Nanophase Technologies Corporation

Investor Relations +

THIRD QUARTER 2022 CONFERENCE CALL

Jess Jankowski, President & CEO

Thank you, Howard.

Good morning to all of those listening live, and welcome to those who choose to listen later online.

Thanks for joining us on today’s call. Our discussion will cover 3rd quarter and year-to-date results, the current state of the business, and some of our planning for the balance of 2022, and entering 2023.

Kevin Cureton, our Chief Operating Officer, is also with me here today.

In discussing our results, we’re going to separate the gross profit discussion from the bottom-line earnings discussion.

The third quarter’s margins followed the trend we’ve seen in terms of our production costs reflecting the inefficiencies we’ve been discussing this year. We have also seen increases in raw materials costs and labor, some of which we’ve recouped with price increases where the markets and contracts allow.

I take solace in the fact that we’ve been able to achieve stronger margins in the past on lower volumes, AND with less sophisticated production equipment. I’m confident that our gross margins will improve.

Our bottom line was disappointing, with a large Q3 2022 loss bringing us to a loss for the nine months. While the majority of this was a result of our depressed gross profit margin, some of this was also due to strategic decisions we made, and, among other things, some was due to litigation costs.

We remain optimistic about our future results, and the acceleration of our continued growth.

After the numbers, I’ll expand on this further.

Unless identified otherwise, all numbers will be stated in approximate terms.

- We had $9.7M in Q3 revenue this year, versus $7.9M for the same period last year. This brought us up to $29M YTD at 9/30, versus $22M at this time last year.

- Total YTD revenue numbers were up 31% in 2022 over 2021.

- Solésence revenue was up 39%; AND

- Personal Care Ingredients revenue was up 61%

Revenues continue to go in the right direction. Kevin will talk more about this, but we’re excited to see our strategy continue to unfold.

As in Q1 and Q2, Q3 had a month during the quarter, in this case July, that was about one-third lower than the average month, and we also saw another month, August, that was almost one-third above the average for the months within each quarter. While we enjoy big revenue months, particularly as they can point to future run rates, they can also negatively impact margins when the other months in a given quarter are lower than expected. This has led to poorer overhead absorption during the lower months, as well as labor inefficiencies. Given that we can never get those inefficiencies back, we’re working hard to stabilize the business within the constraints of what we expect to be continued significant growth.

Additionally, we’ve seen the added expenses come through for the expansion of our facilities and our operations team. This expansion was both necessary for us to get our costs down on the volume we currently have, as well as to support future growth with a much more workable footprint.

In the short-term, these increases added to some of the inefficiencies we’ve been tackling, leading to gross profit margins of 26% and 25% for the three- and nine-month periods of 2022, respectively. For the nine-month period year-over-year, this reflects a 9% decrease. About a third of this decrease is related to occupancy costs for our new facility, which we expect to better absorb as we continue to grow. Without which, I have to add, we wouldn’t be able to pull costs out of the current Solésence business.

Kevin will be addressing this in greater detail in a few minutes.

In terms of the remaining 6% shortfall, when compared to 2021, in dollar terms meant we had approximately two-point-five-million fewer margin dollars to cover R&D and SG&A expenses, and to generate cash. Over the nine-month period in 2022, we had a series of investments in our R&D and SG&A capability that, while helping to facilitate some of our growth immediately, represented more of an investment toward future growth.

We saw R&D expense, which includes Engineering, increase by about $600K year over year. Two thirds of this related to staffing. This included the expansion of our Engineering team to help with equipment installation and optimization, and an addition to our formulation group. I’d characterize these as changes to both reduce manufacturing costs, and to increase throughput. The balance in R&D reflected increases in legal fees for patent and intellectual property development. This is strictly an investment in securing and expanding our franchise within our Solésence products.

Our SG&A expenses were up considerably too, an increase of roughly $2.5M year over year. Almost a million, or 40%, of this related to additional staffing, primarily within the Sales, Marketing, and Business Development teams. We added two new senior leaders in the 1st quarter, additional marketing resources, and more customer support people. Related recruiting costs amounted to about 15% of that total, which we don’t expect to reoccur. The bulk of these additions relate to future business development and demand acceleration, with the balance helping us to catch-up with our much higher sales volume. Not just in Sales & Marketing, but companywide, the business has been impacted by the growth in our Solésence business in a way that is difficult to understand from the outside.

