Description

This is a microcap idea only suitable for PAs (only small and patient PAs)

Nanophase (OTC:NANX) is a microcap R&D and contract manufacturer for high end sun protection cosmetics trading at ~1.3x 2023 revenue ($45mn) assuming they hit sales guide of ~30% this year for their key new business line which is positioned to tap long term trend of increasing use of mineral sunscreen (zinc based instead of chemical), cosmetics incorporating sun / skin UV protection agents, and growth of niche brands from creators/celebrities, which collectively make several years of 30% growth possible for the unit. 

Since the time NANX was founded in 1989 the company has seemed more of a research organization in search of a product than a company. But in 2018 they finally landed on a product in high demand based on their years of research into nanoparticles: UV protection in high-end cosmetics.

Since then the company has transitioned its business model from selling large quantities of zinc oxide to BASF, which acts as a distributor, to also formulating, designing, manufacturing and packaging consumer sunscreen and cosmetics (white labeled) through a subsidiary called Solésence. They are aiming to be a one stop shop for any brand wanting high end UV protection cosmetics.  

Management have struggled with the manufacturing ramp up and seen gross margins decline as they try to scale Solésence without the correct processes in place and an over reliance on employee overtime etc – there have been a litany of manufacturing issues. But they may now be on the verge of turning the corner as they shift lines to a new larger facility and automate more of the fill and packaging. They were slightly profitable in ‘21 and estimate they will be again this year. 

The production hiccups and a lawsuit from BASF (their largest customer) have contributed to NANX 65% share price collapse over the past year, presenting a good entry point for a company that should have years of growth ahead. Average volume is only about $30k a day and NANX’s largest shareholder family owns 66% of the company and continues to buy shares in the ~$1 range, somewhat providing a floor for the share price. 

BASF lawsuit

Most concerning is the BASF lawsuit. BASF has long been NANX’s largest customer and has an exclusive relationship for buying some forms of zinc from NANX. NANX’s shift to selling zinc products to other brands prompted BASF to sue over breach of the exclusivity clause. BASF and NANX are in negotiations to settle and we think the two parties will eventually make a deal instead of taking it to trial. Positive resolution will remove a major overhang for the stock.

NANX started its second business providing Zinc products to prestige consumer care groups in ~2018 but BASF didn’t intervene with a suit until August 2022. From reading the complaint it seems NANX’s inability to provide BASF with promised volumes and appearance of prioritizing its own business was a trigger for the suit. NANX management claims to have been caught off guard by its filing. 

The heart of the dispute is over the exclusivity agreement in the BASF / NANX contract. BASF argues that NANX must exclusively sell all types of zinc to BASF, whereas NANX believes the exclusivity provision only applies to certain zinc formulations. Unfortunately for NANX their lawyers did not make that crystal clear when the first exclusivity agreement was drawn up in 1999. This is how that clause reads: 

2.1. Nanophase Exclusivity. Nanophase covenants that, during the term of this Agreement and for two years after effectiveness of any termination of this Agreement, Nanophase will not, directly or indirectly, knowingly sell zinc oxide to any person other than Purchaser for use in the Field or resale (directly or indirectly) to any person for use in the Field.

BUT other parts of contract including the first lines stipulate that the contract concerns purchase and sales of “zinc oxide meeting the specifications set forth in Exhibit A”, and NANX lawyers argue that the exclusivity clause only relates to the zinc formulated as prescribed for in Exhibit A. They cite case law arguing that any contract must be read as a whole instead of referring to a specific unclear line. 

NANX and BASF have updated the agreement several times since 1999. NANX put forward amendments in 2019, after Solésence was already started, but didn’t seek to change the exclusivity wording, indicating management didn’t believe that they were breaking the exclusivity clause with Solésence.

CEO Jess Jankowski says: “that contract as far as we are concerned, involves the sale of ingredients, active pharmaceutical ingredients or APIs, and their [BASF] perspective on it has been -- it doesn't matter where they go. We think we as BSF, should control that. And that's never been our understanding of it.”

