Solesence Inc (SLSN) 2008 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the second quarter 2008 conference call. (OPERATOR INSTRUCTIONS)

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 the 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.

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

Thank you. Welcome to Nanophase's conference call to review the second quarter of 2008. Especially given the current economic conditions, Nanophase had a solid quarter and we're pleased that you're taking the time to be with us today. Jess Jankowski, Nanophase's CFO, and I, will be hosting this session. To begin our discussion, Jess will comment on the second quarter financial reporting.

Good afternoon and thank you for your continuing support of Nanophase. The second quarter has been a good one. We have seen the rewards of being vigilant in reducing and controlling costs. We had relatively flat revenue from Q1, as we expected, but we had strong margins that have grown for the three and six-month period, even though last year's second quarter's spike resulted in lower revenue overall in 2008's first half. This reduction in comparative revenue was largely created by last year's Q2 volume being inflated, ironically by a demand spike from our architectural coatings customer that was achieved just prior to the much publicized slowdowns in the housing and mortgage markets, which added to this pressure.

I'm about to walk you through some of the good and telling things we've seen this year. Let's get into some of the details. As always, I'll discuss the financial results in approximate terms. For more details, please see the financial statements, along with the supplementary non-cash item schedule accompanying today's press release.

Second quarter 2008 revenue amounted to $2.9 million, which is relatively flat with Q1's revenue, but lower than last year's Q2. Six-month 2008 revenue was $6 million, down about 15% from the same period last year due to the revenue spike that I mentioned, in Q2 of 2007. Due to the irregular revenue patterns we're analyzing, I'll focus most of my attention on the six-month comparison, along with a few notable changes from the preceding quarter and discuss some great progress in managing costs.

For the six months of 2008 versus 2007, on the revenue side, we saw reductions of $880,000 from BSF, $570,000 from Altana, and $320,000 from our architectural coatings customer, offset by a $640,000 increase from Rohm and Haas. This resulted in a net revenue decrease of just over $1 million year-over-year.

What this tells us about the strengths of these underlying businesses is not obvious. We entered 2008 with a view to our year-over-year unit sales growth with our partners BSF and Altana, tempered by the fact that commodity pricing was receding and we expected dollar revenue might flatten, particularly for BSF in the form of commodity surcharge reductions. As a matter of fact, 15 to 20% of the reduction in BSF's 2008 revenue is due to lower commodity raw material pricing.

For the balance of the reductions, we now believe that BSF and Altana left 2007 with significant inventory levels, which has masked our previous views of their growth. These two partners, along with our large architectural coatings customer, also seem to be experiencing the impact of consumer sentiment and ongoing concerns about the economy in the industrial side, as it impacts demand for their downstream products.

Rohm and Haas, while delivering on the growth we expected this year, is also purchasing material more evenly in 2008 than it did in 2007, which was back-loaded. We don't believe that BSF or Altana have seen large downturns in what they have been selling, as much as they've purchased less to offset previous inventory builds.

Our large architectural coatings customer has a solid business that is doing well, but may, along with the two partners, be impacted by the economy in the second half. This variability drives home the reasons for our migration from the partnership model to more of a direct sales approach. We've had limited success pushing our partners to sell in a more iterative fashion, because their business models aren't built that way. Our partners have brought us to a good spot, giving us the legs to stand on, now we need to take the next step.

When we secured the large architectural coatings customer, it took an iterative collaborative process that brought us a profitable revenue stream that relies on the strength of both our materials and our applications development expertise. This was a signal event in our history that told us we could sell our materials effectively into new markets that were seeking advantages unavailable elsewhere, and at good margins. It also taught us that we needed to touch our end-use customer directly in order to have greater success.

This knowledge is what precipitated the changes to our sales and marketing focus that we believe will propel us to a positive cash flow position and profitability. We're building a pipeline that we expect will begin to bear fruit next year. We had hoped to show earlier signs of progress via greater revenue volume this year, but what we have seen is the addition of several alpha customers in target markets, new markets that we expect to grow and to help us to gain additional customers. We continue to invest in applications development in order to accelerate this process. Joe will address this more completely in his comments.

