FOURTH QUARTER 2003 CONFERENCE CALL

Joseph Cross, President & CEO

• Welcome to the Nanophase conference call to review the fourth quarter for 2003 and fiscal year 2003. Jess Jankowski, vice president and Corporate Controller, and I will be hosting this session.

• For today’s discussion, Jess will review the financial results for the two periods. After which, I will return to discuss 2003 highlights, the Company’s position entering 2004, and some of our expectations for the New Year.

• Jess, would you please review the financial results?

Jess Jankowski, CFO, VP Controller

• Good morning and thanks for your continuing interest in Nanophase.

• As I review the financial performance of the Company for 2003, I intend to do so at a more strategic level for this call. This way, I can highlight what’s been driving the financial results of the business versus line items on the financials. More details are included in the financials accompanying our press release of March 3.
  All numbers will be in approximate terms for ease of discussion.

• Revenues for 2003 were roughly flat relative to 2002 at $5.4 million. For the year, product Revenue was down $120K and Other Revenue was up $166K. The increase in Other Revenue for 2003 related to the sale of a PVS reactor to C.I. Kasei, our Japanese licensee.

• Relative to product sales, actual revenues were approximately $1 million below our expectations entering 2003, which were based on current customer forecasts at that time. These reductions were due to unplanned weakness in some key areas.

  • Sunscreen revenue from our largest customer was down about $600K from 2002. This has been attributed to excessively overcast weather, particularly in the eastern U.S., and the impact that that had on the sunscreen business in general. Management expects 2004 to be somewhat stronger than 2003 with respect to this sector and orders to date for the first quarter appear to support this view.

  • The Company saw little volume in its abrasion-resistant flooring and auto catalyst businesses for 2003. Taken together, these reductions in volume represent a $450K decrease in product revenue from 2002. Our current flooring and automotive catalyst customers are not predicting particularly strong comebacks in ’04, but management expects several other similar initiatives in these markets to take root this year. We believe that the technology is sound, and that it allows for a competitive advantage. With customers who are more focused on these developing markets, we anticipate that inroads should be made during the year.

• On the positive side, the fine polishing material business was up by more than $900K in 2003. Although we have not seen end users of these materials move significantly to commercial production, we have been continually informed by our customers that our material is performing much better than industry standard materials. In some cases, on joint customer calls, we have been given firsthand corroboration that our nanomaterial’s performance has been stronger than other materials tested. None of this means that we will have significant 2004 volume in CMP materials, but it does lead us to expect that Nanophase will benefit from revenue growth once these materials get past the remaining hurdles to adoption.

• Backing-out the cost of the PVS reactor sold to C.I. Kasei, the cost of product revenue was roughly flat year to year. Depreciation was up $175K on items that were in service for all of 2003, versus only a portion of 2002, so…hard costs were driven down again. It’s important to note that Nanophase has an existing manufacturing infrastructure that can support a multiple of 2003’s volume without significant augmentation.

  Our margins suffered this past year from not having enough revenue to absorb the manufacturing overhead that is required to work with the customers we have and the new ones we expect to have. Much of this infrastructure supports compliance with FDA and USP standards for sunscreen materials, as well as the exacting performance requirements of the electronic chemicals industry for CMP materials. The good news is that as volume grows, we expect our solid variable margins to drive gross margin growth.

• R&D Expenses were up $330K year over year. R&D Salaries, which encompass our R&D and Advanced Engineering groups, were up $150K, but are expected to drop by a similar amount during 2004. Our scientists and engineers also spent about $100K in additional materials development and testing (much of this was related to our new NanoArc™ synthesis technology), and, as part of our recurring theme for 2003, depreciation increased by about $64K.

• SG&A Expenses expanded by $240K year over year. While total salary cost was down slightly, D&O insurance premium increases amounted to more than $300K, but are expected to actually decrease to some extent during 2004.

• In total, the Company lost $0.38/share this year versus $0.35/share last year. Note that depreciation amounted to about $0.10 cents or $1.5 million of the Company’s loss for the year.

