SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

For quarterly period ended September 30, 2004

For the transition period from                                        to                                       

Commission file number 1-13738

PSYCHEMEDICS CORPORATION

Issuer’s telephone number, including area code (978-206-8220)

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, 2004: Common Stock $.005 par value (5,126,907 shares).

PSYCHEMEDICS CORPORATION

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PSYCHEMEDICS CORPORATION

See accompanying notes to financial statements.

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PSYCHEMEDICS CORPORATION

See accompanying notes to financial statements.

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PSYCHEMEDICS CORPORATION

See accompanying notes to financial statements.

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PSYCHEMEDICS CORPORATION

See accompanying notes to financial statements.

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PSYCHEMEDICS CORPORATION

September 30, 2004

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, 2003. 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, 2004 may not be indicative of the results that may be expected for the year ending December 31, 2004, 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, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure.

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:

No options were granted for the three months ended September 30, 2004. The fair value of options granted for the three months ended September 30, 2003 was $2.45 per share. The fair value of options granted for the nine months ended September 30, 2004 and 2003 was $2.19 per share and $2.73 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.

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

For the three months ended September 30, 2004 and 2003, options to purchase 368,912 and 449,094 common shares, respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive. For the nine months ended September 30, 2004 and 2003, options to purchase 384,362 and 449,094 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

The Company performs drug testing as well as provides training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. The revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer. The Company also provides expert testimony, when and if necessary, to support the results of the tests, which is generally billed separately and recognized as the services are provided.

In 2003, the Company adopted Emerging Issue Task Force 00-21, Revenue Arrangements with Multiple Deliverables, which was effective for all transactions entered into subsequent to June 15, 2003. The Company applied the consensus reached under EITF 00-21 and concluded that the testing, training and storage elements are considered one unit of accounting for revenue recognition purposes as the training and storage costs do not have stand-alone value to the customer. The Company has concluded that the predominant deliverable in the arrangement is the testing of the units and has recognized revenue as that service is performed and reported to the customer.

At September 30, 2004 and December 31, 2003, the Company had deferred revenue of approximately $469,000 and $432,000, respectively, reflecting sales of its personal drug testing service for which the performance of the related test had not yet occurred.

5. Reclassifications

The Company has reclassified the cost of collecting hair samples from sales and marketing expenses to cost of services to permit comparison with the current year. The impact of this reclassification reduced gross profit by $165,533 in the third quarter of 2003 and $503,327 for the nine months ended September 30, 2003 and was offset by reduced sales and marketing expenses of $165,533 in the third quarter of 2003 and $503,327 for the nine months ended September 30, 2003, but had no effect on operating income or net income in the third quarter of 2003 or nine months ended September 30, 2003.

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6. Recent Accounting Pronouncements

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities. In December 2003, the FASB issued a revised interpretation. Interpretation No. 46 requires variable interest entities to be consolidated if the total equity investment at risk is not sufficient to permit the entity to finance its activities without financial support from other parties or the equity investors lack certain specified characteristics of a controlling financial interest. The guidelines of Interpretation No. 46 were applicable for the Company during the first quarter of 2004. The Company’s adoption of Interpretation No. 46 did not have any impact on the Company’s consolidated financial statements.

7. Contingencies

The Company is subject to legal proceedings and claims, which arise in the ordinary course of its business. The Company believes that based upon information available to the Company at this time, the expected outcome of these matters would not have a material impact on the Company’s results of operations or financial condition.

8. Subsequent Event — Dividends

On October 27, 2004, the Company declared a quarterly dividend of $.08 per share, which will be paid on December 24, 2004 to shareholders of record on December 10, 2004.

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Item 2

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

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.

Revenue for the third quarter of 2004 was $4.9 million and was 17% above revenue of $4.2 million for the third quarter of 2003. Revenue for the first three quarters of 2004 was $14.4 million and was 19% above revenue of $12.1 million for the first three quarters of 2003. Due to the increase in revenue and by maintaining tight controls over expenses, the Company reported net income of $0.16 per share in the quarter ended September 30, 2004 and net income of $0.43 per share for the nine months ended September 30, 2004. At September 30, 2004, the Company had $3.7 million of cash and cash equivalents. The Company distributed $0.4 million, or $0.08 per share, of cash dividends to its shareholders in each of the first three quarters of 2004, which represented year to date totals of $1.2 million, or $0.24 per share. As of the date of this Report, the Company has paid thirty-two consecutive quarterly cash dividends.

