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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

     (Mark One)

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

PHARMCHEM, INC.

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 whether the Registrant is an accelerated filer. Yes o No þ

     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 $0.86 as reported on the Nasdaq SmallCap on June 28, 2002, was approximately $1,755,000 (and approximately $352,000 based on the closing price of $0.13 as reported on the Nasdaq SmallCap on February 28, 2003). 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 February 28, 2003 was 5,852,593.

DOCUMENTS INCORPORATED BY REFERENCE

     Portions of the PharmChem, Inc. Proxy Statement for the 2003 Annual Meeting of Stockholders to be filed with the Commission on or before April 19, 2003 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 in the United States and Puerto Rico who seek to detect and deter the use of illegal drugs and alcohol. We are certified by a number of state 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 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 PharmScreen^® and PharmView™ on-site screening devices and the PharmChek^®Drugs of Abuse Patch (for testing with sweat). 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. In March 2002, we sold Medscreen. When we refer to “we”, “our” or “PharmChem” in this Form 10-K, we mean the current Delaware corporation (PharmChem, Inc.).

          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) 581-2049 and our home web site is www.pharmchem.com. Reports filed on Form 10-K, Form 10-Q and Form 8-K are available on our home web site.

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. In October 2001, all operations were centralized to Haltom City. During the process of relocating to Texas, we incurred significant costs that were financed through a combination of internal operations, increased borrowing under our credit facilities and a sale-leaseback transaction. As further discussed in Note 13, “Sale of Medscreen”, 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.

          On February 20, 2003, the Company received notification from Nasdaq that, for the past 30 consecutive trading days, the Company’s common stock has not maintained a minimum market value of publicly held shares of $1 million as required for inclusion by Marketplace Rule 4310(c)(7). Publicly held shares exclude shares held directly or

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indirectly by any officer or director of the Company or by any person who is beneficial owner of more than 10% of total shares outstanding. The Company will be provided with 90 calendar days, or until May 21, 2003, to regain compliance. If, at anytime before May 21, 2003, such market value is $1,000,000 or more for a minimum of 10 consecutive trading days, Nasdaq will provide written notification that the Company is in compliance. If compliance cannot be demonstrated by May 21, 2003, Nasdaq will provide written notification that the Company’s securities will be delisted. At that time, the Company may appeal to a Listing Qualifications Panel.

          In addition, as previously reported, the Company is not in compliance with the $1.00 minimum bid price as required for listing on the Nasdaq SmallCap Market. The Company has been granted a grace period until April 7, 2003, to comply with this rule.

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. The PharmScreen^® product line was extended in 2002 to include the PharmView™ on-site screening devices.

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.
	•		We identify and track the specimens using unique bar-coded laboratory specimen identification numbers (accessioning).

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	Screening Analyses
	•		We screen each specimen submitted for the presence of the drugs specified by the customer.
	•		In 2002, we performed approximately 970,000 laboratory screening tests on approximately 140,000 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.
	•		In 2002, we performed approximately 27,000 laboratory confirmation tests per month to detect the presence of drugs.
	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 substantially all 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 72 hours for specimens that require confirmation.

PharmScreen^® and PharmView™ On-Site Screening Devices

          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 and workplace employers, 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 two lines of on-site screening devices to supplement our laboratory-based testing services. PharmScreen^® and newly introduced PharmView™ are portable, hand-held devices used for on-site screening of drugs of abuse and are available in single, dual, four and five drug 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^® and PharmView™ provide only a preliminary analytical result, and a more specific alternative chemical method, such as GC/MS, is necessary to obtain a confirmed analytical result. There can be no assurance that the historical profit margins of PharmScreen^® will continue due to increasingly competitive market pressures or that PharmView™ will be commercially accepted.

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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. 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).

          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.

          Our sales of PharmChek^® have been targeted toward criminal justice agencies and drug rehabilitation customers. There can be no assurance that PharmChek^® will generate significant revenues in the future or be accepted by various jurisdictions as an alternative method of detecting drugs of abuse or customers will continue to secure funding for alternative methods of drug testing, including PharmChek^®.