• Moving to the balance sheet, Nanophase ended the year with $5 million in cash and investments and expects to exit the first quarter of 2004 at about the same levels. This is an area that we continue to monitor closely.

• Looking at A/R, less than ½ of one percent of our $1.2 million in accounts receivable are past due. Ninety-six percent of this balance is made up of receivables from our three largest customers, BASF, Rodel, now Rohm and Haas Electronic Materials, and C.I. Kasei. These same customers accounted for 61%, 22% and 7% of our 2003 revenue, respectively.

• As you can see, inventories have gone down by $300K to $683K. Approximately $150K of this total represents raw materials with the balance being finished goods. Given the Company’s Lean Manufacturing discipline, it is a priority to keep inventory levels as low as possible while still maintaining the ability to respond to requests for material volumes outside of what has been planned.

  This balance may fluctuate based upon product revenue mix, materials lead times, and the overall economics of batch production of various materials. Management continues to minimize required working capital by holding inventory growth to a practical minimum.

• Equipment and leasehold improvements amounted to $8.2 million in total, which includes $220K for capital additions for 2003. As our previous build-outs are largely complete, 2004 capital requirements are projected to be minimal. Any larger capital expenditures would be market-driven, and no such large projects are currently planned.

• On the liabilities side, adding the current and long-term debt and lease obligations together, the Company has about $1.3 million in total debt. $850K of this represents the note in favor of our largest customer for equipment to produce sunscreen nanomaterials, which, you may recall, we pay back on a per kilogram shipped basis. The lion’s share of the remaining balance relates to financed business insurance premiums.

• Payables were flat year over year, and accrued expenses went down by $250K. Highlighting the largest categories of accrued expenses, forty percent of the total relates to accrued payroll items and fifteen percent relates to accrued professional fees.

• Looking at Additional paid-in capital, you‘ll notice that it has increased by $2.6 million year over year. This is due to the September 2003 private placement by Grace Investments for $2 million and approximately $600K received by Nanophase throughout 2003 relating to option exercises.

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

Joseph Cross, President & CEO

• Thank you, Jess.

• I would like to briefly summarize the Company’s progress during 2003 in two general areas: first, technology and operations; and secondly, business development and sales. After which, I would like to review some expectations and target markets for 2004.

• Beginning with technology during 2003, Nanophase continued to strengthen its intellectual property portfolio adding to its patents, pending patents, and proprietary knowledge. Ending the year, Nanophase had 6 US patents for its nanoparticle synthesis technologies, two US patents for its surface treatment technologies, and one US patent for nanoparticle applications in coating. Additionally, the Company has the following pending US patents: three in nanoparticle synthesis, two in nanoparticle surface treatments involving dispersion of nanopaticles in various media, and three in nanoparticle applications. Correspondingly, there are 12 foreign counterpart patent applications pending. We believe that some of these patents will issue this year at a time and choosing of the U.S. Patent Office and the appropriate foreign patent authorities. Additionally, we plan to file at least three new patent US applications during the coming year.

• 2003 saw continued improvement and evolution of the Company’s process technology:

  • We were able to again reduce the variable portion of manufactured product cost by 4-27%, depending on the specific nanomaterial, which translates directly into increased gross margin. I think that it is indicative of our capability and expertise that since starting this manufacturing cost reduction effort in late 1999, the Company has reduced the variable manufacturing cost on volume products by about 2/3.

  • Following the Company’s Lean Manufacturing discipline, we were able to increase PVS reactor utilization during 2003 by 7% and the new NanoArc™ synthesis reactor utilization by 25%. Looking at this from a different view, by increasing utilization in the PVS reactor bank, Nanophase effectively added another PVS reactor without any capital cost.

  • We also developed a major process innovation during 2003, which we are now implementing, that we expect will increase our PVS reactor output by about 30% for volume products. This innovation is expected to reduce manufacturing cost, but, equally as important, coupled with increased reactor utilization, this new technology is anticipated to significantly reduce the Company’s need for capital, infrastructure, and facilities to add PVS reactors as volume grows. In other terms, ignoring facilities cost, coupling increased utilization and increased rate, the Company will add almost $1 million of current reactor capacity and output for no capital investment.

