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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-K

For the transition period from                      to
Commission File Number 0-19371

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (817) 605-5300
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:

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

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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. o

     The aggregate market value of the voting stock held by non-affiliates of the Registrant (based on the closing price of $0.68 as reported on the Nasdaq/NMS on March 29, 2002) was approximately $1,421,000. Shares of voting stock held by each executive officer and director and by each holder of 5% or more of the outstanding voting stock have been treated as shares held by affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes. The number of outstanding shares of the Registrant’s Common Stock as of March 29, 2002 was 5,852,593.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the PharmChem, Inc. Proxy Statement for the 2002 Annual Meeting of Stockholders to be filed with the Commission on or before April 22, 2002 are incorporated by reference into Part III of this Annual Report on Form 10-K. With the exception of those portions which are specifically incorporated by reference in this Annual Report on Form 10-K, such Proxy Statement shall not be deemed filed as part of this Report.

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PHARMCHEM, INC.
ANNUAL REPORT ON FORM 10-K
INDEX

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PART I

ITEM 1. BUSINESS

GENERAL OVERVIEW

     PharmChem, Inc. is a leading independent laboratory that provides integrated drug testing services. Our customers include private and public employers, criminal justice agencies and drug treatment programs primarily in the United States (serviced by our domestic operations) and Europe (serviced by Medscreen, Limited) who seek to detect and deter the use of illegal drugs and alcohol. We are certified by a number of states agencies, as well as by the following organizations to conduct drug testing using forensic procedures:

	•		Substance Abuse and Mental Health Service Administration (SAMHSA) of the US Department of Health and Human Services
	•		College of American Pathologists (CAP)

     Our domestic laboratory is certified under the Clinical Laboratory Improvement Amendments of 1988 (CLIA) or has “deemed status” under CLIA as a result of state certification. Our forensic procedures provide accurate and reliable test results and a chain of custody for each specimen from its collection to the reporting of its test result.

     We test for a number of drugs of abuse, including cocaine, methamphetamine, heroin, phencyclidine (PCP), marijuana (THC) and alcohol.

     We test primarily by urinalysis but also with the PharmChek® Drugs of Abuse Patch (for testing with sweat) and the PharmScreen® on-site screening devices. Under our Premium Comprehensive Management program, we offer a comprehensive set of services customized to assist customers in implementing cost-effective drug testing programs.

CORPORATE BACKGROUND

     In March 2000, PharmChem, Inc. was formed as a Delaware corporation and in May 2000, PharmChem Laboratories, Inc., a California corporation was merged into PharmChem, Inc. PharmChem Laboratories, Inc. was incorporated in 1987 to acquire PharmChem Laboratories Operations, Inc., a California corporation founded in 1971. In 1991, we completed our initial public offering. In 1992, we expanded our operations through the acquisition of London-based Medscreen, Limited (Medscreen), a certified laboratory providing international drug testing services. In 1992 we also acquired a certified laboratory in Fort Worth, Texas. When we refer to “we”, “our” or “PharmChem” in this Form 10-K, we mean the current Delaware corporation (PharmChem, Inc.) and Medscreen.

     Our principal executive offices are located at 4600 N. Beach Street, Haltom City, Texas, 76137. Our main telephone number is (817) 605-5300, our fax number is (817) 215-8863 and our home web site is www.pharmchem.com.

RECENT EVENTS

     During 2001, we relocated our corporate headquarters, distribution center and laboratory operations from the Silicon Valley area of Northern California to a new facility in Haltom City, Texas. We vacated our primary Menlo Park, California facility in May 2001 and temporarily moved to our existing facility in Fort Worth, Texas until construction was completed at the new Haltom City facility. During the process of relocating to Texas, we have incurred significant costs that have been financed through a combination of internal operations, increased borrowing under our existing and new credit facilities and a sale-leaseback transaction. We believe these costs were of a nonrecurring nature and principally relate to the period prior to occupying our new Haltom City facility. Our laboratory operations and distribution center relocated to the Haltom City facility in September and October, respectively. To mitigate further operating losses, we implemented a cost containment program in the fourth quarter of 2001. This cost containment program included two rounds of layoffs whereby our employee population has decreased approximately 30% from mid-2001 levels, significant reductions in discretionary spending, including travel, renegotiations with certain suppliers to

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secure more favorable pricing of materials and services and closure of our California laboratory that offered customers methadone testing using thin layer chromatography.

     We were not in compliance with certain covenants under our credit facility with our primary bank for the last three quarterly periods of 2001 due principally to the restructuring charge and nonrecurring expenses associated with the relocation to Texas, the slowdown of the US economy throughout 2001 and the September 11, 2001 event that adversely affected the volume of pre-employment drug testing. In July, our bank waived the covenant violations for the quarter ended June 30, 2001. As further discussed in Note 13, “Subsequent Events”, in the accompanying Notes to Consolidated Financial Statements, in March 2002 we completed the sale of entire share capital of Medscreen for approximately $10,000,000 in cash. In connection with the sale of Medscreen, we entered into an Amendment and Forbearance Agreement with our bank and the bank waived covenant violations for the quarterly periods ended September 30, 2001 and December 31, 2001. A portion of the sale proceeds were used to repay $4,310,000 of debt and the remainder is expected to be sufficient to fund the general corporate needs of the US operations for at least the next year.

INDUSTRY BACKGROUND

     National clinical laboratory chains, independent national drug testing laboratories, like ourselves, and numerous regional and local laboratories have historically served the drug testing market. Thousands of general clinical laboratories nationwide can conduct forensic and non-forensic drug testing, and are increasingly bidding on local contracts. Over the past several years, through consolidations and restructurings, there has been a decline in the number of independent laboratories whose sole business is conducting forensic drug testing. Many corporate and governmental organizations require drug testing laboratories to be certified to conduct forensic drug tests and to offer integrated cost-effective testing services. Many large organizations, particularly those in the public sector, use a competitive bidding procedure to select their drug testing laboratories. These organizations often limit the bidding to certified drug testing laboratories that can demonstrate the ability to meet their specified service and volume levels.

FORENSIC DRUG TESTING

     The essential elements of forensic drug testing are (1) a secure chain of custody for each specimen from its collection to the reporting of its test result and (2) accurate and reliable testing in which a second independent test is performed to confirm each positive test result. We carefully control each step of the testing process with detailed written procedures and by using the specific forensic testing methods required for legal defensibility of results. We perform the majority of our testing at our laboratory in Haltom City, Texas, which operates six days per week, 24 hours a day. In recent years, we introduced two product lines, the PharmScreen® On-Site Screening Device and the PharmChek® Drugs Of Abuse Patch, to provide alternatives to traditional urinalysis laboratory testing. We also provided complete testing services at Medscreen in London, England.

Urinalysis

     The steps in PharmChem’s forensic drug testing process by urinalysis, our primary drug testing method, are as follows:

     Specimen Collection and Transportation

	•		Forensic drug testing begins with specimen collection conducted under carefully controlled conditions. Once a donor has provided a specimen, we assign a unique specimen identification number.
	•		We then record information pertinent to the specimen on a chain of custody form numbered to match the specimen bottle.
	•		Specimens, together with chain of custody forms, are delivered to PharmChem by courier or mail.

     Receiving and Accessioning

•

We receive specimens in our restricted accessioning rooms, where we inspect them for tampering and check for proper chain of custody documentation.

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•

We identify and track the specimens using unique bar-coded laboratory accessioning numbers.

     Screening Analyses

	•		We screen each specimen submitted for the presence of the drugs specified by the customer.
	•		We perform approximately 1,250,000 screening tests on more than 180,000 specimens per month to determine the presence of drugs.
	•		The screening methods we use include enzyme immunoassay and enzyme assay.

     Results/Confirmation Testing

	•		We report negative screening results to the customer.
	•		If the specimen tests positive, we confirm the results by testing a separate aliquot using a different and independent technology from that used for the initial screening.
	•		Confirmation technologies we use include gas chromatography/mass spectrometry (GC/MS) and gas chromatography. GC/MS confirmation is required for federally-regulated drug testing and most other workplace drug testing. Its use has been cited with approval in numerous legal proceedings.