I’d like to put a finer point on what we mean when we talk about “catching-up with growth”:

Solésence sales have grown from less than $2M in 2018 and 2019, to $7M in 2020, during the Pandemic, to $18M in 2021. At our current level, we will have tripled the size of a thirty-year-old Company in the past three years! Given the different business model for Solésence, many more shipments of smaller quantities of materials, while the size of our entire organization tripled in terms of dollar volume, our transaction volume has been a multiple of that again. This tremendous increase in volume, and its related activity, put a huge strain on our organization, but it was worth it!

Another third of the $2.5M increase was due to a series of growth-related items:

The enhancement of our marketing suite, as well as the increase in the number of users throughout the Company, plus a big push toward automation, resulting in higher software spending. Also, we finally felt it safe enough to start exhibiting at trade shows again, and we saw insurance costs increase significantly as a function of both our rapid growth in volume and assets, as well as the general insurance markets.

Lastly, we incurred approximately $250K in Bad Debt Expense, which is an unfortunate consequence of rapid sales growth, with limited resources to apply to collections and regular, frequent, customer contact earlier in the cycle. We may be able to collect a portion of this in the future, but we’re reserving for it now. With more experience and deeper staffing, we don’t expect this to continue at this magnitude going forward.

Several other items, which I would characterize as being outside the “normal course” of business, are the $530K we mentioned in our earnings release, made up most of the balance of the change in SG&A expenses:

We accrued some contingency fees for what we hope will be a successful recovery of our staffing commitment during the pandemic, under the Employee Retention Credit. We hope to have this finalized early in 2023. We also saw increases in legal fees relating to our pending litigation with BASF, which I’ll address in a few minutes.

Lastly, to follow up on our note in the release, we’re in the process of investigating instances of cyber theft that appear to have begun in September 2022 and persisted into October. There were six instances of cyber theft, totaling $660,000. We have been engaged actively with federal and local law enforcement, within the banking system, and with our insurance company. We are pursuing the recovery of these funds aggressively. If unrecoverable, our insurance may reimburse 25% of the losses. We elected to recognize a loss of $188K in Q3, reflecting the portion that occurred in September.

We believe we have put controls in place to stop this from happening again and are undergoing an independent assessment of our related systems to ensure that we will be operating in a best practices environment going forward. It's been a rough quarter in these respects, but we can see our way through them.

Our bottom line was impacted by a series of items that we don’t expect to be repeated. This is highlighted even further when compared to year-over-year numbers, given that 2021 income included almost $1M relating to the forgiveness of our PPP loan. Regarding the strategic spending we made in 2022, in the end, we had a series of planned increases that we were unable to offset due to our gross profit margins falling below our expectations. Unfortunately, as it concerns staffing and some other strategic spending, the expenditures are planned, and incurred, well in advance of current results becoming clear.

I’m sure that many of you are curious about the litigation we have been involved in with BASF, our long-time Personal Care Ingredients customer. Given that this litigation is pending, I will tell you what I can, and can’t expand much on this during Q&A. BASF filed a complaint in NJ in August claiming that we were in violation of our Supply Agreement. They allege several issues, the one having the biggest potential impact on Nanophase, being a claim that our sales through Solésence violate the exclusivity provision of the agreement. Also, in the same complaint, and I know that this may make a number of you more comfortable, BASF expressly states that it is not seeking termination of the Agreement. In September, Nanophase filed a complaint in Illinois court asking the Court to declare, contrary to BASF’s claims, that, among other things, the exclusivity provision of our contract does not prohibit Nanophase’s sales of Solésence products containing zinc oxide as an ingredient. Although we believe BASF’s claims are wrong, we intend to keep negotiating with BASF in good faith to resolve these issues. If this can’t be accomplished, and litigation proceeds, the ultimate resolution would be difficult to determine with certainty at this point in time. All this being said, management believes that Nanophase will ultimately prevail, under the terms of the Agreement, and under governing law.

Let’s switch over to some more upbeat news.

As I’ve mentioned before, and this hasn’t changed, your management team is optimistic, and we’ll share some of that good news with you during the rest of this call. We also intend to prove it with our results. From September 30th, out through the end of 2022, we have more than $9M in shipped orders and POs in hand. Additionally, in November of 2022, we have almost $16M in 2023 purchase orders in hand. For the most part, this demand, this future demand, this growth that has pushed us to become a $40M company, is all based on brand partners and customers that we were working with before 2021. We’ve nurtured them, we’ve given them new products to sell, and the consumers in their markets have demanded more of our products.