In terms of our revenue for the recent six months ended, BSF has made up 37%, our architectural coatings customer 32%, Rohm and Haas 13% and BYK Chemie accounted for 8% of total revenues.

Now let's talk about the bright spot shown via margin performance for the second quarter and the first half of 2008. Gross margins for Q2 amounted to 38% of revenue, versus 37% for Q2 of '07. Gross margins for the six months ended June 30th amounted to 36% this year versus 32% for the same period last year. Why are a few percentage points so remarkable? Because, in Q2 of 2007, we had a record high degree of capacity utilization having produced a record amount of material. For margins to grow in 2008, on significantly reduced revenue, that's a strong indication that our organization is running leaner and more effectively.

Let me put it more concretely. Our revenue was down about $1 million while our gross margin was only down $65,000 and we built more finished goods inventory in the first six months of 2007 than we did in 2008, which can inflate margins. What we're seeing here is that as we transition towards the direct sales model, we should be able to maintain a leaner manufacturing infrastructure, given that applications development and the actual pallet of products produced will be more focused. We are moving in the right direction. Product mix also contributed to the higher margins realized, but the lion's share is due to the factors I just discussed.

Moving down, R&D expenses were down 8% quarter-over-quarter and down 12% for the six-month period. The bulk of these decreases were due to reductions in compensation expense that have been possible due to the migration of the business model to being more focused on applications development than on broad new material development. We believe we are now doing more effective applications development with fewer, better focused resources.

SG&A expenses were up 12 and 16% respectively when comparing the three and six-month periods in 2008 to those in 2007. Several anomalies and nonrecurring items have created this disparity, which amounted to $450,000 for the six-month period.

The company's annual option grants were made in Q2 of this year, versus in the second half of last year, resulting in non-cash equity compensation expense that contributed $100,000 to the difference. This should balance itself out in the second half. The Q1 2008 patent abandonment also contributed to $150,000 of the variance, and per new SEC guidance, audit fees were all expensed in Q1 as earned, versus being accrued evenly throughout 2007. This contributed $90,000 of the variance and should also balance itself out in the second half. Further, we incurred $40,000 in recruiting costs for our new Director of Sales.

Some of the other increases were due to added compensation, mainly related to changes in the sales and marketing group, offset by reductions in consulting fees for 2008, given the extensive 2007 market spending we commissioned. We also had some similar back and forth accrual timing issues on a smaller scale. Most of the increases in SG&A are easily explainable and not expected to recur for the rest of the year.

On a GAAP basis, as reported, Nanophase lost $0.04 per share in Q2 of 2008, versus $0.01 per share in Q2 of 2007, with six month losses holding at $0.08 per share for 2007 and 2008. Analyzing the non-cash components of the six-month '08 loss, we have depreciation and amortization of about $645,000, which is a regular component of our GAAP bottom line and amounted to about $0.03 per share of the $0.08 loss.

Equity compensation, also a non-cash expense, amounted to $430,000 and contributed another $0.02 per share to the loss. In total, depreciation and equity compensation expense amounted to about 60% of the most recent six-month loss.

Moving to the balance sheet highlights, Nanophase ended Q2 with $15.8 million in cash and investments. Q3 inventories are up to $1.6 million, about 39% higher than last quarter. This increase largely relates to material for which we have orders and solid forecasts, as well as a significant amount of raw material, some of which comes via China, that we ordered in advance of the Summer Olympics to avoid logistics problems.

Equipment and leasehold improvements amounted to about $300,000 for the first half of this year, and until our view of 2009 and beyond solidifies, we plan on limiting CapEx to a bare minimum.

In closing, I'd like to draw your attention to another operational metric. Given that cash burn from operations was less than $700,000 for the first six months of 2008, versus $1.6 million for the same period in 2007, we are confident that Nanophase is in a very stable financial position. We remain on the right track. We also invite you to review our upcoming 10-Q, which we expect to be filed by August 11th. Thanks for your attention. Now I'd like to turn things over to our President and CEO, Joseph Cross.

