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NANOPHASE TECHNOLOGIES CORPORATION - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 12, 2014

Overview

Nanophase is an advanced materials and applications developer and commercial manufacturer with an integrated family of materials technologies. We produce engineered nano and sub-micron materials for use in a variety of diverse markets: personal care including sunscreens, architectural coatings, industrial coating applications, abrasion-resistant additives, plastics additives, medical diagnostics, energy, and a variety of surface finishing technologies (polishing) applications, including optics. We target markets in which we feel practical solutions may be found using our products. We work closely with current and potential customers in these target markets to identify their material and performance requirements and market our materials to various end-use applications manufacturers. Recently developed technologies have made certain new products possible and opened potential new markets. For example, we have applied our skills at producing precisely defined nanomaterials to now create and sell larger, sub-micron material products. Our focus is on customer need where we believe we have an advantage, as opposed to finding uses for one particular technology. We expect growth in end-user (manufacturing customers, including customers of our customers) adoption in 2014 and beyond. Our initiatives in targeted market areas are progressing at differing rates of speed, but we have been broadly moving through testing and development cycles, and in a number of cases believe we are approaching first revenue or next stage revenue with particular customers in the industries referenced above. For example, we recently developed new solutions in the surface finishing technologies (polishing) and energy-management areas, with commercial order flow accelerating in the former and significant commercial testing happening in the latter. We expect that we will both work more deeply with current customers and attract additional customers, which should help us achieve growth in these markets in 2014 and beyond.

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Results of Operations

Total revenue increased to $2,878,000 for the three months ended June 30, 2014, compared to $2,683,000 for the same period in 2013. Total revenue decreased to $5,462,000 for the six months ended June 30, 2014, compared to $5,662,000 for the same period in 2013. Product revenue, the primary component of our total revenue, increased to $2,848,000 for the three months ended June 30, 2014, compared to $2,677,000 for the same period in 2013. Orders from our largest customer in personal care and sunscreen applications were more strongly weighted towards the first quarter during 2013, while 2014 was more balanced between the first and second quarters. As a result, there was a year-over-year increase in the second quarter of 2014, with a smaller year-over-year increase in the first six months of 2014 from this customer. We also experienced increased order flow from heightened initiatives in surface finishing technologies (polishing). Product revenue decreased to $5,423,000 for the six months ended June 30, 2014, compared to $5,653,000 for the same period in 2013. One large coatings customer had a product ramp during 2013 that was not repeated during 2014, and another is managing its supply chain more aggressively in 2014.

A substantial majority of our revenue for the three and six month periods ended June 30, 2014 and 2013 was from our largest customer in personal care and sunscreen applications. Revenue from our top three customers was approximately 68%, 10% and 6%, respectively, during the three months ended June 30, 2014, and 74%, 5% and 6%, respectively, for the six months ended June 30, 2014. Revenue from these three customers constituted approximately 62%, 11% and 9%, respectively, of our total revenue for the three months ended June 30, 2013 and 71%, 5%, and 8%, respectively, for the six months ended June 30, 2013.

Other revenue increased to $30,000 and $39,000 for the three and six months ended June 30, 2014, compared to $6,000 and $9,000 for the same periods in 2013, primarily due to a specific fee-based development project that was completed during 2014. We do not anticipate this to be recurring.

Cost of revenue generally includes costs associated with commercial production. Cost of revenue increased to $1,846,000 for the three months ended June 30, 2014, compared to $1,834,000 for the same period in 2013. Cost of revenue decreased to $3,723,000 for the six months ended June 30, 2014, compared to $3,907,000 for the same period in 2013, primarily due to decreased revenue volume year over year, and net efficiencies. We expect to continue new nanomaterial development, primarily using our NanoArc® synthesis and dispersion technologies, for targeted applications and new markets during 2014 and beyond. At current revenue levels we have generated a positive gross margin, though margins have been impeded by not having enough revenue to efficiently absorb manufacturing overhead that is required to work with current customers and expected future customers. We believe that our current fixed manufacturing cost structure is sufficient to support significantly higher levels of production. The extent to which margins grow, as a percentage of total revenue, will be dependent upon revenue mix, revenue volume, our ability to continue to cut costs and pass commodity market-driven raw materials increases on to customers. As product revenue volume increases, this should result in our fixed manufacturing costs being more efficiently absorbed, leading to increased margins. We expect to continue to focus on reducing controllable variable product manufacturing costs, with potential variability related to the commodity metals markets, but may or may not continue to realize absolute dollar gross margin growth through 2014 and beyond, dependent upon the factors discussed above.

