##### Table of Contents



---

---

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549




---



FORM 10-Q

(Mark One)

|    |                                                                                         
|--- | ----------------------------------------------------------------------------------------
|[X] | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

For the quarterly period ended September 30, 2001

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



(Exact name of registrant as specified in its charter)


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

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

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

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such report(s), and (2) has been subject to
such filing requirements for the past 90 days.   Yes  [X]   No  [   ]

As of October 31, 2001, the registrant had outstanding 5,852,593 shares of
Common Stock, $0.001 par value.



---

---





---

TABLE OF CONTENTS



|                              |                                                                                               |                                                                  |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------------------- |  |  |  |  |  | 
|PART I. Financial Information
|                              | Item 1. Condensed Consolidated Financial Statements                                          
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS                           
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS                 
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS                 
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS            
|                              | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|PART II. Other Information   
|                              | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                              | Item 6. Exhibits and Reports on Form 8-K                                                     
|Signature                    
|EXHIBIT INDEX                
|EXHIBIT 10.45                



---



##### Table of Contents



PHARMCHEM, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX

|          |  |                                                                                                                                              |  |     
|--------- |  | -------------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|          |  |                                                                                                                                              |  | Page
|          |  |                                                                                                                                              |  |     
|         
|         
|         
|         
|Part I    |  | Financial Information                                                                                                                        |  |     
|         
|         
|         
|         
|Item 1.   |  | Condensed Consolidated Financial Statements                                                                                                  |  | 3   
|         
|         
|         
|         
|          |  | Condensed Consolidated Balance Sheets (unaudited) at
September 30, 2001 and December 31, 2000                                                |  | 4   
|         
|         
|         
|         
|          |  | Condensed Consolidated Statements of Operations (unaudited) for the
Three and Nine Months ended September 30, 2001 and 2000                  |  | 5   
|         
|         
|         
|         
|          |  | Condensed Consolidated Statements of Comprehensive Income (Loss)
(unaudited) for the Three and Nine Months ended September 30, 2001 and 2000 |  | 6   
|         
|         
|         
|         
|          |  | Condensed Consolidated Statements of Cash Flows (unaudited)
for the Nine Months ended September 30, 2001 and 2000                            |  | 7   
|         
|         
|         
|         
|          |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                                             |  | 8   
|         
|         
|         
|         
|Item 2.   |  | Managements Discussion and Analysis of Financial Condition
and Results of Operations                                                        |  | 11  
|         
|         
|         
|         
|Part II   |  | Other Information                                                                                                                            |  |     
|         
|         
|         
|         
|Item 4.   |  | Submission of Matters to a Vote of Security Holders                                                                                          |  | 17  
|         
|         
|         
|         
|Item 6.   |  | Exhibits and Reports on Form 8-K                                                                                                             |  | 17  
|         
|         
|         
|         
|Signature |  |                                                                                                                                              |  | 18  

2



---



##### Table of Contents






|       |                      
|------ | ---------------------
|PART I | Financial Information




|        |                                            
|------- | -------------------------------------------
|Item 1. | Condensed Consolidated Financial Statements

The condensed consolidated financial statements included herein have been
prepared by the Company, without audit, pursuant to the rules and regulations
of the Securities and Exchange Commission. Certain information and footnote
disclosures normally included in complete financial statements prepared in
accordance with accounting principles generally accepted in the United States
of America have been condensed or omitted pursuant to such rules and
regulations, although the Company believes that the disclosures made are
adequate to make the information presented not misleading. It is suggested
that the condensed consolidated financial statements be read in conjunction
with the consolidated financial statements and the notes thereto for the year
ended December 31, 2000 included in the Companys Annual Report on Form 10-K.

