NANOPHASE TECHNOLOGIES CORPORATION - 10-Q Quarterly Report

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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

As of May 13, 2003, there were outstanding 15,181,491 shares of Common Stock, par value $.01, of the registrant.

The accompanying unaudited interim financial statements of Nanophase Technologies Corporation (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, 2003 are not necessarily indicative of the results that may be expected for the year ended December 31, 2003.

These financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto for the year ended December 31, 2002, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002, as filed with the Securities and Exchange Commission.

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 is engaged in the manufacture and engineering of nanocrystalline materials. The Company works collaboratively with a variety of other companies in meeting their application needs, effectively providing value-enhanced solutions for commercial applications in multiple global markets. Nanophase does this by recognizing a need to offer enhanced performance and assist customers with their product improvements. 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.

The Company’s typical credit terms are thirty days from shipment and invoicing.

Revenue from international sources approximated $318,000 and $172,000 for the three months ended March 31, 2003 and 2002, respectively.

Investments are classified by the Company at the time of purchase for appropriate designation and such designation is reevaluated as of each balance sheet date. The Company’s policy is to classify money market funds and certificates of deposit as investments. Investments are classified as held-to maturity when the Company has the positive intent and ability to hold the securities to maturity. Held-to maturity securities are stated at amortized cost and are adjusted to maturity for the amortization of premiums and accretion of discounts. Such adjustments for amortization and accretion are included in interest income. The Company’s investments are held by its investment bank who is a member of all major stock exchanges and the Securities Investor Protection Corporation (SIPC). Securities and cash held in custody by the Company’s investment bank are afforded unlimited protection through SIPC and a commercial insurer, however, it does not protect against losses from the rise and fall in market value of investments.

During the three months ended March 31, 2003, 24,350 shares of Common Stock were issued in the form of an annual restricted stock grant to the Company’s outside directors, compared to 20,425 shares of Common Stock in the same period in 2002, of which 12,700 shares related to the previously discussed annual restricted stock grant and 7,725 shares being issued pursuant to option exercises.

As permitted by Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (FASB 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. FASB 123, established an alternative fair value method of accounting for stock-based compensation plans. As required by FASB 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 FASB Statement No. 123.

Pro forma information regarding net income is required by FASB 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, 2003 and 2002:

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. Because FASB No. 123 is applicable only to options granted subsequent to December 31, 1994, its pro forma impact was not fully reflected until 2002. The pro-forma impact for the three months ended March 31, 2003 and 2002 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 FASB Statement No. 123, Accounting for Stock-Based Compensation):

Revenue from three customers constituted approximately 67.0%, 18.8%, and 12.6%, respectively, of the Company’s total revenue for the three months ended March 31, 2003. Amounts included in accounts receivable at March 31, 2003 relating to these three customers were approximately $438,000, $522,000, and $159,000, respectively. Revenue from these three customers constituted approximately 70.7%, 9.4%, and 1% respectively, of the Company’s total revenue for the three months ended March 31, 2002. Amounts included in accounts receivable at March 31, 2002 relating to these three customers were approximately $553,000, 384,000, and $2,000, respectively. The Company currently has supply agreements with two of the aforementioned customers that have contingencies

outlined in them which could potentially result in the license of technology and/or, as provided for in the supply agreement, as amended on March 17, 2003, with the Company’s largest customer, 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 included in the Company’s supply agreement with its largest customer “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 liquid 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) 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 $2,000,000 “trigger” referenced above was recently reduced from $4,000,000 pursuant to an amendment to the supply agreement with the Company’s largest customer.