Research and development expense, which includes all expenses relating to the technology and advanced engineering groups, primarily consists of costs associated with the development or acquisition of new product applications and coating formulations and the cost of enhancing our manufacturing processes. As an example, we have been, and continue to be, engaged in research to enhance our ability to disperse material in a variety of organic and inorganic media for use as coatings and polishing materials, including window cleaning and polishing products. Much of this work has led to several new products and additional potential new products.

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Having demonstrated the capability to produce pilot quantities of mixed-metal oxides in a single crystal phase, we do not expect development of further variations on these materials to present material technological challenges. Many of these materials exhibit performance characteristics that can enable them to serve in various catalytic applications. We are now working on several related commercial opportunities using the same materials. We expect that this technique should enable us to scale to large quantity commercial volumes once application viability and firm demand are established. We also have an ongoing advanced engineering effort that is primarily focused on the development of new nanomaterials as well as the refinement of existing nanomaterials, as dictated by our customer-driven marketing strategy. We are not certain when or if any significant revenue will be generated from the production of the materials described above.

Research and development expense decreased to $336,000 and $673,000 for the three and six months ended June 30, 2014, respectively, compared to $453,000 and $882,000 for the same periods in 2013. The decreases were primarily attributed to reduced product development costs (salaries and materials) as we have transferred projects from development into commercial operations. We expect research and development expense to increase slightly from the current rate during the remainder of 2014.

Selling, general and administrative expense decreased to $765,000 and $1,563,000 for the three and six months ended June 30, 2014, respectively, compared to $857,000 and $1,818,000 for the same periods in 2013. The net decreases were primarily attributed to decreased salary and personnel costs, offset in part by increases in consulting fees and marketing expenses, all related to our stronger focus on a few, well-qualified initiatives. We expect total expense in this area to increase slightly, but not significantly, during the remainder of 2014 as we continue commercial activities in recently launched initiatives.

Interest income relates to bank yields on excess funds, while interest expense relates to capital leases. Neither was significant during the reported periods.

Inflation

We believe inflation has not had a material effect on our operations or financial position. However, supplier price increases and wage and benefit inflation, both of which represent a significant component of our costs of operations, may have a material effect on our operations and financial position in 2014 and beyond if we are unable to pass through any applicable increases under our present contracts or through to our markets in general.

Liquidity and Capital Resources

Our cash, cash equivalents and short-term investments amounted to $2,438,000 on June 30, 2014, compared to $3,306,000 on December 31, 2013 and $3,191,000 on June 30, 2013. The net cash used in our operating activities was $739,000 for the six months ended June 30, 2014, compared to $862,000 for the same period in 2013, primarily due to working capital fluctuations of approximately $0.6 million during the first six months of 2014 and $0.5 million during the first six months of 2013. Net cash used in investing activities amounted to $114,000 for the six months ended June 30, 2014, compared to $62,000 for the same period in 2013. Capital expenditures, including those under capital leases amounted to $102,000 and $59,000 for the six months ended June 30, 2014 and 2013, respectively. Net cash used in financing activities was $15,000 for the six months ended June 30, 2014 compared to $39,000 for the same period in 2013, as we paid off a capital lease during 2013.

Our supply agreements with our largest customer, BASF, contain certain financial covenants which could potentially impact our liquidity. The most restrictive financial covenants under these agreements require that we maintain a minimum of $1 million in cash, cash equivalents and certain investments, and that we not have the acceleration of any debt maturity having a principal amount of more than $10 million, in order to avoid triggering the customer's potential right to transfer certain

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technology and equipment to that customer at a contractually defined price. We had approximately $2.4 million in cash, cash equivalents and short-term investments on June 30, 2014, with no debt. This supply agreement and its covenants are more fully described in Note 7 to our Financial Statements in Part I, Item 1 of this Form 10-Q.

