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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

[X]Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the fiscal year ended December 31, 1997.

[_]Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the transition period from to
.

COMMISSION FILE NUMBER
0-20819

THERMATRIX INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 94-2958515
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)

101 METRO DRIVE, SUITE 248
SAN JOSE, CALIFORNIA 95110
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

(408) 453-0490
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK,
$.001 PAR VALUE

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 at least the past 90 days:

Yes X No
--- ---

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (Paragraph 229.405 of this Chapter) is not contained
herein, and will not be contained, to the best of Registrant's knowledge, in
definitive proxy or information statements incorporated by reference in Part
III of this Form 10-K or any amendment to this Form 10-K. X

On February 28, 1998, there were issued and outstanding 7,641,842 shares of
Common Stock. The aggregate market value of Common Stock held by non-
affiliates of the Registrant on that date was approximately $11,780,000, based
on the closing sale price of the Common Stock, as reported by the NASDAQ
National Market.

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PART I

ITEM 1. BUSINESS

FORWARD-LOOKING INFORMATION

Statements in this Report concerning expectations for the future constitute
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These
statements are subject to a number of known and unknown risks, uncertainties
and other factors which may cause actual results, performance or achievements
of the Company to differ materially from those expressed or implied by such
forward-looking statements. Relevant risks and uncertainties include, among
others, those discussed in Item 1 of Part I under the heading "Risk Factors"
and elsewhere in this Report and those described from time to time in the
Company's other filings with the Securities and Exchange Commission, press
releases and other communications.

DESCRIPTION OF BUSINESS

Thermatrix Inc. ("Thermatrix" or the "Company") is a global industrial
technology company engaged in the development, manufacture and sale of
industrial process equipment for the destruction of volatile organic compounds
and hazardous air pollutants (collectively, "VOCs"). The core component of the
Company's technology is its proprietary flameless thermal oxidizer ("FTO"),
which is capable of treating virtually all VOCs while achieving destruction
removal efficiency ("DRE") of 99.99% or higher with de minimis formation of
hazardous by-products such as oxides of nitrogen ("NOx"), carbon monoxide
("CO") and products of incomplete combustion ("PICs"). The Company sells its
flameless thermal oxidizer as a stand-alone unit or as an integrated system.
In addition, the Company's product line also includes PADRE(R), a proprietary
technology used to capture and recover very low concentration VOCs from low-
to-medium vapor streams, and through its exclusive marketing agreement with
White Horse Technologies, Inc., B.O.S.S.(TM), a proprietary Boiler Oxidizer
Steam System that destroys VOCs and produces steam for process applications.

To date, the Company has focused on the industrial VOC market where it
believes the Company's FTO system offers the greatest economic and
environmental advantages over other treatment methods. These advantages
include: (i) low operating and maintenance costs; (ii) product safety; (iii)
application to a wide range of VOCs, including difficult-to-treat chlorinated,
sulfonated and fluorinated compounds; (iv) the ability to economically treat
fume streams with variable flows and concentrations; (v) high operating
reliability; (vi) high DRE; and (vii) de minimis formation of hazardous by-
products.

The Company's strategy is to expand the use and application of its
proprietary FTO technology and to become a leading global supplier of
industrial VOC treatment systems by: (i) increasing market penetration for
established applications; (ii) broadening application of the Company's
proprietary FTO technology for new industrial VOC applications; and (iii)
expanding the Company's product line to include complementary technologies.

The Company has achieved a number of significant milestones in
commercializing its technology in the industrial VOC market, including: (i)
establishing the application of its proprietary FTO technology in the
petroleum, chemical/petrochemical, pulp and paper, medical sterilization and
pharmaceutical industries with "market leader" customers, and for soil and
groundwater remediation; (ii) selling more than 70 commercial-scale systems;
(iii) establishing a global sales and marketing organization; and (iv) the
receipt of regulatory approvals by the Company's customers for the use of the
Company's systems in the United States, Canada, England, Ireland, France and
Taiwan. The Company's customers in 1997 included: Chesebrough-Pond's USA Co.,
Formosa Petrochemical Corporation, Mobil Chemical Company, PPG Industries,
Inc., Bayer Corporation, Zeneca, Ltd., B.F. Goodrich, Marathon Oil, BASF, Shin
Foong, Sorex Medical, Zeon Chemicals and Warner-Lambert as well as the United
States Departments of Defense and Energy (the "DOD" and the "DOE",
respectively).

The Company is pursuing a strategy to selectively provide complementary
technologies in order to expand its presence in the VOC treatment market. In
April 1996, the Company acquired all rights to the PADRE VOC adsorption
technology from Purus, Inc. and in April 1997 the Company entered into an
exclusive marketing agreement with White Horse Technologies, Inc. pursuant to
which the Company has the exclusive right to sell B.O.S.S.(TM).

In addition to its core industrial VOC emissions control business, the
Company has embarked on a strategy of working with strategic partners to
evaluate the feasibility of applying the Company's FTO technology to other
markets. In light of the recent technological advances in the diesel program
and the significant amount of federal and international attention being
focused on particulate matter ("PM") reductions from diesel engines, the
Company is currently focusing its development activities on the application of
the Company's FTO technology to the treatment of emissions from stationary and
mobile diesel engines.

INDUSTRIAL VOC EMISSIONS

VOCs are an unavoidable by-product of many manufacturing and process
industries worldwide and must be controlled due to significant health, safety
and environmental risks. The primary conventional industrial VOC treatment
methods are flame-based thermal oxidation, activated carbon adsorption and
scrubbing systems, which are installed in many industries, including
petroleum, chemical/petrochemical, pulp and paper and pharmaceutical.

In the United States, the health, safety and environmental risks presented
by VOCs have led to significant federal regulations, which are enforced by the
Occupational Safety and Health Administration ("OSHA"), the United States
Environmental Protection Agency ("U.S. EPA") and various state and local
agencies. Non-compliance with these regulations carries substantial civil and
criminal penalties. The United States Clean Air Act Amendments of 1990 (the
"CAAA") significantly expanded the scope of air pollution regulations
established in the 1970s, and required the reduction and control of a wide
range of air pollutants, including 189 hazardous air pollutants ("HAPs"), most
of which are VOCs. The CAAA also addressed for the first time the reduction of
NOx that, in combination with VOCs, produce smog. The CAAA introduced new
regulatory requirements and timetables for the abatement of VOCs and NOx for
most geographic areas that become progressively more stringent through the
year 2010.

In addition, international demand for VOC control equipment is rapidly
growing. While many European nations have comprehensive health, safety and
environmental regulations in force, certain Asian and Latin American nations
have only recently begun to recognize the need to more stringently control VOC
emissions. In addition, many multinational companies have recognized the
benefits of global health, safety and environmental standards and are
collaborating in the development of comprehensive voluntary environmental
performance standards such as ISO 14000.

THE THERMATRIX SYSTEM FOR INDUSTRIAL VOC CONTROL

The core component of the Company's system is its proprietary FTO, a highly
engineered, insulated vessel packed with ceramic material. Due to its
flameless design and consistent temperature profile (between 1600(degrees) and
1800(degrees)F), the Company's FTO system achieves high destruction with very
low energy usage and with de minimis formation of NOx and CO. The FTO system
can also be combined with an energy recovery system if the waste stream
contains a surplus of energy over and above that required for VOC destruction.
Recovery of usable materials from halogenated or sulfonated fume streams is
also possible due to the high DRE of the FTO system.

The Thermatrix technology has the following attributes, which individually
or in combination provide advantages over competing methods for industrial VOC
treatment:

Energy Efficiency. The FTO system can operate effectively on VOC fume
streams of moderate-to-high concentrations with less than 30% of the energy
required for flame-based systems. The FTO's energy efficiency

is particularly significant in geographic locations where the cost of energy
is many times higher than in the United States.

Safety. The FTO is certified for use in flameproof areas where conventional
flame-based systems are prohibited.

Flexibility. The FTO can process a broad range of VOCs, including difficult-
to-treat compounds and those with variable flows and concentrations.

Reliability. The FTO operates within wide tolerance limits, is fully
automatic, has no moving parts, no catalysts and requires little off-line
maintenance.

High DRE. The Thermatrix system consistently achieves DRE of 99.99% or
higher, which exceeds the DRE achieved by competing technologies. The high DRE
of the Thermatrix system makes it particularly useful in applications
involving the most highly toxic and complex VOCs.

De minimis By-products. The absence of a flame minimizes the formation of
by-products generated by flame-based systems, including NOx, CO and PICs. The
reduced energy requirement for the FTO system also results in a corresponding
reduction in the formation of greenhouse gases.

Regulatory Advantages. The Company's systems often exceed regulatory
performance requirements because of the high DRE and the de minimis formation
of by-products.

In February 1998, the Company successfully completed six months of full-
scale testing of a new FTO design. The oxidizer was reconfigured to create an
almost spherical flameless reaction front within the reactor's ceramic matrix,
as compared to the planar flameless reaction front, which until now was a
signature feature of the Company's technology. The Company believes the new
development will result in the following business advantages and design
features:

. A greater than 60% reduction in the size of a typical non-recuperative
flameless thermal oxidizer for the same processing capability.

. A hot-wall reactor with the ability to process chlorinated, sulfonated and
fluorinated waste streams without the need for expensive and exotic
materials of construction to prevent corrosion.

. The ability to use horizontal as well as vertical vessels, which will
extend the applicable range of non-recuperative oxidizers to over 40,000
scfm.

. The incorporation of electric-assisted preheat, which will enable the
Company to offer flameless startup and operation.

. The ability to offer, for the first time, a flameless thermal oxidizer for
the destruction of hazardous liquids by direct injection into the oxidizer.

. The ability to offer, for the first time, a flameless oxidizer using liquid
fuels such as diesel, kerosene or waste solvents rather than other fuels
such as natural gas or propane, which are not available in all areas.

VOC BUSINESS STRATEGY

The Company seeks to expand the use and application of its proprietary FTO
technology and to become a leading global supplier of industrial VOC treatment
systems. The Company's strategy in the industrial VOC market is to: (i)
increase market penetration for established applications; (ii) broaden
application of the Company's technology in the industrial VOC market; and
(iii) selectively provide complementary technologies in order to expand its
presence in the VOC treatment market. Key elements of the Company's industrial
VOC strategy are as follows:

Increase Market Penetration for Established Applications. Thermatrix systems
have now been successfully installed in the petroleum, chemical/petrochemical,
pharmaceutical, medical sterilization, and pulp and paper industries, and for
soil and groundwater remediation, at facilities operated by customers such as
Chevron U.S.A. Inc., Dow Chemical Company, PPG Industries, Inc., Simpson Paper
and Bayer Corporation, as well as facilities operated by the DOD and DOE. Many
of these customers have already purchased multiple units. The Company is using
these reference accounts to promote follow-on sales to the same customers and
to expand sales within these industries, both in the United States and
overseas.

Broaden Application of the Company's Technology in the Industrial VOC
Market. The Company is continuing to identify new customers within industrial
VOC applications not currently served by the Company, such as the electronics
and semiconductor industries. In addition, there is an increasing demand from
customers for the Company to supply turnkey systems that combine the Company's
FTO technology with other technologies. These "hybrid" systems may provide
energy recovery or product recovery, as well as treatment of the customer's
fume stream.

Provide Complementary Technologies. Customers are increasingly seeking
suppliers who can solve a wide range of VOC problems. To provide such
solutions the Company continues to seek opportunities to expand its technology
portfolio through joint ventures, selective marketing arrangements and
acquisitions. In April 1996, the Company acquired all rights from Purus, Inc.
to a VOC adsorption technology known as PADRE, which uses a regenerative
synthetic adsorption resin to capture and recover very low concentration VOCs
from low-to-medium flow vapor streams. In April 1997 the Company entered into
an exclusive marketing agreement with White Horse Technologies, Inc. to market
their products, including B.O.S.S.(TM), a proprietary Boiler Oxidizer Steam
System that destroys VOCs and produces steam for process applications, and
other thermal oxidizers for the treatment of VOCs.

The Company believes that its installed base and proven applications provide
a solid foundation for growth in both the United States and overseas. The
Company received its first order from Europe in 1995. The percentage of sales
to international customers increased to 14% in 1996 and 35% in 1997. The
Company expects this trend to continue and anticipates that over 60% of its
1998 sales will be for overseas installations. During 1997, the Company
relocated its European operation from London to an expanded facility near
Hull, England. The Company's United Kingdom capabilities now include sales,
applications engineering, project management and service. The Company has
established relationships with qualified subcontractors for fabrication and
assembly in Europe and has agreements with engineering partners in Asia for
construction and installation support.

INDUSTRIAL VOC CONTROL COMPETITIVE ENVIRONMENT

The industrial VOC control equipment market is mature and highly fragmented
among a large number of competitors, none of whom have a significant industry-
wide market share. The Company currently competes primarily with suppliers of
flame-based thermal oxidation systems, carbon adsorption systems and scrubbing
systems. Within each of these categories, the technologies are generally
undifferentiated and characterized by commodity pricing. Since many of these
technologies have been in use for over thirty years, these technologies are
familiar and predictable to companies requiring VOC controls and to
regulators, and are available from and promoted by a large number of
suppliers. In addition, some of the Company's competitors have substantially
greater financial resources, operating experience and market presence than the
Company. There can be no assurance that the Company's existing competitors or
new market entrants will not develop new technologies or modifications to
existing technologies that are superior to or more cost-effective than the
Company's FTO technology. In addition, increased competition could result in
price reductions and reduced gross margins and could limit the Company's
market share.