The Company believes that it has complied with all contractual requirements and that it has not had a “triggering event”. The Company further believes that the proceeds of the May 29, 2002 private placement provide sufficient cash balances to avoid the first triggering event referenced above through at least December 31, 2003. If a triggering event were to occur and our largest customer elected to proceed with the transfer and related sale mentioned above, the Company would receive royalty payments from its customer for products sold using our 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 would 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. This shortfall might put the Company in a position where it would be difficult to secure additional funding given an already tenuous cash position. 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 would 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 1998, Harbour Court LPI, a small stockholder of the Company, sued the Company in the United States District Court for the Northern District of Illinois. The complaint alleged that the Company, certain of its officers and directors, and the underwriters of the Company’s initial public offering of common stock (the “Offering”) had violated the federal Securities Exchange Act of 1934 by making supposedly fraudulent material misstatements of fact in connection with soliciting consents to proceed with the Offering from certain of the Company’s preferred stockholders. The supposed misrepresentations concerned purported mischaracterization of revenue that the Company received from its then-largest customer. The complaint further alleged that the action should be maintained as a plaintiff class action on behalf of certain former preferred stockholders whose shares of preferred stock were converted into common stock on or about the date of the Offering. The complaint sought unquantified compensatory damages and attorneys’ fees. In September 2000, each defendant answered the complaint, denying all wrongdoing. Following certain discovery, the Company agreed to settle all claims against all defendants for $800,000, plus up to an additional $50,000 for the cost of settlement notices and administration. The settlement did not admit liability by any party. The Court ordered final approval of the settlement in January 2002 and concurrently dismissed the complaint with prejudice. In January 2003, the Court approved interim payment to plaintiffs of $17,102 in settlement administration costs. Because both the settlement and the settlement administration costs were funded by the Company’s directors and officers liability insurance, neither the settlement nor the settlement administration costs payment have had a material adverse effect on the Company’s financial position or results of operations.

In November 2001, George Tatz, a purchaser of 200 shares of the Company’s common stock, filed a separate complaint in the United States District Court for the Northern District of Illinois against the Company and Joseph Cross, its president and CEO. The complaint alleged that defendants violated the federal Securities Exchange Act of 1934 by making supposedly fraudulent material misstatements of fact in connection with the Company’s public disclosures, including certain press releases, concerning the Company’s dealings with Celox, a British customer. The complaint further alleged that the action should be maintained as a plaintiff class action on behalf of certain persons who purchased shares of the Company’s common stock from April 5, 2001 through October 24, 2001. The complaint sought relief including unquantified compensatory damages, attorneys’ and expert witness’ fees. In March 2002, plaintiff filed an amended complaint, alleging that the Company and four of its current or former officers (Joseph Cross; Daniel Bilicki, its vice president of sales and marketing; Jess Jankowski, its acting chief financial officer; and Gina Kritchevsky, its former chief technology officer) are liable under the federal Securities Exchange Act of 1934 for making supposedly fraudulent material misstatements and omissions of fact in connection with the Company’s press releases, publicly-filed reports and other public disclosures concerning the Company’s relationship with Celox and the Company’s purportedly improper booking, and later reversal, of $400,000 in revenue from a one-time sale to Celox treated as a bill and hold transaction. The amended complaint alleges the same putative class and seeks the same relief as in plaintiff’s initial complaint. Defendants moved to dismiss the amended complaint in April 2002. In October 2002, the Court denied defendants’ motion, finding that plaintiff’s 40-page amended complaint asserted sufficient allegations to permit the case to proceed. Defendants filed their answer to the amended complaint in November 2002, denying all wrongdoing, and the parties began discovery which currently continues. In December 2002, plaintiff filed his motion for class certification, briefing on which was completed in March 2003. The Court has not yet ruled on the class certification motion nor has the Court indicated when it anticipates ruling. Although the Company believes that the allegations of the amended complaint are without merit, it is not feasible for the Company to predict at this time the ultimate outcome of this litigation or whether its resolution could have a material adverse effect on the Company’s results of operations or financial condition.

SFAS No. 143, Accounting for Asset Retirement Obligations, addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The statement requires that the fair value of a liability for an asset retirement obligation be recognized in the period it is incurred if a reasonable estimate of fair value can be made. The associated retirement costs are capitalized as a component of the carrying amount of the long-lived asset and allocated to expense over the useful life of the asset. The statement is effective for financial statements issued for fiscal years beginning after June 15, 2002. The Company adopted the statement as of January 1, 2003 and recorded an asset retirement obligation relating to the potential removal of leasehold improvements in accordance with the Company’s existing leases at an estimated fair value of $82,000. The implementation of this standard resulted in $2,878 in amortization expense and $9,599 in accretion expense for the three months ended March 31, 2003. After the recognition of the first quarter 2003 accretion, the net balance of this obligation amounted to $72,401 at March 31, 2003.