Thank you, Jess. Let me start by reviewing the company's operational progress for the first half of 2008, after which I would like to discuss our business development sales initiatives. Through the first six months, Nanophase achieved a customer complaint rate of zero and a customer service level of 99.9%. This is generally regarded as world-class product and service quality, an attribute that clearly differentiates Nanophase in the market.

As we have repeatedly demonstrated since 1999, we continue to improve product cost, which is clearly demonstrated in our increasing gross margins by improving output on our current assets and improving product quality. Based on our Lean Six-Sigma manufacturing methodology, we have now improved product quality to Six-Sigma for our largest volume products. This represents quality level of 99.9999%, essentially zero defects. Simultaneously, we have increased product yields by 6%, further reducing costs and improving gross margins.

Again, during the first half, the company was recertified as meeting the standards of ISO 9001 international quality management standard and ISO 14001 international environmental management standard. Exiting the second quarter, Nanophase has now accumulated almost 900,000 hours without a lost-time accident. This remains an exemplary record for a company of our size. While perhaps not as exciting to the investment community, this progress and continuing achievement demonstrate the company's expectation and drive for excellence.

Moving to business development sales, let me first discuss pertinent updates for our market partners and major customers, followed by new sales initiatives. Beginning with BSF in sunscreens and personal care, we have recently learned that they appear to have an excess inventory situation, but it does not appear to be a sales related issue, but due to over-ordering in 2007. We believe this is a short-term situation that will likely impact two quarters, but given BSF's volume and revenue with the company, the impact will be material in the second half. Still, BSF business continued to grow year-over-year. We are also working with BSF on some new product initiatives to increase business further over time.

Rohm and Haas CMP Technologies, and I'll refer to them as [RHEM] going forward, continues to make progress in the market. Usage of our current ceria based polish and product is meeting the forecast and annual purchase order placed with Nanophase. We have some indication that the volume appears to be growing over original projections, which seems encouraging for future orders. RHEM has stated that it is in the final stages of closing new business for our alumina based slurry, which is a new product for our partnership, and as such would represent a new revenue stream for Nanophase. We're unable to speculate on the timing of this, but are optimistic that it may occur in the near-term. But obviously, until an order is received, it is still speculative.

RHEM is also starting field trials of a new Nanophase ceria based slurry in the next 30 to 60 days with a major semiconductor manufacturer, which is a positive development for the new product. We are optimistic for success and will support RHEM however needed.

In summary, RHEM is moving forward and we are optimistic for continuing revenue growth in this EMP area. BYK Chemie appears to be seeing some impact of challenging economic conditions, especially in the US, and their demand level from Nanophase during 2008 is disappointing. BYK's inventory rates are deemed high at this time and we now expect weak demand from BYK during the second half.

Based on our recent 8-K filing, you may be aware that we have restructured our relationship with Altana BYK Chemie to allow Nanophase more direct marketing to sales access into the field of exclusivity. We have several market initiatives in this area.

Our largest architectural paint customer is seeing continuous success with our nanomaterial base formulation and has stated they are pleased with market adoption, customer acceptance and growth. One year after market introduction, the new product launch is deemed successful and we are optimistic about continuing growth in the future. We are also involved in a specific new product development with this customer that appears promising at this time and if successful, would represent a new revenue source for Nanophase.

As you may be aware, architectural coating companies have publicly announced as recently as last week, revenue and financial impacts from the housing market and the consumer slowdown in the US. While our customers' forecast for the second half of 2008 is essentially to our expectation entering the year, we remain cautious given current market conditions and uncertainties in the second half of 2008.

Moving to business development new opportunities. We're excited about the progress we have made in 2008, gaining new opportunities to our sales pipeline and moving those forward. As we have noted, three of these opportunities have now transitioned into initial revenue streams; new consumer and industrial glass polishing applications, electrostatic discharge protection for electronics applications, and animal hygiene product. We are optimistic that each of these will continue to grow going forward.