SUPPLIERS

          We are dependent upon single suppliers for the PharmScreen^®, PharmView™ and PharmChek^® products and we continue to seek 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 4,000 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. We also offer our customers integrated web-based specimen collection management services. In 2002, PharmChem managed approximately 450,000 collections.

Transportation

          Specimens are transported to PharmChem by overnight delivery couriers 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.

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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 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 database of collection sites and on-call collections for rapid response
	•		alternatives to laboratory urine testing including on-site screening devices such as PharmScreen® and PharmView™, sweat testing with PharmChek® and hair testing
	•		PharmTrack®, our secure internet-based tracking and reporting system
	•		FAST® (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:

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, a 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 36%, 41% and 43% of our total net sales in 2002, 2001 and 2000, respectively. Sales to Sears, Roebuck & Co. accounted for approximately 15%, 12% and 14% of our total net sales in 2002, 2001 and 2000, respectively, while sales to Lowes Companies, Inc. were 10% in 2002 and less than 10% in 2001 and 2000.

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 63%, 56% and 54% of our total net sales in 2002, 2001 and 2000 , respectively. Sales to Federal Probation accounted for approximately 31%, 24% and 21% of our total net sales in 2002, 2001 and 2000, respectively.

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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 sales in 2002, 2001 and 2000. In November 2001, we ceased offering our customers specialized methadone testing using thin layer chromatography.

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, Medtox Scientific, Inc. and Northwest Toxicology, Inc.
	•		regional and local laboratories
	•		third party administrators
	•		medical review officers
	•		manufacturers and distributors of on-site screening devices and equipment

          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.

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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 laboratory is certified by CLIA and SAMHSA and as a clinical laboratory and forensic drug testing laboratory by CAP.

          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. During the past year, we have achieved favorable results on ten laboratory inspections conducted by various federal and local regulatory agencies.

          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.

          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, 2002, we had approximately 170 full-time employees. Since August 2001, the Company has laid off approximately 30% of its workforce to more closely align its cost structure to the reduction in specimen volume resulting from the slowing U.S. economy. Our employees are not represented by labor organizations and we consider relations with our employees to be good.

CODE OF ETHICS

          The Company has adopted a code of ethics that applies to its chief executive officer, chief financial officer, principal accounting officer or controller, and persons performing similar functions. Such code of ethics may be found on the Company’s website at www.pharmchem.com.

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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. Historically, 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.

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.

          Although no lawsuit has been filed, our attorneys received a letter on September 19, 2002, from the landlord of our former Menlo Park, California facility claiming damages in the amount of $4,700,000. This amount is based primarily on the landlord’s claim for lost and reduced rents arising from our alleged failure to vacate the Menlo Park facility under the terms of the lease. We will defend ourselves vigorously against this claim. Refer to Note 12, “Restructuring Charge”, in the accompanying Notes to Consolidated Financial Statements.

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

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, 2002

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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, logistics, 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 an 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. 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 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 an 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 Dallas.

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PART II

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

          Our common stock trades on The Nasdaq SmallCap 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. Nasdaq approved PharmChem’s application to transfer its securities to The Nasdaq SmallCap Market.

          On February 20, 2003, the Company received notification from Nasdaq that, for the past 30 consecutive trading days, the Company’s common stock has not maintained a minimum market value of publicly held shares of $1 million as required for inclusion by Marketplace Rule 4310(c)(7). Publicly held shares exclude shares held directly or indirectly by any officer or director of the Company or by any person who is beneficial owner of more than 10% of total shares outstanding. The Company will be provided with 90 calendar days, or until May 21, 2003, to regain compliance. If, at anytime before May 21, 2003, such market value is $1,000,000 or more for a minimum of 10 consecutive trading days, Nasdaq will provide written notification that the Company is in compliance. If compliance cannot be demonstrated by May 21, 2003, Nasdaq will provide written notification that the Company’s securities will be delisted. At that time, the Company may appeal to a Listing Qualifications Panel.