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

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, 2003, the Company was primarily capitalized through the private offering of approximately $25.8 million of equity securities and its initial public offering of $28.8 million of Common Stock in November of 1997 and $6.2 million of Common Stock in a private placement offering in May of 2002, each net of issuance costs. The Company has incurred cumulative losses of $41.3 million from inception through March 31, 2003.

We utilize certain accounting measurements under applicable generally accepted accounting principles, which involve the exercise of management’s judgment about subjective factors and estimates about the effect of matters which are inherently uncertain. The following is a summary of those accounting measurements which we believe are most critical to our reported results of operations and financial condition.

Revenue Recognition. Product revenue consists of sales of product that are recognized when realized and earned. This occurs when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectibility is reasonably assured. Other revenue consists of revenue from research and development arrangements with non-governmental entities, fees from the transfer of technology and, principally, for the quarter ended March 31, 2003 the sale of equipment discussed below as well as related royalties, with similar royalties being reflected in the quarter ended March 31, 2002. For the quarter ended March 31, 2003, the Company recognized the sale of production equipment that was designed and built by the Company. These types of equipment sales occur on occasion and are also treated as other revenue. This transaction is discussed in further detail below. Research and development arrangements include both cost-plus and fixed fee agreements and such revenue is recognized when specific milestones are met under the arrangements. Fees related to the transfer of technology are recognized when the transfer of technology to the acquiring party is completed and the Company has no further significant obligation. Royalties are recognized when earned pursuant to the contractual arrangement.

Inventory Valuation. Cost is determined on a first-in, first-out basis. Inventory is stated at the lower of cost, maintained on a first in, first out basis, or market. The Company has recorded allowances to reduce inventory relating to excess quantities of certain materials. Write-downs of inventories establish a new cost basis, which is not increased for future increases in market value of inventories or changes in estimated excess quantities.

Trade Receivables. Trade receivables are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management determines the allowance for doubtful accounts by identifying troubled accounts and by using historical experience applied to an aging of accounts. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received.

Total revenue increased to $1,664,082 for the three months ended March 31, 2003, compared to $1,407,683 for the same period in 2002. The increase in total revenue was primarily attributed to growth with existing customers and revenue from a new customer. Product revenue increased to $1,350,338 for the three months ended March 31, 2003, compared to $1,313,577 for the same period in 2002. Other revenue increased to $313,744 for the three-month period ended March 31, 2003, compared to $94,106 for the same period in 2002. The majority of the revenue generated during the three months ended March 31, 2003 was from customers in the healthcare and Chemical Mechanical Planarization (CMP) markets. Other revenue in the amount of $226,450 was recognized relating to the sale of production equipment to the Company’s Japanese licensee that was designed and built by the Company. These types of equipment sales occur on occasion and are treated as other revenue.

Cost of revenue generally includes costs associated with commercial production and customer development arrangements. Cost of revenue increased to $1,546,722 for the three months ended March 31, 2003, compared to $1,295,024 for the same period in 2002. The increase in cost of revenue was generally attributed to increased revenue volume and increased depreciation expense resulting from the completion, and placement in service of the Company’s build out of its manufacturing and powder coating facilities, and increased facility costs, somewhat offset by efficiencies in the manufacture of the Company’s products. Cost of revenue as a percentage of total revenue increased from 92% for the three months ended March 31, 2002 to 93% for the three months ended March 31, 2003, due primarily to the effects of the previously discussed completion, and additional depreciation expense recorded by the placement in service of the Company’s build out of its manufacturing and powder coating facilities. Management expects gross margins, taken for the year as a whole, to be positive. The extent to which the Company’s margins remain positive, as a percentage of revenue, will be dependent upon revenue mix, revenue volume, and the Company’s ability to continue to cut costs.

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. The Company is currently 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. Recently, the Company has demonstrated the capability to produce pilot quantities of mixed-metal oxides in a single crystal phase. This development has been driven largely by customer demand. Management is now working on several related commercial applications. 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. Research and development expense decreased to $461,537 for the three months ended March 31, 2003, compared to $523,685 for the same period in 2002. The decrease in research and development expense was primarily attributed to bonuses accrued for the three months ended March 31, 2002 being higher than bonuses being accrued for the same period in 2003 and one less employee between the same two periods.