The Company believes that the major considerations in selecting industrial
VOC control systems are safety; capital, operating and maintenance costs; high
DRE; ease of permitting; process stream characteristics; unit location; and
on-line reliability. The Company believes it competes favorably with respect
to these factors.

INDUSTRIAL VOC REGULATORY ENVIRONMENT

VOCs are an unavoidable by-product of many manufacturing and process
industries worldwide and must be controlled due to the significant health,
safety and environmental risks. Many of these VOCs are flammable, explosive or
highly toxic. To control these significant health and safety risks,
regulations have been promulgated and enforced in the United States and
overseas. These regulatory requirements are expanding globally into developing
nations.

The United States Clean Air Act Amendments of 1990 (the "CAAA")
significantly expanded the scope of air pollution regulations established in
the 1970s, and required the reduction and control of a wide range of air
pollutants, including 189 hazardous air pollutants, most of which are VOCs.
The CAAA also addressed the reduction of NOx that, in combination with VOCs,
produces smog. The CAAA introduced new regulatory requirements and timetables
for the abatement of VOCs and NOx for most geographic areas that become
progressively more stringent through the year 2010. Specifically, Title I and
Title III of the CAAA address emissions of VOCs. Principal provisions of these
titles are discussed below.

Title I establishes requirements for attaining and maintaining national
ambient air quality standards ("NAAQS"). Key provisions of Title I are aimed
at bringing cities and other areas which are not in attainment in line with
NAAQS in most areas by the year 2000 and all cities by 2010. In addition,
measures for all regions require the application of technological controls to
reduce emissions of ozone precursors, such as VOCs, from a broad range of
industrial activities, including chemicals production, petroleum refining,
pharmaceutical production, gasoline distribution, wastewater treatment,
solvent use, coating operations, hazardous waste treatment storage and
disposal facilities, solid waste landfills and marine terminal loading and
unloading.

Title III establishes a new program for the regulation of toxic air
pollutants. The combined federal and state program provided for in the
legislation creates a comprehensive and coordinated nationwide effort to deal
with these pollutants. Title III specifically lists 189 substances as
hazardous air pollutants, of which most are VOCs. Title III defines three
significant programs that will require substantial pollution control
expenditures by industry across the nation: (i) control of routine releases of
air toxins from major industrial and commercial sources; (ii) control of air
toxic releases from area sources, primarily in urban areas; and (iii) control
of accidental releases of air toxins from industrial and commercial sources.
To reduce emissions of the 189 listed toxic hazardous air pollutants, the
application of the maximum achievable control technology at major air emitting
sources may be required.

The Company works with regulatory agencies both domestically and overseas to
inform these agencies about the Company's FTO technology in order to
facilitate the permitting process for its customers. In England, Her Majesty's
Inspectorate of Pollution has issued Technical Note ITN/IPCX/02 identifying
the flameless oxidation process benefits of high destruction (greater than
99.99%) and low formation of NOx and CO. The Company's FTO system was selected
for inclusion in the Texas Natural Resource Conservation Commission's list of
innovative environmental technologies. Thermatrix is currently under review
for certification by the California Environmental Protection Agency ("CalEPA")
as a flameless thermal destruction technology. The CalEPA program is closed to
incineration technologies. Also, the U.S. EPA and its equivalent agencies in
the U.K., Ireland, Italy and the Netherlands have recognized the Company's FTO
technology as not being incineration.

CURRENT THERMATRIX INDUSTRIAL VOC CUSTOMERS

The Company has identified industries that are large generators of VOCs and
where it believes its FTO technology provides significant competitive
advantages over existing treatment methods. The Company has sought acceptance
of its systems, in each of its initial target markets, through the utilization
of "market leader" customers. To date, the Company has sold over 70 systems
across a range of industries including petroleum, chemical/petrochemical,
pharmaceutical, pulp and paper manufacturing, medical sterilization and for
soil and groundwater remediation. The following table sets forth the Company's
target markets, representative customers and the types of VOCs treated by its
systems:

TARGET MARKETS REPRESENTATIVE CUSTOMER VOCS TREATED
- ---------------------- ----------------------------------- -------------------------

Petroleum/Refining Chevron, Marathon Oil Hydrocarbons
Chemical/Petrochemical Dow Chemical, Bayer Corporation, Chlorinated and
Manufacturing Mobil Chemical Company, Formosa Fluorinated Compounds
Petrochemical Corporation, BASF,
PPG Industries, Inc., B.F. Goodrich
Pharmaceuticals Zeneca, Warner-Lambert, Chlorinated Compounds
Manufacturing Chesebrough-Pond's USA Co.
Pulp and Paper Georgia Pacific, Simpson Paper Sulfonated Compounds
Manufacturing
Medical Sterilization Sorex Medical Ethylene Oxide
Soil and Groundwater DOD, DOE, Thermo Remediation Chlorinated Compounds and
Remediation Hydrocarbons

SALES AND MARKETING

The Company has experienced a shift in market demand for its products, both
in terms of the geographic distribution of the orders it has received and the
complexity of the systems ordered.

The Company has experienced an increase in order volume from overseas as
orders from the United States declined. The Company expects this trend to
continue and anticipates that over 60% of its sales in 1998 will be for
overseas installations, up from 35% in 1997.

In addition, the Company's clients have increasingly outsourced the process
design of air pollution control systems. Instead of sourcing components
individually, clients are seeking a design partner willing to provide an
integrated system on a turnkey basis coupled with appropriate system
performance guarantees. In response to this shift in demand, the Company
restructured its sales organization in 1997 to replace most outside
manufacturers' representatives with direct selling by the Company's process
and application engineers in order to increase focus on marketing and account
management.

Two sales directors manage the Company's sales efforts. Sales for North
America and Asia are managed from San Jose, California and those for Europe
are managed from Hull, England. The sales directors hold engineering degrees
and have an average of ten years of industrial selling experience.

In addition, where cost effective, the Company has selectively retained some
of its independent commissioned sales representatives in the United States and
Canada and currently has agreements with eight representative organizations
with over 26 sales agents selling the Company's FTO system. In Asia, the
Company has agreements with ICI Taiwan Limited for sales representation in
Taiwan and the Peoples' Republic of China, with ICI Japan in Japan, and with
Miju Entech in South Korea. All independent representatives are paid solely on
commission, which is calculated on a sliding scale as a percentage of sales
revenues. The Company retains responsibility for pricing and terms and
conditions.

ENGINEERING AND MANUFACTURING

The Company's Engineering group, located in Knoxville, Tennessee, provides
global support to the Company's customers. The Company's project management
and assembly operations for the United States and Asia are managed from
Knoxville, Tennessee and those for Europe are based in Hull, England. In
addition, the Company has agreements with engineering partners in Asia for
construction and installation support of the Company's systems. These partners
include Toray Engineering Co. and Nittetu Chemical Engineering Ltd. in Japan
and Miju Entech in South Korea. The Company will continue to engineer and
assemble the proprietary components of its FTO systems, but will utilize its
Asian partners to supply the balance of plant. The Company had maintained its
own assembly facility in Knoxville, Tennessee but closed that facility at the
end of 1997 due to the decrease in United States sales.

The Company has focused on modularizing and standardizing components of its
technology and utilizes sophisticated software to integrate these components
into comprehensive air pollution control systems. This system's integration
expertise allows the Company to provide comprehensive systems centered on the
Company's FTO technology. The engineers utilize state-of-the-art, PC-based,
computer-aided engineering and database management tools, including three-
dimensional design tools.

The Company manufactures its systems to customer order. Qualified
subcontractors specializing in the manufacture of the particular component
carry out component fabrication. These specialized subcontractors adhere to
and carry formal certification with national and international codes and
standards for electrical and mechanical construction. The Company's
subcontractors have been selected to allow the Company to expand its capacity
to manufacture additional systems while minimizing the Company's investment in
fixed costs. The Company uses qualified subcontractors throughout the United
States and overseas and is not dependent on any one or subset of these
subcontractors.

In the fabrication process, no one subcontractor is exposed to the entire
technology package and final assembly of the systems is completed by a
separate subcontractor. Throughout the delivery cycle, the manufacturing
process is managed to conform to ISO 9001.

During the period that the technology was developed, an extensive empirical
database of performance characteristics for waste flows of different volumes
and compositions was compiled. The Company has used this database to develop a
proprietary, software-based design tool. In the design process, the software
tools analyze the characteristics of the customer's fume flow and determine
the optimal system configuration and size. Not only does this process specify
the correct system characteristics, but also it automates the task of
generating budget proposals. The Company is continuing to expand this database
as new systems are installed.

RESEARCH AND DEVELOPMENT

The Company believes that its continued commitment to developing new
applications and refining its technology is critical to remaining competitive
in the industry. During 1997, the Company devoted its technical resources to
product development. The Company achieved a significant breakthrough in the
reconfiguration of its basic proprietary FTO technology, which the Company
believes will result in new, lower cost products and will enable the Company
to expand into liquid waste disposal. Also, the Company designed a modified
recuperative oxidizer to improve the operability and increase the range of the
FTO. In addition, the Company introduced a continuous adsorption product based
on its proprietary PADRE technology.

The Company's industrial VOC applications development efforts are managed by
the Engineering group located in Knoxville, Tennessee. The group's primary
mission is to optimize the Company's technology for new applications in the
industrial VOC control market. The Company's research and development
activities are now primarily focused on its diesel engine emission control
program. The Technology Development group, located in San Jose, California,
carries out these activities in conjunction with selected strategic partners.
When areas of specialized expertise are required, such as advanced metallurgy
or numerical modeling, the Company relies on consulting relationships with a
number of top tier research institutes, including SRI International, Lawrence
Berkeley National Laboratory and Oak Ridge National Laboratory.

POTENTIAL APPLICATIONS UNDER DEVELOPMENT

The Company's strategy to expand its presence in the VOC market is to work
with strategic partners to evaluate the feasibility of applying the Company's
technology to other industries. During 1996 and 1997, the Company initiated
joint development programs with leading organizations to explore the
application of the Company's FTO technology to the control of diesel engine
emissions and the treatment of radioactive mixed wastes and sought a
development partner to pursue destruction of chemical weapons. By the end of
1997, the Company decided to focus its development business interests on its
diesel engine emission control activities due to the recent technological
advances in the diesel program, coupled with the uncertainties in the timing
and the withdrawal of federal funding for new technologies in the other areas.

The engineering challenges involved in treating diesel emissions are
different in a number of respects from the conditions in which the Thermatrix
system has been used in the past, and there can be no assurance that the
Thermatrix technology will prove successful in this new application.

Diesel Engine Emission Control. The fume and soot emissions from static and
mobile diesel engines create a serious environmental problem. In late 1997,
the Company signed a joint development agreement with Lucas Diesel Systems, a
division of LucasVarity plc, for the application of the FTO technology to the
treatment of diesel engine emissions from mobile sources. Initial testing in
1997 indicated that the FTO technology could destroy a wide size range of soot
particles while lowering NOx missions. The joint development agreement will
determine whether the technology can be employed economically at a size
suitable for mobile applications.

Market Overview

The market for diesel engine emission control is separate and distinct
from the industrial VOC market. Approximately eight million diesel vehicles
are manufactured each year and there are approximately 40 million diesel
vehicles in operation worldwide. Diesel engines provide improved fuel
economy, ease of serviceability and greater durability over gasoline
engines and are commonly used for medium and heavy-duty trucks, buses,
industrial, agricultural, construction, mining, recreational and marine
applications, but the VOC and particulate matter ("PM") emissions from
diesel engines create a serious environmental problem, which is being
addressed in new proposed regulations by the U.S. EPA and its counterparts
in Europe and Asia.

The Thermatrix System

Many of the advantages of the Thermatrix system for industrial VOC
emission control are equally applicable to the destruction of VOCs in
diesel engine emissions. Preliminary tests conducted during 1997
demonstrated that the FTO technology could destroy a wide size range of PM
while lowering NOx emissions, in addition to destroying VOCs.

The Company believes the new FTO design announced in February 1998, with
its horizontal/vertical configuration, reduced size and all electric
preheat design, could accelerate the timetable for the potential
commercialization of the Company's technology for the control of fumes from
diesel engines, both mobile and stationary.

Competition

There are a number of companies working toward diesel emissions reduction
solutions. For example, in the post-combustion or exhaust after-treatment
sector there are companies such as Englehard Corporation and Johnson-
Matthey plc that currently supply a majority of the market with their
existing catalyst systems. However, there has been, and continues to be, a
need for improvement in the use of catalysts for heavy-duty engine
applications. The Company's new FTO design offers the potential for an
innovative, non-catalytic solution for diesel engine emission control.

Regulation

Diesel engine manufacturers have faced continually increasing governmental
regulation of their products especially in the environmental area. In
particular, engine manufacturers will have to achieve lower emissions
levels in terms of unburned hydrocarbons, PM and NOx. These regulations
have imposed and will continue to impose significant research, design and
tooling costs on engine manufacturers.

Specific emissions standards for engines are imposed by the U.S. EPA and
by other regulatory agencies such as the California Air Resources Board
("CARB"). Many of the manufacturers believe that their engine products
comply with all applicable emissions requirements currently in effect.
Their ability to comply with emissions requirements that may be imposed in
the future is an important element in maintaining and improving their
position in the engine marketplace.

