THIRD QUARTER 2003 CONFERENCE CALL

Joseph Cross, President and CEO

• Welcome to the Nanophase conference call to review the third quarter for 2003. Nanophase attendees for this session, beside me, are Jess Jankowski, VP and Corporate Controller; and, Dan Bilicki, VP of Marketing and Sales.

• The agenda for today's discussion is, first, Jess will review the financial results for the quarter. I will then return to summarize the Company's progress during the quarter and update business and market development initiatives. After our prepared comments, we will be available for questions.

• Jess, would you please review the financial results?

Jess Jankowski, CFO and Controller

• Good morning and thank you for your continuing interest.

• Please remember, all numbers are approximate. For the third quarter of 2003, our revenues at $1.24million are essentially flat compared to the same quarter last year. For the nine-months ended September 30, '03, our revenues were $4.2million versus $4.3million for the same period last year, a 2 percent decrease. Given quarter-to-quarter variability, for purposes of today's discussion I will speak mainly in terms of nine month comparative numbers which are more representative of the financial condition of the business.

• Lower product sales to our largest customer, combined with essentially no volume from two of our smaller-but-consistent customers for the first nine months of 2003, has resulted in a reduction in product revenue of $280,000 for the period. These two smaller customers have taken relatively consistent volumes of materials for the past several years and, relative to the Company's revenue expectations, originally thought that 2003 volumes would be similar to those of 2002. This reduction was partially offset by sales volume from Rodel, which we expect to be our second largest customer in 2003.

• Nanophase had $263,000 in gross margin for the nine months of this year versus a $541,000 gross margin for the same period in '02.

  Analyzing a bit more, we see that the decrease in margin has been driven mainly by the increased depreciation along with the relative proportion of what we know to be our minimum required manufacturing infrastructure to support and expand the business. As volumes grow, more of these fixed costs will be absorbed. Based on Q303 data, annualized depreciation expense recognizable as part of fixed costs of manufacturing amounts to $1.1 million.

• On the whole, management expects that gross margins for the year should be positive. Given our visibility, quarter-to-quarter variability in various margin drivers, such as product mix and volume, are difficult to predict. We continue to aggressively attack variable product costs.

• Further, research and development expense is up about $156,000 from the nine month period last year to the same period of 2003. This increase relates mainly to new product development costs fueled by our NAS reactors and the expanded palette of nanomaterials that are now available and, to a lesser extent, additional depreciation expense.

• SG&A increased by $134,000 in the first nine months of 2003 compared to the same period last year.

• There were a few compensating changes within SG&A expenses that will impact future costs. Director compensation appeared to go down by $133,000, due to a change in recording convention and related one-time charges in 2002. An offset to this favorable variance was that business insurance costs and legal fees relating to our current securities litigation increased by almost $360,000. I will speak more to this later.

• On the bottom line, we lost 29 cents per share for the first nine months of this year versus 26 cents per share for the same period in 2002.

• It should be noted that, on an annualized basis, the Company will now recognize approximately $1.5 million, or 10 cents per share, in depreciation and amortization expense. This total is up $300,000, or 2 cents per share, from the annualized number at September 30th of last year. Without this additional depreciation, the loss per share for the nine months ended September 30th, 2003 would have been 27 cents per share.

• I continue to mention, as it is a passion around here, that management has not let up in terms of cost containment. We have been driving discretionary costs out of the business wherever we can. Part of the cost escalations, or seeming lack of substantial cost-reduction progress, you're seeing relates to those costs that are tough to control. Insurance and legal costs continue to be difficult to manage. There should be some relief with respect to insurance costs in 2004 as many insurers over-reacted to various factors prior to pricing D&O and other coverages for the 2003 policy year. Legal fees should also begin to go down now that the Company has reached settlement in the current litigation. On the downside, Audit fees, along with securities-related legal fees, continue to climb with the advent of all the new shareholder protection legislation that has been passed in 2002 and continues to be expanded in 2003.

• Now let's walk through the major categories on the September 30, 2003 balance sheet:

• Again, all numbers are approximate….

  • We exited the third quarter with $6.2million in cash and investments. This included $2million in proceeds from the private placement of 453,000 shares of Nanophase common stock with Grace Brothers Ltd. on September 8th.

  • Accounts Receivable amounted to $800,000. 98% of this balance is current and management expects all of it to be fully collectible.

    Receivables from the Company's largest customer, plus those from Rodel, its largest polishing customer, and CIK, its Japanese licensee, amounted to 97% of the total.

