SECOND QUARTER 2005 CONFERENCE CALL

Joseph Cross, President and CEO

• Welcome to the Nanophase conference call to discuss the Company’s record second quarter and first half 2005 revenues. The Company had a strong quarter and first half and we are pleased that you are taking the time to be here today. Jess Jankowski, Nanophase’s CFO, and I will be hosting this session. To begin the review, Jess will summarize the financial highlights of the quarter and first half. Jess….

Jess Jankowski, CFO and Controller

• Good afternoon!

• As I review the financial performance of the Company for the second quarter and six-month period, I‘ll continue to do so at a strategic level, highlighting points of specific interest and significant variances. More details are included in the financials that accompanied our press release earlier this afternoon.
  All numbers will be in approximate terms for ease of discussion.

• Total revenues for the second quarter of 2005 were up $543K, or 35%, compared to the second quarter of 2004. Total revenues for the six months ended June 30th were up $863K, or 30%, compared to the same period in 2004.

  For the six months of 2005, Product Revenue was up 50%, to $3,526K, a new Nanophase record. This increase was largely composed of sales of sunscreen materials and growth in sales of personal care materials to BASF, plus the $375K in material that was shipped to a new customer in the medical diagnostics market. This $375K sale reflects business that, we believe, should be annual in nature, but may not repeat next year at the same level. At this point, it is too soon to tell. We also saw Rohm & Haas Electronics Materials taking product in keeping with their commitment for 2005. More to follow on this in the margin discussion.

• For the six month periods presented, Other Revenue was down $309K. This decrease in Other Revenue, when compared to the same period of last year, related to the Company recognizing the first two quarterly payments of $150K, or $300K in aggregate, in technology development funding from Rohm & Haas in 2004. This funding was part of its $600,000 commitment to support Nanophase’s efforts in jointly developing slurry products for current and future semiconductor technologies during 2004.

  Rohm & Haas’ commitment to Nanophase for 2005 will ultimately be greater, and be in the form of product sales. As discussed previously, we began shipping to this product commitment in Q2 of this year.

• We have generated a positive gross margin of $659K for the 2005 six month period. About $490K, of this was margin purely on product sales. We view this as a validation of our business plan and our financial modeling. As we continue to discuss, our margins have been impeded by not having enough revenue to absorb the manufacturing overhead that’s required to work with the customers we have and the new ones we expect to have. The additional product revenue this quarter showed that, as volume grows and manufacturing overhead is absorbed, our solid variable margins have an appreciable impact on gross margins. The medical diagnostic material I discussed earlier helped to give Nanophase an excellent product mix for this period. Had that material been our lowest margin volume material, we still would have had around $400K in gross margin on product sales.

  This continued validation of our business model is an important financial turning point.

  As the Rohm & Haas and Altana volumes begin to grow this year and next, our typical margins will continue to grow. The variable margins on the materials we sell to BASF, which are still the lion’s share of our sales, are typically lower than those we expect from our other customers in different applications.

We are on the path to profitability.

Moving down the P&L….

• R&D Expenses were relatively flat period to period. In SG&A, which was up 8% over the six month period, we saw increases in auditing and SOX-404-related expenses and compensation, offset by reductions in legal fees, business insurance costs, and other items.

• In total, the Company lost $0.14/share for the first six months of 2005 versus $0.17/share for the same period last year. Note that depreciation and amortization amounted to about $0.04 cents per share, or $640K of the Company’s loss for the first half of 2005.

• Moving to the balance sheet, Nanophase ended the second quarter with $8.9 million in cash and investments compared to about $11.6 million at the end of 2004.

• Looking at cash burn, we used $2.4M for operations and about $280K for capital improvements in Q1 and Q2 of 2005.

• Note that accounts receivable were $679K higher than at year-end. This created a working capital drain due to timing more than anything else and should swing back favorably as the year progresses. Forty percent of the June 30 Trade Accounts Receivable was paid before the second week in July.

  The Company also reduced debt by $238K in the first half. Management expects the note to BASF, currently at $343K, to be paid off no later than mid-2006.