The CAAA established the United States emissions standards for on-highway
engines produced through 2001. For light and medium to heavy-duty engines,
the CARB standards are similar to those adopted by the U.S. EPA. In North
America, both Canada and Mexico are expected to adopt United States
emissions standards. Various diesel engine manufacturers have voluntarily
signed a memorandum of understanding with the Canadian government, pursuant
to which these manufacturers agreed to sell only United States certified
engines in Canada beginning in 1995. In June 1993, Mexico proposed a
regulatory program that incorporates United States standards and test
procedures. Similar programs are in place throughout Europe and Japan.

Diesel engines are primarily regulated for PM and NOx. Federal standards
for 1998 for buses and trucks for PM are 0.10 grams per brakehorsepower
hour, and 5.0 for NOx. These are expected to decrease to 0.05 for PM and
2.0 for NOx by Year 2004. California standards are even stricter.

The CAAA gave individual states the option to mandate the new federal
requirements or the CARB plan in their states. Twelve Northeast states and
Texas have agreed to adopt the CARB rules. The vehicles in operation in those
thirteen states comprise more than one-third of the United States vehicle
population.

Radioactive Mixed Wastes. In October 1996, the Company announced the
formation of Formatrix, LLC ("Formatrix"), a joint venture with ThermoChem,
Inc., a Maryland-based leader in steam reforming systems, to combine, under
license, the patented technologies from Thermatrix and ThermoChem to create a
treatment system for significantly reducing the volume of the radioactive
wastes prior to their encapsulation or vitrification for long-term burial. A
prototype Thermatrix-ThermoChem system was constructed under a contract with
the DOE and successfully and reliably treated a number of non-radioactive
surrogate mixed wastes. However, the likelihood of short-term deployment of
the Formatrix system for radioactive mixed waste processing appears to be
receding as federal funding for new technologies has been postponed. In view
of these uncertainties, the Company plans to discontinue its joint venture
arrangement and will undertake any future projects for the processing of
radioactive mixed waste on a teaming basis. Accordingly, the Company wrote off
its investment in the joint venture in 1997.

Chemical Demilitarization. Chemical demilitarization refers to the safe
disassembly and destruction of stockpiled chemical warfare agents such as
mustard and nerve gases. The chemical makeup of many of these agents is
similar to compounds that the Company is currently destroying in the
commercial industrial market. As an example, the Company has built and brought
on-line in 1997 a full-scale commercial facility for the destruction of
phosgene and its derivatives associated with the manufacture of specialty
chemicals. The Company had been seeking a strategic operating partner to
pursue this market, but is no longer actively pursuing this area due to the
withdrawal of federal funding for new technologies.

INTELLECTUAL PROPERTY

As of February 28, 1998, the Company owned 10 United States and 11
international patents, had received notice of allowance for two additional
United States patent applications and two additional international patent
applications, and had a further nine United States and 36 international patent
applications pending relating to its thermal treatment technology. All issued
United States patents expire during the period between July 31, 2005 and July
13, 2015. The Company has granted a license of its patents to Formatrix for
restricted use in the field of low-level radioactive spent ion exchange
resins.

The Company's twelve issued and allowed United States patents include
several hundred claims of varying scope relating to many of the Company's
inventive methods and apparatuses. These patents cover fundamental aspects of
flameless thermal oxidation that are the bases of the Company's technology and
their application. Aspects of the technology, including the use and
maintenance of a "flameless reaction wave" of gases or vapors in a matrix of
heat resistant materials, are covered under a variety of claiming formats.

In addition to patents, the Company relies on trade secrets and proprietary
know-how, which it seeks to protect, in part, through appropriate
confidentiality and proprietary information agreements. The confidentiality
and proprietary information agreements generally provide that all confidential
information developed or made known to individuals by the Company during the
course of the relationship with the Company is to be kept confidential and not
disclosed to third parties, except in specific circumstances. The agreements
also generally provide that all inventions conceived by the individual in the
course of rendering services to the Company shall be the exclusive property of
the Company.

In addition to the foregoing patents and patent applications, the Company
has four issued United States trademarks, and has received notice of allowance
for one additional United States trademark. The Company also has an additional
five international trademark applications pending for certain of the Company's
tradenames and other intellectual property.

EMPLOYEES

As of February 28, 1998, the Company had 62 full-time employees, 16 of whom
hold advanced degrees. The Company believes that it has been successful in
attracting experienced and capable engineering, operations and management
personnel. None of the Company's permanent, full-time employees is covered by
collective bargaining agreements.

RISK FACTORS

Operating Losses and Accumulated Deficit; Uncertainty of Future
Profitability. The Company had a net loss of approximately $9.6 million in
1997 and an accumulated deficit of approximately $36.7 million at December 31,
1997. Since 1992 when the Company restructured its operations, the Company has
financed its operations primarily through private placements of equity
securities totaling approximately $20.3 million, an initial public offering of
its common stock with net proceeds totaling approximately $22.1 million, and a
credit facility with its bank of $4.0 million. The Company does not expect to
be profitable unless and until sales of its systems generate sufficient
revenues with an appropriate gross margin to fund its operations. There can be
no assurance that the Company will achieve such revenues or margins.

Ability to Compete Against Lower Cost Technologies. To date, FTO systems
have been installed in a small segment of a number of industries. There can be
no assurance that the Company's FTO technology will receive broad market
acceptance as an economically and environmentally acceptable means of
destroying VOCs. The Company's ability to compete will depend upon the
Company's ability to persuade potential customers to adopt its FTO technology
in place of certain, more established, competing technologies, including
flame-based destruction and carbon adsorption systems. The failure of the
Company to persuade a significant number of potential customers to adopt its
FTO technology would have a material adverse effect on the growth of the
Company's business, results of operations and financial condition.

Sensitivity to Major Projects. In 1997, two projects accounted for 38% of
the Company's revenues. In 1996, three projects accounted for 38% of the
Company's revenues and in 1995, two projects accounted for 59% of the
Company's revenues. Although the Company is expanding the number of its
customers and installations, the average size and dollar volume of each
installation has been increasing. The Company anticipates the size of turnkey
projects in 1998 will range from $1 million to $4 million, up from an average
of $850,000 in 1996. As a result, the Company's results of operations are
likely to continue to be dependent on major projects. Such a reliance on major
orders is likely to lead to fluctuations in, and to reduce the predictability
of, quarterly results.

Larger projects also pose other challenges. The sales cycle for larger
projects tends to be longer than for smaller projects, and, when orders are
received, projects may be delayed by factors outside the Company's control,
including customer budget decisions, design changes and delays in obtaining
permits. Orders for large systems often have tight delivery schedules and the
customer will often attempt to negotiate penalties for late delivery and/or
the ability to assess liquidated damages for lost production if the delivery
schedule is not met.

Also, because the dollar volumes are larger, the costs of providing warranty
services could increase. The Company's business, results of operations and
financial condition could be materially adversely affected if the Company were
to fail to obtain major project orders, if such orders were delayed, if
installations of such systems were delayed, or if such installations
encountered operating, warranty or other problems.

Management of Growth. Although it relies on subcontractors to fabricate
subassemblies and to assemble and install completed systems, the Company uses
its own employees to design, test and commission systems. The Company seeks to
maintain engineering and design staffing levels adequate for current and near-
term demand. During periods of rapid growth, such as that experienced by the
Company during 1996, the Company's engineering and design personnel generally
operate at full capacity. As a result, future growth, if any, is limited by
the Company's ability to recruit and train additional engineering, design and
project management personnel and by the ability and performance of the
individual employees in managing more and larger projects. Furthermore, any
failure to maintain quality or to meet customer installation schedules could
damage relationships with important customers, damage the Company's reputation
generally and result in contractual liabilities. There can be no assurance
that the Company will be able to effectively manage an expansion of its
operations or that the Company's systems or controls will be adequate to
support the Company's operations if expansion occurs. In such event, any
failure to manage growth effectively could have a material adverse effect on
the Company's business, results of operations and financial condition.

Risks Associated with International Operations and Sales. In 1997, sales to
international customers in Europe and Asia increased to 35%, up from 14% in
1996. The Company plans to increase its revenues, in part, through an
expansion of its overseas operations. Expansion internationally encompasses
the need to provide an infrastructure for operations, sales and
administration. The Company's overseas growth has placed, and could continue
to place, a significant strain on its managerial, operational and financial
resources. There can be no assurance that the Company will be able to attract,
hire and train personnel or to continue to develop the infrastructure needed
on a timely basis, which may have an adverse impact on the Company's business,
results of operations and financial condition.

Additionally, the Company's business, results of operations and financial
condition may be materially adversely affected by fluctuations in currency
exchange rates and duty rates, and therefore its ability to maintain or
increase prices due to competition. The Company denominates international
sales in either U.S. dollars or local currencies. Sales in Europe have been
primarily denominated in pounds sterling. Since some expenses in connection
with international contracts are often incurred in U.S. dollars, there can be
a short-term exchange risk created. If the Company has significant
international sales in the future denominated in foreign currencies, the
Company may purchase hedging instruments to mitigate the exchange risk on
these contracts.

Risks Associated with Fixed Price Contracts. A majority of the Company's
contracts are performed using "fixed-price" rather than "cost-plus" terms.
Under fixed-price terms, the Company quotes firm prices to its customers and
bears the full risk of cost overruns caused by estimates that differ from
actual costs incurred or manufacturing delays during the course of the
contract. Some costs, including component costs, are beyond the Company's
control and may be difficult to predict. If manufacturing or installation
costs for a particular project exceed anticipated levels, gross margins would
be materially adversely affected, and the Company could experience losses. In
addition, the manufacturing process may be subject to significant change
orders. However, in some cases the cost of these change orders may not be
negotiated until after the system is installed. The failure of the Company to
recover the full cost of these change orders could materially adversely affect
gross margins and also cause the Company to experience losses.

Dependence on Key Personnel. The Company's success depends to a significant
extent upon its executive officers and key engineering, sales, marketing,
financial and technical personnel, both in the United States and overseas.
Employees may voluntarily terminate their employment with the Company at any
time, and none of the Company's employees is subject to any term employment
contract with the Company. The Company has

limited personnel resources available to address the different activities in
its business. The loss of the services of one or more of the Company's key
employees could have a material adverse effect on the Company's business,
results of operations and financial condition.

The Company also believes that its future success will depend in large part
upon its ability to attract and retain additional highly skilled personnel,
particularly design and process engineers. Because of the technical
sophistication of the Company's systems and the sophisticated engineering
software utilized by the Company, design and process engineers who join the
Company generally are required to have advanced technical knowledge and
significant training to perform efficiently and productively. The availability
of such personnel is limited, and the Company has at times experienced
difficulty in locating new employees with the requisite level of expertise and
experience. In addition, the Company believes its ability to manage the
anticipated increase in customer orders for the Company's products in Europe
will depend in a large part on its success in attracting and retaining skilled
engineers or project managers in Europe. There can be no assurance that the
Company will be successful in retaining its existing key personnel or in
attracting and retaining the personnel it requires in the future.

The Company maintains key employee life insurance on the life of its
Chairman, President and Chief Executive Officer, John T. Schofield, in the
amount of $2,000,000. There can be no assurance that such amount will be
sufficient to compensate the Company for the loss of the services of such
individual.

Dependence on the Reliability and Performance of Subcontractors. The Company
relies on subcontractors to build system components and to assemble and
install systems, both in the United States and overseas. The Company's ability
to deliver high quality systems on time will depend upon the reliability and
performance of its subcontractors. The failure of a subcontractor to meet
delivery schedules could cause the Company to default on its obligations to
its customers, which could materially adversely affect the Company's
reputation, business, results of operations and financial condition. In
addition, the Company's reliance on subcontractors for manufacturing, assembly
and installation places a significant part of the Company's quality control
responsibilities on these subcontractors. There can be no assurance that the
Company will be able to continue to contract for the level of quality control
required by the Company's customers. The failure to provide such quality
control could result in manufacturing and installation delays, which could
have a material adverse effect on the Company's business, results of
operations and financial condition.

Dependence on Customer Information. The Company is highly dependent upon
information provided by its customers concerning the type, volume and flow
rate of VOC emissions to be treated by the Company's systems. If the
customer's information is inaccurate or the customer operates the facility
outside its design parameters, a malfunction in the Company's FTO system could
occur, resulting in damage to the customer's facilities or personal injury. In
addition, incorrect information could cause delays in the design, manufacture
and installation of the customer's system. Through no fault of its own, the
Company could then be held liable for damages resulting from such malfunction
or delay. Any of these factors could have a material adverse effect on the
Company's business, results of operations and financial condition.

Fluctuations in Quarterly Operating Results. The Company's quarterly
revenues and operating results have varied significantly in the past and may
fluctuate significantly in the future as a result of a variety of factors,
many of which are outside the Company's control. Such factors include the size
and timing of individual orders, the timing and amount of project change
orders, customer delays, order cancellations, general economic and industry
conditions, the amount of first-time engineering needed, the introduction of
new products or services by the Company or its competitors or the introduction
of the Company's products to new markets, changes in the levels of operating
expenses, including development costs, and the amount and timing of other
costs relating to the expansion of the Company's operations.

the Company has little or no control, including customer budgetary
constraints. The Company historically has operated with little backlog because
most customer orders are placed with relatively short lead times, usually from
four to thirty weeks. Variations in the timing of recognition of specific
revenues due to changes in project scope and timing may adversely and
disproportionately affect the Company's operating results for a quarter
because the Company establishes its expenditure levels on the basis of
expected future revenues, and a significant portion of the Company's expenses
do not vary with current revenues.