Speaking of good news, now I’d like to introduce Kevin Cureton, our Chief Operating Officer, to discuss where we are, and where we are going, in greater detail. Kevin?

Kevin Cureton, COO

Thanks, Jess.

As always, I will begin by thanking our talented team for their continued efforts in our work to not only transform our company but to simultaneously transform a market.

The transition of our business from being a personality drive entrepreneurial company to a process drive growth company has been challenging – even painful. Despite this challenge and realizing that we still have several steps to take to achieve our goals – we remain positive about our future. Please be reassured that our positivity about the business in no way should be construed that we somehow do not take seriously the need to improve our profitability – we are absolutely focused on doing just that.

To that point, I will speak a bit more about the steps we are taking to continue to grow aggressively while improving our profitability. What I plan to do today is, in part, set up a framework we will use to help consistently communicate some of the important aspects of our business that will enable our continued transformation. The areas that we will focus on are Revenue, Pricing, Direct Labor Costs, and Inventory Management. Each of these areas offer excellent potential for near term improvement and can ultimately reach the world class status of our products. I’ll further note that the primary focus of my comments will be our Solésence business.

Let’s start at the top by talking about our revenue and pricing. Our growth story is clear and consistent. Our lead generation, which has helped to expand our customer base to well over 70 companies, continues to be strong. As importantly, we also expect to have a similar number of new launches in 2023 as we had in 2022 – further evidence of both a robust pipeline and that we are still selected as the primary choice of premium skin care brands seeking to launch new products.

Looking at some industry specific data, Nielsen recently reported in the publication “Beauty Inc,” that year over year growth in our segments, premium skin care, color cosmetics, and sun care together averaged over 30%. If you factor in our growth, we are clearly getting our fair share of the growth and a little bit more. In fact, our results in this quarter could have been 5% higher for our Solésence business had we received packaging components from our customers as had been scheduled. We expect this supply challenge will continue in Q4 and beyond. With this continued supply disruption in mind, we are also continuing our efforts to transition more of our clients to turnkey where we supply the packaging in addition to the product development and manufacturing services. By taking more control of the component supply, we will both improve top line and margin growth and help mitigate some of these surprises.

Transitioning to pricing, our average price per unit improved by approximately 12% in the quarter over the first half of 2022 due to a combination of product mix and the implementation of price increases with over 90% of our clients. Unfortunately, we still suffered a net decrease of 1% in materials margin as we continued to play catch up with the materials cost increases early in this year. Our final price increases are being implemented in Q1 2023 due to contractual limitations.

We will now turn our attention to another critical element in our COGS – our labor costs:

Gross profit margins have obviously negatively impacted performance, primarily due to direct labor inefficiencies along with planned increases in our indirect labor which increased our overhead costs. Looking more at our labor inefficiencies, in our earnings announcement I mentioned that we have seven figures of cost reductions that are achievable. We will see these improvements in two phases: improvements in staffing labor planning and automation.

Starting with the labor planning, note that over 70% of our direct labor expenses is related to filling and assembly and that, with the exception of our key supervisory labor, a great share of the labor we use in our filling and assembly operations is contract labor. As a result, we can more readily flex our staffing levels up and down based upon demand and when we appropriately plan the requirements consistent with the production we are expecting to achieve. We believe these simple and effective methods will reduce labor costs by approximately 25%. While we started to implement these procedures in Q3, we did not really see the full impact until October, due in part to labor increases in our batch making processes. We have further addressed this issue and have seen the improvement in labor costs we expected in October.

The second phase of the labor cost reduction is automation. Here we will achieve the full benefit of automation when we move our filling and assembly processes into our new facility. Historically, we have been space limited which restricted our ability to implement automation for the production of the Solésence products. Our space issues are completely resolved with our move and the start-up of the new lines we have already purchased. While we will only have one of the fully automated lines running in January, by the middle of Q2 we expect to have 3 fully automated lines make over 90% of our demand. Through automation, we expect to conservatively reduce our labor costs another 25%, which would mean that by the end of Q2 2023 we would have cut our per unit labor expense by 50% from current 2022 levels. Of course, realization of the cash savings from this work only occurs by reducing the total labor or redistribution of the labor over more total units of production – which we are doing – while we are also significantly reducing overtime that was previously needed to produce these units.

