NANOPHASE FOURTH QUARTER & YEAR END 2018 CONFERENCE CALL
Thank you, Mark, & Good morning everybody. I appreciate everyone being here, and those choosing to listen later online.
We’re happy that you’re able to join us to discuss our fourth quarter, and record full-year 2018 financial results, and of course, business updates. I’ll discuss the growth we’re seeing with our Solésence products, some temporary setbacks within our personal care ingredients business, and, critically, the improving outlook for minerals-based sunscreens. These market dynamics continue to validate our strategy of focusing on the sun- and skin-care markets.
Our CFO, Jaime Escobar, is unable to attend today’s call, so I’ll cover the financial component of this call in my comments as well. Our 2018 total revenue was $14.2 million, a new all-time record! It was up by 14%, or about $1.7million dollars from 2017.
Solésence had a good year, but we’re expecting even better in 2019! We had $1.3M in Solésence product revenue in 2018, which fell short of our expectations by about $600K, most of which we expect to recoup in 2019, in addition to further growth. We’ll expand on that later in the call, but suffice it to say: Solésence has some nice traction.
This excellent progress was somewhat offset by a reduction in demand for our architectural coatings products of $1.2M, and reductions in the other industrial businesses, some of which may be temporary. Going forward, we don’t expect these products, part of our Advanced Materials Business, to be a growth driver.
The rest of the increase in 2018 revenue was driven by a temporary upswing in unit volume of almost 40% in our personal care ingredients business, which is composed mainly of active ingredients for skin- and sun-care products. We don’t expect this new volume to be repeated in 2019, leading to lower revenue volume from Personal Care Ingredients this year. I’ll speak more to this developing situation in a few minutes.
Throughout 2018, we continued to invest in product and market development for our Solésence suite of fully formulated skin care products. We also worked through many start-up related issues in delivering these products to a new and different market, relying heavily on outside contractors for processing and filling, often at costs that significantly exceeded our estimates.
Let me give a quick overview of financial results first, then I’ll follow with more discussion of our strategy, its execution, and business development. Please remember that all financial information is stated in approximate terms.
Our 2018 fourth quarter revenue was $3.1 million, compared to $2.6 million in 2017. We experienced an increase in our net loss quarter-over-quarter,…. at $1.1M, or $0.03 per share in 2018,…. compared to $0.2M, or $0.01 per share for the same period in 2017.
These poor results reflected a series of things, some that also impacted our financials throughout 2018, some unique to Q4. The biggest factor in Q4 was our inability to get approximately $600K of Solésence finished products shipped. There were several contributing factors, the top one being that we couldn’t get our outside vendors to fill, pack, and ship our finished products as quickly as we expected.
Let me get through the full year results, then come back to discuss some of the expenses in a year-over-year context. 2018 revenue increased to $14.2million, achieving a new Nanophase record, up from $12.5 million in 2017, which was also a record revenue year.
In terms of our cost of goods, two general areas require further explanation. In our personal care ingredients business, unit volume was at an all-time high. This volume came on suddenly, generating added fixed costs, and heavy overtime charges. Additionally, due to the structure of our contract with our largest customer, this volume brought us to the lowest priced volume tier, accounting for approximately $500K of our second half loss, when compared to prior year pricing. This impact is more acute, because the peak efficiencies in our production process are reached at significantly lower levels of volume than we experienced in 2018.
In costs of goods for Solésence, as I mentioned, we relied heavily on outside vendors to process, fill and pack our consumer-ready finished products, and at costs that significantly exceeded our estimates. Some of this was due to our newness to the business, and a bit of trial-and-error learning on our part, some was due to the nature of any new product launch, and some was due to small volumes being less interesting to some of our vendors, and, in some cases, we paid to expedite things to avoid holding up any of our customer’s launches. We have a plan in place to reduce a good deal of this cost relating to Solésence in 2019, with initial savings seen in Q12019, and maximum savings expected to be realized later in Q3.
For 2018, we also saw increases in Operating expenses relating to three areas:
1) We incurred additional R&D costs for added staffing to support new Solésence formulations, outside testing, & legal work relating to new patents;
2) In SG&A, we expanded our product marketing costs, which we believe will continue to lead us to good results for Solésence going forward; and,
3) We also increased spending in outside consulting and IT, some of which was related to personnel changes and the related backfilling earlier in the year, and some of it was to help absorb the increase in transaction volume that accompanies a growing and consumer-product focused business like Solésence.
Looking at our Balance Sheet, we also executed two significant loan agreements in Q4 of 2018. One for a term loan of $500K, along with another for a $2M receivables-based revolving line of credit. This liquidity has helped to reduce some of the working capital pressure, as we continue to invest in building the Solésence business.
In terms of where the business is going in 2019, I need to start with a refreshed definition of our product areas, each of which has a different strategic focus. We are now going to add a third product area, splitting out our Personal Care Ingredients business from Advanced Materials. The three areas will be:
1) Personal Care Ingredients;
2) Solésence; &
3) Advanced Materials
The bulk of our sales as a Company are currently of active ingredients, specifically in to the sun- and skin-protection markets. We refer to this as our Personal Care Ingredients business. This is where we sell coated and uncoated powders, occasionally in dispersions, to manufacturers of sunscreens, or to their suppliers. BASF is our largest customer here. The structure of our agreement keeps us further away from the ultimate users of our products, but we have a strong franchise here that is well known, and well-appreciated, in the sun- and skin-care markets.