     Quality Control

We carefully monitor the accuracy and reliability of our test results by internal and external quality assurance and quality control programs. Our staff evaluates laboratory performance with open and blind quality control samples. We are subject to frequent proficiency testing by various certifying bodies, which send their own open and blind samples to the laboratory. We are also subject to frequent inspections by certifying agencies. We put each test result through several independent levels of review before a certified scientist reports the results to our customer.

     Reporting of Test Results

We transmit most of our test results electronically. We use various secure communication networks and automated voice reporting systems. Our information systems make each test result available to the customer’s computer or secure facsimile machine, via the internet, by email, by telephonic inquiry or by mail delivery. We routinely report results for specimens that screen negative within 24 hours of receipt in the laboratory and within 48 hours for specimens that require confirmation.

PharmScreen® On-Site Screening Device

     In recent years there has been a growing trend toward the use of on-site screening for drugs of abuse by a number of agencies, including some of our customers. On-site screening relies upon portable diagnostic devices that the customer may use at the point of specimen collection to readily identify drugs of abuse in urine specimens. This technology is advantageous because it provides virtually immediate test results. There are several states whose legislation still requires the use of traditional laboratory testing and does not recognize the on-site screening devices as an alternative means of screening for drugs of abuse.

     We offer a line of on-site screening devices to supplement our laboratory-based testing services. PharmScreen® is a portable, hand-held device used for on-site screening of drugs of abuse and is available in single, dual, four, five and ten test configurations. PharmScreen® is currently being used by certain government agencies, including the Administrative Office of the United States Courts (Federal Probation), and by certain private employers, including Sears Roebuck & Co. PharmScreen® provides only a preliminary analytical result, and a more specific alternative chemical method, such as GC/MS, is necessary to obtain a confirmed analytical result. Although our sales of PharmScreen® have steadily increased, there can be no assurance that it will remain commercially accepted by existing or new customers, generate significant revenues in the future or be accepted by various jurisdictions as an alternative method of screening for drugs of abuse.

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PharmChek® Drugs Of Abuse Patch

     PharmChek® is a system that uses sweat to detect the presence of illegal drugs and has been under development by us since 1992. It consists of a transparent polyurethane outer covering, a small absorbent pad and a release liner. A unique number is printed on the underside of the polyurethane layer for identification and anti-counterfeiting purposes. Unlike urinalysis, flushing or employing a diuretic to rid the body of drugs of abuse does not affect PharmChek® test results, since the drugs in the sweat simply collect on the absorption pad until the pad is removed for analysis.

     PharmChek® may offer other advantages over other drug detection systems currently available. First, it does not require the handling of urine or blood, which may be objectionable to some people. Second, the use of sweat as a testing medium may lengthen the drug use detection period and decrease testing costs by reducing the need for specialized specimen collection facilities and staff. PharmChek® has been used for detecting illegal drug use in highly sensitive cases, including child custody matters. Court cases in California, Missouri and Nevada have recognized the validity of PharmChek® for detecting the use of illegal drugs.

     The Food and Drug Administration (FDA) has cleared PharmChek® for detecting the use of cocaine, opiates (including heroin), amphetamines (including methamphetamine), phencyclidine (PCP) and marijuana (THC). Our sales of PharmChek® have not been significant and there can be no assurance that it will remain commercially accepted by existing or new customers, generate significant revenues in the future or be accepted by various jurisdictions as an alternative method of detecting drugs of abuse.

SUPPLIERS

     We are dependent upon single suppliers for the PharmChek® and PharmScreen® products and we are in the process of seeking alternative suppliers. Recently, there has been a consolidation of suppliers to the drugs of abuse testing laboratories. We are not dependent upon any other single supplier for our raw materials.

CUSTOMER SERVICE AND TECHNICAL SUPPORT

     We provide a variety of drug testing services which are customized to each customer’s specific needs. We employ a customer service and technical support staff specializing in one or more of the following areas of service:

Specimen Collection

     We manage specimen collection services for a number of our customers. We maintain a list of more than 5,000 clinics and other organizations throughout the United States (US) and Puerto Rico that offer specimen collection services that comply with forensic drug-testing procedures. Our customer service staff identifies collectors conveniently located to customer sites, prepares customized specimen collection procedures, conducts training of collection personnel and monitors their performance. In 2001, PharmChem managed approximately 530,000 collections in the US, while Medscreen managed approximately 48,000 collections throughout the United Kingdom (UK) and at over 300 shipping ports throughout the world.

Transportation

     Most specimens are transported to PharmChem by overnight or same-day courier, or by mail. We offer special specimen transportation services for selected areas that provide for pickup of specimens before the close of each business day.

Technical Consultation

     The technical specialists on our staff are experienced in drug metabolism and other technical aspects of drug testing. These specialists respond to requests from customers to interpret test results. In addition, we are often called upon to assemble the complete chain of custody and testing data package for specimen results that have been challenged and to provide expert witness testimony in legal proceedings. The technical consultation group also provides

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comprehensive in-service training for customers on topics such as substance abuse trends, toxicology and drug pharmacology, breath alcohol testing and technical information on PharmChem’s testing procedures.

Program Analysis

     We collect and analyze data on test results in order to provide comprehensive monthly statistical reports to meet customers’ regulatory requirements and to assist with drug program management.

SALES AND MARKETING

     We sell our integrated drug testing services to corporate and governmental customers. Our sales force uses a consultative selling approach — Premium Comprehensive Management (PCM®). PCM® emphasizes the full scope of integrated services we offer and customizes these services to meet customers’ particular needs. PCM® provides customized services including:

	•		a worldwide database of collection sites and on-call collections for rapid response
	•		alternatives to laboratory urine testing including on-site screening devices such as PharmScreen®, sweat testing with PharmChek® and hair testing
	•		PharmTrackTM, our secure internet-based tracking and reporting system
	•		FASTTM (Federal Agency Specimen Tracking), our secure internet-based collection scheduling and management system
	•		statistical management reporting, centralized billing and other services

CUSTOMERS

     PharmChem provides integrated drug testing services to three primary customer groups in the United States and provided these services internationally through Medscreen:

Public and Private Workplace Employers

     Public and private workplace employers use drug testing as part of their hiring decisions in order to increase safety and reduce costs associated with drug abuse in the workplace. In addition, an increasing number of public and private workplace employers test employees in certain positions on a periodic or random basis and test other employees upon reasonable suspicion of drug use.

     Sales of laboratory services and products to public and private workplace employers accounted for 34%, 40% and 38% of our total net sales in 2001, 2000 and 1999, respectively. Sales to Sears, Roebuck & Co. accounted for approximately 10%, 11% and 10% of our total net sales in 2001, 2000 and 1999, respectively.

Criminal Justice Agencies

     Criminal justice agencies use drug testing results in criminal proceedings and to assist with making parole, drug treatment and probation decisions. These agencies also use drug testing to monitor drug treatment of individuals under supervision and to track drug use trends within the United States.

     Sales of laboratory services and products to criminal justice agencies accounted for 47%, 41% and 43% of our total net sales in 2001, 2000 and 1999, respectively. Sales to Federal Probation accounted for approximately 20%, 18% and 19% of our total net sales in 2001, 2000 and 1999, respectively.

Drug Treatment Programs

     Drug treatment programs use drug testing to monitor the treatment and rehabilitation of drug users in their care. Sales of laboratory services and products to drug treatment programs accounted for approximately 2% of our total net

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sales in 2001, 2000 and 1999. In November 2001, we ceased offering our customers methadone testing using thin layer chromatography.

