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SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

For quarterly period ended September 30, 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 November 5, 2003: Common Stock $.005 par value (5,163,125 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 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

September 30, 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 and the nine months ended September 30, 2003 may not be indicative of the results that may be expected for the year ending December 31, 2003, or any other period.

2. 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 income and basic and diluted net income per share would have been as follows:

The fair value of options granted for the three months ended September 30, 2003 was $2.45 per share. No options were granted for the three months ended September 30, 2002. The fair value of options granted for the nine months ended September 30, 2003 and 2002 was $2.73 per share and $3.52 per share, respectively.

3. Basic and Diluted Net Income Per Share

Basic net income per share was 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 September 30, 2003 and 2002, options to purchase 449,094 and 428,605 common shares, respectively, were outstanding but not included

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in the diluted weighted average common share calculation as the effect would have been antidilutive. For the nine months ended September 30, 2003 and 2002, options to purchase 449,094 and 418,948 common shares, respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive.

4. Revenue Recognition

Revenues from the Company’s services are generally recognized upon reporting of drug test results to the customer. At September 30, 2003 and December 31, 2002, the Company had deferred revenue of approximately $424,000 and $386,000, respectively, reflecting sales of its personal drug testing service for which the performance of the related test had not yet occurred.

5. Recent Accounting Pronouncements

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure”. SFAS No. 148 amended 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 amended 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 were 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.

In November 2002, the EITF finalized its consensus on EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables (EITF 00-21), which provides guidance on the timing and method of revenue recognition for sales arrangements that include the delivery of more than one product or service. EITF 00-21 is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. Under EITF 00-21, revenue must be allocated to all deliverables regardless of whether an individual element is incidental or perfunctory. The Company adopted EITF 00-21 in the third quarter of 2003 and its adoption did not have any impact on the Company’s financial statements.

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (FIN No. 46) to clarify the conditions under which assets, liabilities and activities of another entity should be consolidated into the financial statements of a company. FIN No. 46 requires the consolidation of a variable interest entity by a company that bears the majority of the risk of loss from the variable interest entity’s activities, is entitled to receive a majority of the variable interest entity’s residual returns or both. The provisions of FIN No. 46 are required to be adopted by the Company in fiscal 2003. The adoption of FIN No. 46 is not expected to have a material impact on the Company’s overall financial position or results of operations.

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6. Subsequent Event - Dividends

On November 3, 2003, the Company declared a quarterly dividend of $.08 per share, which will be paid on December 19, 2003 to shareholders of record on December 5, 2003.

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.

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     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.

     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 $4,166,055 for the three month period ended September 30, 2003 as compared to $4,344,685 for the comparable period of 2002, representing a decrease of 4%. The revenue decrease for the third quarter of 2003 was due primarily to a 1% decrease in testing volume, along with a decrease in the average revenue per sample of 3% for the three month period ended September 30, 2003 as compared to the year earlier period. Revenue was $12,090,389 for the nine month period ended September 30, 2003 as compared to $12,706,049 for the comparable period of 2002, representing a decrease of 5%. The revenue decrease for the nine months ended September 30, 2003 was due primarily to a 4% decrease in testing volume, along with a decrease in the average revenue per sample of 1% for the nine month period ended September 30, 2003 as compared to the year earlier period. Although the Company added new customers in the first three 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 58% of revenue for the three month period ended September 30, 2003, as compared to 59% for the comparable period of 2002. Gross margin was 56% for the nine months ended September 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, along with the aforementioned decreases in average revenue per sample and testing volume.

