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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] 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 LABORATORIES, INC.
(Exact name of registrant as specified in its charter)
CALIFORNIA 77-0187280
(State or other jurisdiction (IRS Employer
of incorporation or organization) Identification Number)
1505-A O'BRIEN DRIVE
MENLO PARK, CALIFORNIA 94025
(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (650) 328-6200
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Name of each exchange
Title of each class on which registered
------------------- ----------------------
COMMON STOCK NASDAQ NATIONAL MARKET
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-K 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. [X]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant (based on the closing price of $4.00 as reported on the
Nasdaq/NMS on January 29, 1999) was approximately $23,127,000. Shares of voting
stock held by each executive officer and director and by each holder of 5% or
more of the outstanding voting stock have been treated as shares held by
affiliates. This determination of affiliate status is not necessarily a
conclusive determination for other purposes. The number of outstanding shares of
the Registrant's Common Stock as of January 29, 1999 was 5,781,706.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the PharmChem Laboratories, Inc. Proxy Statement for the
1999 Annual Meeting of Shareholders to be filed with the Commission on or before
April 30, 1999 are incorporated by reference into Part III of this Annual Report
on Form 10-K. With the exception of those portions which are specifically
incorporated by reference in this Annual Report on Form 10-K, such Proxy
Statement shall not be deemed filed as part of this Report.
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PHARMCHEM LABORATORIES, INC.
ANNUAL REPORT ON FORM 10-K
INDEX
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PART I. PAGE
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Item 1. Business................................................................ 3
Item 2. Properties.............................................................. 9
Item 3. Legal Proceedings....................................................... 10
Item 4. Submission of Matters to a Vote of Security Holders..................... 10
PART II.
Item 5. Market for Registrant's Common Equity and Related Shareholder Matters... 11
Item 6. Selected Consolidated Financial Data.................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations .................................................. 13
Item 7A. Quantitative and Qualitative Disclosures About Market Risk ............. 18
Item 8. Financial Statements and Supplementary Data............................. 18
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.................................................... 40
PART III.
Item 10. Directors and Executive Officers of the Registrant...................... 40
Item 11. Executive Compensation.................................................. 40
Item 12. Security Ownership of Certain Beneficial Owners and Management.......... 40
Item 13. Certain Relationships and Related Transactions.......................... 40
PART IV.
Item 14. Exhibits, Financial Statement Schedule and Reports on Form 8-K.......... 40
Signatures......................................................................... 45
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PART I
ITEM 1. BUSINESS
Unless the context indicates otherwise, all references herein to
"PharmChem" or the "Company" include PharmChem Laboratories, Inc. and its
wholly-owned subsidiary, Medscreen Limited ("Medscreen").
GENERAL
PharmChem Laboratories, Inc. is a leading independent laboratory
providing integrated drug testing services to corporate and governmental
customers seeking to detect and deter the use of illegal drugs and alcohol.
PharmChem is certified by the Substance Abuse and Mental Health Service
Administration (SAMHSA) of the US Department of Health and Human Services, the
College of American Pathologists (CAP) and a number of states to conduct drug
testing using forensic procedures. The Company's domestic laboratories are
certified under the Clinical Laboratory Improvement Amendments (CLIA) or have
"deemed status" under CLIA as a result of state certification. The forensic
procedures provide accurate and reliable test results and a chain of custody for
each specimen from its collection to the reporting of its test result. PharmChem
tests for a number of drugs of abuse, including cocaine, methamphetamine,
heroin, phencyclidine (PCP), marijuana (THC) and alcohol, primarily by
urinalysis but also with the PharmChek(R) Drugs of Abuse Patch (for testing with
sweat). PharmChem also offers PharmScreen(R) on-site screening devices and a
comprehensive set of services that are customized to assist customers in
implementing cost-effective drug testing programs.
PharmChem was incorporated in California in 1987 to acquire PharmChem
Laboratories Operations, Inc., a California corporation, which was founded in
1971. In 1991, the Company completed its initial public offering. In 1992,
PharmChem expanded its operations through the acquisitions of London-based
Medscreen (a certified laboratory providing international drug testing services)
and of a certified laboratory in Fort Worth, Texas. The Company's customers
include private and public employers, criminal justice agencies and drug
treatment programs, primarily in the United States and in Europe.
INDUSTRY BACKGROUND
Historically, the drug testing market has been served by national
clinical laboratory chains, independent national drug testing laboratories, such
as PharmChem, and numerous regional and local laboratories. Thousands of general
clinical laboratories nationwide can conduct forensic and non-forensic drug
testing, and are increasingly bidding on local contracts. Over the past several
years, through consolidations, restructurings and bankruptcies, there has been a
decline in the number of independent laboratories whose sole business is
conducting forensic drug testing. Many corporate and governmental organizations
are requiring drug testing laboratories to be certified to conduct forensic drug
tests and to offer integrated cost-effective testing services. Also, many large
organizations, particularly those in the public sector, use a competitive
bidding procedure to select their drug testing laboratories. The bidding process
for these competitive contracts is often limited to qualified bidders and
certified drug testing laboratories, which can demonstrate the ability to meet
the service and volume levels specified by the customer.
DRUG TESTING OPERATIONS
The essential elements of forensic drug testing are a secure chain of
custody for each specimen from its collection to the reporting of its test
result and accurate and reliable testing in which a second independent test is
performed to confirm each positive test result. PharmChem carefully controls
each step of the testing process with detailed written procedures and using the
specific forensic testing methods required for legal defensibility of results.
The Company performs the largest portion of its testing at its laboratory in
Menlo Park, California, which operates six days per week, 24 hours a day. The
Company also provides complete testing services at its Texas Division in Fort
Worth and its London-based subsidiary, Medscreen. The steps in the Company's
forensic drug testing process by urinalysis, the Company's primary drug testing
method, are as follows:
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Specimen Collection and Transportation. Forensic drug testing begins
with specimen collection conducted under carefully controlled conditions. Once a
donor has provided a specimen, it is assigned a unique specimen identification
number. Information pertinent to the specimen is then recorded on a chain of
custody form numbered to match the specimen bottle. Specimens, together with
chain of custody forms, are delivered to PharmChem by courier or mail.
Receiving and Accessioning. PharmChem receives specimens in its
restricted accessioning rooms, where they are inspected for tampering and
checked for proper chain of custody documentation. Specimens are identified and
tracked using unique bar-coded laboratory accessioning numbers.
Screening. Each specimen submitted is screened for the presence of the
drugs specified by the customer. PharmChem performs in excess of 1,600,000
screening tests on more than 230,000 specimens per month to determine the
presence of drugs. The screening methods used by the Company include enzyme
immunoassay, radioimmunoassay (RIA) and thin layer chromatography (TLC).
Confirmation Testing. Results of specimens that screen negative are
reported to the customer. Specimens that screen positive are confirmed by
testing a separate aliquot using a different and independent technology from
that used for the initial screening. Confirmation technologies employed by
PharmChem include gas chromatography/mass spectrometry (GC/MS) and gas
chromatography (GC). GC/MS confirmation is required for federally-regulated drug
testing and most other workplace drug testing and its use has been cited with
approval in numerous legal proceedings.
Quality Assurance/Quality Control (QA/QC). PharmChem carefully monitors
the accuracy and reliability of its test results by internal and external QA/QC
programs. The Company's staff evaluates laboratory performance with open and
blind quality control samples. In addition, the Company is subject to frequent
proficiency testing by various certifying bodies, which send their own open and
blind samples to the laboratory. Further, the Company is subject to frequent
inspections by certifying agencies.
Data Review. Each test result undergoes several independent levels of
review before being reported by a certifying scientist.
Reporting of Results. PharmChem transmits most of its test results
electronically using various secure communication networks and through automated
voice reporting systems. Upon release by a certifying scientist, each test
result is made available by the Company's information systems to the customer's
computer or secure facsimile machine, by telephonic inquiry or by mail delivery.
The Company routinely reports results for specimens that screen negative within
24 hours of receipt in the laboratory and within 48 hours for specimens that
require confirmation.
CUSTOMER SERVICES AND TECHNICAL SUPPORT
PharmChem provides a variety of drug testing services which are
customized to each customer's specific needs. The Company employs a customer
service and technical support staff specializing in one or more of the following
areas of service.
Specimen Collection. PharmChem manages specimen collection services for
a number of its customers. The Company maintains a list of more than 5,000
clinics and other organizations throughout the United States (US) and Puerto
Rico that offer specimen collection services that comply with forensic
drug-testing procedures. PharmChem's customer service staff identifies
collectors conveniently located to customer sites, prepares customized specimen
collection procedures, conducts training of collection personnel and monitors
their performance. In 1998, PharmChem managed approximately 500,000 collections
in the US, while Medscreen managed approximately 25,000 collections throughout
the United Kingdom (UK) and at over 300 shipping ports throughout the world.
Transportation. Most specimens are transported to PharmChem by overnight
or same-day courier, or by mail. The Company offers special specimen
transportation services for selected areas throughout the country, which provide
for pickup of specimens before the close of each business day.
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Technical Consultation. The technical specialists on PharmChem's staff
are experienced in drug metabolism and other technical aspects of drug testing.
These specialists respond to requests from customers to interpret test results.
In addition, the Company is often called upon to assemble the complete chain of
custody and testing data package for specimen results that have been challenged
and to provide expert witness testimony in legal proceedings. The technical
consultation group also provides comprehensive in-service training for customers
on topics such as substance abuse trends, toxicology and drug pharmacology,
breath alcohol testing and technical information on the Company's testing
procedures.
Program Analysis. PharmChem collects and analyzes data on test results
in order to provide comprehensive monthly statistical reports to meet customers'
regulatory requirements and to assist with drug program management.
RESEARCH AND DEVELOPMENT
PharmChem's most experienced scientists and technicians perform research
and development activities. The Company's research and development efforts
continually focus upon improving laboratory procedures and processes. The
Company believes it has engineered a number of efficiencies to improve the
accuracy and reliability of its drug tests.
PHARMSCREEN(R) ON-SITE SCREENING DEVICE
In recent years there has been a growing trend toward the use of on-site
screening for drugs of abuse by a number of agencies, including some of the
Company's customers. On-site screening relies upon portable diagnostic devices
that may be used at the point of specimen collection to readily identify drugs
of abuse in urine specimens. This technology is advantageous in that it provides
virtually immediate test results.
The Company offers a line of on-site screening devices to supplement its
laboratory-based testing services. In 1996, PharmChem acquired marketing rights
in non-clinical markets for PharmScreen(R), a portable, hand-held device used
for on-site screening of drugs of abuse. In 1996, the US Food and Drug
Administration (FDA) cleared PharmScreen(R) for detecting the use of cocaine,
opiates (including heroin), amphetamines and methamphetamine. In 1997, the FDA
cleared PharmScreen(R) for detecting PCP, benzodiazepines, barbiturates and
methadone. PharmScreen(R) is available in single, dual, four and five test
configurations and is currently being used by certain government agencies,
including the Michigan Department of Corrections (Michigan DOC) and the
Administrative Office of the United States Courts (Federal Probation).
PharmScreen(R) provides only a preliminary analytical result, and a more
specific alternative chemical method, such as GC/MS, is necessary to obtain a
confirmed analytical result. Although sales of PharmScreen(R) by the Company
have steadily increased, there can be no assurance that it will be commercially
accepted by existing or new customers or generate significant revenues in the
future.
PHARMCHEK(R) DRUGS OF ABUSE PATCH
Since 1992, the Company has been investing in and developing
PharmChek(R), a system that uses sweat to detect the use of illegal drugs, for
use in the US. PharmChek(R) consists of a transparent polyurethane outer
covering, a small absorbent pad and a release liner. A unique number is printed
on the underside of the polyurethane layer for identification and
anti-counterfeiting purposes. Flushing or employing a diuretic to rid the body
of drugs of abuse do not affect PharmChek(R) test results, since the drugs in
the sweat simply collect on the absorption pad until the pad is removed for
analysis. PharmChek(R) may offer several other advantages over other drug
detection systems currently available. It does not require the handling of urine
or blood, which may be objectionable to some people. The use of sweat as a
testing medium may lengthen the drug use detection period and decrease testing
costs by reducing the need for specialized specimen collection facilities and
staff.
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Recent state and federal court cases in California and Nevada have
affirmed the validity of PharmChek(R) for detecting the use of illegal drugs. In
1995, the FDA cleared PharmChek(R) for detecting the use of cocaine, opiates
(including heroin), and amphetamines (including methamphetamine) and, in 1996,
clearance was obtained for detecting the use of phencyclidine (PCP) and
marijuana (THC). The Company previously conducted pilot programs using
PharmChek(R) with the Michigan DOC and the Federal Probation.
The Company has incurred significant costs in connection with the
commercialization of PharmChek(R). To date, sales of PharmChek(R) by the Company
have not been material and there can be no assurance that it will be
commercially accepted by existing or new customers or generate significant
revenues in the future. Refer to "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
SALES AND MARKETING
PharmChem sells its integrated drug testing services to corporate and
governmental customers. The sales force uses a consultative selling approach,
Premium Comprehensive Management(TM) (PCM) emphasizing the full scope of
integrated services offered by the Company and customizing these services to
meet customers' particular needs. PCM consists of providing customized services
including a worldwide database of collection sites and on-call collections for
rapid response; alternatives to laboratory urine testing including on-site
screening devices such as PharmScreen(R), sweat testing with PharmChek(R) and
hair testing; statistical reporting; centralized billing and other services.
