Description

If you went to the pool or the beach this summer, you probably have some leftover sunscreen sitting in your medicine cabinet.  Go take a look at the back of the container and check the active ingredients… odds are that your sunscreen is a common cocktail of chemicals, which work together to absorb UV rays across the UVA/UVB spectrum, the most typical being oxybenzone, avobenzone, octisalate, octocrylene, homosalate or octinoxate.  This is a multi-billion-dollar market ripe for disruption, as regulatory pressures mount in response to a rising tide of scientific research that these chemicals cause bodily and environmental harm, and consumers opt for safer and more effective mineral-based alternatives with greatly improved look and feel on the skin over mineral formulas of the past.  Whether these chemicals are regulated out of existence or gradually melt away as consumers change their habits, the market for mineral UV filters is growing rapidly, which will likely continue over the medium to long-term.  There is at least one clear winner in the space that is making this shift possible, with no legacy chemical business, a significant cost and quality advantage over competitors, a management team with a decades-long track record of brilliant capital allocation, and a stock price that has yet to catch up with the company’s present performance, much less its future potential.  In the long run, Advance Nanotek Limited (ANO) also has the potential to be competitive across a wide range of advanced material applications due to the inherent cost and quality advantages of their mechanochemical processing technology (MCP) over legacy solvent-based chemical processes.

Organic (chemical) UV filters have been in use since the 1940s and were grandfathered in as GRASE (Generally Regarded As Safe and Effective) ingredients by the FDA in 1978, when it first started regulating sunscreen as OTC drugs.  The GRASE list for sunscreen is under serious review for the first time in 40 years; only two minerals, titanium dioxide and zinc oxide, will be considered GRASE in the newly proposed rules, while the FDA is requesting more data to consider the safety and effectiveness of another dozen chemicals that were formerly considered GRASE.  The FDA released a study earlier this year finding that several of the most common sunscreen chemicals, avobenzone, oxybenzone, and octocrylene, rapidly enter the bloodstream at concentrations high enough to require further data on the substances’ safety, a threshold set by the FDA in 2016. 

Proposed FDA Rule: https://www.federalregister.gov/documents/2019/02/26/2019-03019/sunscreen-drug-products-for-over-the-counter-human-use

FDA Study on Plasma Concentrations of Sunscreen ingredients: https://jamanetwork.com/journals/jama/article-abstract/2733085?guestAccessKey=e1ad4492-fe70-4f53-970d-d63bfa1cdccd

The most common organic UV filters also face growing environmental concerns.  Oxybenzone, which can be found in 60% of sunscreen currently on the market, has been found to contribute to the degradation of coral reefs, prompting reef-centric tourist destinations such as Hawaii and the Florida Keys to outright ban the sale of certain chemical sunscreens. The U.S. Virgin Islands is the latest territory to ban coral-damaging sunscreens containing oxybenzone, octocrylene, and octinoxate, with an accelerated timeline that means it will be the first to take effect within the U.S. 

U.S. Virgin Islands bans coral-damaging sunscreens: https://news.mongabay.com/2019/07/u-s-virgin-islands-bans-coral-damaging-sunscreens/

Similar legislation is being considered in California and Australia.  The inclusion of octocrylene in the Virgin Islands law puts chemical sunscreens in a particularly tough spot.  Octocrylene is commonly used to stabilize avobenzone, the only FDA-approved chemical that absorbs a critical range of UVA rays, which penetrate the skin more deeply than burn-inducing UVB rays, where they cause genetic damage to cells leading to premature skin aging and skin cancer.  Avobenzone is the most commonly used ingredient in chemical sunscreens because it is needed to achieve broad spectrum protection, which will soon be required by the FDA for sunscreens claiming an SPF of 15 or greater.  However, avobenzone when used alone undergoes rapid photodegradation, that is it breaks down very quickly in the sun, which would require reapplication every thirty minutes or so to maintain a stated level of SPF.  Without octocrylene, avobenzone is much less useful, and without avobenzone, chemical formulas cannot meet the FDA’s proposed broad-spectrum rules, which require proportional UVA protection in relation to UVB protection at a given SPF level.

Sunscreen Stability Study: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC5489936/

UV Filter Spectrum Coverage (April 2019):

April 2019 Presentation: https://hotcopper.com.au/threads/ann-investor-presentation.4730590/

The alternatives to organic UV filters are two minerals, zinc oxide and titanium dioxide.  Zinc oxide is the only active ingredient that protects against the full spectrum of UVA and UVB rays. Titanium dioxide primarily covers UVB rays and does not extend far enough into UVA to achieve broad spectrum protection; thus, it still needs to be combined with either chemicals or zinc oxide.  Mineral (inorganic) UV filters work differently than chemical UV filters; rather than soaking into the skin and absorbing UV rays, they form a protective layer on top of the skin and reflect the rays.  Zinc oxide is considered safe enough to use on babies in high concentrations in diaper rash cream, and the FDA has determined that there is ample data to label it as GRASE, but the problem has always been that zinc oxide particles are too large and difficult to formulate with, resulting in an unappealing thick and pasty feel and a white cast on the skin.  The trade-off of safety for aesthetics in the past meant zinc oxide formulations were primarily marketed for use on children and appropriately paranoid hippies. In an attempt to solve the aesthetic problem, several companies developed nanoparticle titanium dioxide and zinc oxide, but the nanoparticles come with their own set of issues, such as a significantly higher cost than organic UV filters, not being deemed safe for sprays (nanoparticles do not enter the skin but can be inhaled), agglomeration of the particles leading to both inconsistent transparency for visible light and protection across the entire UV spectrum, requiring the addition of organic UV filters or photostabilizers to achieve acceptable SPF testing results.

