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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934



For the Quarterly Period Ended: March 31, 2005



Commission File Number: 0-22333



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Nanophase Technologies Corporation

(Exact name of registrant as specified in
its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 36-3687863                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



1319 Marquette
Drive, Romeoville, Illinois 60446

(Address of principal executive offices, and zip code)



Registrants telephone number, including area code: (630) 771-6708



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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange
Act)    Yes  x    No ̈



As of May 6, 2005, there were 17,912,852 shares outstanding of Common
Stock, par value $.01, of the registrant.



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##### Table of Contents

NANOPHASE TECHNOLOGIES CORPORATION



QUARTER ENDED MARCH 31, 2005



INDEX



|                               |  |                                                                                       |  |     
|------------------------------ |  | ------------------------------------------------------------------------------------- |  | ----
|                               |  |                                                                                       |  | Page
|PART I - FINANCIAL INFORMATION |  | 3                                                                                    
|                               |  |                                                                                      
|Item 1.                        |  | Financial Statements                                                                  |  | 3   
|                               |  |                                                                                      
|                               |  | Unaudited Balance Sheets as of March 31, 2005 and December 31, 2004                   |  | 3   
|                               |  |                                                                                      
|                               |  | Unaudited Statements of Operations for the three months ended March 31, 2005 and 2004 |  | 4   
|                               |  |                                                                                      
|                               |  | Unaudited Statements of Cash Flows for the three months ended March 31, 2005 and 2004 |  | 5   
|                               |  |                                                                                      
|                               |  | Notes to unaudited Financial Statements                                               |  | 6   
|                               |  |                                                                                      
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 11  
|                               |  |                                                                                      
|Item 3.                        |  | Quantitative and Qualitative Disclosures About Market Risk                            |  | 24  
|                               |  |                                                                                      
|Item 4.                        |  | Controls and Procedures                                                               |  | 24  
|                               | 
|PART II - OTHER INFORMATION    |  | 24                                                                                   
|                               |  |                                                                                      
|Item 1.                        |  | Legal Proceedings                                                                     |  | 24  
|                               |  |                                                                                      
|Item 5.                        |  | Other Information                                                                     |  | 25  
|                               |  |                                                                                      
|Item 6.                        |  | Exhibits and Reports on Form 8-K.                                                     |  | 25  
|                               | 
|SIGNATURES                     |  | 26                                                                                   



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##### Table of Contents

PART I - FINANCIAL INFORMATION



Item 1. Financial Statements



NANOPHASE TECHNOLOGIES CORPORATION



BALANCE SHEETS

(Unaudited)



|                                                                                                                                                                         |  |                |             |   |                   |   |             |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------- | ----------- | - | ----------------- | - | ----------- | -
|                                                                                                                                                                         |  | March 31, 2005 |             |   | December 31, 2004 |  
|ASSETS                                                                                                                                                                   |  |                |             |   |                   |   |             |  
|Current assets:                                                                                                                                                          |  |                |             |   |                   |   |             |  
|Cash and cash equivalents                                                                                                                                                |  | $              | 570,899     |   |                   | $ | 475,185     |  
|Investments                                                                                                                                                              |  |                | 9,639,827   |   |                   |   | 11,155,126  |  
|Trade accounts receivable, less allowance for doubtful accounts of $24,271 on March 31, 2005 and December 31, 2004                                                       |  |                | 1,026,636   |   |                   |   | 792,662     |  
|Other receivable                                                                                                                                                         |  |                | 1,949       |   |                   |   | 3,498       |  
|Inventories, net                                                                                                                                                         |  |                | 821,292     |   |                   |   | 837,336     |  
|Prepaid expenses and other current assets                                                                                                                                |  |                | 453,753     |   |                   |   | 499,697     |  
|                                                                                                                                                                         |  |                |             |   |                   |   |             |  
|Total current assets                                                                                                                                                     |  |                | 12,514,356  |   |                   |   | 13,763,504  |  
|                                                                                                                                                                         |  |               
|Equipment and leasehold improvements, net                                                                                                                                |  |                | 7,256,275   |   |                   |   | 7,457,764   |  
|Other assets, net                                                                                                                                                        |  |                | 587,560     |   |                   |   | 571,027     |  
|                                                                                                                                                                         |  |                |             |   |                   |   |             |  
|                                                                                                                                                                         |  | $              | 20,358,191  |   |                   | $ | 21,792,295  |  
|                                                                                                                                                                         |  |                |             |   |                   |   |             |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                                     |  |                |             |   |                   |   |             |  
|Current liabilities:                                                                                                                                                     |  |                |             |   |                   |   |             |  
|Current portion of long-term debts                                                                                                                                       |  | $              | 460,427     |   |                   | $ | 579,472     |  
|Current portion of capital lease obligations                                                                                                                             |  |                | 6,321       |   |                   |   | 11,826      |  
|Accounts payable                                                                                                                                                         |  |                | 410,410     |   |                   |   | 324,485     |  
|Accrued expenses                                                                                                                                                         |  |                | 891,391     |   |                   |   | 894,022     |  
|                                                                                                                                                                         |  |                |             |   |                   |   |             |  
|Total current liabilities                                                                                                                                                |  |                | 1,768,549   |   |                   |   | 1,809,805   |  
|                                                                                                                                                                         |  |                |             |   |                   |   |             |  
|Contingent liabilities:                                                                                                                                                  |  |                |            |   |                   |   |            |  
|                                                                                                                                                                         |  |               
|Stockholders equity:                                                                                                                                                    |  |                |             |   |                   |   |             |  
|Preferred stock, $.01 par value, 24,088 shares authorized and no shares issued and outstanding                                                                           |  |                |            |   |                   |   |            |  
|Common stock, $.01 par value, 25,000,000 shares authorized; 17,912,852 and 17,895,482 shares issued and outstanding on March 31, 2005 and
December 31, 2004 respectively |  |                | 179,129     |   |                   |   | 178,955     |  
|Additional paid-in capital                                                                                                                                               |  |                | 72,010,083  |   |                   |   | 71,987,565  |  
|Accumulated deficit                                                                                                                                                      |  |                | (53,599,570 | ) |                   |   | (52,184,030 | )
|                                                                                                                                                                         |  |                |             |   |                   |   |             |  
|Total stockholders equity                                                                                                                                               |  |                | 18,589,642  |   |                   |   | 19,982,490  |  
|                                                                                                                                                                         |  |                |             |   |                   |   |             |  
|                                                                                                                                                                         |  | $              | 20,358,191  |   |                   | $ | 21,792,295  |  
|                                                                                                                                                                         |  |                |             |   |                   |   |             |  



See Notes to
Financial Statements.



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NANOPHASE TECHNOLOGIES CORPORATION



STATEMENTS OF OPERATIONS

(Unaudited)

|                                                     |  |                              |            |   |      |   |            |  
|---------------------------------------------------- |  | ---------------------------- | ---------- | - | ---- | - | ---------- | -
|                                                     |  | Three months ended March 31, |           
|                                                     |  | 2005                         |            |   | 2004 |  
|Revenue:                                             |  |                              |            |   |      |   |            |  
|Product revenue                                      |  | $                            | 1,526,304  |   |      | $ | 1,066,138  |  
|Other revenue                                        |  |                              | 87,078     |   |      |   | 227,221    |  
|                                                     |  |                              |            |   |      |   |            |  
|Total revenue                                        |  |                              | 1,613,382  |   |      |   | 1,293,359  |  
|                                                     |  |                              |            |   |      |   |            |  
|Operating expense:                                   |  |                              |            |   |      |   |            |  
|Cost of revenue                                      |  |                              | 1,444,500  |   |      |   | 1,213,110  |  
|Research and development expense                     |  |                              | 494,439    |   |      |   | 474,885    |  
|Selling, general and administrative expense          |  |                              | 1,143,144  |   |      |   | 1,058,944  |  
|                                                     |  |                              |            |   |      |   |            |  
|Total operating expense                              |  |                              | 3,082,083  |   |      |   | 2,746,939  |  
|                                                     |  |                              |            |   |      |   |            |  
|Loss from operations                                 |  |                              | (1,468,701 | ) |      |   | (1,453,580 | )
|Interest income                                      |  |                              | 65,047     |   |      |   | 14,661     |  
|Interest expense                                     |  |                              | (11,899    | ) |      |   | (24,838    | )
|Other, net                                           |  |                              | 13         |   |      |   | 693        |  
|                                                     |  |                              |            |   |      |   |            |  
|Loss before provision for income taxes               |  |                              | (1,415,540 | ) |      |   | (1,463,064 | )
|Provision for income taxes                           |  |                              |           |   |      |   | (7,500     | )
|                                                     |  |                              |            |   |      |   |            |  
|Net loss                                             |  | $                            | (1,415,540 | ) |      | $ | (1,470,564 | )
|                                                     |  |                              |            |   |      |   |            |  
|Net loss per share-basic and diluted                 |  | $                            | (0.08      | ) |      | $ | (0.09      | )
|                                                     |  |                              |            |   |      |   |            |  
|Weighted average number of common shares outstanding |  |                              | 17,907,063 |   |      |   | 16,209,660 |  
|                                                     |  |                              |            |   |      |   |            |  



See Notes to
Financial Statements.