  In terms of gauging future cash burn, last year, Nanophase used an average of $1.2M per quarter in operations and $175K for capital improvements and capitalized patents. Management expects 2005 operational cash burn to be lower than in 2004, heading toward a planned positive operating cash flow run-rate by the end of 2006, assuming revenue growth continues as currently forecasted. Capitalized expenditures should be a little higher, with patent costs being the component that is more difficult to predict.

  As an administrative matter, I would like to discuss our new conference call timing. In order to accommodate those of you that have difficulty focusing on earnings calls occurring during market hours, we have decided to try afternoon press releases followed quickly by our earnings call. We hope that this will work better for all of you and help to stimulate further interest in Nanophase.

• Thank you for your attention, now I'd like to turn things back over to Joe Cross, our CEO.

Joseph Cross, President and CEO

• Thank you, Jess

• Let me emphasize a couple of critical financial points Jess covered and ensure that the connection between the Nanophase’s operational strategies and its resultant financial performance are clearly communicated. Again, all numbers will be approximated for ease of discussion.

  • As I stated in the opening conference call of 2005, management’s first priority is to grow revenue. Relative to sequential revenue growth, revenue increased 62% from the fourth quarter of 2004 to the first quarter of 2005, and then increased 29% from the first to the second quarter of 2005. We reached record Company revenue in each of the first and second quarter of 2005. While we do not expect such dramatic material increases every quarter, it appears that we have reached a new revenue operating level and we remain positive about overall revenue growth during 2005 and in the future.

  • For several quarters we have made a couple of critical points about the Company’s financial performance that need to be understood. First, our business model and corresponding financial models predict that gross margin grows quickly with increasing volume and continued Company efforts to reduce variable manufacturing cost. Nanophase has the ability to increase output volumes without significantly increasing manufacturing overhead costs and a consistent track record of reducing variable manufacturing costs. We have actually made significant progress on this during the first half of 2005 as I will discuss later. The net effect of reduced variable manufacturing cost and increased volume is gross margin growth. As we noted in the earnings release, gross margins in the second quarter of 2005 equated to 24% of total revenues versus 7% in the same period last year. For the first half of 2005, gross margins averaged 18% of revenues versus 7% in the same period of 2004. Stated differently, gross margin dollars were about 3.4 times greater in the first half of 2005. This is a result of both increased volume and continuing decreased variable manufacturing costs, which, we believe, affirms our business and financial models.

• Moving from financials to an overview of the Company’s performance in the first half of 2005, let me begin by reviewing operations and engineering. Building on our momentum in continuous improvement, variable manufacturing cost reduction, and gross margin growth, we again made excellent progress during the second quarter and first half.

  Viewing improvement over the first half,

  • We continue to increase PVS reactor rates, which equate directly to output per hour, and have achieved an increase of about 35% during the first half of 2005 compared to the average rate throughout 2004. This results in a twofold financial improvement: first, it reduces capital required for investment in new reactors as volume grows since total output or production capability is increased by a similar number and, secondly, increased output rates reduce variable cost per unit. With all improvements to-date during 2005, the Company has increased total capacity on existing equipment by 40%. As a side note, Nanophase has now increased reactor output rates by an aggregate greater than 700% over the past five years.

  • In conjunction with rate increases, we have been able to increase PVS reactor yields by 3% and improve equipment uptime, or reduce the downtime required for maintenance, which, again, reduces variable manufacturing cost and increases total capacity.

  • During the last quarter, Nanophase’s facilities were recertified to ISO9001 and certified to ISO14001, the international environmental management standard. While these certifications clearly reflect the Company’s world-class operations, they are also vital to our revenue growth plans since the designations are required to attract and retain potential large customers.

• New nanomaterial development based on market pull continues in several areas. While we are unable to discuss specifics, the Company has a rather robust new nanomaterial development schedule that already stretches into 2006. To expedite new nanomaterial development based on market-pull, we have and are taking two definitive actions.

  • First, we have designed, fabricated, and will be installing a second-generation NanoArc Synthesis reactor that will be dedicated to ultra-transparent nanomaterials for UV attenuation and abrasion or scratch resistant coatings, primarily for our relationship with BYK Chemie, which has several new products envisioned for these nanomaterials based on market needs from its customers. The second generation reactor has been designed to produce approximately 20 nanometer nanoparticles at high production rates.

