-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, C1/oZ69OMx1aMbFqSX2H9lAFNyOpQAiPvU/43vYQvcks6OKJTlp0Jk5IkaktVCqN tszIysEjFuDiFizgKBK/Xg== 0000950135-98-000241.txt : 19980128 0000950135-98-000241.hdr.sgml : 19980128 ACCESSION NUMBER: 0000950135-98-000241 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19980127 SROS: AMEX FILER: COMPANY DATA: COMPANY CONFORMED NAME: PSYCHEMEDICS CORP CENTRAL INDEX KEY: 0000806517 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-MEDICAL LABORATORIES [8071] IRS NUMBER: 581701987 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 001-13738 FILM NUMBER: 98513480 BUSINESS ADDRESS: STREET 1: 1280 MASSACHUSETTS AVENUE STREET 2: SUITE 200 CITY: CAMBRIDGE STATE: MA ZIP: 02138 BUSINESS PHONE: 6178687455 MAIL ADDRESS: STREET 1: 1280 MASSACHUSETTS AVE STREET 2: SUITE 200 CITY: CAMBRIDGE STATE: MA ZIP: 02138 10-K/A 1 PSYCHEMEDICS, CORP. 1 U. S. SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K/A AMENDMENT NO. 1 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 COMMISSION FILE NUMBER: 1-13738 PSYCHEMEDICS CORPORATION (exact name of registrant as specified in its charter) Delaware 58-1701987 - ------------------------------- ------------------------------------ (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 1280 Massachusetts Ave., Cambridge, MA 02138 - ---------------------------------------- ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 617-868-7455 Securities registered pursuant to Section 12(b) of the Act: Common Stock, $.005 Par Value American Stock Exchange - ----------------------------- ------------------------------------------- (Title of class) (name of each exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None 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 reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-B is not contained herein and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [ ] On March 14, 1997 the aggregate market value of the voting stock held by non-affiliates of the registrant was $ 91,553,934 and 21,827,791 shares of Common Stock, $.005 par value, were outstanding at such date. DOCUMENTS INCORPORATED BY REFERENCE ----------------------------------- Part III - Portions of the Registrant's Proxy Statement relative to the 1997 Annual Meeting of Stockholders to be held on May 8, 1997. 2 PART I ------ The information provided by the Company in this Report may contain "forward-looking" information which involves risks and uncertainties, such as statements of the Company's plans, objectives, expectations and intentions. The cautionary statements made in this report should be read as being applicable to all forward-looking statements wherever they appear in this report. The Company's actual results could differ materially from those discussed herein. Factors that could cause or contribute to such differences include those discussed in Item 7 below, as well as those discussed elsewhere herein. Item 1. Business - -------------------- GENERAL Psychemedics Corporation ("the Company") is a Delaware corporation organized on September 24, 1986 to provide testing services for the detection of abused substances through the analysis of hair samples. The Company's testing methods utilize a patented technology for performing immunoassays on enzymatically dissolved hair samples with confirmation testing by gas chromatography/mass spectrometry ("GC/MS"). The Company's first application of its patented technology is a testing service which screens for the presence of certain drugs of abuse in hair. The application of radioimmunoassay procedures using hair differs from the more widely used application of radioimmunoassay procedures using urine samples. The Company's tests provide quantitative information which indicates the approximate amount of drug ingested as well as historical data which can show a pattern of individual drug use over a period of time. This information is useful to employers in both applicant and employee testing, to physicians, treatment professionals, law enforcement agencies, to the insurance industry, to other individuals and entities engaged in any business where drug use is an issue, and to parents concerned about drug use by their children. The Company provides commercial testing and confirmation by GC/MS using industry accepted practices for cocaine, marijuana, PCP, methamphetamine, and opiates. In addition, the Company has developed a test for methadone for use in the treatment industry. Testing services are currently performed at the Company's laboratory at 5832 Uplander Way, Culver City, California. The Company's services are marketed under the name RIAH (Radioimmunoassay of Hair), a registered service mark. DEVELOPMENT OF RADIOIMMUNOASSAY OF HAIR The application of special radioimmunoassay procedures to the analysis of hair was initially developed in 1978 by the founders of the Company, Annette Baumgartner and Werner A. Baumgartner, Ph.D. The Baumgartners demonstrated that when certain chemical substances enter the bloodstream, the blood carries them to the hair where they become "entrapped" in the protein matrix in amounts roughly proportional to the amount ingested. The Company's drugs of abuse testing procedure involves washing the hair sample to clean it of surface contaminants and then subjecting the cleaned hair sample to the Company's unique proprietary process which involves the direct analysis of liquefied hair samples by radioimmunoassay procedures utilizing special reagents and antibodies. The antibodies detect