  • Responding to market demand for liquid format versus solid nanomaterials, we implemented pilot nanoparticle dispersion capability for additional nanomaterials for targeted markets. Nanophase’s patent-pending dispersion technology provides the capability to manufacture 30-50% by weight non-agglomerated, nanoparticle dispersions that are highly stable for up to two years on nanomaterials dispersions tested to date. As mundane as this newly developed technology may sound on the surface, we believe that nanoparticle dispersions are an absolutely critical capability for success in the nanomaterials market. We also believe that Nanophase has now developed an industry-leading position in nanoparticle dispersion technology.

  • Lastly, we introduced several new nanomaterials during 2003 that are targeted to focus markets or applications.

• Operationally, the Company continued its excellent performance:

  • We achieved ISO9001:2000 certification, which represents the most current global quality standard. This level of operational performance is vital to successfully sell to large US and European companies;

  • We, again, achieved 100% customer product acceptance and 99.9% customer service levels on 2003 product shipments.

  • We continue to make excellent progress in our drive for six-sigma process control in Nanophase. We have progressed from about one sigma in 1999 to well over five sigma as an average in all of our processes.

  • Lastly, Nanophase continues to enjoy excellent relations with local, state, and federal agencies in safety and environmental areas.

• From a Marketing, Business Development, and Sales perspective:

  • During 2003, we added a new vice president of business development, Dr. Ed Ludwig, and a new inside sales/customer service Manager, Bo Kowalczyk. Both of these individuals have added considerable talent to the entire effort.

  • We believe that we have considerably improved our marketing activities during 2003 and entering 2004. As a nanomaterial technologies and market leader, we believe that we need to be better known, especially during a time when manufacturing industries are getting increasingly interested and active in nanotechnology. We constructed a new, and improved, web site with greater search capability that has doubled the number of site visits with increased time per visit of about 50%. Correspondingly, the number of contacts to Nanophase has approximately doubled. We have, and are continuing to improve, the identification capability of our web site for major search engines, such as Google and Yahoo, that handle the bulk of global searches. With continuing improvement, we expect this trend to continue in 2004.

  • In parallel, we have initiated an identity ad marketing campaign entitled “Driving Product Innovation” that we expect to appear in targeted publications (such as Small Times, Chemical and Engineering News, and the Chemical Market reporter) during 2004, specifically around nanotechnology-focused issues.

  • Thirdly, in regard to marketing, we have increased our efforts in industry organizations and conferences to improve our presence and communicate the Company’s technology and capability. The Nanotech 2004 meeting next week in Boston is a good example. At this globally attended conference, we are scheduled to deliver three technical papers as well as exhibiting our integrated platform of nanotechnologies. Literally at the same time, Dr. Brotzman is scheduled to present a keynote address to the Nanoparticles 2004 conference. We believe that all of these activities will contribute to an increase in business development opportunities.

  • We have also reorganized the entire business development and sales effort during the last four months of 2003 to increase the structure and focus of development efforts. We are taking a much more rigorous approach to quantifying and qualifying market opportunities and a much more active approach to partnering with companies in target markets. Similarly, we are not continuing in areas where there is not a clear, active market pull; we have spent too much time in areas where there was only a technical pull, such as with a central research organization in a company. We have instituted a PVP process for business development efforts and a stage-gate process to monitor, measure, and judge progress. Business development and sales executives have been given well-defined assignments and goals aligned along target markets and customers. We have identified tactics and actions for focus markets, customers, and potential partners and are executing on those throughout the organization. We are becoming increasingly market-driven and have restructured organizational activities and assignments accordingly.

• Entering 2004, we believe that our strategy has been effective and we have now developed the integrated nanomaterials technology, infrastructure, manufacturing prowess, and business development focus to broadly attack target markets. We are also considerably more optimistic about market conditions and business development initiatives that are underway.