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NANOPHASE TECHNOLOGIES CORPORATION



STATEMENTS OF CASH FLOWS

(Unaudited)

|                                                                                   |  |                                   |             |   |                                   |   |             |  
|---------------------------------------------------------------------------------- |  | --------------------------------- | ----------- | - | --------------------------------- | - | ----------- | -
|                                                                                   |  | Three months ended March 31, 2005 |             |   | Three months ended March 31, 2004 |  
|Operating activities:                                                              |  |                                   |             |   |                                   |   |             |  
|Net loss                                                                           |  | $                                 | (1,415,540  | ) |                                   | $ | (1,470,564  | )
|Adjustments to reconcile net loss to net cash (used in) operating activities:      |  |                                   |             |   |                                   |   |             |  
|Depreciation and amortization                                                      |  |                                   | 320,779     |   |                                   |   | 353,799     |  
|Stock compensation expense                                                         |  |                                   | 15,188      |   |                                   |   |            |  
|Allowance for excess inventory quantities                                          |  |                                   | (329        | ) |                                   |   | (1,543      | )
|Changes in assets and liabilities related to operations:                           |  |                                   |             |   |                                   |   |             |  
|Trade accounts receivable                                                          |  |                                   | (353,019    | ) |                                   |   | 235,615     |  
|                                                                                   |  |                                  
|Other receivable                                                                   |  |                                   | 1,549       |   |                                   |   |            |  
|Inventories                                                                        |  |                                   | 16,373      |   |                                   |   | (32,702     | )
|Prepaid expenses and other assets                                                  |  |                                   | 45,944      |   |                                   |   | 157,654     |  
|Accounts payable                                                                   |  |                                   | 157,991     |   |                                   |   | 247,355     |  
|Accrued liabilities                                                                |  |                                   | (4,131      | ) |                                   |   | 108,787     |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Net cash (used in) operating activities                                            |  |                                   | (1,215,195  | ) |                                   |   | (401,599    | )
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Investing activities:                                                              |  |                                   |             |   |                                   |   |             |  
|Acquisition of equipment and leasehold improvements                                |  |                                   | (182,415    | ) |                                   |   | (13,543     | )
|Acquisition of Patents                                                             |  |                                   | (23,974     | ) |                                   |   | (17,256     | )
|Purchases of investments                                                           |  |                                   | (63,327,887 | ) |                                   |   | (19,111,855 | )
|Sales of investments                                                               |  |                                   | 64,843,186  |   |                                   |   | 9,510,478   |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Net cash provided by (used in) investing activities                                |  |                                   | 1,308,910   |   |                                   |   | (9,632,176  | )
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Financing activities:                                                              |  |                                   |             |   |                                   |   |             |  
|Principal payment on debt obligations, including capital leases                    |  |                                   | (5,505      | ) |                                   |   | (169,995    | )
|                                                                                   |  |                                  
|Proceeds from sale of common stock, net, and exercise of stock options             |  |                                   | 7,504       |   |                                   |   | 10,411,475  |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Net cash provided by financing activities                                          |  |                                   | 1,999       |   |                                   |   | 10,241,480  |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Increase in cash and cash equivalents                                              |  |                                   | 95,714      |   |                                   |   | 207,705     |  
|Cash and cash equivalents at beginning of period                                   |  |                                   | 475,185     |   |                                   |   | 399,999     |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Cash and cash equivalents at end of period                                         |  | $                                 | 570,899     |   |                                   | $ | 607,704     |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Supplemental cash flow information:                                                |  |                                   |             |   |                                   |   |             |  
|Interest paid                                                                      |  | $                                 | 11,899      |   |                                   | $ | 24,838      |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Supplemental non-cash investing and financing activities:                          |  |                                   |             |   |                                   |   |             |  
|Accounts receivable paid through offset of long-term debt                          |  | $                                 | 119,045     |   |                                   | $ | 74,722      |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  
|Accounts payable incurred for the purchase of equipment and leasehold improvements |  | $                                 | 72,066      |   |                                   | $ |            |  
|                                                                                   |  |                                   |             |   |                                   |   |             |  



See Notes to
Financial Statements.



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NANOPHASE TECHNOLOGIES CORPORATION



NOTES TO FINANCIAL STATEMENTS

(Unaudited)



(1) Basis of Presentation



The accompanying unaudited interim financial statements of Nanophase Technologies Corporation (Nanophase or the Company) reflect
all adjustments (consisting of normal recurring adjustments) which, in the opinion of management, are necessary for a fair presentation of the financial position and operating results of the Company for the interim periods presented. Operating
results for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ended December 31, 2005.



These financial statements should be read in conjunction with the Companys audited financial statements and notes thereto for the year ended
December 31, 2004, included in the Companys Annual Report on Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission.



Certain items in the 2004 financial statements have been reclassified to conform to the 2005 presentation with no effect on
net loss.



(2) Description of Business



The Company was incorporated on November 30, 1989 for the purpose of
developing nanocrystalline materials for commercial production and sale in domestic and international markets.



Nanophase Technologies is a nanocrystalline materials developer and commercial manufacturer with an integrated family of nanomaterial technologies.
Nanophase produces engineered nanomaterials for use in a variety of diverse markets: personal care, sunscreens, abrasion-resistant applications, environmental catalysts, antimicrobial products and a variety of polishing applications, including
semiconductors and optics. New markets and applications also are being developed. The Company targets markets in which it feels practical solutions may be found using nanoengineered products. The Company works with leaders in these target markets to
identify their material and performance requirements.



The
Company also recognizes regular other revenue from a technology license. This activity is not expected to drive the long-term growth of the business. License revenue is recognized as other revenue in the Companys Statement of
Operations, as they do not represent revenue directly from the Companys Nanocrystalline materials.



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(3) Inventories



Inventories consist of the following:



|                                          |  |                |           |   |                   |   |           |  
|----------------------------------------- |  | -------------- | --------- | - | ----------------- | - | --------- | -
|                                          |  | March 31, 2005 |           |   | December 31, 2004 |  
|Raw materials                             |  | $              | 369,471   |   |                   | $ | 391,346   |  
|Finished goods                            |  |                | 1,057,037 |   |                   |   | 1,051,535 |  
|                                          |  |                |           |   |                   |   |           |  
|                                          |  |                | 1,426,508 |   |                   |   | 1,442,881 |  
|Allowance for excess inventory quantities |  |                | (605,216  | ) |                   |   | (605,545  | )
|                                          |  |                |           |   |                   |   |           |  
|                                          |  | $              | 821,292   |   |                   | $ | 837,336   |  
|                                          |  |                |           |   |                   |   |           |  



(4) Employee Stock Options,
Warrants and Stock Grants



During the three months ended
March 31, 2005, 17,370 shares of Common Stock were issued pursuant to option exercises compared to 212,859 shares in the same period in 2004. During the three months ended March 31, 2005 there were no warrants outstanding compared to 453,001
warrants outstanding during the same period in 2004.



As
permitted by Statement of Financial Accounting Standards No. 123 Accounting for Stock-Based Compensation (SFAS No. 123), the Company accounts for stock options granted to employees in accordance with APB Opinion No. 25, Accounting
for Stock Issued to Employees (APB No. 25). As long as the exercise price of the options granted equals the estimated fair value of the underlying stock on the measurement date, no compensation expense is recognized by the Company for these
options. SFAS No. 123 established an alternative fair value method of accounting for stock-based compensation plans. As required by SFAS No. 123 for companies using APB No. 25 for financial reporting purposes, the Company makes pro forma disclosures
regarding the impact on net loss of using the fair value method of SFAS No. 123.



Pro forma information regarding net income is required by SFAS No. 123, which also requires that the information be determined as if the Company had accounted for the employee stock options granted subsequent to
December 31, 1994 under the fair value method of that Statement. The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model with the following assumptions for the three months ended March 31, 2005
and 2004. No options were granted for the three months ended March 31, 2005.