We believe that cash from operations and cash, cash equivalents and investments on hand will be adequate to fund our operating plans through the remainder of 2014. Our actual future capital requirements in 2014 and beyond will depend, however, on many factors, including customer acceptance of our current and potential nanomaterials and product applications, continued progress in research and development activities and product testing programs, the magnitude of these activities and programs, and the costs necessary to increase and expand our manufacturing capabilities and to market and sell our materials and product applications. Other important issues that will drive future capital requirements will be the development of new markets and new customers as well as the potential for significant unplanned growth with existing customers. Depending on the success of certain projects, we expect that capital spending relating to currently known capital needs for the remainder of 2014 will be between $250,000 and $300,000, as we intend to purchase additional capital equipment to facilitate further growth in surface finishing technologies (polishing). If those projects are delayed or ultimately prove unsuccessful, we would expect our capital requirements to be lower.

Should events arise that make it appropriate for us to seek additional financing, such additional financing may not be available on acceptable terms or even at all, and any such additional financing could be dilutive to our shareholders. Such financing could be necessitated by such things as the loss of existing customers; currently unknown capital requirements in light of the factors described above; new regulatory requirements that are outside our control; the need to meet previously discussed cash requirements to avoid a triggering event under our BASF agreement; or various other circumstances coming to pass that we currently do not anticipate. The failure to have access to sufficient capital to fund our business plans may result in a curtailment or other change in those plans.

On June 30, 2014, we had a net operating loss carryforward of approximately $79 million for income tax purposes. Because we may have experienced "ownership changes" within the meaning of the U.S. Internal Revenue Code in connection with our various prior equity offerings, future utilization of this carryforward may be subject to certain limitations as defined by the Internal Revenue Code. If not utilized, the remaining carryforward will expire at various dates between January 1, 2018 and December 31, 2033. As a result of the annual limitation and uncertainty as to the amount of future taxable income that will be earned prior to the expiration of the carryforward, we have concluded that it is likely that some portion of this carryforward will expire before ultimately becoming available to reduce income tax liabilities. During 2011, the state of Illinois suspended the utilization of NOL carryforwards for four years, extending their duration by an equivalent number of years.

Off-Balance Sheet Arrangements

We have not created, and are not party to, any special-purpose or off-balance sheet entities for the purposes of raising capital, incurring debt or operating our business. We do not have any off-balance sheet arrangements or relationships with entities that are not consolidated into our financial statements that are reasonably likely to materially affect our liquidity or the availability of capital resources.

Safe Harbor Provision

We want to provide investors with more meaningful and useful information. As a result, this Quarterly Report on Form 10-Q (the "Form 10-Q") contains and incorporates by reference certain "forward-looking statements", as defined in Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These statements reflect our current expectations of the future results of

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our operations, performance and achievements. Forward-looking statements are covered under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. We have tried, wherever possible, to identify these statements by using words such as "anticipates", "believes", "estimates", "expects", "plans", "intends" and similar expressions. These statements reflect management's current beliefs and are based on information now available to it. Accordingly, these statements are subject to certain risks, uncertainties and contingencies that could cause our actual results, performance or achievements in future reporting periods to differ materially from those expressed in, or implied by, such statements. These risks, uncertainties and factors include, without limitation: our ability to become profitable despite the losses we have incurred since our incorporation; our dependence on our principal customers and the terms of our supply agreements with BASF which could trigger a requirement to transfer technology and/or sell equipment to that customer; our potential inability to obtain working capital when needed on acceptable terms or at all; our ability to obtain materials at costs we can pass through to our customers, including Rare Earth elements, specifically cerium oxide; uncertain demand for, and acceptance of, our nanocrystalline materials; our limited manufacturing capacity and product mix flexibility in light of customer demand; our limited marketing experience; changes in development and distribution relationships; the impact of competitive products and technologies; our dependence on patents and protection of proprietary information; the resolution of litigation in which we may become involved; our ability to maintain an appropriate electronic trading venue for our securities; and the impact of any potential new governmental regulations that could be difficult to respond to or costly to comply with. In addition, our forward-looking statements could be affected by general industry and market conditions and growth rates. Readers of this Quarterly Report on Form 10-Q should not place undue reliance on any forward-looking statements. Except as required by federal securities laws, we undertake no obligation to update or revise these forward-looking statements to reflect new events or uncertainties.


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