  • First, as the manufacturing sector has improved, we have seen increased interest and demand for nanomaterials in new products and to improve current products from this sector. Additionally, as I stated during the last conference call, The Chemical Market Reporter, as well as other industry newsletters, is forecasting continuing improvement in the chemical industry during 2004. We believe this is promising since this is a sector that we view as a prime market for nanomaterials. 2003 may have been the year where nanotechnology, and specifically nanomaterials, started a solid migration from the academic and government realm into the business new product development arena and increased application use.

  • We believe this trend is apparent in the 37% growth in the Company’s research materials business during 2003 and the 72% growth in nanomaterial samples requested from the Company. This is also buttressed by the strong business development activity the Company has seen since about October of 2003.

  • As the manufacturing sector continues to improve and expands its nanotechnology initiatives, we believe that Nanophase is exceptionally well-positioned in the nanomaterials field due to the evolution and improvement in our technology, infrastructure, and manufacturing capability over the last two years. The Company has a strong IP position, which we anticipate will continue to get stronger; our technologies have been demonstrably scalable and robust; we have an integrated platform of commercial nanomaterial technologies to deliver nanoparticles, coated nanoparticles, and nanoparticle dispersions; and, we clearly have the infrastructure and capability to deliver commercial quantity and quality of the nanomaterials we manufacture. We believe that Nanophase is in a leadership position in the nanomaterials field and fully capable of addressing the Company’s focus markets.

  • Lastly entering 2004, the Company is pleased with its cash position and, assuming timely collection of accounts receivable, should leave the first quarter with about $5 million in cash. As you are aware, Nanophase has filed a universal shelf registration statement and hopes to raise at least $10 million during 2004 in an orderly fashion that will be used to increase business development, sales, and marketing efforts, and for general corporate purposes.

• During 2004, Nanophase plans to focus on three primary areas. First and foremost, business development and revenue growth – this is clearly the most critical area in the Company and where I will be spending most of my time. Secondly, expanding the Company’s intellectual property portfolio and, thirdly, continuing to improve operations and process technology, and developing new nanomaterials for targeted markets. Since I have addressed the latter two areas earlier in this conference call, I would like to confine my remaining 2004 comments to business development and potential revenue growth by specific key market targets

  Before I begin, let me remind you that much of Nanophase’s activities involve business and application development with specific partners or companies in targeted markets. Since it is the beginning of a new year and the Company has evolved and improved its approach, I would like to provide an overview of target markets and a summary of the Company’s anticipated activities in these areas.

• In the personal care market, we have seen increased interest from several companies for nanomaterial applications, both in the US and in Europe. While we have several development efforts underway, let me comment on just a few.

  • Beginning with our partner in the sunscreen and personal care markets, BASF and Nanophase have a technology development agreement in place to jointly develop a second sunscreen material, which is targeted for Europe and Asia. Assuming that the target launch is reached, we expect that nanomaterial demand for sunscreens should begin growth during late 2004 and appreciable growth during 2005. As part of the technology development agreement, BASF and Nanophase also plan to co-develop products for other personal care applications.

  • Secondly, we have just signed a development agreement with a $1+Billion company to co-develop personal care products, apart from those we are collaborating on with BASF, based on nanomaterials technology. We expect that development to begin around second quarter 2004 for two specific product areas. Depending on the scope of specific development projects as they become defined, we would expect our co-development partner to fund some agreed portion of the specific development projects.

  • Thirdly, we have been developing nanomaterials for a personal care application with a leading global supplier of personal care products. They have stated that they expect to begin launching new products containing our nanomaterials during the second half of 2004.

  • In summary, Nanophase continues to believe that sunscreens and personal care products represent a significant market opportunity for nanomaterials with definitive revenue growth potential over the next three years.