  • Moving down, Inventory has decreased by $140,000 between the end of 2002 and September 30th of this year. For the nine months ended September 30, '03, inventory turns amount to SEVEN times annualized total sales. Keep in mind that this number was five and a half turns at December 31st of 2002. Also keep in mind that Nanophase is often subject to rapid changes in its customers' demand for product on a quarterly basis. Given our current visibility, which is still not much better than 60 days, and our reliance on a few significant customers for the bulk of our volume, quarter to quarter inventory comparisons don't always yield meaningful information. Inventory control is another issue we're quite passionate about around here, and we continue to manage inventory closely.

  • Nanophase anticipates spending approximately $325,000 in capital for new projects in 2003 along with some smaller expenditures to close projects that began last year. For comparative purposes, the company spent a total of $1.7million during 2002.

  • Lastly, I would like to address the Company's $1million dollars in long and short-term debt. The majority of this, which is currently classified as both current and long-term, reflects funds received against the previously discussed $1.3million loan from our largest customer which is being paid back on a per unit of product shipped basis.

• Before I give it back to Joe, remember that all of our EDGARized public securities filings, including financials, and all of our current press releases are accessible via our new website at www.nanophase.com. The new site also has a lot more information describing our wide array of available nanomaterials and products and their related markets and applications. We think you'll like what you see there.

• Thanks again, now I'd like to hand things back over to Joseph Cross, our President and CEO.

Joseph Cross, President and CEO

• Thank you, Jess.

• Since Nanophase's operational progress during the third quarter, which was again quite outstanding, was adequately summarized in the earnings release, I would like to spend my time today discussing the Company's actions to increase revenues - this is clearly our most pressing priority. The third quarter and 2003 to-date have been most frustrating in the revenue short-fall from existing customers. Entering 2003, as is our typical process, we gather forecasts from existing customers relative to purchase quantities by quarter so that we can plan adequate resources to perform to expectations. This year, economic conditions have rendered our customer's 2003 forecasts extremely inaccurate.

  As we outlined in the earnings release, Nanophase has experience unplanned short-falls in orders for sunscreen nanomaterials versus 2002, abrasion-resistant flooring, and catalytic converter markets for the reasons stated in the release. Photomask polishing nanomaterial dispersions have been down in the first three quarters due to the softness in the semiconductor market. Had our customer's forecasts actually materialized as stated entering 2003, the Company would be approximately 20% ahead of 2002's revenue rate for the first three quarters.

  While all indications are that economic activity in the manufacturing sector, which is our marketplace, continues to lag, we currently believe that most, if not all, of the above mentioned markets should recover in 2004. Obviously, a loss of $900,000 in expected revenues from existing customers due to several economic situations has been extremely difficult for the Company to overcome during 2003.

• However, the Company's clear priority must be to build new business. There are at least three macro trends that should auger well for Nanophase in this regard during 2004-2005. Forecasts, notably from The Chemical Market Reporter, are predicting that the chemical industry will continue to improve during this period. The chemical industry is a prime market for nanomaterials. Secondly, several companies have announced nanomaterial initiatives as strategic imperatives; examples include HP, GE, and Rohm & Haas. Evidence of the increased interest is demonstrated in the 70% growth of nanoengineered samples that have been requested from Nanophase during 2003 for applications development. Thirdly, we are seeing significantly increased interest in nanoparticles for personal care and antimicrobial applications from quarters that have been previously uninterested.

• Continuing more from a tactical level, to augment the Company's increased business development activities, Nanophase is initiating a marketing campaign composed of specific actions to obtain wider global and US exposure:

  • First, we have created a new web site that has just been activated to increase our global exposure in multiple markets. This effort will continue over the next few months to ensure that Nanophase ranks highly with the seven or so respective search engines to draw interested companies to us. I would encourage each of you to visit the new site.

  • Secondly, we are increasing the Company's exposure at industry forums and conferences. For example, between now and the end of 2003, the Company is chairing sessions and presenting papers at the Nanoparticles 2003 conference next week in Boston, the American Chemical Engineers conference, the Material Research Society conference, and the NanoCommerce conference.

  • Thirdly, we are creating an identity ad campaign that will be debuted in parallel with the NanoCommerce conference in Chicago during early December. This conference is one of the first nanoconferences to focus on business and market applications, rather than academia and government. We plan to use the identity ad to get our name better recognized in multiple global markets though advertising in appropriate publications during 2004.

• On a specific market basis, let me summarize where the Company assesses its position in focus market areas. I would like to note before I start, that we are approaching this differently than in previous conference calls. We are taking great pains to be as specific as possible given agreements in place and the time constraints of a conference call. While my comments may be somewhat lengthy attempting to accomplish this, I think that it is important to provide investors with a view of the breath and depth of our business and market development activities. Lastly, while we are attempting to present as complete a picture as practical, it is not possible to cover each opportunity under development and there are some areas that we are just not at liberty to discuss.