Considering the points above, the holy grail of sunscreen is a mineral-based product that will provide long-lasting broad-spectrum protection, meet consumer demands for feel and aesthetics, and be cost competitive with chemicals to address the mass market.  This is indeed possible thanks to the mechanochemical processing technology patented by ANO.  MCP enables ANO to finely control particle size in a highly efficient manufacturing process with zero wastage, resulting in porous clusters of zinc oxide nanoparticles (technically microparticles >100nm in diameter) that provide superior broad-spectrum protection and market-leading transparency at a significantly lower cost than competing nanoparticle zinc oxides.  If your sunscreen lists only zinc oxide as an active ingredient, is free of chemical UV photostabilizers, claims the zinc oxide is non-nano or micronized, rubs on clear and feels light on the skin, then your sunscreen is likely formulated with Zinclear, ANO’s best-selling product.

The following explanation of the MCP comes from ANO’s prospectus:

All of Advanced Nano’s nanomaterials are produced through its patented MCP technology.  MCP technology features a top-down, dry milling method using a low temperature ball mill that grinds compounds together in a salt matrix.  When the balls collide, the intensification of focal pressure and heat induces chemical reactions that create nanoparticles.  The firm’s primary nanoparticle materials are zinc oxide, alumina and ceria.  The low ambient temperature of MCP allows for a high degree of control in particle size, particle size distribution and dispersibility, which are all critical properties that determine the overall efficiency and relevant application of nanopowders.

The MCP™ technology is unique and differentiated from existing nanopowder production processes by virtue of the solid-state chemical reactions that enable the formation of dispersed nanoparticles with mean particle sizes less than 30 nm

Key advantages of the MCP™ technology include: • Small discrete particles. MCP™ produces nanoparticles with a low level of agglomeration (the particles do not clump together), satisfying quality requirements for applications that require such low levels of particle agglomeration; • Narrow size distribution. The MCP™ technology inherently produces nanoparticles with a narrow size distribution. This means the nanoparticles are all approximately the same size, an important attribute required for many applications. • Size and shape control. A key attribute of the MCP™ technology is that it allows control of particle size to meet customer’s particle size requirements. By controlling surface chemistry it is also possible to produce particles with well defined shapes, such as rods or plates. • Cost. The MCP™ technology utilises standard industrial process equipment and standard industrial chemicals, which the Company expects will provide a relatively low cost base for its high quality products

Advanced Nano’s analysis of nanoparticles manufactured using vaporization techniques generally reveals wide distributions of particle size and high levels of agglomeration. Manufacturers using precipitation techniques routinely produce very small nanoparticles, however the Company’s analysis indicates the process can present a challenge to control agglomeration. The ability to manufacture dispersed nanoparticles with a mean particle sizes less than 100 nm and a narrow particle size distribution is very important to many applications of nanopowders.

The MCP™ technology is differentiated from existing nanopowder production processes in that MCP™ nanopowders are formed by a solid-state reaction, which allows control over particle size, size distribution and agglomeration.

Whereas vaporization techniques require extremely high temperatures to vaporize the precursor metal and then the addition of a solvent to achieve a desired chemical reaction, the MCP technique generates the desired chemical reactions at relatively low temperatures due to the high pressure of the ball mill, and no solvent is needed.

MCP Flow Chart:

Source: http://www.advancenanotek.com/irm/showcontent.aspx?CPID=1748&InstanceVersionNumber=0&PageName=MCP%20Technology&ReturnTo=showcategory.aspx?CategoryID=0

The Turnaround

The MCP technology is not exactly new; ANO commenced commercial production in 2002 and listed on the ASX in 2005.  However, the promise of the technology in particular applications was consistently hindered by a lack of organizational focus and poor financial management.  The Company was incubated in the University of Western Australia (UWA), following its listing it was still managed by researchers from the university.  Consequently, there were typically lots of different R&D projects going in different directions and a sea of red ink that required numerous capital raises for the company to survive.  As the company struggled financially and shareholders headed for the exits, an accomplished entrepreneur and investor, Lev Mizikovsky, began buying shares aggressively on the open market and fully participated in all capital raises (rights issues that diluted UWA’s stake down as they did not participate), ultimately gaining control of the board and replacing management to implement a turnaround for the record books.  When Mizikovsky’s associate Rade Dudurovic took over the role of non-executive Chairman of the Board in February 2012, the Company had a $7m market cap and was losing in excess of $2m annually on about $4m of revenue.  Today, the Company has a market cap of $270m, and based on management guidance, it should generate a minimum of $30m revenue in FY2020 (ending June) with EBIT margins approaching 50%, a massive increase over the $12.6m revenue and $3.4m operating income reported in FY2019.

Following the change of control at the end of 2011, the Board announced a shift in corporate strategy from the “research and development of advanced materials” towards “providing customer solutions based on the Company’s unique technologies.”   The Board undertook a comprehensive review of all ANO activity in order to focus on those that were already commercially viable with realistic prospects to deliver revenue and earnings growth.  The Board concluded to prioritize Zinclear and Alusion, an aluminum oxide pigment used in cosmetics for its sparkling effect, while exiting their diesel fuel additive segment.