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

3



---



##### Table of Contents






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

|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |        |        | 
|------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------ | ------------- | ------ | ------------ | ------ | ------ | ------ | 
|                                           |                                                                                                                                                                   |                            |        | September 30, |        | December 31,
|                                           |                                                                                                                                                                   |                            |        | 2001          |        | 2000        
|                                           |                                                                                                                                                                   |                            |        |               |        |             
|ASSETS                                    
|CURRENT ASSETS:                            |                                                                                                                                                                   |                            |        |               |        |              |        |       
|                                           | Cash and cash equivalents                                                                                                                                         |                            | $      | 1,040         |        |              | $      | 1,714  |       
|                                           | Accounts receivable, net                                                                                                                                          |                            |        | 7,578         |        |              |        | 8,004  |       
|                                           | Inventory                                                                                                                                                         |                            |        | 2,654         |        |              |        | 1,855  |       
|                                           | Deferred income taxes                                                                                                                                             |                            |        | 390           |        |              |        | 386    |       
|                                           | Prepaid expenses and other current assets                                                                                                                         |                            |        | 791           |        |              |        | 834    |       
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|                                           |                                                                                                                                                                   | TOTAL CURRENT ASSETS       |        |               | 12,453 |              |        |        | 12,793 | 
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|PROPERTY AND EQUIPMENT, net                |                                                                                                                                                                   |                            | 13,962 |               |        |              | 11,026 |       
|DEFERRED INCOME TAXES                      |                                                                                                                                                                   |                            | 690    |               |        |              | 690    |       
|OTHER ASSETS                               |                                                                                                                                                                   |                            | 73     |               |        |              | 136    |       
|GOODWILL, net                              |                                                                                                                                                                   |                            | 2,482  |               |        |              | 2,620  |       
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|TOTAL ASSETS                               |                                                                                                                                                                   | $                          | 29,660 |               |        | $            | 27,265 |       
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|LIABILITIES AND STOCKHOLDERS EQUITY      
|CURRENT LIABILITIES:                       |                                                                                                                                                                   |                            |        |               |        |              |        |       
|                                           | Revolving line of credit                                                                                                                                          |                            | $      | 4,576         |        |              | $      | 731    |       
|                                           | Current portion of long-term debt                                                                                                                                 |                            |        | 2,879         |        |              |        | 1,368  |       
|                                           | Accounts payable                                                                                                                                                  |                            |        | 6,773         |        |              |        | 4,097  |       
|                                           | Accrued compensation                                                                                                                                              |                            |        | 1,096         |        |              |        | 1,404  |       
|                                           | Accrued collectors and other liabilities                                                                                                                          |                            |        | 3,581         |        |              |        | 2,786  |       
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|                                           |                                                                                                                                                                   | TOTAL CURRENT LIABILITIES  |        |               | 18,905 |              |        |        | 10,386 | 
|LONG-TERM DEBT, net of current portion     |                                                                                                                                                                   |                            | 3,262  |               |        |              | 1,731  |       
|OTHER NONCURRENT LIABILITIES               |                                                                                                                                                                   |                            | 101    |               |        |              | 153    |       
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|                                           |                                                                                                                                                                   | TOTAL LIABILITIES          |        |               | 22,268 |              |        |        | 12,270 | 
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|STOCKHOLDERS EQUITY:                      |                                                                                                                                                                   |                            |        |               |        |              |        |       
|                                           | Common stock, $0.001 par value, 25,000 shares authorized,
5,853 and 5,847 shares issued and outstanding at
September 30, 2001 and December 31, 2000, respectively |                            |        | 6             |        |              |        | 6      |       
|                                           | Additional paid-in capital                                                                                                                                        |                            |        | 19,589        |        |              |        | 19,233 |       
|                                           | Accumulated other comprehensive loss                                                                                                                              |                            |        | (172          | )      |              |        | (142   | )     
|                                           | Accumulated deficit                                                                                                                                               |                            |        | (12,031       | )      |              |        | (4,102 | )     
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|                                           |                                                                                                                                                                   | TOTAL STOCKHOLDERS EQUITY |        |               | 7,392  |              |        |        | 14,995 | 
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY |                                                                                                                                                                   | $                          | 29,660 |               |        | $            | 27,265 |       
|                                           |                                                                                                                                                                   |                            |        |               |        |              |        |       