RESULTS OF OPERATIONS

Revenue was $4,870,218 for the three month period ended September 30, 2004 as compared to $4,166,055 for the comparable period of 2003, representing an increase of 17%. Revenue was $14,373,139 for the nine month period ended September 30, 2004 as compared to $12,090,389 for the comparable period of 2003, representing an increase of 19%. The increase in revenue for the third quarter of 2004 was due to an increase of 12% in testing volume from both new and existing clients, while the average revenue per sample increased by approximately 5% as compared to the comparable period of 2003. The increase in average revenue per sample was due primarily to a short-term fluctuation in client mix and additional billable amounts (shipping and collection charges) to certain clients. The increase in revenue for the nine months ended September 30, 2004 was due to an increase of 17% in testing volume from both new and existing clients, while the average revenue per sample increased by 2% as compared to the comparable period of 2003. The Company believes that the growth in testing volume was due to an improvement in the hiring environment at new and existing customers. The Company continued to add approximately the same number of new clients for the nine months ended September 30, 2004 as it did in the comparable period of 2003.

Gross margin was approximately 57% of revenue for the three month period ended September 30, 2004, as compared to 54% for the comparable period of 2003. Gross margin was 56% of revenue for the nine month period ended September 30, 2004, as compared to 52% for the comparable period of 2003. Reduced depreciation and amortization expense contributed to a decline in fixed costs for the three month period and the nine month period ended September 30, 2004 as compared to the year earlier periods. The Company experienced reduced depreciation and amortization as more of its fixed assets became fully depreciated. Also, fixed and semi-variable direct costs were spread over a greater number of tests performed and average revenue per

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sample increased by 5% and 2% for the three month period and the nine month period ended September 30, 2004, respectively, as compared to the same periods of 2003.

General and administrative (“G&A”) expenses were $803,940 for the three month period ended September 30, 2004 as compared to $879,420 for the comparable period of 2003, representing a decrease of 9%. G&A expenses were $2,416,796 for the nine month period ended September 30, 2004 as compared to $2,509,607 for the comparable period of 2003, representing a decrease of 4%. The decrease in general and administrative expenses for the three month period ended September 30, 2004 as compared to the comparable period of 2003 was due primarily to a decrease in personnel expenses of approximately $26,000, a drop in professional fees related to legal services of approximately $57,000, a reduction in professional fees related to strategic corporate development of approximately $28,000 and a decrease in bad debt expense of approximately $11,000, offset by an increase professional fees related to investor relations, accounting services, and corporate governance of approximately $35,000. Minor variations in all other general and administrative expenses amounted to an increase of approximately $12,000. The decrease in general and administrative expenses for the nine month period ended September 30, 2004 as compared to the comparable period of 2003 was due primarily to a drop in personnel expenses of approximately $108,000, a reduction in professional fees related to strategic corporate development of approximately $56,000, a decrease in bad debt expense of approximately $72,000 and a drop in professional fees related to legal services of approximately $20,000, partially offset by an increase of approximately $113,000 in professional fees related to investor relations, auditing fees, and corporate governance and an increase in business insurance costs of approximately $28,000. Minor variations in all other general and administrative expenses amounted to an increase of approximately $22,000. As a percentage of revenue, G&A expenses decreased to 17% for the three month period ended September 30, 2004 from 21% for the comparable period of 2003 and decreased to 17% for the nine months ended September 30, 2004 from 21% for the comparable period of 2003. The decrease in G&A expenses as a percentage of revenue is due to the aforementioned decreases and the fact a significant portion of G&A expenses consist of costs that are primarily fixed and semi-variable being spread over a greater revenue base.