Uncertain Regulatory Environment. The Company's customers are required to
comply with environmental laws and regulations in the United States and
elsewhere which limit the emission of VOCs and other chemicals. The level of
enforcement activities by environmental protection agencies and changes in
laws and regulations will affect demand for the Company's systems. To the
extent that the burden of complying with such environmental laws and
regulations may be eased, the demand for the Company's systems could be
materially adversely affected.

Although the Company believes that its FTO technology does not come under
the United States Environmental Protection Agency's ("U.S. EPA") current
definitions of incineration, there can be no assurance that the U.S. EPA will
not classify the Company's FTO technology as an incineration technology in the
future. Classification as an incineration technology could significantly
increase the length of time and cost of the permitting process for customers
because of the requirement for a public hearing, especially where community
sentiment is opposed to incineration technology. A lengthier permitting
process could reduce the competitive advantages of the Company's technology
and materially adversely affect the Company's business, results of operations
and financial condition.

Proprietary Technology and Unpredictability of Patent Protection. The
Company relies on patents, trade secrets and proprietary know-how, which it
seeks to protect, in part, through appropriate confidentiality and proprietary
information agreements with its strategic partners, employees and consultants.
There can be no assurance that the proprietary information or confidentiality
agreements will not be breached, that the Company will have adequate remedies
for any breach, or that the Company's trade secrets and proprietary know-how
will not otherwise become known to or be independently developed by others.

Possible Product Liability. The Company's FTO systems are designed to
destroy VOCs, which are highly toxic and flammable. If the Company's systems
are improperly designed or operated outside of design parameters and operating
instructions provided by the Company, there is a risk of system failure or
release of VOCs, which could require the Company to defend itself against a
product liability or personal injury claim. Although the Company has product
liability and commercial general liability insurance in scope and amount that
it believes to be sufficient for the conduct of its business, there can be no
assurance that such insurance will cover or be adequate to cover such claims.
In addition, the Company's general liability insurance is subject to coverage
limits and excludes coverage for losses or liabilities relating to
environmental damage or pollution. Accordingly, the Company's efforts to
defend itself against such claims could have a material adverse effect on the
Company's business, results of operations and financial condition.

Potential Environmental Liability. Although the Company does not believe
that its activities would directly expose it to liabilities under local, state
or federal environmental laws and regulations, if the Company were to
improperly design, manufacture or test its systems or fail to properly train
its customer's employees in the operation of the systems, it could be exposed
to possible liability for investigation and clean-up costs under such
environmental laws.

Under some environmental laws and various theories of tort and contract law,
it is also possible that the Company could be liable for damages to its
customers and third parties resulting from the actions of its customers or
arising from the failure or malfunction, or the design, construction or
operation of, the Company's FTO systems or products, even if the Company were
not at fault. The Company's general liability insurance is subject to coverage
limits and generally excludes coverage for losses or liabilities relating to
or arising out of environmental damage or pollution. The Company's business,
results of operations and financial condition could be materially adversely
affected by an uninsured or partially insured claim.

Risks Associated With the Diesel Engine Emission Control Development
Program. The engineering challenges involved in treating diesel emissions are
different in a number of respects from the conditions in which the Thermatrix
system has been used in the past, and there can be no assurance that the
Thermatrix technology will prove successful in this development area.
Moreover, the Company's extensive database of test results that it uses to
design systems for industrial installations may not be relevant to diesel
engine emission control. Although pilot test results to date have been
positive, the Company will need to engage in extensive and costly applications
development and engineering in order to commercialize its system for such use,
and there can be no assurance as to the success of any such effort.

ITEM 2. PROPERTIES

The Company leases approximately 5,000 square feet of office space in San
Jose, California under a three-year lease terminating in July 1998, which the
Company uses as its research and development, and United States and Asia sales
offices. The Company has a remaining two-year lease for approximately 15,000
square feet of office space in Knoxville, Tennessee, which it primarily uses
for design engineering, project management and accounting offices.

In addition, the Company leases approximately 5,000 square feet of office
space in Hull, England under a six-year lease, accommodating all European
activities, including sales, operations and engineering. The Company also
leases approximately 1,000 square feet of office space in London, England
under a five-year lease, which the Company is currently subletting on a month-
to-month basis.

ITEM 3. LEGAL PROCEEDINGS

The Company is involved in various routine legal proceedings incident to the
ordinary course of its business. Management believes that the outcome of all
pending legal proceedings in the aggregate will not have a material effect on
the Company's business, financial condition or result of operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of stockholders during the fourth
quarter of the Company's fiscal year.

PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The common stock of the Company is traded on the NASDAQ National Market
under the symbol "TMXI." The following table sets forth, for the periods
indicated, the high and low sales prices of the common stock (as reported by
NASDAQ):

PERIOD HIGH LOW
------ ----- -----

First Quarter 1997............................................... 9.375 3.375
Second Quarter 1997.............................................. 5.750 3.000
Third Quarter 1997............................................... 3.250 1.875
Fourth Quarter 1997.............................................. 3.250 1.125

As of February 28, 1998, there were over 1,000 holders of the Company's
Common Stock. The Company has never declared or paid dividends on its stock.
The Company currently intends to finance the growth and development of its
business and does not anticipate paying dividends in the foreseeable future.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

The selected consolidated financial data set forth below with respect to the
Company's statements of operations for each of the three years in the period
ended December 31, 1997 and with respect to the Company's balance sheets as of
December 31, 1997 and 1996 are derived from the consolidated financial
statements included elsewhere in this report and should be read in conjunction
with those financial statements and related notes thereto and "Management's
Discussion and Analysis of Financial Condition and Results of Operations." The
statement of operations data for the years ended December 31, 1994 and 1993
and the balance sheet data as of December 31, 1995, 1994 and 1993 are derived
from audited financial statements not included in this report.

YEARS ENDED DECEMBER 31,
--------------------------------------------
1997 1996 1995 1994 1993
-------- ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

CONSOLIDATED STATEMENT OF
OPERATIONS DATA:
Revenues................ $ 7,011 $13,605 $ 6,494 $ 3,135 $ 881
Cost of revenues........ 8,351 12,002 6,064 3,099 966
-------- ------- ------- ------- -------
Gross margin............ (1,340) 1,603 430 36 (85)
-------- ------- ------- ------- -------
Research and
development............ 1,203 748 1,084 1,326 483
Selling, general and
administrative......... 7,705 6,168 4,740 4,503 2,100
-------- ------- ------- ------- -------
Loss from operations.... $(10,248) $(5,313) $(5,394) $(5,793) $(2,668)
======== ======= ======= ======= =======
Net loss................ $ (9,640) $(4,876) $(5,194) $(5,821) $(2,621)
======== ======= ======= ======= =======
Basic net loss per
share(/1/)............. $ (1.28) $ (1.22) $(65.75) $(95.43) $(72.81)
======== ======= ======= ======= =======
Basic weighted average
common shares.......... 7,548 3,994 79 61 36
======== ======= ======= ======= =======

DECEMBER 31,
--------------------------------------------
1997 1996 1995 1994 1993
-------- ------- ------- ------- -------

CONSOLIDATED BALANCE SHEET
DATA
Cash, cash equivalents
and short-term
investments............ $ 7,577 $16,199 $ 981 $ 6,930 $ 1,730
Total assets............ 13,987 24,009 4,228 9,223 2,072
Redeemable convertible
preferred stock........ -- -- 11,321 11,321 --
Stockholders' equity
(deficit)................ 11,949 21,398 (9,345) (4,209) 1,611

- --------
(1) See Note 2 of Notes to Consolidated Financial Statements--Summary of
Significant Accounting Policies--Basic Net Loss Per Share.

THERMATRIX INC.

SUPPLEMENTARY CONSOLIDATED FINANCIAL DATA
(IN THOUSANDS, EXCEPT PER SHARE DATA)

Quarterly Financial Data (Unaudited)

YEAR ENDED DECEMBER 31, 1997
----------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------- ------- ------- -------

Net Sales................... $ 1,084 $ 2,250 $ 2,304 $ 1,373
Gross Margin................ (322) (233) (7) (778)
Net Loss.................... (1,952) (2,291) (2,050) (3,347)
Basic Net Loss Per Share.... $ (0.26) $ (0.30) $ (0.27) $ (0.44)

YEAR ENDED DECEMBER 31, 1996
----------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
------- ------- ------- -------

Net Sales................... $ 2,735 $ 3,406 $ 4,402 $ 3,062
Gross Margin................ 229 441 817 116
Net Loss.................... (1,243) (1,249) (836) (1,548)
Basic Net Loss Per Share.... $ (9.61) $ (1.31) $ (0.11) $ (0.21)

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

GENERAL

Thermatrix Inc. is a global industrial technology company engaged in the
development, manufacture and sale of industrial process equipment for the
destruction of volatile organic compounds and hazardous air pollutants
(collectively, "VOCs"). The core component of the Company's technology is its
proprietary flameless thermal oxidizer ("FTO"). The Company's product line
also includes PADRE(R), a proprietary technology used to capture and recover
very low concentration VOCs from low-to-medium vapor streams. The Company also
distributes and sells B.O.S.S.(TM), a proprietary Boiler Oxidizer Steam System
that destroys VOCs and produces steam for process applications, and other
thermal oxidizers for the treatment of VOCs, through its exclusive marketing
agreement with White Horse Technologies, Inc.

The Company derives its revenues from contracts to design, develop,
manufacture, and install systems for the treatment of VOCs. The Company uses
the percentage-of-completion method of accounting to recognize contract
revenues. Losses on contracts are charged to cost of revenues as soon as such
losses become known.

The Company's core technology has been successfully commercialized in the
industrial VOC control market for applications in the petroleum,
chemical/petrochemical, pharmaceutical, medical sterilization and pulp and
paper industries, and for soil and groundwater remediation, and the Company is
continuing to expand into additional segments of the industrial VOC control
market. Because the Company's technology has been commercialized, the Company
does not expect that costs associated with further research and development of
its core FTO technology for the industrial VOC control market will be material
to the Company's results of operations.

In 1997, the Company experienced a shift in market demand for its products.
The United States VOC market has declined, reflecting, the Company believes,
low capital expenditures in new process facilities. However, the Company has
experienced an increase in demand for its products overseas, primarily due to
the continued globalization of the chemical and pharmaceutical industries,
increased adoption of ISO 14000 standards, and capital expenditures by
overseas companies. In 1997, the Company responded to this shift by reducing
its United States sales and operations staff and increasing its presence
overseas. The Company increased its own staff in Europe and has also added
engineering and manufacturing partners in Asia.

In addition to its primary focus on the industrial VOC emission control
market, the Company is currently working with strategic partners to evaluate
the feasibility of applying the Company's technology to other markets. For
example, the Company is engaged in a joint development program with Lucas
Diesel Systems, a division of LucasVarity plc, for the development of a system
to treat emissions from diesel engines. The strategic partners generally share
some, but not all, of the evaluation costs. Evaluation expenses incurred by
the Company, primarily labor and equipment operation costs, are generally
recorded as research and development expenses. To the extent the strategic
partner reimburses such research and development expenses, these amounts are
reflected as a reduction of research and development expenses. If evaluation
costs are reimbursed under the terms of a purchase contract, these amounts are
reflected as cost of revenues. In addition, the Company, may provide an
evaluation system as part of a joint development program. The capital cost of
the evaluation system is amortized over the estimated useful life of the
evaluation system. In 1997, expenses incurred by the Company for these recent
development programs have not been material. However, due to the positive
preliminary test results in the diesel emissions program, the Company
anticipates that more extensive development and engineering will be needed in
order to commercialize its technology for such use. There can be no assurance
as to the outcome of such evaluation programs or, if initiated, the outcome of
any such applications development and engineering effort.

The Company's quarterly revenues and operating results have varied
significantly in the past and may fluctuate significantly in the future as a
result of a variety of factors, many of which are outside the Company's
control. Such factors include general economic and industry conditions, the
size and timing of individual orders, the timing and amount of project change
orders, the amount of first-time engineering needed, the introduction of

new products or services by the Company or its competitors or the introduction
of the Company's products to new markets, changes in the levels of operating
expenses, including development costs, and the amount and timing of other
costs relating to the expansion of the Company's operations.

Furthermore, the purchase of the Company's products, particularly for major
projects, may involve a significant commitment of capital, with the attendant
delays frequently associated with large capital expenditures and authorization
procedures within its customers' organization. For these and other reasons,
the sales cycle for the Company's products can be lengthy (up to two years)
and subject to a number of significant risks over which the Company has little
or no control, including customer budgetary constraints. The Company
historically has operated with little backlog because most customer orders are
placed with relatively short lead times, usually from four to thirty weeks.
Variations in the timing of recognition of specific revenues due to changes in
project scope and timing may adversely and disproportionately affect the
Company's operating results for a quarter because the Company establishes its
expenditure levels on the basis of expected future revenues, and a significant
portion of the Company's expenses do not vary with current revenues.

Although the Company is expanding the number of its customers and
installations, the average size and dollar volume of each installation is
increasing. As a result, the Company's results of operations are likely to
continue to be dependent on major projects. Such a reliance on major orders is
likely to lead to fluctuations in, and to reduce the predictability of,
quarterly results. Larger projects also pose other challenges. The sales cycle
for larger projects tends to be longer than for smaller projects, and, when
orders are received, projects may be delayed by factors outside the Company's
control, including customer budget decisions, design changes and delays in
obtaining permits. Orders for large systems often have tight delivery
schedules and the customer will often attempt to negotiate penalties for late
delivery and/or the ability to assess liquidated damages for lost production
if the delivery schedule is not met. Also, because the dollar volumes are
larger, the costs of providing warranty services could increase. The Company's
business, results of operations and financial condition could be materially
adversely affected if the Company were to fail to obtain major project orders,
if such orders were delayed, if installations of such systems were delayed, or
if such installations encountered operating, warranty or other problems.