CUSTOMERS
PharmChem provides integrated drug testing services to three primary
customer groups in the United States:
Public and Private Employers. Public and private employers use drug
testing as part of their hiring decisions in order to increase safety and reduce
costs associated with drug abuse in the workplace. In addition, an increasing
number of public and private employers test employees in certain positions on a
periodic or random basis and test other employees upon reasonable suspicion of
drug use. Sales of laboratory services and products to public and private
employers accounted for 42%, 45% and 50% of the Company's total net sales in
1998, 1997 and 1996, respectively. Sales to Sears, Roebuck & Co. accounted for
approximately 11%, 10% and 10% of the Company's total net sales in 1998, 1997
and 1996, respectively.
Criminal Justice Agencies. Criminal justice agencies use drug testing
results in criminal proceedings and to assist with making parole, drug treatment
and probation decisions. In addition, these agencies use drug testing to monitor
drug treatment of individuals under supervision and to track drug use trends
within the United States. Sales of laboratory services and products to criminal
justice agencies accounted for 39%, 41%, and 37% of the Company's total net
sales in 1998, 1997 and 1996, respectively. Sales to Federal Probation accounted
for approximately 18%, 17% and 19% of the Company's total net sales in 1998,
1997 and 1996, respectively.
Drug Treatment Programs. Drug treatment programs use drug testing to
monitor the treatment and rehabilitation of drug users in their care. Sales of
laboratory services and products to drug treatment programs accounted for less
than 5% of the Company's total net sales in 1998, 1997 and 1996.
Medscreen, the Company's London-based subsidiary, accounted for 15%,
11%, and 8% of the Company's total net sales in 1998, 1997 and 1996,
respectively. Medscreen's primary customers operate in the criminal justice,
maritime, oil and transportation industries. During 1998, approximately 62% of
Medscreen's sales were from UK-based customers with the balance from customers
in other countries in Europe, Asia, Middle East and South America.
SUPPLIERS
PharmChem is dependent upon a single supplier for the PharmChek(R)
product. The Company is not dependent upon any other single supplier for its raw
materials.
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CONTRACTING
Many of PharmChem's large potential customers, including the majority of
public employers and criminal justice agencies, use a formal competitive bid
process in which the potential customer provides a detailed specification of the
drug testing services it requires. Because many of the Company's customers use a
competitive bidding process, there is no assurance that the Company will be the
successful bidder when such contracts are up for renewal. While price is an
important factor, in most cases these organizations are not required to accept
the lowest bid, but rather may choose the winning bidders on the basis of
technical superiority and customer service.
The failure to renew a significant contract, if not replaced by
comparable contracts, could result in lower sales, lower profit margins,
decreased cash flows and losses. PharmChem's contracts generally allow
termination at the customer's discretion on short notice with little or no
penalty. In particular, many contracts contain provisions that provide for
termination for convenience. Although the Company's experience has been that its
customers generally do not exercise these early termination rights, there can be
no assurance that this will continue in the future. For some customers, the
Company performs drug testing services under a standard service contract. With
other customers, the Company has no formal contract. In these cases, the Company
typically accepts and tests specimens for an agreed upon price which is
generally renegotiated every twelve months. Backlog is not a significant
statistic for the Company due to the short turnaround time for processing
specimens.
COMPETITION
The market for drug testing services became increasingly competitive in
the early 1990's, and continues to be competitive. Drug testing laboratories
compete primarily on the basis of customer service, technical capability and
price. The Company believes it competes favorably in each of these categories.
PharmChem has significantly expanded its scope of services and its average total
price per specimen has increased slightly. PharmChem's competitors include
national clinical laboratory companies, such as Smith-Kline Beecham Clinical
Laboratories, Laboratory Corporation of America (National Health
Laboratories/Roche Biomedical Laboratories) and Quest Diagnostics (formerly
Corning Clinical Laboratories); independent national drug testing laboratories,
such as Psychemedics Corporation and Medtox Scientific, Inc.; third party
administrators; medical review officers; manufacturers and distributors of
on-site screening devices and equipment; and numerous regional and local
laboratories. The national clinical laboratories have greater financial,
marketing, laboratory and related resources than the Company. In addition, some
customers and potential customers of the Company operate their own drug testing
facilities or may develop such facilities in the future. A majority of the
Company's sales are derived from competitive bids, and the Company believes that
competitive pressure with respect to these bids, particularly large multi-year
contracts, has intensified.
CERTIFICATION AND GOVERNMENT REGULATION
Laboratories which compete in the domestic forensic drug testing market
generally must be certified by SAMHSA. In addition, some state and local
jurisdictions require their own certification for testing of specimens involving
their residents. Such state and local certifications are essential to the
Company's business in each such respective jurisdiction. The Company's
laboratories are currently certified by SAMHSA, CAP and certain state and local
jurisdictions. Further, the Company's Texas laboratory is certified by CLIA and
the California laboratory has received "deemed status" under CLIA as a result of
its State of California certification. The Company believes it is certified in
all jurisdictions in which it operates.
The Company is subject to frequent inspection by certifying bodies,
including annual CAP and semi-annual SAMHSA inspections. Inspections generally
result in reports describing areas for improvement or suggesting changes in
procedures. The Company may be required to take actions with respect to the
items noted in the inspection report in order to remain certified. Failure to
meet certification requirements could result in suspension or loss of
certification. The Company has never been decertified as the result of an
inspection. Certification is essential to the Company's business because some of
its customers are required to use a certified laboratory, and many of its
customers look to certification as an indication of reliability and accuracy of
results.
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Employee drug testing by federal agencies and certain private employers
is regulated by certain federal agencies. Court precedent currently exists in a
number of states regarding the circumstances under which employers may test
employees and the procedures under which such tests must be conducted. The
circumstances under which drug testing can legally be required by employers is
subject to judicial review, and is challenged from time to time by employees,
unions and other groups on constitutional, privacy and other grounds.
DOMESTIC AND FOREIGN OPERATIONS
Refer to Note 10 to the Consolidated Financial Statements for reportable
segment information and financial information about geographic areas.
ENVIRONMENTAL MATTERS
A small portion of the Company's business involves testing procedures
requiring the use of chloroform and radioactive reagents, which are considered
to be hazardous materials. Failure to comply with current or future federal,
state or local environmental laws or regulations regarding these hazardous
materials could have a material adverse effect on the Company. The Company
believes that it has adequately notified employees of potential risks associated
with working at the Company and has provided a workplace safe from hazard, as
required by the Occupational Safety and Health Administration and certain state
laws. The Company believes it is in compliance with all applicable environmental
laws and regulations.
EMPLOYEES
As of December 31, 1998, the Company had approximately 300 full-time
employees. PharmChem's employees are not represented by labor organizations. The
Company considers relations with its employees to be good.
SEASONAL OPERATING FACTORS
PharmChem's operations are affected by seasonal trends to which drug
testing laboratories are generally subject. In the past, testing volume tends to
be higher in the second and third calendar quarters and lower in the fourth and
first calendar quarters, primarily due to the hiring patterns of the Company's
public and private employer customer group which affect pre-employment drug
testing. Further, demand for the Company's services is dependent on general
economic conditions.
YEAR 2000
The Year 2000 ("Y2K") issue is the result of date-sensitive devices,
systems and computer applications that were deployed using two digits rather
than four digits to define the applicable year. Therefore, these technologies
may improperly recognize a year containing "00" as 1900 rather than the year
2000. This may result in a system failure or miscalculations causing disruptions
of operations. The Company is subject to various risks associated with the Y2K
impact on information systems software and hardware.
The Company has completed its assessment of the Y2K impact on internal
information systems. The assessment identified operational inefficiencies and
Y2K non-compliance of the existing laboratory information system ("LIS"). The
Company has commenced replacing its existing LIS with a new system that is Y2K
ready. The new LIS is expected to be implemented in mid-third quarter of 1999.
The Company estimates the cost to purchase and install the new LIS and related
hardware will be approximately $1 million. Excluding the LIS expenditures, the
Company estimates additional Y2K related expenditures of approximately $100,000
representing consulting costs and payroll for employees dedicated to Y2K
projects.
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Due to the large volume of electronic transmissions, the Company has
conducted inquiries of customers, vendors and key business partners to identify
Y2K issues and continues to evaluate responses. During the second quarter of
1999, the Company will commence limited transmissions of test results to
selected customers using a four digit year to determine which customers can and
cannot receive such electronic results with a year field of four digits. The
Company's various internal drug test results reporting systems have been
reprogrammed and tested in a parallel systems environment and the Company
continues to test external results reporting services. The Company has reviewed
its facilities systems and found that many are not date sensitive. With respect
to other facilities systems and financial accounting systems, the Company is in
the process of obtaining documentation of Y2K compliance or replacing systems
that are not Y2K compliant.
For the period January 1, 1996 through December 31, 1998, the Company
has invested $5.4 million in new IS assets which have been designed to enhance
its operational capabilities as well as meet Y2K requirements. The Company
expects to complete all Y2K projects at various dates through the end of the
third quarter of 1999. All investments in information systems and other Y2K
projects have been funded or are expected to be funded by internally generated
cash, leases or bank financing
The Company is in the process of refining its contingency plans to
consider additional scenarios whereby Y2K readiness is not significantly
achieved by the Company and/or its key customers, business partners and vendors.
The Company believes that the "most reasonably likely worst case Year 2000
scenario" would result from a failure of third party transportation systems
which would prevent the Company from receiving specimens to test. These
contingency plans, including issues involving providers of transportation
services, are expected to be completed in mid-1999. If the Company determines
that any critical supplier is not Y2K compliant, it will seek alternate
suppliers and, if it finds that alternate suppliers are not available, the
Company will purchase inventory in advance in excess of normal purchase levels.
In the event of information systems failures, the Company may utilize
appropriate manual procedures or alternate information systems for an interim
period. Due to the general uncertainty inherent in the Y2K issues, resulting in
part from the uncertainty of Y2K readiness of third party providers, suppliers
and customers, the Company is unable to determine at this time whether the
consequences of Y2K non-compliance will have a material impact on the Company's
results of operations, liquidity or financial position.
ITEM 2. PROPERTIES
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LOCATION USE SQUARE FOOTAGE REMAINING LEASE TERM
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1505-A O'Brien Drive World Headquarters 35,719 2 years
Menlo Park, CA 94025 and Laboratory
1275 Hamilton Court Distribution Center 11,925 6 Months (1)
Menlo Park, CA 94025
7606 Pebble Drive Texas Division and 15,000 2 years with a 5 year
Fort Worth, TX 76118 Laboratory option
1A Harbour Quay Medscreen 13,350 4 years with a 10 year
100 Preston's Road Headquarters and option
London, E14 9PH Laboratory
England
</TABLE>
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(1) The Company anticipates renewing the existing lease or securing
comparable facilities elsewhere.
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ITEM 3. LEGAL PROCEEDINGS
In the ordinary course of its business, PharmChem is sued by
individuals, primarily those in the criminal justice system, who have tested
positive for drugs of abuse. In addition, the Company frequently testifies in
administrative and court proceedings involving the results of its tests. To
date, the Company has not experienced any material liability related to these
claims, although there can be no assurance that the Company will not at some
time in the future experience significant liability in connection with such
claims. There are no pending legal proceedings, other than ordinary routine
litigation incidental to the Company's business, to which PharmChem is a party
or to which any of its property is subject and management does not believe the
outcome of any of the proceedings will have a material impact on its financial
position or results of operations. The Company believes that its liability
insurance coverage is adequate for its business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the
fourth quarter of 1998.
EXECUTIVE OFFICERS OF PHARMCHEM
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NAME AGE POSITION WITH THE COMPANY
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Joseph W. Halligan....... 54 President, Chief Executive Officer and
Director
David A. Lattanzio....... 56 Vice President, Finance and Administration,
Chief Financial Officer and Secretary
Neil A. Fortner.......... 44 Vice President, Laboratory Operations
Elizabeth M. Lison....... 41 Vice President, Customer Service
Joseph L. Kurta.......... 47 Vice President, Sales and Marketing
</TABLE>
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Mr. Halligan has been President, Chief Executive Officer and Director
since November 1995. From 1988 to 1995, Mr. Halligan was President and CEO of
E.S.I. Consulting Group, a private consulting practice, specializing in advising
and operating high growth, consumer and service oriented companies. Before
forming his consulting practice, Mr. Halligan served from 1983 to 1987 as
President and CEO of a privately-held company, Laura Scudder's, Inc. From 1969
to 1983, Mr. Halligan served as Senior Vice President of Fotomat Corporation and
President of its subsidiary, Video Services of America. He holds a B.S. in
Management and Business Administration from Columbia Pacific University.
Mr. Lattanzio has been Vice President, Finance and Administration, and
Chief Financial Officer since April 1996 and Secretary since January 1997. He is
responsible for all business aspects of the Company's operations, including
accounting, corporate finance, treasury, logistics, human resources and risk
management. From 1995 to March 1996, Mr. Lattanzio performed private consulting
for several companies, including the Company. He served as Vice President,
Finance and Chief Financial Officer of Mission Foods from 1991 to 1995. Mr.
Lattanzio holds a B.B.A. in Accounting from the University of Notre Dame and is
a certified public accountant.