          In addition, the Company is not in compliance with the $1.00 minimum bid price as required for listing on the Nasdaq SmallCap Market. The Company has been granted a grace period until April 7, 2003, to comply with this rule.

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 2002 and 2001, as reported by the Automated Quotation System of the National Association of Securities Dealers (Nasdaq). 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 1, 2003, there were approximately 110 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 760 stockholders as of March 1, 2003.

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.

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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 13, “Sale of Medscreen,” for the sale of Medscreen and Note 14, “Selected Quarterly Financial Data (Unaudited),” for quarterly financial data.

ITEM 7. 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 (“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. In October 2001, all operations were centralized to Haltom City. During the process of relocating to Texas, we incurred significant costs that were financed through a combination of internal operations, increased borrowing under our credit facilities and a sale-leaseback transaction. As further discussed in Note 13, “Sale of Medscreen”, 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.

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.

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          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 decreases beyond our expectations of recovery, 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 we 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 increase 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.

RESULTS OF OPERATIONS

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

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

2002 vs. 2001

          Net sales for the twelve months ended December 31, 2002 decreased $6,481,000 (17.7%) to $30,085,000 in 2002 from $36,566,000 in 2001. Specimen volume was down 23.1% reflecting decreases in all customer classes with workplace volume down significantly more than criminal justice. Sales of products and other services were lower by only 5.1%. Sales of PharmChek^® sweat patches and PharmScreen^® onsite testing devices decreased 34.6% and 21.7%, respectively.

          Net sales for the three months ended December 31, 2002 were $7,227,000, a decrease of 10.5% from last year’s fourth quarter sales of $8,078,000. In this year’s fourth quarter, laboratory specimen volume fell by 16.1% from

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the same period a year ago. Volume from criminal justice customers was negatively affected because certain of these customers have migrated from laboratory testing to less costly on-site testing devices sold by the Company’s competitors, while volume from workplace customers was adversely affected by the continued slowdown in the US economy. Average selling prices of laboratory analysis rose slightly in the current quarter but this is a function of customer and service mix as there have been no significant price increases in 2002. Sales of products and other services, 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, were higher by 4.8% due to higher managed collections for the PharmScreen^® onsite testing devices.

          Cost of sales for the twelve months ended December 31, 2002 decreased $9,517,000 (29.3%) to $23,013,000 in 2002 (76.5% of net sales) from $32,530,000 in 2001 (89.0% of net sales). Last year’s cost of sales includes $4,106,000 of nonrecurring costs directly related to our relocation to Texas. Excluding these nonrecurring costs, last year’s cost of sales on a pro forma basis would have been $28,424,000 (77.7% of net sales). This year’s cost of sales is lower than last year’s pro forma cost of sales by $5,411,000, or 19.0%. This reduction is attributable to lower specimen volume, operating efficiencies, and the cost containment program implemented late last year. Nearly all cost components were lower with the exception of health insurance and depreciation. Collection costs were lower in absolute dollars by 14.8% versus a 15.4% decrease in the number of collections. Gross profit as a percentage of net sales increased to 23.5% in 2002 from 11.0% in 2001. Excluding the nonrecurring costs, 2001’s gross profit would have been, on a pro forma basis, $8,142,000 and the gross profit margin would have been 22.3%.

          Cost of sales for the three months ended December 31, 2002 was $5,306,000 (73.4% of net sales), a decrease of 20.4% from last year’s fourth quarter cost of sales of $6,667,000 (82.5% of net sales). Nearly every cost element was lower in 2002 versus 2001 with the exception of health insurance and depreciation. The cost of specimen collections (conducted for the Company by third parties) was unchanged versus the prior year’s quarter, reversing the trend of sequential increases in each of the past three quarters. The lower cost of sales this year is a result of lower specimen volume coupled with operating efficiencies and a cost reduction program implemented in late 2001, which is continuing into 2003. Fixed overhead was lower by 21.0% in spite of higher depreciation related to systems and equipment at our new facility being placed into service. Gross profit as a percentage of net sales increased to 26.6% in 2002 from 17.5% in 2001.

