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 the Company’s 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.

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	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.

	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.

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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 $4,266,767 for the three month period ended June 30, 2003 as compared to $4,792,903 for the comparable period of 2002, representing a decrease of 11%. Revenue was $7,924,334 for the six month period ended June 30, 2003 as compared to $8,361,364 for the comparable period of 2002, representing a decrease of 5%. The revenue decrease for the second quarter of 2003 and for the six months ended June 30, 2003 were due primarily to a decrease in testing volume, along with a decrease in the average revenue per sample of 1% for the three month period ended June 30, 2003 and for the six month period ended June 30, 2003 as compared to the year earlier periods. Although the Company added new customers in the first two quarters of 2003, this new business was partially offset by lower volume from existing customers. The Company believes that this lower volume from existing customers was 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 59% of revenue for the three month period ended June 30, 2003, as compared to 61% for the comparable period of 2002. Gross margin was 55% of revenue for the six month period ended June 30, 2003, as compared to 57% for the comparable period of 2002. The decrease in gross margin was due to moderate increases in labor and material costs, a decrease of 1% in average revenue per sample and a decrease in testing volume.

General and administrative (“G&A”) expenses were $862,875 for the three month period ended June 30, 2003 as compared to $820,746 for the comparable period of 2002, representing an increase of 5%. G&A expenses were $1,630,187 for the six months ended June 30, 2003 as compared to $1,566,584 for the comparable period of 2002, representing an increase of 4%. The increase in general and administrative expenses was due to greater professional fees related to legal and accounting services, greater personnel costs during the first quarter of 2003 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. Professional fees related to strategic corporate development increased during the three month period ended June 30, 2003 as compared to the three month period ended June 30, 2002, and decreased during the six month period ended June 30, 2003 as compared to the six month period ended June 30, 2002. All other general and administrative expenses remained relatively constant. As a percentage of revenue, G&A expenses increased to 20% for the three month period ended June 30, 2003 from 17% for the comparable period of 2002 and increased to 21% for the six months ended June 30, 2003 from 19% for the comparable period of 2002.

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Marketing and selling expenses were $884,625 for the three month period ended June 30, 2003 as compared to $941,177 for the comparable period of 2002, a decrease of 6%. Marketing and selling expenses were $1,756,487 for the six month period ended June 30, 2003 as compared to $1,825,113 for the comparable period of 2002, a decrease of 4%. 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 21% of revenues in the second quarter of 2003 and 20% of revenues in the second quarter of 2002. Total marketing and selling expenses represented 22% of revenues for both six month periods ended June 30, 2003 and June 30, 2002, respectively. 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 June 30, 2003 decreased by $12,134 from the comparable period of the prior year to $76,666, a decrease of 14%. Research and development (“R&D”) expenses for the six month period ended June 30, 2003 decreased by $25,029 from the comparable period of the prior year to $160,400, a decrease of 13%. This decrease was primarily due to reduced personnel and consulting costs. R&D expenses represented 2% of revenues for the three month periods and the six month periods ended June 30, 2003 and June 30, 2002, respectively.

Interest income for the three month period ended June 30, 2003 increased by $83 and increased by $1,561 for the six month period ended June 30, 2003 as compared to the comparable year earlier periods and represented interest earned on cash equivalents. Greater average investment balances in 2003 as compared to 2002 caused the increase in interest income.

During the three month period ended June 30, 2003, the Company recorded a tax provision of $285,000 reflecting an effective tax rate of 41.7% as compared to a tax provision of $443,900 reflecting an effective tax rate of 41.0% for the three month period ended June 30, 2002. During the six months ended June 30, 2003 and June 30, 2002, the Company recorded tax provisions of $360,000 and $490,000 representing effective tax rates of 41.7% and 41.5%, respectively. The variation in the effective tax rate was due primarily to the impact of permanently non-deductible items, on a lower base of pre-tax income for 2003.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2003, the Company had approximately $3.2 million of cash and cash equivalents. The Company’s operating activities generated net cash of $580,767 in the six months ended June 30, 2003. Investing activities used $102,554 in the six month period while financing activities used a net amount of $877,992 during the period.