• The fine polishing market, we believe, represents a promising area for potential revenue growth and is a market where we believe that Nanophase may be uniquely positioned. This is a market where nanomaterials bring value, both in size and uniformity, for instance, as semiconductor feature size decreases, as well as rather novel application selectivity. It is also a market where we believe that Nanophase’s technologies offer distinct competitive advantages in nanoparticle creation and in-situ surface chemistry modification, via our NanoArc™ synthesis process, and in the Company’s ability to manufacture highly stable nanoparticle dispersions. Moreover, the Company’s ability to manufacture multiple elements in a single nanoparticle, including rare earth materials, we believe, is potentially a competitive advantage for future technology nodes. In view of the Company’s technologies, initial results from several application trials during 2003, and the relationships that we have formed, we are optimistic about revenue growth in fine polishing markets during 2004-2007. Within the fine polishing market, Nanophase is focused on the following sectors: CMP for semiconductors; hard disk substrates, particularly the newer glass-based compositions; optics; and photomasks. This market, which is estimated to be about $900 million in total slurry value by 2005 – note that is slurry value and not nanomaterial value, is and will continue to be, a major focus for Nanophase. Do understand that an often unpredictable amount of time, which I recognize is a frustrating concept for investors, is required to fully develop and sell applications in this highly demanding market and then to significantly penetrate the market.

  • Addressing CMP for semiconductors first, our market partner, Rodel (which has been recently been renamed as Rohm & Haas Electronic Materials CMP Technologies, and which I will call RHEM as we go forward) continues to make definitive strides towards market penetration. Although the rate of market introduction has been slower than RHEM or Nanophase initially expected, we believe that RHEM is now well-positioned for significant growth in this market.

    During the last quarter of 2003 there was a considerable flurry of activity. RHEM made significant progress in slurry formulation to improve defect levels in wafer polishing. Also during the last quarter, IMEC, which is the European testing facility that is supported by semiconductor manufacturers and chartered with testing and identifying “best of breed” technologies, released its report which evaluated the RHEM slurry as its ‘process of record’, which is the top rating. IMEC’s recommendation is essentially an endorsement and has created considerable interest for RHEM on the continent among semiconductor manufacturers. At about the same time RHEM officially market-launched its new slurry, Celexis™ (which RHEM identified as using Nanophase’s technologies) for the STI segment of the market as offering a high selectivity, low defectivity slurry that provides excellent planarization and clearing.

    Entering 2004, RHEM and Nanophase have again collaborated to further improve the slurry product. We believe that current testing results from the improved Celexis™ slurry are exciting and demonstrate wafer polishing results that would clearly seem to be market-leading based on our knowledge of competitor’s products from actual production testing. At this point in time, approximately five semiconductor manufacturers, representing several actual fabs, have stated that they plan to enter trials during 2004, although that number may increase over time. RHEM and Nanophase have an active partnership. We are making joint sales calls at potential customers, recently for example in Europe; joint industry presentations, for instance, just last week at the CMP- Multilayer Interconnecting Conference; and are continuing development for current and future technology nodes in semiconductors.

    Despite everyone’s best efforts, the timing of customer testing and acceptance, we have found, is not feasible for RHEM to predict, which makes the amount and timing of revenue flow to Nanophase equally difficult to accurately predict. Nanophase now anticipates that our previously stated expectations of revenue under our cooperation agreement will be largely deferred to 2005 and thereafter. In view of that and the importance of continued joint product development for current and future semiconductor technology nodes, RHEM has arranged a $600,000 funded development agreement with Nanophase for 2004. Both RHEM and Nanophase have every expectation that the Celexis™ slurry will make significant inroads into this market and are looking forward to expanding our mutual growth over the next three years.

  • Turning to hard disk drives, or hard disk substrates composed of glass and/or ceramic materials for the new generation of disk drives, as we stated in our last conference call, is an estimated $180 million slurry value market opportunity that the Company is pursuing. Focusing on a market-leading manufacturer to optimize our nanoparticle dispersion formulation and obtain empirical test data, we are in testing for glass and ceramic hard disks for their new 2004 product line. Comparing current market materials to our NanoArc™ dispersions, test data to date remains encouraging with improved planarity, high selectivity, and very low surface roughness. In a parallel effort, we are also involved in testing with a manufacturer of read-write heads. This is an area where we expect continued progress during 2004.

