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Good day, and thank you for standing by. Welcome to the Nanophase Second Quarter 2023 Financial Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded.
The words believe, expects, 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 that 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 personal care ingredients, advanced materials, and formulated products, changes in development and distribution relationships, the impact of competitive products and technologies, possible disruption in commercial activities occasioned by public health issues, 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 hand the conference over to your speaker today, Jess Jankowski, President and CEO. Please go ahead.
Thank you, Abigail. Good morning to all of those listening live, and we also welcome those who choose to listen later online. Thanks for joining us today for our discussion of our second quarter 2023 results, the state of the business, and our outlook for the rest of the year. Kevin Cureton, our Chief Operating Officer, is joining me on the call today.
Our prepared comments will be brief, and as always, we're looking forward to some good Q&A afterward. Our second quarter was much stronger than the first, but still beneath our expectations when entering 2023. While there's definitely room for improvement, there's also definitely room for optimism as we assess our performance.
On the last call, I mentioned that margin improvement and profitability are a major focus for the company. We discussed the plans we've put into place, and I told you we expected to see at least a 2% improvement to gross margin this year. With that commitment in mind, it was gratifying to see the 31% gross profit in Q2 and also to see the improvement compared to the prior year's Q2 and the 6-month numbers. These numbers are even better when taking into account that we had more than $400,000 in other revenue in Q2 of 2022, which added about 4% to the quarterly margin last year and 2% to the 6-month margins. If we pull this other revenue out, which practically represented all profit, year-over-year, we saw a 4% improvement in gross profit for the first half, even after a historically tough Q1, and an 11% improvement over the second quarter.
We continue to struggle with unsteady customer demand, which, while continuing to grow, pops up and down month-to-month. This makes it challenging to predict future margins over short windows like a 3-month quarter. We've also historically struggled with getting product out the door due to external supply chain issues and internal bottlenecks. The good news here is that most of our external supply chain issues have been resolved. We've also seen some nice productivity improvements coming online recently, which will help to reduce internal bottlenecks. Kevin will touch on this during his comments as well.
Moving down to P&L. It's also important to recognize that we're incurring expenses relative to the litigation with BASF that we believe will not reflect ongoing operating expenses once we resolve the open issues. We spent roughly $1 million here during the 6 months ending June 30, distributed almost equally in the 2 quarters. That comes to a bit more than $0.02 per share. And were these costs not incurred, we'd be looking at a profitable 6 months and about a 7% net income for Q2. We did incur these costs, however, and we will continue down the path we're on, ideally, to a negotiated settlement, but not necessarily so. We think we have a good case and continue to work to resolve these issues with BASF as quickly and fairly as is practical.
We're approaching the situation in light of our view that Nanophase and Solesence promise a great deal of unrecognized value that we intend to realize. We need to protect that value and ideally help to expand both our active pharmaceutical ingredient or API business with BASF by adding new products, which remains an ongoing discussion. We will also enhance that value by driving more growth through the expansion of our Solesence business.
Before we continue, let's walk through the numbers. Unless I identify it otherwise, all numbers will be stated in approximate terms. Our Q2 '23 revenue was $11.9 million versus $11.2 million for the same period last year, up 6%. At $11.9 million, Q2 of '23 also represents the highest quarterly revenue we've ever recorded. A few short years ago, $12 million would have represented a pretty good year for your company. As an additional point of reference, Q2 '23 revenue exceeded Q1 revenue by 25%. For the second quarter of '23, we had a net income of $337,000 or $0.01 a share, which represented a multiple of 2022 second quarter earnings of $50,000 coming in at well less than $0.01 a share.
Looking at the 6-month comparable numbers, we had $21.3 million in revenue in the first half of 2023 versus $19.4 million in the same period in 2022. This represented a 10% improvement year-over-year. Also, when looking at the strides made since 2022, note that we had a good deal of other revenue that came from sources not directly related to product revenue, which is our core business. Looking only in terms of product revenue growth, the 6% improvement in Q2 goes up to 10%. Taking the same way, the increase for the 6-month period goes from 10% to 12%. These are good indicators of where our business is headed and how we plan to strengthen it going forward.
Our ongoing challenges are to balance production resources to demand and to continue to increase throughput to help reduce our reliance on overtime and to avoid having unabsorbed direct labor during periods of waning demand.
