SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the quarterly period ended June 30, 2003


o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 0-19371

(PHARMCHEM LOGO)

(Exact name of registrant as specified in its charter)


Delaware		77-0187280
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification Number)


4600 North Beach Street Haltom City, Texas		76137
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (817) 605-5300

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report(s), 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 (as defined in Rule 12b-2 of the Exchange Act.) Yes o No þ

As of July 31, 2003, the registrant had outstanding 5,852,593 shares of Common Stock, $0.001 par value.

TABLE OF CONTENTS


PART I. Financial Information
	Item 1. Condensed Consolidated Financial Statements
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II.Other Information
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 6. Exhibits and Reports on Form 8-K
Signature
EXHIBIT INDEX
EXHIBIT 10.38
EXHIBIT 10.39
EXHIBIT 10.40
EXHIBIT 10.41
EXHIBIT 10.42
EXHIBIT 10.43
EXHIBIT 10.44
EXHIBIT 10.45
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PHARMCHEM, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX


		Page

Part I	Financial Information
Item 1	Condensed Consolidated Financial Statements		3
	Condensed Consolidated Balance Sheets (unaudited) at June 30, 2003 and December 31, 2002		4
	Condensed Consolidated Statements of Operations (unaudited) for the Three and Six Months ended June 30, 2003 and 2002		5
	Condensed Consolidated Statements of Comprehensive Income (Loss) (unaudited) for the Three and Six Months ended June 30, 2003 and 2002		6
	Condensed Consolidated Statements of Cash Flows (unaudited) for the Three and Six Months ended June 30, 2003 and 2002		7
	Notes to Condensed Consolidated Financial Statements (unaudited)		8
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations		12
Item 3	Quantitative and Qualitative Disclosures About Market Risk		18
Item 4	Controls and Procedures		18
Part II	Other Information
Item 4	Submission of Matters to a Vote of Security Holders		18
Item 6	Exhibits and Reports on Form 8-K		19
Signature			20

PART I. Financial Information

Item 1. Condensed Consolidated Financial Statements

The condensed consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in complete financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations, although the Company believes that the disclosures made are adequate to make the information presented not misleading. It is suggested that the condensed consolidated financial statements be read in conjunction with the consolidated financial statements and the notes thereto for the year ended December 31, 2002 included in the Company’s Annual Report on Form 10-K.

These financial statements have been prepared in all material respects in conformity with the standards of accounting measurements set forth in Accounting Principles Board Opinion No. 28, “Interim Financial Reporting,” and the rules and regulations as specified by the Securities and Exchange Commission and reflect all adjustments, consisting only of normal recurring adjustments which, in the opinion of management, are necessary to summarize fairly our consolidated financial position and the results of operations and cash flows for the periods presented. The results of operations for such interim periods are not necessarily indicative of the results to be expected for the full year.

PHARMCHEM, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except par value)


			June 30,			December 31,
			2003			2002

ASSETS
CURRENT ASSETS:
	Cash and cash equivalents		$	2,426		$	4,213
	Accounts receivable, net of allowance for doubtful accounts of $246 and $197			3,851			3,792
	Inventories			1,055			1,318
	Prepaid expenses			505			501

		TOTAL CURRENT ASSETS		7,837			9,824

PROPERTY AND EQUIPMENT, net				11,246			12,074
OTHER ASSETS				39			40
GOODWILL, net of amortization of $1,892				729			729

		TOTAL ASSETS	$	19,851		$	22,667

LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
	Revolving line of credit		$	—		$	3,334
	Current portion of long-term debt			1,879			2,388
	Accounts payable			2,153			2,918
	Accrued compensation			593			837
	Accrued collectors and other liabilities			2,529			2,017

		TOTAL CURRENT LIABILITIES		7,154			11,494
LONG-TERM DEBT, net of current portion				3,626			814

		TOTAL LIABILITIES		10,780			12,308

STOCKHOLDERS’ EQUITY:
	Common stock, $0.001 par value, 25,000 shares authorized, 5,853 shares issued and outstanding at June 30, 2003 and December 31, 2002			6			6
	Additional paid-in capital			19,589			19,589
	Accumulated deficit			(10,524	)		(9,236	)

		TOTAL STOCKHOLDERS’ EQUITY		9,071			10,359

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY			$	19,851		$	22,667

The accompanying notes are an integral part of these condensed consolidated financial statements.

PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share amounts)


				Three Months Ended						Six Months Ended
				June 30,						June 30,

				2003			2002			2003			2002

NET SALES				$	7,114		$	8,066		$	13,449		$	15,542
COST OF SALES					5,545			6,249			10,670			11,917

GROSS PROFIT					1,569			1,817			2,779			3,625

OPERATING EXPENSES:
	Selling, general and administrative				1,984			1,933			3,782			3,946

		Total operating expenses			1,984			1,933			3,782			3,946

LOSS FROM OPERATIONS					(415	)		(116	)		(1,003	)		(321	)
Interest expense					143			177			303			339
Other income					(3	)		(98	)		(18	)		(73	)

					140			79			285			266

LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES					(555	)		(195	)		(1,288	)		(587	)
PROVISION FOR (BENEFIT FROM) INCOME TAXES					—			13			—			(69	)

LOSS FROM CONTINUING OPERATIONS					(555	)		(208	)		(1,288	)		(518	)
DISCONTINUED OPERATIONS:
	Income from discontinued operations, net of applicable income taxes of $184				—			—			—			359
	Gain on disposition, net of applicable income taxes of $1,116				—			—			—			4,277

NET INCOME (LOSS)				$	(555	)	$	(208	)	$	(1,288	)	$	4,118

NET INCOME (LOSS) PER COMMON SHARE:
	BASIC:		Continuing operations	$	(0.09	)	$	(0.04	)	$	(0.22	)	$	(0.09	)
			Discontinued operations		—			—			—			0.79

			Net income (loss)	$	(0.09	)	$	(0.04	)	$	(0.22	)	$	0.70

	DILUTED:		Continuing operations	$	(0.09	)	$	(0.04	)	$	(0.22	)	$	(0.09	)
			Discontinued operations		—			—			—			0.79

			Net income (loss)	$	(0.09	)	$	(0.04	)	$	(0.22	)	$	0.70

WEIGHTED AVERAGE SHARES OUTSTANDING:
	BASIC				5,853			5,853			5,853			5,853

	DILUTED				5,853			5,853			5,853			5,853

The accompanying notes are an integral part of these condensed consolidated financial statements.

PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(Unaudited)
(In thousands)


		Three Months Ended						Six Months Ended
		June 30,						June 30,

		2003			2002			2003			2002

NET INCOME (LOSS)		$	(555	)	$	(208	)	$	(1,288	)	$	4,118
OTHER COMPREHENSIVE INCOME (LOSS):
	Foreign currency translation		—			—			—			(53	)
	Reclassification adjustment for realized foreign currency exchange loss included in net income		—			—			—			332
			—			—			—			279

COMPREHENSIVE INCOME (LOSS)		$	(555	)	$	(208	)	$	(1,288	)	$	4,397

The accompanying notes are an integral part of these condensed consolidated financial statements.

PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)
					Six Months Ended
					June 30,

					2003			2002

CASH FLOWS FROM OPERATING ACTIVITIES
	Net income (loss)				$	(1,288	)	$	4,118
	Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
			Income from discontinued operations			—			(359	)
			Depreciation and amortization			1,091			1,121
			Bad debt expense			55			35
			Gain on sale of disposition of subsidiary, net of tax			—			(4,277	)
			Amortization of discount on subordinated debt			86			86
	Changes in operating assets and liabilities:
			Accounts receivable			(114	)		553
			Inventory			263			555
			Prepaids and other current assets			(4	)		91
			Other assets			1			(2	)
			Accounts payable and other accrued liabilities			(497	)		(1,674	)

				Net cash provided by (used in) operating activities of continuing operations		(407	)		247

				Net cash provided by operating activities of discontinued operations		—			161

CASH FLOWS FROM INVESTING ACTIVITIES
		Purchases of property and equipment				(267	)		(836	)
		Proceeds from sale of property and equipment				4			—
		Proceeds from sale of discontinued operations				—			10,000

				Net cash provided by (used in) investing activities of continuing operations		(263	)		9,164

				Net cash used in investing activities of discontinued operations		—			(40	)

CASH FLOWS FROM FINANCING ACTIVITIES
		Principal payments on long-term debt				(610	)		(1,994	)
		Repayments on revolving line of credit, net of borrowings				(507	)		(663	)

				Net cash used in financing activities of continuing operations		(1,117	)		(2,657	)

				Net cash used in financing activities of discontinued operations		—			(1,987	)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS						(1,787	)		4,888
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD						4,213			197

CASH AND CASH EQUIVALENTS AT END OF PERIOD					$	2,426		$	5,085

The accompanying notes are an integral part of these condensed consolidated financial statements.