Medscreen’s Customer Base

     PharmChem’s London-based subsidiary accounted for 17%, 16% and 16% of our total net sales in 2001, 2000 and 1999, respectively. Medscreen’s primary customers operate in the maritime, criminal justice, oil, chemical, utilities and transportation industries. Medscreen has customers in 35 countries. Approximately 62% of Medscreen’s 2001 sales were from UK-based customers with the balance from customers in other countries in Europe, Asia and South America.

CONTRACTING

     Customers engage us to provide services through the following:

	•		the formal competitive bid process
	•		standard service contracts
	•		without a formal contract, but by accepting test specimens for an agreed upon price renegotiated every twelve months

     A majority of our sales are derived from competitive bids, and we believe that competitive pressure with respect to these bids, particularly for large multi-year contracts, has intensified. Many of our large potential customers, including the majority of public employers and criminal justice agencies, use a formal competitive bid process in which the potential customer provides a detailed specification of the drug testing services it requires. There is no assurance that we will be the successful bidder when these contracts are up for renewal. While price is an important factor, in most cases these organizations are not required to accept the lowest bid, but rather may choose the winning bidders based on technical superiority and customer service.

     The failure to renew a significant contract, if not replaced by comparable contracts, could result in lower sales, lower profit margins, decreased cash flows and losses. Our contracts generally allow termination at the customer’s discretion on short notice with little or no penalty. Many contracts provide for termination for convenience. Although in the past our customers generally have not exercised these early termination rights, there can be no assurance that this will continue in the future.

     Backlog is not a significant statistic for PharmChem due to the short turnaround time for processing specimens.

COMPETITION

     The market for drug testing services became increasingly competitive in the early 1990’s, and continues to be very competitive. Drug testing laboratories compete primarily on the basis of customer service, technical capability and price. We believe that PharmChem competes favorably in each of these categories. In recent years, we have expanded our scope of services and invested heavily in information technology to provide flexible, responsive and customized drug testing programs while maintaining a competitive average total selling price per specimen. Our competitors include:

	•		national clinical laboratory companies, such as Laboratory Corporation of America Holdings and Quest Diagnostics, Inc.
	•		independent national drug testing laboratories, such as Psychemedics Corporation and Medtox Scientific, Inc.
	•		regional and local laboratories
	•		third party administrators
	•		medical review officers
	•		manufacturers and distributors of on-site screening devices and equipment

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     The national clinical laboratories have significantly greater financial, marketing, laboratory and related resources than PharmChem. In addition, some of our customers and our potential customers operate their own drug testing facilities or may develop such facilities in the future.

CERTIFICATION AND GOVERNMENT REGULATION

     Laboratories which compete in the U.S. forensic drug testing market generally must be certified by SAMHSA. In addition, some state and local jurisdictions require their own certification for testing of specimens of their residents. Such state and local certifications are essential to our business in each such respective jurisdiction. Our domestic laboratory is certified under the CLIA or has “deemed status” under CLIA as a result of state certification.

     We are subject to frequent inspection by certifying bodies, including annual CAP and semi-annual SAMHSA inspections. Inspections sometimes result in reports describing areas for improvement or suggesting changes in procedures. We may be required to take actions on the items noted in the inspection report in order to remain certified. Failure to meet certification requirements could result in suspension or loss of certification.

     We have never been decertified as the result of an inspection. Certification is essential to our business because some of our customers are required to use a certified laboratory, and many of our customers look to certification as an indication of reliability and accuracy of results. In connection with the consolidation of our laboratory operations into our new Haltom City, Texas laboratory, in November 2001 we voluntarily withdrew our Fort Worth, Texas laboratory’s license to conduct laboratory testing of federally regulated specimens. Federally regulated specimens represented approximately 3% of our specimen volume in 2001. We are currently in the process of applying for certification of our new laboratory and we believe that a license will be granted in the second quarter of 2002. Until the new laboratory is certified, we have temporarily outsourced our customers’ federally regulated specimens to another certified laboratory. In the event the certification process is delayed, our plan will be to continue to outsource such specimens until the certification is achieved.

     Court precedent currently exists in a number of states regarding the circumstances under which employers may test employees and the procedures under which such tests must be conducted. The circumstances under which drug testing can legally be required by employers is subject to judicial review, and is challenged from time to time by employees, unions and other groups on constitutional, privacy and other grounds.

     In 2001, a revision of the Federal Register, CFR Part 40, was implemented. This revision imposed more stringent requirements for the training and retraining of specimen collector service providers. This may negatively impact the pool of available service providers and may result in higher costs for the services they perform.

ENVIRONMENTAL MATTERS

     A small portion of our business involves testing procedures requiring the use of small amounts of chloroform, which is considered to be a hazardous material. Failure to comply with current or future federal, state or local environmental laws or regulations regarding this hazardous material could have an adverse effect on us. We believe that we have adequately notified employees of potential risks associated with working at PharmChem and have provided a workplace safe from hazard, as required by the Occupational Safety and Health Administration and certain state laws. We believe we are in compliance with all applicable environmental laws and regulations.

EMPLOYEES

     As of December 31, 2001, we had approximately 200 full-time employees. In 2001, we had a significant turnover in personnel at the non-executive levels as we relocated our main laboratory, distribution center and headquarters from California to Texas. To minimize the impact on our operations, we maintained a duplicate workforce during the transition to Texas. In addition, we implemented layoffs of personnel during the second half of 2001 in response to lower specimen volume encountered after September 11, 2001. Our employees are not represented by labor organizations, and we consider relations with our employees to be good.

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SEASONAL OPERATING FACTORS

     PharmChem’s operations are affected by both seasonal trends to which drug testing laboratories are generally subject and general economic conditions. Our laboratory testing volume tends to be higher in the second and third calendar quarters and lower in the fourth and first calendar quarters, primarily due to the hiring patterns of our public and private employer customer group which affect pre-employment drug testing.

RESEARCH AND DEVELOPMENT

     Our most experienced scientists and technicians perform research and development activities. Our research and development efforts continually focus upon improving laboratory procedures and processes. We believe we have engineered a number of efficiencies to improve the accuracy and reliability of our drug tests.

DOMESTIC AND FOREIGN OPERATIONS

     Refer to Note 11, “Reportable Segments”, in the accompanying Notes to Consolidated Financial Statements for reportable segment information and financial information about geographic areas.

ITEM 2. PROPERTIES

ITEM 3. LEGAL PROCEEDINGS

     In the ordinary course of our business, we are sued by individuals, primarily those in the criminal justice system, who have tested positive for drugs of abuse. In addition, we frequently testify in administrative and court proceedings involving the results of our tests. To date, we have not experienced any material liability related to these claims, although there can be no assurance that we will not at some time in the future experience significant liability in connection with such claims. There are no pending legal proceedings, other than ordinary routine litigation incidental to our business, to which we are a party or to which any of our property is subject and our management does not believe the outcome of any of the proceedings will have a material impact on our financial position or results of operations.

     We believe that our liability insurance coverage is adequate for our business.

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

     No matters were submitted to a vote of PharmChem’s stockholders in the quarter ended December 31, 2001.

EXECUTIVE OFFICERS OF PHARMCHEM

     The executive officers of the Company are as follows:

     Mr. Halligan has been PharmChem’s President, Chief Executive Officer and Director since November 1995. From 1988 to 1995, he was President and CEO of E.S.I. Consulting Group, a private consulting practice, specializing in advising and operating high growth, consumer and service-oriented companies. Before forming his consulting practice, Mr. Halligan served from 1983 to 1987 as President and CEO of a privately-held company, Laura Scudder’s, Inc. From 1969 to 1983, he served as Senior Vice President of Fotomat Corporation and President of its subsidiary, Video Services of America. He holds a B.S. in Management and Business Administration from Columbia Pacific University.

     Mr. Lattanzio has been PharmChem’s Vice President, Finance and Administration, and Chief Financial Officer since April 1996 and Secretary since January 1997. He is responsible for all financial and administrative aspects of our operations, including accounting, corporate finance, treasury, purchasing, human resources and risk management. From 1995 to March 1996, Mr. Lattanzio performed private consulting for several companies, including PharmChem. He served as Vice President, Finance and Chief Financial Officer of Mission Foods from 1991 to 1995. Mr. Lattanzio holds a B.B.A. in Accounting from the University of Notre Dame and is a Certified Public Accountant.