Marketing and selling expenses were $673,724 for the three month period ended September 30, 2004 as compared to $703,370 for the comparable period of 2003, a decrease of 4%. Marketing and selling expenses were $1,893,877 for the nine month period ended September 30, 2004 as compared to $2,122,063 for the comparable period of 2003, a decrease of 11%. The decrease for the three month period ended September 30, 2004 as compared to the comparable period of 2003 was due primarily to a reduction in personnel expenses resulting from operational efficiencies pertaining to the Company’s customer service staff along with a decrease in amortization expense pertaining to software development costs. The decrease for the nine month period ended September 30, 2004 as compared to the comparable period of 2003 was due primarily to a reduction in personnel expenses pertaining to the Company’s sales, sales support and customer service staff along with a decrease in amortization expense

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pertaining to software development costs. Total marketing and selling expenses represented 14% of revenue in the third quarter of 2004 and 17% of revenue in the third quarter of 2003. Total marketing and selling expenses represented 13% of revenue for the nine month period ended September 30, 2004 and 18% of revenue for the nine month period ended September 30, 2003. The Company believes that revenue growth not only was due to an improvement in the hiring environment at existing customers, but also reflected the addition of new clients. The Company expects to continue to aggressively promote its drug testing services during the remainder of 2004 and in future years in order to expand its client base.

Research and development (“R&D”) expenses for the three month period ended September 30, 2004 increased by $13,589 from the comparable period of the prior year to $83,854, an increase of 19%. Research and development (“R&D”) expenses for the nine month period ended September 30, 2004 increased by $3,527 from the comparable period of the prior year to $234,192, an increase of 2%. This increase was primarily due to increased personnel and consulting costs. R&D expenses represented 2% of revenue for both of the three month periods and both of the nine month periods ended September 30, 2004 and September 30, 2003.

Interest income for the three month period ended September 30, 2004 decreased by $1,143 and decreased by $8,259 for the nine month period ended September 30, 2004 as compared to the comparable year periods and represented interest earned on cash equivalents. Lower average investment balances along with a decrease in the yield on investment balances in 2004 as compared to 2003 caused the decrease in interest income.

During the three month period ended September 30, 2004, the Company recorded a tax provision of $414,000 reflecting an effective tax rate of 34.1% as compared to a tax provision of $252,000 reflecting an effective tax rate of 41.8% for the three month period ended September 30, 2003. During the nine months ended September 30, 2004 and September 30, 2003, the Company recorded tax provisions of $1,282,000 and $612,000 representing effective tax rates of 36.6% and 41.8%, respectively. A portion of the variation in the effective tax rate resulted from the Company reducing its tax accrual and tax provision by $40,000 during the third quarter of 2004 in order to properly reflect its estimated taxes payable. The variation in the effective tax rate was also due to reduced state income taxes due to lower expected state taxes than provided for in the prior year and the reduced impact of permanently non-deductible items, on a higher base of pre-tax income for 2004.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2004, the Company had approximately $3.7 million of cash and cash equivalents. The Company’s operating activities generated net cash of $2,142,029 in the nine months ended September 30, 2004. Investing activities used $257,854 in the nine month period while financing activities used a net amount of $1,230,458 during the period.

Operating cash flow of $2,142,029 for the nine months ended September 30, 2004 principally reflected net income of $2,218,186, adjusted for depreciation and amortization of $404,491, along with the increase in accrued expenses and accounts payable offset primarily by the growth in accounts receivable and prepaid expenses. The growth in revenue outpaced the collection of receivables, thereby causing the

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growth in accounts receivable. Operating cash flow of $2,142,029 for the nine months ended September 30, 2004 was greater than operating cash flow of $1,111,181 for the nine months ended September 30, 2003 due principally to an increase in net income and an increase in accrued expenses and accounts payable, partially offset by reduced depreciation and amortization and an increase in accounts receivable.

Capital expenditures in the first three quarters of 2004 were $251,674 as compared to $106,182 for the comparable period of 2003. The expenditures primarily consisted of new equipment, including laboratory and computer equipment. The Company currently plans to make additional capital expenditures of approximately $200,000 during the balance of 2004, primarily in connection with the purchase of additional 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 nine month period ended September 30, 2004, the Company distributed $1,230,458 in cash dividends to its shareholders. The Company did not repurchase any shares for treasury during the nine month period ended September 30, 2004. 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. The Company has authorized 500,000 shares for repurchase since September of 1998 of which 466,351 shares have been repurchased as of September 30, 2004.

