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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

OR

Commission File Number 0-19371

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (817) 605-5300

     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 report(s), and (2) has been subject to such filing requirements for the past 90 days. Yes [X]    No [   ]

     As of October 31, 2002, the registrant had outstanding 5,852,593 shares of Common Stock, $0.001 par value.

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PHARMCHEM, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX

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PART I. Financial Information

Item 1. Condensed Consolidated Financial Statements

     The condensed consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made are adequate to make the information presented not misleading. It is suggested that the condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto for the year ended December 31, 2001 included in the Company’s Annual Report on Form 10-K.

     These financial statements have been prepared in all material respects in conformity with the standards of accounting measurements set forth in Accounting Principles Board Opinion No. 28, “Interim Financial Reporting,” and the rules and regulations as specified by the Securities and Exchange Commission and reflect all adjustments, consisting only of normal recurring adjustments which, in the opinion of management, are necessary to summarize fairly our consolidated financial position and the results of operations and cash flows for the periods presented. The results of operations for such interim periods are not necessarily indicative of the results to be expected for the full year.

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PHARMCHEM, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except par value)

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

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PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)

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

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PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(In thousands)

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

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PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

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

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PHARMCHEM, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation, General and Business

     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 in the United States who seek to detect and deter the use of illegal drugs and alcohol. The consolidated financial statements include the accounts of PharmChem and Medscreen Limited (“Medscreen”), a United Kingdom company. Medscreen was sold on March 25, 2002 and, as a result, is presented as discontinued operations in the accompanying financial statements for all periods presented. Medscreen’s financial statements were translated based on the month-end spot rate for the balance sheets and a weighted average of the spot rates for the statements of operations.

     The accompanying condensed consolidated financial statements are prepared in accordance with the instructions to Form 10-Q, are unaudited and do not include all the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. We have made certain reclassifications to prior year amounts to conform to current year presentation. All adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations for the interim periods have been made and are of a recurring nature unless otherwise disclosed herein. The results of operations for such interim periods are not necessarily indicative of results of operations for a full year.

     In the first quarter of 2002, we implemented Financial Accounting Standards Board Statement No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 requires 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 further requires intangible assets with definite useful lives to be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. As permitted by SFAS 142, we implemented the impairment provisions in the second quarter of 2002. On an ongoing basis, the amortization of goodwill noted in the Condensed Consolidated Statements of Operations was eliminated beginning January 1, 2002. The following table shows the Company’s net loss excluding the goodwill amortization in 2001 (in thousands, except per share amounts):

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2. Discontinued Operations

     On March 25, 2002, we completed the sale of Medscreen for approximately $10.0 million. In connection with the sale, Medscreen’s two loan facilities totaling approximately $1,663,000 were fully repaid. Closing and other settlement costs totaled approximately $324,000 and approximately $929,000 was used to repay a portion of our revolving line of credit. In April 2002, we fully repaid the term loan ($989,000) with our primary bank and made further repayments on our revolving line of credit (see Note 5 of the Notes to Condensed Consolidated Financial Statements). The remainder of the proceeds have been and will be used for general corporate purposes.

     Net sales of the discontinued operations were $1,786,000 for the three months ended September 30, 2001, and $1,949,000 and $5,460,000 for the nine months ended September 30, 2002 and 2001, respectively. We recorded a gain on the sale of Medscreen of $0.73 per diluted share.

3. Net Income (Loss) per Share

     We compute and disclose our income (loss) per share in accordance with Statement of Financial Accounting Standards No. 128, “Earnings Per Share,” which requires the presentation of basic and diluted income per share. Basic income (loss) per share is calculated using the weighted average number of common shares outstanding during the period. Diluted income per share is calculated using the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares represent shares issuable upon the exercise of outstanding options and warrants and are calculated using the treasury stock method.

     Options and warrants to purchase 1,185,000 and 1,209,000 shares of our common stock for the three and nine months ended September 30, 2002 and 2001, respectively, were not included in the computation of diluted income per share because their effect would have been anti-dilutive.