SG&A expenses were reduced by more than 50% from FY2012 to FY2014 as non-core activities were curtailed and staff count was reduced from 31 to 15.  Lev rejoined the board in 2015, taking no salary, and another long-time associate, Geoff Acton, joined as Company Secretary and later took on the role of Managing Director and CEO.  The Company realized significant savings from reduced directors’ fees and insurance just by replacing management and the Board, who then rebuilt the organization from the ground up with a results-oriented and cost-conscious culture.  Wages as a percentage of revenue fell from 30% in 2013 to less than 10% last year.

Geoff previously served as CFO and Executive Director at Tamawood for more than a decade, breaking his time up with a four-year stint refereeing professional Rugby games around the world, fulfilling a lifelong ambition.  As an unfortunate result of his time spent out on the field, Geoff has had 30 skin cancer-related operations to date.  Accordingly, his commitment to growing this business goes beyond his stock options.

When Geoff joined, he let go 15 of the 16 employees at their Perth operations and hired 7 new employees to right-size the business with the right culture in place.  The main issue in Perth was what Lev called a “silo mentality,” that is, employees thought they would not be fired if nobody knew what exactly they did.  Extracting information proved to be so difficult that it was easier to let everybody go and scan all the documentation in Western Australia onto a server.  Once management had all the accumulated institutional knowledge at their fingertips in an easily searchable database, they were able to do two things: extract efficiencies in the Zinclear production process and identify promising IP that had been left dormant.

After examining the Zinclear supply chain, management concluded that they needed to find new zinc carbonate precursor suppliers.  Their zinc carbonate was previously coming from industrial grade producers in Italy and Germany, which often resulted in finished batches of Zinclear contaminated with whatever other materials were being processed there, such as heavy metals.  Previous management had stated for years that they were looking for alternate precursor suppliers but never seemed to be able to find any.  It turned out that due to the previously mentioned communication and competence issues, the Company had simply been sending out the wrong specs to potential suppliers.  Once the Company started sending out the correct specs, they quickly found several FDA-approved pharmaceutical grade zinc carbonate manufacturers in China and India, who could deliver a much higher quality product at a significantly cheaper price.  ANO has now secured enough annual precursor supply to expand sales by another 1,000% over expected FY2020 volumes.  This is a key competitive advantage, as their competitors will likely struggle to scale their vertically integrated solvent-based processes.

There was also a mess to clean up on the distribution side.  The Company was previously operating a territorial distribution model, which did not appropriately incentivize distributors with global accounts.  For instance, Deveraux Specialties, ANO’s North American distributor, has a relationship with Estée Lauder, a known end-customer for Zinclear based in New York.  Any product formulated with Zinclear would be done in New York through the relationship with Deveraux, but when the products were manufactured outside of North America, for instance at their manufacturing site in Belgium, another distributor serving that territory was entitled to the revenue.  The Company switched to a global accounts model to correct this.  Underperforming distributors, some of which had conflicting arrangements with competing products, were dropped in favor of new ones.  The Company is still adding distributors to its network and over the summer announced several new relationships in Europe.

In tandem with fixing the distribution model, management created a global chemist network to assist with formulation and sales.  Largely thanks to Google, management was able to identify experts around the world with the ability to formulate products with zinc oxide, the difficulty of which has proven to be a major stumbling block for new product launches.  The introduction of the chemist network has significantly reduced the cost of formulation for brands.  For example, management was able to find a professor in Peru who could do formulations in a matter of hours for less than $10k.  Under previous management, ANO spent about $1m and more than a year on one sunscreen formulation.  The chemist network has also significantly reduced travel expenses at ANO, as the chemists are better suited than management to sit in on meetings and answer questions about Zinclear, and they don’t have to fly from another hemisphere to get there.  Travel expenses as a percentage of revenue fell from over 4% in 2013 to about 1% last year.

The key bottleneck that management had to tackle was the subscale manufacturing operation in Perth.  The company sells Zinclear in two forms, one is powder (XP Powder) and the other is a dispersion (Zinclear-IM), which is basically the powder mixed with oils.  Management explored the possibility of outsourcing all or part of this operation and seems to have settled on outsourcing some of the dispersion production to contract, while keeping all powder production in-house.  This protects their IP and gives the Company tighter control over monitoring quality of the batches.  In 2017, the Company consolidated their two Perth sites to one, which manufactures Alusion, and moved the XP powder manufacturing and offices to Brisbane, where Lev’s other companies are based.  In moving powder production to Brisbane, the Company realized savings on annual rent of over $500k compared to their space in Perth and will benefit from lower freight and logistics costs going forward.

XP Powder is expected to be the main driver of sales going forward.  While the dispersions cater to smaller brands by simplifying the formulation and manufacturing process, larger brands prefer to use the raw ingredients and add their own special sauce.  In response to a surge in orders, the Company scaled up their XP powder production significantly in FY2019, beginning the year with 200MT of annual capacity and ending the year with 1400MT.  In order to meet demand in a timely manner, the Company issued a rights offering for about 3% of the shares outstanding (also worth noting here that the Company bought out UWA’s remaining stake, a bit more than 4% of the shares outstanding, one year earlier at a much lower share price).  The new facility has been operating at full capacity since early May, but shipments were withheld pending the facility’s TGA (Therapeutic Goods Administration) approval, required to make therapeutic claims in Australia.  The TGA approval was received in September.  Based on the most recent guidance provided in August, management expects a minimum of 1000MT of XP powder to be delivered in FY2020 and a further increase in capacity by the end of June 2020 to 3500MT.  Given the outstanding economics of this operation, I do not expect the Company to require another capital raise to continue growing sales at current rates.  The cost of the equipment is relatively inconsequential, there is room to improve the financing of working capital down the road, and with production running at near full capacity the return on invested capital is easily in the triple digits.  On top of this, management is still looking for ways to do more with less, and they think they can further increase capacity without additional equipment by improving the facility’s power infrastructure.