the presence of a specific drug or metabolite in the liquefied hair sample by reacting with the drug present in the sample solution and an added radioactive analog of the drug. The resulting antibody-drug complex is precipitated and analyzed. The amount of drug present in the sample is inversely proportional to the amount of radioactive analog in the precipitate. Depending upon both the length of hair and the hair growth rate (hair grows 2 3 approximately 1.3 centimeters per month), the Company is able to provide historical information on drug use by the person from whom the sample was obtained. Another testing option involves sectional analysis of the hair sample. In this procedure, the hair is sectioned lengthwise to approximately correspond to certain time periods. The sections are then labeled by time period, which allows the Company to provide trend information on drug use. When quantitative results of this test are reported and compared to dose correlation graphs, information is provided about the individual's approximate drug usage during the period being tested. VALIDATION OF THE COMPANY'S PROPRIETARY TESTING METHOD The process of analyzing human hair for the presence of drugs using the Company's patented method has been the subject of over fifty scientific field studies. Results from the studies that have been published or accepted for publication in scientific journals are generally favorable to the Company's technology. These studies were performed with the following organizations: Citizens for a Better Community Court, Columbia University, Koba Associates-DC Initiative, Harvard Cocaine Recovery Project, Hutzel Hospital, ISA Associates (Interscience America)-NIDA Workplace Study, University of California-Sleep State Organization, Maternal/Child Substance Abuse Project, Matrix Center, National Public Services Research Institute, Narcotic and Drug Research Institute, San Diego State University-Chemical Dependency Center, Spectrum Inc., Stapleford Centre (London), Task Force on Violent Crime (Cleveland, Ohio); University of Miami-Department of Psychiatry, University of Miami-Division of Neonatology, University of South Florida-Operation Par Inc., University of Washington, VA Medical Center-Georgia, U.S. Probation Parole-Santa Ana. The above studies include research in the following areas: prenatal, treatment evaluation, workplace drug use, the criminal justice system and epidemiology. Many of the studies have been funded by the National Institute of Justice or the National Institute on Drug Abuse ("NIDA"). Over 300 research articles written by independent researchers have been published supporting the general validity and usefulness of hair analysis. An additional independent evaluation of the technology, favorable to the Company's services, has been performed by submission of blind samples by Dr. Robert DuPont, President of the Institute of Behavior and Health, Inc., the first Director of the National Institute on Drug Abuse and presently Chairman of the Company's Scientific Advisory Board. Some of the Company's customers have also completed their own testing to validate the Company's proprietary hair testing method as a prelude to utilizing the Company's services. These studies have consistently confirmed the Company's superior detection rate. When the results from utilizing the Company's patented hair testing method were compared to urine results in side-by-side evaluations, 5 to 10 times as many drug abusers were accurately identified with the Company's proprietary method. In addition to these studies, the Company is now performing testing for over 750 clients. During 1996, the Company's patented method was utilized in a number of important research application studies. In a study funded by the White House Office of National Drug Control Policy (the Drug Czar's office) in 1996, hair analysis was used to assess levels of drug use in hard-core drug abusers. The National Institute of Justice sponsored an investigation using hair analysis to determine the extent of drug use among prison inmates. Additional research studies were conducted at Texas Christian University, Texas A & M, UCLA, University of Pennsylvania and the University of South Florida. These studies investigated drug abuse among juvenile delinquents, homeless individuals, HIV patients and pregnant women. 3 4 ADVANTAGES OF USING THE COMPANY'S PATENTED METHOD The Company asserts that hair testing using its patented method confers substantive advantages relative to existing means of drug detection through urinalysis. Although urinalysis testing can provide accurate drug use information, the scope of the information is short-term and is generally limited to the type of drug ingested within a few days of the test. Studies published in many scientific publications including NIDA RESEARCH MONOGRAPH and the JOURNAL OF FORENSIC SCIENCES have indicated that cocaine, PCP, opiates, and methamphetamine disappear from urine within 72 to 96 hours of use, although marijuana may take a week or more. In contrast to urinalysis testing, hair testing using the Company's patented method provides long-term historical drug use information resulting in a significantly wider "window of detection." This "window" may be three months or longer depending on the length of the hair sample. The Company's standard test offering, however, uses a 3.9 centimeter length cut close to the scalp; therefore, it measures use for approximately the previous 90 days. This wider window of detection enhances