PHARMCHEM, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation, General and Business

PharmChem, Inc. is a leading independent laboratory that provides integrated drug testing services. Our customers include private and public employers, criminal justice agencies and drug treatment programs in the United States who seek to detect and deter the use of illegal drugs and alcohol. The consolidated financial statements include the accounts of PharmChem and Medscreen Limited (“Medscreen”), a United Kingdom company. Medscreen was sold on March 25, 2002 and, as a result, is presented as discontinued operations in the accompanying financial statements for all periods presented. Medscreen’s financial statements were translated based on the month-end spot rate for the balance sheets and a weighted average of the spot rates for the statements of operations.

The accompanying condensed consolidated financial statements are prepared in accordance with the instructions to Form 10-Q, are unaudited and do not include all the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. We have made certain reclassifications to prior year amounts to conform to current year presentation. All adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations for the interim periods have been made and are of a recurring nature unless otherwise disclosed herein. The results of operations for such interim periods are not necessarily indicative of results of operations for a full year.

In the first quarter of 2002, we implemented Financial Accounting Standards Board Statement No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 requires goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of SFAS 142. This Statement further requires intangible assets with definite useful lives to be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. As permitted by SFAS 142, we implemented the impairment provisions in the second quarter of 2002. On an ongoing basis, the amortization of goodwill noted in the Condensed Consolidated Statements of Operations was eliminated beginning January 1, 2002.

Stock Based-Compensation

In December 2002, the Financial Accounting Standards Board issued SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure — an amendment of SFAS No. 123. This statement amends SFAS No. 123, Accounting for Stock-Based Compensation, 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, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of

accounting for stock-based employee compensation and the effect of the method used on reported results. We continue to account for stock-based compensation using Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and have not adopted the recognition provisions of SFAS No. 123, as amended by SFAS No. 148. However, we have adopted the disclosure provisions for the current fiscal year. The exercise price of options granted under our stock option plans is equal to the market price of our stock on the date of grant. Therefore, we have not recorded compensation cost under APB No. 25.

We continue to apply APB No. 25 in accounting for our stock-based compensation plans. Accordingly, no compensation cost has been recorded in the consolidated statements of operations for the stock option plans. If we had determined compensation cost for all of our stock based compensation plans in accordance with the fair value method prescribed by SFAS No. 123, our proforma net income (loss) and income (loss) per share for the three months and six months ended June 30 would have been as follows (in thousands, except per share amounts):


	Three Mos. Ended June 30,						Six Mos. Ended June 30,

	2003			2002			2003			2002

Net income (loss), as reported	$	(555	)	$	(208	)	$	(1,288	)	$	4,118
Stock-based employee compensation expense, net of related tax effects		(33	)		(40	)		(67	)		(68	)

Net income (loss), pro forma	$	(588	)	$	(248	)	$	(1,355	)	$	4,050

Basic income (loss) per share, as reported	$	(0.09	)	$	(0.04	)	$	(0.22	)	$	0.70

Basic income (loss) per share, pro forma	$	(0.10	)	$	(0.05	)	$	(0.23	)	$	0.69

Diluted income (loss) per share, as reported	$	(0.09	)	$	(0.04	)	$	(0.22	)	$	0.70

Diluted income (loss) per share, pro forma	$	(0.10	)	$	(0.05	)	$	(0.23	)	$	0.69

2. Discontinued Operations

On March 25, 2002, we completed the sale of Medscreen for approximately $10.0 million. In connection with the sale, Medscreen’s two loan facilities totaling approximately $1,663,000 were fully repaid. Closing and other settlement costs totaled approximately $324,000 and approximately $929,000 was used to repay a portion of our revolving line of credit. The remainder of the proceeds have been and will be used for general corporate purposes.

Net sales of the discontinued operations were $1,949,000 for the six months ended June 30, 2002. We recorded a gain on the sale of Medscreen of $0.73 per share.

3. Net Income (Loss) per Share

We compute and disclose our income (loss) per share in accordance with Statement of Financial Accounting Standards No. 128, Earnings Per Share, which requires the presentation of basic and diluted income per share. Basic income (loss) per share is calculated using the weighted average number of common shares outstanding during the period. Diluted income per share is calculated using the weighted average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares represent shares issuable upon the exercise of outstanding options and warrants and are calculated using the treasury stock method.