We've been having success in addressing these things. As we mentioned in the release, we recently commissioned our first fully automated filling process, enhancing throughput per labor hour by 100%. We continue to work to automate more of our processes where demand can support it with expectations that this will bring benefits not only in enhancing our ability to deliver, but also to reduce costs. Keep in mind that even without the additional automation, we're still producing at record levels. As we get our new manufacturing organization humming, we'll continue to deliver on opportunities to produce more efficiently and profitably. We're in a good spot.
As I mentioned last time, we're highly focused on increasing our margins, knowing that this will yield significant increases, first, in profitability, then to our enterprise valuation. We're all investors in Nanophase and Solesence, and we all stand to reap the rewards we're working towards together.
Looking now at operating expenses, we saw R&D expense, which includes our engineering group, while down a little from Q1, was up 35% year-over-year. Roughly half of that increase was related to compensation expense. An important part of this came from the expansion of our engineering team to help speed the build-out of capacity in our new Bolingbrook facility. These types of additions will pay for themselves. The rest of the R&D investment in people is to support the continued enhancement of our technology, our intellectual property, and ultimately, our highly rated line of award-winning innovative products.
We operate in markets, particularly with respect to our Solesence business where new products drive growth and product life cycles can be really short. We've made remarkable progress since we started developing and marketing our formulated products, and we're working to maintain the advantage we have.
Moving to SG&A expenses, which were also down sequentially from Q1, we were up just over $1 million year-over-year to about $4.3 million for the 6 months of 2023. Of this increase, the lion share related to the $1 million in BASF litigation costs we incurred this year. Again, we don't expect these to be ongoing expenses. Also contributing to this variance were smaller increases in compensation expense, insurance costs, and audit fees, offset by reductions in bad debt expense and other items.
We also saw interest expense more than triple, a $280,000 increase from the same period in 2022 due to the combination of expanded borrowing and a 5% increase in the prime lending rate over the past year or so. As you can see, we keep moving ourselves into a better position to win. We've maintained our focus on capturing the bottom-line benefits that the changes we've implemented beginning in 2022 were designed to deliver. The bottom line takeaway here is that we're focused, motivated, and working hard to build the value of our company.
Now I'd like to introduce Kevin Cureton, our Chief Operating Officer, to discuss progress in some of these areas and their drivers in greater detail. Kevin?
Thanks, Jess. As always, I would like to begin by thanking our team for their efforts in helping fulfill our mission and enhancing people's lives through the world's best skin care products, as we also work tirelessly towards creating a more valuable company for our shareholders. I also would like to thank all of our investors, who remain steadfast in their support of our company.
While it was nice to return to profitability in Q2, it by no means represents a finish line of any sort. Instead, Q2 represents us starting to realize our goal in achieving both growth in revenue and increased profitability. A critical part in achieving our goal is having the right team in place. We now, for the first time since we began the Solesence business, have a complete leadership team in place in commercial, operational, and financial roles that will serve as the team to lead us into the future.
We have already demonstrated that our business processes enable us to sustain our status as a world-class innovator. Our latest Cosmoprof award really enforces that -- reinforces that. That is why we are increasingly focused on building the business processes that will enable us to become a best-in-class manufacturer and distributor.
As our Board often asks, "How will this translate? What are the KPIs that will demonstrate that we are on track with achieving our goal?" Achieving operational excellence translates into meaningful improvements in gross profit margins. Over the next two quarters, that will primarily be through improvements in two key areas: our labor efficiency and lowering material costs. While 31% gross profit was certainly a significant improvement over the underperformance we had in the previous quarters, we believe there is much more improvement that can be realized in a relatively short period of time.
I'll end my comments by saying that our confidence in the future, again, is largely because of our confidence in our team's ability to achieve our mission, continued innovative leadership while simultaneously growing our profitability. They have the right stuff to achieve our vision, but, of course, that must be proven during the rest of this year and the years to come. Jess?
Thanks, Kevin. Why don't we dig right in? Although we know that most of our investors listen to the webcast to review the transcript after the live call, we'd like to invite those participating in today's call to ask any questions you may have or to share your comments. Afterward, I'll offer a few critical closing comments. Abigail, would you please begin the Q&A session?
[Operator Instructions] Our first question comes from the line of Tony Rubin, an individual investor.