Management estimates that the net result of these improvements to the supply chain and manufacturing process is a 30% to 50% lower cost of production than competitors.  ANO has passed on these savings to their distributors to the extent that I suspect it is financially impossible for competitors to try to match them on price.  At the same time, ANO’s differentiated production process is particularly suited to processing zinc oxide as a UV filter for cosmetic applications.  In addition to having a major cost advantage, Zinclear also comes out on top among competing mineral UV filters in terms of transparency and performance:

Performance vs. Competitors (April 2019)

April 2019 Presentation: https://hotcopper.com.au/threads/ann-investor-presentation.4730590/

Performance vs. Transparency (February 2018)

February 2018 Presentation: https://hotcopper.com.au/threads/ann-investor-presentation-february-2018.4049656/

Customers

Most sunscreen brands do not talk much about their active ingredients, as much of the chemical formulations are roughly the same and any discussion of how chemical sunscreen works only detracts from their appeal.  Mineral sunscreens do not typically specify what brand of zinc oxide they are using, and ANO can’t be completely sure of which brands are using Zinclear as they conduct all sales through distributors.  Some brands emphasize the characteristics of their zinc oxide as a unique selling point, and there are certain characteristics of their formulations that competing zinc oxides can’t match.  Here are a few brands that use Zinclear as the only active ingredient:

Badger Clear Zinc

https://www.badgerbalm.com/s-33-zinc-oxide-nanoparticles-clear-zinc-sunscreens.aspx

https://www.badgerbalm.com/p-955-clear-zinc-oxide-sport-sunscreen-spf-35.aspx

Ethical Zinc – launched by three major ANO shareholders in January 2019

https://ethicalzinc.com/

Ethical Zinc Launch https://hotcopper.com.au/threads/ann-major-shareholder-launches-ethical-zinc-sunscreen-brand.4603545/

These are tiny but likely quite profitable fish in a global sun care market approaching $20B, growing in excess of 5% annually.  Of this $20B in global retail sales, I estimate that the value of the ingredients market is about $2 billion, with the bulk of the industry’s gross margins going to marketing and distribution.  Most sunscreen is based around the same chemicals, but there is a lot of slight differentiation in formulas and advertising, making for a highly segmented consumer market.  The FDA reports that in 2016 there were 772 brands with over 8,000 approved formulations.  In North America, several major players split the mass market with about 20% share each: Edgewell (spin-off from Energizer, owns Banana Boat and Hawaiian Tropic), Beiersdorf AG (completing acquisition of Coppertone from Bayer in Q3 2019, Nivea), and Johnson and Johnson (Neutrogena).  While there has been some consolidation due to brand acquisitions, the market now seems poised to become more fragmented as new brands emerge to take advantage of growth opportunities in ecommerce, emerging markets, and cosmetic and natural sun care.

The sun care market is considerably more concentrated at the active ingredients level than it is at the brand level.  Edgewell’s sun care business recorded about $440 million revenue in 2018, with a cost of goods sold of about $240 million, which would imply global share around 10%.  BASF, the German chemical giant, recorded H1 2019 sales in their Care Chemicals sub-segment of about €2 billion.  Within this sub-segment, BASF’s sun care formulation business is most prominent.  ANO management has estimated that BASF’s sun care business generates at least €750 million of annual revenue. 

BASF Care Creations: https://www.carecreations.basf.com/

Competition

BASF/Nanophase – Z-Cote

There is little evidence that BASF’s competitive advantage in chemical UV filters has translated into much of an edge in the mineral UV filter market, although it appears that they are the market leader in terms of sales.  BASF’s nanoparticle zinc oxide product, Z-Cote, is one of two major competitors to Zinclear.  BASF outsources much if not all of its Z-Cote production under an exclusive supply agreement with US-listed Nanophase Technologies, which uses a physical vapor synthesis process that first vaporizes the precursor zinc using jets of thermal energy then introduces a reactive gas to cool the vapor down into liquid molecular clusters which combine with oxygen and eventually freeze into solid nanoparticle zinc oxide.

Source: https://www.pharmaceuticalonline.com/doc/basf-provides-nanophase-technologies-with-13-0001

In 2018, 74% of Nanophase’s $14 million of revenue came from BASF.  The company has been largely reliant on sales to BASF since 1999, despite sinking a significant amount of capital into R&D over the years for diversification efforts that have never panned out.  Nanophase has never turned a profit with accumulated losses nearing $100 million, and if it fails to meet certain financial covenants in the BASF supply agreement, a technology transfer (license and equipment sale) would be triggered at BASF’s option.  Even if Nanophase were to halt all R&D, operating profit would still be negative.  We do not know what the mark up is when BASF resells zinc oxide from Nanophase as Z-Cote as this is a relatively tiny segment for BASF, but we know from an ANO presentation in 2018 that “Uncoated Z-Cote sells for $37.50-$55.00 USD per kg, depending on volume,” which is 50% to 120% higher than the selling price of Zinclear.  The data is limited, but based on Nanophase’s financials, I think it is unlikely that BASF will be able to compete with ANO on price using Nanophase’s production process.  Given Nanophase’s dire financial straits, it is a long shot that they will be able to survive as an independent company, much less raise the capital required for any capacity expansion.

