SECURITIES AND EXCHANGE COMMISSION

Form 10-Q

(Mark One)

For quarterly period ended March 31, 2005

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 þ No o

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

Yes o No þ

Number of shares outstanding of only class of Issuer’s Common Stock as of May 12, 2005: Common Stock $.005 par value (5,161,947 shares).

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PSYCHEMEDICS CORPORATION

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PSYCHEMEDICS CORPORATION

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

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

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

March 31, 2005

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, 2004. 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, 2005 may not be indicative of the results that may be expected for the year ending December 31, 2005, 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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PSYCHEMEDICS CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

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 March 31, 2005. The fair value of options granted for the three months ended March 31, 2004 was $2.86 per share.

3. 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 is 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, 2005 and 2004, options to purchase 291,283 and 378,375 common shares, respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive.

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PSYCHEMEDICS CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

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 March 31, 2005 and December 31, 2004, the Company had deferred revenue of approximately $503,000 and $488,000, 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 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The new standard will be effective for the Company on January 1, 2006. The Company has not yet assessed the impact of adopting this new standard.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions. The amendments made by SFAS No. 153 are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, the amendments eliminate the narrow exception for nonmonetary exchanges of similar productive assets and replace it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. Previously, Opinion No. 29 required that the accounting for an exchange of a productive asset for a similar productive asset or an equivalent interest in the same or similar productive asset should be based on the recorded amount of the asset relinquished. The new standard will be effective for nonmonetary asset exchanges

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PSYCHEMEDICS CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

occurring in fiscal periods beginning after June 15, 2005. The Company has not yet assessed the impact of adopting this new standard.

6. 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.

7. Subsequent Event — Dividends

On April 27 2005, the Company declared a quarterly dividend of $.08 per share, which will be paid on June 24, 2005 to shareholders of record on June 10, 2005.

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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 was $5.3 million for the first quarter of 2005 and was 28% above revenue of $4.2 million for the first quarter of 2004. Due to the increase in revenue and gross profit, the Company reported net income of $0.18 per share in the quarter ended March 31, 2005 as compared to $0.09 per share in the quarter ended March 31, 2004. At March 31, 2005, the Company had $4.1 million of cash, cash equivalents, and short-term investments and securities held for sale. During the first quarter of 2005, the Company distributed $0.4 million, or $0.08 per share, of cash dividends to its shareholders. As of the date of this Report, the Company has paid thirty-four consecutive quarterly cash dividends.

RESULTS OF OPERATIONS

Revenue was $5,337,750 for the three months ended March 31, 2005 as compared to $4,155,872 for the comparable period of 2004, representing an increase of 28%. The increase in revenue for the first quarter of 2005 was due to an increase of 31% in testing volume from both new and existing clients, while the average revenue per sample decreased by 3% as compared to the comparable period of 2004. The Company continued to add approximately the same number of new clients in the first quarter of 2005 as it did in the first quarter of 2004.

Gross margin was 59% of revenue for the three months ended March 31, 2005, as compared to 52% for the comparable period of 2004. Even though average revenue per sample decreased by 3%, fixed and semi-variable direct costs were spread over a greater number of tests performed for the three months ended March 31, 2005, as compared to the same period of 2004. Also, reduced depreciation and amortization expense contributed to a decline in fixed costs for the three months ended March 31, 2005 as compared to the comparable period of 2004.

General and administrative (“G&A”) expenses were $872,638 for the three months ended March 31, 2005 as compared to $743,801 for the comparable period of 2004, representing an increase of 17%. The increase in general and administrative expenses was due primarily to greater professional fees related to accounting services and Sarbanes-Oxley compliance along with an increase in personnel expenses. All other general and administrative expenses remained relatively constant. As a percentage of revenue, G&A expenses represented 16% of revenues in the first quarter of 2005 and 18% of revenues in the first quarter of 2004. The Company expects general and administrative expenses to increase in absolute dollars and decrease as a percentage of revenue during the remainder of 2005 primarily due to increased professional fees and costs related to corporate governance and Sarbanes-Oxley compliance.

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Marketing and selling expenses were $729,081 for the three months ended March 31, 2005 as compared to $606,529 for the comparable period of 2004, an increase of 20%. This increase was due primarily to an increase in personnel expenses pertaining to the Company’s sales and support staff for the three months ended March 31, 2005 as compared to the comparable period of 2004. Total marketing and selling expenses represented 14% of revenues in the first quarter of 2005 and 15% of revenues in the first quarter of 2004. The Company expects marketing and selling expenses to increase in absolute dollars and decrease as a percentage of revenue during the remainder of 2005 as resources are committed to direct selling efforts to aggressively promote its drug testing services in order to expand its client base.

