THIRD QUARTER 2007 CONFERENCE CALL

Joseph Cross, President and CEO

• Welcome to Nanophase's conference call to review the third quarter of 2007. Jess Jankowski, Nanophase's CFO, and I will be hosting this session.
• To begin our discussion, Jess will summarize the financial highlights of the quarter. Jess....

Jess Jankowski, CFO

• Good afternoon and thank you for your continuing support of Nanophase.
• This third quarter has certainly been one of surprises. We saw lower than expected revenue for the quarter, following an excellent Q2. We need to keep many factors in perspective while reviewing these results. The previous quarter's outstanding growth was achieved just prior to the much-publicized slowdowns in the housing and mortgage markets. We believe this may have impacted our sales to the architectural coatings market. That being said, Nanophase exits Q3 with an excellent long-term outlook and much to build upon. Joe will cover more of this in detail in terms of customer and market updates and our developing strategy.
• As always, I'll discuss the financial results in approximate terms. For more details, please see the financial statements accompanying today's press release. We have added a supplementary schedule, along with the press release, to break out depreciation and equity compensation expense, both of which are non-cash items, in order not to bog down the call.
• 3rd quarter 2007 revenue amounted to $2.6million, about 5% higher than last year's. With nine-month 2007 revenue reaching $9.6million, or 41% higher than the same period last year. Due to Nanophase being a much different business today than it was last year, I will focus most of my attention on the nine-month comparisons, along with a few notable changes from the preceding quarter.
• The reduction in volume from our architectural coatings customer in Q3, versus Q2, has had an outsized impact on the financials for both the three- and nine-month 2007 periods. Where we had $1.7million in revenue from this customer last quarter, we only had $550K in revenue for Q3. Given that the cycle time from our shipping this material to it being incorporated in to the end products is a matter of weeks, this decrease appears to be a statement on the outlook of the typical American regarding consumer spending in today's climate more than anything. We think this downturn is temporary, but have little concrete customer feedback to allow us to predict when volume will increase.
  
  Still, for the nine months ended September 30, 2007, we had $2.8million in sales versus $1.6million for the same period in 2006 from this customer...significant growth. We also note that Q3 of 2006 reflected 66% of the nine-month's sales for this customer last year while Q2 of this year reflected 61% of their nine-month's sales for 2007. While we don't have enough history to call a pattern here, we did experience nice year over year growth with this customer from 2006 to 2007, even given that last year's Q3 revenue concentration amounted to more than 50% of 2006's total revenue. We hope to develop a clearer view in the coming months.
• The growth from BASF and, from the expanding markets being reached through our relationship with BYK Chemie, showed increased revenue when compared with last year's third quarter, of $350K and about $360K, respectively.
  
  For the nine-month period of ‘07, these customers showed revenue increases of $400K and $1.2million, respectively, when compared to the same period in ‘06.
  
  For the recent nine months ended, BASF, our architectural coatings customer and BYK Chemie accounted for 45%, 29% and 14% of total revenue, respectively.
  
  For the recent quarter, BASF, our architectural coatings customer and BYK Chemie accounted for 48%, 21% and 15% of total revenue, respectively.
• Gross margins for Q307 amounted to 21% of revenue, versus 30% for Q306. Gross margins for the nine months ended September 30th amounted to 29% of revenue this year, versus 23% for the same period last year.
  
  Generally, we like the margin growth we've seen. For this past quarter, margin has suffered mainly from lower revenue volume which did not allow us to absorb fixed overhead, along with the Company having some excess direct labor that had been put in place to support the higher run rate that management had expected given Q2's record volume.
  
  Product mix and market stage also figured in the lower margins realized. While we build the BYK business, we are shipping a wide variety of products in relatively small lots. This has lead to a degree of near-term margin erosion.
• As the demand within the umbrella of underlying BYK business grows, and we see large quantities of each type of product within that group being shipped, margins should improve. This situation is typical when building new business with the characteristics we see with BYK Chemie, namely: A large catalog of products, a lot of sampling and engineering of initial quantities from sample through pilot phase, and, the building of product awareness in the marketplace.
  
  As the product mix matures and stabilizes, we expect margins to grow. Still, given the external environment and its unknown impacts on the parts of our business that seem to track the housing markets, predicting a trend will be difficult for the balance of the year.
  