Contractual obligations as of September 30, 2004 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 $329,301 for the nine months ended September 30, 2004 as compared to $328,548 for the comparable period of 2003. The Company expects to purchase approximately $439,000 for all of 2004. 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, 2004, the Company’s principal sources of liquidity included an aggregate of approximately $3.7 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

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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 September 30, 2004, the Company had no long-term debt.

CRITICAL ACCOUNTING POLICIES

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

     Revenue Recognition

The Company is in the business of performing drug testing and reporting the results thereof. The Company performs drug testing which includes training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. The revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer. The Company also provides expert testimony, when and if necessary, to support the test results, which is generally billed separately and recognized as the services are provided.

In 2003, the Company adopted Emerging Issue Task Force 00-21, Revenue Arrangements with Multiple Deliverables, which was effective for all transactions entered into subsequent to June 15, 2003. The Company applied the consensus reached under EITF 00-21 and concluded that the testing, training and storage elements are considered one unit of accounting for revenue recognition purposes as the training and storage costs do not have stand-alone value to the customer. The Company has concluded that the predominant deliverable in the arrangement is the testing of the units and has recognized revenue as that service is performed and reported to the customer.

Deferred revenue represents payments received in advance of the performance of drug testing procedures. Deferred revenue is reclassified as revenue when the underlying test results are delivered. With respect to a portion of these transactions, there may be instances where the customer ultimately does not require performance (referred to as breakage). Revenue is then recognized (as other income) when the Company can reasonably, reliably and objectively determine the breakage has occurred. Breakage is deemed to occur only at the point it becomes remote that performance will be required. The Company has not recorded any breakage in the first three quarters of 2004 and during 2003. The Company continues to monitor this to determine whether breakage can be reasonably, reliably and objectively determined.

     Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates, including bad debts and income taxes, 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. Management reviews its accounts receivable aging for doubtful accounts and specifically identifies accounts that may not be collectible. 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. Bad debt expense and the issuance of credit memos have been within management’s expectations.

     Income Taxes

The Company accounts for income taxes using the liability method, which requires the Company to recognize a current tax liability or asset for current taxes payable or refundable and a deferred tax liability or asset for the estimated future tax effects of temporary differences between the financial statement and tax reporting bases of assets and liabilities to the extent that they are realizable. Deferred tax expense (benefit) results from the net change in deferred tax assets and liabilities during the year. A deferred tax valuation allowance is required if it is more likely than not that all or a portion of the recorded deferred tax assets will not be realized.

     The Company operates within multiple taxing jurisdictions and could be subject to audit in these jurisdictions. These audits may involve complex issues, which may require an extended period of time to resolve. The Company has provided for its estimated taxes payable in the accompanying financial statements.

     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, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure.

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.

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, strategies with respect to governmental agencies and regulations, cash dividends, cost savings, capital expenditures and

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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, 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. With respect to the continued payment of cash dividends, factors include, but are not limited to, available surplus, cash flow, capital expenditure reserves required, and other factors that the Board of Directors of the Company may take into account.

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.

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

As of 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 over financial reporting or in other factors that could significantly affect these internal controls over financial reporting subsequent to the date of the most recent evaluation.

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PART II OTHER INFORMATION

Item 1 Legal Proceeding

The Company is named in a lawsuit as a codefendant with Anderson Chevrolet, AutoNation Inc., and two of Anderson Chevrolet’s employees. The plaintiff is a former employee of Anderson Chevrolet who has alleged that she was wrongfully terminated by Anderson Chevrolet after two drug tests utilizing the Company’s technology indicated a positive result for the presence of cocaine. The plaintiff maintains that the positive results were caused by passive exposure. She has also alleged that the Company violated her civil rights by disclosing the positive test results to the client. Finally, she has alleged that the Company engaged in conduct that constitutes a violation of California law prohibiting intentional and negligent interference with prospective economic advantage. The court denied the Company’s Motions for Summary Judgement and Motion for Summary Adjudication with respect to these alleged claims. The case was scheduled to go to trial on September 7, 2004, but has now been rescheduled for May 2005. 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 and based on the information the Company has at the present time, 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 6. Exhibits

			See Exhibit Index included at Page 20 of this Report

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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, 2004