The Black-Scholes option pricing model:



|                                                        |  |                |   |  |                |  
|------------------------------------------------------- |  | -------------- | - |  | -------------- | -
|                                                        |  | March 31, 2005 |   |  | March 31, 2004 |  
|U.S. Government zero coupon 7-year bond interest rates: |  | 4.33           | % |  | 3.31           | %
|                                                        |  |               
|Dividend yield:                                         |  | 0.00           | % |  | 0.00           | %
|                                                        |  |               
|Weighted-average expected life of the option:           |  | 7 years        |   |  | 7 years        |  
|                                                        |  |               
|Volatility factors:                                     |  | 65.24          | % |  | 106.92         | %
|                                                        |  |               
|Weighted-average fair value of the options granted:     |  | N/A            |   |  | N/A            |  



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For purposes of the pro forma disclosures, the estimated fair value of the options is amortized to
expense over the vesting period of the respective option. The pro forma impact for the three months ended March 31, 2005 and 2004 shown is meant to approximate the effects of the expensing of stock options.



The following table illustrates the effect on net loss and loss per share had
compensation cost for all of the stock-based compensation plans been determined based on the grant date fair values of awards (the method described in SFAS No. 123, Accounting for Stock-Based Compensation):



|                                                                                                               |  |                |            |   |                |   |            |  
|-------------------------------------------------------------------------------------------------------------- |  | -------------- | ---------- | - | -------------- | - | ---------- | -
|                                                                                                               |  | March 31, 2005 |            |   | March 31, 2004 |  
|Net Loss:                                                                                                      |  |                |            |   |                |   |            |  
|As reported                                                                                                    |  | $              | (1,415,540 | ) |                | $ | (1,470,564 | )
|Deduct total stock-based employee compensation expense determined under fair value based method for all awards |  |                | (117,893   | ) |                |   | (268,111   | )
|                                                                                                               |  |                |            |   |                |   |            |  
|Pro forma net loss                                                                                             |  | $              | (1,533,433 | ) |                | $ | (1,738,675 | )
|                                                                                                               |  |                |            |   |                |   |            |  
|Loss per share:                                                                                                |  |                |            |   |                |   |            |  
|                                                                                                               |  |               
|Basic - As reported                                                                                            |  |                | (0.08      | ) |                |   | (0.09      | )
|                                                                                                               |  |               
|Basic  Pro forma                                                                                              |  |                | (0.09      | ) |                |   | (0.11      | )
|                                                                                                               |  |               
|Diluted - As reported                                                                                          |  |                | (0.08      | ) |                |   | (0.09      | )
|                                                                                                               |  |               
|Diluted  Pro forma                                                                                            |  |                | (0.09      | ) |                |   | (0.11      | )



On October 11, 2004,
the Company granted 33,333 shares of restricted stock rights at market value consisting of 16,666 restricted share rights and 16,667 performance share rights respectively. The restricted share rights vest in lump sum or cliff vest on
October 30, 2007, provided that the grantee has not terminated service prior to the vesting date. The performance share rights also vest in lump sum or cliff vest upon achievement of certain performance goals or milestones on or before
October 30, 2007, provided that the grantee has not terminated service prior to the vesting date. The Company as required pursuant to APB No.25 recognized $7,473 for the restricted share rights and $7,715 for the performance share rights totaling
$15,188 in stock-based compensation expense for the period ending March 31, 2005. Compensation expense for performance share rights is determined using variable plan accounting based upon managements estimate of the number of share rights that
will eventually vest.



(5) Significant Customers and Contingencies



Revenue from three customers constituted approximately
87%, 0% and 5%, respectively, of the Companys total revenue for the three months ended March 31, 2005. Amounts included in accounts receivable on March 31, 2005 relating to these three customers were approximately $641,000, $2,000 and



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$319,000, respectively. Revenue from these three customers constituted approximately 74%, 15% and 6% respectively, of the Companys total revenue for
the three months ended March 31, 2004. Amounts included in accounts receivable on March 31, 2004 relating to these three customers were approximately $436,000, $150,000 and $356,000, respectively.



The Company currently has supply agreements with BASF Corporation
(BASF), the Companys largest customer, and Rohm and Haas Electronic Materials CMP, Inc. (RHEM), that have contingencies outlined in them which could potentially result in the license of technology and/or the sale of
production equipment, providing capacity sufficient to meet the customers production needs, from the Company to the customer, if triggered by the Companys failure to meet certain performance requirements and/or certain financial
condition covenants. The financial condition covenants in the Companys supply agreement with its largest customer, as amended, triggers a technology transfer (license or, optionally, an equipment sale) in the event (a) that
earnings of the Company for a twelve month period ending with its most recently published quarterly financial statements are less than zero and its cash, cash equivalents and investments are less than $2,000,000, (b) of an acceleration of any debt
maturity having a principal amount of more than $10,000,000, or (c) of the Companys insolvency, as further defined within the agreement. In the event of an equipment sale, upon incurring a triggering event, the equipment would be sold to the
customer at 115% of the equipments net book value.



The
Company believes that it has sufficient cash balances to avoid the first triggering event for the foreseeable future. If a triggering event were to occur and BASF elected to proceed with the transfer and related sale mentioned above, the Company
would receive royalty payments from this customer for products sold using the Companys technology; however, the Company would lose both significant revenue and the ability to generate significant revenue to replace that which was lost in the
near term. Replacement of necessary equipment that could be purchased and removed by the customer pursuant to this triggering event could take in excess of twelve months. Any additional capital outlays required to rebuild capacity would probably be
greater than the proceeds from the purchase of the assets as dictated by the Companys agreement with the customer. Such an event would also result in the loss of many of the Companys key staff and line employees due to economic
realities. The Company believes that its employees are a critical component of its success and could be difficult to replace and train quickly. Given the occurrence of such an event, the Company might not be able to hire and retain skilled employees
given the stigma relating to such an event and its impact on the Company.



In February of 2004, the Company amended its original agreement with Rohm and Haas Electronic Materials CMP, Inc. (RHEM, formerly known as Rodel, Inc). This amendment allows for RHEM to maintain
exclusivity based upon it purchasing lower dollar amounts of nanocrystalline materials, while extending the agreement through 2009. This amendment did not require RHEM to purchase any materials from the Company in 2004, but it did require an
aggregate of $600,000 in development funding be paid to Nanophase in four equal quarterly installments in 2004 to support its efforts in joint slurry product development with RHEM for current and future semiconductor technologies.



(6) Business Segmentation and Geographical Distribution



Revenue from international sources approximated $111,000 and $110,000
for the three months ended March 31, 2005 and 2004, respectively. As part of its revenue from international sources, the Company recognized $75,000 in other revenue from a technology license fee from its Japanese licensee for the three months ended
March 31, 2005 and 2004, respectively.



The Companys
operations comprise a single business segment and all of the Companys long-lived assets are located within the United States.



(7) Administrative Actions



On February 23, 2004, an unidentified party filed a Petition to Request a Reexamination of US Patent No. 6,669,823 B1 in the U.S. Patent and Trademark
Office, or USPTO. US Patent No. 6,669,823



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B1 relates to certain parts of one of the Companys nanoparticle manufacturing processes, NanoArc Synthesis. The Company subsequently received notice that the USPTO had granted the Request for
Reexamination. The reexamination process is provided for by law and requires the USPTO to consider the scope and validity of the patent based on substantial new questions of patentability raised by a third party or the USPTO. Because Nanophase
believes that the scope and validity of the patent claims in this patent are appropriate and that the USPTOs prior issuance of the patent was correct, the Company will vigorously defend its patent position. It is not feasible to predict
whether the Company ultimately will succeed in maintaining the scope and validity of the claims of this patent during reexamination. If the patent claims in this patent ultimately are narrowed substantially by the USPTO, the patent coverage afforded
to certain parts of the Companys NanoArc Synthesis nanoparticle manufacturing process could be impaired, which could impede the extent of Nanophases legal protection of the invention that is subject to this patent and potentially harm its business and operating
results.



(8) Subsequent Event



In November 2000, the Company executed a three-year promissory note, held by
BASF, the Companys largest customer, in the amount of $1,293,895 for the construction of additional production capabilities at the Companys Romeoville, Illinois facility. The outstanding balance of this note was $460,427 on March 31,
2005. The note bears interest at 8.45% per annum and is collateralized by certain powder coating, packaging, lab and related equipment. On May 1, 2005 an amendment to the BASF promissory note was executed for the purpose of extending the date when
any unpaid balance will be due upon demand from June 1, 2005 to June 1, 2007.