  Moving down,
• R&D Expenses were down 26% quarter over quarter and down 13% for the nine-month periods. The lion's share of these reductions were due to the completion of a PVS yield improvement project in 2006 which we expect to pay dividends going forward and in the reduction in outside testing and new materials development done in 2007 relative to 2006. The reduction in new materials development dovetails with the further commercialization of the BYK products and is also a by-product of our continued strategic shift further toward market-driven products. Joe will add more color to this later. We also saw a reduction in salary expense resulting from this change in focus.

• SG&A Expenses were up 13% and 8%, respectively, when comparing the three and nine-month periods in 2007 to those in 2006. The increases were due to added compensation, mainly related to changes in the sales and marketing group, along with consulting fees incurred to study materials and markets with an eye towards expanding our technologies. We don't expect these consulting fees to be continued at a significant level. Joe will discuss this project further in a few minutes.
  
  These increases were offset by reductions in several other expense areas.
  
  On a GAAP basis, as reported, Nanophase lost $0.05/share in Q3 of 2007 versus $0.05/share in Q3 of '06, with nine-month losses improving from $0.20/share in 2006 to $0.12/share in 2007.
  
  Analyzing the non-cash components of the nine-month ‘07 loss, we have depreciation and amortization of about $1.1Million. This depreciation and amortization, a regular component of our GAAP bottom line, amounted to about five and ½ cents/share of the twelve cent loss. Equity compensation, also a non-cash expense, amounted to $420K and contributed another $0.02 per share to the loss. In total, depreciation and equity compensation expense amounted to about 60% of the most recent nine-month loss.
  
  Moving to the balance sheet highlights;
• Nanophase ended Q3 with $17.1million in cash and investments. This puts Nanophase in a very strong financial position. This balance includes the $10.6million we raised this summer, with Fidelity as a lead investor. Fidelity announced that, along with shares it has accumulated in the open market, it now owns more than 11% of Nanophase.
  
  Moving on....
• Q3 inventories are up to $1.7M, about 22% higher than last quarter. This increase largely relates to material for which we have orders and solid forecasts, but at a higher level than we would normally hold. In this case, as we've discussed, the change in demand from our architectural coating customer caught us off guard.
  
  Equipment and leasehold improvements amounted to about $525K for the quarter. As our view toward 2008 and beyond unfolds, we may need to add capital equipment and, potentially, floor space to support future demand. Much of this is product mix dependent and, therefore, difficult to schedule. Of the $950K in capital expenditures so far this year, $550K relates to an additional dispersion line we put in place in anticipation of future product demand from BYK Chemie.
  
  On the liabilities side, the Company now has $1.8million in total debt. All but $85K of this, representing capital leases on lab equipment, relates to the BYK Chemie loan of $1.6M plus deferred revenue less related discounts. Again, given that the loan financing terms are very favorable to Nanophase, we were required under GAAP to adopt this special treatment.
  
  Accounts payable have grown also, mainly in relation to the timing of payments for operational expenses and capital expenditures.
  
  We would invite you to review our upcoming 10-Q which we expect to be filed by November 9th.
• Thanks for your attention, now I'd like to turn things over to our President and CEO, Joseph Cross.

Joseph Cross, President and CEO

• Thank you, Jess
• The third quarter of 2007 represents the eleventh consecutive quarter of record annual quarter-over-quarter revenue growth stretching back to 2005. However, third quarter revenues were considerably below our expectations entering the quarter and quite disappointing to the Company.
  
  As we noted in the earnings release, we experienced an unexpected revenue shortfall in architectural coatings this quarter. Direct feedback from our major customer in this market leads us to believe that the reduction in demand is attributable to the dramatic downturn in the new housing market and a reduction in consumer spending in the DIY market. Based on available recent public information, this view seems to coincide with reduced revenue expectations from home builders, DIY retailers, and some other architectural coating companies.
  
  As we channel check at multiple locations with DIY retailers, we continue to hear positive statements and recommendations for the nanomaterial-enabled architectural coating. In parallel, feedback from our major customer has been positive. Moreover, we are actively continuing new product development with this customer and other manufacturers in architectural coatings and products. The value proposition and performance advantage for architectural coatings is demonstrably real. We continue to believe in nanomaterial market penetration and revenue growth in an estimated $40B architectural coating global market.
  
  We are, however, cautious over the near term given the surprising falloff last quarter and uncertainty in near-term demand level. We have reduced operational cost appropriately and are going forward with a leaner cost structure.
  