RESULTS OF OPERATIONS

Fiscal years Ended December 31, 1997 and 1996

Revenues. Revenues decreased 49% to $7.0 million in 1997 from $13.6 million
in 1996. The decrease in revenues reflects the decline in the United States
VOC market, as well as the cancellation of three orders in three different
countries due to changing customer circumstances after engineering work had
been completed. In 1997, two customers accounted for 28% and 10% of revenues,
respectively. Sales to international customers increased to 35% of revenues in
1997, up from 14% in 1996.

Gross Margin. The Company had a gross margin loss of $1.3 million in 1997
versus a gross margin contribution of $1.6 million, or 11.8%, in 1996. The
decrease in gross margin was primarily attributable to lower revenues, which
were insufficient to absorb the ongoing fixed costs of engineering and
operations in the United States and Europe. As of December 31, 1997, the
Company also recorded a charge to cost of revenues of $500,000 to establish a
reserve against the costs accumulated in connection with certain change orders
and contracts that had not been settled as of December 31, 1997. The Company
is in various stages of negotiations with the parties to the respective
contracts and will continue to pursue collection of such balances, including
taking legal action when necessary. Historically, the Company has been
successful in recovering substantially all charges incurred with respect to
change orders. However, given the passage of time from the incurrence of the
related costs, the Company felt it was prudent to take the reserve to address
the Company's legal and other costs relating to the closing out of these
projects. In addition, gross margin was also impacted by increased overhead
costs incurred as the Company put infrastructure in place to increase its
presence in Europe and to manage the anticipated increase in customer orders
for the Company's products. Also, gross margin was impacted by first-time
shipments to foreign countries, as the Company had to comply with the
different construction and regulatory codes of those countries, the full
design cost of which was charged to the first project in a given country.

The Company anticipates that gross margins will continue to be adversely
affected by numerous factors including growth of the operations
infrastructure, international expansion, initial systems addressing new
industries or new applications, larger, more complex systems and the extent
and timing of change orders. As the Company grows, the Company will need to
hire additional design engineers, instrumentation and control engineers and
project management personnel. Significant training and familiarization with
the Company's FTO technology will result in these new individuals not being
fully engaged in revenue producing activities, which reduces gross margin
percentages. As the Company grows internationally, operations infrastructure
needs to be added to support the sales activities. New industry and/or fume
characteristics require the Company to expend significantly greater
engineering resources in process and system design. Also such new applications
are usually sold at lower initial gross margins as the customer and the
Company make investments in the development effort. As systems get larger and
more complex with hybrid technologies and purchased components, overall gross
margin percentages are affected by the Company's ability to mark up the
purchased components in the final system. Project change orders can be nominal
or can be significant. The Company does not recognize change orders as revenue
until the customer accepts the implemented change order or acceptance is
probable. Depending upon the magnitude of the change order, gross margins can
also be affected.

Research and Development. Research and development expenses include
applications engineering expenses not chargeable to specific customer
projects, personnel costs related to patent activities, and the expenses
incurred in connection with the Company's development programs to evaluate the
feasibility of applying the Company's technology to markets other than
industrial VOC emissions control. Research and development expenses during
1997 and 1996 were $1.2 million and $748,000, respectively. The increase in
research and development expenses in 1997 is attributable to a significant
increase in product development activities in 1997. A modified recuperative
oxidizer was designed and installed to improve the operability and increase
the range of the FTO. A portion of the increase in research and development
expenses is attributable to the design of a continuous PADRE system. Also, the
first test unit for the treatment of emissions from dry cleaning operations
was completed and shipped. In addition, a new FTO design with an almost
spherical flameless reaction front within the reactor's ceramic matrix was
constructed and tested.

Selling, General and Administrative. Selling, general and administrative
expenses increased 25% to $7.7 million in 1997 as compared with $6.2 million
in 1996. The increase is primarily attributable to the 1997 fourth quarter
charge of $891,000 recorded for certain nonrecurring items including $472,000
for the costs relating to (i) the move of the Company's administrative center
from San Jose, California to Knoxville, Tennessee, (ii) the closure of the
Knoxville fabrication and assembly facility, and (iii) the relocation of the
Company's European operations from London to an expanded facility near Hull,
England. The charge also includes severance and other related closure and
relocation costs associated with these activities. Another component of the
nonrecurring charges relates to the non-cash provision of approximately
$390,000 recorded to write off the Company's minority interest position in the
Formatrix, LLC joint venture with ThermoChem, Inc.

In addition to the nonrecurring charge taken in 1997, the increase in
selling, general and administrative expenses reflects the impact of increased
staffing and related costs incurred in Europe and Asia as a result of the
higher level of sales activity in those regions, which was partially offset by
the decrease in the Company's United States sales staff. The increase is also
reflective of the full-year costs of being a public company. The Company's IPO
was completed June 20, 1996.

Interest Income. Interest income increased to $697,000 in 1997, from
$548,000 in 1996. The increase primarily resulted from the investment of the
net proceeds from the Company's initial public offering completed in June
1996.

Income Taxes. As a result of recurring losses, the only income taxes
provided for relate to certain state taxes not fully offset by net operating
losses.

Fiscal years Ended December 31, 1996 and 1995

Revenues. Revenues grew 110% to $13.6 million in 1996, from $6.5 million in
1995, with three customers accounting for 13%, 13% and 12% of revenues in
1996. The increase in revenues from 1995 to 1996 is primarily attributable to
an increased acceptance of the Company's technology resulting in contracts for
systems used in chemical/petrochemical, petroleum, and pulp and paper industry
applications, orders for systems used in remediation projects, and the first
unit for use in medical sterilization. Revenues in 1996 also reflected the
Company's first sales of PADRE units, the technology acquired from Purus, Inc.
in April 1996.

Gross Margin. Gross margin as a percentage of revenues for 1996 and 1995 was
11.8% and 6.6%, respectively. The increase in gross margin in 1996 was
attributable in part to an increase in follow-on sales for existing
applications, increased pricing as the Company began to value price its
systems and, to a lesser extent, reductions in costs from repeat sales of
systems for established applications.

Research and Development. Research and development expenses during 1996 and
1995 were $748,000 and $1.1 million, respectively. The reduction in research
and development expenses from 1995 to 1996 was primarily due to the Company's
success in developing collaborative efforts with its core industrial VOC
customers, thereby reducing its own independent expenditures for applications
development.

Selling, General and Administrative. Selling, general and administrative
expenses increased to $6.2 million in 1996 as compared with $4.7 million in
1995. The increase in selling, general and administrative expenses from 1995
to 1996 was primarily a result of increased sales commissions, proposal
activity, liability insurance and other costs related to the increased level
of sales. The increase is also reflective of the costs of being a public
company. The Company's IPO was completed June 20, 1996.

LIQUIDITY AND CAPITAL RESOURCES

In February 1996, the Company sold 284,594 shares of its Series D Preferred
Stock at $7.50 per share to existing investors for next cash of $2.1 million.
In June 1996, the Company completed its initial public offering raising net
proceeds of $22.1 million. The Company used the proceeds of these prior equity
issuances to finance its operations throughout 1996 and 1997. At December 31,
1997, the Company had an accumulated deficit of $36.7 million, and working
capital of $9.9 million.

At December 31, 1997, the Company had cash and cash equivalents and short-
term investments totaling $7.6 million, as compared to $16.2 million in
December 31, 1996. The $8.6 million decrease in 1997 resulted primarily from
$7.7 million of cash used in operating activities, and $1.1 million of cash
used in the purchase of property and equipment, the acquisition of other
assets and the prosecution of patents, offset by $191,000 of cash provided by
the sale and issuance of common stock.

In addition to cash used for operating activities in 1998, the Company
expects to spend approximately $1 million in 1998 to fund additional research
and development activities relating to the treatment of emissions from diesel
engines. However, the Company is actively seeking strategic partners to assist
in the funding of the diesel engine emission control program and if the
Company is successful in finding a strategic partner, its research and
development expenditures could total less than the $1 million forecasted. The
Company is not contractually committed to provide any fixed level of funding
for the diesel program and had no other capital commitments at December 31,
1997.

In February 1997, the Company entered into an Amended and Restated Loan and
Security Agreement (the "1997 Agreement"), which provides for a $4,000,000
accounts receivable line of credit and a $2,500,000 acquisition facility. The
committed line bears interest at the prime interest rate plus 0.50% and will
be subject to certain financial and non-financial covenants. Any borrowings
under the acquisition facility bore interest at the prime interest rate plus
1.00%. No amounts were outstanding under the 1997 Agreement as of December 31,
1997.

March 1998 when certain financial covenants were amended. The committed line
will bear interest at the prime interest rate plus 0.50% and will be subject
to certain financial and non-financial covenants. There are no interest
bearing borrowings outstanding under the line of credit as of February 28,
1998. The Company has a stand-by letter of credit issued under the sub-
facility in the amount of $280,000.

The Company anticipates satisfying its 1998 cash requirements from, among
other things, (i) its cash and short-term investments, (ii) increased revenues
and positive gross margin, (iii) the timely collection of accounts receivable,
and (iv) the line of credit facility. These strategies are dependent on the
Company's ability to meet its forecasts, including developing increased sales
and generating positive gross margins therefrom, the timely collection of
amounts due to the Company and compliance with the line of credit agreement
covenants. The Company believes that its existing cash and short-term
investments and line of credit facility will provide sufficient liquidity for
it to meet its obligations throughout 1998.

YEAR 2000 COMPLIANCE

The Year 2000 issue arises from computer programs that use two digits rather
than four to define the applicable year. Such computer programs may cause
computer systems to recognize a date using "00" as the calendar year 1900
rather than the calendar year 2000. Systems that do not properly recognize
such information could generate erroneous dates or cause a system to fail.

The Company has conducted a preliminary review of its products and internal
computer systems to identify the systems that could be affected by the Year
2000 issue. The Company believes its products and most of its management
information systems are already Year 2000 compliant, however its existing
accounting system is not. The Company plans to upgrade to a Year 2000
compliant version of its accounting system and does not anticipate that the
cost of such a conversion will be material.

While the Company currently expects the Year 2000 issue will not pose
significant operational problems, failure to fully identify all Year 2000
dependencies in the Company's systems could have a material adverse effect on
the Company's business, results of operations and financial condition. In
addition, the Company cannot be sure that systems of other companies on which
the Company relies will be converted in a timely manner. The failure of other
companies to convert systems on which the Company relies may have a material
adverse effect on the Company's business, results of operations or financial
condition.

ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See pages 24 through 38.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES

None

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

As of December 31, 1997, the executive officers of the Company, who are
elected by and serve at the discretion of the Board of Directors, are as
follows:

NAME AGE POSITION
---- --- --------

John T. Schofield........... 60 Chairman, President and Chief Executive
Officer
Barbara E. Krimsky.......... 37 Acting Chief Financial Officer, Vice
President, Finance and Administration and
Secretary
Richard J. Goodier.......... 51 Director, European Engineering and
Operations

John T. Schofield. Mr. Schofield has been President and Chief Executive
Officer of the Company since April 1992, and Chairman of the Board since
December 1993. From April 1981 to September 1991, Mr. Schofield served in
various executive positions at International Technology Corporation, an
environmental management company, where he directed technical services,
business activities, strategic planning and development. Mr. Schofield holds a
BSc Honours in Chemistry from the University of Manchester, England.

Barbara E. Krimsky. Ms. Krimsky has been Acting Chief Financial Officer and
Vice President, Finance and Administration of the Company since January 1998.
She was Vice President, Administration of the Company from November 1993 to
December 1997. In April 1996, Ms. Krimsky was appointed Secretary of the
Corporation. From February 1990 through October 1993, Ms. Krimsky was the
Director, Contracts Management for Quotron Systems, Inc., a financial
information services company. Ms. Krimsky holds a B.A. in Economics and
Computer Science from Duke University and a M.M. from Northwestern
University's Kellogg Graduate School of Management.

Richard J. Goodier. Mr. Goodier joined the Company as Director, European
Engineering and Operations, in February 1997. Prior to joining Thermatrix, he
held a variety of senior management positions in Hickson International PLC,
AltMarks, AE&CI (South Africa), Amoco Europe and Shell Chemicals. Mr. Goodier
holds a B.Sc. in Mechanical Engineering and is a Chartered Engineer with the
Institution of Mechanical Engineers in London.

Information concerning the Company's Directors and compliance with Section
16 of the Securities Exchange Act is incorporated herein by reference to the
Company's definitive proxy statement for its Annual Meeting of Stockholders to
be held on June 11, 1998, which is intended to be filed with the Securities
and Exchange Commission no later than 120 days after the close of the fiscal
year ended December 31, 1997.

ITEMS 11, 12 AND 13

The information called for by Part III (Items 11, 12 and 13) is incorporated
herein by reference to the Company's definitive proxy statement for its Annual
Meeting of Stockholders to be held on June 11, 1998, which is intended to be
filed with the Securities and Exchange Commission no later than 120 days after
the close of the fiscal year ended December 31, 1997.