  • Secondly, we have decided to build and install an additional NanoArc reactor based on product and product development demand. We currently expect this reactor to be funded by a loan from one of our market partners. Once all the details are finalized, we plan to make the appropriate announcement.

• Relative to revenue growth in 2005 and forward, we remain positive. We are encouraged with the 50% increase of first half 2005 product revenues year-over-year and the progress of our market partners. We continue to believe that expected revenue growth will be driven by our market partners and Nanophase’s internal business development initiatives.

• Beginning the revenue growth discussion with our market partners, BASF’s sun care and personal care product demand continues to grow. Organic growth in the original product lines, which are trademarked as Z-Cote, that we were expecting to increase around 25% during 2005, now appears to be in excess of 30% for 2005. Based on recent discussions with BASF, we have been led to expect continuing organic market growth throughout 2005 and into 2006.

  As you may recall, BASF loaned Nanophase $1.3 million to purchase and install nanoparticle coating and packing equipment to support the initial sun care and personal care business. Since Nanophase has been designated a strategic partner, BASF has agreed to extend the original loan for equipment until June 2007, or an additional two years. However, based on expected volume, we believe that the loan should be repaid by our normal discount on product pricing during early 2006. Once repaid, Nanophase expects to see about $500,000 improvement to the Company’s annual cash flows.

  • In the new product area, the second generation sunscreen, trademarked Z-Cote Max, which was developed using Nanophase’s patented nanoparticle coating technology, is now well into the initial market introduction phase and appears to gaining solid acceptance based on our feedback from BASF. You can access information on this product at www.Z-CoteMax.com. While BASF believes that there is solid market interest and demand for the new product, it is too early to predict volumes and revenue impact for Nanophase. However, we believe that the production ramp should begin in early 2006 and positively impact revenues in 2006.

  • Continuing with new products, during the last quarter we signed specific development agreements with BASF for two new personal care products. Product development, testing, and market evaluation is underway.

    Additionally, there are three new products under consideration and in various stages of development.

  • In summary, revenue growth through our partnership with BASF is expected to be driven by organic market growth in current products, new revenue from the second generation sunscreen, and new products development and market introduction.

• Turning to semiconductor CMP, Rohm & Haas Electronic Materials CMP Technologies appears to be building momentum in the marketplace and remains upbeat for 2005 and 2006. We continue to expect revenue growth of about 25% in 2005 over 2004. Development also continues for new slurry products in the copper and tungsten technology nodes.

• BYK Chemie and Nanophase continue development in several product areas. Development efforts range from new product market introduction to product development, which has several levels, to new nanomaterial development. We continue to believe that our market relationship with Altana Chemie will be a material revenue growth area for the Company over the next three years and the foreseeable future.

• Moving to business development, we added new customers during the first half of 2005.

  • First, we are pleased to have received the first production order for a medical diagnostic application from a multi-national company, which we are not at liberty to identify. Based on forecasts from this customer, we expect this to be a continuing annual business

  • As we stated previously, we continue to grow our glass polishing business, which is a rather fragmented market, primarily for high-end applications. We added two new customers and continue to expect to grow revenues from these applications over time.

  • Lastly, we have previously discussed the potential of securing a major new customer and accompanying revenue stream. That situation continues to mature. There are two products involved that will be distributed through a big box retailer. According to our customer, the first product has been approved by the big box and is now expected to start hitting retail shelves in August and be in full retail distribution by Labor Day. Nanophase has already delivered nanomaterials for this product. The second product, which is the large volume and potential revenue stream to Nanophase, is still in the cycle between our customer and the big box. While plans have changed several times and may again in the future, our latest current information is that our customer expects this should move to retail introduction at the big box during the third quarter of 2005. When this occurs, we will, of course, make the appropriate announcement. Once ramped and in full volume production, we anticipate, based on customer information, that this should be an annual revenue stream of $1-2 million.

• Our other business development initiatives continue to progress. The business development pipeline remains robust and growing, and is more active than at any time in our history. We believe that current growth with our market partners and new customer additions from vigorous business development should support our aggressive revenue growth plans for 2005-2006. This concludes our prepared remarks; we are now open for questions.