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SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

For quarterly period ended March 31, 2003

For the transition period from         to

Commission file number 1-13738

PSYCHEMEDICS CORPORATION

Issuer’s telephone number, including area code (617) 868-7455

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15 (d) of the Exchange Act during the past 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    [X]     No    [   ]

Indicate by check mark whether the registrant is an accelerated filer.

Yes    [  ]     No    [X ]

Number of shares outstanding of only class of Issuer’s Common Stock as of May 13, 2003: Common Stock $.005 par value (5,213,725 shares).

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PSYCHEMEDICS CORPORATION

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PSYCHEMEDICS CORPORATION
CONDENSED BALANCE SHEETS

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

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PSYCHEMEDICS CORPORATION
CONDENSED STATEMENTS OF INCOME
(UNAUDITED)

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

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PSYCHEMEDICS CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

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PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS

March 31, 2003

1.

Interim Financial Statements

The accompanying unaudited interim financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission for reporting on Form 10-Q. Accordingly, certain information and footnote disclosure required for complete financial statements are not included herein. It is recommended that these financial statements be read in conjunction with the financial statements and related notes of Psychemedics Corporation (the “Company”) as reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of financial position, results of operations, and cash flows at the dates and for the periods presented have been included. The results of operations for the three months ended March 31, 2003 may not be indicative of the results that may be expected for the year ending December 31, 2003, or any other period.

2.

Reverse Stock Split

On August 1, 2002, the Company effected a one-for-four reverse stock split. All common shares, common stock equivalents and per share amounts in the accompanying financial statements and footnotes have been retroactively adjusted to reflect the reverse stock split.

3.

Stock-Based Compensation

The Company accounts for its stock compensation arrangements with employees under the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. The Company has adopted the disclosure-only provisions of SFAS No. 123, Accounting for Stock-Based Compensation.

Statement of Financial Accounting Standards, (SFAS) No. 123, Accounting for Stock-Based Compensation, requires the measurement of the fair value of stock options or warrants to be included in the statement of income or disclosed in the notes to financial statements. The Company has computed the value of options using the Black-Scholes option pricing model prescribed by SFAS No. 123.

The assumptions used and the weighted average information are as follows:

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Consistent with SFAS No. 123, net (loss) income and basic and diluted net (loss) income per share would have been as follows:

Stock based compensation, net of tax, used to arrive at pro forma net income (loss) amounted to $50,369 and $69,547 for the three months ended March 31, 2003 and 2002, respectively. The fair value of options granted for the three months ended March 31, 2003 and 2002 was $2.85 per share and $3.51 per share, respectively.

4.

Basic and Diluted Net Income Per Share

Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share was computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period. The number of dilutive common equivalent shares outstanding during the period has been determined in accordance with the treasury-stock method. Common equivalent shares consist of common stock issuable upon the exercise of outstanding options.

Basic and diluted weighted average common shares outstanding are as follows:

For the three months ended March 31, 2003 and 2002, options to purchase 455,805 and 339,410 common shares, respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive.

5.

Revenue Recognition

Revenues from the Company’s services are generally recognized upon reporting of drug test results to the customer. At March 31, 2003 and December 31, 2002, the Company had deferred revenue of approximately $401,000 and $386,000, respectively, reflecting sales of its personal drug testing service for which the performance of the related test had not yet occurred.

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6.

Recent Accounting Pronouncements

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”. SFAS No. 148 amends SFAS No. 123, 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, SFAS No. 148 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 transition guidance and annual disclosure provisions of SFAS No. 148 was effective for fiscal years ending after December 15, 2002 and the Company complied with the disclosure guidance in its Annual Report filed on Form 10-K for the year ended December 31, 2002. The interim disclosure provisions are effective for financial reports containing financial statements for interim periods beginning after December 15, 2002. The Company has provided the required disclosure about the effects on reported net income (loss) of the Company’s accounting policy decisions with respect to stock-based employee compensation.

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Item 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FACTORS THAT MAY AFFECT FUTURE RESULTS

From time to time, information provided by the Company or statements made by its employees may contain “forward-looking” information which involves risks and uncertainties. In particular, statements contained in this report which are not historical facts (including but not limited to the Company’s expectations regarding revenues, business strategy, anticipated operating results, cash dividends and anticipated cash requirements) may be “forward looking” statements. The Company’s actual results may differ from those stated in any “forward looking” statements. Factors that may cause such differences include, but are not limited to, employee hiring practices of the Company’s principal customers, risks associated with the expansion of the Company’s sales and marketing network, market acceptance of the Company’s products, development of markets for new products and services offered by the Company, the economic health of principal customers of the Company, financial and operational risks associated with possible expansion of testing facilities used by the Company, government regulation (including, but not limited to, Food and Drug Administration regulations), competition and general economic conditions.