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Mr. Fortner has been Vice President, Laboratory Operations, since
February 1992. Mr. Fortner joined the Company as Director, Laboratory Operations
in July 1991. He is the Scientific Director and is responsible for all
production aspects of laboratory operations. From 1985 to 1991, he served as
Director of Toxicology at Southgate Medical Services. Mr. Fortner has more than
15 years experience in forensic toxicology and he is a qualified SAMHSA and CAP
laboratory inspector. He is a member of the American Association of Clinical
Chemistry and a full member of the Society of Forensic Toxicologists, the
American Academy of Forensic Sciences and the American Board of Forensic
Examiners. Mr. Fortner holds a B.A. in Biology from Hiram College and a M.S. in
Biochemistry from Western Kentucky University.
Ms. Lison has been Vice President, Customer Service, since March 1997.
Ms. Lison joined the Company's Medscreen subsidiary in 1993, where she held
various management positions in sales and customer service. In June 1996, she
relocated to the Corporate office to serve as Director, Customer Service. From
1979 to 1993, Ms. Lison worked in various aspects of the design and delivery of
workplace drug testing programs for companies based in the UK. Ms. Lison holds a
B. Tech (Hons) in Medical Science from the University of Bradford, UK.
Mr. Kurta has been Vice President, Sales and Marketing since joining the
Company in March 1998. Mr. Kurta is responsible for sales, marketing and the
commercial development of the Company's laboratory services and the
PharmScreen(R) and PharmChek(R) product lines. Prior to joining the Company, Mr.
Kurta served as Director of Business Development and Director of Sales and
Marketing for the Unilab Corporation and served in various capacities at Damon
Laboratories and Corning/Metpath Laboratories. From 1979 to 1986, Mr. Kurta
owned and operated Spectrum Helicopters, Inc., Copter Quik Delivery Systems and
Geriatric HealthCare Group. Mr. Kurta holds B.A. and M.S. degrees from Alfred
University in New York.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS
The Company's Common Stock trades on The Nasdaq Stock Market under the
symbol PCHM.
STOCK PRICES
The following table summarizes the high and low closing bid prices for
the Company's Common Stock by quarter for years 1998 and 1997, as reported by
the Automated Quotation System of the National Association of Securities Dealers
(Nasdaq). The prices shown represent quotations among securities dealers, do not
include retail markups, markdowns or commissions and may not represent actual
transactions.
<TABLE>
<CAPTION>
CALENDAR CALENDAR
QUARTER HIGH LOW QUARTER HIGH LOW
------- ---- --- ------- ---- ---
<S> <C> <C> <C> <C> <C>
Q1 1998 $ 2.750 $ 2.188 Q1 1997 $ 5.313$ 3.875
Q2 1998 $ 2.875 $ 2.125 Q2 1997 $ 4.375$ 3.500
Q3 1998 $ 3.500 $ 2.250 Q3 1997 $ 4.125$ 2.625
Q4 1998 $ 4.750 $ 2.375 Q4 1997 $ 3.250$ 2.000
</TABLE>
As of March 1, 1999, there were approximately 150 holders of record of
PharmChem's Common Stock. A large number of shares were held in nominee name.
Based upon information furnished by the Company's proxy solicitor, Skinner &
Co., the Company believes it had approximately 1,500 shareholders as of the same
date.
11
<PAGE> 12
DIVIDENDS
PharmChem has never paid cash dividends on its Common Stock. The Company
plans to retain all earnings to further the operation and expansion of its
business and therefore does not expect to pay dividends in the foreseeable
future. The Company's current revolving credit agreement prohibits the
declaration or payment of dividends.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
(In thousands, except per share data)
<S> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Net sales ................................. $ 43,172 $ 39,233 $ 41,255 $ 39,111 $ 33,640
Cost of sales ............................. 31,653 31,311 31,757 29,771 25,777
-------- -------- -------- -------- --------
Gross profit .......................... 11,519 7,922 9,498 9,340 7,863
-------- -------- -------- -------- --------
Selling, general and administrative
expenses ................................ 9,713 8,053 7,234 6,966 6,213
Marketing rights and research costs ....... 87 181 1,455 1,039 854
Amortization of goodwill .................. 185 185 185 247 246
Provision for doubtful accounts ........... 325 350 206 575 72
Restructuring and unusual charges (1) ..... -- -- -- 8,775 --
-------- -------- -------- -------- --------
Total operating expenses ....................... 10,310 8,769 9,080 17,602 7,385
-------- -------- -------- -------- --------
Income (loss) from operations ............. 1,209 (847) 418 (8,262) 478
Other expenses, net ....................... 288 389 372 368 279
-------- -------- -------- -------- --------
Income (loss) before income taxes ......... 921 (1,236) 46 (8,630) 199
Provision for (benefit from) income taxes . 286 34 -- (1,819) 148
-------- -------- -------- -------- --------
Net income (loss) ......................... $ 635 $ (1,270) $ 46 $ (6,811) $ 51
======== ======== ======== ======== ========
Basic earnings (loss) per share ........... $ 0.11 $ (0.22) $ 0.01 $ (1.23) $ 0.01
======== ======== ======== ======== ========
Diluted earnings (loss) per share ......... $ 0.10 $ (0.22) $ 0.01 $ (1.23) $ 0.01
======== ======== ======== ======== ========
Basic weighted average shares outstanding . 5,764 5,734 5,622 5,542 5,510
======== ======== ======== ======== ========
Diluted weighted average shares outstanding 6,238 5,734 5,710 5,542 5,560
======== ======== ======== ======== ========
Cash dividends per share .................. -- -- -- -- --
======== ======== ======== ======== ========
CONSOLIDATED BALANCE SHEET DATA:
Working capital (deficiency) .............. $ (319) $ (1,147) $ 1,707 $ 4,283 $ 4,243
Total assets .............................. 22,063 22,246 21,647 22,236 28,306
Long-term debt, net of current portion .... 656 696 1,205 3,401 1,972
Shareholders' equity ...................... 10,910 10,211 11,431 11,026 17,767
</TABLE>
(1) In 1995, the Company recorded a provision for restructuring and unusual
charges of $8.8 million related to the marketing rights and development
of PharmChek(R), computer and peripheral equipment, Medscreen goodwill
and other unusual charges.
Selected quarterly financial data is included in Note 11 to the Consolidated
Financial Statements.
12
<PAGE> 13
ITEM 7. 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. The
Company's 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 the Company's recent results and those
projected in the forward-looking statements are described in this section. Refer
to "Factors Affecting Operating Results." The Company assumes no obligation to
update the forward-looking statements or such factors.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain financial data
(dollars in thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED DECEMBER 31, TWELVE MONTHS ENDED DECEMBER 31,
------------------------------- --------------------------------
1998 1997 1998 1997 1998 1997 1998 1997
-------- -------- ----- ----- -------- -------- ----- -----
(As a % of net (As a % of net
sales) sales)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
NET SALES:
Public and private employers analyses $ 4,328 $ 4,632 39.8% 45.7% $ 17,440 $ 17,318 40.4% 44.1%
Criminal justice agencies analyses .. 4,010 3,403 36.8 33.6 15,214 14,505 35.2 37.0
Drug rehabilitation programs analyses 407 352 3.8 3.5 1,581 1,447 3.7 3.7
Domestic product shipments & other .. 600 601 5.5 5.9 2,528 1,700 5.9 4.3
Medscreen ........................... 1,537 1,147 14.1 11.3 6,409 4,263 14.8 10.9
-------- -------- ----- ----- -------- -------- ----- -----
Total net sales .................... 10,882 10,135 100.0 100.0 43,172 39,233 100.0 100.0
COST OF SALES ....................... 7,955 7,739 73.1 76.4 31,653 31,311 73.3 79.8
-------- -------- ----- ----- -------- -------- ----- -----
GROSS PROFIT ........................ 2,927 2,396 26.9 23.6 11,519 7,922 26.7 20.2
-------- -------- ----- ----- -------- -------- ----- -----
OPERATING EXPENSES:
Selling, general and administrative .. 2,364 1,890 21.7 18.6 9,713 8,053 22.5 20.5
Marketing rights and research costs . 37 5 0.3 0.0 87 181 0.2 0.5
Amortization of goodwill ............ 46 46 0.4 0.5 185 185 0.4 0.5
Provision for doubtful accounts ..... 103 278 1.0 2.8 325 350 0.7 0.9
-------- -------- ----- ----- -------- -------- ----- -----
Total operating expenses ........... 2,550 2,219 23.4 21.9 10,310 8,769 23.8 22.4
-------- -------- ----- ----- -------- -------- ----- -----
INCOME (LOSS) FROM OPERATIONS ........ 377 177 3.5 1.7 1,209 (847) 2.9 (2.2)
-------- -------- ----- ----- -------- -------- ----- -----
OTHER EXPENSES, net .................. 32 106 0.3 1.0 288 389 0.7 0.9
PROVISION FOR INCOME TAXES ........... 108 34 1.0 0.3 286 34 0.7 0.1
-------- -------- ----- ----- -------- -------- ----- -----
NET INCOME (LOSS) .................... $ 237 $ 37 2.2% 0.4% $ 635 $ (1,270) 1.5% (3.2)%
======== ======== ===== ===== ======== ======== ===== =====
</TABLE>
1998 Compared to 1997. Net sales increased 10.0% to $43,172,000 in 1998
from $39,233,000 in 1997. This increase is attributed primarily to sales
increases of 49% at Medscreen and 37% of product shipments (excluding related
analyses). Medscreen's 1998 results reflect a full year of the HM Prisons
contract. Sales of PharmScreen(R) increased 73% attributed to the gaining
popularity of the single, dual, four and five test configurations. The Company's
total urinalysis volume increased 3.5% to almost 2,800,000 specimens and average
selling prices increased 4.7% from 1997 levels. Net sales for the 1998 fourth
quarter of $10,882,000 increased 7.4% from the prior year, primarily reflecting
higher Medscreen sales.
13
<PAGE> 14
Cost of sales for the year increased 1.1% to $31,653,000 in 1998
from $31,311,000 in 1997. Cost of sales as a percentage of net sales decreased
to 73.3% in 1998 from 79.8% in 1997 and reflects improved operating efficiencies
and favorable results from the Company's cost containment program initiated in
1997, principally in the areas of direct labor and results transmissions. Gross
profit as a percentage of net sales increased to 26.7% in 1998 from 20.2% in
1997 reflecting improved profit margins. Cost of sales for the 1998 fourth
quarter of $7,955,000 increased slightly from the prior year due to increased
specimen volume.
Selling, general and administrative (SG&A) expenses for the year
increased 20.6% to $9,713,000 in 1998 from $8,053,000 in 1997. The percent of
SG&A expenses to net sales increased to 22.5% in 1998 from 20.5% in 1997. SG&A
expenses for the 1998 fourth quarter increased 25.1% to $2,364,000. These
increases reflect the Company's continued rebuilding of the sales, marketing,
information systems and administrative infrastructure and higher depreciation
expenses.
Income from operations for the year was $1,209,000 in 1998
compared to a loss from operations of $847,000 in 1997. Other expense, which
includes interest expense and interest income, decreased to $288,000 in 1998
from $389,000 in 1997 due to lower average debt levels in 1998. The Company
recorded a provision for income taxes of $286,000 in 1998.
Net income for the year was $635,000 in 1998 compared to a net
loss of $1,270,000 in 1997. The Company reported net income of $237,000 in the
1998 fourth quarter compared to net income of $37,000 in 1997.
1997 Compared to 1996. Net sales decreased 4.9% to $39,233,000 in 1997
from $41,255,000 in 1996. This decrease is attributed to urinalysis sales
decreases of 13% to criminal justice agencies and the August 1996 awarding of
the US Army contract to another laboratory, which more than offset sales
increases of 23% at Medscreen and higher PharmScreen(R) and PharmChek(R) product
sales. The Company's total urinalysis volume decreased 15% to 2,681,000
specimens from 1996 levels. Net sales for the 1997 fourth quarter of $10,135,000
increased slightly from the prior year, reflecting higher product sales and
Medscreen sales partially offset by lower criminal justice sales.
Cost of sales for the year decreased 1.4% to $31,311,000 in 1997
from $31,757,000 in 1996. The decrease was due primarily to decreased specimen
volume. Cost of sales as a percentage of net sales increased to 79.8% in 1997
from 77.0% in 1996. Gross profit as a percentage of net sales decreased to 20.2%
in 1997 from 23.0% in 1996. Cost of sales for the 1997 fourth quarter of
$7,739,000 decreased slightly from the prior year due to decreased specimen
volume partially offset by higher product cost of sales.
Selling, general and administrative (SG&A) expenses for the year
increased 11.3% to $8,053,000 in 1997 from $7,234,000 in 1996. The percent of
SG&A expenses to net sales increased to 20.5% in 1997 from 17.5% in 1996. SG&A
expenses for the 1997 fourth quarter increased 25% to $2,215,000. These
increases reflect the Company's continued rebuilding of the sales, marketing,
information systems and administrative infrastructure.
Marketing rights and research costs for the year decreased to
$181,000 in 1997 from $1,455,000 in 1996. Marketing rights and research costs
for the 1997 fourth quarter decreased substantially from 1996. These 1997
expenses include the costs associated with the development and commercialization
of new laboratory methods and other drug testing systems. The decreases were due
to significant expenses in 1996 associated with the commercialization of
PharmChek(R). For the year, the percent of marketing rights and research costs
to net sales decreased to 0.5% in 1997 from 3.5% in 1996.