Options and warrants to purchase 1,150,000 and 1,190,000 shares of our common stock for the three months ended June 30, 2003 and 2002, respectively, and 1,150,000 and 1,190,000 shares for the six months ended June 30, 2003 and 2002, respectively, were not included in the computation of diluted income per share because their effect would have been anti-dilutive.

4. Inventories

Inventories include laboratory materials, collection materials and products and are stated at the lower of cost or market. Cost is determined using standard costs, including freight, that approximate actual costs on a first-in, first-out basis. Inventories consisted of the following at June 30, 2003 and December 31, 2002 (in thousands):


	2003		2002

Laboratory materials	$	147	$	225
Collection materials		542		542
Products		366		551

	$	1,055	$	1,318

5. Debt

Our debt at June 30, 2003 and December 31, 2002 consisted of the following (in thousands):


	2003			2002

Revolving line of credit	$	2,827		$	3,334
Subordinated debt, net of discount of $43 and $129 at June 30, 2003 and December 31, 2002, respectively (paid July 2, 2003)		1,457			1,371
Obligations under capitalized leases, due in monthly installments through 2005, secured by laboratory equipment, office equipment and computer software, interest rates ranging from 8% to 9%		1,221			1,831

		5,505			6,536
Less: current portion and revolving line of credit		(5,106	)		(5,722	)

		399			814
Add: Debt reclassified to long-term pursuant to new borrowings funded in July, 2003		3,227			—

Long-term portion	$	3,626		$	814

commitment fee of $15,000 and is repayable monthly over 36 months; the initial draw down under this term loan facility was $900,000. These facilities funded on July 2, 2003 at which time our prior credit facility was fully paid and terminated. The remaining $600,000 balance of the term loan, if drawn, must be drawn within ninety days from the date of the loan agreement.

The new Agreement is secured by a lien on a significant portion of our assets and permits up to $1,500,000 of the revolving line of credit to be used to repurchase our common stock under our common stock repurchase program and permits the declaration and distribution of a dividend in connection with our stockholder rights plan. Should the revolving line of credit be paid off prior to the end of the term, there would be a prepayment penalty of $35,000.

As of June 30, 2003, the calculated maximum that could be borrowed and the amount outstanding were $3,319,000 and $2,827,000, respectively.

On June 30, 2003, the Company’s subordinated debt holders agreed to an early payoff of the subordinated debt at a 50% discount. The subordinated debt, as discounted, was repaid from proceeds of the term loan facility. The Company agreed to a reduction in the exercise price of the 150,000 warrants held by the subordinated debt holders from $3.00 to $0.29 (the average of the closing prices for the 30 days ending June 26, 2003). The warrants continue to expire on September 30, 2006.

As a result of the foregoing, the Company will report a gain on the early extinguishment of debt in the third quarter of approximately $665,000 which includes reductions for the unamortized discount (established when the subordinated debt was issued) and the fair value of re-pricing the warrants.

6. Restructuring Charge

During the second quarter of 2001, our Board of Directors approved a plan to close our Menlo Park, California corporate headquarters, main laboratory and distribution center and relocate these operations to Texas. These expenses were accrued and recorded in continuing operations for the three months ended June 30, 2001. Detail of the payment activity and ending accrual balance related to the restructuring is presented in the following table (in thousands):


		Accrual					Accrual
		As of		2003			As of
		December 31, 2002		Payments			June 30, 2003

Severance and related benefits		$	26	$	(4	)	$	22
Clean-up and remediation			171		—			171
Repairs			9		—			9
Legal and other			28		(3	)		25

	Total	$	234	$	(7	)	$	227

The restructuring plan was designed to provide for costs associated with leaving our facilities in Menlo Park, California. The restructuring expenses represent estimated and actual costs related to workforce reductions, clean-up, repairs and legal services. As part of the workforce reduction, we recorded severance and related fringe benefits costs for approximately 160 employees from operations

and administration, of which 157 employees were terminated as of June 30, 2003. The clean-up and remediation includes removal of a previously unknown storage vault and potential restoration of the facility per the lease agreement. Repairs includes sewer line repair or replacement as contractually provided for in the lease agreement. In addition, we expect to continue to incur legal and other fees related to interpretation of the lease’s contractual obligations. The accrual balance of $227,000 is classified as a component in “Accrued collectors and other liabilities” on the balance sheet. Costs for relocation were expensed as incurred.