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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations



Overview



Nanophase Technologies is a nanocrystalline materials developer and commercial manufacturer with an integrated family of nanomaterial technologies.
Nanophase produces engineered nanomaterials for use in a variety of diverse markets: sunscreens, personal care, abrasion-resistant applications, environmental catalysts, antimicrobial products and a variety of polishing applications, including
semiconductors, hard disk drives and optics. The Company targets markets in which it feels practical solutions may be found using nanoengineered products. The Company works closely with leaders in these target markets to identify their material and
performance requirements. Newer developed technologies have made certain new products possible and opened potential new markets. With the commercialization of the Companys NanoArc synthesis and new dispersion technologies in 2002, and the expansion of these
capabilities in 2003 and 2004, Nanophase is focusing on penetrating the chemical-mechanical-planarization (CMP) and fine polishing markets. CMP is the process of polishing various types of integrated circuits or chips to be used in
various commercial electronics applications. Management believes that the Companys inroads in the CMP and fine polishing markets would have been very difficult without the Company being able to produce its materials to exacting specifications
verified by in-house and customer-based testing. Management expects growth in end-user (customers of Nanophases customers) adoption in 2005 and revenue growth beginning in 2005 in both of these areas. Additionally, the Company feels that its
exclusive relationship with Altana Chemie (Altana), a global ingredients supplier to various coatings industries, will lead to growth in several of its abrasion-resistant applications in the marketplace. Nanophase shipped initial
quantities of material to Altana in the second, third and fourth quarters of 2004, and in the first quarter of 2005. Management expects this relationship to continue to develop through 2005.



From its inception in November 1989 through December 31, 1996, the Company
was in the development stage. During that period, the Company primarily focused on the development of its manufacturing processes in order to transition from laboratory-scale to commercial-scale production. As a result, the Company developed an
operating capacity to produce significant quantities of its nanocrystalline materials for commercial sale. The Company was also engaged in the development of commercial applications and formulations and the recruiting of marketing, technical and
administrative personnel. Since January 1, 1997, the Company has been engaged in commercial production and sales of its nanocrystalline materials, and the Company no longer considers itself in the development stage. From inception through March 31,
2005, the Company was primarily capitalized through the private offering of approximately $32.0 million of equity securities prior to its initial public offering, its initial public offering of $28.8 million of common stock in November of 1997, its
private offering of $6.2 million of common stock in May of 2002, its private offering of $1.95 million of common stock in September of 2003, its equity investment of $9.2 million in March 2004 and its private offering of $1.95 million of common
stock in September of 2004 (through the conversion of warrants that were attached to its September 2003 offering), each net of issuance costs. The Company has incurred cumulative losses of $53.6 million from inception through March 31, 2005.



Pending Accounting Standards



See Companys 2004 10-K for a more detailed discussion regarding
adoption of SFAS 123R. On April 14, 2005, the SEC announced it would permit most registrants subject its oversight, additional time to implement the requirements in FASB Statement No. 123 (Revised 2004), Share-Based Payment. As originally issued by
the FASB, public companies subject to SEC oversight were required to implement Statement 123R as of the beginning of the first interim or annual reporting period that begins after June 15, 2005, or after December 15, 2005 for small business issuers.
As announced, the SEC will permit companies to implement Statement 123R at the beginning of their next fiscal year, instead of the next reporting period as required by Statement 123R. SFAS 123R will be effective for Nanophase for the first fiscal
quarter ending March 31, 2006, beginning on January 1, 2006. The Company is in the process of evaluating the impact of adopting SFAS 123R and of determining the impact on our results of operations or financial position.



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Results of Operations



Total revenue increased to $1,613,382 for the three months ended March 31, 2005, compared to $1,293,359 for the same period in 2004. A substantial
majority of the Companys revenue for the three months ended March 31, 2005 is from the Companys largest customer. See Note 5 to the Financial Statements for additional information regarding the revenue the Company derived from this
customer in the first quarter of 2005. Product revenue increased to $1,526,304 for the three months ended March 31, 2005, compared to $1,066,138 for the same period in 2004. The increase in product revenue was primarily attributed to increased sales
of sunscreen and personal care materials to BASF, the Companys largest customer, in the first quarter of 2005. The increase was partially offset by decreased sales of CMP materials to Rohm and Haas Electronic Materials CMP, Inc.
(RHEM, formerly known as Rodel, Inc.), the Companys second largest customer, in the first quarter of 2004. The Company and its largest customer currently have a technology agreement in place to jointly develop the second generation
of sunscreen nanomaterials for other potential personal care applications. Management anticipates the launch of one or more new sunscreen or personal care applications during 2005.



Other revenue decreased to $87,078 for the three months ended March 31, 2005, compared to $227,221 for the same period in
2004. This decrease was primarily attributed to no technology development funding being received in the first quarter of 2005, compared to $150,000 for the same period in 2004 from RHEM. This technology development funding from RHEM was part of its
$600,000 commitment in 2004 described below which was amended for 2005.



In February of 2004, the Company amended its original agreement with RHEM. This amendment allows for RHEM to maintain exclusivity based upon it purchasing lower dollar amounts of nanocrystalline materials, while extending the agreement
through 2009. This amendment did not require RHEM to purchase any materials from the Company in 2004, but it did require an aggregate of $600,000 in development funding be paid to Nanophase in four equal quarterly installments in 2004 to support its
efforts in joint slurry product development with RHEM for current and future semiconductor technologies. In October of 2004, the Company amended its original agreement with RHEM a second time. This amendment reduced the minimum purchase requirements
necessary to maintain the Companys exclusivity obligations to RHEM by approximately 44% during 2005. The reduction reflects the parties recognition of the difficulty in precisely estimating the timing of product development and sales in
the semiconductor polishing market.



The majority of the total
revenue generated during the period ended March 31, 2005 was from the Companys largest customer in the healthcare (sunscreens) market as described above.



Cost of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue increased to
$1,444,500 for the three months ended March 31, 2005, compared to $1,213,110 for the same period in 2004. The increase in cost of revenue was generally attributed to increased revenue volume somewhat offset by decreases in depreciation and the
Companys continued efficiencies in reducing its variable manufacturing costs on nanomaterials. The Company is completing a series of process improvements that are targeted to increase PVS reactor output by 20-30% in conjunction with a
re-engineering program that has reduced the expected operational labor cost by 25% on high volume PVS-produced nanomaterials. The Company expects this project to be largely complete by mid-2005. Nanophase expects to maintain an aggressive schedule
for new nanomaterial development, primarily using its NanoArc synthesis and dispersion technologies, for targeted applications and new markets throughout 2005. At current revenue levels the Company has generated a modest positive gross margin. The Companys margins have been
impeded by not having enough revenue to absorb the manufacturing overhead that is required to work with current customers and the new ones the Company expects to have. Management believes that the current fixed manufacturing cost structure is
sufficient to support significantly higher levels of production and resultant product



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revenue. The extent to which the Companys margins remain positive, as a percentage of total revenue, will be dependent upon revenue mix, revenue volume
and the Companys ability to continue to cut costs. As product revenue volume increases, this will result in more of the Companys fixed manufacturing costs being absorbed, leading to increased margins. The Company expects to continue
reducing its variable product manufacturing costs in 2005 but may or may not continue to operate at a positive gross margin in 2005, dependent upon the factors discussed above.



Research and development expense, which includes all expenses relating to the technology and advanced engineering groups,
primarily consists of costs associated with the Companys development or acquisition of new product applications and coating formulations and the cost of enhancing the Companys manufacturing processes. For example, the Company has been
and continues to be engaged in research to enhance its ability to disperse its material in a variety of organic and inorganic media for use as coatings and polishing materials. Much of this work has led to new potential products for use by Altana.
Now that the Company has demonstrated the capability to produce pilot quantities of mixed-metal oxides in a single crystal phase, the Company does not expect development of further variations on these materials to present material technological
challenges. Many of these materials exhibit performance characteristics that can enable them to serve in various catalytic applications. This development has been driven largely by customer demand. Management is now working on several related
commercial applications. The Company expects that this technique should not be difficult to scale to large quantity commercial volumes once application viability and firm demand are established. The Company also has an ongoing advanced engineering
effort that is primarily focused on the development of new nanomaterials as well as the refinement of existing nanomaterials. The Company is not certain when or if any significant revenue will be generated from the production of the materials
described above. Research and development expense increased to $494,439 for the three months ended March 31, 2005, compared to $474,885 for the same period in 2004. The increase in research and development expense was largely attributed to materials
development and salary expenses. These increases were partially offset by decreased depreciation expenses. The Company does not expect research and development expense to increase significantly in 2005.



Selling, general and administrative expense increased to $1,143,144 for the
three month period ended March 31, 2005, compared to $1,058,944 for the same period in 2004. The net increase was primarily attributed to increases in compensation, audit fees and consulting expenses. These increases were partially offset by
decreases in director and officers and business insurance, expense estimates and legal fees.



Interest income increased to $65,047 for the three month period ended March 31, 2005, compared to $14,661 for the same period in 2004. This increase was primarily due to an increase in funds available for investment,
largely composed of the March 23, 2004 equity investment from Altana which resulted in net proceeds of approximately $9.2 million.