  As Jess noted, we continue to see solid growth in our BYK Chemie and BASF partnerships and the markets served, as well as other customer areas. The revenue shortfall in Q3 is attributable to an unexpected reduction in demand from one of our major customers due economic factors effecting architectural coatings. We are positive about the architectural coatings products and have growth expectations for the long-term. I will cover our market areas in more detail later in the conversation.
• Before we leave the third quarter, I would like to note the continuing operational improvements at Nanophase. We were again recertified to ISO 14001, the international environmental standard, by an independent auditing firm. As a testimony to the Company's EH& S practices, we reached a new milestone in employee safety with over 800,000 hours worked without a lost time accident. In a manufacturing company, this is quite an achievement, especially for one of our size. We also hit a new production level in our continuing efforts for PVS reactor output improvements. Since 1999, we have now increased PVS reactor production rates an aggregate of about 1900% while improving product consistency and quality under Nanophase's Lean Six Sigma process . . . and we are not done. We will do even more in the future. This record of continuous improvement demonstrates the collective and individual commitment to excellence by the talented Nanophase team. It is a record stockholders should note.
• After attending several investment conferences and large institutional investor meetings recently, it strikes me that it might be worthwhile to take some time summarizing our assessment of where we see the global adoption cycle of this new technology, where we believe Nanophase is in relation to potential global competition, and, lastly, but most importantly, outline some of the new tactics we are implementing to increase the Company's revenue ramp.
  
  Relative to adoption, every new technology has an adoption cycle; for example, the cycle for something now as common as the TV was over 40 years. We believe that nanomaterials are still early in the adoption cycle for several reasons. Globally, we are seeing what we term ‘alpha adopters' in Europe, the US, Japan and parts of Asia. In these areas, we are now seeing increasing product development activity, not R&D initiatives, and Nanophase has been getting increased interest and requests. This year, we have seen a rise in inquiries and product development interest in Latin America and India. So, we tend to believe that the adoption cycle is gathering momentum, but it is still early in the typical adoption cycle for a new technology. Obviously, the ‘alpha adopters' who are creating products or processes for nanomaterials are proving the value propositions in their markets and creating additional serious interest. A clear example of this is architectural coatings. The current products have driven interest from other architectural coatings manufacturers.
  
  During the fourth quarter of 2006 and through the first half of this year, we contracted what we perceive is the leading research company in the nanotechnology industry to perform a global evaluation to assess our competitive position and also determine if there were unknown opportunities that Nanophase should consider. Based on their evaluation, buttressed by our own internal evaluation and comments from our customers and market partners, we believe that Nanophase has a global leadership position in total nanomaterials capability. We are one of the few companies who can produce discrete nanoparticles, and I emphasize discrete nanoparticles, in commercial quality and quantity. We are one of the very few who can surface treat, or engineer the nanoparticle surface, and produce stable nanomaterial dispersions in commercial quality and quantity. I do not believe I could over emphasize the importance of surface engineering nanoparticles and, especially, dispersing nanomaterials for commercial market success. We appear to have one of the broadest patent portfolios and ‘know-how' in the field. Also, based on this independent opinion, the Company has developed a reputation for operational excellence and performance in its customer base. Quoting from the report, “Nanophase's partners continually report satisfaction with the company's products, and especially its willingness to co develop materials, a claim few other nanomaterial suppliers can make.” Based on this independent assessment, we believe Nanophase is well-positioned on the global stage.
• From a marketing and sales perspective, there are a couple of points that I would like to make. First, while the Company has grown revenue about 32% annually over the past few years, management firmly believes that we need to achieve at least 50% growth per year, primarily by expanding our market and customer base.
  
  To routinely reach this level, we continue to believe that we have to improve Nanophase's marketing and sales organization and, simultaneously, we have to improve our business development and sales processes. We have taken and are continuing to take actions to address each of these areas directed to achieving our 50% annual revenue growth goals.
  
  Relative to the marketing and sales organization, Nanophase hired Kevin Wenta as the EVP of Sales and Marketing early in 2007. Kevin has brought the needed leadership and fresh vision to drive the organization and forward revenue growth. As we assessed the skill sets and effectiveness of our sales organization, we became convinced that changes were needed. During April 2007, we added David Nelson as vice president of sales. David has an impressive background of successful business development and sales growth, most recently with Eastman Chemical. At this point in time, we are in the process of hiring another professional in sales and marketing to drive new market areas and opportunities. We intend to staff this organization with the professional, results-oriented staff needed for the Company to reach its revenue growth goals.
  