     Mr. Fortner has served as Vice President, Laboratory Operations of PharmChem since February 1992. He joined PharmChem as Director, Laboratory Operations in July 1991. He is the Scientific Director and is responsible for all production aspects of laboratory operations. From 1985 to 1991, he served as Director of Toxicology at Southgate Medical Services. Mr. Fortner has more than 20 years experience in forensic toxicology and he is a qualified SAMHSA and CAP laboratory inspector. He is a member of the American Association of Clinical Chemistry and a full member of the Society of Forensic Toxicologists, the American Academy of Forensic Sciences (Fellow) and the American Board of Forensic Examiners. Mr. Fortner holds a B.A. in Biology from Hiram College and a M.S. in Biochemistry from Western Kentucky University. He is certified as a Forensic Toxicology Specialist by the American Board of Forensic Toxicologists and as a Toxicological Chemist by the National Registry of Certified Chemists.

     Mr. Kurta has served as Vice President, Sales and Marketing since joining PharmChem in March 1998. He is responsible for sales, marketing and the commercial development of our laboratory services and the PharmScreen® and PharmChek® product lines. Prior to joining PharmChem, Mr. Kurta served as Director of Business Development and Director of Sales and Marketing for the Unilab Corporation and served in various capacities at Damon Laboratories and Corning/Metpath Laboratories. From 1979 to 1986, Mr. Kurta owned and operated Spectrum Helicopters, Inc., Copter Quik Delivery Systems and Geriatric HealthCare Group. Mr. Kurta holds B.A. and M.S. degrees from Alfred University in New York.

     Mr. Merryman has served as Vice President, Customer Service since joining PharmChem in November 2000. He is responsible for all customer service functions. Prior to joining PharmChem, Mr. Merryman served in various customer service capacities at Quest Diagnostics from 1982 to 1990 and from 1996 until he joined PharmChem. From

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1990 to 1996, Mr. Merryman held management positions at Laboratory Corporation of America. Mr. Merryman holds a B.B.A. degree in Computer Sciences from Ursinus College in Pennsylvania and a M.B.A. degree from the University of Phoenix.

     Mr. Parakkal has served as Vice President, Information Systems since November 2000. He is responsible for all information service functions. He has also served as Director, Systems Development at PharmChem since 1997. Prior to joining PharmChem, Mr. Parakkal served in project management at Transworld Information Systems, Inc. from 1996 to 1997. He was responsible for directing the development of cross-functional systems, software and databases. From 1987 to 1995, Mr. Parakkal worked in Information Technology in various aspects of design, development and implementation of business applications in India. Mr. Parakkal holds a B.S. degree in Physics from University of Madras, India and a B.S. degree in Business Management from the University of Phoenix. Mr. Parakkal is in the process of completing his M.B.A. degree from the University of Phoenix.

PART II

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

     Our common stock trades on The Nasdaq National Market (Nasdaq) under the symbol “PCHM”. In February 2002, Nasdaq informed us we were not in compliance with the $5,000,000 minimum market value requirement for our publicly held shares, as stated in Marketplace Rule 4450(a)(2). Publicly held shares exclude shares held directly or indirectly by any officer or director of PharmChem and by any person who is the beneficial owner of more than 10% of the total shares outstanding. The letter provides us with 90 calendar days, or until May 15, 2002, to come into compliance with this rule, which would require PharmChem’s publicly held shares to maintain a minimum market value of $5,000,000 for a minimum of ten consecutive trading days during that period. If PharmChem fails to meet this requirement, it will become subject to delisting from Nasdaq, at which time PharmChem can appeal the delisting to the Nasdaq Listing Qualifications Panel. Alternatively, PharmChem has the option, during the 90 day period, of applying to transfer its securities to The Nasdaq SmallCap Market, where it would have to satisfy continued inclusion requirements for that market. Market value of publicly held shares on The Nasdaq SmallCap Market must be $1,000,000 or more.

STOCK PRICES

     The following table sets forth for the periods indicated the high and low closing bid prices for our common stock by quarter for years 2001 and 2000, as reported by the Automated Quotation System of the National Association of Securities Dealers (Nasdaq). Refer to Note 13, “Subsequent Events”, to the accompanying Notes to Consolidated Financial Statements for further information on our noncompliance with Nasdaq’s Marketplace Rule 4450(a)(2). The prices shown represent quotations among securities dealers, do not include retail markups, markdowns or commissions and may not represent actual transactions.

     As of March 29, 2002, there were approximately 120 holders of record of our common stock. A large number of shares were held in nominee name. Based upon information furnished by our proxy solicitor, Skinner & Co, we believe we have approximately 1,000 stockholders as of March 29, 2002.

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DIVIDENDS

     We have never paid cash dividends on our common stock. We currently anticipate that we will retain all future earnings for use in the operation and expansion of our business and do not anticipate paying any dividends in the foreseeable future. In addition, our current revolving credit agreement prohibits the declaration or payment of dividends except in connection with our stockholder rights plan.

ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

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	In our Notes to Consolidated Financial Statements, see Note 11, “Reportable Segments,” for operating results by operating segment, Note 12, “Restructuring Charge,” for further details of the restructuring charge in 2001, Note 14, “Selected Quarterly Financial Data (Unaudited),” for quarterly financial data and Note 13, “Subsequent Events,” for the sale of Medscreen and other events.

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

FORWARD LOOKING STATEMENTS

     “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933 (“Forward-looking Statements”), which are subject to the “safe harbor” created by these Sections. Forward-looking statements are statements about future financial results, future products or services and other events that have not yet occurred. These forward looking statements contain words such as, but not limited to, “expect,” “anticipate”, “estimate”, “believe”, “will”, “may” or “might.” Investors should be aware that actual results may differ materially from our expressed expectations because of risks and uncertainties about the future. We will not necessarily update the information in this Form 10-K if any forward-looking statement later turns out to be inaccurate. Details about risks affecting various aspects of our business are discussed throughout this Form 10-K and include the risks identified in “Factors Affecting Operating Results.”

RECENT EVENTS

     During 2001, we relocated our corporate headquarters, distribution center and laboratory operations from the Silicon Valley area of Northern California to a new facility in Haltom City, Texas. We vacated our primary Menlo Park, California facility in May 2001 and temporarily moved to our existing facility in Fort Worth, Texas until construction was completed at the new Haltom City facility. During the process of relocating to Texas, we have incurred significant costs that have been financed through a combination of internal operations, increased borrowing under our existing and new credit facilities and a sale-leaseback transaction. We believe these costs were of a nonrecurring nature and principally relate to the period prior to occupying our new Haltom City facility. Our laboratory operations and distribution center relocated to the Haltom City facility in September and October, respectively. To mitigate further operating losses, we implemented a cost containment program in the fourth quarter of 2001. This cost containment program included two rounds of layoffs whereby our employee population has decreased approximately 30% from mid-2001 levels, significant reductions in discretionary spending, including travel, renegotiations with certain suppliers to secure more favorable pricing of materials and services and closure of our satellite laboratory in Menlo Park that performed methadone drug testing.