Selling, general and administrative expense decreased to $1,076,709 for the three-month period ended March 31, 2003, compared to $1,085,215 for the same period in 2002. The net decrease was primarily attributed to decreased director compensation due to recognition of this expense in a lump sum, when it was paid in January, 2002 and additionally as a monthly accrual throughout 2002. This treatment effectively resulted in twice as much total director compensation expense being recognized in 2002, the year of the change in recording convention, than in 2003. These decreases were somewhat offset by increases in business insurance and legal expenses relating to the Company’s current securities litigation.

Interest income decreased to $22,064 for the three-month period ended March 31, 2003, compared to $28,136 for the same period in 2002. This decrease was primarily due to reduced investment yields.

The Company’s cash, cash equivalents and investments amounted to $6,239,809 at March 31, 2003, compared to $7,508,492 at December 31, 2002. The net cash used in the Company’s operating activities was $870,705 for the three months ended March 31, 2003, compared to $913,639 for the same period in 2002. Net cash provided by investing activities, which is due to maturities of securities offset somewhat by capital expenditures and purchases of securities, amounted to $883,517 and $651,000 for the three months ended March 31, 2003 and 2002, respectively. Capital expenditures, primarily related to the continued build out of the Company’s pilot plant manufacturing facility within its Romeoville, Illinois facility and further expansion of the Company’s existing manufacturing facilities and the purchase of related operating equipment, amounted to $95,311 and $172,828 for the three months ended March 31, 2003 and 2002, respectively. Net cash used in financing activities, which related to principal payments on debt and capital lease obligations and accounts payable incurred for the purchase of equipment and leasehold improvements, somewhat offset by the issuance of shares of Common Stock pursuant to the exercise of options, amounted to $102,305 for the three-month period ended March 31, 2003, compared to $31,976 for the same period in 2002.

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 proceeds to fund expected growth in new markets as well as to provide for expanded working capital needs expected to arise as sales volume grows.

The Company’s supply agreement with its largest customer contains several financial covenants which could potentially impact the Company’s liquidity. The most restrictive financial covenants under this agreement require the Company to maintain a minimum of $2.0 million in cash and investments, and no more than $10.0 million in debt, in order to avoid an event which could trigger a transfer of technology and equipment to the Company’s largest customer in the event that the Company’s cash, cash equivalents and investment balances drop below $2.0 million. The Company had approximately $6.2 million in cash and investments and debt of less than $1.5 million at March 31, 2003. Management expects that the proceeds received from the May, 2002 private placement offering should be sufficient to enable the Company to comply with these financial covenants through at least December 31, 2003. This supply agreement and its covenants are more fully described in Note 6 of the Company’s financial statements.

The Company believes that cash from operations and cash, cash equivalents and investments on hand, together with the remaining net proceeds from the Company’s initial public offering of Common Stock (“the Offering”), and with its most recent funding received through a private placement offering, and interest income thereon, will be adequate to fund the Company’s operating plans for the next twelve months. The Company’s actual future capital requirements 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 capital spending in 2003 to be approximately $525,000, of which $200,000 relates to payments of accounts payable incurred in 2002 but not payable until 2003.

At March 31, 2003, the Company had a net operating loss carryforward of approximately $46.6 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 2023. As a result of the annual limitation, a portion of this carryforward may expire before ultimately becoming available to reduce income tax liabilities. At March 31, 2003, the Company also had a foreign tax credit carryforward of $253,500, which could be used as an offsetting tax credit to reduce U.S. income taxes. The foreign tax credit will expire at various dates between 2017 and 2023 if not utilized before that date.

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 which may be needed to retain existing business or remain competitive in the seeking of new business; new regulatory requirements that are outside the Company’s control; or various other circumstances coming to pass that are currently not anticipated by the Company.

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 on 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 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 2003 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; uncertain demand for, and acceptance of, the Company’s nanocrystalline materials; the Company’s dependence on a limited number of key customers; the Company’s limited manufacturing capacity and product mix flexibility; 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 the Company is involved in; the possible disruption of

commercial activities occasioned by terrorist activity and armed conflict; and other risks set forth under the Company’s previous filings with the Securities and Exchange Commission. 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.

Within 90 days prior to the filing date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Acting Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures pursuant to Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Company’s Chief Executive Officer and Acting Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective. It should be noted that in designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management, necessarily, was required to apply its judgment in evaluating the cost-benefit relationship relating to possible controls and procedures. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date of the evaluation referred to above.