  • The optics area, which is estimated at over $70 million in slurry value, has had considerable activity since our last conference call. One supplier of optical polishing equipment has selected Nanophase’s NanoArc™ nanoparticle dispersion as their recommended polishing media. Additionally, one end-user of polishing slurries has selected the Company’s nanoparticle dispersion for an optics polishing application. The Company expects both of the new application customers to begin ramping production during 2004. Additionally, several customer-specific application development projects remain underway for optics polishing equipment. Fine polishing for optics is a market sector where the Company expects continued growth.

• Relative to catalysts, under which we would include both chemical and environment catalysts, we have made inroads during 2003 and expect further progress during 2004. For example, we have been in development with a company for a chemical curing catalyst application. Developmental results have been excellent and the product is now in field test in Europe and the US. Based on information from the customer, we believe that this product should launch by late-summer.

  While we currently have a small level of sales into the catalytic converter market, we would like to appreciably increase sales in this area and have modified our approach to the market during 2003, which we anticipate will produce positive results. We are currently in second level testing with a major automotive OEM and undergoing development with two catalytic converter manufacturers.

• In the industrial antimicrobial area, we launched several business development initiatives during 2003 that are continuing into 2004. Current application development includes wood preservation, antimicrobial clear coatings, adhesive caulks and sealants, thermoplastics, and textile applications.

  • Relative to wood preservation, which refers to pressure treated wood, we are working with a major supplier in the industry and have nanomaterials in approximately ten different formulations that are in testing. In accelerated life testing to date, nanoparticles have demonstrated the unique ability to penetrate deeply into wood fibers and provide long-term preservative capability. While success is not assured, we are optimistic at this point. If successful, this application would represent a significant revenue opportunity and growth market for the Company.

  • While we are unable to be specific, the textile application involves both UV protection and antimicrobial activity in textiles. Our development partner has stated that they intend to begin product market launch during mid -2004.

  • The adhesive and caulk applications typically involve some combination of antimicrobial activity, increased abrasion resistance, or increased temperature resistance.

  • Lastly, we have recently introduced a silver doped tin oxide for industrial antimicrobial activities and have received solid initial interest. We plan to continue the market introduction and application testing of the material during 2004.

• Our last major focus market, but clearly one of the best opportunities, is coatings. Several advanced forecasting studies indicate that nanocomposites in coatings will become a large market for nanomaterials. This is a very broad field that includes such areas as paints and coatings (for example, powder coatings, general industrial coatings, architectural coatings, coil coatings, printing inks, automotive OEM and refinish coatings, and UV curable coatings); additives for polymers and plastics; and applications for use in coatings and sealants for food packaging, varnishes and compounds made for electrical insulation purposes. We have received considerable interest in this market over the past six months, are excited about the application development underway, and believe that coatings may become a major growth area for Nanophase over the next three years. Since this is such a broad field, let me discuss a few examples.

  • One area of opportunity that Nanophase plans to attack this year is abrasion, or scratch, resistance for automotive clear coatings. We have completed considerable development work during 2003 for this market and have a plan in place that we expect will make further inroads. We believe that this is a market that appears to have potential demand and market pull for this application in both the US and in Europe. We expect to be launching two new nanomaterials by summer that are directed to this market, as well as other abrasion resistant coating applications. We have customer-specific development for this application and expect definitive progress during 2004. Do understand that this is an application that may take some time to get to the market.

  • As a second example, one customer is currently launching a sublimation coating with our nanoparticles in a decorative application for plastic and ceramic materials.

  • We expect that the Company will make considerable progress in coatings during 2004 -2007 and believe that this market may well be a significant revenue growth area.

• In summary, we believe that Nanophase has significantly improved its new business development processes and marketing efforts during 2003 and is keenly focused on markets that we expect are of adequate size to drive revenue that meets the Company’s goals over the next 2-3 years. We believe that these efforts are well-directed, robust, and cover opportunities that offer significant revenue potential. Relative to perceived competition, with the Company’s solid infrastructure and operational expertise, leadership in its platform of nanomaterial technologies, and solid, growing IP portfolio, Nanophase is well-positioned for its target markets and revenue growth.

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