Loss from operations for the year was $847,000 in 1997 compared
to income from operations of $418,000 in 1996. Other expense, which includes
interest expense and interest income, increased slightly to $389,000 in 1997
from $372,000 in 1996. The Company recorded a provision for deferred income
taxes of $34,000 in the 1997 fourth quarter related to the operations of
Medscreen. The Company had no provision for income taxes in 1996.
Net loss for the year was $1,270,000 in 1997 compared to net
income of $46,000 in 1996. The Company reported net income of $37,000 in the
1997 fourth quarter compared to a net loss of $13,000 in 1996.
14
<PAGE> 15
LIQUIDITY AND CAPITAL RESOURCES
The Company's operations during the years ended December 31, 1998, 1997
and 1996 provided cash of approximately $4,596,000, $1,140,000 and $2,827,000,
respectively. The increase in cash flow from operations between 1998 and 1997
reflects the Company's improved operations and better working capital management
incorporated by the Company. The decrease in cash flow from operations between
1997 and 1996 principally reflects the net loss reported by the Company in 1997.
As of December 31, 1998 and 1997, PharmChem had $802,000 and $372,000 in
cash and cash equivalents, respectively. During 1998, the Company had net pay
downs on the revolving line of credit of $1,702,000 and used $2,889,000 to
acquire property and equipment. In addition, the Company successfully completed
a sale-leaseback transaction involving computer software. During 1997, the
Company had net borrowings on the revolving line of credit of $3,079,000 which
were used to acquire $2,798,000 of property and equipment and to reduce term
debt and capital lease obligations by $1,339,000.
On December 5, 1997, PharmChem entered into a new revolving credit
agreement ("Credit Agreement") whereby the maximum line of credit was increased
to $6,000,000. Proceeds from the Credit Agreement were used to immediately repay
the revolver balance outstanding under the Company's previous credit agreement.
The Credit Agreement permits borrowings of 85% of qualified accounts receivable,
bears interest at the bank reference rate plus 1.0% (8.75% at December 31, 1998)
and is secured by a lien on all assets of the Company. The mark-up of 1.0% over
the reference rate can, under certain conditions, be reduced to 0.5%. At
December 31, 1998, the available maximum that could be borrowed under the Credit
Agreement was $4,486,000. The Credit Agreement contains certain financial
covenants which, among others, require the Company to maintain certain ratios of
working capital and net worth and restricts the payment of dividends. On August
10, 1998, the Credit Agreement was amended to provide for $500,000 of additional
borrowing capacity (which was never accessed) through September 1998 and to
provide for greater flexibility with respect to certain financial covenants. As
of December 31, 1998, the Company was in compliance with all covenants with the
exception of exceeding the limitation on annual capital expenditures, for which
the Company obtained a waiver.
The Company anticipates that existing cash balances, amounts available
under the Credit Agreement and funds to be generated from future operations will
be sufficient to fund operations and budgeted capital expenditures through 1999.
FACTORS AFFECTING OPERATING RESULTS
PharmChem is subject to a number of risks which could affect operating
results and liquidity, which risks include, among others, the following:
Competition and Customer Contracts. The drug testing industry in which
PharmChem competes is often characterized by competitive bidding which results
in the award of contracts based on technical superiority, customer service and
price. The Company competes for customer contracts against firms that may have
greater financial, marketing, laboratory and related resources. The market for
drug testing services became increasingly competitive in the 1990's, and
continues to be competitive. A majority of the Company's sales arise out of
competitively bid contracts. While many of the Company's contracts have
multi-year terms, most contracts are subject to discretionary termination on
short notice by the Company's customers. In particular, many contracts contain
provisions that provide for termination for convenience. In addition, relatively
few of the Company's contracts call for minimum contract amounts or payments.
Although the Company's historical experience has been that customers generally
use its services for the entire length of the contract term, early termination
of a substantial contract, if not replaced by comparable contracts, could have a
material adverse effect on the Company.
15
<PAGE> 16
PharmChek(R) Drugs of Abuse Patch. Since 1992, the Company has been
investing in and developing PharmChek(R), a system which uses sweat to detect
the use of illegal drugs, for use in the US. To date, sales of PharmChek(R) have
not been material and there is no assurance that it will be commercially
accepted by existing or new customers or generate significant revenues in the
future. While the company that developed PharmChek(R) has obtained patents
relating to its technology, there is no assurance as to the validity of such
patents, that the products marketed by the Company will be covered by such
patents, that competitors will not infringe upon such patents or successfully
design similar or competing products that do not infringe upon such patents, or
that the company that obtained the patents will continue to be able to deliver
products to the Company. The Company had incurred significant costs in
connection with the commercialization of PharmChek(R).
Customer Concentration. The Company's two largest customers combined
accounted for approximately 29%, 27% and 29% of the Company's sales in 1998,
1997 and 1996, respectively. The loss of these contracts, if not replaced by
comparable contracts, could result in lower sales, lower profit margins,
decreased cash flows and losses. The Company has in the past failed to renew
significant contracts which has had adverse effects on the Company. See
"Competition and Customer Contracts" above.
Certification. The Company is certified by SAMHSA, CAP and a number of
states to conduct drug testing using forensic procedures. Further, the Company's
Texas laboratory is certified by CLIA and the California laboratory has received
"deemed status" under CLIA as a result of its State of California certification.
Certification is essential to the Company's business because some of its
customers are required to use certified laboratories, and many of its customers
look to certification as an indication of accuracy and reliability of results.
In order to remain certified, the Company is subject to frequent inspections and
proficiency tests. Failure to meet any of the numerous certification
requirements to which the Company is subject could result in suspension or loss
of certification. Such suspension or loss of certification could have a material
adverse effect on the Company.
Fluctuations in Operating Results. Along with competition and customer
contracts, PharmChem's operations are affected by seasonal trends to which drug
testing laboratories are generally subject. In the past, testing volume tends to
be higher in the second and third calendar quarters and lower in the fourth and
first calendar quarters, primarily due to the hiring patterns of the Company's
public and private employer customer group which affect pre-employment drug
testing. Further, demand for the Company's services is dependent on general
economic conditions. Recessionary periods generally result in fewer new hires,
and therefore may lead to fewer pre-employment drug tests for public and private
employer customers. Budget cuts at the federal, state, or local level could
reduce business from the Company's public employer, criminal justice agency and
government funded drug treatment program customers. Because expenses associated
with maintaining the Company's testing work force are relatively fixed over the
short term, the Company's profit margins tend to increase in periods of higher
testing volume and decrease in periods of lower testing volume.
Judicial Decisions and Government Policy. State and federal courts have
generally permitted the use of drug testing under certain circumstances and
using certain procedures. However, challenges to drug testing programs are
raised from time to time by employees, unions and other groups in litigation on
constitutional, privacy and other grounds. In addition, legal precedent in a
number of states governs the circumstances under which employers may test
employees and the procedures under which such tests must be conducted. Although
the Company believes that, to date, no such litigation or law has had a material
adverse impact upon its business, new decisions, legislation or policies which
restrict the use of drug testing could have a material adverse effect on the
Company.
Credit Availability. PharmChem maintains a revolving credit agreement
with a bank. All borrowings are secured by a lien on all assets of the Company.
The credit agreement contains certain financial covenants, with which the
Company anticipates that it will be able to comply with throughout 1999,
although there can be no assurance that such compliance will be maintained.
16
<PAGE> 17
Legal Proceedings. In the ordinary course of its business, PharmChem is
sued by individuals, primarily those in the criminal justice system, who have
tested positive for drugs of abuse. In addition, the Company frequently
testifies in administrative and court proceedings involving the results of its
tests. To date, the Company has not experienced any material liability related
to these claims, although there can be no assurance that the Company will not at
some time in the future experience significant liability in connection with such
claims.
Environmental Matters. A small portion of the Company's business
involves testing procedures requiring the use of chloroform and radioactive
reagents, which are considered to be hazardous materials. Failure to comply with
current or future federal, state or local environmental laws or regulations
regarding these hazardous materials could have a material adverse effect on the
Company. The Company believes it is in compliance with all applicable
environmental laws and regulations.
Dependence on Key Personnel. The success of PharmChem is dependent in
part on its key management and technical personnel, the loss of one or more of
whom could have a material adverse effect on the Company. None of the Company's
key employees has an employment contract with the Company. The Company believes
that its future success will depend in part upon its continued ability to
attract, retain and motivate additional highly skilled personnel.
Year 2000. The Year 2000 ("Y2K") issue is the result of date-sensitive
devices, systems and computer applications that were deployed using two digits
rather than four digits to define the applicable year. Therefore, these
technologies may improperly recognize a year containing "00" as 1900 rather than
the year 2000. This may result in a system failure or miscalculations causing
disruptions of operations. The Company is subject to various risks associated
with the Y2K impact on information systems software and hardware. The Company
began its evaluation of and action steps to correct Y2K problems at the end of
1995 when it recorded a one-time restructuring charge of $8.8 million, which
included $1.9 million to write-down certain information systems ("IS") assets.
All of the IS assets written-down were inadequate to move the Company forward
operationally. For the period January 1, 1996 through December 31, 1998, the
Company has invested $5.4 million in new IS assets which have been designed to
enhance its operational capabilities as well as meet Y2K requirements. All
investments in information systems and other Y2K projects have been funded or
are expected to be funded by internally generated cash, leases or bank
financing.
The Company has completed its assessment of the Y2K impact on internal
information and facilities systems. The assessment identified operational
inefficiencies and Y2K non-compliance of the existing laboratory information
system ("LIS"). The Company is in the process of replacing its existing LIS with
a new system that is Y2K compliant and the implementation is scheduled to be
completed by the end of the third quarter of 1999. The Company estimates the
cost to purchase and install the new LIS and related hardware will be
approximately $1 million. Excluding the LIS expenditures, the Company estimates
additional Y2K related expenditures of approximately $100,000 representing
consulting costs and payroll for employees dedicated to Y2K projects.
Due to the large volume of electronic transmissions, the Company has
conducted inquiries of customers, vendors and key business partners to identify
Y2K issues and continues to evaluate responses. Customers, business partners and
vendors responses are currently being reviewed and evaluated. During the second
quarter of 1999, the Company will commence limited transmissions of test results
to selected customers using a four digit year to determine which customers can
and cannot receive such electronic results with a year field of four digits. The
Company's various internal drug test results reporting systems have been
reprogrammed and tested in a parallel systems environment and the Company
continues to test external results reporting services. The Company has reviewed
its facilities systems and found that many are not date sensitive. With respect
to other facilities systems and financial accounting systems, the Company is in
the process of obtaining documentation of Y2K compliance or replacing systems
that are not Y2K compliant. The Company expects to complete all Y2K projects at
various dates through the end of the third quarter of 1999.
17
<PAGE> 18
The Company is in the process of refining its contingency plans to
consider additional scenarios whereby Y2K compliance is not significantly
achieved by the Company and/or its key customers, business partners and vendors.
The Company believes that the "most reasonably likely worst case Year 2000
scenario" would result from a failure of third party transportation systems
which would prevent the Company from receiving specimens to test. These
contingency plans, including issues involving providers of transportation
services, are expected to be completed in mid-1999. If the Company determines
that any critical supplier is not Y2K compliant, it will seek alternate
suppliers and, if it finds that alternate suppliers are not available, the
Company will purchase inventory in advance in excess of normal purchase levels.
In the event of information systems failures, the Company may utilize
appropriate manual procedures or alternate information systems for an interim
period. Due to the general uncertainty inherent in the Y2K issues, resulting in
part from the uncertainty of Y2K readiness of third party providers, suppliers
and customers, the Company is unable to determine at this time whether the
consequences of Y2K non-compliance will have a material impact on the Company's
results of operations, liquidity or financial position.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PharmChem is subject to market risk with respect to its debt outstanding
and foreign currency transactions: The Company's revolving credit agreement
carries interest at the prime rate plus 1.0%. As the prime rate increases, the
Company will incur higher relative interest expense and similarly, a decrease in
the prime rate will reduce relative interest expense. In recent years, there
have not been significant fluctuations in the prime rate. A 1.0% change in the
prime rate would not materially change interest expense assuming levels of debt
consistent with historical amounts. Due to the Company's international
operations, certain transactions are conducted in foreign currencies.
Medscreen's transactions are denominated approximately 85% in pound sterling and
15% in US currency. During 1998 and 1997, Medscreen's net sales represented 15%
and 11%, respectively, of the Company's total net sales and, as a result, the
impact of market risk on foreign currency transactions is not considered
material. These market risks are not considered significant and, therefore, the
Company does not intend to engage in hedging transactions.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See Index at page 40, Item 14. (a) (1).