Z-Cote demonstrates significantly worse UV absorbance across the spectrum compared to Zinclear, as we can see from the following graph from a July 2018 ANO presentation (Z-Cote data provided by BASF):

July 2018 Presentation: https://hotcopper.com.au/threads/ann-marketing-presentation.4286880/

In the same presentation, ANO asserts that Neutrogena products that were originally formulated with Zinclear in 2014 subsequently reformulated with Z-Cote.  I suspect that Neutrogena would have made this move based on the difficulty of securing adequate supply of Zinclear at the time, which no longer appears to be an issue going forward. Nanophase management made comments in a conference call in March 2019 that they expect their zinc oxide sales to BASF to fall about 30% in 2019, not because of any market weakness but primarily because “other manufacturers ramped-up production later in the year and absorbed some of the demand, and there may have been some amount of customer reformulation.”  Now that the supply bottlenecks have been lifted, it is very likely that some Z-Cote customers are reformulating to Zinclear due to the significant difference in price and quality.

Nanophase Q4 2018 Conference Call: http://nanophase.com/investors-section/investors/conference-call-information/2018-q1-4/

EverZinc - Zano

Another major competitor to Zinclear is Zano, produced by EverZinc, a former division of publicly listed Umicore acquired by private equity firm OpenGate Capital in November 2016.  EverZinc now exclusively focuses on specialty zinc materials for a wide range of industrial applications.  According to a Umicore presentation prior to the acquisition closing, the segment was generating about €30m EBIT on €300m annual revenue; however, this also includes sales from building products.

Umicore FY2015 Presentation: https://www.umicore.com/storage/main/2015fy-presentationen.pdf

In December 2018, EverZinc announced an investment of €5m to increase production capacity of Zano, which will expand current capacity by 50% and be operational by Q1 2020.  In the same announcement, they noted that the price of Zano would be raised in 2019 due to “severe cost increases related to energy inflation, zinc’s higher price, carbon emission rights, and staff costs,” whereas ANO was able to drop prices on Zinclear following their capacity expansion despite already being 30-50% cheaper than competitors.  ANO management noted in a February 2019 presentation that they expect this expansion will add 800MT of annual capacity, to a total of about 2400MT.  Zano’s capacity expansions have been significantly more expensive than Zinclear and has taken twice as long as the comparable capacity expansion at ANO.

EverZinc Capacity Announcement: https://www.businesswire.com/news/home/20181204005362/en/

February 2019 Presentation: https://hotcopper.com.au/threads/ann-ano-investor-presentation-update.4646015/

There are two likely reasons for the significant difference in cost and speed of expansion between EverZinc and ANO.  One is that EverZinc’s process is vertically integrated, meaning they also need to process the precursor material, a step that ANO outsources.  The other would be that it is most likely a vaporization process like Z-Cote, as the characteristics of Zano suggest it is a conventional nanoparticle zinc oxide.  The following 2008 presentation on Umicore’s nano-sized oxide powders for UV applications is a bit dated, but it states that the mean particle size of Zano is 35nm:

Umicore UV Absorbers Presentation: http://www.i-sup2008.org/presentations/Conference_1/Put_S.pdf

This presentation also notes that because inorganic pigments like titanium dioxide and zinc oxide have a relatively high refractive index (they reflect visible light), “particle size distribution should be well below 100nm” and “particles should be well dispersed in application to maintain transparency.”  In practice, both Nanophase (Z-Cote) and EverZinc (Zano) seem to have difficulty controlling particle size and agglomeration of smaller particles.  A 2012 study from the EU Scientific Committee of Consumer Safety (SCCS) made the following observations on particle size:

Zano: “ZnO nanoparticles have different shapes (rod-like, star-like and isometric) and a broad size distribution range of 30–150 nm. The ZnO particles were present mainly as clusters.”

Z-Cote: “ZnO particles have different shapes (rod-like and isometric) and a broad size distribution range of 30–200 nm. The ZnO particles were generally present as clusters.”

EU SCCS study on Nanoparticle Zinc Oxide: https://ec.europa.eu/health/scientific_committees/opinions_layman/zinc-oxide/es/l-3/3.htm

Zinclear, by contrast, is comprised of porous clusters of nanoparticles, which are technically micron sized particles larger than 100nm.  Despite having larger particles than Zano or Z-Cote, Zinclear is more transparent due to finer control of particle size with minimal agglomeration.

Zinclear Particle Size Statement: https://solimara.net/wp-content/uploads/2018/11/ZinClear-Particle-Size-Statement.pdf

Tayca

Since much of the discussion from management of competition in North America and Europe focuses on BASF and EverZinc, I was surprised to find that the largest competitor globally might actually be Tayca in Japan.  In the following slide, Tayca claims to have 60% share of the global market for fine particle titanium dioxide and 50% for fine particle zinc oxide used in sunscreen and cosmetics.