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4. Inventory

     Inventory includes laboratory materials, collection materials and products and is stated at the lower of cost or market. Cost is determined using standard costs, including freight, that approximate actual costs on a first-in, first-out basis. Inventory consisted of the following at September 30, 2002 and December 31, 2001 (in thousands):

5. Debt

     Our debt at September 30, 2002 and December 31, 2001 consisted of the following (in thousands):

     On July 31, 2002, the Company entered into a Second Amended and Restated Loan and Security Agreement (the “Agreement”) with its principal lender whereby the line of credit is $4,250,000, the maturity date is June 30, 2003, interest is at the prime rate plus one-half percent (5.25% as of September 30, 2002), and the annual fee is 0.10% of the credit line, payable quarterly. The financial covenants include a current ratio of no less than 0.85 to 1.00, total liabilities to effective tangible net worth of not more than 2.00 to 1.00, and minimum effective tangible net worth of not less than $10 million (including subordinated debt)—all measured quarterly. In addition, the Company is required to be profitable for the 2002 fiscal year and quarterly in 2003. Also, the Agreement provides for a limitation on capital expenditures and requires a restricted cash balance of $500,000.

     The July 31, 2002 Agreement permits borrowings on eligible receivables up to 85% thereof and is secured by a lien on a significant portion of our assets. It also 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 plan.

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     As of September 30, 2002, the calculated maximum that could be borrowed and the amount outstanding were both $3,681,000. We were in compliance with our covenants as of September 30, 2002.

6. Restructuring Charge

     During the second quarter of 2001, our Board of Directors approved a plan to close our Menlo Park, California corporate headquarters, main laboratory and distribution center and relocate these operations to Texas. These expenses were accrued and recorded in continuing operations for the three months ended June 30, 2001. Detail of the payment activity and ending accrual balance related to the restructuring is presented in the following table (in thousands):

     The restructuring plan was designed to provide for costs associated with leaving our facilities in Menlo Park, California. The restructuring expenses represent estimated and actual costs related to workforce reductions, clean-up, repairs and legal services. As part of the workforce reduction, we recorded severance and related fringe benefits costs for approximately 160 employees from operations and administration, of which 155 employees were terminated as of September 30, 2002. The clean-up and remediation includes removal of a previously unknown storage vault and potential restoration of the facility per the lease agreement. Repairs includes sewer line repair or replacement as contractually provided for in the lease agreement. The accrual balance of $254,000 is classified as a component in “Accrued collectors and other liabilities” on the balance sheet. Costs for relocation were expensed as incurred.

     On September 19, 2002, the Company’s attorneys received a letter from counsel for the landlord of the Company’s former Menlo Park, California facility claiming damages in the amount of $4.7 million. This amount is based primarily on the landlord’s claim for lost and reduced rent arising from the Company’s alleged failure to vacate the Menlo Park premises timely under the terms of the lease. The Company and its counsel are currently reviewing the details of this claim and the Company will defend itself vigorously.

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

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, which are subject to the “safe harbor” created by these Sections. Our actual future results could differ materially from those projected in the forward-looking statements. Some factors which could cause future actual results to differ materially from our recent results and those projected in the forward-looking statements are described in our Annual Report on Form 10-K for the year ended December 31, 2001. We assume no obligation to update the forward-looking statements or such factors.

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 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 incurred significant costs that were 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, 2001, respectively. To mitigate further operating losses, we implemented a cost containment program in September of 2001 which is continuing in 2002. 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 and marketing, renegotiations with certain suppliers to secure more favorable pricing of materials and services, and the closure of our satellite laboratory in California that performed methadone drug testing.

     As further discussed in Note 2 of the accompanying Notes to Condensed Consolidated Financial Statements, in March 2002 we completed the sale of Medscreen for approximately $10,000,000 in cash. A portion of the sale proceeds were used to repay debt and the remainder is expected to be sufficient to fund the general corporate needs of the US operations for 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, goodwill, 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 contract specimen collector 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 decreases 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. 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 2, “Discontinued Operations”, to the accompanying Notes to Condensed 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):