Liquidity and Capital Resources



The Companys cash, cash equivalents and investments amounted to $10,210,726 on March 31, 2005, compared to $11,630,311 on December 31, 2004. The net
cash used in the Companys operating activities was $1,215,195 for the three months ended March 31, 2005, compared to $401,599 for the same period in 2004. Net cash provided by investing activities, which is due to sales of securities and
partially offset by purchases of securities and capital expenditures, amounted to $1,308,910 for the three months ended March 31, 2005 compared to $9,632,176 of net cash used in investing activities for the same period in 2004. Capital expenditures
amounted to $182,415 and $13,543 for the three months ended March 31, 2005 and 2004, respectively. In 2005 the Company expects to complete implementation of a PVS process innovation started in late 2003, within the current capital budget, that is
expected to increase PVS reactor output by approximately 20%. The Company expects that this innovation should result in the need for less future capital as the Companys PVS reactor-produced business grows. Currently, all sunscreen and personal
care nanomaterials are manufactured via the PVS process. Net cash provided by financing activities is primarily due to the issuance of shares of common stock pursuant to the exercise of options,



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partially offset by principal payments on debt and capital lease obligations, amounting, in total, to $1,999 for the three months ended March 31, 2005. Net
cash provided by financing activities is primarily due to the Company securing financing through an equity investment in March 2004 and, to a lesser extent, by the issuance of shares of common stock pursuant to the exercise of options, partially
offset by principal payments on debt and capital lease obligations, amounting, in total, to $10,241,480 for the same period in 2004.



On March 23, 2004, the Company sold, in a private placement to Altana Chemie AG (Altana), 1,256,281 shares of common stock at $7.96 per share
and received gross proceeds of $10.0 million. On January 22, 2004, the Company filed a universal shelf registration statement with the Securities and Exchange Commission to allow Nanophase to offer up to $15.0 million of Nanophase securities, in the
form of common stock or various types of debt securities, in the future. In August 2004, the Company withdrew its universal shelf offering due to unfavorable market conditions and the Companys adequate cash position to cover expected growth
through 2006. The Company incurred expenses in 2004 relating to the filing and subsequent withdrawal of its universal shelf offering of approximately $288,000. On September 8, 2003, the Company secured equity funding through a private placement
offering with Grace Brothers, Ltd., its largest investor. The Company issued 453,001 shares of additional common stock at $4.415 per share and received gross proceeds of $2.0 million. Grace Brothers, Ltd. also had the right to purchase an additional
453,001 shares for an additional $2.0 million pursuant to the terms of a warrant issued in such private placement. In accordance with the terms of such private placement, on June 7, 2004, the Company filed a registration statement for such 453,001
shares and the additional 453,001 shares issuable upon exercise of the warrant which registration statement was declared effective on August 13, 2004. On September 2, 2004, Grace Brothers, Ltd. exercised its warrant rights to acquire 453,001 newly
issued shares of common stock and the Company received $2 million in gross proceeds. On May 29, 2002, the Company secured equity funding through a private placement offering. The Company issued 1.37 million shares of additional common stock at $5.00
per share and received gross proceeds of $6.85 million. Net proceeds were approximately $6.2 million after commissions, legal, accounting and other costs. The Company intends to use the remaining proceeds from the foregoing offerings to fund
expected growth in new markets as well as to provide for expanded working capital needs expected to arise as sales volume grows and pay existing debts.



In November 2000, the Company executed a three-year promissory note, held by the Companys largest customer, in the amount of $1,293,895 for the
construction of additional production capabilities at the Companys Romeoville, Illinois facility. The outstanding balance of this note was $460,427 on March 31, 2005. The note bears interest at 8.45% per annum and is collateralized by certain
powder coating, packaging, lab and related equipment. In May 2005, an amendment to this promissory note was executed for the purpose of extending the date when any unpaid balance will be due upon demand from June 1, 2005 to June 1, 2007. Management
expects this debt to be fully paid during 2006.



The Company
believes that cash from operations and cash, cash equivalents and investments on hand and interest income thereon, will be adequate to fund the Companys operating plans for the foreseeable future. The Companys actual future capital
requirements in 2005 and beyond will depend, however, on many factors, including customer acceptance of the Companys current and potential nanocrystalline materials and product applications, continued progress in the Companys research
and development activities and product testing programs, the magnitude of these activities and programs, and the costs necessary to increase and expand the Companys manufacturing capabilities and to market and sell the Companys materials
and product applications. Other important issues that will drive future capital requirements will be the development of new markets and new customers as well as the potential for significant unplanned growth with the Companys existing
customers. The Company expects that capital spending relating to currently known capital needs in 2005 will be approximately $500,000, but could be even greater due to the factors discussed above.



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Should events arise that make it appropriate for the Company to seek additional financing, it should be
noted that additional financing may not be available on acceptable terms or at all, and any such additional financing could be dilutive to the Companys stockholders. Such a financing could be necessitated by such things as the loss of existing
customers; currently unknown capital requirements in light of the factors described above; new regulatory requirements that are outside the Companys control; the need to meet previously discussed cash requirements to avoid a triggering event;
or various other circumstances coming to pass that are currently not anticipated by the Company.



On March 31, 2005, the Company had a net operating loss carryforward of approximately $61.8 million for income tax purposes. Because the Company may have
experienced ownership changes within the meaning of the U.S. Internal Revenue Code in connection with its various prior equity offerings, future utilization of this carryforward may be subject to certain limitations as defined by the
Internal Revenue Code. If not utilized, the carryforward expires at various dates between 2005 and 2014. As a result of the annual limitation and uncertainty as to the amount of future taxable income that will be earned prior to the expiration of
the carryforward, the Company has concluded that it is likely that some portion of this carryforward will expire before ultimately becoming available to reduce income tax liabilities. On March 31, 2005, the Company also had a foreign tax credit
carryforward of $156,000, which could be used as an offsetting tax credit to reduce U.S. income taxes. The foreign tax credit will expire in 2014, if not utilized before that date.



RISK FACTORS



The following risks, uncertainties, and other factors could have a material adverse affect on our business, financial condition, operating results and
growth prospects.



We have a limited operating history and may not be able
to address difficulties encountered by early stage companies in new and rapidly evolving markets.



We have only a limited operating history. We were formed in November 1989 and began our commercial nanocrystalline materials operations in January 1997.
We have not yet generated a significant amount of revenue from our nanocrystalline materials operations. Because of our limited operating history and the early stage of development of our rapidly evolving market, we have limited insight into trends
that may emerge and adversely affect our business and cannot be certain that our business strategy will be successful or that it will successfully address these risks. In addition, our efforts to address any of these risks may distract personnel or
divert resources from other more important initiatives, such as attracting and retaining customers and responding to competitive market conditions.



We have a history of losses that may continue in the future.



We have incurred net losses in each year since our inception with net losses of $5.16 million in 2002, $5.83 million in 2003 and $6.45 million in 2004. As
of March 31, 2005, we had an accumulated deficit of approximately $53.6 million and presently expect to continue to incur losses on an annual basis through at least the end of 2005. We believe that our business depends, among other things, on our
ability to significantly increase revenue. If revenue fails to grow at anticipated rates or if operating expenses increase without a commensurate increase in revenue, or if we fail to adjust operating expense levels accordingly, then the imbalance
between revenue and operating expenses will negatively impact our cash balances and our ability to achieve profitability in future periods.



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We depend on a small number of customers for a high percentage of our sales, and the loss of orders from a significant
customer could cause a decline in revenue and/or increases in the level of losses incurred.



Sales to our customers are executed pursuant to purchase orders and annual supply contracts; however, customers can cease doing business with us at any
time with limited advance notice. We expect a significant portion of our future sales to remain concentrated within a limited number of strategic customers. We may not be able to retain our strategic customers, such customers may cancel or
reschedule orders, or in the event of canceled orders, such orders may not be replaced by other sales or by sales that are on as favorable terms. In addition, sales to any particular customer may fluctuate significantly from quarter to quarter,
which could affect our ability to achieve anticipated revenues on a quarterly basis.



Revenue from BASF Corporation, Rohm and Haas Electronic Materials CMP, Inc. (formerly known as Rodel) and C.I. Kasei, a division of Itochu Corporation, accounted for approximately 89% of total revenue for
the year ended December 31, 2004, and revenue to the same three customers accounted for approximately 94% of total revenue in 2003. For the years ended December 31, 2004 and 2003, BASF accounted for 70% and 61% of our total revenue, respectively.
BASF and C.I. Kasei also represented a significant majority of total revenue for the three months ended March 31, 2005, as described in Note 5 to the Financial Statements. If we were to lose, or receive significantly decreased orders from, any of
these three customers, then our results of operations would be materially harmed. While our agreements with our three largest customers are long-term agreements, they may be terminated by the customer with reasonable notice and do not provide any
guarantees that these customers will continue to buy our products. In addition, while our agreements with our three largest customers contain minimum order requirements, the only repercussion under the agreements for missing the minimum order
requirement is that we would be freed from the exclusivity obligations under these contracts.