          Selling, General & Administrative (SG&A) expenses for the twelve months ended December 31, 2002 decreased $4,085,000 (34.5%) to $7,744,000 in 2002 (25.7% of net sales) from $11,829,000 in 2001 (32.3% of net sales). Last year’s SG&A expenses include $1,761,000 of nonrecurring costs associated with the relocation of our Company from California to Texas. These nonrecurring costs include significant relocation, travel and subsistence expenses. This year’s SG&A expenses reflect a reduction in costs related to sales, marketing, customer service, professional fees and information systems. On a pro forma basis, last year’s SG&A for the twelve months would have been $10,068,000 (27.5% of net sales), or 23.1% higher than this year’s SG&A amount.

          SG&A expenses for the three months ended December 31, 2002 decreased $281,000 (14.2%) to $1,701,000 in 2002 from $1,982,000 in 2001. The decrease partially reflects lower bad debts, professional fees and consulting expenses resulting from the cost containment program implemented in the latter part of 2001. SG&A expenses as a percentage of net sales decreased to 23.6% in 2002 from 24.6% in 2001.

          Restructuring Charge of $1,029,000 was recorded in 2001’s second quarter in accordance with a plan approved by our Board of Directors to provide for costs associated with closing our former headquarters and main laboratory 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.

          Discontinued Operations for the twelve months ended December 31, 2002 resulted in net income of $4,636,000 (or $0.79 per share), which is comprised of net income from Medscreen’s operations for three months of $359,000 (or $0.06 per share) and the gain on the sale of Medscreen of $4,277,000 (or $0.73 per share). These operations in 2001 generated net income of $999,000 (or $0.17 per share) and reflect twelve months of operations.

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          Net Loss from continuing operations for the twelve months ended December 31, 2002 was $1,294,000 or $0.22 per share compared to a net loss in 2001 of $9,475,000, or $1.62 per share. Excluding the impact of the $5,867,000 in nonrecurring costs, the $1,029,000 restructuring charge and $130,000 of goodwill amortization, the net loss from continuing operations for the twelve months ended December 31, 2001 would have been $2,449,000, or $0.42 per share. The net income for the twelve months ended December 31, 2002, including discontinued operations, was $3,342,000 or $0.57 per diluted share versus a net loss in 2001 of $8,476,000, or $1.45 per share.

          Net income from continuing operations for the three months ended December 31, 2002 was $49,000 or $0.01 per share compared to a net loss of $824,000 or $0.14 per share in 2001. The net loss in 2001, after the inclusion of income from discontinued operations, was $547,000, or $0.09 per share. Excluding the $33,000 of goodwill amortization, the pro forma loss from continuing operations in 2001 would have been $791,000, or $0.14 per share.

2001 vs. 2000

          Net Sales for the year decreased $2,828,000 (7.2%) to $36,566,000 in 2001 from $39,394,000 in 2000. This decrease is principally attributed to 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. 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 after the September 11, 2001 tragedy, which contributed to a further slowdown in the US economy. Contributing to the decreased specimen volume was the November 2001 closure of our California laboratory that offered customers methadone testing using thin layer chromatography. Average laboratory selling prices increased 3.7% in 2001 compared to 2000. 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. 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.

          Cost of Sales for the year increased $3,561,000 (12.3%) to $32,530,000 in 2001 from $28,969,000 in 2000. This increase is 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. Excluding the non-recurring expenses, the proforma gross profit as a percentage of net sales would have decreased to 22.3% in 2001 from 26.5% in 2000.