The Company undertakes no obligation to update any forward-looking statement, and investors are advised to review disclosures by the Company in our filings with the Securities and Exchange Commission. It is not possible to foresee or identify all factors that could cause actual results to differ from expected or historic results. Therefore, investors should not consider the foregoing factors to be an exhaustive statement of all risks, uncertainties, or factors that could potentially cause actual results to differ.

CRITICAL ACCOUNTING POLICIES

Management believes the most critical accounting policies include revenue recognition and income taxes.

	Revenue Recognition

Revenues from the Company’s services are recognized upon reporting of drug test results to the customer. Deferred revenue represents payments in advance of performance of drug testing procedures.

	Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

	Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on management’s assessment of the collectibility of its customer accounts. The Company routinely assesses the financial strength of its customers and, as a consequence, believes that its accounts receivable credit risk exposure is limited. The Company maintains an allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area.

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	Income Taxes

As part of the process of preparing the Company’s financial statements, the Company is required to estimate income taxes in each of the jurisdictions in which it operates. This process involves the preparation of an estimate of the Company’s actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the balance sheet. The Company must then assess the likelihood that the deferred tax assets will be recovered from future taxable income and to the extent it believes that recovery is not likely, it must establish a valuation allowance. To the extent the Company establishes a valuation allowance or increases this allowance in a period, it must include an expense within the tax provision in the statement of operations.

     Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against net deferred tax assets. In the event that actual results differ from these estimates or the Company adjusts these estimates in future periods, it may need to establish a valuation allowance, which could materially impact the Company’s financial position and results of operations. The Company does not believe any valuation allowance is necessary at this time given the level of pre-tax earnings over the past several years and its expected future earnings.

The above listing is not intended to be a comprehensive list of all of the Company’s accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.

OVERVIEW

Psychemedics Corporation was incorporated in 1986. The Company utilizes a patented hair analysis method involving radioimmunoassay technology to analyze human hair to detect abused substances.

RESULTS OF OPERATIONS

Revenue was $3,657,567 for the three month period ended March 31, 2003 as compared to $3,568,461 for the comparable period of 2002, representing an increase of 2%. The increase in revenue for the first quarter of 2003 was due to an increase in testing volume, while the average revenue per sample remained relatively constant as compared to the comparable period of 2002. Although the Company added new customers in the first quarter of 2003, this new business was partially offset by lower volume from existing customers. The Company believes that this lower volume from existing customers is due largely to the continued current economic downturn as many existing clients experienced deep reductions in their new hires and the related number of their drug tests.

Gross margin was 52% of revenue for the three month period ended March 31, 2003, as compared to 51% for the comparable period of 2002. Reduced depreciation expense contributed to a decline in fixed costs for the three month period ending March

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31, 2003 as compared to the year earlier period. Also, fixed and semi-variable direct costs were spread over a greater number of tests performed and average revenue per sample remained approximately the same for the three month period ended March 31, 2003, as compared to the same period of 2002.

General and administrative (“G&A”) expenses were $767,312 for the three month period ended March 31, 2003 as compared to $745,838 for the comparable period of 2002, representing an increase of 3%. The increase in general and administrative expenses was due to greater professional fees related to legal and accounting services, greater personnel costs and an increase in business insurance costs, partially offset by reduced professional fees related to strategic corporate development and a decrease in bad debt expense. All other general and administrative expenses remained relatively constant. As a percentage of revenue, G&A expenses represented 21% of revenues in both the first quarter of 2003 and the first quarter of 2002.

Marketing and selling expenses were $871,862 for the three month period ended March 31, 2003 as compared to $883,936 for the comparable period of 2002, a decrease of 1%. This decrease was primarily due to a reduction in selling expenses related to the Company’s personal drug testing kits while all other marketing and selling expenses remained relatively constant. Total marketing and selling expenses represented 24% of revenues in the first quarter of 2003 and 25% of revenues in the first quarter of 2002. The Company expects to continue to aggressively promote its drug testing services during the remainder of 2003 and in future years in order to expand its client base.