We have been consistently expanding both our marketing and business development efforts and our production efficiency in order to address the issues of our dependence upon a limited amount of customers, enhancement of
gross profit and operating cash flows, and the achievement of profitability. We currently have customers that may grow to the point where they generate significant revenues and margins as relationships expand. Given the special nature of our
products, and the fact that markets for them are not yet fully developed, it is difficult to accurately predict when additional large customers will materialize. On a going forward basis, our margins, as a percentage of revenue, will be dependent
upon revenue mix, revenue volume and our ability to continue to cut costs. The extent of the growth in revenue volume and the related gross profit that this revenue generates, will be the main drivers in generating positive operating cash flows and,
ultimately, net income.



Any downturn in the markets served by us would harm
our business.



A majority of our products are incorporated
into products such as sunscreens, polishing slurries, personal care and to a lesser extent abrasion-resistant coatings for flooring and other products. These markets have from time to time experienced cyclical, depressed business conditions, often
in connection with, or in anticipation of, a decline in general economic conditions. These industry downturns have resulted in reduced product demand and declining average selling prices. Our business would be harmed by any future downturns in the
markets that we serve.



Our products often have long adoption cycles, which
could make it difficult to achieve market acceptance and makes it difficult to forecast revenues.



Due to their often novel characteristics and the unfamiliarity with them that exists in the marketplace, our nanocrystalline materials often exhibit
longer adoption cycles than existing materials technologies. Our nanomaterials have to receive appropriate attention within any potential customers organization, then they must be tested to prove a performance advantage over existing
materials, typically on a systems-cost basis. Once we have proven initial commercial viability, pilot scale production runs must be completed by the customer, followed by further testing. Once



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production-level commercial viability is established, then our nanomaterials can be introduced, often to a downstream marketplace that needs to be
familiarized with them. If we are unable to convince our potential customers of the performance advantages and economic value of our nanocrystalline materials over existing and competing materials and technologies, we will be unable to generate
significant sales. Our long adoption cycle makes it difficult to predict when sales will occur.



We depend on collaborative development relationships with our customers and do not have a substantial direct sales force or an established distribution network. If we are unable to initiate or sustain such
collaborative relationships or if the terms of these relationships limit the distribution of our products, then we may be unable to independently develop, manufacture or market our current and future nanocrystalline materials or applications.



We have established, and will continue to pursue,
collaborative relationships with many of our customers and do not have a substantial direct sales force or an established distribution network. Through these relationships, we seek to develop new applications for our nanocrystalline materials and
share development and manufacturing resources. We also seek to coordinate the development, manufacture and marketing of our nanocrystalline products. Future success will depend, in part, on our continued relationships with these customers and our
ability to enter into similar collaborative relationships with other customers. Our customers may not continue in these collaborative development relationships, may not devote sufficient resources to the development or sale of our materials or may
enter into collaborative development relationships with our competitors. These customers may also require a share of control of these collaborative programs. Some of our agreements with these customers limit our ability to license our technology to
others and/or limit our ability to engage in certain product development or marketing activities. These relationships generally can be terminated unilaterally by customers.



Additionally, these customers generally require exclusive distribution arrangements within the field of application covered
by our agreement with these customers, and the very nature of these collaborative relationships limits the distribution of our products to the distribution networks available to our collaborative relationship partners. In addition, the development
agreements with some of our larger customers contain provisions that require us to license our intellectual property to these customers on disadvantaged terms and/or transfer equipment to these customers in the event that we materially breach these
agreements or fail to satisfy certain financial covenants. For example, see Risk FactorsWe may need to raise additional capital in the future.



If we are unable to initiate or sustain such collaborative relationships or if the terms of these relationships materially limit our access to
distribution channels for our products, then we may be unable to independently develop, manufacture or market our current and future nanocrystalline materials or applications.



If a catastrophe strikes either of our manufacturing facilities or if we were to lose our lease for either facility due to non-renewal or
other unforeseen events, we may be unable to manufacture our materials to meet customers demands.



Our manufacturing facilities are located in Romeoville and Burr Ridge, Illinois. These facilities and some of our manufacturing and testing equipment
would be difficult to replace in a timely manner. Therefore, any material disruption at one of our facilities due to a natural or man-made disaster or a loss of lease due to non-renewal or other unforeseen events could have a material adverse effect
on our ability to manufacture products to meet customers demands. While we maintain customary property insurance, this insurance may not adequately compensate us for all losses that we may incur and would not compensate us for any interruption
in our business.



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If we are unable to expand our production capabilities to meet unexpected demand, we may be unable to manage our
growth and our business would suffer.



Our success will
depend, in part, on our ability to manufacture nanocrystalline materials in significant quantities, with consistent quality and in an efficient and timely manner. We expect to continue to expand our current facilities or obtain additional facilities
in the future in order to respond to unexpected demand for existing materials or for new materials that we do not currently make in quantity. Such unplanned demand, if it resulted in rapid expansion, could create a situation where growth could
become difficult to manage, which could cause us to lose potential revenue.



Protection of our intellectual property is limited and uncertain.



Our intellectual property is important to our business. We seek to protect our intellectual property through patent, trademark, trade secret protection and confidentiality or license agreements with our
employees, customers, suppliers and others. Our means of protecting our intellectual property rights in the United States or abroad may not be adequate and others, including our competitors, may use our proprietary technology without our consent. We
may not receive the necessary patent protection for any applications pending with the U.S. Patent and Trademark Office (USPTO) and any of the patents that we currently own or license may not be sufficient to keep competitors from using
our materials or processes. In addition, patents that we currently own or license may not be held valid if subsequently challenged by others and others may claim rights in the patents and other proprietary technology that we own or license.
Additionally, others may have already developed or may subsequently develop similar products or technologies without violating any of our proprietary rights. If we fail to obtain patent protection or preserve our trade secrets, we may be unable to
effectively compete against others offering similar products and services. In addition, if we fail to operate without infringing the proprietary rights of others or lose any license to technology that we currently have or will acquire in the future,
we may be unable to continue making the products that we currently make.



Moreover, at times, attempts may be made to challenge the prior issuance of our patents. For example, the USPTO has granted a third-party request for re-examination with respect to one patent relating to one of our
nanoparticle manufacturing processes. While we will vigorously defend our patent position, we may not be successful in maintaining the scope of the claims of this patent during re-examination. If our patent claims are narrowed substantially by the
USPTO, the patent coverage afforded our nanoparticle manufacturing process could be impaired. While we would not expect such impairment to affect the value of our manufacturing trade secrets that have not been disclosed in the patent, it could
impede the extent of our legal protection of the invention that is subject to this patent and potentially harm our business and operating results.



Furthermore, litigation may be necessary to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of
the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could harm our business, operating results and financial condition. In
addition, if others assert that our technology infringes their intellectual property rights, resolving the dispute could divert our management team and financial resources.



In the future, we may license certain of our intellectual property, such as trademarks or copyrighted material, to third
parties. While we would attempt to ensure that any licensees maintain the quality and value of our brand, these licenses might diminish this quality and value.



We may be subject to claims that one or more of the business methods used by us infringe upon patents held by others. The defense of any claims of
infringement made against us by third parties could involve significant legal costs and require our management to divert time and other resources from our business operations. Either of these consequences of an infringement claim could have a
material adverse effect on our operating results. If we are unsuccessful in defending any claims of infringement, we may be forced to obtain licenses or pay royalties to continue to use our technology. We may not be able to obtain any necessary
licenses on commercially reasonable terms or at all. If we fail to obtain necessary licenses or other rights, or if these licenses are costly, our operating results may suffer either from reductions in revenue through our inability to serve clients
or from increases in costs to license third-party technology.



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Our industry is experiencing rapid changes in technology. If we are unable to keep pace with these changes, our
business will not grow.



Rapid changes have occurred, and
are likely to continue to occur, in the development of advanced materials and processes. Our success will depend, in large part, upon our ability to keep pace with advanced materials technologies, industry standards and market trends and to develop
and introduce new and improved products on a timely basis. We expect to commit substantial resources to develop our technologies and product applications and, in the future, to expand our commercial manufacturing capacity as volume grows. Our
development efforts may be rendered obsolete by the research efforts and technological advances of others and other advanced materials may prove more advantageous than those we produce.