     We were not in compliance with certain covenants under our credit facility with our primary bank for the last three quarterly periods of 2001 due principally to the restructuring charge and nonrecurring expenses associated with the relocation to Texas, the slowdown of the US economy throughout 2001 and the September 11, 2001, event that adversely affected the volume of pre-employment drug testing. In July, our bank waived the covenant violations for the quarter ended June 30, 2001. As further discussed in Note 13, “Subsequent Events”, in the accompanying Notes to Consolidated Financial Statements, in March 2002 we completed the sale of entire share capital of Medscreen for approximately $10,000,000 in cash. In connection with the sale of Medscreen, we entered into an Amendment and Forbearance Agreement with our bank and the bank waived covenant violations for the quarterly periods ended September 30, 2001 and December 31, 2001. A portion of the sale proceeds were used to repay $4,310,000 of debt and the remainder is expected to be sufficient to fund the general corporate needs of the US operations for at least the next year.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

     The discussion and analysis of our financial condition and results of operations are based upon PharmChem’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate these estimates, including those related to bad debts, inventories, intangible assets, income taxes, restructuring accruals, contingencies, revenue recognition, specimen collector accruals and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     PharmChem believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of the consolidated financial statements. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We estimate the quantity and value of our unused specimen collection kit inventory existing at our customer and contractor field locations using a model that considers actual shipments to these locations, specimens returned to our laboratory for processing, replacement costs and estimates of shrinkage. If the estimated value of this inventory increases beyond our expectations of recovery, additional inventory write-downs may be required.

     Future adverse changes in market conditions or poor operating results of our operations could result in losses or an inability to recover the carrying value of the related goodwill, thereby possibly requiring an impairment charge in the future. We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While PharmChem has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that it would be able to realize the deferred tax assets in the future in excess of the net recorded amount, an adjustment to the deferred tax asset valuation allowance would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of the net deferred tax asset in the future, an adjustment to the deferred tax asset valuation allowance would be charged to income in the period such determination was made.

     Revenue is recognized upon the communication of results from laboratory analysis of specimens submitted by our customers, at the time of shipment for products and at the completion of rendered services. We accrue expected payments to specimen collectors who perform specimen collection services on behalf of our managed customers. The specimen collector accrual calculation is based on a combination of our reporting of results from laboratory analysis of specimens and cost information maintained in our internal systems for each specimen collector. We include in the accrual estimates of retroactive rate increases and services performed but not reported to customers.

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RESULTS OF OPERATIONS

     Refer to Note 13, “Subsequent Events”, to the accompanying Notes to Consolidated Financial Statements for further information on the recently completed sale of Medscreen in March 2002.

     The following table sets forth for the periods indicated certain financial data (dollars in thousands):

2001 Compared to 2000

Net Sales

     Consolidated net sales for the year decreased $2,855,000 (6.1%) to $43,977,000 in 2001 from $46,832,000 in 2000. This decrease is principally attributed to our domestic operations which reported a $3,661,000 (11.0%) decrease in laboratory sales that more than offset increases of $405,000 (10.6%) in product sales and $428,000 (19.3%) in other non-laboratory sales. Domestic laboratory specimen volume decreased 14.1% to 2,162,000 in 2001 compared to 2000, led by a 16.8% decrease in workplace customers and a 12.1% decrease in criminal justice customers. The decrease in our domestic specimen volume accelerated following September 11, 2001, which contributed to a further slowdown in the US economy following the tragedy. Contributing to the decreased specimen volume was the November 2001 closure of our California laboratory that offered customers methadone testing using thin layer chromatography.

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Domestic average laboratory selling prices increased 3.7% in 2001 compared to 2000. Domestic product sales reflect a $194,000 (47.4%) increase in the PharmChek® sweat patch, due to 41.2% higher volume and higher average selling prices, and a $209,000 (6.2%) increase in PharmScreen® onsite screening devices driven by higher volume of our 5-test drug device. Domestic non-laboratory sales, which includes our online e-commerce system providing order processing, chain of custody forms printing, collection scheduling, specimen tracking and results reporting through secure internet transmission, increased approximately $430,000 (19.3%) in 2001 on higher volume. Medscreen’s sales in 2001 were relatively unchanged from the prior year. For the fourth quarter of 2001, consolidated net sales decreased $2,659,000 (21.0%) compared to the prior year’s quarter. Domestic sales decreased $2,731,000 (25.3%), reflecting the significant slowdown in specimen testing following September 11, 2001, and the slowing US economy. Domestic average laboratory selling prices increased 1.2% in 2001 compared to 2000. Medscreen’s sales increased $72,000 (3.8%) during the current year’s quarter.

Cost of Sales

     Consolidated cost of sales for the year increased $3,629,000 (11.0%) to $36,544,000 in 2001 from $32,915,000 in 2000. Domestic cost of sales increased $3,479,000 (12.0%) due principally to $4,106,000 of non-recurring expenses associated with the transfer of production to the new Texas laboratory from our Menlo Park, California laboratory. These nonrecurring costs include duplicate payroll, lab materials, training and transportation. Our relocation to Texas was predicated on our belief that the cost structure was severely challenged in the Silicon Valley area of Northern California due to the region’s higher wages, rents, insurance programs and overall high cost of living and the uncertainty of electric power. Medscreen’s cost of sales were relatively unchanged from 2001. Excluding the non-recurring expenses, the gross profit as a percentage of net sales would have decreased to 26.2% in 2001 from 29.7% in 2000. Cost of sales for the 2001 fourth quarter of $7,764,000 decreased 15.6% from the prior year’s period due to lower volume and reductions in our domestic workforce.

Selling, General and Administrative

     Consolidated selling, general and administrative (SG&A) expenses for the year increased $2,130,000 (18.6%) to $13,590,000 in 2001 from $11,460,000 in 2000. Domestic SG&A expenses increased $2,151,000 (22.3%) due to $1,761,000 of nonrecurring costs associated with the relocation to Texas. The nonrecurring costs included relocation, travel and subsistence expenses. The percent of SG&A expenses to net sales increased to 30.9% in 2001 from 24.5% in 2000. SG&A expenses for the 2001 fourth quarter decreased 16.4% to $2,274,000 from $2,720,000 in the prior year period and reflects favorable results from a cost containment program implemented in the fourth quarter of 2001, which included employee headcount reductions of approximately 30%.

Restructuring Charge

     We recorded a restructuring charge in the amount of $1,029,000 in the current year’s second quarter in accordance with a plan approved by our Board of Directors to provide for costs associated with closing our former headquarters, main laboratory and distribution center in Menlo Park, California. The charge consisted of $330,000 for severance and related benefits costs of a workforce reduction and $699,000 for repairs, clean-up and professional services.

Income (Loss) From Operations

     Consolidated loss from operations for the year was $7,558,000 in 2001 compared to income of $2,391,000 in 2000, while the loss from operations for the fourth quarter was $187,000 in 2001 compared to income of $612,000 in 2000.

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Provision for Income Taxes

     During 2001, we recorded a provision for taxes of $471,000 for the year and $147,000 for the fourth quarter attributed to the profitable UK operating results. During 2000, we recorded a provision for taxes of $772,000 for the year and $219,000 for the fourth quarter.

Net Income (Loss)

     Consolidated net loss for the year was $8,476,000 in 2001 compared to net income of $1,361,000 in 2000. Excluding the restructuring charge of $1,029,000 and nonrecurring expenses of $5,867,000, proforma net loss would have been $1,580,000 in 2001. We reported a net loss of $547,000 in the 2001 fourth quarter compared to net income of $302,000 in the 2000 fourth quarter.

2000 Compared to 1999

Net Sales

     Consolidated annual net sales increased 5.3% to $46,832,000 in 2000 from $44,487,000 in 1999. This increase mostly reflects the continued growth of PharmScreen®, our line of onsite screening products, and our international drug testing operations. Medscreen’s sales increased 5.1% on the strength of a 12.9% increase in specimen volume. The 2000 year sales in the US increased 5.3% and reflect increases of $1.3 million (54.0%) in product sales and $1.8 million (367.3%) in non-laboratory sales that more than offset a $1.1 million (3.2%) decrease in traditional laboratory sales. Our non-laboratory sales include our web-based collection management system and related collector management services. Domestic specimen volume decreased 5.4% compared to 1999 levels as more testing volume was shifted to PharmScreen®. Our consolidated laboratory specimen volume decreased 4.2% to 2,730,000 and average selling prices for laboratory analysis increased 2.9% compared to 1999 levels. Net sales for the fourth quarter of 2000 increased 12.3% and laboratory average selling prices increased 6.0% from the comparable 1999 periods. As part of our Premium Comprehensive Management program of fully integrated drug testing services, in the fourth quarter of 1999 we launched our e-commerce system which provides for order processing, forms printing, collection scheduling, specimen tracking and results reporting through secure internet transmission. The fourth quarter of 2000 reflects a full three months of revenues from our web-based system compared to one month in 1999.