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

4



---



##### Table of Contents






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

|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |       |       | 
|----------------------------------------------- | ----------------------------------- | ------------------------ | ------ | ------------------ | ----- | ----------------- | ------ | ----- | ----- | ---- | ------ | ------ | ------ | - | ------ | ----- | ----- | 
|                                                |                                     |                          |        | Three Months Ended |       | Nine Months Ended
|                                                |                                     |                          |        | September 30,      |       | September 30,    
|                                                |                                     |                          |        |                    |       |                  
|                                                |                                     |                          |        | 2001               |       | 2000              |        | 2001  |       | 2000
|                                                |                                     |                          |        |                    |       |                   |        |       |       |     
|NET SALES                                       |                                     | $                        | 11,610 |                    |       | $                 | 11,956 |       |       | $    | 33,948 |        |        | $ | 34,144 |      
|COST OF SALES                                   |                                     |                          | 9,907  |                    |       |                   | 8,463  |       |       |      | 28,780 |        |        |   | 23,711 |      
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|GROSS PROFIT                                    |                                     |                          | 1,703  |                    |       |                   | 3,493  |       |       |      | 5,168  |        |        |   | 10,433 |      
|OPERATING EXPENSES                              |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|                                                | Selling, general and administrative |                          |        | 3,136              |       |                   |        | 2,797 |       |      |        | 11,372 |        |   |        | 8,515 |      
|                                                | Amortization of goodwill            |                          |        | 47                 |       |                   |        | 47    |       |      |        | 139    |        |   |        | 139   |      
|                                                | Restructuring charge                |                          |        |                   |       |                   |        |      |       |      |        | 1,029  |        |   |        |      |      
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|                                                |                                     | Total operating expenses |        |                    | 3,183 |                   |        |       | 2,844 |      |        |        | 12,540 |   |        |       | 8,654 | 
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|INCOME (LOSS) FROM OPERATIONS                   |                                     |                          | (1,480 | )                  |       |                   | 649    |       |       |      | (7,372 | )      |        |   | 1,779  |      
|Interest expense                                |                                     |                          | 121    |                    |       |                   | 67     |       |       |      | 276    |        |        |   | 227    |      
|Other expense (income), net                     |                                     |                          | (3     | )                  |       |                   | 7      |       |       |      | (43    | )      |        |   | (60    | )    
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|                                                |                                     | Total other expenses     |        |                    | 118   |                   |        |       | 74    |      |        |        | 233    |   |        |       | 167   | 
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|INCOME (LOSS) BEFORE PROVISION FOR INCOME TAXES |                                     |                          | (1,598 | )                  |       |                   | 575    |       |       |      | (7,605 | )      |        |   | 1,612  |      
|PROVISION FOR INCOME TAXES                      |                                     |                          | 74     |                    |       |                   | 172    |       |       |      | 324    |        |        |   | 553    |      
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|NET INCOME (LOSS)                               |                                     | $                        | (1,672 | )                  |       | $                 | 403    |       |       | $    | (7,929 | )      |        | $ | 1,059  |      
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|EARNINGS (LOSS) PER SHARE:                      |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|                                                | Basic                               |                          | $      | (0.29              | )     |                   | $      | 0.07  |       |      | $      | (1.36  | )      |   | $      | 0.18  |      
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|                                                | Diluted                             |                          | $      | (0.29              | )     |                   | $      | 0.07  |       |      | $      | (1.36  | )      |   | $      | 0.17  |      
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|WEIGHTED AVERAGE SHARES OUTSTANDING:            |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|                                                | Basic                               |                          |        | 5,853              |       |                   |        | 5,824 |       |      |        | 5,850  |        |   |        | 5,818 |      
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      
|                                                | Diluted                             |                          |        | 5,853              |       |                   |        | 6,063 |       |      |        | 5,850  |        |   |        | 6,080 |      
|                                                |                                     |                          |        |                    |       |                   |        |       |       |      |        |        |        |   |        |      