On September 19, 2002, the Company’s attorneys received a letter from counsel for the landlord of the Company’s former Menlo Park, California facility claiming damages in the amount of $4.7 million. This amount is based primarily on the landlord’s claim for lost and reduced rent arising from the Company’s alleged failure to vacate the Menlo Park premises timely under the terms of the lease. On April 30, 2003, the Company’s attorneys received a second letter together with a draft complaint from the landlord’s counsel reiterating these allegations and requesting that the parties meet and confer to resolve the matter; otherwise the complaint will be filed. On May 14, 2003, the Company’s attorneys met with the landlord’s counsel. Further discussions will be held during which time the complaint will not be filed. The Company and its counsel are continuing to review the details of this claim and the Company will defend itself vigorously.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

“Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933, which are subject to the “safe harbor” created by these Sections. Our actual future results could differ materially from those projected in the forward-looking statements. Some factors which could cause future actual results to differ materially from our recent results and those projected in the forward-looking statements are described in our Annual Report on Form 10-K for the year ended December 31, 2002. We assume no obligation to update the forward-looking statements or such factors.

Recent Events

See Note 5, (“Debt”) to the Notes to Condensed Consolidated Financial Statements for information regarding a Loan and Security Agreement entered into on June 26, 2003 between the Company and a new lender.

On July 11, 2003, the Company received a Nasdaq Staff Determination Letter stating that it had evidenced compliance with the $1 million minimum market value requirement for its publicly held shares (“MVPHS”) as required by Marketplace Rule 4310(c)(7) for continued listing on the Nasdaq SmallCap Market. However, the Company is no longer in compliance with the $1 minimum bid price requirement as set forth in Marketplace Rule 4310(c)(4). The Company had previously been provided until July 7, 2003 to regain compliance with this rule.

The Company appeared at a hearing (the request for which stays the delisting of the Company’s securities) on July 17, 2003 before a Nasdaq Listing Qualification Panel (the “Panel”), to review the Staff Determination. The panel is expected to report its findings shortly; however, there can be no assurance the Panel will grant the Company’s request for continued listing on the Nasdaq SmallCap Market.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon PharmChem’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate these estimates, including those related to bad debts, inventories, goodwill, restructuring accruals, contingencies, revenue recognition, specimen collector accruals and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

PharmChem believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of the consolidated financial statements. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. We estimate the quantity and value of our unused specimen collection kit inventory existing at our customer and contract specimen collector field locations using a model that considers actual shipments to these locations, specimens returned to our laboratory for processing, replacement costs and estimates of shrinkage. If the estimated value of this inventory decreases beyond our expectations of recovery, additional inventory write-downs may be required.

Continued adverse changes in market conditions or poor operating results of our operations could result in additional losses or an inability to recover the carrying value of the related goodwill, thereby possibly requiring an impairment charge in the future. Revenue is recognized upon the communication of results from laboratory analysis of specimens submitted by our customers, at the time of shipment for products and at the completion of rendered services. We accrue expected payments to specimen collectors who perform specimen collection services on behalf of our managed customers. The specimen collector accrual calculation is based on a combination of our reporting of results from laboratory analysis of specimens and cost information maintained in our internal systems for each specimen collector. We include in the accrual estimates of retroactive rate increases and services performed but not reported to customers.

Results of Operations

Refer to Note 2, “Discontinued Operations”, to the accompanying Notes to Condensed Consolidated Financial Statements for further information on the sale of Medscreen in March 2002. The following table sets forth for the periods indicated certain financial data (dollars in thousands):


			Three Months Ended June 30,												Six Months Ended June 30,

			2003			2002			2003			2002			2003			2002			2003			2002

									(As a % of net sales)												(As a % of net sales)
NET SALES:
	Workplace employers analysis		$	2,018		$	2,473			28.4	%		30.7	%	$	3,722		$	4,713			27.7	%		30.3	%
	Criminal justice agencies analysis			3,352			3,844			47.1			47.6			6,624			7,732			49.2			49.7
	Other analysis			89			45			1.2			0.6			170			90			1.3			0.6
	Products and other			1,655			1,704			23.3			21.1			2,933			3,007			21.8			19.4