the detection efficiency of hair analysis making it particularly useful in pre-employment testing. Hair testing not only identifies more drug users, but also uncovers patterns and severity of drug use, information most helpful in determining the scope of an individual's involvement with drugs and serves as a deterrent against the use of drugs. Hair testing using the Company's patented method greatly reduces the incidence of "false negatives" associated with evasive measures typically encountered with urinalysis testing. Urinalysis test results are impacted adversely by excessive fluid intake prior to testing as well as adulteration of the sample. Moreover, a drug user who abstains from use for a few days prior to urinalysis testing can usually escape detection. Hair testing is effectively free of these problems as it cannot be thwarted by evasive measures typically encountered with urinalysis testing. It is also attractive to customers since sample collection is typically performed under close supervision yet is less intrusive and embarrassing for test subjects. Hair testing using the Company's patented method (with GC/MS confirmation) further reduces the prospects of error in conducting drug detection tests. Urinalysis testing is more susceptible to problems such as "evidentiary false positives" resulting from passive drug exposure (e.g. poppy seeds.) In the event a positive urinalysis test result is challenged based on passive exposure, the only remedy is a newly collected sample. Depending on the drug usage of the forewarned individual prior to the date of the newly collected sample, a re-test may yield a negative result when using urinalysis testing because of temporary abstention. In contrast, when the Company's hair testing method is offered on a repeat hair sample the individual suspected of drug use cannot as easily affect the results because historical drug use data remain locked in the hair fiber. DISADVANTAGES OF HAIR TESTING There are some disadvantages of hair testing as compared to drug detection through urinalysis. Because hair starts growing below the skin surface, drug ingestion evidence does not appear in hair above the scalp until five to seven days after use. Thus, hair testing is not suitable for use in "for cause" testing such as is done in connection with an accident investigation. It does, however, provide a drug history which can complement urinalysis information in "for cause" testing. Currently, radioimmunoassay testing using hair samples under the Company's patented method is only practiced by Psychemedics Corporation. The absence of widespread familiarity and use of hair testing may adversely impact the Company's revenue growth. 4 5 The Company's prices for its tests are generally somewhat higher than prices for comparable tests using urinalysis, but the Company believes that its superior detection rates provide more value to the customer. This pricing policy could, however, adversely impact the growth of the Company's sales volume. PATENTS In December 1987, Dr. Werner A. Baumgartner, the Company's founder and Director of Research and Development, with the assistance of the Company's patent counsel, filed the first in a series of patent applications in the U.S. Patent and Trademark Office on his inventions relating to radioimmunoassay using hair. In 1994, U.S. Patent No. 5,324,642 (the "642 Patent") was issued to the Company. This patent pertains to the universal drug extraction procedure and immunoassay technology for the detection of drugs in hair specimens. In 1995, the Company was granted an additional patent covering Dr. Baumgartner's inventions pertaining to the immuno chemical screening assay for marijuana, which is the most difficult drug to detect. Dr. Baumgartner has continued his research, and the Company has pending two additional patent applications in the U.S. Patent and Trademark Office with respect to his inventions relating to procedures using hair. The Company believes that additional patents will be granted as a result of Dr. Baumgartner's pending patent applications although there can be no assurance that any such additional patents will be granted. Pursuant to an agreement dated January 1987, Werner A. Baumgartner and Annette Baumgartner granted to the Company an exclusive royalty-free worldwide license of all of their rights in and to their inventions relating to radioimmunoassay using hair. Most of Dr. Baumgartner's research on the inventions covered by the 642 Patent was conducted while he was employed by the Veteran's Administration Hospital ("VA"). Dr. Baumgartner has, therefore, also granted to the U.S. government, for all Governmental purposes, a nonexclusive, irrevocable, royalty-free license to use the basic invention during the term of the patent with respect to such invention. Certain aspects of the Company's hair analysis method are based on trade secrets owned by the Company. The Company's ability to protect the confidentiality of these trade secrets is dependent upon the Company's internal safeguards and upon the laws protecting trade secrets and unfair competition. In the event that patent protection or protection under the laws of trade secrets were not sufficient and the Company's competitors succeeded in duplicating the Company's products, the Company's business could be materially adversely affected. TARGET MARKETS 1. Industry The Company has focused its primary marketing efforts on the private sector. The Company believes that the market for job applicant and employee