          Selling, General and Administrative (SG&A) expenses for the year increased $2,124,000 (21.9%) to $11,829,000 in 2001 from $9,705,000 in 2000. Included in SG&A expenses are $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 32.3% in 2001 from 24.6% in 2000.

          Restructuring Charge in the amount of $1,029,000 was recorded in 2001’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.

          Discontinued Operations for the twelve months ended December 31, 2001 resulted in net income of $999,000 (or $0.17 per share), which is comprised of net income from Medscreen’s operations for twelve months. These operations in 2000 generated net income of $1,067,000 (or $0.17 per share) and reflect twelve months of operations.

          Net Loss from continuing operations for the twelve months ended December 31, 2001 was $9,475,000 or $1.62 per share compared to net income in 2000 of $294,000, or $0.05 per share. Excluding the impact of the $5,867,000 in

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nonrecurring costs, the $1,029,000 restructuring charge and $130,000 of goodwill amortization, the proforma net loss from continuing operations for the twelve months ended December 31, 2001 would have been $2,449,000, or $0.42 per share.

LIQUIDITY AND CAPITAL RESOURCES

          Reference should be made to Note 13, “Sale of Medscreen”, in the accompanying Notes to Consolidated Financial Statements for further discussion of the sale of Medscreen in March 2002. In addition, refer to Item 5., “Market for Registrant’s Common Equity and Related Stockholder Matters,” for discussion of the Company’s transfer to the Nasdaq SmallCap Market and subsequent noncompliance with minimum market value and minimum bid requirements.

          Our continuing operations during the year ending December 31, 2002 provided cash of approximately $1,176,000, for the year ending December 31, 2001, used cash of approximately $4,739,000, and for the year ending December 31, 2000, provided cash of approximately $2,568,000. The increase in cash flow from operations between 2002 and 2001 is principally due to 2002’s smaller net loss from continuing operations and, in 2001, nonrecurring expenses related to the relocation of our Company from California to Texas. The decrease in cash flow from operations between 2001 and 2000 reflects 2001’s operating loss and nonrecurring expenses related to the relocation.

          As of December 31, 2002 and 2001, we had $4,213,000 and $197,000 in cash and cash equivalents, respectively. The increase in cash reflects the remaining proceeds from the sale of Medscreen that was completed in March 2002. During 2002, we had net repayments on the revolving line of credit totaling $1,210,000 and repayments on term debt and capital leases totaling $2,669,000. We also used $1,415,000 to acquire property and equipment, mostly related to computer software. During 2001, we had a net increase in debt proceeds of $6,686,000 to finance the relocation to Texas and completion of the new facility.

          On July 31, 2002, we entered into a Second Amended and Restated Loan and Security Agreement (the “Agreement”) with our 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 December 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. As of December 31, 2002, we were in compliance with all covenants. Our intent is to seek a similar agreement from another financial institution or renew the Agreement with our primary bank.

          The 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. As of December 31, 2002, the calculated maximum that could be borrowed and the amount outstanding under the Agreement were $3,674,000 and $3,334,000, respectively.

          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%

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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, 2002, the unamortized discount was $129,000.

          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. 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.

IMPACT OF RECENT ACCOUNTING PRONOUNCEMENTS

          In August 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 144 (SFAS No. 144), “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 supercedes SFAS No. 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 No. 144 retains the fundamental provisions of SFAS No. 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 No. 144 also supercedes the business 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 No. 144 retains the requirement of APB Opinion No. 30 to report discontinued operations separately from continuing operations. We adopted the provisions of SFAS No. 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.

          Effective January 1, 2002, we implemented FASB Statement No. 142 (SFAS No. 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 No. 142. As permitted by SFAS No. 142, we implemented the impairment provisions in the second quarter of 2002. 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 No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. On an ongoing basis, the amortization of goodwill noted in the Consolidated Statements of Operations was eliminated beginning January 1, 2002.

          In June 2001, the FASB issued Statement No. 143 (SFAS No. 143), “Accounting for Asset Retirement Obligations.” SFAS No. 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 No. 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.