18
<PAGE> 19
REPORT OF KPMG LLP, INDEPENDENT AUDITORS
To the Board of Directors and Shareholders
of PharmChem Laboratories, Inc.:
We have audited the accompanying consolidated balance sheets of
PharmChem Laboratories, Inc. and subsidiary (the Company) as of December 31,
1998 and 1997, and the related consolidated statements of operations,
comprehensive income (loss), shareholders' equity and cash flows for the years
then ended. In connection with our audit of the consolidated financial
statements, we also have audited the financial statement schedule as listed in
the accompanying index in Item 14(a)(2). These consolidated financial statements
and financial statement schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of PharmChem
Laboratories, Inc. and subsidiary as of December 31, 1998 and 1997, and the
results of their operations and their cash flows for the years then ended in
conformity with generally accepted accounting principles. Also in our opinion,
the related consolidated financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
KPMG LLP
San Francisco, California
February 12, 1999
19
<PAGE> 20
REPORT OF ARTHUR ANDERSEN LLP, INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders
of PharmChem Laboratories, Inc.:
We have audited the accompanying consolidated statements of operations,
comprehensive income (loss), shareholders' equity and cash flows of PharmChem
Laboratories, Inc. and subsidiary (the Company) for the year ended December 31,
1996. These financial statements and schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the results of operations and cash flows of
PharmChem Laboratories, Inc. and its subsidiary for the year ended December 31,
1996 in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
San Jose, California
February 13, 1997
20
<PAGE> 21
PHARMCHEM LABORATORIES, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------
1998 1997
-------- --------
ASSETS
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents $ 802 $ 372
Accounts receivable, net of allowance for doubtful
accounts of $562 and $468, respectively 6,522 7,608
Inventory 1,525 1,609
Prepaids and other current assets 719 456
-------- --------
TOTAL CURRENT ASSETS 9,568 10,045
-------- --------
PROPERTY AND EQUIPMENT, net 8,508 7,788
OTHER ASSETS 997 1,238
GOODWILL, net of accumulated amortization
of $6,241 and $6,056, respectively 2,990 3,175
-------- --------
$ 22,063 $ 22,246
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Revolving line of credit $ 2,379 $ 4,081
Current portion of long-term debt 465 503
Accounts payable 3,123 3,322
Accrued compensation 1,155 990
Accrued collectors and other liabilities 2,765 2,296
-------- --------
TOTAL CURRENT LIABILITIES 9,887 11,192
-------- --------
LONG TERM DEBT, net of current portion 656 696
OTHER NONCURRENT LIABILITIES 610 147
-------- --------
TOTAL LIABILITIES 11,153 12,035
-------- --------
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Common stock, no par value, 10,000 shares authorized,
5,782 and 5,750 shares issued and outstanding at December 19,090 19,027
31, 1998 and 1997, respectively
Accumulated other comprehensive income 83 82
Accumulated deficit (8,263) (8,898)
-------- --------
TOTAL SHAREHOLDERS' EQUITY 10,910 10,211
-------- --------
$ 22,063 $ 22,246
======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
21
<PAGE> 22
PHARMCHEM LABORATORIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
NET SALES $ 43,172 $ 39,233 $ 41,255
COST OF SALES 31,653 31,311 31,757
-------- -------- --------
GROSS PROFIT 11,519 7,922 9,498
-------- -------- --------
OPERATING EXPENSES:
Selling, general and administrative 9,713 8,053 7,234
Marketing rights and research costs 87 181 1,455
Amortization of goodwill 185 185 185
Provision for doubtful accounts 325 350 206
-------- -------- --------
Total operating expenses 10,310 8,769 9,080
-------- -------- --------
INCOME (LOSS) FROM OPERATIONS 1,209 (847) 418
-------- -------- --------
OTHER EXPENSE, net:
Interest expense 293 397 435
Interest income (3) (8) (63)
Other (2) -- --
-------- -------- --------
Other expense, net 288 389 372
-------- -------- --------
INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES 921 (1,236) 46
PROVISION FOR INCOME TAXES 286 34 --
-------- -------- --------
NET INCOME (LOSS) $ 635 $ (1,270) $ 46
======== ======== ========
EARNINGS (LOSS) PER SHARE:
Basic $ 0.11 $ (0.22) $ 0.01
======== ======== ========
Diluted $ 0.10 $ (0.22) $ 0.01
======== ======== ========
WEIGHTED AVERAGE SHARES OUTSTANDING:
Basic 5,764 5,734 5,622
======== ======== ========
Diluted 6,238 5,734 5,710
======== ======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
22
<PAGE> 23
PHARMCHEM LABORATORIES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
NET INCOME (LOSS) $ 635 $(1,270) $ 46
OTHER COMPREHENSIVE INCOME (LOSS):
Foreign currency translation 1 (62) 147
------- ------- -------
COMPREHENSIVE INCOME (LOSS) $ 636 $(1,332) $ 193
======= ======= =======
</TABLE>
See accompanying notes to consolidated financial statements.
23
<PAGE> 24
PHARMCHEM LABORATORIES, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
ACCUMULATED
COMMON STOCK OTHER TOTAL
--------------------- ACCUMULATED COMPREHENSIVE SHAREHOLDERS'
SHARES AMOUNT DEFICIT INCOME EQUITY
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31, 1995 5,587 $ 18,703 $ (7,674) $ (3) $ 11,026
Exercise of stock options 108 212 -- -- 212
Foreign currency translation -- -- -- 147 147
Net income -- -- 46 -- 46
-------- -------- -------- -------- --------
BALANCE AT DECEMBER 31, 1996 5,695 18,915 (7,628) 144 11,431
Exercise of stock options 55 112 -- -- 112
Foreign currency translation -- -- -- (62) (62)
Net loss -- -- (1,270) -- (1,270)
-------- -------- -------- -------- --------
BALANCE AT DECEMBER 31, 1997 5,750 19,027 (8,898) 82 10,211
EXERCISE OF STOCK OPTIONS 32 63 -- -- 63
FOREIGN CURRENCY TRANSLATION -- -- -- 1 1
NET INCOME -- -- 635 -- 635
-------- -------- -------- -------- --------
BALANCE AT DECEMBER 31, 1998 5,782 $ 19,090 $ (8,263) $ 83 $ 10,910
======== ======== ======== ======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
24
<PAGE> 25
PHARMCHEM LABORATORIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR YEARS ENDED DECEMBER 31,
---------------------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 635 $(1,270) $ 46
Adjustments to reconcile net income (loss) to net
Cash provided by operating activities:
Depreciation and amortization 1,999 1,917 1,979
Provision for doubtful accounts 325 350 206
Loss (gain) on dispositions and sales of equipment (2) 6 (51)
Deferred gain on sale of equipment (82) -- --
Change in operating assets and liabilities:
Accounts receivable 761 210 627
Inventory 84 (595) 674
Income tax refund receivable -- 351 (351)
Prepaids and other current assets (263) 315 (71)
Other noncurrent assets 241 (252) 216
Accounts payable and other accrued liabilities 435 100 (587)
Other noncurrent liabilities 463 8 139
------- ------- -------
Net cash provided by operating activities 4,596 1,140 2,827
------- ------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (2,889) (2,798) (2,731)
Proceeds from sales of equipment 439 -- 230
------- ------- -------
Net cash used in investing activities (2,450) (2,798) (2,501)
------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings (repayments) on revolving lines of credit, net (1,702) 3,079 (848)
Proceeds from financing leases 435 -- 1,203
Principal payments on long-term debt and capital leases (513) (1,339) (1,447)
Proceeds from exercise of stock options 63 112 212
------- ------- -------
Net cash provided by (used in) financing activities (1,717) 1,852 (880)
------- ------- -------
Foreign currency translation 1 (62) 147
------- ------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 430 132 (407)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 372 240 647
------- ------- -------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 802 $ 372 $ 240
======= ======= =======
Supplemental Disclosures of Cash Flow Information:
Cash paid for interest, net of $153, $46 and $0 capitalized in
1998, 1997 and 1996, respectively $ 305 $ 376 $ 548
======= ======= =======
Cash paid for taxes $ 1 $ 3 $ --
======= ======= =======
</TABLE>
See accompanying notes to consolidated financial statements.
25
<PAGE> 26
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
1. THE COMPANY
PharmChem Laboratories, Inc. is a leading independent laboratory providing
integrated drug testing services. PharmChem tests for a number of drugs of
abuse, primarily by urinalysis. In addition to forensic drug testing, PharmChem
offers a range of services which are customized to assist customers in
implementing cost-effective drug testing programs. PharmChem's customers include
private and public employers, criminal justice agencies and drug treatment
programs primarily in the United States and the United Kingdom (UK).
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION
The consolidated financial statements include the accounts of the PharmChem
Laboratories, Inc. and its wholly-owned subsidiary, Medscreen Limited
("Medscreen"), a UK company (collectively referred to as the "Company"), after
elimination of all intercompany accounts and transactions. The functional
currency of Medscreen is the local currency.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amount of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash balances and all highly liquid
investments with original maturities of three months or less at the date of
purchase. At December 31, 1998 and 1997, cash and cash equivalents consist of
demand deposits maintained at established commercial banks. Such cash deposits
periodically exceed the Federal Deposit Insurance Corporation insured limit of
$100,000 for each account.
CONCENTRATIONS OF CREDIT RISK
The Company is subject to a number of risks which include, among others,
competition related to customer contracts, development and marketing of
PharmChek(R) and PharmScreen(R), customer concentration and laboratory
certification. Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash investments, trade
receivables and debt. The Company has cash investment policies that limit
investments to short-term, low risk instruments. At December 31, 1997, one
customer accounted for approximately 17% of the accounts receivable balance.
Although two customers accounted for approximately 29%, 27% and 29% of the
Company's sales for the years ended December 31, 1998, 1997 and 1996,
respectively, concentrations of credit risk with respect to trade receivables
are mitigated by (i) one of the customers is a federal government agency; (ii)
the remaining customer base is diversified among many corporate industries and
other government agencies; (iii) the Company's ongoing credit evaluation
process; and (iv) the allowance for doubtful accounts.
26
<PAGE> 27
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
INVENTORY
Inventory is 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. At December 31, inventory consisted of the following:
<TABLE>
<CAPTION>
1998 1997
------ ------
(In thousands)
<S> <C> <C>
Laboratory materials ............. $ 529 $ 412
Collection materials ............. 801 1,072
Products ......................... 195 125
------ ------
$1,525 $1,609
====== ======
</TABLE>
PROPERTY AND EQUIPMENT
Property and equipment is recorded at cost. Depreciation and amortization
are provided using the straight-line method over the estimated useful lives.
Leasehold improvements and equipment held under capital leases are amortized
over the lease term. At December 31, property and equipment consisted of the
following:
<TABLE>
<CAPTION>
USEFUL LIVES 1998 1997
IN YEARS ------- ------
--------
(In thousands)
<S> <C> <C> <C>
Lab equipment........................ 5 to 10 $6,920 $7,066
Computer hardware and software....... 3 to 10 5,107 3,861
Office equipment..................... 3 to 7 500 493
Furniture, other fixtures and ....... 3 to 10 785 765
Leasehold improvements............... - 3,942 3,822
Construction in progress............. - 2,113 1,692
------- ------
19,367 17,699
Less: accumulated depreciation and
amortization...................... (10,859) (9,911)
------- ------
Property and equipment, net.......... $8,508 $7,788
======= ======
</TABLE>
The Company capitalizes software development costs for internal use in
accordance with Statement of Position (SOP) 98-1, "Accounting for Costs of
Computer Software Developed or Obtained for Internal Use." Capitalization of
software development costs begins in the application development stage and ends
when the asset is placed into service. The Company amortizes such costs using
the straight-line basis over estimated useful lives. Under SOP 98-1, the Company
capitalized $1,590,000 and $1,856,000 of software development costs in 1998 and
1997, respectively, related to systems supporting the Company's infrastructure.
Expenditures for maintenance and repairs are expensed as incurred. Costs of
major replacements and betterments are capitalized. When property is retired or
otherwise disposed of, the cost and accumulated depreciation and amortization
are removed from the appropriate accounts and any gain or loss is included in
the statement of operations.
27
<PAGE> 28
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
LONG-LIVED ASSETS, INCLUDING GOODWILL
In accordance with Statement of Financial Accounting Standards (SFAS) No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of," the Company reviews, as circumstances dictate, the
carrying amount of its long-lived assets. The purpose of these reviews is to
determine whether the carrying amounts are recoverable. Recoverability is
determined by comparing the projected undiscounted net cash flows of the
long-lived assets against their respective carrying amounts. The amount of
impairment, if any, is measured based on the excess of the carrying value over
the fair value. Management believes that no impairment of long-lived assets has
occurred during the three years ended December 31, 1998.
Goodwill consists of the excess of cost over the fair value of the net
assets of businesses acquired and is being amortized on a straight-line basis
over periods ranging from 20 to 40 years. Amortization expense for the years
ended December 31, 1998, 1997 and 1996 was $185,000 each year.
REVENUE AND OTHER DEFERRED CREDITS
Revenue is recognized upon completion of laboratory analyses of specimens
submitted by customers and at the time of shipment for products. Deferred
credits include deferred rent and deferred service revenues. Deferred rent
represents unrealized rent abatements granted by the lessor of the facility
occupied by Medscreen, and is being amortized on a straight-line basis as a
reduction to rent expense over the remaining lease term. Deferred service
revenues represents amounts billed in advance of laboratory analysis performed.
Deferred revenues expected to be realized beyond one year are classified as
other noncurrent liabilities.
INCOME TAXES
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes," which requires recognition of deferred tax assets
and liabilities for the expected future tax consequences of events that have
been included in the financial statements or tax returns. Under this method,
deferred tax assets and liabilities are determined based on temporary
differences between the financial statement and tax bases of assets and
liabilities using enacted tax rates in effect for the year in which the
differences are expected to reverse.