testing will yield the most immediate beneficial impact to the business of the Company and assist in establishing a regular client base. The number of businesses using drug testing to screen job applicants and employees has increased significantly in the last nine years. The 1996 American Management Association (AMA) survey indicated that 81% of surveyed firms were engaged in some form of drug testing, a 277% increase since the initial AMA survey in 1987. The prevalence of drug 5 6 screening programs reflects a growing concern that drug use contributes to employee health problems and costs (increased absenteeism, reduced productivity, etc.) and in certain industries, safety hazards. It has been estimated that the cost to industry in terms of health care costs and lost productivity is at least $60 billion annually. The principal criticism of employee drug screening programs centers on the effectiveness of the testing program. Most private sector screening programs use urinalysis. Such programs are susceptible to evasive maneuvers and the inability to obtain identical repeat samples in the event of a challenged result. Moreover, many employers, to accommodate concerns of their employees and to avoid infringement of employee privacy rights, conduct their programs on a pre-announced schedule, thereby providing an opportunity for many drug users to abstain in order to escape detection. The Company presents its patented hair analysis method to potential clients as a better technology well suited to employer needs. Field studies and actual client results support the accuracy and effectiveness of the Company's patented technology and its ability to detect even casual drug use. The historical aspect of the Company's patented method as well as the Company's ability to provide correlation of the measured drug with approximate amount of ingestion, furnish an employer with greater flexibility in assessing the scope of an applicant's or an employee's drug problem. The Company provides clients confirmation of positive results through GC/MS. The use of GC/MS is an industry accepted practice used to confirm positive drug test results of an initial screen. In an employment setting, GC/MS confirmation is typically used prior to the taking of any disciplinary action against an employee. The Company offers its clients a five-drug screen with GC/MS confirmation of cocaine, PCP, marijuana, methamphetamine, and opiates. 2. Home Use In 1995, the Company began marketing "PDT-90", its hair testing service to parents concerned about drug use by their children. It allows parents to collect a small sample from their child in the privacy of the home and have it tested for drugs of abuse by the Company. The PDT-90 testing service uses the same patented method that is used with the Company's workplace testing service. The Company commenced a marketing campaign in the third quarter of 1995 for the new service. 3. Medical The Company has developed a medical market for its proprietary hair testing method consisting mostly of testing services for use by treatment professionals for drug recovery programs and prenatal care. In the drug treatment area, the Company's patented method can be used by treatment professionals to obtain background information on drug use, information most critical in structuring an individual's recovery program. Under traditional drug detection tests, this information is obtained from self-reporting, an approach generally deemed unreliable for various reasons, including reluctance to discuss the nature of one's drug habit, memory failure, and unknown substance purity. As a follow-up to a rehabilitation process, the Company's patented method provides additional support by generating feedback to individual physicians, psychiatrists and therapists on the success of their methods. The utility of the 6 7 Company's technology in monitoring recovery after discharge from employee assistance programs has been validated by the Company's customers. The Company's recently developed methadone test can also assist treatment professionals in their treatment efforts. The Company has engaged in, and continues to engage in, studies supporting the utility of its patented hair analysis method in the evaluation of drug use during pregnancy and the corresponding treatment of newborns. Studies are under way at University of Pennsylvania, Hutzel Hospital, University of Washington, Columbia University, University of Miami, National Public Services Research Institute, University of California-Sleep State Organization and Maternal/Child Substance Abuse Project. The Company expects that these cost-benefit and application studies will demonstrate the utility of its proprietary screen in the prenatal market. SALES AND MARKETING The Company markets its corporate drug testing services primarily through its own direct sales force. The Company's in-house efforts are supplemented by a limited network of independent sales representatives who are thoroughly trained by the Company. The Company markets PDT-90, its home testing drug service, through a toll-free number. For both its business-to-business and consumer direct services, the Company has undertaken an integrated marketing campaign to enhance the market presence within each respective segment. COMPETITION The Company competes directly with numerous commercial laboratories which test for drugs through urinalysis testing. Most of these laboratories, such as Laboratory Corporation of America, SmithKline Beecham Clinical Laboratories