Cost of Sales

     Consolidated cost of sales for the year increased 4.9% to $32,915,000 in 2000 from $31,374,000 in 1999. Cost of sales as a percentage of net sales decreased to 70.3% in 2000 from 70.5% in 1999 and reflects improved operating efficiencies and continued favorable results from our cost containment program initiated in 1997, principally in direct labor. We incurred higher specimen collection costs due to the growth in customers requiring nationwide collection services. Gross profit as a percentage of net sales increased to 29.7% in 2000 from 29.5% in 1999 reflecting higher sales. Cost of sales for the 2000 fourth quarter of $9,204,000 increased 13.4% from the same prior year period due to higher sales volume and related specimen collection costs.

Selling, General and Administrative

     Consolidated SG&A expenses for the year increased 14.2% to $11,460,000 in 2000 from $10,033,000 in 1999 due to our continued investment in our sales and marketing strategy, additional staffing in our customer service functions and higher depreciation expenses from our implementation of the Unified Database (UDB) software project in the third quarter of 1999. The percent of SG&A expenses to net sales increased to 24.5% in 2000 from 22.6% in 1999. SG&A expenses for the 2000 fourth quarter increased 4.9% to $2,720,000 from $2,594,000 in 1999 and reflects higher staffing in our sales and customer service functions.

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Income From Operations

     Consolidated income from operations for the year was $2,391,000 in 2000 compared to $2,754,000 in 1999, while income from operations for the fourth quarter was $612,000 in 2000 compared to $530,000 in 1999.

Provision for (Benefit from) Income Taxes

     During 2000, we recorded a provision for taxes of $772,000 for the year and $219,000 for the fourth quarter. The 1999 provision for current income taxes of $482,000 for the year was more than offset by a reversal of $336,000 of tax accruals no longer required due to a favorable settlement of an IRS review (recorded in the first quarter of 1999) and the recognition of an income tax benefit of approximately $440,000 from reducing the deferred tax valuation allowance (recorded in the fourth quarter of 1999). In addition, we offset approximately $347,000 of federal and state taxes with utilization of net operating loss carryforwards in 1999.

Net Income

     Consolidated net income for the year was $1,361,000 in 2000 compared to net income of $2,800,000 in 1999. Excluding the favorable impact of the 1999 tax adjustments, net income for the year in 1999 was $1,677,000. We reported net income of $302,000 in the 2000 fourth quarter compared to net income of $1,082,000 in 1999. Excluding the favorable impact of the 1999 tax adjustments, proforma income in the 1999 fourth quarter would have been $295,000.

LIQUIDITY AND CAPITAL RESOURCES

     Reference should be made to Note 13, “Subsequent Events”, in the accompanying Notes to Consolidated Financial Statements for further discussion of the sale of Medscreen in March 2002, an Amendment and Forbearance Agreement with our primary bank, the debt reduction of approximately $4,310,000, waivers granted by our primary bank for violations of financial covenants that existed at September 30, 2001, and December 31, 2001, and the potential delisting by Nasdaq for noncompliance with the $5,000,000 minimum market value requirement for our publicly held shares.

     Our operations during the year ending December 31, 2001, used cash of $3,607,000 and for the years ending December 31, 2000 and 1999, provided cash of approximately $3,753,000 and $3,437,000, respectively. The decrease in cash flow from operations between 2001 and 2000 is principally due to the $5,867,000 of nonrecurring expenses related to the relocation of our Company from California to Texas in 2001 and a 6.1% decrease in consolidated annual net sales and higher cost of sales as a percentage of net sales compared to 2000. The increase in cash flow from operations between 2000 and 1999 reflects improved collections on accounts receivable and higher payables due to a higher volume of business in the prior year’s fourth quarter compared to 1999.

     As of December 31, 2001 and 2000, we had $1,137,000 and $1,714,000 in cash and cash equivalents, respectively. During 2001, we completed two capital lease financing transactions totaling $3,590,000 and a significant portion of the proceeds were used for repayment of existing debt. We had net borrowings of the revolving line of credit totaling $3,813,000 and repayments on term debt and capital leases totaled $2,217,000. We also used $5,345,000 to acquire property and equipment, mostly related to computer software, laboratory analyzers and leasehold improvements in the new Texas facility. During 2000, we had net repayments on the revolving line of credit of $2,643,000 and we acquired $3,546,000 of property and equipment.

     We have a Loan and Security Agreement (“Credit Agreement) with our bank. The Credit Agreement provides for borrowings under the revolving line of credit limited to 85% of qualified accounts receivables and is secured by a lien on a significant portion of our assets. The Credit Agreement contains certain financial covenants, which, among others, require PharmChem to maintain certain ratios of working capital and net worth. The Credit Agreement permits up to $2,000,000 of the revolving line of credit to be used to repurchase our common stock under our common stock repurchase program and permits the declaration and distribution of a dividend in connection with our stockholder rights

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plan. The Credit Agreement expires in May 2002 and our intent is to renew the Credit Agreement with our primary bank or to seek a similar agreement from another financial institution.

     The Credit Agreement was amended at various times during 2001 to provide for $600,000 of construction financing (fully repaid in 2001), change the revolving maturity date to May 31, 2002, provide for $600,000 of short-term borrowing capacity under our revolving line of credit (fully repaid in 2001), reduce the interest rate to the bank’s prime rate, reduce the maximum line of credit to $5,750,000, reduce the commitment fee to 0.25% of the maximum line of credit, modify our existing covenants and provide for the issuance of subordinated debt. As of December 31, 2001, the calculated maximum that could be borrowed and the amount outstanding under the Credit Agreement were $4,838,000 and $4,544,000, respectively. As discussed in Note 13, “Subsequent Events”, in the accompanying Notes to Consolidated Financial Statements, we entered into an Amendment and Forbearance Agreement with our bank and the revolver was partially repaid with proceeds from the sale of Medscreen.

     During 2001, our total debt increased from $3,830,000 on December 31, 2000 to $12,029,000 on December 31, 2001, as follows (amounts in thousands):

     In the past few years, we have initially financed our capital expenditures using our revolving line of credit. Upon certain project milestones being achieved under the capital project, certain expenditures would be refinanced by entering into capital leases. We completed two such capital lease refinancings in January 2001 and August 2001. The increase in the second quarter reflects advances on our revolving line of credit as we commenced the relocation of the Company to Texas from California. The increase in the third quarter principally reflects the issuance of subordinated debt in September 2001 and the increase in the fourth quarter reflects Medscreen’s two new loan facilities completed in October 2001.

     On October 31, 2001, Medscreen completed two term loan facilities with its bank in the aggregate amount of £1,250,000 pound sterling. The first loan facility is for £900,000 pound sterling and carries an interest rate at the bank’s lending rate plus 1.75% (5.75% at December 31, 2001). The second loan facility is in US Dollars up to a principal sum of £350,000 pound sterling and carries an interest rate at the bank’s federal lending rate plus 1.75% (4.25% at December 31, 2001). These facilities are for a term of 48 months, are secured by a debenture deed on Medscreen’s assets and contain a financial covenant requiring a minimum net worth of £1,500,000 pound sterling. Refer to Note 13, “Subsequent Events”, in the Notes to Consolidated Financial Statements for further discussion of these loan facilities being fully repaid in March 2002.