Our second area is for the products marketed under the Solésence umbrella. These are fully formulated, consumer-ready products that we sell directly to various cosmetics “brands,” to be sold to consumers under those brand names, and through their channels. This is where we are looking for the fastest and most significant growth going forward.
Our third product area, with a newly amended definition, is what we refer to as Advanced Materials. This area captures our industrial products, relating to coatings, a diverse grouping of customers buying higher value specialties, and the surface finishing or polishing products sold through our partner, Eminess.
Advanced Materials represented about $2.3M in sales for 2018, and remains good business for us, but not where we are investing for future growth. Most of Advanced Materials is composed of long-standing customers, whose use of our material has remained fairly consistent over the years, but has not grown significantly, nor is it expected to grow significantly in the future. This is not an area for investment and development. Our continued support here, will be through providing the high-quality products these customers have come to expect.
In a minute, you will see why the first two categories have become such a strategic focus for us, as we discuss the market dynamics, and the future of Personal Care Ingredients & Solésence.
We talk a lot about the advantages of minerals-based sun- and skin- protection, versus chemicals-based alternatives. The markets we serve are seeing more and more demand for our mineral products, and the demand keeps going up.
There has been a worldwide shortage of zinc oxide and titanium dioxide, most noticeably to us beginning in late Q1 of 2018. The shortage is demand-driven, and we are in a position to increase capacity to meet new demand. In 2018, the increased volume for Nanophase was rapid and temporary, exacerbated by other producers reaching their capacity limits before we did. Global capacity will surely expand, but industry sources have been predicting a 300% increase in demand for zinc oxide, our primary mineral product, over the next five years. We don’t know what share we’ll gain from that growth, but it certainly supports all of the strategic moves we’ve been making to increase our focus on skin- and sun-care, whether on the ingredients side, or on the finished products side.
In more good news, last month, the Food and Drug Administration announced the 1st new proposal on sunscreen ingredient safety, in decades. Our feeling is that this will potentially further increase demand for our ingredients and finished products. The proposal is out for comment and will probably be modified somewhat before it becomes law, but the FDA’s initial approach was quite surprising.
Of the 16 active ingredients currently listed on what the FDA calls the “Monograph,” for use in human sunscreens in the United States, they have concluded that two are unsafe for humans. The FDA then classified 12 more of the 16 actives in a group saying that “there is not enough data” to determine if they are safe for human use. Combined, those fourteen active ingredients represent all the ingredients currently allowed in the monograph that we refer to as “chemicals-based sunscreens.” That’s fourteen out of the sixteen. Zinc oxide and titanium dioxide, the two remaining options in the current monograph, are the only two that the FDA has deemed to be safe for human use.
I don’t know where this will end up, but it’s a good thing for minerals, and it’s also a different criticism than we’ve been seeing recently of several chemicals-based sunscreens.
The FDA is responsible for human safety. But chemicals-based actives have been subject to scrutiny and regulation in other areas as well. You may recall that over the past few years, some of the most common chemical sunscreens have been banned due to their environmental impacts.
Australia, Palau, Hawaii, and the Florida Keys have banned these chemicals due to the fact that they contribute to coral reef damage. They have not found this to be the case for the two mineral products.
These macro-issues have been good for minerals-based products generally, and are therefore good for Nanophase and Solésence, but it gets better!
Historically, zinc oxide has been viewed as a healthy choice, but not a “happy choice.” Minerals can have a major whitening effect, either due to their formulations, or the quantity of active ingredients required to achieve good protection. This has been a market impediment. With our multiple technologies in this area, first applied to the ingredients we have been selling for some time through our largest customer, and now our patented Active Stress Defense technology, that we bring to market via Solésence, we are able to provide people with a much more pleasant experience than was typical with minerals-based sun- and skin-protection. We expect our Personal Care Ingredients business to continue to benefit from this, but the leverage created through our Solésence strategy will allow us to achieve much more rapid growth, while requiring a lower investment per margin dollar.
Further, the Active Stress Defense technology also allows us to formulate with non-nano minerals and achieve the same performance. This presents another marketing advantage, as it is important to many consumers of cosmetics.
In terms of consumer benefits, I mentioned that we spent a good amount of money on product testing in 2018. Much of this was undertaken to help our customers more effectively differentiate the products we develop for them under Solésence. Some of the key benefits we have proven are:
· Comprehensive environmental protection, including protection against pollution;
· Broad spectrum UV protection, protecting the skin from damage that can be caused by both UVA and UVB light; and,
· Stopping the formation of free radicals, which contribute to premature aging, such as wrinkle formation & skin discoloration.
These claims for Solésence products help the Brands to provide evidence of “anti-aging” benefits, which continue to be one of the biggest drivers of demand from consumers.