I'm very pleased with this quarter, and I can see from your tone that you guys are much happier having the call this quarter than the previous quarter.
A little bit.
And Kevin, I really liked your comment about much more improvement that can be realized in a short period of time. So given that you've made great strides in gross margin improvement, though not where you were a couple of years ago, what do you think is an end-of-year gross margin target or a steady-state gross margin target? Anything you can share on that?
It's hard to say because -- I mean, as big as we feel we are, we're a really small company. One of the things that was great about Q2 is we had production that aligned very well. It was easier to schedule than it's been, historically, not lumpy as much. And that's where Q1 was -- financially looked like a disaster. But as we talked back then, if you looked at January, then February, then March, March was a good month. It's just that we had such a dip in January that made it difficult.
So when it comes to what the year is going to be, I think we need more steady-state operation to lock that down regularly. Because Q4, generally, just in this business, you have a couple of things. The API business usually peak somewhere between Q1 and Q2 and a little bit at the beginning of Q3. And then the Solesence business, the Q4 volume that comes through there generally is going to be setting up for launches in Q1 versus the volume that comes on for reorders and everything else when you're getting into later Q1, Q2, Q3. So that's where I generally expect Q4 to dip down.
So do we hit 31% or more through the rest of the year for both quarters? I don't know. I think probably not when we get into Q4. But certainly, it's possible. Q3 will depend on order volume and how variable it is. So far, it's been good. And July was actually an okay month, given that you have the holidays in there and our annual maintenance and things like that usually around that week.
So I think we could expect it to continue to move up. It's going to be better than last year. I said by a few points when we talked last partly because we just had such a tough Q1 to make up from. I think steady state at some point for this company can easily be over 30% and probably getting up towards the 40% range. That's something that we're very into doing, working on. And it's also something that our Board of Directors is very demanding when it comes to. So that's in the works.
Okay. No, that's -- I understand that. To be honest, I never really completely understood your seasonality. And discussing your revenue growth, in your press release, you mentioned a $15 million backlog going into Q3, which I take from your comments not to mean that, that will all be recognized in Q3. So do you typically then take your backlog one quarter out, two quarters out, three quarters out?
What we said there -- and it's partly -- you hate to make this into a word salad, which, obviously, for you we did. Leaving June 30, so when we put the press release together between what we've already shipped and what's on the books, we've got $15 million in volume, of which 2/3 of that $15 million reflects potential Q3 volume. So that's -- you're in a $10 million-plus range depending on what else we can pull in. We are expecting more orders coming in for Q4, which is the balance of most of those orders. And then we have a few orders so far in for 2024, we expect more as we go. So we try to use that metric. I think when we get a more steady-state flow of business, it will be easier for us to say we have x amount planned for Q4, plus or minus -- Q3, plus or minus, whatever, 10%, and then we have x amount for Q4. But we're not quite there yet.
Tony, just to add one more comment to what Jess offered. It's a little different in 2023 than it has been in previous years because there was a lot, as I'm sure you know as well or better than us, there was a lot of concern in consumer markets about what was going to happen to the economy. And so there was a lot of inventory control that was happening on the retail end that then fed back to our clients, which then ultimately fed to us in terms of just timing on orders.
So they were holding back and still are anticipating or giving us indication that there's demand out there and that they're going to place orders, but they're waiting to the very last moment these days versus being a little bit more aggressive as they were in '21 and '22 in placing orders further ahead. So that's part of the reason why we're not giving as much guidance on the total volume because we don't have as much visibility as we might have had in last year just based upon the behavior of the client base. I will finish by saying that doesn't mean that there's a weakness in the business per se. It's just a change based upon the whole channel being more conservative on inventory.
Okay. No, that's an excellent point. Right. I mean people were just scrambling to lock in. And just one final question and I'll obviously give others a chance. I'm used to be kind of being at the end, not in the beginning. Jess, in your comments about BASF, and not to use your words, word salad, but are you implying that BASF's claim or their litigation revolves, at least in part, around looking for more product support going forward and perhaps feeling neglected because the company has emphasized Solesence as opposed to something else or different? And obviously, you haven't reached the settlement, so there's nothing definitive. But that was something I thought I heard you suggest in your comment.