Tayca August 2019 Presentation: http://www.tayca.co.jp/ir/pdf/20190824.pdf

It will be interesting to see whether they continue to highlight their market share in zinc oxide as ANO rapidly ramps up Zinclear sales.  They may not include Zinclear in this calculation; it depends whether their definition of “fine particle” encompasses particle sizes over 100nm. According their specs, Tayca’s zinc oxide is nanoparticle, with an average size of 25nm to 35nm:

Tayca Zinc Oxide Specs: http://www.tayca.co.jp/english/products/micro_zinc_oxide/spec.html

In March 2019, the Company announced a capacity expansion to increase total annual capacity (they don’t specify between titanium dioxide and zinc oxide) by 1600MT to 5200MT.  The capacity increase is expected to cost 3 to 4 billion yen and production is expected to begin by the end of 2020, and sales are expected to increase by about 4 billion yen by 2023.  The expected cost of Tayca’s expansion per MT is about 3x the cost of EverZinc’s expansion, and the forecasted sales increase suggests that they will only use about half of the capacity by year 3.

Tayca Capacity Announcement: http://www.tayca.co.jp/english/ir/pdf/20190319.pdf

Over 50% of Tayca’s sales and 70% of operating profits come from titanium dioxide products, and only about 30% of sales come from outside of Japan.  Tayca has a partnership with U.S.-listed Ashland to combine their minerals with bemotrizinol, compounds marketed as Escalol, which is approved in the EU but not US.  This is very similar to BASF’s Tinosorb.  There are applications submitted to approve bemotrizinol in the U.S., but given that the FDA is currently weighing to drop all the chemicals from the GRASE list, it seems unlikely that they would approve new chemicals at this time.

Tayca Escalol Brochure: http://www.tayca.co.jp/products/pdf/20170525a.pdf

Bemotrizinol: https://en.wikipedia.org/wiki/Bemotrizinol

Bemotrizinol Application: https://www.happi.com/contents/view_breaking-news/2019-08-29/dsm-seeks-fda-approval-for-parsol-shield/

Tayca’s position of having a large global market share but also a high proportion of domestic sales suggests that Japan currently has a more developed market for inorganic UV absorbers than the rest of the world.  Despite what looks like a more capital-intensive operation with higher costs, Tayca may be able to maintain a leading position in Japan going forward due to the difficulty for foreign firms to develop relationships with distributors, chemists, and companies.  ANO does not currently have a Japanese distributor.

Sakai Chemical Industry

Despite its original focus on zinc oxide when founded in 1918, Sakai Chemical Industry has become a much more diversified chemical company than Tayca with an even larger proportion of domestic sales, lower operating margins and a chronically low ROE.   Although it is playing second fiddle in the Japanese inorganic UV absorber market, which may not be globally relevant, there were a few interesting kernels of information to be gleaned from taking a closer look.

Sakai notes the growing inorganic UV absorber market as a key area of focus in its medium-term management plan.  The Company pegs the total market at 6,000MT for 2020 and says that supply shortages have occurred despite manufacturers expanding their capacity.  The market is expected to grow rapidly due to increased use in cosmetics in China and Southeast Asia, where sunscreen has not been widely used in the past, as well as the pending chemical sunscreen bans in Hawaii and Florida.  I think the market growth here may be considerably underestimated, but 6,000MT today is a useful data point.

Sakai Chemical Medium Term Management Plan: http://www.sakai-chem.co.jp/jp/ir/pdf/pr190412.pdf

While most of Sakai’s zinc oxide products for cosmetic applications appear to be either the standard nanoparticle zinc oxide or “large particle” zinc oxide, there is one product that sounds like Zinclear.  Sakai’s XZ-100P is hexagonal pillar-shaped zinc oxide with uniform 100nm size particles that scores exceptionally well on UVA protection and visible light transparency. Sakai is doing about $700m of annual sales and clearly has organizational issues with capital allocation, so I don’t necessarily think this is a serious threat to Zinclear for now. I think it indicates that the Japanese competitors may have the technical capability to compete in the long run, but they will have a hard time competing on price in the global market.

Sakai Zinc Oxide Product List: http://www.sakai-chem.co.jp/en/products/product_03_03.html

XZ-100P Brochure: http://www.sakai-chem.co.jp/en/products/pdf/muki_xz-100p.pdf

Regardless of the ultimate size of the zinc oxide sun care market, BASF’s dominance in chemical UV filters suggests that a high degree of market consolidation is a likely outcome, particularly if one supplier can secure significant and durable advantages in cost and quality.  For now, ANO appears to be rapidly gaining share following management’s operational overhaul, while competitors do not appear to be making major changes to their cost structure or production process.  Apart from Nanophase, ANO’s competitors are also much more diversified and may choose to focus on other rapidly growing segments of the nanoparticle zinc oxide market, which is growing at about 20% annually:

Source: https://www.alliedmarketresearch.com/nano-zinc-oxide-market/amp#aoh=15689701480437&referrer=https%3A%2F%2Fwww.google.com&amp_tf=From%20%251%24s

The total global market of UV absorbers for sunscreen and cosmetics is at least 40,000MT, 6,000MT of which is inorganic.  Of this 6,000MT, I estimate that zinc oxide may make up only 2000MT or less, as it was only approved in Europe as a UV absorber in 2016.  ANO delivered 292MT of Zinclear in FY2019 and has guided for a minimum of 1000MT to be shipped in FY2020.  As the global sunscreen market is only growing about 6% annually, Zinclear’s triple digit growth is likely a combination of taking share from competitors in zinc oxide, zinc oxide taking share from titanium dioxide in the UV mineral market, and minerals taking share from chemicals in the total UV actives market.