General and administrative (“G&A”) expenses were $879,420 for the three month period ended September 30, 2003 as compared to $787,965 for the comparable period of 2002, representing an increase of 12%. The increase in general and administrative expenses for the three month period ended September 30, 2003 as compared to the year earlier period was due to greater professional fees related to legal and accounting services, an increase in business insurance costs and an increase in professional fees related to strategic corporate development, partially offset by a decrease in bad debt expense. G&A expenses were $2,509,607 for the nine months ended September 30, 2003 as compared to $2,354,549 for the comparable period of 2002, representing an increase of 7%. The increase in general and administrative expenses for the nine month period ended September 30, 2003 as compared to the year earlier period was due to greater professional fees related to legal and accounting services, an increase in business insurance costs and greater personnel costs during the first quarter of 2003, partially offset by a decrease in bad debt expense. All other general and administrative expenses remained relatively constant. As a percentage of revenue, G&A expenses increased to 21% in the third quarter of 2003 from 18% in the third quarter of 2002 and increased to 21% for the nine months ended September 30, 2003 from 19% for the comparable period of 2002.

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Marketing and selling expenses were $868,903 for the three month period ended September 30, 2003 as compared to $959,566 for the comparable period of 2002, a decrease of 9%. Marketing and selling expenses were $2,625,390 for the nine months ended September 30, 2003 as compared to $2,784,679 for the year earlier period, representing a decrease of 6%. This decrease was primarily due to a reduction in customer service costs and selling expenses related to the Company’s personal drug testing kits while all other marketing and selling expenses remained relatively constant. As a percentage of revenue, marketing and selling expenses decreased to 21% for the three months ended September 30, 2003 from 22% in the third quarter of 2002 and remained at 22% for the nine month periods ended September 30, 2003 and 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 were $70,265 for the three month period ended September 30, 2003 as compared to $84,460 for the comparable period of 2002, a decrease of 17%. R&D expenses were $230,665 for the nine months ended September 30, 2003 as compared to $269,889 for the comparable period of 2002, representing a decrease of 15%. 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 nine month periods ended September 30, 2003 and 2002.

Interest income decreased by $450 for the three month period ended September 30, 2003 and increased by $1,111 for the nine month period ended September 30, 2003 as compared to the year earlier periods. Interest income decreased for the three month period ended September 30, 2003 as compared to the year earlier period due to a decrease in average investment balances, partially offset by an increase in the yield on investment balances. Interest income increased for the nine month period ended September 30, 2003 as compared to the year earlier period due to an increase in the yield on investment balances, partially offset by a decrease in average investment balances.

During the three months ended September 30, 2003, the Company recorded a tax provision of $252,000 reflecting an effective tax rate of 41.8% as compared to a tax provision of $306,400 and an effective tax rate of 41.4% for the three months ended September 30, 2002. During the nine months ended September 30, 2003 and September 30, 2002, the Company recorded tax provisions of $612,000 and $796,400 representing effective tax rates of 41.8% and 41.4%, 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 September 30, 2003, the Company had $3,082,218 of cash and cash equivalents. The Company’s operating activities generated net cash of $1,111,181 in the nine months ended September 30, 2003. Investing activities used $106,182 in the nine month period while financing activities used $1,571,694 during the period.

Operating cash flow of $1,111,181 principally reflected net income of $853,611 adjusted for depreciation and amortization of $666,972 offset by the net change in operating assets and liabilities.

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Capital expenditures in the first three quarters of 2003 were $106,182. 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 nine month period ended September 30, 2003, the Company distributed $1,249,030 in cash dividends to its shareholders and repurchased a total of 38,000 shares of common stock for treasury at an aggregate cost of $322,664.

Contractual obligations as of September 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 $328,547 for the nine months ended September 30, 2003 as compared to $327,168 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 September 30, 2003, the Company’s principal source of liquidity was $3,082,218 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 September 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 Company does not use derivative financial instruments for speculative or trading purposes.

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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.

PART II OTHER INFORMATION

Item 1 Legal Proceeding

On October 24, 2003, a jury in Orange County, Florida ruled in favor of the Company on one count, and the Company received a directed verdict in its favor on the remaining count, in its dispute with R.N. Expertise, Inc. The plaintiff had 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.

Item 6. Exhibits and Reports on Form 8-K

	(a)		Exhibits
			See Exhibit Index included in this Report
	(b)		Reports on Form 8-K
			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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PSYCHEMEDICS CORPORATION
FORM 10-Q
September 30, 2003
EXHIBIT INDEX

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