Solesence Inc (SLSN) 2007 Q2 法說會逐字稿

Good afternoon. My name is Dennis, and I will be your conference operator today. At this time, I would like to welcome everyone to the Nanophase Technologies Second Quarter 2007 Conference Call.

All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session.

(OPERATOR INSTRUCTIONS)

During this conference call, the words expect, anticipates, plans, forecasts and similar expressions are intended to identify forward-looking statements. Statements contained in this news release that are not historical facts are forward-looking statements that are made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements reflect the Company's current beliefs, and a number of important factors could cause actual results for future periods to differ materially from those expressed in this news release.

These important factors include, without limitation, a decision of the customer to cancel a purchase order or supply agreement, demand for and acceptance of the Company's nanocrystalline materials, changes in development and distribution relationships, the impact of competitive products and technologies, possible disruption in commercial activities occasioned by terrorist activity and armed conflict and other risks indicated in the Company's filings with the Securities and Exchange Commission.

Nanophase undertakes no obligation to update or revise these forward-looking statements to reflect new events or uncertainties.

I would now like to turn the conference over to Mr. Joe Cross, President and CEO of Nanophase. Thank you. Mr. Cross, you may begin your conference.

Thank you. Welcome to Nanophase's conference call to review the record second quarter and record first half of 2007. The Company experienced exceptionally strong revenue growth in the second quarter and first half. It is an excellent way to continue fiscal 2007.

The second quarter marks the 10th consecutive quarter of record year-over-year revenue growth. To begin our discussion, Jess Jankowski will summarize the financial highlights of the quarter and first half. Jess?

Good afternoon, and thank you for your continuing support of Nanophase. The second quarter results highlight the achievement of three exciting milestones. First, we achieved another quarterly revenue record, with $4.1 million in Q2 revenue, a 73% improvement over Q2 of last year.

The second milestone is really more of an internal metric. We achieved positive EBITDA of $60,000 and, when adjusted for equity compensation expense and imputed revenue, we achieved EBITDAO, for want of a better term, of $138,000. This is an important milestone, marking progress towards our goal of GAAP profitability.

Lastly, we concluded an equity financing, which closed on June 29th and was funded in the amount of $10.6 million at the beginning of Q3. More to follow on that later.

Reviewing the financial performance, I intend to only address significant areas comparing Q2 of '07 to Q2 of '06. I'll also discuss some of the half-year '07 to half-year '06 comparisons, but I feel like Q2 of '07 is more representative of the Company's current performance path. As always, all numbers for this call will be in approximate terms for ease of discussion.

For more details, please see the financials accompanying today's press release. We've added a supplementary schedule, along with the press release, to break out depreciation and equity compensation expense, both of which are non-cash items, in order not to bog down the call with detailed verbalized information. I will also continue to discuss a few new metrics that highlight some important positive shifts in our business.

The growth from our architectural coatings customer and from the expanding relationship with BYK-Chemie showed increased revenue when compared with last year's second quarter of $1.2 million and $500,000, respectively. These represent the main differentiators between this past quarter and Q2 of 2006.

In terms of revenue mix, Nanophase used to have one major customer, BASF, which has been responsible for the great majority of our sales over the preceding five years. In 2006, sales to BASF accounted for 56% of total revenue, while continuing to grow in dollar value. BASF's historical average had been 69% from 2001 to 2005. In keeping with this trend toward greater diversification, for this past quarter, revenue from BASF amounted to 36% of total revenue and was surpassed by our architectural coatings customer, which accounted for 41% of Q2 sales.

Revenue from BYK-Chemie, our largest industrial coatings customer, accounted for an additional 14% of sales this quarter. As you can see, our revenue is getting better distributed between several large customers, which makes us less dependent upon any single customer. For the recent six months ended, BASF, our architectural coatings customer and BYK-Chemie accounted for 44%, 32% and 14% of total revenue, respectively.

Although these three entities often represent the faces we shift to, there are certainly more than three companies that are driving 90% plus of our current revenue. Particularly with BASF and BYK-Chemie, many underlying customers of our two partners create demand for Nanophase's materials. BASF has multiple customers driving their demand for our materials, each having gone through product qualification cycles, some extending beyond a year.

BYK-Chemie is selling our materials to an even larger number of downstream manufacturers and processors. As an aside, this is also true of Rohm and Haas's CMP business, which sells to a broad group of polishing customers, each of whom has rigorous qualification standards.

I reiterate this because many people initially assume that Nanophase's concentration of sales to several customers represents a liability. With BASF and BYK-Chemie, we have effectively increased the breadth and reach of our market attack. We are now selling materials for use on almost every continent. This broad distribution, both among end-user manufacturers and geographically, is a stabilizing force for Nanophase that will only strengthen over time. Our business model is now delivering.