• Relative to chemical/mechanical polishing or CMP, Nanophase continues to focus on specific market areas: Semiconductors through our partnership with Rodel; and separately, Nanophase is pursuing hard disk drives, read/write heads, fine optics, photomasks, and, a new area since the last conference call, color filter polishing. As stated on the last call, Nanophase's NanoArcä synthesis and dispersion technologies - technologies that have all been developed over the past two years- provide a critical advantage in these markets. They allow the company to engineer an evolving platform of nanomaterials, including single-crystal mixed elements, in highly stable dispersions to address current and future technology nodes for semiconductor manufacturing, and other noted markets, in a manner that we believe is quite unique. We continue to believe that CMP is a prime market for nanomaterials, it is of sufficient size at $900 million in annual slurry value estimated for 2005 to have adequate entry points, and is an area of major opportunity for the Company.

  • In the semiconductor area, the current Rodel/Nanophase slurry is at various stages of evaluation and production testing at top tier manufacturers representing over 20 semiconductor facilities globally. Evaluation is also being discussed with additional manufacturing fabs that may begin testing early in 2004. Results continue to be positive during production and industry testing. We have been told that the Rodel/Nanophase slurry was 'best of breed' during industry testing at IMEC, which is the European testing facility for equipment and processes that is sponsored by semiconductor manufacturers. Reports from fabs evaluating the product also continue to be positive. Nanophase continues to have high expectations for this market. Again, the timing of a potential customer's full production adoption is not predictable at this time.

  • In parallel, Rodel/Nanophase, especially during this past quarter, have designed and are implementing a technology roadmap in response to market feedback to penetrate additional specific areas of semiconductor polishing. We now expect that one of these new slurries should begin market testing early in 2004 followed by others later in the year and throughout 2005. This expansion in polishing is, again, largely due to the technology available from Nanophase's NanoArc™ and dispersion technologies. As we have stated before, this partnership has and is forming plans to introduce nanoslurry products in a significant portion of the $700 million semiconductor slurry polishing market by 2005. We fully expect this development plan to be enlarged with continuing slurry product development beyond 2005. I do not believe that I can over-emphasize the importance of this partnership and this market opportunity to Nanophase.

  • As we stated last conference call, the hard disk drive slurry polishing market is estimated to be about $180 million. Largely concentrating on a leading large disk drive manufacturer, we have slurry in testing on glass and ceramic hard disks for their 2004 product line that, we are told, will be introduced in mid-to-late 2004. Our nanomaterials continue to provide improved planarity, high selectivity, and a very low surface roughness. We are also involved with two glass suppliers to the hard disk drive industry. Again, results continue to be positive. In a secondary, but also valuable, effort, we are co-developing a slurry solution for read/write heads, but expect that the time-to-market is longer in this area.

    Continuing the hard disk drive discussion, during the third quarter, we began discussions and preliminary testing with another leading manufacturer of hard disk drives and expect to have active development over at least the next two quarters.

  • Photomask, which is estimated to be around $10 million in market slurry value, is an area that Nanophase and its partner have made significant progress during the year, even though revenues for this product line have been down. As calibration for conditions in the industry, our partner has informed us that this is the worst first half of a fiscal year that they have experienced in over ten years. However, during this period, we have improved on the current second stage slurry polishing and obtained market-leading results which were presented by our customer at a major photomask conference in September. We are also expanding on this partnership and jointly developing a first stage polishing slurry. While results will not be complete until at least the end of the year, initial indications are highly positive. As we have stated, the objective here is for Nanophase to have a complete photomask polishing line of nanomaterial dispersion products in 2004. We are well on our way to accomplishing this.

  • In the area of fine optics, which is estimated to have a market slurry value of about $70 million, we have made significant progress during the past three months. At least two manufacturers of optical polishing equipment indicate that they plan to standardize on our nanomaterials for their recommended slurries. Nanophase's nanomaterials are also in testing in at least six other applications at the present time - from space-based optics to wafer stepper optics. This is a relatively low volume, high margin market niche that the Company plans to grow in 2004-2005.

  • A new area for Nanophase, polishing color filters, received interest during the past quarter. We are working with an Asian slurry manufacturer that supplies this market and have received small initial orders for nanomaterials to test with color filter manufacturers. We are still early into this potential application and do not know, as of yet, the potential market value nor the timing of appreciable revenue.

  • In summary, over the past 12 months, Nanophase significantly increased its market attack and development of noted CMP markets and is meeting with considerable success in all testing to-date. We are quite optimistic about revenue growth in this $900 million during 2004-2006.

• Considering the sunscreen and beach wear market, particularly our partnership with BASF, revenues have been below expectations due to the cool spring and summer in the Midwest and east coast (the US is the world's largest sun care market according to Datamonitor with over $1.2B in annual volume), and continuing problems with the formulation relative to European and Asian formulations. Again, we currently expect this area to continue growing and believe that sales should potentially increase in the US during 2004, barring weather related impacts. During the second and third quarter, a major pharmaceutical and cosmetic manufacturer launched five new products containing our nanoparticles under a major brand. We have been informed that the launch is successful and trust that it will add to volumes in 2004.