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Thermatrix Inc.:

We have audited the accompanying consolidated balance sheets of Thermatrix
Inc. (a Delaware corporation) and subsidiary as of December 31, 1997 and 1996,
and the related consolidated statements of operations, stockholders' equity
(deficit) and cash flows for each of the three years in the period ended
December 31, 1997. These financial statements and the schedule referred to
below are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Thermatrix Inc. and
subsidiary as of December 31, 1997 and 1996, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 1997 in conformity with generally accepted accounting
principles.

Our audits were made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. The schedule listed under
Item 14(a) is presented for purposes of complying with the Securities and
Exchange Commission's rules and is not a required part of the basic
consolidated financial statements. This schedule has been subjected to the
auditing procedures applied in the audit of the basic consolidated financial
statements and, in our opinion, fairly states in all material respects the
financial data required to be set forth in relation to the basic consolidated
financial statements taken as a whole.

/S/ ARTHUR ANDERSEN LLP

San Jose, California
March 5, 1998

THERMATRIX INC.

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)

DECEMBER 31,
-----------------
1997 1996
-------- -------

ASSETS
CURRENT ASSETS:
Cash and cash equivalents............................... $ 3,990 $ 4,781
Short-term investments.................................. 3,587 11,418
Accounts receivable, net................................ 3,520 4,899
Costs of uncompleted contracts in excess of billings,
net.................................................... 547 809
Prepaid expenses and other current assets............... 250 334
-------- -------
Total current assets.................................. 11,894 22,241
-------- -------
PROPERTY AND EQUIPMENT:
Machinery and equipment................................. 857 750
Furniture and fixtures.................................. 322 307
Demonstration equipment................................. 506 179
-------- -------
1,685 1,236
Less--Accumulated depreciation.......................... (749) (423)
-------- -------
Net property and equipment.................................. 936 813
-------- -------
PATENTS AND OTHER ASSETS, net............................. 1,157 955
-------- -------
$13,987 $24,009
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable........................................ $ 1,055 $ 1,779
Billings on uncompleted contracts in excess of costs and
revenue recognized..................................... 181 8
Accrued liabilities..................................... 802 824
-------- -------
Total current liabilities............................. 2,038 2,611
-------- -------
COMMITMENTS AND CONTINGENCIES (Note 4)
STOCKHOLDERS' EQUITY:
Convertible preferred stock: $0.001 par value
Authorized--5,000,000 shares
Outstanding--None..................................... -- --
Common stock: $0.001 par value
Authorized--50,000,000 shares
Outstanding--7,627,674 and 7,466,683 shares, respec-
tively............................................... 8 7
Additional paid-in capital.............................. 48,644 48,454
Accumulated deficit..................................... (36,703) (27,063)
-------- -------
Total stockholders' equity.............................. 11,949 21,398
-------- -------
$ 13,987 $24,009
======== =======

The accompanying notes are an integral part of these consolidated financial
statements.

THERMATRIX INC.

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)

FOR THE YEARS ENDED
DECEMBER 31,
-------------------------
1997 1996 1995
------- ------- -------

REVENUES.................................... $ 7,011 $13,605 $ 6,494
COST OF REVENUES............................ 8,351 12,002 6,064
------- ------- -------
Gross margin.............................. (1,340) 1,603 430
------- ------- -------
OPERATING EXPENSES:
Research and development.................. 1,203 748 1,084
Selling, general and administrative....... 7,705 6,168 4,740
------- ------- -------
Total operating expenses................ 8,908 6,916 5,824
------- ------- -------
Loss from operations.................... (10,248) (5,313) (5,394)
INTEREST INCOME (EXPENSE):
Interest income........................... 697 548 231
Interest expense.......................... (23) (48) --
------- ------- -------
Total interest income (expense)......... 674 500 231
------- ------- -------
Net loss before provision for income
taxes.................................. (9,574) (4,813) (5,163)
PROVISION FOR INCOME TAXES.................. 66 63 31
------- ------- -------
Net loss................................ $(9,640) $(4,876) $(5,194)
======= ======= =======
BASIC NET LOSS PER SHARE.................... $ (1.28) $ (1.22) $(65.75)
======= ======= =======
BASIC WEIGHTED AVERAGE COMMON SHARES........ 7,548 3,994 79
======= ======= =======

The accompanying notes are an integral part of these consolidated financial
statements.

THERMATRIX INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)

CONVERTIBLE
PREFERRED STOCK COMMON STOCK
------------------ ----------------
TOTAL
ADDITIONAL STOCKHOLDERS'
PAID-IN ACCUMULATED EQUITY
SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT (DEFICIT)
---------- ------ --------- ------ ---------- ----------- -------------

BALANCE, DECEMBER 31,
1994................... 2,554,631 $9,304 61,841 $-- $ 3,480 $(16,993) $(4,209)
Exercise of stock op-
tions at $0.30 to
$1.50 per share....... -- -- 57,549 -- 43 -- 43
Stock bonus at $1.50
per share............. -- -- 9,968 -- 15 -- 15
Net loss............... -- -- -- -- -- (5,194) (5,194)
---------- ------ --------- --- ------- -------- -------
BALANCE, DECEMBER 31,
1995................... 2,554,631 9,304 129,358 -- 3,538 (22,187) (9,345)
Common stock issued in
initial public offer-
ing at $12.50 per
share, net of issuance
costs of $2,940....... -- -- 2,000,000 2 22,058 -- 22,060
Exercise of stock op-
tions at $0.30 to
$3.00 per share....... -- -- 44,430 -- 33 -- 33
Exercise of warrants at
$3.00 to $5.25 per
share................. -- -- 21,415 -- 72 -- 72
Common stock issued for
cash at $12.00 per
share................. -- -- 4,167 -- 50 -- 50
Conversion of redeem-
able convertible pre-
ferred stock.......... -- -- 2,712,682 3 13,401 -- 13,404
Conversion of convert-
ible preferred stock.. (2,554,631) (9,304) 2,554,631 2 9,302 -- --
Net loss............... -- -- -- -- -- (4,876) (4,876)
---------- ------ --------- --- ------- -------- -------
BALANCE, DECEMBER 31,
1996................... -- -- 7,466,683 7 48,454 (27,063) 21,398
Exercise of stock op-
tions at $0.30 to
$3.00 per share....... -- -- 109,613 1 72 -- 73
Common stock issued for
cash at $2.76 per
share................. -- -- 19,695 -- 54 -- 54
Common stock issued for
cash at $2.02 per
share................. -- -- 31,683 -- 64 -- 64
Net loss............... -- -- -- -- -- (9,640) (9,640)
---------- ------ --------- --- ------- -------- -------
BALANCE, DECEMBER 31,
1997................... -- $ -- 7,627,674 $ 8 $48,644 $(36,703) $11,949
========== ====== ========= === ======= ======== =======

The accompanying notes are an integral part of these consolidated financial
statements.

THERMATRIX INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

FOR THE YEARS ENDED
DECEMBER 31,
---------------------------
1997 1996 1995
-------- -------- -------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss........................................ $ (9,640) $ (4,876) $(5,194)
Adjustments to reconcile net loss to net cash
used in operating activities--
Depreciation and amortization................. 453 281 162
Provision for doubtful accounts............... 220 190 229
Provision for uncollectible costs of
uncompleted contracts in excess of billings.. 500 -- --
Write-off of investment in joint venture...... 390 -- --
Stock bonus compensation expense.............. -- -- 15
Changes in assets and liabilities--
(Increase) decrease in accounts receivable.. 1,160 (2,949) (910)
(Increase) decrease in costs of uncompleted
contracts in excess of billings............ (238) (724) 223
(Increase) decrease in prepaid expenses and
other current assets....................... 84 (153) (130)
Increase (decrease) in accounts payable..... (724) 292 29
Increase (decrease) in billings on
uncompleted contracts in excess of costs
and revenue recognized..................... 173 (332) 149
Increase (decrease) in accrued liabilities.. (90) 399 (37)
-------- -------- -------
Net cash used in operating activities....... (7,712) (7,872) (5,464)
-------- -------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment............. (465) (408) (381)
Purchase of short-term investments.............. (27,887) (11,844) --
Proceeds from sale of short-term investments.... 35,718 426 3,801
Increase in patents and other assets............ (636) (800) (147)
-------- -------- -------
Net cash (used in) provided by investing
activities................................. 6,730 (12,626) 3,273
-------- -------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings under line of credit................. -- 1,000 --
Repayment of line of credit borrowing........... -- (1,000) --
Net proceeds from sale of Series D redeemable
preferred stock................................ -- 2,083 --
Net proceeds from sale/issuance of common stock. 191 22,215 43
-------- -------- -------
Net cash provided by financing activities... 191 24,298 43
-------- -------- -------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS.. (791) 3,800 (2,148)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD.. 4,781 981 3,129
-------- -------- -------
CASH AND CASH EQUIVALENTS AT END OF PERIOD........ $ 3,990 $ 4,781 $ 981
======== ======== =======
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest.......................... $ 23 $ 48 $ --
======== ======== =======
Cash paid for income taxes...................... $ 104 $ 13 $ 26
======== ======== =======
Non-cash conversion of redeemable preferred
stock.......................................... $ -- $ 13,404 $ --
======== ======== =======
Non-cash conversion of convertible preferred
stock.......................................... $ -- $ 9,304 $ --
======== ======== =======

The accompanying notes are an integral part of these consolidated financial
statements.

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION AND OPERATIONS OF THE COMPANY

Thermatrix Inc. (the "Company") is a global industrial technology company
primarily engaged in the development, manufacture and sale of industrial
process equipment for the destruction of volatile organic compounds and
hazardous air pollutants (collectively, "VOCs"). The Company markets its
products to a wide variety of industries, including petroleum,
chemical/petrochemical, pharmaceutical, pulp and paper, and medical
sterilization and for soil and groundwater remediation, throughout the world.

In June 1996, the Company completed an initial public offering of 2,000,000
shares of common stock at $12.50 per share. Total proceeds to the Company, net
of underwriting discounts and other direct expenses, were approximately $22.1
million.

The Company is subject to certain risks that include, but are not limited
to, the history of operating losses and uncertainty of future profitability;
sensitivity to major projects; fixed price contracts; and dependence on a
limited set of customers and key employees. At December 31, 1997, the Company
had an accumulated deficit of approximately $36.7 million and expects to incur
additional losses in the future. The Company does not expect to be profitable
unless and until such time as sales of flameless thermal oxidation systems at
appropriate gross margins generate sufficient revenue to fund its operations.
There can be no assurance that the Company will achieve such revenues or
margins. The Company's operating results are sensitive to major projects such
that results of operations and financial condition could be adversely affected
if the Company failed to obtain major projects, if a major project order was
delayed, if the Company was unable to complete the project within its cost
estimate or if such installations encountered operating or warranty problems.

The Company anticipates satisfying its 1998 cash requirements from, among
other things, (i) its cash and short-term investments, (ii) increased revenues
and positive gross margin, (iii) the timely collection of accounts receivable,
and (iv) the line of credit facility (Note 9). These strategies are dependent
on the Company's ability to meet its forecasts, including developing increased
sales and generating positive gross margin therefrom, the timely collection of
amounts due to the Company and compliance with the line of credit agreement
covenants. The Company believes that its existing cash and short-term
investments and line of credit facility will provide sufficient liquidity for
it to meet its obligations throughout 1998.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Use of Estimates

The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
period. The Company prepares and evaluates ongoing cost to complete estimates
in order to monitor its project costs. These estimates form the basis for
calculating revenues and gross margins for each project under the percentage-
of-completion method of accounting. Due to uncertainties inherent in the
estimation process, estimated total costs are subject to revision on an on-
going basis as additional information becomes available. The estimates are
subject to change and actual results could be materially different from these
estimates.

Principles of Consolidation and Foreign Currency Translation

The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiary. The functional currency of the subsidiary is
the U.S. dollar. Accordingly, all translation gains and losses resulting from
transactions denominated in currencies other than the U.S. dollar are included
in the statement of operations. To date, the translation gains and losses have
not been material. All intercompany accounts and transactions have been
eliminated.

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

Joint Venture

In October 1996, the Company entered into an agreement with ThermoChem, Inc.
to establish a joint venture, Formatrix, LLC, to combine, under license, the
patented technologies of the joint venture partners. The Company owns 40% of
Formatrix, LLC. Formatrix, LLC has had no operations in the period from its
inception to December 31, 1997. In December 1997, the Company recorded a non-
cash provision of $390,000 to write-off its investment in this area due to the
uncertainties in the timing of the deployment of its technology for the
processing of radioactive mixed waste. In view of these uncertainties, the
Company plans to discontinue its joint venture arrangement and will undertake
any future projects for the processing of radioactive mixed waste on a teaming
basis.

Cash and Cash Equivalents

For purposes of the statements of cash flows, the Company considers all
short-term investments purchased with a maturity of three months or less to be
cash equivalents.

Short-term Investments

Under Statement of Financial Accounting Standards ("SFAS") No. 115,
"Accounting for Certain Investments in Debt and Equity Securities" the Company
classifies its short-term investments as "held to maturity." Therefore all of
these investments are carried at amortized cost. As of December 31, 1997,
short-term investments mature at various dates through March 1998.