Gross margins for Q2 '07 amounted to 37% of revenue, versus 23% for Q2 of '06. In dollars, we had almost $1 million more in gross margin, or gross profit, on additional revenue of $1.7 million. Looking closer, that shows we had an incremental gross margin in excess of 56% on the added volume.

While we like the margin growth we've seen, some of it has been offset by increases in commodity metal prices that we have largely recovered, albeit not at the percentage margins of the pre-increase sales and in overtime work to react to demand that has been difficult to predict.

We also added direct labor and hourly manufacturing support staff in Q1 to support our revenue ramp. As the product mix matures and stabilizes, we expect margins to grow. Still, predicting a precise trend will be difficult for the balance of the year.

Moving down, R&D expenses with some puts and takes were relatively flat from second quarter '06 to '07. SG&A expenses were up a bit for the period shown, mainly due to nonrecurring events.

On a GAAP basis, as reported, Nanophase lost $0.01 per share in Q2 of 2007, versus $0.06 per share in Q2 of '06. Analyzing the non-cash components of our second quarter '07 loss, we have depreciation and amortization of about $356,000. This depreciation and amortization, a regular component of our GAAP bottom line, amounted to almost $0.02 per share of the Q2 '07 loss.

Equity compensation, also a non-cash expense, amounted to $109,000 and contributed almost $0.01 per share to the loss. In total, depreciation and equity compensation expense amounted to about $0.025 per share. Excluding these items from our GAAP net loss, we had a positive $0.01 per share in non-GAAP earnings for Q2 of '07.

Moving to the balance sheet highlights, Nanophase ended Q2 with $6.6 million in cash and investments. We also closed an equity investment, for which you may have seen our S-3 filing, that resulted in net proceeds of $10.6 million. This put today's cash and invested balance at more than $17 million.

This financing merits further discussion, as the circumstances around it were, in management's view, quite favorable. We were able to secure a marquis investor without spending time away from the business and a 4% discount to a market average with a smaller-than-typical commission and no warrant coverage.

Based upon our experience and feedback from other investment bankers we work with, the terms of this financing were excellent. We intend to use this money largely to fund expansion of our plant and equipment to accommodate growth over the next several years.

Our outlook for 2008 and 2009 is positive. And depending, of course, on difficult-to-predict customer demand, we expect to begin utilizing this capital late next year. However, we do not expect to need this additional $10.6 million to fund day-to-day operations of the business.

Earlier, I talked about EBITDAO positive. And that's a good rough approximation of positive cash flow from operations before funding working capital needs. Without the increase in working capital required to support our revenue ramp, we would have been about $200,000 cash flow positive for the three months of Q2 on a standalone basis. We can see the light at the end of the tunnel.

Moving down further, Q2 inventories are up about $1.4 million, about 50% higher than at 12/31, which is about the same as they were a quarter ago. This increase largely relates to material for which we have orders and solid forecasts. In this case, we continue to make the choice to negatively impact working capital in order to allow for manufacturing flexibility.

This all ties back to what I said about product mix, predictability and the margin discussion, along with the revenue ramp. The equipment and leasehold improvements amounted to about $430,000 for the quarter. As 2007 and our view toward 2008 and beyond unfold, as we discussed, we will need to add capital equipment and potentially floor space to support future demand. Much of this is product mix dependent and, therefore, difficult to schedule. We still classify this as a great problem to have.

On the liability side, the Company now has $1.8 million in total debt. All but $105,000 of this representing capital leases on lab equipment relates to the BYK-Chemie loan of $1.6 million, plus deferred revenue, less related discounts. Again, given that the loan financing terms are very favorable to Nanophase, including interest-free periods and a low interest rate, we were required under GAAP to adopt this special treatment.

Accounts payable have grown also, directly in relation to the same issues. We would invite you to review our upcoming 10-Q, which we expect to be filed by August 9th. Thanks for your attention. I would like to turn things over to our President and CEO, Joseph Cross.

Thank you, Jeff. During the second quarter and for the entire first half, revenue growth has been driven primarily by two market areas -- industrial coatings through our market partner, BYK-Chemie, and architectural coatings through both direct customers and our market partner, BYK-Chemie.

Through the first half of '07, industrial coating revenues increased almost 12 times comparable '06 sales, growing over 1,000% year-over-year. BYK-Chemie is aggressively marketing the branded NanoByk products globally, but notably in the U.S., Europe, India and Asia.