STOCK BASED-COMPENSATION
The Company accounts for its stock-based compensation in accordance with
SFAS No. 123, "Accounting for Stock-Based Compensation." As allowed by SFAS No.
123, the Company continues to measure compensation expense for awards granted to
employees and directors under the provisions of Accounting Principles Board
Opinion (APB) No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. The exercise price of options granted under the Company's stock
option plans is equal to the market price of the Company's stock on the date of
grant, and accordingly, no compensation cost has been recorded under APB No. 25.
28
<PAGE> 29
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
EARNINGS (LOSS) PER SHARE
The Company computes and discloses its earnings (loss) per share in
accordance with SFAS No. 128, "Earnings Per Share," which requires the
presentation of basic and diluted earnings (loss) per share. Basic earnings
(loss) per share is calculated using the weighted average number of common
shares outstanding during the period. Diluted earnings (loss) 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
are calculated using the treasury stock method.
FAIR VALUE OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures About Fair
Value of Financial Instruments," requires certain disclosures regarding the fair
value of financial instruments. The carrying amounts of accounts receivable,
accounts payable and accrued liabilities approximate fair value because of the
short-term maturity of these instruments. The fair values of revolving credit
agreements, long-term debt and notes payable do not materially differ from their
carrying amounts since the majority of such debt bears interest at variable
rates and the fixed rate obligations generally have near-term maturities or have
matured.
RECLASSIFICATIONS
Certain reclassifications have been made to prior year amounts to conform to
current year presentation.
3. DEBT
Revolving credit agreement and capitalized lease obligations at December 31
consist of the following:
<TABLE>
<CAPTION>
1998 1997
------- -------
(In thousands)
<S> <C> <C>
Revolving credit agreement pursuant to a revolving loan agreement ............. $ 2,379 $ 4,081
Obligations under capitalized leases, due in monthly installments through 2001,
secured by laboratory equipment, office equipment and computer
software, interest rates ranging from 6% to 10%............................ 1,121 1,164
Other ......................................................................... - 35
------- -------
3,500 5,280
Less: current portion and revolving line of credit ............................ (2,844) (4,584)
------- -------
Long-term portion ............................................................. $ 656 $ 696
======= =======
</TABLE>
On December 5, 1997, PharmChem entered into a new revolving credit agreement
("Credit Agreement") whereby the maximum line of credit was increased to
$6,000,000. Proceeds from the Credit Agreement were used to immediately repay
the revolver balance outstanding under the Company's previous credit agreement.
The Credit Agreement permits borrowings of 85% of qualified accounts receivable,
bears interest at the bank reference rate plus 1.0% (8.75% at December 31, 1998)
and is secured by a lien on all assets of the Company. The mark-up of 1.0% over
the reference rate can, under certain conditions, be reduced to 0.5%. At
December 31, 1998, the available maximum that could be borrowed under the Credit
Agreement was $4,486,000.
29
<PAGE> 30
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The Credit Agreement contains certain financial covenants, which among
others, require the Company to maintain certain ratios of working capital and
net worth and restricts the payment of dividends. On August 10, 1998, the Credit
Agreement was amended to provide for $500,000 of additional borrowing capacity
(which was never accessed) through September 1998 and to provide for greater
flexibility with respect to certain financial covenants. The weighted average
interest rate for 1998 and 1997 was 9.2% and 9.1%, respectively. At December 31,
1998, the Company was in compliance with all covenants with the exception of
exceeding the limitation on annual capital expenditures, for which the Company
obtained a waiver.
The Company has leased certain laboratory equipment, office equipment and
computer software with an original cost of approximately $2,139,000 and
$2,197,000 under capital lease agreements at December 31, 1998 and 1997,
respectively. The accumulated depreciation of such leased equipment was
approximately $691,000 and $779,000 at December 31, 1998 and 1997, respectively.
At December 31, 1998, the future minimum lease payments, together with the
present value of the net minimum lease payments under these agreements, were as
follows (in thousands):
<TABLE>
<S> <C>
1999 ...................................................... $546
2000 ...................................................... 524
2001 ...................................................... 177
2002 ...................................................... -
------
Total minimum lease payments ................ 1,247
Less: amount representing interest .......... (126)
------
Present value of net minimum lease payments . $1,121
======
</TABLE>
4. INCOME TAXES
The income (loss) before income taxes based upon the geographic locations of
the Company's operations consisted of the following for the year ended December
31:
<TABLE>
<CAPTION>
1998 1997 1996
------- ------- -------
(In thousands)
<S> <C> <C> <C>
Domestic ....................... $ 148 $(1,552) $ (144)
Foreign ........................ 773 316 190
------- ------- -------
Consolidated............ $ 921 $ 1,236 $ 46
======= ======= =======
</TABLE>
30
<PAGE> 31
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The provision for income taxes consisted of the following for the year ended
December 31:
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
(In thousands)
Current:
<S> <C> <C> <C>
Federal ...................... $ - $ - $ -
State ........................ 5 - -
Foreign ...................... 129 - -
---- ---- ----
Total current ............ 134 - -
---- ---- ----
Deferred:
Federal ...................... 83 - -
State ........................ 27 - -
Foreign ...................... 42 34 -
---- ---- ----
Total deferred ........... 152 34 -
---- ---- ----
Provision for income taxes $286 $ 34 $ -
==== ==== ====
</TABLE>
The deferred tax provision in 1997 represents the partial utilization of
foreign net operating losses previously recorded as a deferred tax asset at the
statutory rate. As a result, the deferred tax asset decreased by $34,000. No
provision has been recorded on foreign income in 1996 because of the utilization
of tax loss carryforwards. Undistributed earnings of the Company's foreign
subsidiary are not significant. The provision for income taxes is reconciled
with the federal statutory rate for the year ended December 31 as follows:
<TABLE>
<CAPTION>
1998 1997 1996
----- ----- -----
(In thousands)
<S> <C> <C> <C>
Tax provision (benefit) computed at the federal
statutory tax rate ........................... $ 313 $(420) $ 16
State taxes, net of federal tax benefit ....... 13 (30) 3
Utilization of net operating loss carryforwards (146) - -
Effects of foreign operations ................. (1) (27) -
Amortization of goodwill ...................... 131 44 66
Change in the beginning of the year
valuation allowance ........................... (24) 438 (83)
Other ......................................... - 29 (2)
----- ----- -----
Provision for income taxes...... $ 286 $ 34 $ -
===== ===== =====
</TABLE>
31
<PAGE> 32
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
The major components of temporary differences which give rise to the
deferred tax accounts at December 31 are as follows:
<TABLE>
<CAPTION>
1998 1997
------- -------
(In thousands)
<S> <C> <C>
Current deferred tax assets:
Reserves and accruals ...................... $ 653 $ 373
Net operating loss carryforwards ........... 188 -
------- -------
Total gross current asset .............. 841 373
Deferred tax valuation allowance ........... (523) (219)
------- -------
Net current asset ... $ 318 $ 154
======= =======
Non-current deferred tax assets:
Net operating loss carryforwards ........... $ 657 $ 1,064
Difference between book and tax depreciation 396 93
Capital loss carryforwards ................. 171 -
Restructuring and unusual charges .......... - 526
Research tax credit carryforwards and other 281 449
------- -------
Total gross non-current asset .......... 1,505 2,132
Deferred tax asset valuation allowance ..... (927) (1,255)
------- -------
Net non-current asset .................. $ 578 $ 877
======= =======
</TABLE>
The deferred tax asset accounts are classified with "Other current assets"
and "Other assets" on the accompanying Consolidated Balance Sheets. Deferred
income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting and income
tax purposes. Although realization is not assured, the Company believes it is
more likely than not that the net deferred tax asset will be realized in the
future primarily from the generation, in subsequent years, of US source taxable
income. The amount of the deferred tax asset considered realizable, however,
could be reduced in the near term if estimates of future taxable income during
the carryforward periods are lowered or are lower than currently estimated. The
valuation allowance increased (decreased) by $(24,000), $438,000 and $(434,000)
in 1998, 1997 and 1996, respectively.
As of December 31, 1998, the Company has net operating loss carryforwards
for federal and state income tax reporting purposes of approximately $2,281,000
and $1,295,000, respectively. The federal loss carryforwards expire between 2008
and 2012 and the state loss carryforwards expire between 1999 and 2003. The Tax
Reform Act of 1986 contains provisions which may limit the net operating loss
carryforwards to be used in any given year upon the occurrence of certain
events, including a significant change of ownership.
The Internal Revenue Service ("IRS") examined the Company's income tax
returns for years 1990 to 1995, and issued a Notice of Deficiency resulting from
the IRS challenging the deductibility of research expenses related to the
development of the PharmChek(R) sweat patch device. The Company has appealed the
Notice of Deficiency with an IRS Appeals Officer and has received a preliminary
assessment that no amounts are due. However, the ruling remains subject to
appeal.
32
<PAGE> 33
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
5. INCENTIVE STOCK PLANS
1997 AND 1988 INCENTIVE STOCK PLANS
In May 1997, the Company's shareholders approved the 1997 Incentive Stock
Plan ("the 1997 Plan") whereby stock options, including incentive stock options,
non-qualified options, restricted shares, performance shares, bonus shares and
stock appreciation rights may be granted to employees, consultants and
directors, for up to 500,000 shares of common stock. This 1997 Plan, which
expires in 2007, is administered by the Officers Compensation Committee of the
Board of Directors ("the Committee"). The Committee shall determine the term of
each stock option (up to a maximum of ten years) and the exercise price cannot
be less than 100% of the fair market value of the common stock on the date the
option is granted. Except as otherwise provided, options will be exercisable
with respect to 6.25% of the shares corresponding to the grant on the first day
of each of the first sixteen calendar quarters after the grant date. As of
December 31, 1998, 210,059 options have been granted and no options have been
canceled or exercised under the 1997 Plan.
In November 1988, the Company adopted the 1988 Incentive Stock Plan ("the
1988 Plan"). Under this 1988 Plan, nonstatutory options and stock purchase
rights may be granted to employees and consultants, while incentive stock
options may only be granted to employees, for up to a total of 1,280,000 shares
of common stock. The 1988 Plan, which expired in 1998, was administered by the
Committee. Options granted under the 1988 Plan vest generally over a 48-month
period and expire ten years after date of grant.
Effective March 24, 1998 the Company engaged in a stock option exchange
program that effectively repriced all then outstanding options having an
exercise price above the then current market price of $2.375 ("Repriced
granted/canceled" in the following table). The repriced options began vesting
effective April 24, 1998 over a 48-month period. The exercise price for all
options exchanged was $2.375.