On November 26, 1997 the Company’s Registration Statement on Form S-1 (File No. 333-36937) relating to the Company’s initial public offering of common stock (the “Offering”) was declared effective by the Securities and Exchange Commission. The market price established for the Company’s initial public offering was $8.00 per share. On May 29, 2002, the Company issued 1,370,000 shares of common stock in a private placement offering, taken collectively with the Company’s November 26, 1997 Offering as “the Offerings.” Since November 26, 1997, of its $35,033,231 of net proceeds from the Offerings, the Company has used approximately $9,843,000 for capital expenditures primarily related to the further expansion of the Company’s existing manufacturing facility and the purchase of operating equipment and approximately $18,951,000 for working capital and other general corporate purposes. The remainder of the net proceeds has been invested by the Company, pending its use, in short-term, investment grade, interest-bearing obligations.

On May 29, 2002, the Company sold, in a private placement to qualified accredited investors, 1.37 million shares of common stock at $5.00, an approximate 3% discount from market, per share and received gross proceeds of $6.85 million. The closing market price of Nanophase’s stock was $5.15 per share on May 29, 2002. Net proceeds were approximately $6.2 million after commissions, legal, accounting, and other costs. The Company intends to use the proceeds to fund expected growth in new markets as well as to provide for expanded working capital needs expected to arise as sales volume grows. The preceding issuance was made in reliance on the exemption from registration found in section 4(2) of the Securities Act of 1933.

The Company did not file any Current Reports on Form 8-K during the first quarter of 2003.

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.

1. I have reviewed this quarterly report on Form 10-Q of Nanophase Technologies Corporation;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

(a) designed such disclosure controls and procedures to ensure that material information relating to the registrant is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

(b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

(c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

(a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

/S/ JOSEPH E. CROSS

Joseph E. Cross

Chief Executive Officer

1. I have reviewed this quarterly report on Form 10-Q of Nanophase Technologies Corporation;

(b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

(c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

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

		Page
PART I—FINANCIAL INFORMATION		3
Item 1. Financial Statements		3
Unaudited Balance Sheets as of March 31, 2003 and December 31, 2002		3
Unaudited Statements of Operations for the three months ended March 31, 2003 and 2002		4
Unaudited Statements of Cash Flows for the three months ended March 31, 2003 and 2002		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		15
Item 4. Controls and Procedures		15
PART II—OTHER INFORMATION		16
Item 1. Legal Proceedings		16
Item 2. Changes in Securities and Use of Proceeds		16
Item 6. Exhibits and Reports on Form 8-K.		16
SIGNATURES		17
CERTIFICATIONS		18

	March 31, 2003			December 31, 2002
ASSETS
Current assets:
Cash and cash equivalents	$	356,191		$	445,684
Investments		5,883,618			7,062,808
Trade accounts receivable, less allowance for doubtful accounts of $25,000 at March 31, 2003 and December 31, 2002		1,104,243			941,335
Other receivable		20,850			16,790
Inventories, net		724,288			981,834
Prepaid expenses and other current assets		594,373			747,042

Total current assets		8,683,563			10,195,493
Equipment and leasehold improvements, net		9,169,264			9,433,237
Other assets, net		454,748			384,240

	$	18,307,575		$	20,012,970

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debts	$	848,496		$	1,283,554
Current portion of capital lease obligations		61,368			62,099
Accounts payable		554,865			480,789
Accrued expenses		815,896			989,000

Total current liabilities		2,280,625			2,815,442

Long-term debt, less current maturities		505,732			309,128
Long-term portion of capital lease obligations, less current maturities		39,576			55,435

		545,308			364,563


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; 15,162,227 and 15,137,877 shares issued and outstanding at March 31, 2003 and December 31, 2002, respectively		151,622			151,379
Additional paid-in capital		56,732,103			56,658,080
Deferred stock compensation		(55,941	)		(67,069	)
Accumulated deficit		(41,346,142	)		(39,909,425	)

Total stockholders’ equity		15,481,642			16,832,965

		$18,307,575		$	20,012,970

	Three months ended March 31,
	2003			2002
Revenue:
Product revenue	$	1,350,338		$	1,313,577
Other revenue		313,744			94,106