Our market is highly competitive, and if we are unable to compete effectively, then our business will not grow.



The advanced materials industry is new, rapidly evolving and intensely
competitive, and we expect competition to intensify in the future. The market for materials having the characteristics and potential uses of our nanocrystalline materials is the subject of intensive research and development efforts by both
governmental entities and private enterprises around the world. We believe that the level of competition will increase further as more product applications with significant commercial potential are developed. The nanocrystalline product applications
that we are developing will compete directly with products incorporating both conventional and advanced materials and technologies. While we are not currently aware of the existence of commercially available competitive products with the same
attributes as those we offer, other companies may develop and introduce new or competitive products. Our competitors may succeed in developing or marketing materials, technologies and better or less expensive products than the ones we offer. In
addition, many of our potential competitors have substantially greater financial and technical resources, and greater manufacturing and marketing capabilities than we do. If we fail to improve our current and potential nanocrystalline product
applications at an acceptable price, or otherwise compete with producers of conventional materials, we will lose market share and revenue to our competitors.



We may need to raise additional capital in the future. If we are unable to obtain adequate funds, we may be required to delay, scale-back or eliminate some of our
manufacturing and marketing operations or we may need to obtain funds through arrangements on less favorable terms or we may be required to transfer equipment to our largest customer.



We expect to expend significant resources on research, development and
product testing, and in expanding current capacity or capability for new business. In addition, we may incur significant costs in preparing, filing, prosecuting, maintaining and enforcing our patents and other proprietary rights. If necessary, we
may seek funding through public or private financing and through contracts with government or other companies. Additional financing may not be available on acceptable terms or at all. If we are unable to obtain adequate funds, we may be required to
delay, scale-back or eliminate some of our manufacturing and marketing operations or we may need to obtain funds through arrangements on less favorable terms. If we obtain funding on unfavorable terms, we may be required to relinquish rights to some
of our intellectual property.



To raise additional funds in the
future, we would likely sell our equity or debt securities or enter into loan agreements. To the extent that we issue debt securities or enter into loan agreements, we may become subject to financial, operational and other covenants that we must
observe. In the event that we were to breach any of these covenants, then the amounts due under such loans or debt securities could become immediately payable by us, which could significantly harm us. To the extent that we sell additional shares of
our equity securities, our stockholders may face economic dilution and dilution of their percentage ownership.



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We currently have a supply agreement with BASF that contains provisions which could potentially result in
a mandatory transfer of technology and sale of production equipment to BASF providing capacity sufficient to meet BASFs production needs. The transfer and related sale would be triggered only in the event that one of the following
occurs:



| |  |  | our earnings for a twelve month period ending with our most recently published quarterly financial statements are less than zero and our cash, cash equivalents and investments are
less than $2,000,000, or
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the acceleration of any debt maturity having a principal amount of more than $10,000,000, or we become insolvent as defined in the supply agreement.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------



In the event of a triggering event where we are required to sell to BASF
production equipment providing capacity sufficient to meet BASFs production needs, the equipment would be sold at 115% of the equipments net book value.



We believe that we have sufficient cash balances to avoid the first triggering event for the foreseeable future. If a
triggering event were to occur and BASF elected to proceed with the transfer and related sale mentioned above, we would lose both significant revenue and the ability to generate significant revenue to replace that which was lost in the near term.
Replacement of necessary equipment that would be purchased and removed by BASF pursuant to this triggering event could take six months to a year. Any additional capital outlays required to rebuild capacity would probably be greater than the proceeds
from the purchase of the assets pursuant to our agreement with BASF. This shortfall might put us in a position where it would be difficult to secure additional funding given what would then be an already tenuous cash position. Such an event would
also result in the loss of many of our key staff and line employees due to economic realities. We believe that our employees are a critical component of our success and would be difficult to quickly replace and train. Given the occurrence of such an
event, we might not be able to hire and retrain skilled employees given the stigma relating to such an event and its impact on us. We might elect to effectively reduce our size and staffing to a point where we could remain a going concern in the
near term.



We depend on key personnel, and their unplanned departure could
harm our business.



Our success will depend, in large
part, upon our ability to attract and retain highly qualified research and development, management, manufacturing, marketing and sales personnel on favorable terms. Due to the specialized nature of our business, we may have difficulty locating,
hiring and retaining qualified personnel on favorable terms. If we were to lose the services of any of our key executive officers or other key personnel, or if we are unable to attract and retain other skilled and experienced personnel on acceptable
terms in the future, or if we are unable to implement a succession plan to prepare qualified individuals to assume key roles upon any loss of our key personnel, then our business, results of operations and financial condition would be materially
harmed. In addition, we do not currently have key-man life insurance policies covering all of our executive officers or key employees, nor do we presently have any plans to purchase such policies.



We face potential product liability risks which could result in significant costs that
exceed our insurance coverage, damage our reputation and harm our business.



We may be subject to product liability claims in the event that any of our nanocrystalline product applications are alleged to be defective or cause harmful effects. Because our nanocrystalline materials are used in
other companies products, to the extent our customers become subject to suits relating to their products, such as cosmetic, skin-care and personal-care products, these claims may also be asserted against us. We may incur significant costs
including payment of significant damages, in defending or settling product liability claims. We currently maintain insurance coverage in the amount of $10 million



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for product liability claims, which may prove not to be sufficient. Even if a suit is without merit and regardless of the outcome, claims can divert
management time and attention, injure our reputation and adversely affect demand for our nanocrystalline materials.



We are subject to governmental regulations. The costs of compliance and liability for noncompliance with governmental regulations could have a material adverse effect
on our business, results of operations and financial condition.



Current and future laws and regulations may require us to make substantial expenditures for preventive or remedial action. Our operations, business or assets may be materially and adversely affected by governmental interpretation and
enforcement of current or future environmental, health and safety laws and regulations. In addition, our coating operations pose a risk of accidental contamination or injury. The damages in the event of an accident or the costs to prevent or
remediate a related event could exceed our resources or otherwise have a material adverse effect on our business, results of operations and financial condition.



In addition, both of our facilities and all of our operations are subject to the plant and laboratory safety requirements of various occupational
safety and health laws. We believe we have complied in all material respects with regard to governmental regulations applicable to us. However, we may have to incur significant costs in defending or settling future claims of alleged violations of
governmental regulations and these regulations may materially restrict or impede our operations in the future. In addition, our efforts to comply with or contest any regulatory actions may distract personnel or divert resources from other more
important initiatives.



The manufacture and use of certain
products that contain our nanocrystalline materials are subject to intense governmental regulation, including regulations promulgated by the U.S. Food and Drug Administration, the U.S. Environmental Protection Agency and the U.S. Occupational Safety
and Health Administration. As a result, we are required to adhere to the requirements of the regulations of governmental authorities in the United States and other countries. These regulations could increase our cost of doing business and may render
some potential markets prohibitively expensive.



We have implemented
anti-takeover provisions which could discourage or prevent a takeover, even if an acquisition could be beneficial to our stockholders.



In October 1998, we entered into a Rights Agreement, commonly referred to as a poison pill. The provisions of this agreement and some of the
provisions of our certificate of incorporation, our bylaws and Delaware law could, together or separately:



| |  |  | discourage potential acquisition proposals;
| | - |  | -------------------------------------------



| |  |  | delay or prevent a change in control; and
| | - |  | -----------------------------------------



| |  |  | limit the price that investors might be willing to pay in the future for shares of our common stock.
| | - |  | ----------------------------------------------------------------------------------------------------



In particular, our board of directors is authorized to issue up to 24,088 shares of preferred stock (less any outstanding
shares of preferred stock) with rights and privileges that might be senior to our common stock, without the consent of the holders of the common stock, including up to 2,500 shares of Series A Junior Participating Preferred Stock issuable under the
1998 Rights Agreement.



In addition, Section 203 of the
Delaware General Corporations Law and the terms of our stock option plans may discourage, delay or prevent a change in control of our company.



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Future sales of our common stock by existing stockholders could negatively affect the market price of our stock and
make it more difficult for us to sell stock in the future.



