SOLESENCE, INC. annual report, FY2019

Business context and reporting period

Issuer: Nanophase Technologies Corporation, which owns Solésence, LLC. This is the issuer’s Form 10-K for the fiscal year ended December 31, 2019—not a standalone Solésence filing or a quarter-only report. The company develops and manufactures engineered materials, personal-care ingredients and formulated skin-care products; it also sells advanced materials.

Financial performance and liquidity

• Product revenue was $11.852 million, down from $14.040 million. Other revenue rose to $657,000 from $153,000, including a $289,000 capacity-adjustment fee and a $211,000 one-time customer payment for bulk materials.
• By product category, personal-care ingredients revenue fell to $7.919 million from $10.573 million; advanced-materials revenue increased to $2.733 million from $2.253 million; and Solésence revenue increased to $1.857 million from $1.367 million.
• Cost of revenue declined to $9.893 million from $10.903 million, but gross profit and margin also fell. A $390,000 inventory write-down, mostly recorded in the fourth quarter, reduced gross margin by approximately three percentage points.
• R&D expense was $1.870 million, down from $2.057 million; SG&A was $3.542 million, up from $3.256 million. Interest expense rose to $210,000 from $58,000.
• Investing cash outflow was $740,000, versus $160,000 in 2018. Financing provided $3.365 million, including $1.677 million from a stock sale and $2.000 million of convertible-note proceeds.
• At year-end, current assets were $4.985 million and current liabilities $4.409 million. Debt included a $500,000 bank line, a $224,000 related-party revolving balance and a $500,000 related-party term loan. The related-party convertible note had $2.0 million principal, with a $1.170 million unamortized discount and $830,000 net carrying value. Capital-lease obligations totaled $506,000.

Material changes versus prior year

• Revenue declined 11.9%, primarily as personal-care ingredient sales to the largest customer decreased. That customer represented 63% of 2019 revenue, compared with 74% in 2018.
• Solésence sales increased, and the company reported more advanced-materials revenue, but these gains did not offset the decline in personal-care ingredients.
• Net loss widened by $925,000, while operating cash use more than doubled. The company also increased cash capital expenditures and relied on equity and debt financing.
• Shares outstanding increased from 33.912 million to 38.137 million following the 4.189 million-share sale to the largest investor.
• Adoption of the new lease-accounting standard added $2.119 million of operating lease right-of-use assets and $2.392 million of operating lease liabilities at year-end; the company said the effect on 2019 earnings was immaterial.

Outlook, risks and unusual items

• Going concern: The auditor’s report and management disclosures state that recurring losses and limited liquidity raise substantial doubt about the company’s ability to continue as a going concern. Management said available cash and borrowing capacity might not fund operating plans through 2020; no additional financing commitment was in place at filing.
• 2020 expectations: Management expected lower orders from its largest customer and anticipated further Solésence sales growth, potentially requiring additional working capital. It expected R&D spending similar to or modestly higher than 2019 and SG&A approximately 3% lower. Planned 2020 capital spending was $300,000–$800,000, subject to project outcomes and funding.
• Financing and dilution: The company may need additional funding on terms that could be unavailable or dilutive. The $2.0 million, 2% secured convertible note held by the largest investor matures May 15, 2024 and is convertible at the holder’s option at $0.20 per share; conversion could cover up to 10 million shares. The investor and affiliates held approximately 63% of the common stock.
• Customer and covenant concentration: BASF supply-agreement covenants require specified liquidity and inventory levels and can give BASF rights to technology and equipment if trigger conditions occur. A customer loss, lower orders or covenant breach could materially harm revenue and operations. BASF’s expected order reduction adds pressure to liquidity.
• Debt maturities: The Libertyville credit facility was due April 4, 2020; the company said it intended to renew it. A March 23, 2020 amendment extended Beachcorp loan maturities to March 31, 2021. The Beachcorp facilities are related-party financing secured by company assets.
• COVID-19 and suppliers: The filing described uncertainty about pandemic-related disruptions to customers and suppliers, including sole-source and Asian suppliers, and said the potential financial impact could not be estimated as of filing. The company believed its operations qualified as essential under Illinois’ order.
• Other items: No material pending legal proceedings were reported. The company reported no income-tax provision and approximately $77 million of tax net operating loss carryforwards, some subject to ownership-change limitations and expiration.

Important facts for investors to verify

• Whether the company renewed or replaced the Libertyville facility and secured enough financing to meet working-capital needs and fund 2020 plans.
• Actual BASF orders, compliance with supply-agreement liquidity and safety-stock covenants, and whether any technology-transfer or equipment-sale trigger arises.
• Whether Solésence growth can offset ingredient revenue declines while improving gross margins and reducing cash consumption.
• The convertible note’s conversion, dilution and related-party terms, including the potential issuance of up to 10 million shares.
• The realized effect of COVID-19 and supplier disruptions on sales, production, cash flows and the going-concern assessment.