and Corning Clinical Laboratories, Inc. have substantially greater financial resources, market identity, marketing organizations, facilities, and numbers of personnel than the Company. The Company has been steadily increasing its base of corporate customers and believes that future success with new customers is dependent on the Company's ability to communicate the advantages of implementing a drug program utilizing the Company's patented hair analysis method. The Company's ability to compete is also a function of pricing. The Company's prices for its tests are generally somewhat higher than prices for comparable tests using urinalysis. However, the Company believes that its superior detection rates, coupled with the customer's ability to test less frequently due to hair testing's wider window of detection (approximately 90 days verses approximately three days with urinalysis) provide more value to the customer. This pricing policy could, however, lead to slower sales growth for the Company. The Company is not aware of any other laboratories with a hair analysis technology that is comparable in effectiveness to the Company's proprietary procedures. The Company is aware of two laboratories which operate in certain limited employment testing markets and which purport to test hair samples using a method, which the Company presumes, includes the use of a form of immunoassay procedures. The Company, however, does not believe that effective immunoassay testing of hair samples is currently feasible on a commercial basis without using the Company's unique patented method. 7 8 GOVERNMENT REGULATION The Company is licensed as a Clinical Laboratory by the State of California as well as certain other states. All tests are performed according to the standards established by the Clinical Laboratories Improvement Act and the College of American Pathologists. Presently there are no other regulations required for the operation of a clinical laboratory in the State of California. A substantial number of states regulate drug testing. The scope and nature of such regulation varies greatly from state to state. In some states, a clinical laboratory such as the Company is required to satisfy certain requirements as a precondition to the laboratory's certification or right to perform drug testing services with respect to specimens obtained in such state. The laws or regulations in other states, in some instances, limit testing to certain matrixes ("matrix" refers to the substance, blood, urine, hair, etc., which is tested for the presence of drugs) which in two states excludes hair. The Company seeks, through participation in the legislative and regulatory process, to educate the legislative and regulatory agencies of those few states whose statutes have been interpreted to not include the testing of hair. In August 1995, the United States Food and Drug Administration ("FDA") issued a Warning Letter to the Company pertaining to PDT-90, the drug testing service which the Company introduced in July 1995 as a testing service for parents concerned about drug use by their children. The FDA claimed that the collection envelope the Company distributed as part of the PDT-90 testing service constituted a "medical device" under the Federal Food Drug and Cosmetic Act, as amended (the "FDC Act"), and that, because the Company did not seek the approval or permission of the FDA to market the envelope, it was therefore adulterated and misbranded under the FDC Act. In its response, the Company stated its position that the collection envelope is not a medical device under the FDC Act. However, in order to expeditiously resolve the matter with the FDA, the Company submitted a 510(k) premarket notification to the FDA on September 27, 1995 seeking a determination from the FDA that the collection envelope is substantially equivalent to collection envelopes which previously received 510(k) premarket clearance and were currently being commercially marketed. In November 1995, the FDA issued a "Not Substantially Equivalent" ("NSE") determination in response to the Company's 510(k) submission and classified PDT-90 as a Class III device under the FDC Act. In December 1995, the Company filed suit against the FDA in the United States Court of Appeals for the First Circuit seeking to overturn the FDA's NSE determination. In March 1996, the FDA agreed to withdraw the Warning Letter and the NSE determination in exchange for the Company's dismissal of its suit against the FDA. The FDA also confirmed its decision not to actively regulate PDT-90 and not to pursue enforcement action on any of the grounds contemplated in the Warning Letter. On February 6, 1997, the FDA announced a new agency proposal to companies that make "drugs of abuse test systems". Under the proposal, companies engaged in the business of testing for drugs of abuse using immunoassay testing procedures previously recognized by the FDA would be able to market their test systems without pre-market approval or clearance by the FDA so long as the tests are conducted at certain approved laboratories and certain labeling and product information procedures are followed. To date, the FDA has recognized immunoassay testing procedures which involve the use of urine and sweat as the test sample in certain applications. Under the FDA proposal, companies engaged in the business of testing for drugs of abuse using samples other than those previously recognized would effectively be prohibited from operating without FDA approval or clearance. Such