  As we have stated, we are developing a generation two formulation of nanoparticles, primarily the nanoparticle coating, to address the formulation issues in Europe and Asia. Testing of Gen two is underway and about midway through testing, results are promising. BASF is still targeting mid-2004 for the new product introduction, again primarily in Europe and Asia.

• Antimicrobial nanoparticles have received considerable business development attention during 2003. As we have honed our business development strategy, we are grouping applications as either industrial or personal care. Current application development in the industrial area includes wood preservation, surface cleaners, clear coatings, adhesive caulks and sealants, and thermoplastic and textile applications, such as carpet fibers and additives for plastic parts.

  As but one example in the industrial area, wood preservation refers to pressure treated wood used in outdoor applications. As of 12/31 this year, the past chemical treatments that have been used for years have been banned by the EPA because they contain arsenic and other relatively toxic materials. The wood industry is looking for suitable replacements that have adequate life - typically 20-30 years. In testing with a market leader, nanoparticles have demonstrated the unique ability to penetrate the wood fibers rather deeply into the core. We have been testing three nanoparticles, one of which is a novel combination of two metals, and have successfully passed accelerated testing and the six month in ground testing. Full field testing should be complete by mid-second quarter 2004. If testing remains

  successful, we believe that wood preservation using Nanophase's nanoparticle production could begin in third to fourth quarter 2004. As such, this represents a major revenue opportunity for the Company.

  In the personal care area, application development is focused on textile applications for skin contact, underarm products, oral care products, and skin care products. We are working with major pharmaceutical and cosmetic companies on application development for these products. Again, one example that I can only describe rather obliquely. The textile application for skin contact is well down the development path: the potential customer has filed application patents; toxicology testing has been completed; and clinical testing is currently underway. We have been informed that this product is expected to begin launching during mid-2004.

  In each category, industrial and personal care, Nanophase is working with several major companies that serve these markets. Based on information from potential customers in these areas, we would expect to begin shipping products for some of these applications during 2004.

• Relative to coatings, Nanophase has application development in abrasion resistance for polycarbonate plastics; a harsh environment abrasion resistant electronics application; automotive coatings for both abrasion and UV resistance; overprint varnishes and other UV curable applications where color and gloss are critical; and lastly, a consumer abrasion-resistant application. In regard to the latter as an example, Nanophase is working closely and very actively with a global cosmetic company on co-development of the product. The potential new customer has indicated to Nanophase that they intend to launch this product early in 2004.

• Relative to catalytic or catalysis markets, while our current catalytic converter revenue has been less than planned, Nanophase has made strides in other areas. The Company has linked up with a major automotive OEM to develop nanomaterials for catalytic converters. That work is underway and appears promising at this early stage. The Company has also initiated activities with a major catalytic converter manufacturer to explore the use of nanoparticles for diesel particle traps.

  In a second area, while this is a longer-term project, Nanophase is beginning work with a major chemical company to develop nanocatalysts for specific chemical synthesis. This is a rather significant break-through for the Company; we have been trying to find a partner for chemical catalysts synthesis co-development for two years to demonstrate the value of nanoparticle technology.

  While the gestation time for these projects is lengthy, these applications represent significant revenue opportunities.

• Then, Nanophase has some opportunities that do not fit neatly into any of our stated focus markets. Two brief examples for your information:

  • Nanophase is working with a global OEM in the power distribution area to use nanoparticles in composites to generate non-linear dielectric properties in electrical insulation. This concept has been proven, patent applications have been filed by the OEM, and potentially represents a very significant revenue opportunity for Nanophase.

  • To our recent announcement, we are working with a supplier to the medical industry with our nanobismuth oxide on its use in plastic medical appliances. In these applications, indications are that the material provides the desired x-ray opacity while mixing well with the plastic materials during processing and device production. Again, early indications are positive and we are continuing this effort. As an aside, we have also received several inquiries from companies based on the announcement, which was picked up in several technical publications, and are having on-going multiple discussions.

• And lastly, we have development efforts in longer-term markets such as fuel cells and thermal spray that have large revenue potential, but require significant development before revenues can be expected.

• In summary, the Company remains focused on five major market areas: anti-microbial applications for personal and industrial products; personal care, including sunscreens; abrasion and scratch resistant coatings; catalysts; and polishing markets. The Company's business development and marketing efforts have been significantly improved and expanded throughout 2003. We believe that our efforts are well-directed, robust, and cover opportunities that offer significant revenue potential. We fully expect that these markets, and the additional opportunities mentioned previously, will drive the Company's revenues.

• That concludes our prepared remarks. We are available for questions.