Well, I'm pretty limited on what we can share there. One thing is that we've -- the commercial relationship and the litigation have been, for the most part, in this past year now that this is almost going on, have been segregated pretty well. And we are consistently in discussions about new products and getting new products out there. And I think they -- they're smart people, they're good at what they do. And I think they're recognizing as we recognize, which is obvious in our other business, that you just have to have more products out there. And so we're continuing to talk about that.
With respect to what motivated them relative to their claims, I think the -- I think they said it in their claims that -- I don't want to recount them because I won't do it accurately enough, and I could hear my attorney holding -- not breathing right now, holding his breath. But I think that the -- we had some stumbling on delivery, which was difficult when everything went -- the supply chain issues were what they were. And that was problematic for them. And we have -- they certainly are interested in new products, but that really isn't anything that is baked into our existing contract or part of the litigation.
And then with respect to Solesence, the two businesses are very separate from one another, although from the outside looking in, obviously, we had more to do. But we continue to service that business as best we could. And we don't think that there was any kind of a diminution of quality relative to our API business as we built the Solesence volume.
Our next question comes from Ron Richards, a private investor.
You might already have answered my question. I had a little trouble logging in today through no fault of yours. My phone was on. That is true. But that being the case, I missed out on your comments about the lawsuit. When is the next court proceeding? And what would that court proceeding be -- or when is the next court date? And what would be argued at that date?
Well, the next -- in my view, the most significant date coming up is the end of the year we have discovery extended till 12/31. So we've got a fairly good deal of runway to work toward a negotiated settlement, if that's what ends up happening. There are...
Now, is that -- oh, excuse me. Is...
There are -- go ahead. I'm sorry.
Was the discovery extended because of the amount required or because of the possibility for settlement?
It was because we were -- and we have been working together and trying to resolve these issues out of court, if possible, which everybody prefers, including the court. And so we're -- we extended that to allow time to do that while still retain any time we needed should we end up having to litigate this thing all the way.
Have the issues -- have any of the issues been narrowed down in any sort of motion procedure or settlement? Or is it just sort of the original claim as it first stood?
I don't -- I wouldn't say that any of them have been -- there's been no motions or procedures that have changed any of the original issues. I would say that we are working together and have identified the things that we need to address the open issues, and we've been doing that on a fairly regular basis. And I'm optimistic we can work something out that's good for both companies, which any settlement has to be. But I can't say really anything more than that.
Okay. Well, it does look like you've transitioned through your expansion. And I'm glad to see that. I sure hope this lawsuit can be settled in a way that keeps Solesence on the roll, R-o-l-l.
Yes.
We think we're in good shape there. But again, I can't speak for what happens when you litigate, which is partly one of the reasons it's good if you can to come up with an amicable settlement.
[Operator Instructions] Our next question comes from James Lieberman with Revere Securities.
Great. My handset broke. Can you hear me okay?
Yes.
Great quarter, very impressive considering also some of the dropping off, I'm guessing, of some of the COVID testing technology. Could you give a little bit more clarity -- and maybe you've already -- maybe you have and I didn't quite fully understand it -- of how the integration into the new facility is going? I imagine it's still in process. So can you give a little bit more sense of how where that -- how that process is playing out?
I appreciate it. So we'll talk about it in stages because it will happen in stages. Our expectation from the beginning is that it was a multiyear process in large part to make sure that we didn't have any disruption in supply to our key clients or all of our clients really. So what we have completed so far is the move of our warehousing and all of our filling and assembly or the back end of the Solesence manufacturing processes. Those had -- we had completed the move of those, of the warehousing as early as last year this time. And then the filling operations was completed in the end of January, beginning of February of this year.
Over the last few months, we spent most of the time really consolidating some of the new equipment that have been installed, and really, quite honestly, the changes to operating procedures that resulted from our expanded footprint and capability. So that was really what we spent most of the last few months dealing with, including now having a new manufacturing leader on the team who started at the beginning of June. So still a work-in-progress through the rest of the expansion, which we hope to happen over the next -- or consolidation, depending upon your way of viewing it, over the next couple of years, through putting the rest of our upstream operations into the same facility as our current packaging and warehousing.
That's terrific. I really like the methodical way in which you're going about this. And these are terrific accomplishments and a lot of companies don't manage those transitions very well. And the fact that you've got these parallel systems still in place while you're managing it is very commendable. Could you also comment on some of the brand names again that we might see Solesence? Is it -- Kleair is one and there's another one beginning with a B that view as identifiers?