companies 8 9 would be required to submit their test to the FDA for recognition. The FDA's February 1997 announcement states that it intends to implement the proposed new policy through notice and comment rulemaking. The proposal includes a transitional period of approximately two years in order for companies not currently in compliance with the proposed requirements to obtain the necessary data they need for submission to the FDA. The Company believes that its proprietary method of detecting drugs of abuse using hair samples is accurate and reliable and should, therefore, be recognized if necessary. However, the Company maintains that the FDA lacks statutory authority to regulate its drug testing service. There is a risk that, under regulations which may hereafter be adopted in light of the FDA's proposal, an application by the Company for recognition of the Company's proprietary hair testing technology could be denied, in which event, if upheld on appeal, the Company's business would be materially adversely affected. SCIENTIFIC ADVISORY BOARD The Company has established a Scientific Advisory Board which consults with management of the Company to examine and evaluate the progress of the Company's research and development activities, to promote independent validation studies of the Company's patented hair analysis method technology, and to assist in accelerating acceptance of the technology in both the public and private sectors. Members of the Scientific Advisory Board are compensated at the rate of $1,000 per day for each meeting attended plus reimbursement for out-of-pocket expenses. The Chairman of the Scientific Advisory Board is Dr. Robert DuPont. Dr. DuPont's career has included numerous positions in the psychiatric and substance abuse field, including Director, Special Action Office for Drug Abuse Prevention - The White House; the first Director, National Institute on Drug Abuse; President, American Council for Drug Education; and President, Phobia Society of America. Dr. DuPont has received several national awards and presently serves as President: Institute for behavior and Health, Inc.; Vice President, Bensinger, DuPont and Associates, a national drug and alcohol abuse consulting firm; and he maintains a private practice in psychiatry. Dr. DuPont has also been granted options to acquire shares of the Company's common stock. Other members of the Scientific Advisory Board are Edward C. Senay, M.D., a Professor in the Department of Psychiatry at the University of Chicago, and Arthur McBay, Ph.D., a Forensic Toxicologist and former Professor of Pharmacy at the University of North Carolina. RESEARCH AND DEVELOPMENT The Company is continuously engaged in research and development activities. During the years ended December 31, 1996, 1995 and 1994, $413,693, $436,385 and $406,345, respectively, were expended for research and development. The Company continues to perform research activities to develop new products and services and to improve existing products and services utilizing the Company's proprietary technology. Additional research using the Company's proprietary technology is being conducted by outside research organizations through government-funded studies. The Company's research includes "controlled studies" to determine the advantages of hair testing in the medical, forensic and criminal justice markets. The Company has also furnished technical assistance to several distinguished independent researchers whose studies have been funded through government grants. Many such studies are currently in progress. The Company continues to conduct its own research toward the development of new inventions, services and products derived from the Company's patented technology. SOURCES AND AVAILABILITY OF RAW MATERIALS Since its inception, the Company has purchased raw materials for its laboratory services from outside suppliers. The most critical of these raw materials are the radio-labeled drugs which 9 10 the Company purchases from a single supplier, although other supplies of radio-labeled drugs exist. If suitable radio-labeled drugs were to become unavailable, or available only at prohibitive cost, the Company would be required to produce its own radio-chemical supplies, although other suppliers of radio-labeled drugs exist. The Company estimates that it would have to expend approximately $400,000 for capital additions to produce its own supply. Thereafter, direct costs for such raw materials would likely decrease. PRINCIPAL CUSTOMER The Company's largest customer in 1996, Blockbuster Entertainment Group ("Blockbuster"), a division of Viacom, Inc., accounted for approximately 21% of the Company's drug sampling volume and approximately 18% of the Company's revenue during the year ended December 31, 1995, and approximately 19% of drug sampling volume and 15% of the Company's revenue in 1996. EMPLOYEES As of December 31, 1996, the Company had 71 full-time equivalent employees, of which four full-time employees were in research and development. None of the Company's employees is subject to a collective bargaining agreement. Item 7. Management's Discussions and Analysis of Financial Condition - --------------------------------------------------------------------- and Results of Operations. ------------------------- RESULTS OF OPERATIONS The year ended December 31, 1996 was another record year for revenue. Revenue was $12.2 million in 1996 as compared to $10.1 million in 1995 and $8.7 million in 1994, representing an increase of 21% in 