We continue to expect long-term growth in the use of nanoparticles for industrial coatings, a market estimated at about $60 billion, globally. And architectural coatings are now four products incorporating our nanomaterials on two different continents.

In the U.S., there is an interior kitchen and bathroom paint and exterior stain product and, recently released, a hardwood floor coating, all of which are marketed to the consumer by do-it-yourself retailers.

In Europe during this quarter, a major architectural products company also launched an interior paint product. Architectural coating revenues increased over 300% comparing '07 to '06 and now comprise our second-largest product revenue category.

Equally as interesting is the value proposition architectural product companies are advertising -- improved coverage, antimicrobial and antifungal protection, increased or improved wear and longer life. It is a value proposition that we hope will spur additional and continuing adoption interesting the $40 billion global architectural coating market.

During the last conference call, at the end of the first quarter, I discussed Nanophase's business model and the importance and management focus on gross margin growth. Financial results from both quarters of '07 and the accumulated first half demonstrate that our business model is working.

Through a combination of continuously working to reduce manufacturing costs, systematically increasing pricing where possible and increased sales and resultant volume, the Company has experienced sound margin growth, measured both as a percentage of sales and total dollars. Viewed over time, in 2004, gross margin averaged 1.4% of sales, growing almost 10 times to 14% of sales during 2005. During 2006, we were able to grow margins at 22% of revenue, a 50% improvement year-over-year.

During this past quarter, we were able to grow margins to almost 37% of revenue, and because of increased volume and sales, gross margin dollars increased 178% year-over-year. For the first half of 2007, Nanophase's average in cumulative gross margins to 32% of revenue and gross margin dollars have increased 153% compared to the same period of 2006.

I'm taking the time to cover this simply to demonstrate the point that the Company focus areas that we discuss on almost each conference call are real to the management team. We are taking several actions to achieve goals in these areas and believe that we're making significant progress.

From an operational perspective, Nanophase continues to perform and improve. During the first half, the operations team achieved 98.1% customer service levels and zero customer returns, while scaling up and delivering six new nanomaterial dispersion products.

By the end of the second quarter, the Company also achieved 780,000 hours worked continuously without a lost-time accident. This is an extraordinary statistic for a relatively small manufacturing company.

Also during the first half, based on independent, expert audits, Nanophase was recertified to ISO 9001, the International Quality Management System standard, and ISO 1401, the International Environmental Management standard. Operational, environmental and safety excellence are a core competency of Nanophase and are recognized as such by our market partners and customers.

This concludes our prepared remarks. We're available for questions.

(OPERATOR INSTRUCTIONS)

Your first question will come from the line of Avinash Kant with First Albany Capital.

Good afternoon, Joe and Jess.

How are you doing, sir?

Good. One question, of course. You -- the press release that you issued about the money raised, you had talked about you will be using it for additional capital. Now, if I remember in the past, when we have talked about what kind of -- at what revenue level you might need additional capital, you have talked about roughly -- of course, it depends upon the mix, but roughly around $20 million in revenues and that's when you would start to need additional capital.

So the fact that you are raising money, does it mean that you expect '08 revenues to be higher than $20 million?

Now you know we're not going to answer that, Avinash, since we don't do guidance. But that was a clever question. Okay, so here's the situation. Nanomaterial applications are moving largely to coated nanoparticles and dispersed nanoparticles, which are also coated. So from a total market availability, nobody wants to buy just nanoparticles. Okay? Nobody shovels powder.

Nanomaterials are primarily used in processes or products. People want to plumb it, they want to meter it and they want it delivered. So -- and that actually is buttressed by the recent EPA decisions that coated nanoparticles and dispersed nanoparticles are bounded materials and hence not subject to strict environmental regulations, okay? So everybody, again, is moving in those two ways.

So while we have capacity in nanoparticles, what our capacity concerns are are equipment for coating nanoparticles and really for dispersing nanoparticles. Our dispersion volume has really grown in the past six months and the past nine months. Where we have shipped most of our shipments this quarter were dispersions. All the architectural coating customers are dispersions. Most of the industrial coating customers are dispersions in either water or solvents.

So what we're seeing is a shift towards coated and dispersed nanoparticles, which is what we believed would happen five years ago when we developed the technology platform, that people would want nanomaterials coated and they would want nanomaterials dispersed. So the equipment that we may need, based on the product mix that's forecasted, is primarily in those two areas.

We have also reached a position where we have to give some consideration to expanding Romeoville. The reason is this -- quite simply this, that we now have three facilities. We have Burr Ridge, we have an off-site warehouse and we have Romeoville. And we do not want to add overhead in this business as volume grows.