BASF is asking for damages and for a judge to halt all NANX zinc product sales to other customers. Clearly NANX lawyers / executives should have ironed out the BASF contract before starting Solésence. But we think there is room for BASF and NANX to find a compromise. Solésence sales of zinc formulated cosmetics and sunscreen are into the prestige, high end cosmetic market. BASF distributes NANX’s zinc to mass market sunscreen makers (Coppertone, Banana Boat, Hawaiian Tropic).

A possible favorable resolution would cancel the exclusivity provision and maintain some form of a supply relationship for mass market zinc. BASF has continued to buy zinc from NANX and NANX management insists BASF does not want to terminate the supply deal. In June both BASF and NANX petitioned to extend discovery 120 days to continue negotiations:

In an effort to maintain the parties’ professional relationship, BASF and Nanophase have entered into settlement negotiations to explore potential resolution of all claims. To facilitate the ongoing negotiations, the parties have agreed to numerous stipulations including filing a motion to extend the discovery deadline until December 31, 2023. 

BASF lawyer email to NANX lawyers in mid-June said: 

In accord with our conversation earlier this afternoon, BASF proposes that each party mutually withdraw each pending deposition notice, with the right to re-serve such notices on or after July 15, 2023. At that point, both parties will meet and confer on a mutually convenient schedule for all party depositions. Similarly, we propose the parties file a joint motion to extend the case discovery end date to December 31, 2023.

So that the parties can continue to focus on settlement, we likewise are willing to extend Nanophase’s time to answer the outstanding interrogatories for thirty (“30”) days from the current due date.

It looks possible BASF / NANX will reach a settlement soon. Any trial is a long way off and it’s hard to judge NANX’s odds at this point.   

NANX business

The main growth driver is Solésence which custom develops sun protection cosmetics and offers brands market-ready products, both done on a white label basis. Solésence basically plants a bunch of seeds and reaps rewards when any single brand takes off. Currently they have near 80 different customers, with 2-4 products per customer.

They have pioneered formulations of zinc for use in cosmetics that don’t turn your face white, and can be used in different color cosmetics. Their formulations have won lots of industry awards. They also do research studies to provide their customers with a set of consumer claims to be used in marketing. Some of the formulations or coatings are patented and trademarked, like one they call “Active Stress Defense”. Some sample claims they provide customers: “Protects the skin from 98% of UV radiation”. “Reduces pollution-induced free radicals by over 85%” “Blocks more than 35% of blue light”, etc.

Here are how some of the brands market the claims: 

“Formulated with Active Stress Defense™ technology to protect against 97% of UV radiation.” Naomi Osaka’s Kinlo line uses the research in product descriptions.

Another brand partner Colorscience trademarks terms itself but points consumers to research done in conjunction with NANX. A Colorescience exec described it thus in a recent interview:

“We have always only used zinc oxide and titanium dioxide as our sun protection active ingredients. With our technology partner, Solésence, we have developed a patented and proprietary triple-coated mineral formulation called EnviroScreen, which has been tested, proven, peer-reviewed and published to show how our Total Protection Products go beyond SPF and protect skin from UVA, UVB, HEV (blue light), infrared radiation and pollution.”

Some brands don’t use any of the claims but still use NANX formulations and manufacturing, like Cetaphil, which are captured in an OTC medications registration database. 

Sunscreen market

The FDA regulates sunscreens as OTC drugs and has a list of chemical ingredients industry is allowed to put into them, known as the Generally recognized as safe and effective (GRASE) list. Currently the list includes 16 UV reflecting ingredients, but most have not been studied for possible effects on people’s health and have essentially been grandfathered in from when sunscreen was invented in the 1950s.

Starting from 2019, the FDA has reconsidered what ingredients are allowed in sunscreens. In 2021, FDA put out a proposed final order that demands industry do more research on 12 of the ingredients to be included in an updated GRASE list for sunscreen. 

Zinc oxide and titanium dioxide (which NANX supplies) are the only two ingredients proven to be safe and included in the updated GRASE list. Two of the ingredients PABA and trolamine salicylate have already been phased out by industry and will be removed from the GRASE list. 