1996 and 16% in 1995. These increases were due primarily to increases in volume from both new and existing clients of 24% in 1996 and 20% in 1995 offset by average price decreases of 3% in 1996 and 4% in 1995 primarily as the result of volume discounts granted to large customers. The number of employers utilizing the Company's drug testing services increased 20% in 1994, 24% in 1995 and 46% in 1996. As a result, the share of revenues derived from Blockbuster Entertainment Group has decreased from 24% in 1994 to 15% in 1996. Blockbuster's share of drug testing revenues is expected to decline further in subsequent years. Gross margin was 59% of sales in 1996 compared to 54% in 1995 and 58% in 1994. The increase in 1996 was primarily the result of increased efficiencies resulting from increased volume. The decrease in 1995 from the 1994 level was due to higher costs associated with expansion of the Company's laboratory facilities in 1995. General and administrative (G&A) expenses were held to 19% of revenues in 1996, the same percentage as in 1995. G&A expenses represented 15% of revenues in 1994. G&A expenses increased by $415,000 to $2.36 million in 1996, and increased by $604,000 to $1.95 million in 1995. The increase in 1996 was primarily due to increased expenditures for payroll, legal, regulatory and bad debt provisions. The increase in 1995 was also due primarily to higher costs incurred by the Company for payroll, legal and regulatory expenses. Marketing and selling expenses for the year ended December 31, 1996 remained at 17% of revenues in both 1995 and 1996, representing a decrease of 1% as a percent of revenues from the 1994 amount which was 18% of revenues. Marketing and selling expenses 10 11 increased by $311,000 to $2 million in 1996, and by $191,000 to $1.7 million in 1995. The increase in 1996 was due primarily to increased marketing expenses and additional sales staff. The increase in 1995 was due primarily to increases in marketing expenses. The Company currently expects that marketing and selling expenses will exceed 17% of revenues in 1997 as the Company continues its efforts to expand its client base. Research and development expenses remained virtually unchanged in 1996 from 1995 and 1994 amounts, but continued to decline as a percentage of revenues from 5% in 1994 to 3% in 1996. Net interest income increased as a result of higher levels of short-term investments in 1996 as compared to 1995. Net income increased 60% to $2.5 million in 1996, following a decline of 15% to $1.6 million in 1995 . The increase in 1996 was primarily due to increased revenues, and related efficiencies in direct costs derived from increased sales volume. The decrease in 1995 was primarily due to increases in direct costs and increased general and administrative expenses which exceeded increases in revenues in such year. The provision for income taxes in 1996 and 1995 represented the alternative minimum tax due as required under the Internal Revenue Code, and provision for state corporate income taxes. The Company had total net operating loss carryforwards at December 31, 1996 of approximately $3.6 million available to offset future years' cash payments for income taxes, however, approximately $2.6 million of these loss carryforwards were comprised of deductions from the exercise of certain options and warrants which will increase paid-in capital when tax benefits related to these options and warrants are recognized. LIQUIDITY AND CAPITAL RESOURCES At December 31, 1996, the Company had $9.8 million of cash, cash equivalents and short-term investments, compared to $5.5 million at December 31, 1995. The Company's operating activities generated net cash of $2.3 million in 1996 and $2.0 million in 1995. Investing activities used $3.8 million in 1996 and $0.5 million in 1995 while financing activities generated $2.7 million in 1996 and used $1.8 million in 1995. The Company's source of funds in 1996 was derived approximately 53% from financing activities, the major item being the receipt of proceeds from the exercise of stock options and warrants, and approximately 47% from net cash generated from operations. In 1995, the primary source of funds was net cash generated from operations. Operating cash flows increased $379,000 in 1996. Net income was higher in 1996 by $933,000 but this increase was offset by increases in receivables and reductions in accounts payable which were only partially offset by increases in other liability accounts. The non-cash effect of depreciation and amortization in 1996 and 1995 was $535,000 and $600,000, respectively. Capital expenditures in 1996 were $736,000, a reduction of $534,000 from 1995's expenditures of $1.27 million. The expenditures in 1996 primarily consisted of new equipment, including a new gas chromatographer/mass spectrometer (GC/MS). The 1995 expenditures consisted of expansion of the Company's laboratory facilities in Culver City, California, as well as an additional GC/MS machine and other equipment. the Company currently plans to make capital expenditures of approximately $1,300,000 in 1997, primarily in connection with the purchase of 11 12 laboratory and computer equipment. The Company believes that within the next year 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. In December 1994, the Company's Board of Directors authorized the repurchase of up to 1 million shares of the Company's common stock. During 1995, the Company purchased a total of 699,387 shares for an aggregate purchase price