Valuation Model

The following slides from the Company’s August 2019 presentation give expectations for FY2020 production volume and revenue based on the “current pace of sales orders.”

August 2019 Presentation: https://hotcopper.com.au/threads/ann-investor-presentation.4908885/

Management has preferred to err on the conservative side in the past; their original FY2019 revenue guidance for Zinclear was $6.25m, which they ultimately exceeded by over 75%.  Their FY2020 projection, which would be a fantastic result, seems a bit light given the current price of their product and expected sales volumes.  The list price for XP Powder through North American distributor Deveraux Specialties is US$25/kg, or about AU$37 at today’s exchange rate.  This matches up closely with the Company’s average sales price in FY2019 of AU$37.87/kg.  If the Company can deliver the expected volume of 1,000MT at AU$37/kg, total revenue could reach AU$40m.

There could also be further upside to the volume estimate, which is less than half of their expected production capacity for FY2020.  Now that the Company has demonstrated the ability to ramp up capacity quickly while maintaining high quality, the big brands are likely circling to take up capacity as it comes online.  We have seen evidence on the shelves in Australia that suggests that Banana Boat has started using Zinclear in their Simply Protect line, which could find its way to the U.S. next year. 

The final sunscreen monograph is expected to be finalized and made effective by the FDA by November 26, 2019.  The U.S. market for UV absorbers is in excess of 10,000 MT, about 90% of which today is organic.  While the final monograph may allow the continued use of common chemicals pending more ongoing research to fill gaps in the required safety data, there are two rules that are likely to pass that heavily favor zinc oxide.  One is the previously mentioned broad spectrum requirements, which mandate proportional UVA protection that can only be met by avobenzone or zinc oxide.  Because avobenzone loading is limited to 3% (the FDA denied an application earlier this year to boost it to 5%), and due to its inherent instability in sunlight, this should lead to increased use of zinc oxide in formulations.  The second rule that is likely to pass is a requirement that active ingredients be listed in alphabetical order on the front of all sunscreen packaging.  This has the potential to the put the issue at the front of the consumer’s mind and could put considerable pressure on brands that continue to use chemical formulations in favor of relatively safe and simple zinc oxide formulas.

Whether revenue comes in at $30m or $50m, there should be a significant improvement in operating margins.  At scale, I think operating margins could approach 50%.  Thanks to more than $30m of accumulated losses prior to the change of control, the Company has a deferred tax asset of about $8m and will not start paying cash taxes until FY2021.

I peg FY2020 net income at somewhere between $10m and $18m.  At today’s market cap of $365m, that’s a forward P/E between 20x and 36x.  The median valuation for growth stocks on the ASX, defined as stocks forecast to grow EPS by more than 20% annually over the next three years, is nearly 40x.

Source: https://www.afr.com/chanticleer/our-growth-stocks-are-world-s-most-expensive-20190530-p51sml

ANO does not yet have analyst coverage, so there is no forecasted EPS out to year 3.  However, given that revenue and earnings growth have accelerated well into triple digit territory, I think it’s fair to say that ANO would belong in this cohort.  The current valuation does not seem to price in any potential upside to FY2020 guidance or continued growth in FY2021 and beyond.  Given the size of the addressable market, ongoing regulatory developments, and Zinclear’s competitive position and economics, I think it is not unreasonable to expect revenue to continue to grow at triple digit rates for at least the next several years.

I think it is less useful in this case to use peer valuations.  For one, the chemical UV absorber market is under serious pressure, so valuations should be compressed.  BASF is too large and diversified to make any relevant inferences from its valuation.  Nanophase is perennially on the brink of bankruptcy, EverZinc is private, and the Japanese comps are also too diversified and much more asset intensive.  In normal circumstances, revenues in this business should be quite sticky and recurring, as a typical cosmetic product lifecycle lasts between 7 and 15 years.  Once a formulation has passed SPF tests, companies run a big risk of not meeting their stated SPF by swapping out active ingredients.  There was one case years ago of a New Zealand brand that swapped out Zinclear for a competitor and had to pull out of the sunscreen business altogether once news broke that their products were no longer delivering their stated SPF.  Whereas in the past, ANO lost some accounts due to concerns over securing a long-term supply, the company now looks like the industry’s most capable of executing rapid capacity increases.  Relative to competitors, ANO’s revenues should now be considered the most sticky and recurring, as brand owners are currently reformulating existing products to Zinclear due to regulatory issues, cost, quality, and supply stability.  For new product formulations, Zinclear appears to be a no-brainer.

Ultimately the value of Zinclear will depend on what terminal market share it can achieve, in what time frame, and at what price.  If for instance, I assume that Zinclear captures a third of the global UV absorber market in 5-6 years, I get a present value of over $100 per share.  This is feasible for them given the return on capital of the new XP powder capacity, but certainly a lot must go right on the regulatory and consumer sentiment front to force the mass brands to reformulate with zinc oxide.  I’m going to argue that this qualifies as a value investment because the current valuation implies zero probability to the best-case outcome, also known as the Zincularity, when the actual probability is probably better than a coin flip, and anything in between the best and the worst case over the next few years should get you a market-beating result.