  As we study and evaluate how to improve our business development and sales success rate it has become evident that we have to continue evolving and improving our process. Viewed as part of a stage gate process, which is typically considered as five stages running from 0 to 5, we believe that we have to improve the ‘discovery' phases, primarily stages 1 & 2. To achieve our goals, we now believe that we have to extend our application development initiatives to the end product or application. So, viewed as a process that has evolved as we have learned,

  • We have moved from our early practice of sending samples to customers who would try to independently incorporate those into the end application and generally fail. Customer failure in this regard, most often trying to disperse nanomaterials and the “why” is generally hard for us to ascertain and often leads to the customer just losing interest.
  • From samples, we moved to trying to work collaboratively with customers to incorporate a nanomaterial into their application, but relying on them to have the application knowledge and expertise to prove the value proposition and derive the application testing data to show performance improvement. This works in some cases, not in others because many companies are reluctant to collaborate, and the process is often slow and cumbersome;
  • To improve the success rate and try to speed time-to-market, we have now extended application development to be able to test and quantify improved product performance by nanomaterial that has been engineered exactly for the application and formulation. In other words, we engineer a nanomaterial solution for a market segment, for example paints or stain, based on market needs and test the resultant performance improvement in commercially available products and take those results to the product companies.

  Let's review a specific example - a new family of formulated, nano-alumina based dispersions for coating applications. It has long been the goal of paint manufacturers to improve the durability and wear of water-based paints, typically measured as the resistance to abrasion or scratch-resistance, to be equal to oil-based paints. We believe that Nanophase's new formulated dispersions realize this goal.
  
  These new products deliver several property enhancements specifically relating to the paint coating structure and the coating's ability to resist abrasion and wear. Although the dispersions need to be ideally tailored to specific formulations for optimal performance, the formulated alumina dispersions typically yield the following abrasion resistance improvements:
  
  
  1. 250% to 400% for water-based paints, and
  2. 300% to 500% for oil-based paints.
  
  These improvements are observed in most commercial formulations tested, but optimal results will still require NTC to work directly with potential customers since formulations in similar products vary greatly. But, we believe that this approach is key to improving stage 1 & 2 of the stage gate; solving the problem in the customer's own formulation and taking tested performance improvement to the customer. We plan to formally announce this new application break-thru shortly to the noted markets and specific customers. We will also use this same model for other markets and applications where we have the product and testing expertise.
• Despite the unexpected near-term downturn in revenue for architectural coating products, we remain optimistic about growth in our current markets and those where we have initiated penetration. Viewing specific markets,

  • Sunscreen and daily wear demand continues to grow in 2007 over 2006 at a rate similar to previous years. Given the new focus on full spectrum UVA protection, which is about 90% of harmful radiation, such as in the proposed FDA monograph and similar legislation in the EU, we are optimistic about increased adoption and growth for our nanomaterials going forward. Zinc oxide is the only sunscreen agent that provides protection from UVB, short-wave UVA and long-wave UVA.
  • We are working on an increasing number of new opportunities in industrial and architectural coatings markets and believe that both of these markets offer the opportunities for short and near term revenue growth. BYK Chemie, our market partner for these markets, remains positive about growth over the next 2-3 years and is marketing their nano-enabled additives globally.
  • Working with our market partner Rohm & Haas, we believe that we are seeing increased activity and adoption for their CMP slurry products using our nanomaterials. Rohm & Haas is forecasting appreciable growth to Nanophase going forward.
  • Development efforts with a major OEM in electronic component and circuitry printing for flexible displays continue to progress and, we have been informed, should enter the pilot production phase next year.
  • We are also optimistic about our new marketing relationship with our Japanese partner C. I. Kasei, and $750M division of ITOCHU, which is a $22B global conglomerate in Textiles, Machinery, Aerospace, Electronics, Energy, Chemical, Food and Finance. C.I. Kasei, who is viewed as a nano leader in Japan and Asia, has relationships with companies throughout Asia and presents the opportunity for Nanophase to establish a marketing presence and grow sales in Asia going forward.

• In summary, while this past quarter's revenue was disappointing due to softness in one market from a major customer, management's commitment to aggressive revenue growth goals remains positive and proactive actions are well underway to achieve these goals.
• That concludes our prepared remarks and we are now available for questions.