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

5



---



##### Table of Contents






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

|                                   |                              |   |                    |    |                   |   |      |     |      |   |        |     |   |   |       |      |  
|---------------------------------- | ---------------------------- | - | ------------------ | -- | ----------------- | - | ---- | --- | ---- | - | ------ | --- | - | - | ----- | ---- | -
|                                   |                              |   | Three Months Ended |    | Nine Months Ended
|                                   |                              |   | September 30,      |    | September 30,    
|                                   |                              |   |                    |    |                  
|                                   |                              |   | 2001               |    | 2000              |   | 2001 |     | 2000
|                                   |                              |   |                    |    |                   |   |      |     |     
|NET INCOME (LOSS)                  |                              | $ | (1,672             | )  |                   | $ | 403  |     |      | $ | (7,929 | )   |   | $ | 1,059 |     
|OTHER COMPREHENSIVE INCOME (LOSS): |                              |   |                    |    |                   |   |      |     |      |   |        |     |   |   |       |     
|                                   | Foreign currency translation |   |                    | 57 |                   |   |      | (55 | )    |   |        | (30 | ) |   |       | (228 | )
|                                   |                              |   |                    |    |                   |   |      |     |      |   |        |     |   |   |       |     
|COMPREHENSIVE INCOME (LOSS)        |                              | $ | (1,615             | )  |                   | $ | 348  |     |      | $ | (7,959 | )   |   | $ | 831   |     
|                                   |                              |   |                    |    |                   |   |      |     |      |   |        |     |   |   |       |     

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

6



---



##### Table of Contents






PHARMCHEM, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)

|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |       |        |        |        |  
|------------------------------------------------ | ---------------------------------------------------------------------------------------- | ------------------------------------------- | ---------------------------------------------- | --------------------------------------------------- | ------ | ----------------- | ------ | ----- | ------ | ------ | ------ | -
|                                                 |                                                                                          |                                             |                                                |                                                     |        | Nine Months Ended
|                                                 |                                                                                          |                                             |                                                |                                                     |        | September 30,    
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                  
|                                                 |                                                                                          |                                             |                                                |                                                     |        | 2001              |        | 2000 
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|CASH FLOWS FROM OPERATING ACTIVITIES             |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|                                                 | Net income (loss)                                                                        |                                             | $                                              | (7,929                                              | )      |                   | $      | 1,059 |       
|                                                 | Adjustments to reconcile net income (loss) to net cash provided by
operating activities: |                                             |                                                |                                                     |        |                   |        |       |       
|                                                 |                                                                                          |                                             | Depreciation and goodwill amortization         |                                                     |        | 1,692             |        |       |        | 1,654  |       
|                                                 |                                                                                          |                                             | Provision for doubtful accounts                |                                                     |        | 55                |        |       |        | (172   | )     
|                                                 |                                                                                          |                                             | Deferred income taxes                          |                                                     |        | (4                | )      |       |        |       |       
|                                                 |                                                                                          |                                             | Loss on sale or disposal of assets             |                                                     |        |                  |        |       |        | 5      |       
|                                                 |                                                                                          |                                             | Restructuring charge                           |                                                     |        | 1,029             |        |       |        |       |       
|                                                 |                                                                                          |                                             | Amortization of discount on subordinated debt  |                                                     |        | 3                 |        |       |        |       |       
|                                                 | Changes in operating assets and liabilities                                              |                                             |                                                |                                                     |        |                   |        |       |       
|                                                 |                                                                                          |                                             | Accounts receivable                            |                                                     |        | 371               |        |       |        | (1,384 | )     
|                                                 |                                                                                          |                                             | Inventory                                      |                                                     |        | (799              | )      |       |        | 198    |       
|                                                 |                                                                                          |                                             | Prepaids and other current assets              |                                                     |        | 43                |        |       |        | (152   | )     
|                                                 |                                                                                          |                                             | Other assets                                   |                                                     |        | 63                |        |       |        | 253    |       
|                                                 |                                                                                          |                                             | Accounts payable and other accrued liabilities |                                                     |        | 2,188             |        |       |        | (26    | )     
|                                                 |                                                                                          |                                             | Other noncurrent liabilities                   |                                                     |        | (52               | )      |       |        | (43    | )     
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|                                                 |                                                                                          |                                             |                                                | Net cash provided by (used in) operating activities |        |                   | (3,340 | )     |        |        | 1,392  |  
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|CASH FLOWS FROM INVESTING ACTIVITIES             |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|                                                 |                                                                                          | Purchases of property and equipment         |                                                |                                                     | (4,544 | )                 |        |       | (2,659 | )     
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|                                                 |                                                                                          |                                             |                                                | Net cash used in investing activities               |        |                   | (4,544 | )     |        |        | (2,659 | )
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|CASH FLOWS FROM FINANCING ACTIVITIES             |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|                                                 |                                                                                          | Borrowings on revolving line of credit, net |                                                |                                                     | 3,845  |                   |        |       | 1,476  |       
|                                                 |                                                                                          | Principal payments on long-term debt        |                                                |                                                     | (1,665 | )                 |        |       | (2,233 | )     
|                                                 |                                                                                          | Proceeds from financing and short term debt |                                                |                                                     | 3,549  |                   |        |       | 1,674  |       
|                                                 |                                                                                          | Proceeds from issuance of subordinated debt |                                                |                                                     | 1,500  |                   |        |       |       |       
|                                                 |                                                                                          | Proceeds from exercise of stock options     |                                                |                                                     | 11     |                   |        |       | 46     |       
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|                                                 |                                                                                          |                                             |                                                | Net cash provided by financing activities           |        |                   | 7,240  |       |        |        | 963    |  
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|FOREIGN CURRENCY TRANSLATION                     |                                                                                          |                                             | (30                                            | )                                                   |        |                   | (228   | )    
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|NET DECREASE IN CASH AND CASH EQUIVALENTS        |                                                                                          |                                             | (674                                           | )                                                   |        |                   | (532   | )    
|CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD |                                                                                          |                                             | 1,714                                          |                                                     |        |                   | 1,804  |      
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      
|CASH AND CASH EQUIVALENTS AT END OF PERIOD       |                                                                                          | $                                           | 1,040                                          |                                                     |        | $                 | 1,272  |      
|                                                 |                                                                                          |                                             |                                                |                                                     |        |                   |        |      