Moving on to the balance sheet:

As we noted in the earnings announcement, we made some significant changes to our staff in the supply chain management and manufacturing roles. While more remains to be done, we are excited by the positive impact our new leadership has had. We of course need to sustain these improvements – which mostly have been in improving inventory controls and creating a stable, organized execution of the shipping and receiving processes. We have done this, by the way, while consolidating all of our warehousing activities into our new facility during Q3. During this quarter, and the several quarters to come, we are planning to turn our attention toward right sizing our inventory – again. The work right now is just instituting the basic blocking and tackling here, such as improving the managing of the procurement processes like re-setting reorder points and clarification of the lead times, but when these actions are combined with more rigorous manufacturing planning, we are also better able to manage materials requirements. As a result, we should have a meaningful reduction in raw materials inventory, and with the next few quarters get inventory turns up to 4, which will be a significant improvement for our company. I’m sure all of this will generate a lot of questions, so I will stop now to make sure we have plenty of time for Q&A, by simply saying your company has grown to be one of the most impactful businesses in the UV protection segment. With the actions outlined above, we are planning to move from impact to sustainable market changing success – which ultimately improves people’s lives and our shareholder’s returns.

Back to you, Jess.

Jess Jankowski, President & CEO

Thanks, Kevin.

I know everyone wants to get to the Q&A, but I want to reiterate a few things.

Aside from our revenue growth, nobody’s happy about 2022 results to this point. While we are working a process to tighten things up, and I mark us a few quarters behind, we have supported the build-out of an infrastructure that we eventually expect to support a multiple of our volume. There’s more work to do on that piece of our development, but the people we’ve added and the facilities we’ve secured, both of which have increased fixed spending this year, are in place. Essentially, we forced a strategic shift over the past few years on a bottoms-up basis. A few of us muscled our way through building a new $20M business that’s on its way to take off. The only way this happens is with an expanded infrastructure, with the people-side being the key.

This comes in a few parts:

First, we have to fuel the fires of growth.

This Company won’t triple its volume again without expanded marketing and sales efforts. This year has been the first time since 2019 that we made any new investment in our business development process. We expect that these investments, which are stressing our bottom line today, will pay off in a big way with growth late next year, in 2024, and well beyond that.

Second, we have to get our manufacturing operations in order.

Much of this investment has been done in 2022, albeit recently. We will continue to work here to create a production backbone that can support a multiple of current sales. It’s been a bumpier ride than we expected, but we believe our progress will become obvious, in terms of increased margins, and efficiencies in supporting increased volumes.

Lastly, we’re working to shore up our IT, Finance & Accounting infrastructure as our growth adds to our visibility, and to the challenges relating to that.

Additional functionality, and the ability to rely more on our IT infrastructure, rather than hands-on processing, are critical areas of focus. While we do this, we need to work to secure additional financing capacity, and to position ourselves for an up-listing to allow us to gain greater exposure to the investment community.

This is going to help us to become more profitable, and to grow faster.

What we’ve really been talking about today is two things:

How to make all of this growing business we have built more profitable, which is a “today issue,” and how to accelerate our growth even more, through our investment in new business development and infrastructure.

Now, we’d both happy to answer some questions, although we know that most of our investors listen to the webcast, or review the transcript, after the live call, we’d like to invite those participating in today’s call to ask any questions you might have, or to share your comments.

Howard, Would you please begin the Q&A session?

Q&A Session Placeholder

Thank you, Howard.

While our top focus is improving our margins to fund more growth, and to keep stoking demand for additional growth opportunities, we are also working to communicate what information we can, when we can, to our shareholders and stakeholders. This is part of a journey, and we want to make sure that all of you are as excited and optimistic about our future as we are.

Again, what we’ve been talking about today boils down to two things:

- How to make all of this growing business we’ve built more profitable, and

- How to accelerate our growth, even more, through investment in new business development

As you’ve heard us say, we’re on a path forward that we expect to help us enhance our value in all respects, and we are optimistic about the rest of this year, 2023, and beyond that.

We’ll look forward to the opportunity to discuss the business with you again next quarter.

Thank you!