of $2.6 million. No shares were purchased in 1996. On July 3, 1996, the Company distributed a 3% stock dividend to shareholders of record on June 21, 1996. The shares issued in the stock dividend represented shares which the Company acquired in the stock repurchase program. This transaction resulted in an increase of $4.67 million in the accumulated deficit (633,000 shares distributed at a fair market value of $7.37 per share). Treasury stock was reduced by $2.42 million as a result of this distribution. Average shares outstanding and all per share amounts included in the accompanying Financial Statements and Notes are based on the increased number of shares giving retroactive effect to the stock dividend. Since December 31, 1996 and prior to the filing of this Amendment No. 1, the Company has distributed an aggregate of $2,194,000 of cash dividends to its shareholders. At December 31, 1996, the Company's principal sources of liquidity included $9.8 million of cash, cash equivalents and short-term investments. Management believes that such funds, together with future operating profits, 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 include joint ventures, issuance of common stock or debt financing. At December 31, 1996, the Company had no long-term debt. 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 principal customers, business strategy, anticipated operating results 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 difference include, but are not limited to, risks associated with the continued expansion of the Company's sales and marketing network, 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, competition and general economic conditions. 12 13 ' 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: January 27, 1998 By: /s/ Raymond C. Kubacki, Jr. -------------------------------------- Raymond C. Kubacki, Jr. President and Chief Executive Officer Date: January 27, 1998 By: /s/ Bruce M. Stillwell -------------------------------------- Bruce M. Stillwell Vice President, Treasurer & Controller 13 14 January 27, 1998 Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Psychemedics Corporation (the "Company") Form 10-K for the Fiscal Year Ended December 31, 1996 Form 10-Q for the Quarter Ended March 31, 1997 File No. 1-13738 ------------------------------------------------------------------ Dear Sir or Madam : In response to the Staff's comment letter dated June 30, 1997 addressed to Raymond C. Kubacki, Jr., President of the Company, the following materials are hereby being transmitted for filing under the Securities Exchange Act of 1934, as amended: 1. Form 10-K/A Amendment No. 1 to the Company's Annual Report on Form 10-K for the Fiscal Year Ended December 31, 1996; and 2. Form 10-Q/A Amendment No. 1 to the Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1997. The Company wishes to respond to the staff's comments as follows: Form 10-K for FYE December 31, 1996 - ----------------------------------- Item 7. Management's Discussion and Analysis of Financial Condition and - ------ --------------------------------------------------------------- Results of Operations. --------------------- Results of Operations --------------------- 1. The discussion of the results of operations is too general. Please revise to include an analysis and quantification of the particular causes of changes in material line item amounts from period to period. The analysis should identify individual factors (such as change in prices, volume, product mix, 15 Securities and Exchange Commission January 27, 1998 Page 2 etc.), discuss the reasons that these factors changed during the period, and quantify their effects. You should discuss the reasons why management believes reported trends are expected to continue or change. Refer to Item 303 of Regulation S-K and Release No. 34-26831 which discusses the disclosure requirements of Item 303 in detail. Response: The section has been revised to comply with the staff's request. 2. Expand the discussion to include percentage comparisons of each material change in line items from year to year. Please note that while the use of additional statistical analysis such as the common-size analysis the Company has utilized, is encouraged, disclosure and percentage comparisons of material changes in the line items of the financial statements from year to year must be the starting point of the disclosure. Please revise accordingly. Response: The section has been revised to comply with the staff's request. Liquidity and Capital Resources ------------------------------- 3. The statement of cash flows should be utilized to present a balanced discussion dealing with cash flows from investing and financing activities as well as from operations. Response: The section has been revised to comply with the staff's request. 4. Indicate the general purpose of the capital commitments and the anticipated source of funds needed to fulfill such commitments. Response: The section has been revised to comply with the staff's request. 5. Identify and separately describe each internal and external source of liquidity, disclosing the amount of any material unused sources of liquid assets. Response: The section has been revised to comply with the staff's request. 6. Revise the disclosure to discuss liquidity on both a short-term and long-term basis. Response: The section has been revised to comply with the staff's request. 7. Quantify the discussion of the Company's working capital needs. -----END PRIVACY-ENHANCED MESSAGE-----