Research and development (“R&D”) expenses for the three month period ended March 31, 2003 decreased by $12,895 from the comparable period of the prior year to $83,734, a decrease of 13%. This decrease was primarily due to reduced personnel and consulting costs. As a percentage of revenue, R&D expenses decreased to 2% for the three months ended March 31, 2003 from 3% for the comparable period of 2003.

Interest income for the three month period ended March 31, 2003 increased by $1,478 as compared to the year earlier period and represented interest earned on cash equivalents. Greater average investment balances in the first quarter of 2003 as compared to the first quarter of 2002 caused the increase in interest income.

During the three months ended March 31, 2003, the Company recorded a tax provision of $75,000 reflecting an effective tax rate of 41.8% as compared to a tax provision of $46,100 and an effective tax rate of 46.8% for the three months ended March 31, 2002. The variation in the effective tax rate was due primarily to a decrease in non-deductible expenses for tax purposes on a higher base of income before tax in the first quarter of 2003 versus the first quarter of 2002.

LIQUIDITY AND CAPITAL RESOURCES

At March 31, 2003, the Company had approximately $3.2 million of cash and cash equivalents. The Company’s operating activities generated net cash of $7,020 in the three months ended March 31, 2003. Investing activities used $50,756 in the three month period while financing activities used a net amount of $441,416 during the period.

Operating cash flow of $7,020 principally reflected net income of $104,339 adjusted for depreciation and amortization of $240,978 offset by the net change in operating assets and liabilities.

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Capital expenditures in the first three months of 2003 were $50,756. The expenditures primarily consisted of new equipment, including laboratory and computer equipment. The Company believes that within the next two to four years it may be required to expand its existing laboratory or develop a second laboratory, the cost of which is currently believed to range from $2 million to $4 million.

During the three month period ended March 31, 2003, the Company distributed $417,098 in cash dividends to its shareholders and repurchased a total of 2,600 shares of common stock for treasury at an aggregate cost of $24,318.

Contractual obligations as of March 31, 2003 were as follows:

At March 31, 2003, the Company’s principal sources of liquidity included an aggregate of approximately $3.2 million of cash and cash equivalents. Management currently believes that such funds, together with cash generated from operations, should be adequate to fund anticipated working capital requirements and capital expenditures in the near term. Depending upon the Company’s results of operations, its future capital needs and available marketing opportunities, the Company may use various financing sources to raise additional funds. Such sources could potentially include joint ventures, issuances of common stock or debt financing, although the Company does not have any such plans at this time. At March 31, 2003, the Company had no long-term debt.

The Company’s exposure to market risk related to changes in interest rates is limited as the Company maintains a short-term investment portfolio consisting principally of money market securities that are not sensitive to sudden interest rate changes. The Company does not use derivative financial instruments for speculative or trading purposes.

Interest Rate Sensitivity. The Company maintains a short-term investment portfolio consisting principally of money market securities that are not sensitive to sudden interest rate changes.

Item 4. Controls and Procedures

Within the 90 days prior to the date of this report, our Chief Executive Officer and Chief Financial Officer performed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in ensuring the reporting of material information required to be included in the Company’s periodic filings with the Securities and Exchange Commission. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these internal controls subsequent to the date of the most recent evaluation.

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PART II OTHER INFORMATION

Item 6. Exhibits and Reports on Form 8-K

		(a)		Exhibits
				See Exhibit Index included in this Report
				No reports on Form 8-K were filed during the quarter for which this report is filed.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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CERTIFICATIONS

I, Raymond C. Kubacki, Jr., President and Chief Executive Officer of Psychemedics Corporation, certify that:

1.		I have reviewed this quarterly report on Form 10-Q of Psychemedics Corporation;
2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a)

all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

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b)

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.

The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

I, Peter C. Monson, Vice President, Treasurer and Chief Financial Officer of Psychemedics Corporation, certify that:

1.		I have reviewed this quarterly report on Form 10-Q of Psychemedics Corporation;
2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

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5.

The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.

The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: May 13, 2003		By: /s/ Peter C. Monson
		Peter C. Monson Vice President, Treasurer & Chief Financial Officer

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PSYCHEMEDICS CORPORATION
FORM 10-Q
March 31, 2003
EXHIBIT INDEX

Exhibit No.		Description
99.1		Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
99.2		Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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