The amortized cost, aggregate fair value and gross unrealized holding gains
(losses) by major security type at December 31 were as follows (in thousands):

1997
----------------------------------
AMORTIZED AGGREGATE UNREALIZED
COST FAIR VALUE GAINS (LOSSES)
--------- ---------- -------------

Certificates of deposit.............. $ 1,000 $ 1,000 $--
Corporate debt securities............ 5,108 5,106 (2)
Money market instruments............. 1,154 1,154 --
------- ------- ----
$ 7,262 $ 7,260 $ (2)
======= ======= ====

1996
----------------------------------
AMORTIZED AGGREGATE UNREALIZED
COST FAIR VALUE GAINS (LOSSES)
--------- ---------- -------------

Certificates of deposit.............. $ 2,022 $ 2,022 $--
Corporate debt securities............ 8,247 8,251 4
Money market instruments............. 1,149 1,149 --
------- ------- ----
$11,418 $11,422 $ 4
======= ======= ====

Revenue Recognition

The Company principally uses the percentage-of-completion method of
accounting for contract revenues. The percentage-of-completion method is based
on total costs incurred to date compared with estimated total costs upon
completion of contracts. The completed contract method of accounting is used
for certain contracts when the Company does not have sufficient historical
data to enable it to prepare dependable cost estimates. Losses on

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

contracts are charged to cost of revenues as soon as such losses become known.
Due to uncertainties inherent in the estimation process, estimated total costs
are subject to revision on an ongoing basis as additional information becomes
available. The Company recognizes revenue and costs attributable to priced and
unpriced change orders when it is probable that the contract price will be
adjusted and the amount of the change order can be reliably estimated. When
acceptance of the contract change order is not probable or the amount of the
change order cannot be reliably estimated, the Company treats the change order
costs as costs of uncompleted contracts in excess of billing and defers
revenue recognition until the change order is accepted or acceptance is
probable. The Company generally warrants only new systems manufactured by the
Company for defective workmanship and/or materials for a period of 12 months
from initial operation of the system or 18 months after shipment or
notification that the system is ready for shipment, whichever occurs first. A
provision for estimated warranty costs is provided for each unit produced by
the Company.

Accounts Receivable

Accounts receivable consisted of the following (in thousands):

DECEMBER 31,
--------------
1997 1996
------ ------

Billed, subject to retainer provisions................... $ -- $ 19
Billed................................................... 3,003 3,389
Unbilled, including unpriced change orders............... 860 1,756
------ ------
Total receivables........................................ 3,863 5,164
Less: Allowance for doubtful accounts.................... (343) (265)
------ ------
$3,520 $4,899
====== ======

The unbilled amounts represent revenues recognized under the percentage-of-
completion method of accounting which exceed the amounts that are billable
according to contract terms. The unbilled amounts are generally billable as
contract milestones and deliverables are accepted by the customer or as change
orders are submitted and approved. As of December 31, 1997 and 1996, accounts
receivable included approximately $793,000 of unpriced change orders.

As of December 31, 1997, 59% of accounts receivable was concentrated with
eight customers. As of December 31, 1996, approximately 61% of accounts
receivable was concentrated with five customers.

Concentration of Credit Risk

Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of short-term cash investments and accounts
receivable. The Company has cash investment policies that limit its
investments to short-term, low risk investments. With respect to accounts
receivable, the Company performs ongoing credit evaluations of its customers'
financial condition. Additionally, the Company establishes an allowance for
doubtful accounts based upon factors surrounding the credit risk of specific
customers, historical trends and other information.

Property and Equipment

Property and equipment are stated at cost. Depreciation is provided using
the straight-line method over the estimated lives of the assets of three to
five years. Leasehold improvements are amortized over the shorter of the
related lease term or the estimated useful life of the asset. Betterments,
renewals and extraordinary repairs that extend the life of the asset are
capitalized; other repairs and maintenance are expensed.

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

As required by SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of," the Company regularly
evaluates the remaining life and recoverability of its equipment. The Company
adopted the provisions of this statement in 1995. The adoption did not have a
significant effect on the Company's financial position and results of
operations. Given the emerging nature of its markets, it is possible that the
Company's estimate that it will recover the net carrying value of the
equipment from future operations could change in the future.

Patent Costs

Direct costs incurred in connection with the filing of the Company's patent
claims are capitalized as patent costs. Such amounts are amortized over the
estimated economic useful lives of the patents (generally ten years).
Accumulated amortization as of December 31, 1997 and 1996 was approximately
$137,000 and $88,000, respectively.

Significant Customers

Sales to significant customers as a percentage of total revenues for the
years ended December 31, 1997, 1996 and 1995 were as follows:

FOR THE YEARS
ENDED DECEMBER
31,
----------------
1997 1996 1995
---- ---- ----

Customer A................................................ -- -- 2%
Customer B................................................ -- -- --
Customer C................................................ -- -- 7%
Customer D................................................ -- -- 1%
Customer E................................................ -- 5% 41%
Customer F................................................ -- -- 18%
Customer G................................................ 3% 13% --
Customer H................................................ -- 13% --
Customer I................................................ 2% 12% --
Customer J................................................ 28% -- --
Customer K................................................ 10% -- --

Revenues from government contracts as a percentage of total revenues were
10%, 15% and 19% for the years ended December 31, 1997, 1996, and 1995,
respectively. The principal government agencies to which the Company sells are
the Department of Defense and the Department of Energy. Revenues from
international customers as a percentage of total revenues were 35% for the
year ended December 31, 1997, 14% for the year ended December 31, 1996 and
less than 10% for the year ended December 31, 1995.

Basic Net Loss Per Share

Basic net loss per share is computed using the weighted average number of
shares of common stock outstanding. No diluted loss per share information has
been presented in the accompanying statements of operations since potential
common shares from conversion of convertible preferred stock, stock options
and warrants are antidilutive.

As a result of the adoption of Statement of Financial Accounting Standards
(SFAS) No. 128 "Earnings Per Share," net loss per share amounts for the fiscal
years 1996 and 1995 have been restated and historical per share information
has been presented. The effect of this accounting change on previously
reported net loss per share data was as follows:

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

1996
-------

Primary net loss per share as previously reported.................. $ (0.73)
Effect of SFAS No. 128............................................. $ (0.49)
-------
Basic net loss per share......................................... $ (1.22)
=======

1995
-------

Pro forma net loss per share as previously reported................ $ (0.91)
Effect of SFAS No. 128............................................. $(64.84)
-------
Basic net loss per share......................................... $(65.75)
=======

Effect of Recent Accounting Pronouncements

In February 1997, the Financial Accounting Standards Board issued SFAS No.
129, "Disclosure of Information about Capital Structures," which will be
adopted by the Company in fiscal 1998. SFAS No. 129 requires companies to
disclose certain information about their capital structure. The Company does
not anticipate that SFAS No. 129 will have a material impact on its
consolidated financial statement disclosures.

In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
"Reporting Comprehensive Income," which will be adopted by the Company in
fiscal 1998. SFAS No. 130 requires companies to disclose certain information
regarding the nature and amounts of comprehensive income included in the
financial statements. The Company does not anticipate that SFAS No. 130 will
have a material impact on its consolidated financial statement disclosures.

In June 1997, the Financial Accounting Standards Board also issued Statement
No. 131, "Disclosures about Segments of an Enterprise and Related Information"
(SFAS No. 131) which will be adopted by the Company in fiscal 1998. SFAS No.
131 establishes standards for disclosures about operating segments, products
and services, geographical areas and major customers. Management believes the
adoption of SFAS No. 131 will not have a material effect on the Company's
financial statements.

3. ACCRUED LIABILITIES

Accrued liabilities consisted of the following (in thousands):

DECEMBER
31,
---------

1997 1996
---- ----
Commissions payable............................................... $139 $242
Accrued employee compensation cost................................ 167 --
Other............................................................. 496 582
---- ----
$802 $824
==== ====

4. COMMITMENTS AND CONTINGENCIES

The Company leases its facilities and certain equipment under operating
leases that expire through January 2003. Rent expense was approximately
$492,000, $338,000 and $269,000 for the years ended December 31,

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

1997, 1996 and 1995, respectively. As of December 31, 1997, future minimum
payments are as follows (in thousands):

YEAR ENDING
DECEMBER 31,
------------

1998.................................................................... $406
1999.................................................................... 302
2000.................................................................... 90
2001.................................................................... 84
2002 and thereafter..................................................... 9
----
$891
====

In April 1996, the Company purchased all of the respective assets, rights
and properties of Purus Inc.'s VOC adsorption technology ("PADRE"). Concurrent
with the purchase, the Company entered into a License Agreement ("License")
with Purus to manufacture, sell and distribute VOC treatment systems utilizing
the PADRE technology. Under this License, the Company is required to make
quarterly royalty payments of 7% on the aggregate net invoice value of all
PADRE VOC equipment sales. Royalty payments will continue until the earlier of
(i) five years from the date of the License or (ii) such date that Purus has
received $2.0 million in aggregate royalty payments. Royalties paid by the
Company under the License totaled approximately $80,000 and $63,000 for the
years ended December 31, 1997 and 1996, respectively.

5. PREFERRED STOCK

Convertible Preferred Stock

Upon the closing of the Company's initial public offering in June 1996, each
of the 2,554,631 shares of preferred stock then outstanding converted
automatically into common stock.

Redeemable Convertible Preferred Stock

Redeemable convertible preferred stock outstanding as of December 31, 1995,
consisted of 1,614,284 shares of Series D redeemable preferred stock. In
February 1996, the Company sold 284,594 shares of Series D redeemable
preferred stock at $7.50 per share.

Pursuant to the terms of the preferred stock agreement, the conversion price
of Series D redeemable preferred stock was adjusted to $5.25 per share. The
Series D preferred stock was automatically converted into 2,712,682 shares of
common stock upon the closing of the Company's initial public offering.

In connection with a bridge financing in 1994, warrants to purchase 20,672
shares of convertible Series D redeemable preferred stock at $5.25 per share
(as adjusted) were issued. Subsequent to the Company's initial public
offering, these warrants were convertible into warrants to purchase common
stock. The warrants are exercisable at any time and expire in 1999. Warrants
to purchase 3,558 shares of common stock were exercised during 1996.

Preferred Stock

The Company is authorized to issue 5,000,000 shares of $.001 par value
undesignated preferred stock. Upon issuance, the Board of Directors will have
the authority to fix the rights, preferences, privileges and restrictions
thereof.

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

6. COMMON STOCK

As of December 31, 1997, the Company had reserved shares of its common stock
for issuance as follows:

Warrants to purchase common stock.................................. 45,685
Stock options under 1987 Stock Option Plan......................... 500,214
Stock options under 1996 Stock Plan................................ 333,334
Stock options under 1996 Director Option Plan...................... 83,334
Employee Stock Purchase Plan....................................... 65,289
---------
Total shares reserved............................................ 1,027,856
=========

In May 1996, the Board of Directors approved a one-for-three reverse stock
split of all common stock and all designated series of preferred stock
outstanding. The effect of the stock split has been retroactively applied in
the consolidated financial statements.

7. STOCK OPTION PLANS

1987 Stock Option Plan ("1987 Plan")

Under the 1987 Plan, the Board of Directors may grant to employees and
consultants options to purchase the Company's common stock at terms and prices
determined by the Board. Options granted under the 1987 Plan generally expire
ten (10) years from the date of grant. During 1996, the Company adopted new
stock plans (see below); accordingly, the Company does not plan to issue
further options to purchase common stock under the 1987 Plan.

1996 Stock Plan ("1996 Plan")

A total of 333,334 shares of common stock has been reserved for issuance
under the 1996 Plan. The 1996 Plan provides that options and stock purchase
rights may be granted to employees and consultants to the Company. Options
granted under the 1996 Plan may be either incentive stock options or non-
statutory stock options. The Company may also grant stock purchase rights
under the 1996 Plan. The exercise price and vesting of all grants are to be
determined by the Board of Directors or its designee. Options granted under
the 1996 Plan expire 10 years from the date of grant. The 1996 Plan will
terminate in 2006.

The Board of Directors adopted a sub-plan of the 1996 Plan for the purpose
of qualifying for preferred tax treatment under UK tax laws. The UK Inland
Revenue approved the sub-plan effective January 30, 1998.

1996 Director Option Plan ("Directors Plan")

A total of 83,334 shares of common stock has been reserved for issuance
under the Directors Plan. The Directors Plan provides for an automatic grant
to each director of an initial option to purchase 6,667 shares of common stock
("First Option") upon the date on which such person becomes a non-employee
director, and an additional option to purchase 1,667 shares of common stock
("Subsequent Option") each year, if the director has served on the Company's
Board of Directors for at least six months. Options granted under the
Directors Plan expire ten years after the date of grant. Twelve and one-half
percent of the shares subject to a First Option will vest six months after its
date of grant and an additional twelve and one-half percent will vest at the
end of each six-month period thereafter. One-half of the shares subject to a
Subsequent Option will vest six months after the date of the option grant and
as to the remaining one-half, one year after the date of grant. The exercise

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

price per share of all options shall be equal to the fair market value of the
Company's common stock on the date of grant. The Directors Plan will terminate
in 2006.