		Total net sales		7,114			8,066			100.0			100.0			13,449			15,542			100.0			100.0
COST OF SALES				5,545			6,249			77.9			77.5			10,670			11,917			79.3			76.7

GROSS PROFIT				1,569			1,817			22.1			22.5			2,779			3,625			20.7			23.3

OPERATING EXPENSES:
	Selling, general and administrative			1,984			1,933			27.9			24.0			3,782			3,946			28.1			25.4

		Total operating expenses		1,984			1,933			27.9			24.0			3,782			3,946			28.1			25.4

LOSS FROM OPERATIONS				(415	)		(116	)		(5.8	)		(1.5	)		(1,003	)		(321	)		(7.4	)		(2.1	)
OTHER EXPENSE, net				140			79			2.0			1.0			285			266			2.1			1.7
PROVISION FOR (BENEFIT FROM) INCOME TAXES				—			13			—			0.2			—			(69	)		—			(0.4	)

LOSS FROM CONTINUING OPERATIONS				(555	)		(208	)		(7.8	)		(2.7	)		(1,288	)		(518	)		(9.5	)		(3.4	)
DISCONTINUED OPERATIONS:
	Income from discontinued operations, net of applicable income taxes			—			—			—			—			—			359			—			2.3
	Gain on sale of disposition, net of applicable income taxes			—			—			—			—			—			4,277			—			27.5

NET INCOME (LOSS)			$	(555	)	$	(208	)		(7.8	)%		(2.7	)%	$	(1,288	)	$	4,118			(9.5	)%		26.4	%

Second Quarter 2003 vs. 2002

Net sales for the three months ended June 30, 2003 were $7,114,000, a decrease of 11.8% from last year’s second quarter sales of $8,066,000. While the overall volume of laboratory specimen analysis was down by 19.0%, revenue was down only 11.8%. Average selling prices of laboratory analysis rose 5.9% in the current quarter, a function of customer and service mix, as there have been no significant price increases in 2003. The continued weakness in the economy is still having an adverse impact on pre-employment testing by workplace customers. More customers are implementing stringent cost controls and performing less drug testing and criminal justice agencies are performing more in-house testing with external confirmation by laboratories. In addition, presumptive positive test rates of criminal justice customers are increasing, causing more higher priced confirmation tests which is contributing to the higher average price per specimen. Sales of products and other services were lower by only 2.9%, confirming a shift toward in-house testing.

Cost of sales for the three months ended June 30, 2003 were $5,545,000 (77.9% of net sales), a decrease of 11.3% from last year’s second quarter cost of sales of $6,249,000 (77.5% of net sales). Variable costs decreased 13.7% from the second quarter last year, more than the decrease in sales, due to on-going cost reduction efforts. Specimen collection service fees continued to decrease through the implementation of our preferred collector program. Decreases in collection forms and supplies also outpaced the decline in sales. Increases in fixed costs such as business insurance, professional services and depreciation were offset by lower repair and maintenance costs in the quarter.

Selling, General & Administrative (SG&A) expenses for the three months ended June 30, 2003 were $1,984,000 (27.9% of net sales) as compared to $1,933,000 (24.0% of net sales) in 2002. Higher legal and other professional services primarily accounted for the increase.

Net loss from continuing operations for the three months ended June 30, 2003 was $555,000 or $0.09 per share compared to a net loss of $208,000 or $0.04 per share in 2002.

Six Months 2003 vs. 2002

Net sales for the six months ended June 30, 2003 decreased $2,093,000 (13.5%) to $13,449,000 in 2003 from $15,542,000 in 2002. Specimen volume was down significantly for both workplace and criminal justice customers, 23.5% and 19.6% respectively. Sales of products and other services were lower by only 2.5%. Declines in sales of PharmScreen® were largely offset by higher non-laboratory services.

Cost of sales for the six months ended June 30, 2003 decreased $1,247,000 (10.5%) to $10,670,000 in 2003 (79.3% of net sales) from $11,917,000 in 2002 (76.7% of net sales). The increase in cost of sales as a percentage of net sales was the result of increased fixed costs, primarily the result of increases in depreciation expense related to laboratory software and increases in the cost of facility insurance, which were partially offset by lower repair and maintenance expenses for lab equipment. Variable costs decreased 14.3% from the first six months of last year, greater than the decline in sales. Specimen collection service fees continued to decrease through the implementation of our preferred collector program. Collection forms and supplies, labor and fringe benefits, and inbound transportation of specimens account for the majority of the decrease in variable costs. Product costs decreases exceeded the decrease in sales, primarily due to a change in product mix.