Total revenue		1,664,082			1,407,683


Operating expense:
Cost of revenue		1,546,722			1,295,024
Research and development expense		461,537			523,685
Selling, general and administrative expense		1,076,709			1,085,215

Total operating expense		3,084,968			2,903,924

Loss from operations		(1,420,886	)		(1,496,241	)
Interest income		22,064			28,136
Interest expense		(30,395	)		(27,490	)
Other, net		—			900

Loss before provision for income taxes		(1,429,217	)		(1,494,695	)
Provision for income taxes		(7,500	)		—

Net loss	$	(1,436,717	)	$	(1,494,695	)

Net loss per share—basic and diluted	$	(0.09	)	$	(0.11	)

Weighted average number of commonshares outstanding		15,161,686			13,725,801

	Three months ended March 31,
	2003			2002
Operating activities:
Net loss	$	(1,436,717	)	$	(1,494,695	)
Adjustments to reconcile net loss to net cash (used in) operating activities:
Depreciation and amortization		359,364			266,315
Allowance for excess inventory quantities		(1,933	)		41,072
Stock compensation expense		11,128			—
Changes in assets and liabilities related to operations:
Trade accounts receivable		(241,381	)		(31,363	)
Other receivable		(4,060	)		(3,288	)
Inventories		293,313			113,093
Prepaid expenses and other assets		157,901			(25,405	)
Accounts payable		249,662			101,013
Accrued liabilities		(257,982	)		119,619

Net cash (used in) operating activities		(870,705	)		(913,639	)

Investing activities:
Acquisition of equipment and leasehold improvements		(95,311	)		(172,828	)
Payment of accounts payable incurred for the purchase of equipment and leasehold improvements		(200,362	)		(833,824	)
Purchases of held-to-maturity investments		(15,844,782	)		(28,551,400	)
Maturities of held-to-maturity investments		17,023,972			30,209,052

Net cash provided by investing activities		883,517			651,000

Financing activities:
Principal payment on debt obligation, including capital leases		(176,571	)		(129,749	)
Proceeds from sale of common stock, net, and exercise of stock options		74,266			97,773

Net cash (used in) financing activities		(102,305	)		(31,976	)

(Decrease) in cash and cash equivalents		(89,493	)		(294,615	)
Cash and cash equivalents at beginning of period		445,684			582,579

Cash and cash equivalents at end of period	$	356,191		$	287,964

Supplemental cash flow information:
Interest paid	$	30,395		$	27,490

Supplemental non-cash investing activities:
Accounts receivable paid through offset of long-term debt	$	78,473		$	—

Accounts payable incurred for the purchase of equipment and leasehold improvements	$	24,776		$	146,258

Accrual related to asset retirement obligation	$	82,000		$	—

NANOPHASE TECHNOLOGIES CORPORATION

Date: May 15, 2003

/S/ JOSEPH E. CROSS

Joseph E. Cross

President, Chief Executive Officer

(principal executive officer) and a Director

Date: May 15, 2003

/S/ JESS JANKOWSKI

Jess Jankowski

Acting Chief Financial Officer, Vice President,

Corporate Controller, Treasurer and Secretary

(principal financial and chief accounting officer)

	March 31, 2003			December 31, 2002
Raw materials	$	438,620		$	489,730
Finished goods		940,999			1,149,368

		1,379,619			1,639,098

Allowance for excess inventory quantities		(655,331	)		(657,264	)

	$	724,288		$	981,834

	March 31, 2003			March 31, 2002
U.S. Government zero coupon 7-year bond interest rates:		3.34	%		5.14	%

Dividend yield:		0.00	%		0.00	%

Weighted-average expected life of the option:		7 years			7 years

Volatility factors:		59.25	%		74.01	%

Weighted-average fair value of the options granted:	$	2.254		$	4.837

	March 31, 2003			March 31, 2002
Net Loss:
As reported	($	1,436,717	)	($	1,494,695	)
Deduct total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(505,258	)		(569,265	)

Pro forma net loss		(1,941,975	)		(2,063,960	)

Loss per share:
Basic—As reported		(0.09	)		(0.11	)
Basic—Proforma		(0.13	)		(0.15	)
Diluted—As reported		(0.09	)		(0.11	)
Diluted—Proforma		(0.13	)		(0.15	)

Exhibit 99.1		Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.

Exhibit 99.2		Certification of the Acting Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.