Management

Lev Mizikovsky is one of the best capital allocators I have come across.  If one is tempted to make the argument that the incredible result at ANO came down to pure luck, the counterpoint to that would be Lev’s original investment vehicle, the homebuilder Tamawood.  Since listing in August 2000, the total annual return has been 15.7%, while the annual return with dividends reinvested has been 23.7%.  The ASX 200, by comparison, has returned 6.3% annually, or 8.2% with dividends reinvested.  In addition to running the core business with a keen focus on ROIC and regularly returning capital to shareholders through dividends and share buybacks, the Company incubated and spun off two additional listed companies, Astivita (AIR.AX) and Senterprisys (SPS.NSX).  For those of you who read my write-ups on 1010 Printing and Opus Group, Lev’s track record makes me think of him as the Australian CK Lau, but that’s not entirely accurate because he was born in the Soviet Union and immigrated to Australia in his 20s.  

Lev has been in the news over the years for filing a couple of defamation lawsuits, including an ongoing case against the Board of Collection House (CLH.AX) and the ASX itself for publishing an announcement disparaging Lev in order to fend off a proxy battle he had initiated.  This pending litigation seems to have sparked an ongoing feud between Lev and the ASX, which has been unusually active in requesting more information after large price changes in ANO.  Never one to back down from a fight, last year he hired an expert road engineer to fight a $219 motorcycle fine.  At the risk of attracting a defamation lawsuit myself, I’ll admit that I think it’s probably a waste of time to be so litigious.  However, I do believe that Lev is spending most of his time on ANO, his ticket to becoming a billionaire.

ASX Defamation Suit: https://www.afr.com/companies/financial-services/false-claims-asx-targeted-in-defamation-lawsuit-20190425-p51ha2

CLH Rebuttal: https://www.collectionhouse.com.au/pdf/CLH-2018AGM-LettertoShareholders.pdf

Motorcycle Ticket Court Case: https://archive.sclqld.org.au/qjudgment/2018/QDC18-249.pdf

Previous Defamation Suit: https://www.theaustralian.com.au/business/latest/developer-lev-mizikovsky-faces-court-costs-after-losing-defamation-bid-against-a-current-affair/news-story/0a8773321ee6e631bae040a12da72f80

What stands out most about Lev is that he associates himself with very capable people and attributes his success to his willingness to listen to them. In his words, “the most important thing I’ve learned, quite early, is that generally people will volunteer amazing advice and suggestions if you allow them to.  In my view, if you are prepared to listen and learn, that’s pretty much all it takes to do well.  It’s incredible how many people have the knowledge and ability and are delighted to help you.  And it’s amazing how many people reject it because it’s not their own ideas.”

Lev Interview: https://www.youtube.com/watch?v=0o5gqdRzto4

Apart from his longtime associates Rade and Geoff, who have played critical roles in making ANO a success, Lev has also welcomed input from shareholders.  In the Company’s January 2019 presentation, the Board thanks shareholders Brian Kearney, Christopher Silvestro, and Giovanni Diaz for “their significant contribution to ANO’s business by suggesting new products and providing ideas and articles.” 

January Presentation: https://hotcopper.com.au/threads/ann-appendix-4d-investor-presentation.4618141/

It seems the relationship has warmed a bit since February 2016, when Brian and Chris were calling multiple EGMs and Brian attempted to join the Board.  The Company seemed less enthusiastic about his ideas then:

“Further, the question was raised by two shareholders regarding appointing them as Directors of the company. The Board has rejected this proposal as it would result in an approximate increase of $300,000 in Director’s fees and additional cost of management time to Antaria’s operational costs. One of the shareholders who has made the request, cannot be an independent Director as he controls more than 5% of the Antaria shares. At the time of their request we have not received any information regarding their relevant experience and / or knowledge.”

Comments on Board Composition: https://hotcopper.com.au/documentembed?id=uOMxKKzFkiWRTLKhOROKAxjvTUIN5Qy%2BpmGIr5lJ2%2Fk%3D

It was only a matter of time before all these guys recognized each other’s brilliance.  Brian apparently mortgaged everything he owned to build a 10% stake in ANO when it sported a market cap of about $10m, which was about the value of the Company’s off-balance sheet assets.  Then Brian and Chris proceeded to pass it forward by posting all their relevant due diligence, including AGM and EGM notes, for public consumption on the Hotcopper message board.  If you have read this far and still want to learn more, I would recommend starting there.

The Bigger Picture

When the University of Western Australia listed ANO in 2005, they threw in a lot of IP.  Management estimates the original cost of this R&D could have been somewhere between $100m and $200m, on top of the $30m+ of losses the company generated after listing.  After digitizing all the documentation, management began to comb through it to see if there was anything worth reviving and pushing further.  The idea is to do this in a lean way, through partnerships with other companies and universities that may have complementary assets.  I’ve spent a lot of time discussing Zinclear because that is where the value is today, but this may look like a totally different company in ten years.  There may be opportunities around spin-offs, asset sales, or joint ventures, and who knows, there could be something else on the server as big or bigger than Zinclear.  The optionality here is impossible to model, but I think it will turn out to be worth something with this team in charge.  In the long run, I think most of Lev’s focus will be on ANO, and this will be his main platform for value creation.

Catalyst

• Finalization of FDA Monograph in November 2019
• Capacity Increases in H2 FY2020
• Mass market adoption of Zinclear