Relative to the new business, we're actively involved with several opportunities in various markets. Examples include solar energy, animal hygiene, printable electronics, lighting, natural rubber or latex products, SPF clothing, liquid cooling, UV or exterior wood products and several others. We're managing these closely with our stage gate sales process and aggressively moving each along towards revenue generation.

As you know, we have now re-skilled about 75% of our sales team in the last 18 months and are searching for yet another skilled professional to add to the effort. We have also realigned R&D and internal resources solely along new business and product development. This approach is making progress and having success.

Entering 2008, we understood that the company's revenues had to grow enough to equal the one-time inventory ordering we experienced in 2007, that is on a year-to-year comparison basis, before we can show revenue growth in 2008. While we were optimistic entering 2008, as the year has developed situations with two more of our partners have evolved to now make that goal unattainable.

As we noted in the earnings release, excess inventory situations at two of our market partners and the challenging economic environment have impacted our earlier expectations for the last half of the year. This situation with our market partners, we believe validates our technical move to move increasingly to a direct sales model and progressively reduce our reliance on market partners.

While we have made sound progress in business development in building the pipeline, material revenue erosion from market partners is difficult to replace at the current time. As such, we now expect the third and fourth quarters to be relatively flat with the second. While we continue to pursue opportunities and are optimistic we will close some of these situations in the second half, timing is unpredictable at this point.

Given the market partner impact to our earlier estimates, we now unfortunately believe that on a year-over-year basis, 2008 revenue will likely be down 10 to 15% in comparison to 2007, much of that being due to inventory ordering by BYK and BSF during 2007. While we are frustrated with the situation and working hard to ameliorate the revenue effects, the timing is difficult to overcome.

This concludes our prepared remarks and we're available for your question at this time.

(OPERATOR INSTRUCTIONS) Your first question comes from Michael Lew.

Hi, Jess. Can you highlight some of these new market opportunities or rather three new customers, can you provide, like I know it's tough, but the timeframe of when you think you could possibly see revenue contribution or more significant contributions from these customers?

On the glass polishing product, we just got our second order, so that is starting to scale up. We have met with this customer as recently as last week and they have an exciting product. We're under nondisclosure, so I can't discuss it a lot. And it's a commercial product that seems to have a very significant market. They're taking it to the market now. So this could be a seven figure opportunity as well as we can tell, if they're successful in the marketplace.

The ESD protection, we've received several orders for that. We have a team out there actually with a customer today. And that's expected to grow in 2009. I can't say a lot about this application because of nondisclosure. But I can tell you coming from the electronics field, that if this application really takes off, I think it's very exciting. Because essentially what it does is in the event of a surge to a device, think of a laptop or cell phone, instead of frying the components, the layer that's in there composed of nanomaterials, instantaneously at a molecular level, changes from an insulator to a conductor and dissipates the discharge, saving the component and device. So it's a really exciting application. That too, assuming growth, that's a significant opportunity for us.

The animal hygiene product, I'd rather not speculate. It's a market we're just getting into. We've got our first customer. We're working with two other customers also in that industry. And while we've got some estimates of size, Michael, I'm just not real comfortable guessing right this minute.

Okay. And also you'd mentioned obviously you want to shift towards more of a direct sales model. What percentage of revenues are currently direct right now?

I don't have that number off the top of my head.

Well, currently, the revenue from BSF and BYK and Rohm and Haas, we would not define as direct sold revenue, whereas the revenue from the architectural coatings customer is. Right now that's almost 60% is partner revenue, not direct revenue, so there's a lot of room to grow there.

Okay. And the other question I had is you mentioned that you expect revenues to be flat in the second half of this year or in Q3 and Q4, relative to the second quarter, but if we look at an annualized basis, that only amounts to like single digit type of decline on a full year-over-year comp, and you've also indicated being more like 10 to 15% decline. Could you just clarify that?

I think it'll be bigger than that. I think it'll be a decline in the--depending, we don't know exactly what the quarter mix is going to be, but I think a 10 to 15% reduction year-over-year is accurate. So probably 20 or 30% down potentially in one of those quarters, but we don't know yet exactly where the fill is going to be.