The following option activity occurred in all stock option plans during the
three years ended December 31, 1997:

OPTIONS WEIGHTED
AVAILABLE OUTSTANDING PER SHARE AVERAGE
FOR GRANT OPTIONS PRICE EXERCISE PRICE
--------- ----------- ------------ --------------

Balance, December 31, 1994.... 68,834 670,261 $0.30-$ 5.25 $1.99
Authorized.................. 107,317 -- --
Granted..................... (262,020) 262,020 $ 1.50 1.50
Exercised................... -- (57,549) $0.30-$ 1.50 0.75
Canceled.................... 320,255 (320,255) $0.30-$ 5.25 3.55
-------- --------
Balance, December 31, 1995.... 234,386 554,477 $0.30-$ 1.50 0.98
Authorized.................. 416,668 -- --
Granted..................... (273,522) 273,522 $3.00-$12.50 5.74
Exercised................... -- (44,430) $0.30-$ 3.00 0.74
Expired..................... (47,254) -- --
Canceled.................... 5,388 (5,388) $0.75-$ 7.50 2.67
-------- --------
Balance, December 31, 1996.... 335,666 778,181 $0.30-$12.50 2.66
Granted..................... (57,469) 57,469 $3.00-$9.00 5.24
Exercised................... -- (109,613) $0.30-$ 3.00 0.66
Expired..................... (87,352) -- --
Canceled.................... 106,978 (106,978) $0.75-$12.50 4.23
-------- --------
Balance, December 31, 1997.... 297,823 619,059 $0.30-$12.50 2.98
======== ========

The following table summarizes information about stock options outstanding
at December 31, 1997:

OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------- -----------------------
WEIGHTED WEIGHTED
NUMBER AVERAGE WEIGHTED NUMBER AVERAGE
RANGE OF OUTSTANDING REMAINING AVERAGE EXERCISABLE EXERCISE
EXERCISE PRICES AS OF 12/31/97 CONTRACTUAL LIFE EXERCISE PRICE AS OF 12/31/97 PRICE
--------------- -------------- ---------------- -------------- -------------- --------

$ 0.30-- $0.75 165,105 5.69 $ 0.59 138,477 $ 0.56
$ 1.50 226,965 7.40 $ 1.50 167,237 $ 1.50
$ 3.00-- $10.125 193,654 8.49 $ 5.12 59,616 $ 5.20
$12.50 33,335 8.47 $12.50 12,505 $ 12.50
------- ---- ------ ------- --------
619,059 7.34 $ 2.98 377,835 $ 2.10
======= ==== ====== ======= ========

Employee Stock Purchase Plan ("Purchase Plan")

A total of 116,667 shares of common stock were initially reserved for
issuance under the Purchase Plan. The Purchase Plan enables eligible employees
to purchase common stock at the lower of 85% of the fair market value of the
Company's common stock on the first or last day of each six-month offering
period. The first offering period began on June 19, 1996. The Purchase Plan
will terminate in 2006. As of December 31, 1997, 51,378 shares of common stock
had been issued under the Purchase Plan.

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The Company applies Accounting Principles Board Opinion No. 25. "Accounting
for Stock Issued to Employees" and related interpretations in accounting for
its plans. Accordingly, no compensation cost has been recognized for its stock
option plans. Had compensation cost for the Company's plans been determined
based on the fair value at the grant dates for awards under the plans
consistent with the method of SFAS No. 123, "Accounting for Stock-Based
Compensation", the Company's net loss and net loss per share would have been
changed to the pro forma amounts indicated below (in thousands):

1997 1996 1995
------- ------- -------

Net loss
As reported..................................... $(9,640) $(4,876) $(5,194)
Pro forma....................................... $(9,978) $(5,087) $(5,220)
Basic net loss per share
As reported..................................... $ (1.28) $ (1.22) $(65.75)
Pro forma....................................... $ (1.32) $ (1.27) $(66.08)

For the purpose of SFAS No. 123, the fair value of each option grant is
estimated on the date of grant using the Black-Scholes multiple option-pricing
model with the following weighted-average assumptions used for grants in 1997,
1996, and 1995:

1997 1996 AND 1995
---- -------------

Dividend Yield 0% 0%
Expected Volatility 125% 0% prior to the initial public offering and 85% thereafter
Risk-free Interest Rate 5.59-6.50% 5.20-6.80%
Expected Lives for Each
Grant 2.5 to 3 years 1 to 2 years

8. INCOME TAXES

The Company follows SFAS No. 109 which prescribes an asset and liability
approach to income taxes under which deferred income taxes are provided based
upon enacted tax laws and rates applicable to the periods in which the taxes
become payable.

The provision for income taxes differs from the statutory United States
Federal income tax rate due to the following:

FOR THE YEARS
ENDED DECEMBER 31,
------------------------
1997 1996 1995
------ ------ ------

Benefit at U.S.
statutory rate......... (34.0)% (34.0)% (34.0)%
State income taxes, net
of Federal benefit..... (5.8) (6.1) (6.1)
Increase (decrease) in
valuation allowance.... 39.7 40.0 40.0
Other................... 0.1 0.1 0.1
------ ------ ------
-- % -- % -- %
====== ====== ======

The provision for income taxes for the years ended December 31, 1997 and
1996 relates to state taxes against which no net operating loss can be
applied.

THERMATRIX INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

The net deferred income tax asset consisted of the following (in thousands):

DECEMBER 31,
---------------
1997 1996
------- ------

Deferred income tax assets:
Net operating loss carryforwards.......................... $12,719 $9,406
Tax credit carryforwards.................................. 280 193
Cumulative temporary differences.......................... 484 381
------- ------
13,483 9,980
Valuation allowance......................................... (13,483) (9,980)
------- ------
Net deferred income tax asset............................... $ -- $ --
======= ======

As of December 31, 1997, the Company had net operating loss carryforwards
for Federal and state income tax purposes of approximately $34.9 million and
$18.3 million, respectively. The net operating loss carryforwards and tax
credit carryforwards expire on various dates through 2012. The Internal
Revenue Code contains provisions which may limit the net operating loss and
tax credit carryforwards to be used in any given year upon the occurrence of
certain events. Certain of the Company's net operating loss and tax credit
carryforwards are limited due to an ownership change that occurred in June
1996. Cumulative temporary differences consist of reserves and accruals
currently deductible for financial reporting purposes, but not for tax
purposes. The Company believes sufficient uncertainty exists regarding the
realizability of the operating loss and credit carryforwards and, accordingly,
has provided a valuation allowance against the deferred income tax asset.

9. LOAN AND SECURITY AGREEMENT

In December 1995, the Company entered into a Loan and Security Agreement
(the "Agreement") with a bank which provided for a $3,000,000 bridge loan,
available in two equal parts of $1,500,000, and bore interest at the bank's
prime interest rate plus 2.5%. The Agreement was extended past its original
expiration date while new terms and conditions were negotiated. No amounts
were outstanding under the Agreement as of December 31, 1997 and 1996.

In consideration for the Agreement, the Company granted the bank a warrant
to purchase 28,571 shares of Series D redeemable convertible preferred stock
at $5.25 per share (as adjusted). The fair value of the warrants at the date
of issuance was not significant and, therefore, no value was assigned to the
warrants for accounting purposes. Subsequent to the Company's initial public
offering, these warrants were convertible into warrants to purchase common
stock.

In February 1997, the Company entered into an Amended and Restated Loan and
Security Agreement (the "1997 Agreement") with the same bank, which provides
for a $4,000,000 accounts receivable line of credit and a $2,500,000
acquisition facility. The committed line bears interest at the prime interest
rate plus 0.50% and will be subject to certain financial and non-financial
covenants. Any borrowings under the acquisition facility bore interest at the
prime interest rate plus 1.00%. No amounts were outstanding under the 1997
Agreement during 1997.

In January 1998, the Company entered into an Amended and Restated Loan and
Security Agreement (the "1998 Agreement"), which replaced the 1997 Agreement
and which provides for a $4,000,000 accounts receivable line of credit with a
$2,000,000 letter of credit sub-limit. The 1998 Agreement was renegotiated in
March 1998 when certain financial covenants were amended. The committed line
will bear interest at the prime interest rate plus 0.50% and will be subject
to certain financial and non-financial covenants. There are no interest
bearing borrowings outstanding under the line of credit as of March 5, 1998.
The Company has a stand-by letter of credit issued under the sub-facility in
the amount of $280,000.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a)The following documents are filed as a part of this Report:

1. Financial Statements. The following Consolidated Financial Statements of
Thermatrix Inc. and Report of Independent Public Accountants are filed as a
part of this Report:

PAGE
-----

Report of Independent Public Accountants.............................. 24
Consolidated Balance Sheets--As of December 31, 1997 and 1996......... 25
Consolidated Statements of Operations--For the Three Years Ended
December 31, 1997.................................................... 26
Consolidated Statements of Stockholders' Equity (Deficit)--For the
Three Years Ended December 31, 1997.................................. 27
Consolidated Statements of Cash Flows--For the Three Years Ended
December 31, 1997.................................................... 28
Notes to Consolidated Financial Statements............................ 29-38

2. Financial Statement Schedules. For years ended December 31, 1997, 1996 and
1995:

Schedule II. Valuation and Qualifying Accounts and Reserves.............. 40

All other schedules are omitted because they are not applicable or the
required information is shown in the consolidated financial statements or
notes thereto.

3. Exhibits:

3.3 Restated Certificate of Incorporation of Registrant.(**)
3.4 Amended and Restated Bylaws of Registrant.(*)
4.2 Amended and Restated Investor Rights Agreement.(*)
10.1 Form of Indemnification Agreement between the Registrant and each of
its directors and executive officers.(*)
10.2 1987 Incentive Stock Plan, as amended and related agreements.(*)
10.3 1996 Stock Plan and form of Stock Option Agreement thereunder.(*)
10.4 Employee Stock Purchase Plan and forms of agreement thereunder.(*)
10.5 1996 Director Option Plan and form of Director Stock Option Agreement
thereunder.(*)
10.6 Asset Purchase Agreement between the registrant and Purus, Inc. dated
January 4, 1996.(*)
10.7 Lease dated June 12,1995 between the Registrant and Spieker
Properties, L.P., as amended.(*)
10.8 Lease dated June 24, 1995 between the Registrant and American General
Life Insurance Company.(*)
10.11 Amended and Restated Loan and Security Agreement between the
Registrant and Venture Banking Group, a Division of Cupertino National
Bank, dated January 21, 1998.
10.12 1996 Stock Plan: UK Rules for Employees.
10.13 First Amendment to the Amended and Restated Loan and Security
Agreement between Registrant and Venture Banking Group, a Division of
Cupertino National Bank.
21.1 Subsidiary of the Registrant.(*)
23.1 Consent of Indepent Public Accountants.
27.1 Financial Data Schedule.

- --------
(*) Incorporated by reference to exhibits filed with the Registrant's
Registration Statement on Form S-1 (No. 333- 4370) which became effective
June 19, 1996.
(**) Incorporated by reference to exhibits filed with the Registrant's
Quarterly Report on Form 10-Q for the quarter ending September 30, 1997.

(b)Reports on Form 8-K
None.

TRADEMARK ACKNOWLEDGMENTS

. Thermatrix and PADRE are registered trademarks of the Company.
. B.O.S.S. is a registered trademark of White Horse Technologies, Inc.

SCHEDULE II

THERMATRIX INC.

VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)

ADDITIONS
BALANCE CHARGED TO BALANCE
AT BEGINNING COSTS AND AT END
DESCRIPTION OF PERIOD EXPENSES DEDUCTIONS(1) OF PERIOD
- ----------- ------------ ---------- ------------- ---------

Year ended December 31, 1995
Allowance for doubtful
accounts.................... $150 $229 $(189) $190
Reserve for costs of
uncompleted contracts in
excess of billings.......... $200 -- $ 200 --
Year ended December 31, 1996
Allowance for doubtful
accounts.................... $190 $190 $(115) $265
Reserve for costs of
uncompleted contracts in
excess of billings.......... -- -- -- --
Year ended December 31, 1997
Allowance for doubtful
accounts.................... $265 $220 $(142) $343
Reserve for costs of
uncompleted contracts in
excess of billings.......... -- $500 -- $500

- --------
(1) Deductions represent accounts receivable and inventory amounts that were
considered doubtful and previously reserved for that became uncollectible
and were written off in the year.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

THERMATRIX INC.

/s/ John T. Schofield Date: March 31, 1998___________
By: ___________________________
John T. Schofield
Chairman of the Board
President and CEO

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints John T. Schofield and Barbara Krimsky, jointly
and severally, their attorney-in-fact, each with full power of substitution,
for him in any and all capacities, to sign on behalf of the undersigned any
amendments to this Report on Form 10-K, and to file the same, with exhibits
thereto and other documents in connection therewith, with the Securities and
Exchange Commission, and each of the undersigned does hereby ratifying and
confirming all that each of said attorneys-in-fact, of his substitutes, may do
or cause to be done by virtue hereof.

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES AND EXCHANGE ACT OF 1934,
THIS REPORT HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE
REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED.

/s/ John T. Schofield Chairman, President and March 31, 1998
_______________________________ Chief Executive Officer
John T. Schofield (Principal Executive
Officer)

/s/ Barbara E. Krimsky Chief Financial Officer, March 31, 1998
_______________________________ Vice President, Finance
Barbara E. Krimsky and Administration, and
Secretary (Principal
Financial and Accounting
Officer)

/s/ Robi Blumenstein Director March 31, 1998
_______________________________
Robi Blumenstein

/s/ Harry J. Healer, Jr. Director March 31, 1998
_______________________________
Harry J. Healer, Jr.

/s/ Charles R. Kokesh Director March 31, 1998
_______________________________
Charles R. Kokesh

/s/ Rebecca P. Mark Director March 31, 1998
_______________________________
Rebecca P. Mark

/s/ Frank R. Pope Director March 31, 1998
_______________________________
Frank R. Pope

/s/ John M. Toups Director March 31, 1998
_______________________________
John M. Toups

/s/ James M. Strock Director March 31, 1998
_______________________________
James M. Strock