Selling, General & Administrative (SG&A) expenses for the six months ended June 30, 2003 decreased $164,000 (4.2%) to $3,782,000 in 2003 (28.1% of net sales) from $3,946,000 in 2002 (25.4% of net sales). Bad debt expense was lower as a result of improved credit and collection efforts. A corresponding reduction of days sales outstanding from 57.0 days at June, 2002 to 54.1 days in 2003 was also achieved. Lower software development costs and marketing expenses account for the balance of the reduction.

Discontinued Operations for the six months ended June 30, 2002 resulted in net income of $4,636,000 (or $0.79 per share) which is comprised of net income from Medscreen’s operations for three months of $359,000 (or $0.06 per share) and the gain on the sale of Medscreen of $4,277,000 (or $0.73 per share).

Net Loss from continuing operations for the six months ended June 30, 2003 was $1,288,000, or $0.22 per share compared to a net loss in 2002 of $518,000, or $0.09 per share. The net income for the six months ended June 30, 2002 including discontinued operations was $4,118,000, or $0.70 per share. There were no discontinued operations in the first six months of this year.

Liquidity and Capital Resources

Our continuing operations during the six-month period ended June 30, 2003 used cash of $407,000 and provided $247,000 of cash during the first six months in 2002. The decrease in cash flow from operations was principally the result of the larger loss from continuing operations in the first six months of 2003. Working capital management continues to remain a priority.

As of June 30, 2003, we had $2,426,000 in cash and cash equivalents. During the six months ended June 30, 2003, we used approximately $267,000 in cash to purchase property and equipment, principally for information systems development.

On June 26, 2003, the Company entered into a Loan and Security Agreement (“the Agreement”) with a new lender replacing its existing credit agreement. The new Agreement provides for a revolving line of credit of $3,500,000, permits borrowing at 80% of eligible receivables, has a term of three years, bears interest at prime plus 1% (5.0% as of June 30, 2003), has a one-time commitment fee of $10,000, a monthly collateral monitoring fee of $1,000, an unused line fee of 0.50% per annum, and requires the Company to maintain certain financial ratios. In addition, the Agreement provides for a term loan of up to $1,500,000 which bears interest at prime plus 3% (7.0% as of June 30, 2003), has a one-time commitment fee of $15,000 and is repayable monthly over 36 months; the initial draw down under this term loan facility was $900,000. These facilities funded on July 2, 2003 at which time our prior credit facility was fully paid and terminated. The remaining $600,000 balance of the term loan, if drawn, must be drawn within ninety days from the date of the loan agreement.

As of June 30, 2003, the calculated maximum that could be borrowed and the amount outstanding were $3,319,000 and $2,827,000, respectively.

We anticipate the existing cash balances, amounts available under existing and future credit agreements and funds to be generated from future operations will be sufficient to fund operations and forecasted capital expenditures through the foreseeable future.

Impact of Recent Accounting Pronouncements

In June 2001, the FASB issued Statement No. 143 (SFAS 143), Accounting for Asset Retirement Obligations. SFAS 143 requires liability recognition for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. We adopted the provisions of SFAS 143 effective January 1, 2003. The adoption of this standard did not have a material effect on our consolidated financial position or results of operations.

In November 2002, the FASB issued FASB Interpretation No. 45 (FIN45), Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of certain guarantees. FIN 45 also requires disclosure about certain guarantees that an entity has issued. The Company has implemented the disclosure requirements required by FIN 45, which were effective for fiscal years ending after December 15, 2002. The Company will apply the recognition provisions of FIN 45 prospectively to guarantees issued after December 31, 2002. The Company does not expect FIN 45 to have a material effect on its financial condition and results of operations.

In May 2003, the Financial Accounting Standards board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 requires that certain financial instruments, which under previous guidance were accounted for as equity, most now be accounted for as liabilities. The financial instruments affected include mandatorily redeemable stock, certain financial instruments that require or may require the issue to buy back some of its shares in exchange for cash or other assets and certain obligations that can be settled with shares of stock. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 , and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. PharmChem does not expect SFAS No. 150 to have a material effect on its financial condition or results of operations.

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003. For Variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. PharmChem does not expect FIN 46 to have a material effect on its financial condition or results of operations.