Research and development (“R&D”) expenses were $71,947 for the three months ended March 31, 2005 as compared to $77,019 for the comparable period of 2004, a decrease of 7%. This decrease was primarily due to reduced consumables costs. R&D expenses represented 1% of revenues for the three months ended March 31, 2005 and 2% of revenues for the three months ended March 31, 2004. The Company does not expect any significant changes in research and development expenses during the remainder of 2005 as compared to 2004.

Interest income for the three months ended March 31, 2005 increased by $4,715 as compared to the comparable period of 2004 and represented interest and dividends earned on cash equivalents and short-term investments. An increase in the yield on investment balances in the first quarter of 2005 as compared to the first quarter of 2004 caused the increase in interest income, as average investment balances remained relatively constant.

During the three months ended March 31, 2005, the Company recorded a tax provision of $565,000 reflecting an effective tax rate of 37.3% as compared to a tax provision of $282,500 and an effective tax rate of 38.4% for the three months ended March 31, 2004. The lower effective tax rate for the quarter ended March 31, 2005 as compared to the quarter ended March 31, 2004 was due primarily to reduced state income taxes.

LIQUIDITY AND CAPITAL RESOURCES

At March 31, 2005, the Company had approximately $4.1 million of cash, cash equivalents and short-term investments. The Company’s operating activities provided net cash of $946,411 in the three months ended March 31, 2005. Investing activities used $2,037,830 in the three month period while financing activities used a net amount of $99,976 during the period.

Cash provided by operating activities of $946,411 principally reflected net income of $948,140 adjusted for depreciation and amortization of $120,408 as the change resulting from the growth in accounts receivable and prepaid expenses was offset by the growth in accrued expenses.

Capital expenditures in the first three months of 2005 were $40,058. The expenditures primarily consisted of new equipment, including laboratory and computer equipment. The Company currently plans to make capital expenditures of approximately $600,000 in 2005, primarily in connection with the purchase of additional laboratory and computer equipment. The Company believes that within the next two to five years it may be required to expand its existing laboratory or develop a second laboratory, the cost of

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which is currently believed to range from $2 million to $4 million, which the Company expects to fund primarily through its operating cash flows.

During the three months ended March 31, 2005, the Company distributed $410,153 in cash dividends to its shareholders. The Company did not repurchase any shares for treasury during the quarter ended March 31, 2005. The Company has authorized 500,000 shares for repurchase since June of 1998 of which 466,351 shares have been repurchased.

Contractual obligations as of March 31, 2005 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 $123,576 for the three months ended March 31, 2005 as compared to $109,719 for the comparable period of 2004. The Company expects to purchase approximately $370,000 for the remainder of 2005. 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 March 31, 2005, the Company’s principal sources of liquidity included an aggregate of approximately $4.1 million of cash, cash equivalents and short-term investments. 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, 2005, the Company had no long-term debt.

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CRITICAL ACCOUNTING POLICIES

Management believes the most critical accounting policies are as follows:

     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 quarter of 2005 and during 2004. 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.

     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

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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.

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, general and administrative expenses, marketing and selling expenses, research and development expenses, anticipated operating results, strategies with respect to governmental agencies and regulations, cash dividends, cost savings, capital expenditures 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, 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.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity. The Company maintains a short-term investment portfolio consisting principally of money market securities and Taxable Auction Rate Preferred, 7 and 28 day Dutch Auction securities that are not sensitive to sudden interest rate changes. The Company does not use derivative financial instruments for speculative or trading purposes.

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.

PART II OTHER INFORMATION

Item 1 Legal Proceeding

The lawsuit filed against the Company as a co-defendant along with Anderson Chevrolet, AutoNation Inc., and two of Anderson Chevrolet’s employees was resolved during the three months ended March 31, 2005.

Item 6. Exhibits

See Exhibit Index included in 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.

	Psychemedics Corporation
Date: May 12, 2005	By:	/s/ Raymond C. Kubacki, Jr.
	Raymond C. Kubacki, Jr.
	Chairman and Chief Executive Officer

Date May 12, 2005	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, 2005

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