     On September 14 and September 21, 2001, we closed transactions with three stockholders resulting in the issuance of unsecured subordinated promissory notes (“Notes”), in an aggregate amount of $1,500,000. In addition, the stockholders received (without additional consideration) warrants to purchase an aggregate of 150,000 shares of the Company’s common stock. Interest on the Notes accrues at a rate of 9% per annum and is payable annually during the term of the Notes. The Notes will mature on September 30, 2003. Our obligation under the Notes is subordinate in payment and priority to the indebtedness of the Company due and owing to our bank. The warrants are immediately exercisable by each stockholder for shares of the Company’s common stock at an exercise price of $3.00 per share and expire five years from the date of the closing. The warrants also provide each stockholder certain registration rights for the warrant shares. On the closing dates, the fair value of each warrant was $2.30 based on the Black-Scholes option pricing model and using assumptions of a 4.02% risk free rate of return, 5 year life and a 101% annual volatility of our stock price. The fair value of the warrants is classified as a discount to the Notes and is being amortized to expense over a two-year period. As of December 31, 2001, the unamortized discount was $302,000.

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     On January 3, 2001, we completed a $2,363,000 financing lease agreement with a group of lessors to refinance certain modules of ATLAS, our new laboratory information management system. The lease agreement bears interest at 8.9% and is payable over 36 to 48 months. On August 8, 2001, we completed a $1,186,000 financing lease agreement with a lessor to refinance laboratory equipment, other equipment and additional modules of ATLAS. The lease agreement bears interest at 8.7% and is payable over 36 to 48 months. The proceeds from both leases were used to reduce amounts outstanding under our revolving line of credit and to fund additional capital expenditures. These leases have been accounted for as financings.

     On September 7, 2000, we entered into a $1,674,000 Installment Note with our bank, with terms and conditions similar to the Credit Agreement. The majority of the proceeds from the Installment Note were immediately used to pay off the amount outstanding under a separate $1,500,000 installment note with the same bank. The Installment Note is subject to the terms and conditions of the amended Credit Agreement, currently bears interest at the prime rate plus 0.5% and is payable over 43 months. As discussed in Note 13, “Subsequent Events”, in the accompanying Notes to Consolidated Financial Statements, we entered into an Amendment and Forbearance Agreement with our bank and the Installment Note was fully repaid with proceeds from the sale of Medscreen.

     During the process of relocating to Texas, we have incurred significant costs that have been financed through a combination of internal operations, increased borrowing under our existing and new credit facilities and a sale-leaseback transaction. We believe these costs were of a nonrecurring nature and principally relate to the period prior to occupying our new Haltom City, Texas corporate headquarters, main laboratory and distribution center. Our laboratory operations and distribution center relocated to the Haltom City facility in September and October, respectively. Due principally to the restructuring charge and nonrecurring expenses associated with the relocation to Texas, we were not in compliance with certain debt covenants for the last three quarterly periods of 2001. In July, our bank waived the covenant violations for the quarter ended June 30, 2001. As discussed in Note 13, “Subsequent Events”, in the accompanying Notes to Consolidated Financial Statements, we entered into an Amendment and Forbearance Agreement with our bank in connection with the sale of Medscreen and the bank waived the covenant violations for the quarterly periods ended September 30, 2001 and December 31, 2001. The Amendment and Forbearance Agreement required us to partially repay our revolving line of credit and fully repay our term debt with the bank and, therefore, we reclassified $647,000 from long-term debt to current portion of long-term debt on our balance sheet as of December 31, 2001.

     Due to the higher debt leverage of the Company, the net losses incurred during the 2001 year, the slowdown in the US economy that adversely affected the volume of pre-employment drug testing, the low common stock price and the tightening of the credit markets after the September 11, 2001, terrorist tragedy, we expect it to be more difficult to secure additional financing on favorable terms, if needed. To mitigate the needs for further financing, we implemented a cost containment program in the fourth quarter of 2001. This cost containment program included two rounds of layoffs whereby our employee population has decreased approximately 30% from mid-2001 levels, significant reductions in discretionary spending, including travel, renegotiations with certain suppliers to secure more favorable pricing of materials and services and closure of our California laboratory that offered customers methadone testing using thin layer chromatography. In addition, as further discussed in Note 13, “Subsequent Events”, in the accompanying Notes to Consolidated Financial Statements, we completed the sale of Medscreen in March 2002 and we expect the proceeds from the sale of Medscreen to be sufficient to fund the general corporate needs of the US operations for at least the next year. In the event of continued lower specimen volume, we expect to sublet underutilized facilities, further reduce our employee population, lower guidelines for employee wage increases, limit capital expenditures and implement other actions to preserve cash.

IMPACT OF RECENT ACCOUNTING PRONOUNCEMENTS

     In August 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 144 (SFAS 144), “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS 144 supercedes SFAS 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” in that it removes goodwill from its impairment scope and allows for different approaches in cash flow estimation. However, SFAS 144 retains the fundamental provisions of SFAS 121 for (a) recognition and measurement of the impairment of long-lived assets to be held and used and (b) measurement of long-lived assets to be disposed of. SFAS 144 also supercedes the business

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segment concept in APB Opinion No. 30, “Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,” in that it permits presentation of a component of an entity, whether classified as held for sale or disposed of, as a discontinued operation. SFAS 144 retains the requirement of APB Opinion No. 30 to report discontinued operations separately from continuing operations. We adopted the provisions of SFAS 144 in the first quarter of 2002 and the implementation of this standard did not have a material effect on our results of operations or financial position.

     In July 2001, the FASB issued Statement No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142, effective January 1, 2002, which requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. This Statement will further require intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. SFAS 142 will require us to reassess the useful lives and residual values of all intangible assets acquired in purchase business combinations and make any necessary amortization period adjustments by the end of the first interim period after adoption. Any impairment loss will be measured as of the date of adoption and recognized as the cumulative effect of a change in accounting principle in the first interim period. On an ongoing basis, the amortization of goodwill noted in the Statements of Operations will be eliminated beginning January 1, 2002. As of December 31, 2001, we had unamortized goodwill of $2,436,000, of which $729,000 is attributed to the US operations. Amortization expense related to goodwill was $185,000 for the year ended December 31, 2001. At this time, the adoption of the impairment provisions of SFAS 142 is not expected to have a material effect on our consolidated financial position or results of operations.

     In June 2001, the FASB issued Statement No. 143 (SFAS 143), “Accounting for Asset Retirement Obligations.” SFAS 143 requires liability recognition for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. We are required to adopt the provisions of SFAS 143 no later than January 1, 2003. The adoption of this standard is not expected to have a material effect on our consolidated financial position or results of operations.

FACTORS AFFECTING OPERATING RESULTS

     We are subject to a number of risks which could affect operating results and liquidity, including, among others, the following:

Competition and Customer Contracts

     The market for drug testing services became increasingly competitive in the 1990’s, and continues to be very competitive. Drug testing laboratories compete primarily on the basis of customer service, technical capability and price. We compete for customer contracts against firms that may have greater financial, marketing, laboratory and related resources.

     A majority of our sales arise out of competitively bid contracts, which are awarded based on technical superiority, customer service and price. The failure to renew a significant contract, if not replaced by comparable contracts, could result in lower sales, lower profit margins, decreased cash flows and losses. Our contracts generally allow termination at the customer’s discretion on short notice with little or no penalty. Many contracts provide for termination for convenience. In addition, relatively few of our contracts call for minimum contract amounts or payments. Although in the past our customers generally have not exercised these early termination rights, there can be no assurance that this will continue in the future. Early termination of a substantial contract, if not replaced by comparable contracts, could have a material, adverse effect on PharmChem.

PharmChek® Drugs of Abuse Patch

     Since 1992, we have been investing in PharmChek®, a system which uses sweat to detect the use of illegal drugs. To date, our sales of PharmChek® have not been material and there is no assurance that it will continue to be

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commercially accepted by existing or new customers or generate significant revenues in the future. While the company that developed PharmChek® has obtained patents relating to its technology, there are various risks associated with the technology. There is no assurance:

	•		as to the validity of such patents
	•		that the products we market will be covered by such patents
	•		that competitors will not infringe upon such patents or successfully design similar or competing products that do not infringe upon such patents
	•		that the company that obtained the PharmChek® patents will continue to be able to deliver products to PharmChem or that an alternative supplier will be found

Customer Concentration

     Our two largest customers combined accounted for approximately 30% of our sales in 2001 and 29% of our sales in 2000. The loss of these contracts, if not replaced by comparable contracts, could result in lower sales, lower profit margins, decreased cash flows and losses. We have in the past failed to renew significant contracts which has had adverse effects on PharmChem. See “Competition and Customer Contracts” above.