That leaves industry responsible for carrying out research on the 12 other chemicals. An FDA monograph from 2019 notes increasing use of sunscreen and frequent application has made the systemic nature of these other 12 chemicals more concerning, requiring studies. (They are Cinoxate, Dioxybenzone, Ensulizole, Homosalate, Meradimate, Octinoxate, Octisalate, Octocrylene, Padimate O, Sulisobenzone, Oxybenzone, Avobenzone.)

Some of the FDA comments:

“A growing body of data has suggested that the transdermal absorption of some sunscreen active ingredients is greater than previously thought, and thus may raise previously unevaluated safety concerns, including the potential for reproductive, developmental, or carcinogenic effects.

“We note that a recent publication examining the relationship between melting point, molecular weight, and the transdermal delivery rates of the active ingredients in approved drug products shows that products containing active ingredients with melting points and molecular weights similar to many of these 10 sunscreen active ingredients are among those successfully delivered transdermally—and therefore available systemically.

The potential for such systemic exposure is a concern because the available data are inadequate to determine either the level of systemic exposure to these active ingredients or the potential unintended consequences of such exposure.

Oxybenzone is absorbed through the skin and can lead to significant systemic exposure, as well as data showing the presence of oxybenzone in human breast milk, amniotic fluid, urine, and blood plasma.

In the new study, we tested absorption of active ingredients contained in four commercially available sunscreen products (lotion, aerosol spray, nonaerosol spray and pump spray). While additional data are needed, results showed that all six active ingredients were absorbed into the body’s bloodstream – even after a single use. An additional finding from this new study is that once absorbed, these active ingredients can remain in the body for extended periods of time. This study evaluated absorption of the active ingredients avobenzone, oxybenzone, octocrylene, homosalate, octisalate, and octinoxate.”

Only Zinc and titanium dioxide don’t have transdermal absorption properties. Oxybenzone and octinoxate, some of the most widely used chemicals, have been banned from sunscreens in Hawaii and some other regions for their impact on fish and coral reefs. 

The FDA gave industry and the public until the end of 2021 to submit public comments on the updated sunscreen rule. Since then it has been reviewing comments (already 1.5 years) and has said it will issue the final order once it is finished reviewing all the comments – so perhaps in the near term. 

Unless industry presents research to the FDA showing the other 12 ingredients are safe, none will be included in the final order. But as long as industry is carrying out research on the ingredients, it will allow them to defer being left off the GRASE list. So even though the FDA is likely to issue a final order soon, the other ingredients will not immediately be banned.

Industry formed a trade group (PCPC Sunscreen Consortium) to study 7 of the 12 ingredients and estimates the need for time- and cost-intensive tiered studies (approximately $10-$12 million per filter (ingredient)).

Depending on the results of studies, eventually all of NANX’s competing sunscreen ingredients could be phased out of the sunscreen market, which would be huge for its mass market BASF business at the very least. This is chart of US zinc market share from a NANX competitor – NANX supplies BASF: 

Already growing consumer awareness is causing a shift to mineral (zinc & titanium) sunscreen away from chemical sunscreens, especially in the high end of the market. 

Solésence business:

Solésence business has grown from $2mn in 2019 to $23mn last year. But NANX gross margins have actually fallen from 35% in 2020 to 22% last year as NANX insourced filing and packaging for Solésence to become more of a complete R&D contract manufacturer solution for brands. 

Management has done a poor job of planning and executing on scaling manufacturing and last year over promised and under delivered on timelines. But they are running on a shoestring budget, growing quickly and were doing it at a tough time supply chain wise. Jess the CEO is also the CFO. 

They have recently expanded into a new 260,000 square foot facility in the Chicago suburbs (Bolingbrook) which will eventually consolidate all of their assembly lines in one place but has also added $1mn dollars of facility costs weighing on gross margin in q1. They also installed a new director of manufacturing to help on execution.

They are in the process of automating assembly lines – on earnings calls they have given conflicting updates on the timelines. It seems the majority of the Solesence filling and assembly process should have been moved to Bolingbrook and automated by the end of Q1. They’ve indicated more automation equipment is on the way to be installed in Q3/Q4. 