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

7



---



##### Table of Contents






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



|1. |  | Earnings (Loss) per Share
|-- |  | -------------------------

We compute and disclose our earnings (loss) per share in accordance with
Statement of Financial Accounting Standards No. 128, Earnings Per Share,
which requires the presentation of basic and diluted earnings per share. Basic
earnings per share is calculated using the weighted average number of common
shares outstanding during the period. Diluted earnings 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.

Options to purchase 1,059,000 shares of our common stock for the three and
nine month periods ended September 30, 2001, were not included in the
computation of diluted earnings per share because their effect would have been
anti-dilutive. Options to purchase 135,000 shares and 105,000 shares of our
common stock for the three months and nine months ended September 30, 2000,
respectively, were not included in the computation of diluted earnings per
share because their exercise prices were greater than the average market price
of our common stock of $3.31 and $3.43 per share, respectively. Weighted
average dilutive options of 239,000 and 262,000 were used in the computation
of dilutive earnings per share for the three month and nine month periods ended
September 30, 2000, respectively.



|2. |  | Inventory
|-- |  | ---------

Inventory includes laboratory materials, collection materials and products
and 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. Inventory consisted of the following as of September 30, 2001
and December 31, 2000, respectively:

|                     |  |                |       |      |  |   |       | 
|-------------------- |  | -------------- | ----- | ---- |  | - | ----- | 
|                     |  | 2001           |       | 2000
|                     |  |                |       |     
|                     |  | (In thousands)
|Laboratory materials |  | $              | 548   |      |  | $ | 733   | 
|Collection materials |  |                | 1,107 |      |  |   | 841   | 
|Products             |  |                | 999   |      |  |   | 281   | 
|                     |  |                |       |      |  |   |       | 
|                     |  | $              | 2,654 |      |  | $ | 1,855 | 
|                     |  |                |       |      |  |   |       | 

