines the advantages of both. RHEM believes this new slurry will have relatively quick market acceptance and adoption due to its low defectivity performance and the fact that manufacturers can potentially use the one new slurry for both memory and logic, that is standardize and handle one CMP slurry.
Relative to Nanophase’s revenue, we expect moderate growth from sales to RHEM during 2006 with some possible upside depending on the exact scale-up and adoption rates at semiconductor manufacturers followed by some multiple of 2006 revenue in 2007. While we are highly positive about growth in CMP through RHEM, understand that that the exact rate of market adoption, scale-up and associated revenue growth cannot be predicted.
Continuing with CMP, but also considering other polishing applications, Nanophase made a leap in its PVS technology related to alumina during 2005. We now make three different standard sizes of alumina: ~20nm, 45nm and 80nm. We have also developed the capability to specifically tailor particle size in this process, so if needed, we could also produce a 60 nm particle, for example. Relative to other technology nodes, especially copper, we believe that there are opportunities that we can exploit with RHEM going forward. We also believe that we can extend our alumina technology and associated dispersion technologies to other polishing applications and plan to do so.
- During 2005, BYK Chemie and Nanophase focused hard on new product development and defining market attack strategies for the markets in our mutually exclusive relationship. During 2006, we expect to see these efforts result in appreciable revenue growth. BYK Chemie expects to release at least six new NANOBYK products by May/June followed by additional new products in the second half. We created at least three new nanoparticles for NANOBYK applications during 2005 that will result in new products during 2006 and are developing more new nanomaterials for BYK’s NANOBYK product line during 2006.
Based on BYK Chemie’s forecast to the Company, we expect Nanophase’s revenue to grow about 5 times 2005 levels; we anticipate that most of the growth will occur in the second half of 2006. As I have stated before, we believe that the markets represented by our relationship with BYK Chemie offer significant revenue growth opportunities for Nanophase.
As we have announced, BYK Chemie, a company of Altana Chemie, has provided an approximate $1.6M loan to Nanophase to purchase and install capital equipment. The expanded capacity will be used to increase the development rate of new nanoparticles using Nanophase’s patented NanoArc™ Synthesis technology, Generation Two, as well as provide vital dispersion capacity. Nanophase is using the funds to install an additional NanoArc™ Synthesis reactor and associated commercial dispersion equipment for volume production of nanoparticles and nanoparticle dispersions that are targeted for current and planned BYK Chemie NANOBYK additives for coatings and thermoplastics. This capability is now being implemented and we expect it to be fully operational by mid-summer.
One last thought on this, it appears to me that the investment community may not understand or perhaps appreciate the size of the market opportunity for BYK Chemie and Nanophase going forward. Chemical Market Reporter estimates that the global coatings market is about $60 billion annually, which does not include plastics, sealants, and inks – markets that are also significant and part of the combined market penetration strategy. If one visualizes markets as a weighted revenue pyramid with commodities at the bottom of the pyramid and the more specialized or niche applications at the top, consider that nanomaterials offer applications at both ends of the market. On the commodity end, nanomaterials offer improved performance to encompass more applications, while at the top, nanomaterials again offer improved performance for even more demanding applications. It is a broad market attack and Nanophase is fortunate to be a partner with the leading additive supplier to the global industry in every market noted.
- During 2006, in addition to the growth anticipated with market partners, or in some cases in collaboration with our market partners, we also expect or plan for market penetration and/or revenue growth in the following areas:
- From a technology or operational perspective, we have definitive plans for 2006. We expect to develop additional, and perhaps quite novel, NanoArc® nanomaterial based product solutions for several targeted markets and applications as I have discussed today.
We are also working on a substantial improvement to our PVS technology for volume products that would reduce our manufacturing cost quite significantly, which again would improve gross margin similarly. Initial proof-of-concept tests are quite encouraging and we anticipate implementing the improvements around year end. We believe that this would be a major event for this technology and substantially improve our financial model going forward.
- In summary, we believe that Nanophase is well positioned entering 2006 and recognizes that the Company must continue the product revenue growth rate experienced in 2005. We anticipate material revenue growth during 2006 and plan to continue revenue growth in 2007. We continue to maintain and perhaps even grow our leadership position in the global industry and believe that we remain optimally positioned.
- That concludes our planned remarks. We are available for questions at this time.
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