In November 2002, the FASB’s Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. PharmChem does not expect EITF Issue No. 00-21 to have a material effect on its financial condition or results of operations.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are subject to market risk with respect to our debt outstanding. Our new credit agreement carries interest at the prime rate plus 1.0% for the revolving line of credit and prime rate plus 3.0% for the term loan. As the prime rate increases, we will incur higher relative interest expense and similarly, a decrease in the prime rate will reduce relative interest expense. A 1.0% change in the prime rate would not materially change interest expense assuming levels of debt consistent with historical amounts. The market risks are not considered significant and, therefore, we do not intend to engage in significant hedging transactions.

Item 4. Controls and Procedures

Within the 90 days prior to the date of this report, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us required to be included in our periodic SEC filings. There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to the date of their evaluation.

PART II.Other Information

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

At the Annual Meeting of the Company held on May 13, 2003, the Company’s stockholders took the following actions:

(a)

The following directors were elected to serve until the next Annual Meeting:


		Joseph W. Halligan — 5,298,844 shares in favor and 1,900 shares withheld;
		Richard D. Irwin — 5,300,344 shares in favor and 400 shares withheld;
		Stephen I. Schorr — 5,300,344 shares in favor and 400 shares withheld; and
		Donald R. Stroben — 5,300,344 shares in favor and 400 shares withheld.

(b)

Ratification of the appointment of KPMG LLP as Independent Certified Public Accountants for the Company for the 2003 fiscal year, by a vote of 5,300,344 shares in favor, 400 shares against, and zero shares abstained.

Item 6. Exhibits and Reports on Form 8-K

(a)

Exhibits:


10.38	—	Letter agreement between PharmChem, Inc. and Irwin Family Limited Partnership dated June 30, 2003.
10.39	—	Letter Agreement between PharmChem, Inc. and Richard D. Irwin dated June 30, 2003.
10.40	—	Letter Agreement between PharmChem, Inc. and MicroCap Partners, L.P. dated June 30, 2003.
10.41	—	Warrant from PharmChem, Inc. to Irwin Family Limited Partnership dated June 30, 2003.
10.42	—	Warrant from PharmChem, Inc. to Richard D. Irwin dated June 30, 2003.
10.43	—	Warrant from PharmChem, Inc. to MicroCap Partners, L.P. dated June 30, 2003.
10.44	—	Loan and Security Agreement between Silicon Valley Bank and PharmChem, Inc., dated June 26, 2003.
10.45	—	Intellectual Property Security Agreement between Silicon Valley Bank and PharmChem, Inc. dated June 26, 2003.
31.1	—	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	—	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	—	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	—	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	(b)		Reports on Form 8-K:

			Press release issued on August 11, 2003 reporting second quarter 2003 financial results.

			Press release issued on July 15, 2003 reporting Nasdaq determination letter received on July 11, 2003.

			Press Release issued on July 2, 2003 announcing a new loan and security agreement and the early payoff of subordinated debt.

			Press release issued on May 28, 2003 disclosing possible delisting action by Nasdaq.

			Press release issued on May 15, 2003 reporting first quarter 2003 financial results.

Signature

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.


	PharmChem, Inc.
	(Registrant)


Date: August 11, 2003	By:	/s/ David A. Lattanzio

		David A. Lattanzio
		Chief Financial Officer and Vice President,
		Finance and Administration
		(Principal Financial and Accounting Officer)

EXHIBIT INDEX


10.38	—	Letter agreement between PharmChem, Inc. and Irwin Family Limited Partnership dated June 30, 2003.
10.39	—	Letter Agreement between PharmChem, Inc. and Richard D. Irwin dated June 30, 2003.
10.40	—	Letter Agreement between PharmChem, Inc. and MicroCap Partners, L.P. dated June 30, 2003.
10.41	—	Warrant from PharmChem, Inc. to Irwin Family Limited Partnership dated June 30, 2003.
10.42	—	Warrant from PharmChem, Inc. to Richard D. Irwin dated June 30, 2003.
10.43	—	Warrant from PharmChem, Inc. to MicroCap Partners, L.P. dated June 30, 2003.
10.44	—	Loan and Security Agreement between Silicon Valley Bank and PharmChem, Inc., dated June 26, 2003.
10.45	—	Intellectual Property Security Agreement between Silicon Valley Bank and PharmChem, Inc. dated June 26, 2003.
31.1	—	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	—	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	—	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	—	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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PHARMCHEM INC 10-Q