Okay, great. Thank you.

Your next question comes from Jim Lieberman.

The promising opportunities and the improving environment regarding Rohm and Haas. Is it possible that--?

Jim, we missed the first part of what you were saying.

Oh yes, well, this is really more of a comment and a question combined. It's that I'm focusing more on the promising new opportunities, the improving scenario and the environment with Rohm and Haas and the polishing technologies, so that's what I'm sort of thinking about. Is it possible that the Rohm and Haas could actually be a pleasant surprise on the upside and diminish some of your concerns and conservatism going forward?

And then also, is there anything else you'd like to elaborate regarding the BYK Chemie relationship or have you already discussed every aspect of that?

Let me comment on both. Rohm and Haas has, over the last 18 months, in fact there was an announcement and I think it was like two or three months ago again, has moved their CMP technology business primarily to Asia where the customers are. And it appears to us from talking to management at Rohm and Haas, that they're actually getting increased market traction, because they're where their customers are. And that makes sense if you've ever sold in Asia. It's much easier to do business when you are in Asia than selling from the US. Okay?

And in talking to their management, I'm under the impression that they will continue to migrate more and more of that business to Asia. So I think from a commitment standpoint, from putting the resources in place organizationally, Rohm and Haas is making the right moves and it's going to be making progress.

I think they've made a lot of progress technically with this new generation ceria slurry product. I think the trial that's coming up with a large semiconductor manufacturer, frankly, is looked at as a technology leader in the industry. Meaning that if they should adopt, if it will bring peripheral sales, is very important for us. So, we're pleased with the progress at Rohm and Haas at this time.

Relative to BYK, the new agreement we have allows us to sell much more directly into that marketplace under certain conditions which are documented in the 8-K, and I won't go through all those. But, essentially what it does is let us work with customers and formulate our materials directly into their formulation. It's been our experience, especially over the last 12 months, one of the things we've learned is that if we work directly with customers, especially coating customers or paint customers or plastic customers, and we work directly with them on their formulation, we have a higher probability of success than giving them a sample and just letting them go. Okay?

So, from building an opportunity pipeline, increasing the odds of success, we consider this to be a significant situation for Nanophase. So, that's my comments.

Okay, I appreciate that. Now, since you're moving more toward a direct sales model, will you be able to talk more about some of the applications for those or will you still be under certain nondisclosure agreements?

Jim, I imagine we'll be able to talk a little bit more clearly about some of them and then some we won't be able to talk about. You know, it's like our large architectural coating customer, that's a customer, we sell them directly and have all the time and we work with them very closely, they just don't want us to talk about them. And you know, the customer is kind of always right on that.

Some of the others--two of the new customers we currently have, we are talking to them about being able to reveal who they are. Okay? And if we get permission to do that, we will definitely like to do that. But until we get permission, we can't. So, I think it's going to be a mixed bag.

Again, I think investors need to understand that in every case where we have a market partner or a customer, we are sole source for them. They don't buy from anybody else. And a lot of this material, frankly, they can't get from anywhere else, to my knowledge.

And I have one more question. You mentioned that the UV exterior wood base products, the clear coatings, is that something--do you have any clear picture of when it may hit the market?

Yes. We're in testing now with a couple of larger manufacturers of that product. There are two types of outdoor preservation products. One glass is a deep-penetrating product and one's a film forming product. Then different manufacturers have different avenues to get there. We're working in both. The real criteria or the value proposition in that marketplace seems to be if you can extend the clear coating life one year, then it's kind of a win. And so far, the tests for us are very promising. We have tests internally. We have stakes in the ground weathering in Florida. So, we're pretty optimistic about that market. We think we can play in that market.

Thank you very much.

(OPERATOR INSTRUCTIONS) At this time there are no further questions. Mr. Cross, do you have any closing remarks?

We thank you for your attention and we'll look forward to talking to you next quarter. Thank you.

Thank you for attending today's conference call. You may now disconnect.