33
<PAGE> 34
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
Options to purchase approximately 244,081, 309,753 and 206,000 shares of
common stock under both plans were exercisable at December 31, 1998, 1997 and
1996 respectively. As of December 31, 1998, incentive stock options and
non-qualified stock options were outstanding. Option information for the periods
presented is as follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
-----------------------------------------
OPTIONS WEIGHTED
AVAILABLE NUMBER AVERAGE
FOR GRANT OF SHARES RANGE PRICE
--------- --------- ------------ -------
<S> <C> <C> <C> <C>
Balance at December 31, 1995 138,482 779,531 $0.25-$4.75 $2.82
-------- -------- ------------ -----
Granted ............. (191,000) 191,000 3.25-4.63 3.69
Canceled ............ 165,565 (165,565) 0.25-4.00 2.29
Exercised ........... - (108,145) 0.25-2.00 1.94
-------- -------- ------------ -----
Balance at December 31, 1996 113,047 696,821 0.25-4.75 3.32
-------- -------- ------------ -----
Additional shares
approved ........... 500,000 - - -
Granted ............. (40,000) 40,000 3.00-4.38 3.56
Canceled ............ 52,631 (52,631) 0.25-3.25 2.04
Exercised ........... - (55,286) 2.00-3.25 2.06
-------- -------- ------------ -----
Balance at December 31, 1997 625,678 628,904 2.00-4.75 3.55
-------- -------- ------------ -----
1988 Plan expiration (7,739) - - -
Granted ............. (370,250) 370,250 2.38-3.13 2.45
Canceled ............ 42,252 (42,252) 2.00-4.63 3.31
Exercised ........... - (18,394) 2.00-2.38 2.02
Repriced granted .... (463,480) 463,480 2.38 2.38
Repriced canceled ... 463,480 (463,480) 3.25-4.75 3.95
-------- -------- ------------ -----
Balance at December 31, 1998 289,941 938,508 $2.00-$3.13 $2.95
======== ======== ============ =====
</TABLE>
1992 DIRECTOR OPTION PLAN
In May 1992, the Company adopted the 1992 Director Option Plan ("the
Director Plan") and reserved 250,000 shares of common stock for issuance under
this plan. On March 22, 1997, the Director Plan was amended to provide for
grants to outside directors only. The options vest over a 48-month period and
expire five years from the date of grant. Options are granted at fair market
value and the plan expires in 2002. Options to purchase approximately 37,601,
88,332 and 97,912 shares of common stock were exercisable at December 31, 1998,
1997 and 1996 respectively. Option information for the periods presented is as
follows:
34
<PAGE> 35
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
----------------------------------------
OPTIONS WEIGHTED
AVAILABLE NUMBER AVERAGE
FOR GRANT OF SHARES RANGE PRICE
-------- --------- ------------ --------
<S> <C> <C> <C> <C>
Balance at December 31, 1995 120,626 120,000 $2.00-$8.75 $4.59
-------- -------- ------------ -----
Granted ............. (10,000) 10,000 4.50 4.50
Canceled ............ - - - -
Exercised ........... - - - -
-------- -------- ------------ -----
Balance at December 31, 1996 110,626 130,000 2.00-8.75 3.32
-------- -------- ------------ -----
Granted ............. (10,000) 10,000 5.25 5.25
Canceled ............ 30,000 (30,000) 8.75 8.75
Exercised ........... - - - -
-------- -------- ------------ -----
Balance at December 31, 1997 130,626 110,000 2.00-5.25 $3.52
-------- -------- ------------ -----
Granted ............. (15,000) 15,000 2.50-2.63 2.58
Canceled ............ 62,187 (62,187) 2.00-5.25 4.05
Exercised ........... - (12,813) 2.00 2.00
-------- -------- ------------ -----
Balance at December 31, 1998 177,813 50,000 $2.00-$5.25 $2.38
======== ======== ============ =====
</TABLE>
The following summarizes information about all stock option plans at
December 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ------------------------------------------------------------------------ -------------------------
WEIGHTED AVG. WEIGHTED
WEIGHTED REMAINING AVERAGE
RANGE OF OPTIONS AVERAGE CONTRACTUAL OPTIONS EXERCISE
EXERCISE PRICE OUTSTANDING EXERCISE PRICE LIFE EXERCISABLE PRICE
-------------- ----------- -------------- ----------- ----------- ---------
<S> <C> <C> <C> <C> <C>
$ 2.000 108,278 $2.000 5.3 Years 105,706 $2.000
2.375 779,230 2.375 9.3 Years 146,067 2.375
2.50-5.25 101,000 3.126 7.0 Years 29,909 3.273
----------- ------- ------ --------- ------- ------
$2.00-$5.25 988,508 $2.411 8.6 Years 281,682 $2.330
=========== ======= ====== ========= ======= ======
</TABLE>
PROFORMA INFORMATION
The Company continues to apply APB No. 25 in accounting for its stock based
compensation plans. Accordingly, no compensation cost has been recorded in the
consolidated statements of operations for the stock option plans. Had
compensation cost for the Company's stock based compensation plans been
determined in accordance with the fair value method prescribed by SFAS No. 123,
the Company's proforma net income (loss) and earnings (loss) per share for the
years ended December 31 would have been as follows:
35
<PAGE> 36
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
(In thousands, except per share amounts)
<S> <C> <C> <C>
Net income (loss), as reported ............... $ 635 $ (1,270) $ 46
Net income (loss), pro forma ................. 278 (1,737) (203)
Basic earnings (loss) per share, as reported . 0.11 (0.22) 0.01
Basic earnings (loss) per share, pro forma ... 0.05 (0.30) (0.04)
Diluted earnings (loss) per share, as reported 0.10 (0.22) 0.01
Diluted loss per share, pro forma ............ 0.05 (0.30) (0.04)
</TABLE>
The weighted average fair values of options granted during 1998, 1997 and
1996 were $1.44, $2.31 and $2.09, respectively. The fair value of each grant is
estimated on the date of grant using the Binomial option pricing model with the
following weighted average assumptions: risk-free interest rate ranging from
approximately 4.6% to 6.4%, corresponding to government securities with original
maturities similar to the estimated option life; option lives ranging from 3 to
5 years; annual volatility of the Company's stock price ranging from 80% to 89%;
and a dividend yield of 0%. The above proforma amounts include compensation
expense for options granted since January 1, 1995, and may not be representative
of that to be expected in future years.
6. EARNINGS PER SHARE
The calculations of basic and diluted earnings (loss) per share are as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------ --------- ------
(In thousands, except per share amounts)
<S> <C> <C> <C>
Net income (loss) ........................................ $ 635 $ (1,270) $ 46
====== ========= ======
Denominator for basic earnings (loss) per share -
weighted average common shares ....................... 5,764 5,734 5,622
Dilutive stock options ................................... 474 - 88
------ --------- ------
Denominator for diluted earnings (loss) per share ........ 6,238 5,734 5,710
====== ========= ======
Basic earnings (loss) per share .................. $ 0.11 $ (0.22) $ 0.01
====== ========= ======
Diluted earnings (loss) per share ................ $ 0.10 $ (0.22) $ 0.01
====== ========= ======
</TABLE>
Options to purchase 5,000 and 379,480 shares of the Company's common
stock at December 31, 1998 and 1996, respectively, were not included in the
computation of diluted earnings per share because their exercise prices were
greater than the average market share price of the Company's common stock of
$4.63 and $3.96, respectively. All options to purchase shares of the Company's
common stock at December 31, 1997 were not included in the computation of
diluted loss per share as their effect would have been antidilutive.
36
<PAGE> 37
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
7. PROFIT SHARING PLAN
The Company has a 401(k) plan (the "Plan") which is available to all
employees who have reached age 18 and have completed at least one year of
service. The Plan provides that each participant may contribute a portion of his
or her salary, within certain limits set forth in the US Internal Revenue Code,
as amended. The Company will make a matching contribution of 10% of the amount
contributed by each participant and may make additional matching or
discretionary profit sharing contributions. The Company's contributions vest
after three years of service. Total contribution expense recorded by the Company
for 1998, 1997 and 1996 was $46,000, $41,000, and $20,000, respectively.
8. COMMITMENTS
Future minimum lease payments under noncancellable leases for the Company's
office, laboratory and warehouse space at December 31, 1998 were as follows (in
thousands):
<TABLE>
<CAPTION>
AMOUNT
------
<S> <C>
1999 .......................................... $723
2000 .......................................... 703
2001 .......................................... 375
2002 .......................................... 177
2003 .......................................... 104
2004 and thereafter ........................... -
------
Total commitments ......................... $2,082
======
</TABLE>
Rental expense for operating leases amounted to approximately $1,199,000,
$944,000 and $825,000 for the years ended December 31, 1998, 1997 and 1996,
respectively.
In connection with the original employment and relocation of one employee,
the Company has committed to participate in the purchase of the employee's
residence. Pursuant to this commitment, the Company has an outstanding loan to
the employee of $109,000 at December 31, 1998 and 1997. This loan is included in
"Other assets" in the accompanying consolidated balance sheets. The loan is due
upon the earliest of 2001 or the occurrence of certain maturity events defined
in the agreement. The loan is secured by a deed of trust on the residence and
earns contingent interest on the net proceeds, as defined, upon the sale of the
employee's residence, termination of employment or other maturity events. In
certain circumstances, the Company is contingently liable for a portion of the
mortgage payments, insurance costs and property taxes, until such time as the
property is sold.
9. LITIGATION
The Company is the defendant in certain legal matters which are normal for
the industry in which the Company operates. Management believes that these
matters, both individually and in the aggregate, will not have a material
adverse impact on the Company's financial position or results of operations.
37
<PAGE> 38
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
10. REPORTABLE SEGMENTS
The Company adopted SFAS No. 131, "Dislosures about Segments of an
Enterprise and Related Information," effective December 31, 1998. Prior period
amounts have been restated to conform to the presentation required by SFAS No.
131. The Company has two reportable segments, Domestic and International,
providing integrated drug testing services. The Domestic segment serves the
United States and the International segment serves primarily the United Kingdom
and also includes the European, Asian, Middle Eastern and South American
markets. The Domestic segment is serviced by the Company's California and Texas
operations and the International segment is serviced by Medscreen, the Company's
London-based subsidiary. The accounting policies of the segments are the same as
those described in the Summary of Significant Accounting Policies in the
accompanying notes to the consolidated financial statements. The Company
evaluates segment profit based on income or loss from operations before
intercompany interest, other income or expense and income taxes and excluding
goodwill amortization. Intersegment sales and transfers are not material.
Information about the Company's segments as of and for the years ended December
31 is as follows:
<TABLE>
<CAPTION>
DOMESTIC INTERNATIONAL TOTAL
-------- ------------- -----
(In thousands)
<S> <C> <C> <C> <C>
1998: Net sales from external
customers ........................ $36,764 $6,408 $43,172
Depreciation and amortization ..... 1,731 268 1,999
Segment profit .................... 584 810 1,394
Segment assets .................... 16,324 5,739 22,063
Expenditures for segment assets.... 2,550 339 2,889
1997: Net sales from external
customers ......................... $34,970 $4,263 $39,233
Depreciation and amortization ..... 1,669 248 1,917
Segment profit (loss) ............. (1,031) 369 (662)
Segment assets .................... 17,158 5,088 22,246
Expenditures for segment assets ... 2,715 83 2,798
1996: Net sales from external customers.. $37,781 $3,474 $41,255
Depreciation and amortization 1,754 225 1,979
Segment profit .................... 372 231 603
Segment assets .................... 16,652 4,995 21,647
Expenditures for segment assets ... 2,668 63 2,731
</TABLE>
Two customers of the Domestic segment accounted for the following as a
percentage of the Company's consolidated net sales for the year ended December
31:
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Customer A .................... 18.3% 17.1% 18.7%
Customer B .................... 11.1% 10.1% 10.3%
</TABLE>
38
<PAGE> 39
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
11. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized selected quarterly financial data is as follows:
<TABLE>
<CAPTION>
QUARTER ENDED
-----------------------------------------------------
3/31 6/30 9/30 12/31
-------- -------- -------- --------
(In thousands, except per share amounts)
<S> <C> <C> <C> <C>
1998
Net sales ................................. $ 9,528 $ 11,451 $ 11,311 $ 10,882
Gross profit .............................. 2,220 3,236 3,136 2,927
Net income (loss) ......................... (192) 246 344 237
Basic earnings (loss) per share ........... $ (0.03) $ 0.04 $ 0.06 $ 0.04
Diluted earnings (loss) per share ......... $ (0.03) $ 0.04 $ 0.06 $ 0.04
Basic weighted average shares outstanding . 5,751 5,758 5,771 5,780
Diluted weighted average shares outstanding 5,751 5,826 5,903 6,254
1997
Net sales ................................. $ 9,058 $ 10,003 $ 10,037 $ 10,135
Gross profit .............................. 1,902 1,989 1,635 2,396
Net income (loss) ......................... (378) (267) (662) 37
Basic earnings (loss) per share ........... $ (0.07) $ (0.05) $ (0.12) $ 0.01
Diluted earnings (loss) per share ......... $ (0.07) $ (0.05) $ (0.12) $ 0.01
Basic weighted average shares outstanding . 5,714 5,719 5,726 5,729
Diluted weighted average shares outstanding 5,714 5,719 5,726 5,772
</TABLE>
39
<PAGE> 40
PHARMCHEM LABORATORIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEMS 10 TO 13 INCLUSIVE.
These items have been omitted in accordance with the General Instructions to
Form 10-K and are answered by reference to those portions of the Registrant's
definitive proxy statement with respect to the 1999 Annual Meeting of
Shareholders which contain the information required by these items. The
Registrant will file with the Commission not later than 120 days after the end
of the fiscal year covered by this report such definitive proxy statement
pursuant to Regulation 14A. Information regarding executive officers of the
Company is contained in Part I of this Annual Report on Form 10-K under caption
"Executive Officers of PharmChem."
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K
(a) (1) FINANCIAL STATEMENTS.
<TABLE>
<CAPTION>
PAGE
NUMBER
IN THIS
REPORT
------
<S> <C>
Report of KPMG LLP, Independent Auditors ................................. 19
Report of Arthur Andersen LLP, Independent Public Accountants ............ 20
Consolidated Balance Sheets at December 31, 1998 and 1997 ................ 21
Consolidated Statements of Operations for the years ended December 31,
1998, 1997 and 1996 .................................................... 22
Consolidated Statements of Comprehensive Income (Loss) for the years ended
December 31, 1998, 1997 and 1996 ....................................... 23
Consolidated Statements of Shareholders' Equity for the years ended
December 31, 1998, 1997 and 1996 ....................................... 24
Consolidated Statements of Cash Flows for the years ended December 31,
1998, 1997 and 1996 .................................................... 25
Notes to Consolidated Financial Statements ............................... 26
(a) (2) FINANCIAL STATEMENT SCHEDULE
Schedule II--Valuation and Qualifying Accounts ........................... 44
</TABLE>
40
<PAGE> 41
All other schedules are omitted because they are not applicable, not
required, or the required information is shown in the Consolidated Financial
Statements or notes thereto.
(a) (3) EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
<S> <C>
3.01(1) Amended and Restated Articles of Incorporation dated August 21,
1991.
3.02(2),(14) Bylaws, as amended through October 21, 1998.
4.01(1) Restated Modification Agreement dated August 14, 1989.
10.01(1) 1988 Incentive Stock Plan, as amended.
10.02(6) Form of Stock Option Agreement.
10.03(1) Form of Stock Option Agreement (providing for accelerated vesting
upon death or disability).
10.04(6) Form of Stock Option Agreement (January 1, 1995).
10.05(1) Form of Stock Purchase Agreement.
10.06(4) 1992 Director Option Plan.
10.07(4) Form of Director Option Agreement.
10.08(9) Amendment to 1992 Director Option Plan dated February 28, 1996.
10.09(9) Amendment to 1992 Director Option Plan dated March 4, 1997.
10.10(11) 1997 Equity Incentive Plan.