          In June 2002, the FASB issued Statement No. 146 (SFAS No. 146), “Accounting for Costs Associated with Exit or Disposal Activities,” which supersedes EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred, rather than at the date of a commitment to an exit or disposal plan as was required by EITF No. 94-3. This statement is effective for disposal activities initiated after December 31, 2002, with early application encouraged. SFAS No. 146 is not expected to have a material effect on our consolidated financial position or results of operations.

          In December 2002, the FASB issued Statement No. 148 (SFAS No. 148), “Accounting for Stock-Based Compensation—Transition and Disclosure — an amendment of SFAS No. 123.” This statement amends SFAS No.

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123,“Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company continues to account for stock-based compensation using Accounting Principles Board Statement No. 25, “Accounting for Stock Issued to Employees,” and has not adopted the recognition provisions of SFAS No. 123, as amended by SFAS No. 148. However, the Company has adopted the disclosure provisions for the current fiscal year and has included this information in Note 5, “Incentive Stock Plans and Stock Repurchase Program”, in the accompanying Notes to Consolidated Financial Statements.

          In November 2002, the FASB issued FASB Interpretation No. 45 (FIN45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of certain guarantees. FIN 45 also requires disclosure about certain guarantees that an entity has issued. The Company has implemented the disclosure requirements required by FIN 45, which were effective for fiscal years ending after December 15, 2002. The Company will apply the recognition provisions of FIN 45 prospectively to guarantees issued after December 31, 2002. The company does not expect FIN 45 to have a material effect on its financial condition and results of operations.

          In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The Company does not expect FIN 46 to have a material effect on its financial condition and results of operations.

          In November 2002, the FASB’s Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The Company does not expect EITF Issue No. 00-21 to have a material effect on its financial condition and 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

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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. Refer to “Customer Concentration” below for discussion of the Company’s largest customers.

Customer Concentration

          Our three largest customers combined accounted for approximately 56% of our sales in 2002 and 43% of our sales in 2001. The contract for our largest customer, Federal Probation, expired in September 2002 and was subsequently extended through August 1, 2003. We are in continued negotiations with the customer to renew the contract and/or obtain a further extension. We expect Federal Probation will further extend the contract until a new bid process is completed. 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.

Seasonal Trends and Economic Conditions

          Seasonal trends to which drug testing laboratories are generally subject affect our operations. Workplace 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.

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.

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Credit Availability

          We maintain a revolving credit agreement with a bank and it is scheduled to expire in June 2003. All borrowings are secured by a lien on a significant portion of our assets and the Agreement contains certain financial covenants. In addition, our subordinated debt agreement expires in September 2003. Continued operating losses and/or the potential delisting by Nasdaq of our common stock would 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 downturn in the U.S. economy, 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. Refer to Item 3., “Legal Proceedings.”

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 and none of our key employees has an employment contract with us. Currently, all stock option awards granted to employees have an exercise price higher than our closing stock price as of February 28, 2003. We believe that our future success will depend in part upon our continued ability to attract, retain, incentivize 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. 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.

ITEM 8. Financial Statements and Supplementary Data

See Index at page 48, Item 15. (a) (1).

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INDEPENDENT AUDITORS’ REPORT

The Board of Directors
PharmChem, Inc.:

We have audited the accompanying consolidated balance sheets of PharmChem, Inc. and Subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of operations, stockholders’ equity, comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2002. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as listed in the index in Part IV, Item 15 (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 December 31, 2001 and 2000, which has been included as discontinued operations in the accompanying consolidated financial statements, which financial statements reflect total assets constituting 8 percent of consolidated total assets as of December 31, 2001, and total revenues constituting 17 percent and 16 percent for the years ended December 31, 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 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 subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related 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.

As discussed in Note 1 to the consolidated financial statements, effective January 1, 2002, PharmChem, Inc. adopted certain provisions of SFAS No. 142, “Goodwill and Other Intangible Assets.”

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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, except par value)