But what's happening with the off-site warehouse is we're double-handling, essentially, all raw and finished goods that are shelved between the two plants. So what we're thinking that we're going to have to do, and this is an 18-month to two-year project, and that's what people need to understand, is this doesn't get done in three months. We're going to have to add square footage to Romeoville. And conceptually, what we would do is move all the warehousing here, which would reduce our overhead labor to handle material.

We're thinking about and we're considering enlarging the dispersion areas because we've had to add equipment, and we perceive we're going to have to add more equipment, and that's higher-cost manufacturing space than some other areas, okay? So that's kind of the loose plan that's in our mind. We haven't finalized the details and the timing at this moment.

And one follow-up, of course. The 56% incremental gross margin improvement, is that the kind of improvement we should expect going forward for the rest of the year, or it may come down?

I wouldn't say that we would expect that going forward. I would say that that's showing that we're -- that's kind of a shot at our variable margin. It depends on product mix. We had a good product mix this quarter, and it's possible that we'll do that well next quarter, depending on the growth. It's more representative of variable margin than anything else and the variable margin of the product mix that's in there.

Thanks so much, Jess. Thank you.

Sure.

Your next question will come from the line of Eric Glover with Canaccord Adams.

Hi, good afternoon, guys.

Hi, Eric.

I just wanted to sort of follow-up on that question, actually. I'm wondering, first of all, sort of what your target gross margin is in this business and at what revenue level that would be.

Let me answer that in a different way. We're targeting variable margins in excess of 60%. We believe that, according to our financial models, that we can easily achieve 40% gross margins based on those kind of metrics. I would not want to say what volume level that might be.

Okay.

It's also very dependent on product mix, Eric, and that's why we're always sheepish about that question, because it goes back and forth. We certainly don't want to give our customers lots of information about that either, but if one line excels beyond the other line of products, it could change quickly.

Okay, and second question is could you talk a little bit about the business trends so far this quarter and whether you sort of think that the $4 million in revenue you did in June might be sustainable into the September quarter?

We believe that the run rate we hit this quarter is likely sustainable. And I am using the word likely intentionally because our customers, like most customers, are very unpredictable. We're going through the first season we've ever experienced in the architectural coating marketplaces, Eric, and we don't have any experience in this. We've got exactly six months' experience in this marketplace.

So we know what our customers have told us, but we've never lived through it before. So while we think a late rate is likely sustainable, we can't guarantee it's sustainable because we just don't control that. Our customers are indicating it is. But again, we don't have an experience set for an entire year that would make us feel totally comfortable.

Okay, thank you very much.

Thank you.

Your next question will come from the line of Sandeep Mathew with Thomas Weisel.

Hi, guys. Good afternoon. Could you just briefly discuss what are the moving parts in BASF? I think the numbers are slightly lower this quarter. Is there any particular reason for that?

You're talking about the quarterly revenue volume?

Yes, sequentially.

Sequentially. Well, it's almost flat for BASF from -- you're talking about from quarter one to quarter two.

Right.

I don't know that there's a reason for that. As Joe had mentioned about not being through a season with the architectural coating customer, BASF always has some seasonal issues, and in this case they're doing some rollouts, and we're not exactly clear on -- I don't take that as either a bad sign or a good sign or a seasonal sign. I think that's just part of the flow of the business at this point.

As far as this year versus last year, we had said earlier we anticipate growth from BASF year-over-year and we still do.

Right, so have you seen any traction within new products as such?

Well, we're seeing, I think, considerable traction in architectural coatings, as I mentioned. We've seen considerable traction in industrial coatings, both abrasion resistance -- I mean, the new product that was released for the floor care market, it's carried by a major do-it-yourself retailer, is definitely a great product. So we're seeing a lot of adoption in both architectural and industrial coatings, and we've been saying that we thought this was going to happen for over a year now.

We believe those are markets where there's an exceptional value proposition. It's a market pull, it's not a technology push.

Thank you.

(OPERATOR INSTRUCTIONS)

Your next question will come from the line of Nick Tishchenko with Global Crown Capital.

Good afternoon, gentlemen, and congratulations with the first signs of profitability. I have three questions to you. And I will ask them in turn, and then I will let you answer them.

The first one, could you elaborate a little bit on the markets where you see most of expansion of Nanophase in 2008? I'm not talking about Q2 or Q3 this year -- the next year.

Okay, we expect to see -- based on what our market partners have told us, we expect to see continuing growth in personal care. I'm trying to remember the numbers, Nick, but that thing grew about 30% in 2005, about 14% in 2006. So the track history would tend to say that it tends to grow in double digits. So we expect that to continue into 2008.