Yes. Those are Solesence-related brand names, Jim. So Kleair, K-L-E-A-I-R, which everybody always laughs about. But anyway, that is the name of our -- how we brand our zinc oxide. But what you really -- I think you may be alluding to is last call we talked about some of our clients that allow us to reference them publicly. And so we have companies like Colorescience, who we've often talked to as being our launch partner. They were really our first client in the Solesence business. We have other companies like KINLO, which is the Naomi Osaka brand. We have Credo brands, which are products that Credo, the retailer, manages. We have a company called Relevant, who lets us talk about them, and Bloomeffects, who also lets us talk about them.
And so these are all companies that are primarily distributed in places like Sephora or Ulta or other specialty beauty retailers. And there are dozens of others that we're not able to reference publicly yet but are clients of ours.
That's very helpful. That's probably the most complete list I've heard to date. And how many -- this is just a random question, but how many SKUs do you think you're on right now?
Yes. We had a fun discussion about that. I guess it depends actually talking to one of our supplier partners. By the way, it's defined by the FDA. We have almost 500 SKUs. And just to be clear, we could have the same bulk in 3 different packages, and that would be by the FDA's perspective 3 SKUs. So yes, we're closing in on about 500 SKUs that we have active currently.
I just want to wrap up by saying what a terrific job, well done with all these challenges. Congratulations.
[Operator Instructions] Our next question comes from the line of [Stefano Bolis], an individual investor.
First of all, well done for the results in the quarter and Cosmoprof award. I have seen, I think, on -- it was on LinkedIn, a post related to Cosmoprof in Italy in 2024. Is it the first time you participate to that one in Italy?
Yes. We have not yet participated in the Italian event, which I'm sure you may know is the largest event. It wasn't really appropriate for us up until now in large part because of our footprint and our presence. But given the -- what's going to happen -- because we were a winner again of the best formulation, our company is actually being highlighted, or one of the companies being highlighted at that event. So it's an ideal time to broaden our introduction, if you will, to Europe. So that's part of our plan.
So that would also suggest you now feel you have a more robust infrastructure to cope with the increased volumes in case you are opening new markets?
That's correct. We -- with the really expansion -- and we mentioned it in the press release. Some of the new automation that we've already installed, there's still some more that is on its way, literally as we speak for installation, we have really for the first time, addressed our downstream capacity issues as a company. We're really in a good position from that standpoint. There's still some opportunity for us to improve upstream of that. But as it stands today, we're certainly able to meet the demand that we have and look for additional demand out there.
Okay. And one more. So with regard to this equipment for completing the enhancement of end-to-end automation that you were expecting this quarter, is this -- so everything is on track with -- compared to the timeline indicated in the previous call?
Yes. Actually, we are still on schedule with what we had anticipated. We completed the validation on the biggest of the lines. We have -- the secondary packaging lines are still on the same schedule we had anticipated. And as a result, we anticipate the same improvements that we had talked about previously.
Okay. And I'm happy that this quarter, I managed to order some of your products because I'm not based in U.S. and it was always difficult to find customers of yours that are selling outside of the U.S. But with Colorescience, I found a way to buy some products finally.
Yes. Yes. I would say increasingly -- I would expect a big hint that there will be some more announcements related to that in Q1 of 2024. We do have some new clients that -- one of which is actually based in Europe that will be launching and happily talk about their relationship with Solesence. So after that launch, we'll certainly be excited to have you buy those products as well.
I'm showing no further questions at this time. I would like to turn it back to Jess Jankowski for closing remarks.
Thank you, Abigail. As I mentioned, there are a few closing remarks that I want all of you to hear. Our story of the last few years has been one of unrealized value. We've become bigger and more stable. Now we have to become more profitable, then ultimately more valuable.
Demand for our products has not diminished. We're working hard to get them out of the door faster and to introduce more of them. Consumer preference continues to move Solesence forward, and it has had the effect of insulating us from the ups and downs in our economy. We're growing and winning customers and winning new brand partners and consumers. Your patience is going to pay off as we transition to this next phase of development.
Thank you again for joining us today. We'll look forward to our next call when we expect to discuss further improvements to the profitability and stability of our business. Have a great day, everybody.
Thank you for your participation in today's conference. This does conclude the program. You may now disconnect.