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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2003

OR

     For the transition period from                    to                   

Commission File Number 0-19371

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 ü No      

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.) Yes       No ü

     As of October 31, 2003, 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, 2002 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.

Stock-Based Compensation

     In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of SFAS No. 123. This statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair valued 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

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statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. We continue to account for stock-based compensation using Accounting Principles Boards (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and have not adopted the recognition provisions of SFAS No. 123, as amended by SFAS No. 148. However, we have adopted the disclosure provisions for the current fiscal year. The exercise price of options granted under our stock option plans is equal to the market price of our stock on the date of grant. Therefore, we have not recorded compensation cost under APB No. 25.

     We continue to apply APB No. 25 in accounting for our stock-based compensation plans. Accordingly, no compensation cost has been recorded in the consolidated statements of operations for the stock option plans. If we had determined compensation cost for all of our stock-based compensation plans in accordance with the fair value method prescribed by SFAS No. 123, our proforma net income (loss) and income (loss) per share for the three months and nine months ended September 30 would have been as follows (in thousands, except per share amounts):

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 $989,000 was used to repay debt. The remainder of the proceeds have been and will be used for general corporate purposes.

     Net sales of the discontinued operations were $1,949,000 for the nine months ended September 30, 2002. 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

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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 1,150,000 shares of our common stock for the the nine months ended September 30, 2003, and 1,185,000 shares of our common stock for the three months and nine months ended September 30, 2002, were not included in the computation of diluted income per share because their effect would have been anti-dilutive.

4. Inventories

     Inventories include laboratory materials, collection materials and products and are 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, 2003 and December 31, 2002 (in thousands):

5. Debt

     Our debt at September 30, 2003 and December 31, 2002 consisted of the following (in thousands):

     On June 26, 2003, the Company entered into a Loan and Security Agreement (“the Agreement”) with a new lender replacing its existing credit agreement. The new Agreement provides for a revolving line of credit of $3,500,000, permits borrowing at 80% of eligible receivables, has a term of three years, bears interest at prime plus 1% (5.0% as of September 30, 2003), has a one-time commitment fee of $10,000, a monthly collateral monitoring fee of $1,000, an unused line fee of 0.50% per annum, and requires the Company to maintain certain financial ratios. In addition, the Agreement provides for a term loan of up to $1,500,000 which bears interest at prime plus 3% (7.0% as of September 30, 2003), has a one-time commitment fee of $15,000 and is repayable monthly over 36 months. The initial draw down under this term loan facility was $900,000. These facilities funded on July 2, 2003 at which time our

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prior credit facility was fully paid and terminated. The remaining $600,000 balance of the term loan was drawn down on August 12, 2003.

     The new Agreement is secured by a lien on a significant portion of our assets and permits up to $1,500,000 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. Should the revolving line of credit be paid off prior to the end of the term, there would be a prepayment penalty of $35,000.

     As of September 30, 2003, the calculated maximum that could be borrowed and the amount outstanding were $3,213,000 and $2,468,000, respectively.

     As of June 30, 2003, the Company’s subordinated debt holders agreed to an early payoff of the subordinated debt at a 50% discount. The subordinated debt, as discounted, was repaid from proceeds of the term loan facility. The Company agreed to a reduction in the exercise price of the 150,000 warrants held by the subordinated debt holders from $3.00 to $0.29 (the average of the closing prices for the 30 days ending June 26, 2003). The warrants continue to expire on September 30, 2006.

     As a result of the foregoing, the Company reported a gain on the early extinguishment of debt in the current quarter of approximately $665,000, or $0.11 per diluted share, which includes reductions for the unamortized discount (established when the subordinated debt was issued) and the fair value of re-pricing the warrants.

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 158 employees were terminated as of September 30, 2003. The clean-up

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and remediation includes removal of a previously unknown storage vault and potential restoration of the facility per the lease agreement. Repairs include sewer line repair or replacement as contractually provided for in the lease agreement. The accrual balance of $220,000 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. On April 30, 2003, the Company’s attorneys received a second letter together with a draft complaint from the landlord’s counsel reiterating these allegations and requesting that the parties meet and confer to resolve the matter; otherwise the complaint will be filed. On May 14, 2003, the Company’s attorneys met with the landlord’s counsel. It was agreed that the complaint will not be filed while discussions are ongoing. However, the landlord’s counsel has not pursued this matter with the Company’s attorneys in any respect since May, 2003. The Company and its counsel are continuing to review the details of this claim and the Company will defend itself vigorously.

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, 2002. We assume no obligation to update the forward-looking statements or such factors.

Recent Events

     The Administrative Office of U.S. Courts (“AOUSC”) has awarded its drug testing program to three other laboratories. Heretofore, the Company had performed nearly all of the drug testing for AOUSC and has done so for nearly 15 years. The current contract between AOUSC and the Company originally expired late last year after running for five years. During this time, the AOUSC requested and the Company granted several extensions of the term of the existing contract, the last of which ends on November 30, 2003. However, the Company continues to perform drug testing for AOUSC on a national basis and it is unclear when the transition will commence.

     The Company believes that it has grounds to protest the award and filed a protest with the Government Accounting Office on October 23, 2003. If the protest is not successful, the loss of this customer will result in a significant adverse effect on the Company’s operations and will require it to engage in significant cost reduction measures, including sizable layoffs.

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     During the first nine months of 2003, sales to AOUSC comprised nearly $5.8 million, or 28% of the Company’s sales. It is unlikely the Company will be able to replace this business in the near future.

     On October 14, 2003, the Company received a waiver until January, 2004 of the Nasdaq $1.00 minimum bid price requirement. The waiver was granted as a result of a resolution adopted by the Board of Directors whereby the stockholders of the Company will be asked to consider a reverse stock split at a special stockholder meeting. Pursuant to the waiver, the Company must evidence a closing bid price of at least $1.00 per share on or before January 14, 2004 and, immediately thereafter, a closing bid price of at least $1.00 per share for a minimum of ten consecutive trading days. In order to comply with the terms of the waiver, the Company must also be able to demonstrate compliance with all other requirements for continued listing on The Nasdaq SmallCap Market. During this waiver period, the Company’s stock trades under the symbol PCHMC.

     See Note 5 (“Debt”) to the Notes to Condensed Consolidated Financial Statements for information regarding a Loan and Security Agreement entered into on June 26, 2003 between the Company and a new lender.

     The Company implemented further cost reduction initiatives that took effect in September 2003. Layoffs and delaying indefinitely the filling of open positions have reduced administrative headcount by nine. In addition, the salaries of officers and highly compensated employees were reduced by 5% to 25% and their merit increases were temporarily suspended. These steps will reduce costs by over $500,000 on an annualized basis.

     While the Company believes its operations in its Haltom City, Texas laboratory have experienced significant efficiencies, current volume levels and the possible loss of the AOUSC business have and may offset the continued realization of such benefits.

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

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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.

     Continued adverse changes in market conditions or poor operating results of our operations could result in additional 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 sale of Medscreen in March 2002. The following table sets forth for the periods indicated certain financial data (dollars in thousands):