This is a bet that they will get the short term manufacturing issues sorted this year or early next – and if they don’t that the majority shareholder will replace the CEO or the COO.

NANX also has NOLs of $56mn and has bounced between profitability and losses. BASF suit lawyer fees and repeated cybertheft weighed on profitability in Q4 and Q1. Management said starting from Q2 they will be profitable (they made similar promises for Q1 but didn’t deliver).

Capex has been in the $1-6mn dollar range per year and funded mostly by cash flow and relatively cheap loans from the majority shareholder. Capex projections for ‘23 are $3-6mn funded by profits, and existing and new credit. Currently they have the below borrowings (AR, inventory, term, all at prime +.75%) from the majority shareholder all subordinated to a revolver from Libertyville Bank & Trust.

And in May an additional $1.75mn note from the majority shareholder at prime +.75% to cover lease improvements that should be repaid by new landlord.

Steady state gross margins

The value of the business will come down to what steady state gross margins look like. Kevin (COO) says in 1-2 years they can be north of 35%. Q1 was 23% and management says they can increase to 25-30% in coming quarters this year. 

Pure contract manufacturing cosmetic competitors like Intercos have 21% gross margins, Croda in the UK has 23% operating margins for its consumer division, Coty, which licenses brands and has some of its own brands has 64%, DSM has 32% and Australian bulk zinc sunscreen supplier Advance ZincTek Limited has 62%. So it’s a bit all over the map. 

We think 40% gross margins by 2025 is very attainable. Assuming 30% growth for Solésence continues and minimal growth for retained BASF business, that puts current share price at 7x our estimate of 2025 earnings. A 20x multiple gets to $3.5 a share, or a 34x multiple similar to Intercos could get to $6.6 a share. (Estee Lauder took out DECIEM in 2021 at 5x LTM revenue.) 

Any move and success with building their own consumer cosmetic brands or in-licensing of brands for cosmetics (a path some groups have taken) could vastly raise gross margins and the value of the business. 

While management has struggled with manufacturing, they have done a good job with R&D and brand building for Solésence. They are also doing a good job of building up a portfolio of research studies, consumer claims, trademarks and patents (10 patents and 8 pending) to build a moat around the business. Their plant is compliant with cGMP for FDA products. 

Majority shareholder:

Brad Whitmore and sister Janet (chair of board) own about 66% of outstanding shares. Over the past year they have consistently bought more below $1 outside of black out periods around earnings. 

Whitmore is a chairman and director at other small caps. He has been the Managing Partner of Grace Brothers LP, an investment firm since 1985 but owns almost all NANX shares in personal capacity.

Cheapish financing he has provided has been undoubtedly helpful for NANX. The only problematic deal was in Nov 2019, when NANX expanded to provide additional volumes to BASF based on their 2018 requirements, but which did not materialize. In November they were left close to running out of cash and Whitmore had to step in at the last minute with $2mn which he made the company pay dearly for. It was convertible into 10mn shares, or 20 cents a share when shares were trading at 40 cents and expanded outstanding share count from roughly 38mn to 48mn when converted in 2021. 

Whitmore’s approval will also be needed for an uplisting to Nasdaq or AMEX which management have been talking about for ~2 years. From recent commentary it sounds like they want to get manufacturing problems ironed out and profitability secured before doing it, making it a likely 2024 event, which would greatly help with share volume. 

Whitmore’s plan for the company is unclear. He’s 66 years old so could look to sell at some point. 

Risks:

Unfavorable resolution or dragged out BASF suit

Capital raise and dilution to support ramp up

Continued manufacturing issues and sub par execution -- somewhat lessoned by fact Whitmore could step in if these aren't solved 

Early buyout by majority shareholder

Increased competition in high end UV cosmetics

Catalyst

BASF lawsuit resolution

Manufacturing ironed out and automation completed

Return to profitability in Q2 as forecast by management, results come mid-August

Nasdaq uplisting

FDA final order on sunscreen and gradual banning of chemical ingredients