Sales of our common stock in the public market, or the perception that such sales could occur, could result in a decline in the market price of our common stock and make it more difficult for us to complete future equity financings. A
substantial number of shares of our common stock and shares of common stock subject to outstanding warrants and options may be resold pursuant to currently effective registration statements. On April 15, 2005, there are:



| |  |  | 15,733,199 shares of common stock that have been issued in registered offerings, upon the exercise of options under our equity incentive plan or in private placements and are freely
tradable in the public markets,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 1,521,239 shares of common stock that may be issued on the exercise of stock options outstanding and exercisable under our equity incentive plan;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 906,002 shares of common stock that were issued pursuant to our September 8, 2003 private placement and the related warrant which was exercised on September 2, 2004. The resale of
these shares has been registered pursuant to a Registration Statement on Form S-3 which was declared effective by the Securities and Exchange Commission on August 13, 2004; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | 1,256,281 shares of common stock that were issued pursuant to our March 23, 2004 private placement and may be registered for resale after March 23, 2006 pursuant the terms of the
Registration Rights Agreement executed in connection with this private placement.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We cannot estimate the number of shares of common stock that may actually be resold in the public market because this will depend on the market price for
our common stock, the individual circumstances of the sellers, and other factors. If stockholders sell large portions of their holdings in a relatively short time, for liquidity or other reasons, the market price of our common stock could decline
significantly.



Bradford T. Whitmore has significant influence on all
matters requiring stockholder approval because he beneficially owns a large percentage of our common stock, and he may vote the common stock in ways with which our other stockholders disagree.



As of April 15, 2005, Bradford T. Whitmore, together with his affiliates,
Grace Brothers, Ltd. and Grace Investments, Ltd., beneficially owned approximately 19.9% of the outstanding shares of our common stock. As a result, he has significant influence on matters submitted to our stockholders for approval, including
proposals regarding:



| |  |  | any merger, consolidation or sale of all or substantially all of our assets; the election of members of our board of directors; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| |  |  | any amendment to our certificate of incorporation.
| | - |  | --------------------------------------------------



The ownership position of Mr. Whitmore could delay, deter or prevent a change of control or adversely affect the price that investors might be willing to
pay in the future for shares of our common stock. Mr. Whitmores interests may be significantly different from the interests of our



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other stockholders and he may vote the common stock he beneficially owns in ways with which our other stockholders disagree. Investors should also note that
R. Janet Whitmore, one of our directors, is the sister of Mr. Whitmore.



We
have been involved in litigation. If we are involved in similar litigation in the future, the expense of defending such litigation and the potential costs of judgments against us and the costs of maintaining insurance coverage could have a material
adverse effect on our financial performance.



We have been
involved in three securities class action lawsuits, one of which was a consolidation of several related lawsuits. While all of these lawsuits have been settled and dismissed with all settlements funded by our directors and officers liability
insurance, we may be the target of additional securities lawsuits in the future. If we are involved in similar litigation in the future, the expense of defending such litigation, the potential costs of judgments against us, the costs of maintaining
insurance coverage and the diversion of managements attention could have a material adverse effect on our financial performance.



Our stock price is volatile.



The stock markets in general, and the stock prices of technology-based companies in particular, have experienced extreme volatility that often has been
unrelated to the operating performance of any specific public company. The market price of our common stock has fluctuated in the past and is likely to fluctuate in the future as well. Our future financial performance and stock price may be subject
to significant volatility, particularly on a quarterly basis. Shortfalls in our revenues in any given period relative to the levels expected by investors could immediately, significantly and adversely affect the trading price of our common stock.



Dilutive effect of private placements.



On May 29, 2002 we sold 1,370,000 shares of our common stock to selected
accredited investors at a purchase price of $5.00 per share. On May 29, 2002 the closing sale price of our common stock, as reported on NASDAQ, was $5.15 per share. On September 8, 2003 we sold 453,001 shares of our common stock to Grace Brothers,
Ltd. at a purchase price of $4.415 per share together with a warrant to purchase a like number of shares of common stock during the next twelve months also at a price of $4.415 per share. The share price for the common stock was determined based on
the fifteen-day market closing average for our stock ending September 5, 2003. On September 8, 2003 the closing sale price of our common stock as reported on NASDAQ, was $5.50 per share. On March 23, 2004 we sold 1,256,281 shares of our common stock
to Altana at a purchase price of $7.96 per share. On March 23, 2004 the closing sale price of our common stock, as reported on NASDAQ, was $8.26 per share. Each of these issuances of stock at below the then-current market price had a dilutive effect
on existing common stockholders.



We have never paid dividends.



We currently intend to retain earnings, if any, to
support our growth strategy. We do not anticipate paying dividends on our stock in the foreseeable future.



Safe Harbor Provision



Nanophase Technologies Corporation wants to provide investors with more meaningful and useful information. As a result, this Quarterly Report on Form 10-Q (the Form 10-Q) contains and incorporates by reference certain
forward-looking statements, as defined in Section 21E of the Securities Exchange Act of 1934, as amended. These statements reflect the Companys current expectations of the future results of its operations, performance and
achievements. Forward-looking statements are covered under the safe harbor provisions of the Private Securities Litigation Reform Act of



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1995. The Company has tried, wherever possible, to identify these statements by using words such as anticipates, believes,
estimates, expects, plans, intends and similar expressions. These statements reflect managements current beliefs and are based on information now available to it. Accordingly, these statements
are subject to certain risks, uncertainties and contingencies that could cause the Companys actual results, performance or achievements in 2005 and beyond to differ materially from those expressed in, or implied by, such statements. These
risks, uncertainties and factors include, without limitation: a decision by a customer to cancel a purchase order or supply agreement in light of the Companys dependence on a limited number of key customers; uncertain demand for, and
acceptance of, the Companys nanocrystalline materials; the Companys limited manufacturing capacity and product mix flexibility in light of customer demand; the Companys limited marketing experience; changes in development and
distribution relationships; the impact of competitive products and technologies; the Companys dependence on patents and protection of proprietary information; the resolution of litigation in which the Company may become involved; and other
risks set forth under the caption Risk Factors above. Readers of this Quarterly Report on Form 10-Q should not place undue reliance on any forward-looking statements. Except as required by federal securities laws, the Company undertakes
no obligation to update or revise these forward-looking statements to reflect new events or uncertainties.



Item 3. Quantitative and Qualitative Disclosures About Market Risk



The only financial instruments that the Company holds are investments of a short-term duration. Management does not believe that the Company currently has
material market risk relating to its investments.



Item 4. Controls and Procedures



As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of the Companys disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the Exchange Act). Based on this evaluation, the principal executive officer and principal financial officer concluded that
the Companys disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in Securities and Exchange Commission rules and forms. There was no change in the Companys internal control over financial reporting during the Companys most recently completed fiscal quarter that has
materially affected, or is reasonably likely to materially affect, the Companys internal control over financial reporting.



PART II  OTHER INFORMATION



Item 1. Legal Proceedings



None



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Item 5. Other Information



In November 2000, the
Company executed a three-year promissory note, held by the Companys largest customer, in the amount of $1,293,895 for the construction of additional production capabilities at the Companys Romeoville, Illinois facility. The outstanding
balance of this note was $460,427 on March 31, 2005. The note bears interest at 8.45% per annum and is collateralized by certain powder coating, packaging, lab and related equipment. In May 2005, an amendment to this promissory note was executed for
the purpose of extending the date when any unpaid balance will be due upon demand from June 1, 2005 to June 1, 2007. Management expects this debt to be fully paid during 2006.



Item 6. Exhibits and Reports on Form 8-K



| | A. | Exhibits.
| | -- | ---------

|               |  |                                                                                                             
|-------------- |  | ------------------------------------------------------------------------------------------------------------
|               | 
|Exhibit 10.33* |  | Second Amendment to Promissory Note dated May 1, 2005 between the Company and BASF Corporation.             
|               | 
|Exhibit 31.1   |  | Certification of Chief Executive Officer pursuant to Rules 13a-14(a) under the Exchange Act.                
|               | 
|Exhibit 31.2   |  | Certification of Chief Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) under the Exchange Act.  
|               | 
|Exhibit 32     |  | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350.



*Confidentiality requested, confidential portions have been omitted and filed separately with the Commission as required by Rule 24b-2.



B. Reports on Form 8-K.



On March 3, 2005, the Company furnished a Current Report on Form 8-K reporting under Items 2.02 and 9.01 that on March 2, 2005 it issued a press release
announcing its financial results for the year ended December 31, 2004.



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SIGNATURES



Pursuant to the
requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.





|                  |  |                                    |  |                                                                                
|----------------- |  | ---------------------------------- |  | -------------------------------------------------------------------------------
|                  |  | NANOPHASE TECHNOLOGIES CORPORATION
|                  |  |                                   
|Date: May 9, 2005 |  | By:                                |  | /s/ JOSEPH E. CROSS                                                            
|                  |  |                                    |  | Joseph E. Cross                                                                
|                  |  |                                    |  | President, Chief Executive Officer (principal executive officer) and a Director
|                  |  |                                   
|Date: May 9, 2005 |  | By:                                |  | /s/ JESS JANKOWSKI                                                             
|                  |  |                                    |  | Jess Jankowski                                                                 
|                  |  |                                    |  | Chief Financial Officer (principal financial and chief accounting officer)     



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