On top of that, we expect that some of the new products, the Z-COTE MAX products that BASF is selling this year, both the Z-COTE MAX zinc oxide and Z-COTE MAX titanium, we expect them to get some traction and start seeing some reasonable volume on that by 2008.

So we expect that to [grow]. In the CMP area, with Rohm and Haas, we have been told that that business could likely double, but that's -- there's no guarantee to that. That's what they're telling us to get prepared for, but there's no firm orders there.

But I think the major growth that we're going to see is industrial coatings and architectural coatings, where there seems to be just a very good value proposition in that and we have customers coming onboard and scaling up, and we expect that to continue to grow. From the information we've gotten, the consumer reception of these products has been exceptionally good, and it's moving out of the big box retailer. So that's in our expected growth.

We have some other product development efforts in electronic printing that might reach fruition by that point in time. I can't guarantee that, but it looks promising right now, as well as some other product development areas, such as biocides and antimicrobial. But those would be the markets that from our view at this point look like by 2008 should be contributing to revenue.

Joe, did you get any sense of possible seasonality in architectural coating markets?

No, Nick, we don't have a sense of that, really. And honestly, I'm sure you're familiar with this market. I think the do-it-yourself market is just the way it is. There is no forecasting. The way this works, frankly, is that once a week or every other week the representatives from our customers go into the big box stores. They own the inventory, they count the cans and they decide how much to order.

So their metric from the big boxes is the number of turnovers. So our experiences or forecasting ability is not very good, and indeed they admit that. So not having a full year of experience with them, I know what they're telling us, and basically fall is the big paint season.

We've been told by our lead customer they're going to have heavy advertising for this particular product going into the big paint season. If you were watching TV or listening to the radio, you saw some of their advertising even last quarter, frankly, basically centered around brand recognition. But we know what we're being told. But like I said earlier in the conversation, we've never lived through it. So our comfort level is not as high as we'd like it to be.

But at the same time, you cannot be expecting a meaningful seasonality because you are ramping. You are nowhere close to saturation. So it looks like we are not going to see seasonality in this business until, let's say, 2008. Am I right in my assessment?

Well, I don't want you to be misled here. I think that the exterior stain -- in the U.S., the exterior stain and the kitchen and bath product are already loaded in stores. They're on the shelf everywhere, to the best of our knowledge.

Yes, I saw them.

Okay. So that's only replenished again, to our knowledge, as it's sold, and we understand it's selling well, and the order rate would tend to verify that. The product that was just launched in the big box store for floor care, this just happened last quarter, so we don't know much about that one yet.

The product that was launched in Europe was just launched last quarter. We have had some indication that that manufacturer also is going to launch an exterior product, but we don't know the timing on that.

So there is a ramp in a sense of there are other new products coming onboard that have the stocked shelves. That's a ramp. And then there's the ongoing usage relative to those products, which we just don't have a good feel for.

I see. And the last question. Jess was talking about problems that's good to have. I want to ask you a question that is good to ask. What would be expected tax rate when you will report positive numbers?

Nick, I don't know. We have a $60 million NOL right now.

So we're not paying taxes for a long time.

Well, hopefully not forever, but I really haven't done the -- haven't put the work in to determine that, basically because we're not -- it's far away enough where some of that would involve a little bit more knowledge than we think we have in house, and it's just not worth paying for at this point.

Thank you very much.

Your next question will come from the line of [Brad Cassel], a private investor.

Joe and Jess, congratulations on a great quarter.

Thank you.

That floor care product, I don't think we heard about that in the last conference call. Is that something totally new? Is that something you could discuss in any kind of detail? Or greater detail?

Well, it's basically a floor care product. I'm not sure, I'm not sure -- I'm hesitant because we have so many customers that don't want us to talk about them, Brad. I'm just hesitant to talk about it because I don't remember what our exact agreement is with this customer. But it's a floor care product that's in the big box store that's not Home Depot. Okay?

Okay.

And it just hit the shelves, and there's two products. There's basically -- as I understand it, it's polyurethane hardwood floor covering that I believe kind of has a diamond brand in it, and the claim is that it increases the wearability of the floor, actually increases the hardness of the coating two to three times relative to scratching and mar resistance.

And as a homeowner, that would be interesting to most of us, I think. And again, we don't have any history on that yet. It just hit the shelves like three or four months ago.

Is that in all their stores now?

I can't answer that. I don't know where that particular rollout stands. I just don't know.

Okay, thank you.

Thank you.

And at this time, there are no further questions.

We'd like to thank you for your time and attention today. It's been a great quarter for Nanophase, and we will talk to you again next quarter. Thanks again.

Ladies and gentlemen, this does conclude today's Nanophase Technologies second quarter 2007 conference call. You may now disconnect.