We have also produced some world class formulations that feel great! That relates to our investment in formulation expertise, and to the way our Active Stress Defense technology enables more effective and luxurious formulations. We are marketing Solésence products to luxury and prestige brands, and we are having good success, not just in terms of effectiveness, but in terms of feel and appearance.
As we discussed in the press release, we enjoyed another product launch through a leading natural skin and body care products company in Q1, resulting in low six-figure launch revenue for the first quarter of 2019. This product has already received recognition as being one of the best in its class.
We had $1.3M in revenue from Solésence in 2018, and we expect to achieve a multiple of that in 2019. Q1 looks good, and we are excited about our Q2 prospects, with launches currently planned for seven new products.
I know that many of you would like to know, specifically, which customers are launching which products. We aren’t at liberty to disclose their names, but if you follow our Instagram and Twitter feeds, you’ll get a much clearer idea of the types of companies we are working with. It’s also fun to see the way we have transformed the Company, and the way we are really enhancing people’s lives through healthy skin. I think you’ll find the excitement to be contagious!
In addition to following us on Instagram and Twitter, I suggest that you visit the Solésence website, which is constantly evolving. We’re at: www.solesence.com
Regarding the outlook for our Personal Care Ingredients business, we expect dollar volume to be down by up to a third in 2019. Our internal planning is for a $3M reduction in revenue in this year, compared to 2018. This is due to a combination of events, none of which we believe are indicative of market weakness.
There was a panic in Q1 of 2018, when many suppliers simply ran out of zinc oxide. We scaled-up quickly to meet as much of the demand as we could, reaching peak production in Q3. It turns out that there were some “spot-buys” and some inventory building that we have been told not to expect to be repeated in 2019. The inventory build-up appears to have been throughout the supply chain, but was not identified early enough to avoid some of the expenses we incurred.
Additionally, we think other manufacturers ramped-up production later in the year and absorbed some of the demand, and there may have been some amount of customer reformulation. While we’re not thrilled with this near-term reduction in Personal Care Ingredients demand, we do expect increases in Solésence revenue to offset this reduction.
While building this business, we are all working to increase profitability, through better execution, cost management, and entrepreneurial thinking to limit as much of the outside processing and filling as we can.
I’ve been talking a lot about our investments in Solésence and the rapid growth we’re expecting. In light of that, I’d like to talk a little more about working capital and our outlook in that regard.
As many of you may have seen a few weeks ago, we renegotiated our agreement with our largest customer, BASF, to change the composition of the contractual quarterly cash minimums, to a blend of cash, certain receivables, and inventory. Effectively, our cash requirement at quarter close has been reduced from $1.0 million to $500K. For those of you that may be new to this discussion, slipping below this cash requirement, could lead to a triggering event and a technology transfer. This is embedded within the BASF agreement, and it is something we have been dealing with for years. We believe that the “trigger risk” has now been materially reduced.
This was a welcome and timely change, because we are still subject to a good deal of working capital pressure due to our growth trajectory, and some of the inefficiencies we are working through. To that point, it’s likely we are going to need to finance additional working capital this year to ensure that we can continue to execute on our Solésence strategy. The unexpected variability in our Personal Care Ingredients business has only added to the working capital pressures we are under for 2019.
Given this likelihood, we expect to receive a “qualified opinion” from our auditor, RSM, for the 12/31/2018 audit that is always part of our annual report on Form 10-K. For an unqualified opinion, often referred to as a “clean opinion,” to be granted, the “Going Concern” standard, under the GAAP accounting rules, requires that a company show “sufficient liquidity” to fund current operations for the twelve months following the date of the opinion. In our case, that would take us through Q1 of 2020.
I believe we will be able to raise additional capital, and reduce expenses, if necessary, prior to a liquidity shortfall, but, since we do not have any committed financing sources at this point in time, we fail to meet the GAAP 12-month standard.
We are still working through the appropriate disclosures for the 10-K, as well as completing some analyses and supporting information for the finalization of the document. Given that timing, we are going to request the standard 15-day extension for the filing deadline tomorrow. We shouldn’t need that much time, but we’ll need the better part of next week to get everything tied up.
When you review our 10-K, you will see an addition to the footnotes that I think you will appreciate. We have begun to break out the revenue generated by our three different product areas. Given that we have found our growth engine in Solésence, and it is the area of our business where we can exert the greatest degree of influence, I’m looking forward to reviewing our progress in future calls as we discuss our ongoing strategy.
Although most of our investors listen to the webcast, or review the transcript, after the live call, I’d like to invite those participating in today’s call to ask any questions you may have, or to share your comments. Mark, would you please begin the Q&A session?
Q&A SESSION
Thanks Mark. Thanks again to all of you, who have taken the time to listen, and to support Nanophase and Solésence. These are exciting times for all of us at your Company. These are also times that will require hard work, better execution, and aggressive growth to become the exciting company we all envision.
I expect 2019 to be an excellent year for Solésence, and I’m looking forward to the opportunity to discuss the business with you again soon.
Have a great opening day everybody, Go White Sox!