8



---



##### Table of Contents





|3. |  | Reportable Segments
|-- |  | -------------------

We have two reportable segments, Domestic and International, providing
integrated drug testing services. Our Domestic segment serves the United States
(US) and the International segment serves primarily the United Kingdom but also
serves the European, Asian, Middle Eastern and South American markets. The
Domestic segment is serviced by our Texas and California operations and the
International segment is serviced by Medscreen, our London-based subsidiary.
The accounting policies of the segments are the same as those described in the
Summary of Significant Accounting Policies in the notes to the consolidated
financial statements for the year ended December 31, 2000 included in our
Annual Report on Form 10-K. We evaluate segment profit (loss) 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 our segments for the three and
nine month periods ended September 30 is as follows:

| |       |  |  |                                   |  |                |        |               |  |       |       |  |  |   |        |  
| | ----- |  |  | --------------------------------- |  | -------------- | ------ | ------------- |  | ----- | ----- |  |  | - | ------ | -
| |       |  |  |                                   |  | Domestic       |        | International |  | Total
| |       |  |  |                                   |  |                |        |               |  |      
| |       |  |  |                                   |  | (In thousands)
| |       |  |  | Three Months Ending September 30, |  |                |        |               |  |       |       |  |  |   |        |  
| | 2001: |  |  | Net sales from external customers |  | $              | 9,824  |               |  | $     | 1,786 |  |  | $ | 11,610 |  
| |       |  |  | Segment profit (loss)             |  |                | (1,809 | )             |  |       | 376   |  |  |   | (1,433 | )
| | 2000: |  |  | Net sales from external customers |  | $              | 10,149 |               |  | $     | 1,807 |  |  | $ | 11,956 |  
| |       |  |  | Segment profit                    |  |                | 380    |               |  |       | 316   |  |  |   | 696    |  
| |       |  |  | Nine Months Ending September 30,  |  |                |        |               |  |       |       |  |  |   |        |  
| | 2001: |  |  | Net sales from external customers |  | $              | 28,488 |               |  | $     | 5,460 |  |  | $ | 33,948 |  
| |       |  |  | Segment profit (loss)             |  |                | (8,342 | )             |  |       | 1,109 |  |  |   | (7,233 | )
| | 2000: |  |  | Net sales from external customers |  | $              | 28,584 |               |  | $     | 5,560 |  |  | $ | 34,144 |  
| |       |  |  | Segment profit                    |  |                | 733    |               |  |       | 1,185 |  |  |   | 1,918  |  



|4. |  | Restructuring Charge
|-- |  | --------------------

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

|                               |       |        |       |          |             |      |          |          |             |      |               |     |  |   |     |      |         |   |     |     | 
|------------------------------ | ----- | ------ | ----- | -------- | ----------- | ---- | -------- | -------- | ----------- | ---- | ------------- | --- |  | - | --- | ---- | ------- | - | --- | --- | 
|                               |       |        |       |          |             |      |          |          |             |      | Accrual       |     |  |   |     |      | Accrual
|                               |       |        |       |          |             |      |          |          |             |      | As of         |     |  |   |     |      | As of  
|                               |       |        | Total |          | 2nd Qtr '01 |      | June 30, |          | 3rd Qtr '01 |      | September 30,
|Restructuring Expense          |       | Charge |       | Payments |             | 2001 |          | Payments |             | 2001
|                               |       |        |       |          |             |      |          |          |             |     
|Severance and related
benefits |       | $      | 330   |          |             | $    | (140     | )        |             | $    | 190           |     |  | $ | (9  | )    |         | $ | 181 |    
|                               |       |        |       |          |             |      |          |          |             |      |               |     |  |   |     |      |         |   |     |    
|Clean-up and remediation       |       |        | 371   |          |             |      | (78      | )        |             |      | 293           |     |  |   | (84 | )    |         |   | 209 |    
|                               |       |        |       |          |             |      |          |          |             |      |               |     |  |   |     |      |         |   |     |    
|Repairs                        |       |        | 226   |          |             |      | (210     | )        |             |      | 16            |     |  |   | (7  | )    |         |   | 9   |    
|                               |       |        |       |          |             |      |          |          |             |      |               |     |  |   |     |      |         |   |     |    
|Legal and other                |       |        | 102   |          |             |      | (15      | )        |             |      | 87            |     |  |   | (15 | )    |         |   | 72  |    
|                               |       |        |       |          |             |      |          |          |             |      |               |     |  |   |     |      |         |   |     |    
|                               | Total |        | $     | 1,029    |             |      | $        | (443     | )           |      | $             | 586 |  |   | $   | (115 | )       |   | $   | 471 | 
|                               |       |        |       |          |             |      |          |          |             |      |               |     |  |   |     |      |         |   |     |    