Certification

     We are certified by SAMHSA, CAP and a number of states to conduct drug testing using forensic procedures. Certification is essential to our business because some of our customers are required to use certified laboratories, and many of our customers look to certification as an indication of accuracy and reliability of results. In order to remain certified, we are subject to frequent inspections and proficiency tests. Failure to meet any of the numerous certification requirements to which we are subject could result in suspension or loss of certification. Such suspension or loss of certification could have a material adverse effect on PharmChem. In connection with the consolidation of our laboratory operations into our new Haltom City, Texas laboratory, in November 2001 we voluntarily withdrew our Fort Worth, Texas laboratory’s license to conduct laboratory testing of federally regulated specimens. Federally regulated specimens represented less than 10% of our specimen volume in 2001. We are currently in the process of applying for certification of our new laboratory and we believe that a license will be granted in the second quarter of 2002. Until the new laboratory is certified, we have temporarily outsourced our customers’ federally regulated specimens to another certified laboratory. In the event the certification process is delayed, our plan will be to continue to outsource such specimens until the certification is achieved.

Seasonal Trends and Economic Conditions

     Seasonal trends to which drug testing laboratories are generally subject affect our operations. In the past, testing volume tends to be higher in the second and third calendar quarters and lower in the fourth and first calendar quarters, primarily due to the hiring patterns of our public and private employer customer group which affect pre-employment drug testing. Demand for our services is also dependent on general economic conditions. Recessionary periods generally result in fewer new hires, and therefore may lead to fewer pre-employment drug tests for public and private employer customers. Similarly, customers may scale back their drug testing program in a tight labor market to enhance their chances of hiring candidates by expediting the hiring decision-making or by rehiring workers that were subject to a prior layoff and not require the workers to be further drug tested. Budget cuts at the federal, state or local level could reduce business from our public employer, criminal justice agency and government funded drug treatment program customers. An extended recessionary period could have a material, adverse impact on our liquidity if we are unable to reduce our cost structure on a proportionate basis or seek further financing on favorable terms. During high seasonal periods, we have traditionally used temporary personnel to assist our permanent work force with the higher operational requirements of increased specimen volumes. Because expenses associated with maintaining our testing work force are relatively fixed over the short term, our profit margins tend to increase in periods of higher testing volume and decrease in periods of lower testing volume.

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Judicial Decisions and Government Policy

     State and federal courts have generally permitted the use of drug testing under certain circumstances and using certain procedures. However, challenges to drug testing programs are raised from time to time by employees, unions and other groups in litigation on constitutional, privacy and other grounds. In addition, legal precedent in a number of states governs the circumstances under which employers may test employees and the procedures under which such tests must be conducted. Societal changes toward greater acceptance of certain drugs, such as for medical purposes, may result in a relaxation of drug enforcement laws and policies that would decrease demand for drug testing programs. Although we believe that, to date, no such litigation or law has had a material adverse impact upon our business, new decisions, legislation or policies which restrict the use of drug testing could have a material adverse effect on PharmChem.

Credit Availability

     We maintain a revolving credit agreement with a bank. All borrowings are secured by a lien on a significant portion of our assets. The Credit Agreement contains certain financial covenants, of which we were in violation for most of 2001 due to the adverse effects on our Company of the weakened US economy and the significant costs incurred to relocate our Company’s operations from California to Texas. Continued operating losses will generally make it increasingly more difficult for the Company to renew credit facilities on favorable terms and to secure additional or replacement credit facilities. Due to the costs associated with relocating and the investments to complete our new facility in Haltom City, Texas, we have operated at or near the maximum availability of our revolving line of credit since the middle of 2001.

Legal Proceedings

     In the ordinary course of our business, we are sued by individuals, primarily those in the criminal justice system, who have tested positive for drugs of abuse. In addition, we frequently testify in administrative and court proceedings involving the results of our tests. To date, we have not experienced any material liability related to these claims, although there can be no assurance that we will not at some time in the future experience significant liability in connection with such claims.

Environmental Matters

     Prior to the closure of our California laboratories in 2001, a small portion of our California business involved testing procedures requiring the use of radioactive reagents, which are considered to be hazardous materials. Failure to comply with current or future federal, state or local environmental laws or regulations regarding these hazardous materials could have a material adverse effect on PharmChem. We believe we were in compliance with all applicable environmental laws and regulations during the periods we operated the California laboratories. We no longer use such radioactive reagents.

Dependence on Key Personnel

     Our success is dependent in part on our key management and technical personnel, the loss of one or more of whom could have a material adverse effect on PharmChem. All of our key executive officers relocated with the Company to Texas in 2001. None of our key employees has an employment contract with us. We believe that our future success will depend in part upon our continued ability to attract, retain and motivate additional highly skilled personnel.

ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk

     We are subject to market risk with respect to our debt outstanding and foreign currency transactions. Our revolving line of credit and bank installment note carry interest at the prime rate plus 0.5%. As the prime rate increases, we will incur higher relative interest expense and a decrease in the prime rate will reduce relative interest expense. In recent years, there have not been significant fluctuations in the prime rate. Assuming levels of debt consistent with historical amounts, a 1.0% change in the prime rate would not materially change interest expense.

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     Due to our international operations, certain transactions are conducted in foreign currencies. Medscreen’s transactions are denominated approximately 84% in pound sterling and 16% in US currency. Medscreen’s net sales represented 17% and 16% of our total net sales in 2001 and 2000, respectively, and, as a result, we do not consider the impact of market risk on foreign currency transactions material. For that reason, we do not intend to engage in hedging transactions. Refer to Note 13, “Subsequent Events”, in the accompanying Notes to Consolidated Financial Statements for further information on the recently completed sale of Medscreen in March 2002.

ITEM 8. Financial Statements and Supplementary Data

See Index at page 50, Item 14. (a) (1).

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INDEPENDENT AUDITORS’ REPORT

The Board of Directors and Stockholders
of PharmChem, Inc.:

We have audited the accompanying consolidated balance sheets of PharmChem, Inc. and its subsidiary (the Company) as of December 31, 2001 and 2000, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2001. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedule as listed in the accompanying index at Item 14(a)(2). These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits. We did not audit the financial statements of Medscreen Limited (Medscreen), a wholly-owned subsidiary, as of and for the years ended December 31, 2001 and 2000, such financial statements reflect total assets constituting 19 percent and 23 percent and total revenues constituting 17 percent and 16 percent in 2001 and 2000, respectively, of the related consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Medscreen, is based solely on the report of the other auditors.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 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 and the report of the other auditors provide a reasonable basis for our opinion.

In our opinion, based on our audits and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of PharmChem, Inc. and its subsidiary as of December 31, 2001 and 2000, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, based on our audits and the report of the other auditors, the related consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

San Francisco, California
March 14, 2002, except for Note 13
as to which the date is
March 29, 2002

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INDEPENDENT AUDITORS’ REPORT

The Board of Directors
and Stockholders of Medscreen, Limited:

We have audited the accompanying balance sheets of Medscreen, Limited (the Company) as of December 31, 2001 and 2000, and the related statements of income, stockholders’ equity, and cash flows for each of the years in the two-year period ended December 31, 2001. These financial statements 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 auditing standards generally accepted in the United States of America. 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles 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 material respects, the financial position of Medscreen, Limited as of December 31, 2001 and 2000, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America.

GALLAGHER & CO.

London, England
March 14, 2002

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PHARMCHEM, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands)

See accompanying notes to consolidated financial statements.

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PHARMCHEM, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)