Operating cash flow of $580,767 principally reflected net income of $503,120 adjusted for depreciation and amortization of $464,557 offset by the net change in operating assets and liabilities.

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Capital expenditures in the first two quarters of 2003 were $102,554. The expenditures primarily consisted of new equipment, including laboratory and computer equipment. The Company believes that within the next three 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 six month period ended June 30, 2003, the Company distributed $834,196 in cash dividends to its shareholders and repurchased a total of 4,900 shares of common stock for treasury at an aggregate cost of $43,796. During the second quarter of 2003, the Company’s Board of Directors approved the purchase of up to 125,000 additional shares under the Company’s stock buyback program subject to market conditions.

Contractual obligations as of June 30, 2003 were as follows:

	Purchase Commitment

The Company has a supply agreement with a vendor which requires the Company to purchase isotopes used in its drug testing procedures from this sole supplier in exchange for variable annual payments based upon prior year purchases. Purchases amounted to $218,974 for the six months ended June 30, 2003 as compared to $218,113 for the comparable period of 2002, $436,226 in 2002 and $494,672 in 2001. The Company expects to purchase approximately $438,000 for all of 2003. In exchange for exclusivity, the supplier has provided the Company with the right to purchase the isotope technology at fair market value under certain conditions, including the failure to meet the Company’s purchase commitments. This agreement does not include a fixed termination date, however, it is cancelable upon mutual agreement by both parties or six months after termination notice by the Company of its intent to use a different technology in connection with its drug testing procedures.

At June 30, 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, issuance of common stock or debt financing. At June 30, 2003, the Company had no long-term debt. The Company has paid dividends over the past six years. The Company’s current intention is to continue to declare dividends at the discretion of the Board of Directors.

Item 3.      Quantitative and Qualitative Disclosures about Market Risk

     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

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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

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 as of the end of the period covered by this report, pursuant to Exchange Act Rule 13a-15. 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.

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PART II OTHER INFORMATION

Item 1     Legal Proceeding

The Company is currently engaged in a dispute with R.N. Expertise, Inc., which has alleged that Psychemedics breached an agreement to allow R.N. Expertise, Inc. to collect hair test samples for testing by Psychemedics and that Psychemedics interfered with an advantageous business relationship. The case was originally filed on January 24, 2000 in the Circuit Court of Orange County, Florida. The plaintiff’s original and first amended complaint were both dismissed by the Court with leave to amend. In May 2001 the plaintiff filed a second amended complaint. The Company has been defending the case vigorously. Psychemedics has filed a motion for summary judgment, which is currently pending. If the motion is not granted, then the case is scheduled to go to trial in October 2003. The case is also scheduled for court-ordered mediation on August 16, 2003. Although the ultimate outcome cannot be determined, the Company believes the facts do not support the claims in this matter and the Company has meritorious defenses. In the opinion of management, resolution of this lawsuit is not expected to have a material adverse effect on the financial position of the Company. In the event of an unfavorable resolution, the Company’s earnings and cash flows in one or more future periods could be materially adversely affected.

Item 4.     Submission of Matters to a Vote of Security Holders

The Annual Meeting of Shareholders of Psychemedics Corporation was held on May 14, 2003 for the purpose of electing a board of directors. Proxies for the meeting were solicited pursuant to Section 14(a) of the Securities Exchange Act of 1934 and there was no solicitation in opposition to management’s solicitations.

Description and tabulation by the Company’s transfer agent of each matter voted upon at the Annual Meeting of Shareholders of Psychemedics Corporation held on May 14, 2003:

All of management’s nominees for directors, as listed in the proxy statement, were elected with the following votes:

Election of Directors.

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Item 6.     Exhibits and Reports on Form 8-K

	(a)		Exhibits
			See Exhibit Index included at Page 18 of this Report
	(b)		Reports on Form 8-K
			On May 9, 2003, the Company filed a report on Form 8-K to report an event under Item 12.

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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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PSYCHEMEDICS CORPORATION
FORM 10-Q
June 30, 2003

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