10.11(11) Form of Stock Option Agreement (Nonstatutory Stock Option) in
connection with the 1997 Equity Incentive Plan
10.12(11) Stock Option Agreement (Incentive Stock Option) in connection
with the 1997 Equity Incentive Plan.
10.13(1) 401(k) Plan.
10.14(9) Amendment to 401(k) Plan dated August 25, 1996.
10.15 Amendment to 401(k) Plan dated September 15, 1998.
10.16(1) Lease Agreements for the Company's offices in Menlo Park,
California dated October 21, 1988 and September 11, 1990,
respectively.
10.17(8) Lease Amendment for the Company's offices in Menlo Park,
California dated November 30, 1995.
10.18(9) Lease Amendment for the Company's offices in Menlo Park,
California dated March 6, 1996.
10.19(5) Harbour Quay (London) Lease Documents.
10.20(9) Lease Agreement for the Company's offices in Fort Worth, Texas
dated October 24, 1991.
10.21(9) Lease Amendment for the Company's offices in Fort Worth, Texas
dated December 8, 1992.
10.22(9) Lease Amendment for the Company's offices in Fort Worth, Texas
dated February 9, 1996.
10.23(14) Form of Indemnification Agreement.
10.24(13) Loan and Security Agreement between Comerica Bank of California
and PharmChem Laboratories, Inc. dated December 5, 1997.
10.25(13) Security Agreement (all assets) between Comerica Bank of
California and PharmChem
</TABLE>
41
<PAGE> 42
<TABLE>
<S> <C>
Laboratories, Inc. dated December 5, 1997.
10.26 (14) Amendment to Loan and Security Agreement between Comerica Bank
of California and PharmChem Laboratories, Inc. dated August 10.
10.27(4),(12) License and Supply Agreement with Sudormed, Inc. dated March 10,
1992.
10.28(5),(12) License and Supply Agreement with Sudormed, Inc. dated October
25, 1993. Supply Agreement with SolarCare Technologies
Corporation dated August 1, 10.295,12 1993.
10.30(8),(12) First Amendment to Supply Agreement dated December 1, 1995.
10.31(11) Master Lease Purchase Agreement dated December 18, 1995 with
Fidelity Leasing Corporation and Lease Purchase Addenda in
connection therewith.
10.32(11) Master Equipment Lease dated March 17, 1996 with Olympus
Commercial Credit.
16.01(10) Letter dated April 8, 1997 from Arthur Andersen LLP to the
Commission.
21.01 List of Subsidiaries.
23.01 Consent of KPMG LLP.
23.02 Consent of Arthur Andersen LLP.
27.1 Financial Data Schedule.
</TABLE>
(1) Incorporated by reference from the Company's Registration Statement on
Form S-1 (File No. 33-41363), effective August 8, 1991.
(2) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1991.
(3) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarterly period ended June 30, 1992.
(4) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1992.
(5) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1993.
(6) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1994.
(7) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1995.
(8) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1995.
(9) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1996.
(10) Incorporated by reference from the Company's Current Report on Form 8-K
dated April 7, 1997.
(11) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarterly period ended September 30, 1997.
(12) Confidential treatment requested as to certain portions of this exhibit.
42
<PAGE> 43
(13) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1997.
(14) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarterly period ended September 30, 1998.
(b) REPORTS ON FORM 8-K
No reports on Form 8-K were filed during the quarter ended
December 31, 1998.
(c) EXHIBITS
See (a) (3) above.
(d) FINANCIAL STATEMENT SCHEDULE
See (a) (2) above.
43
<PAGE> 44
PHARMCHEM LABORATORIES, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
<TABLE>
<CAPTION>
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND DEDUCTIONS END
DESCRIPTION OF PERIOD EXPENSES (WRITE-OFFS) OF PERIOD
- ----------- --------- --------- ------------ ---------
Allowance for
Doubtful Accounts
<S> <C> <C> <C> <C>
Year ended:
December 31, 1996 $462 $206 $ 58 $610
==== ==== ==== ====
December 31, 1997 $610 $350 $492 $468
==== ==== ==== ====
December 31, 1998 $468 $325 $231 $562
==== ==== ==== ====
</TABLE>
44
<PAGE> 45
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF SECTION 13 OR 15(d) 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, IN THE CITY OF MENLO
PARK, STATE OF CALIFORNIA, ON THIS 9TH DAY OF MARCH, 1999.
PHARMCHEM LABORATORIES, INC.
BY: /S/ Joseph W. Halligan
---------------------------------------
JOSEPH W. HALLIGAN
President and Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL THESE PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Joseph W. Halligan, acting individually,
as such person's true and lawful attorney-in-fact and agent, with full power of
substitution, for such person, in any and all capacities, to sign any and all
amendments (including post-effective amendments) to this report on Form 10-K,
and to file with the same, with all exhibits thereto and other documents in
connection therewith, with the Securities and Exchange Commission, granting unto
said attorney-in-fact and agent, full power and authority to do and perform each
and every act and thing requisite and necessary to be done in connection
therewith, as fully to all intents and purposes as such person might or could do
in person, hereby ratifying and confirming all that said attorney-in-fact and
agent, or his substitutes, may do or cause to be done by virtue hereof.
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS
REPORT ON FORM 10-K HAS BEEN SIGNED BY THE FOLLOWING PERSONS ON BEHALF OF THE
REGISTRANT AND IN THE CAPACITIES AND ON THE DATES INDICATED:
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
-------------------------- ---------------------------------- -------------
<S> <C> <C>
/s/ Joseph W. Halligan
-------------------------
Joseph W. Halligan President, Chief Executive Officer March 9, 1999
and Director (Principal Executive
Officer)
/s/ David A. Lattanzio
-------------------------
David A. Lattanzio Chief Financial Officer, Vice March 9, 1999
President, Finance and
Administration (Principal
Accounting and Financial Officer)
and Secretary
/s/ Richard D. Irwin
-------------------------
Richard D. Irwin Chairman of the Board and Director March 9, 1999
/s/ Donald R. Stroben
-------------------------
Donald R. Stroben Director March 9, 1999
</TABLE>
45
<PAGE> 46
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF DOCUMENT
<S> <C>
3.01(1) Amended and Restated Articles of Incorporation dated August 21,
1991.
3.02(2),(14) Bylaws, as amended through October 21, 1998.
4.01(1) Restated Modification Agreement dated August 14, 1989.
10.01(1) 1988 Incentive Stock Plan, as amended.
10.02(6) Form of Stock Option Agreement.
10.03(1) Form of Stock Option Agreement (providing for accelerated vesting
upon death or disability).
10.04(6) Form of Stock Option Agreement (January 1, 1995).
10.05(1) Form of Stock Purchase Agreement.
10.06(4) 1992 Director Option Plan.
10.07(4) Form of Director Option Agreement.
10.08(9) Amendment to 1992 Director Option Plan dated February 28, 1996.
10.09(9) Amendment to 1992 Director Option Plan dated March 4, 1997.
10.10(11) 1997 Equity Incentive Plan.
10.11(11) Form of Stock Option Agreement (Nonstatutory Stock Option) in
connection with the 1997 Equity Incentive Plan
10.12(11) Stock Option Agreement (Incentive Stock Option) in connection
with the 1997 Equity Incentive Plan.
10.13(1) 401(k) Plan.
10.14(9) Amendment to 401(k) Plan dated August 25, 1996.
10.15 Amendment to 401(k) Plan dated September 15, 1998.
10.16(1) Lease Agreements for the Company's offices in Menlo Park,
California dated October 21, 1988 and September 11, 1990,
respectively.
10.17(8) Lease Amendment for the Company's offices in Menlo Park,
California dated November 30, 1995.
10.18(9) Lease Amendment for the Company's offices in Menlo Park,
California dated March 6, 1996.
10.19(5) Harbour Quay (London) Lease Documents.
10.20(9) Lease Agreement for the Company's offices in Fort Worth, Texas
dated October 24, 1991.
10.21(9) Lease Amendment for the Company's offices in Fort Worth, Texas
dated December 8, 1992.
10.22(9) Lease Amendment for the Company's offices in Fort Worth, Texas
dated February 9, 1996.
10.23(14) Form of Indemnification Agreement.
10.24(13) Loan and Security Agreement between Comerica Bank of California
and PharmChem Laboratories, Inc. dated December 5, 1997.
10.25(13) Security Agreement (all assets) between Comerica Bank of
California and PharmChem Laboratories, Inc. dated December 5,
1997.
10.26 (14) Amendment to Loan and Security Agreement between Comerica Bank
of California and PharmChem Laboratories, Inc. dated August 10.
10.27(4),(12) License and Supply Agreement with Sudormed, Inc. dated March 10,
1992.
10.28(5),(12) License and Supply Agreement with Sudormed, Inc. dated October
25, 1993. Supply Agreement with SolarCare Technologies
Corporation dated August 1, 10.295,12 1993.
10.30(8),(12) First Amendment to Supply Agreement dated December 1, 1995.
10.31(11) Master Lease Purchase Agreement dated December 18, 1995 with
Fidelity Leasing Corporation and Lease Purchase Addenda in
connection therewith.
10.32(11) Master Equipment Lease dated March 17, 1996 with Olympus
Commercial Credit.
16.01(10) Letter dated April 8, 1997 from Arthur Andersen LLP to the
Commission.
21.01 List of Subsidiaries.
23.01 Consent of KPMG LLP.
23.02 Consent of Arthur Andersen LLP.
27.1 Financial Data Schedule.
</TABLE>
(1) Incorporated by reference from the Company's Registration Statement on
Form S-1 (File No. 33-41363), effective August 8, 1991.
(2) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1991.
(3) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarterly period ended June 30, 1992.
(4) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1992.
(5) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1993.
(6) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1994.
(7) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1995.
(8) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1995.
(9) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1996.
(10) Incorporated by reference from the Company's Current Report on Form 8-K
dated April 7, 1997.
(11) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarterly period ended September 30, 1997.
(12) Confidential treatment requested as to certain portions of this exhibit.
(13) Incorporated by reference from the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1997.
(14) Incorporated by reference from the Company's Quarterly Report on Form 10-Q
for the quarterly period ended September 30, 1998.
<PAGE> 1
Exhibit 10.15
AMENDMENT TO 401(K) PLAN DATED SEPTEMBER 15, 1998
RESOLVED, that the recommended revisions to the PharmChem Laboratories, Inc.
401(k) Plan be adopted including:
A. At Section 1.01(c ), add the name of Tom Calderon, Controller, and delete
the name of Patricia Krause, as a member of the Employer Committee acting
as Plan Administrator.
B. Correct the definition of the term "Employer" at Section 1.02(b) of the
Adoption Agreement to state "PharmChem Laboratories, Inc." in place of
"PharmChem Laboratories Operations, Inc."
C. Amend Section 1.04(a) of the Adoption Agreement by including overtime pay,
bonuses and commissions in the definition of Compensation under the Plan.
D. Amend Section 1.05(b)(1) of the Adoption Agreement to provide that Deferral
Contributions may not exceed 15% (rather than 10%) of Compensation.
E. Amend Section 1.14(b) of the Adoption Agreement by increasing the number of
investment options from 5 to 10.
F. Amend the Addendum to Articles I, II, III and IV to provide that the
participant loan setup fee ($75) and the participant loan fee ($6.25 per
quarter, or $25 per year) are to be charged to the Participant rather than
being paid by the Employer.
/s/ David A. Lattanzio
- -------------------------------------
David A. Lattanzio
Chief Financial Officer and Secretary
<PAGE> 1
EXHIBIT 21.01
LIST OF SUBSIDIARIES
Medscreen Limited
1A Harbour Quay
100 Preston's Road
London, England E149PH
<PAGE> 1
EXHIBIT 23.01
CONSENT OF KPMG LLP, INDEPENDENT AUDITORS
The Board of Directors and Shareholders
PharmChem Laboratories, Inc.:
We consent to the incorporation by reference in the registration statements
(File numbers 33-45481, 33-64770 and 333-36885) on Form S-8 of PharmChem
Laboratories, Inc. of our report dated February 12, 1999, relating to the
consolidated balance sheets of PharmChem Laboratories, Inc. and subsidiary as of
December 31, 1998 and 1997, and the related consolidated statements of
operations, comprehensive income (loss), shareholders' equity and cash flows for
the years then ended, and related schedule, which report appears in the December
31, 1998 annual report on Form 10-K of PharmChem Laboratories, Inc.
KPMG LLP
San Francisco, California
March 25, 1999
<PAGE> 1
EXHIBIT 23.02
CONSENT OF ARTHUR ANDERSEN LLP, INDEPENDENT PUBLIC ACCOUNTANTS
The Board of Directors and Shareholders
PharmChem Laboratories, Inc.:
As independent public accountants, we hereby consent to the incorporation of our
report included in this Form 10-K into the PharmChem Laboratories, Inc. and
subsidiary's (the Company's) previously filed Registration Statements (File
numbers 33-45481, 33-64770 and 333-36885) on Form S-8. It should be noted that
we have not audited any financial statements of the Company subsequent to
December 31, 1996 or performed any audit procedures subsequent to the date of
our report.
Arthur Andersen LLP
San Jose, California
March 25, 1999
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<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
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<RECEIVABLES> 7,062
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0
0
<COMMON> 19,090
<OTHER-SE> 83
<TOTAL-LIABILITY-AND-EQUITY> 22,063
<SALES> 0
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