9



---



##### Table of Contents



The restructuring plan was designed to provide for costs associated with
leaving our facilities in Menlo Park, California. The lease on our main Menlo
Park facility terminated on June 1, 2001 and the restructuring expenses
represent estimated and actual costs related to workforce reductions, clean-up,
repairs and legal services. As part of the workforce reduction, we recorded
severance and related fringe benefits costs for approximately 160 employees
from operations and administration, of which 82 employees were terminated as of
September 30, 2001. In addition, we expect to incur legal and other fees
related to our departure. The accrual balance of $471,000 is classified as a
component in Accrued collectors and other liabilities on the balance sheet.



|5. |  | Debt
|-- |  | ----

Our revolving credit agreement, subordinated debt and capitalized lease
obligations as of September 30, 2001 and December 31, 2000 consist of the
following:

|                                                                                                                                                                                                                    |  |                |        |      |  |   |        |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ------ | ---- |  | - | ------ | -
|                                                                                                                                                                                                                    |  | 2001           |        | 2000
|                                                                                                                                                                                                                    |  |                |        |     
|                                                                                                                                                                                                                    |  | (In thousands)
|Revolving credit agreement pursuant to a revolving loan agreement                                                                                                                                                   |  | $              | 4,576  |      |  | $ | 731    |  
|Term installment note                                                                                                                                                                                               |  |                | 1,217  |      |  |   | 1,559  |  
|Subordinated debt, net of discount                                                                                                                                                                                  |  |                | 1,158  |      |  |   |       |  
|Obligations under capitalized leases, due in monthly
installments through 2005, secured by laboratory equipment,
office equipment computer software and computer hardware,
interest rates ranging from 8.9% to 9.9% |  |                | 3,766  |      |  |   | 1,540  |  
|                                                                                                                                                                                                                    |  |                |        |      |  |   |        |  
|                                                                                                                                                                                                                    |  |                | 10,717 |      |  |   | 3,830  |  
|Less: current portion and revolving line of credit                                                                                                                                                                  |  |                | (7,455 | )    |  |   | (2,099 | )
|                                                                                                                                                                                                                    |  |                |        |      |  |   |        |  
|Long-term portion                                                                                                                                                                                                   |  | $              | 3,262  |      |  | $ | 1,731  |  
|                                                                                                                                                                                                                    |  |                |        |      |  |   |        |  

We have a revolving line of credit agreement (Credit Agreement) with a
bank. The Credit Agreement provides for borrowings under the revolving line of
credit limited to 85% of qualified accounts receivable (up to a maximum of
$6,000,000) and is secured by a lien on substantially all of our assets
(excluding computer software and certain other assets). The Credit Agreement
contains certain financial covenants, which, among others, require PharmChem to
maintain certain ratios of working capital and net worth.

On April 17, 2001, our Credit Agreement was amended to provide an
additional $600,000 of short term financing to be used to finance construction
of our new Haltom City, Texas facility. The note carried interest at the prime
rate and $423,000 was outstanding as of September 30, 2001. The note was
repaid in full on October 31, 2001. On May 25, 2001, our Credit Agreement was
amended to change the revolving maturity date to May 31, 2002, reduce the
interest rate to the banks prime rate and reduce the commitment fee to 0.1%
from 0.25% of the maximum line of credit.

On July 18, 2001, our Credit Agreement was amended to provide an
additional $600,000 of short-term borrowing capacity under the revolving line
of credit. On September 12, 2001, the Credit Agreement was amended to, among
other items, waive our noncompliance with covenants for the period

10



---



##### Table of Contents



ending June 30, 2001, modify our existing covenants and provide for the
issuance of subordinated debt. As of September 30, 2001, the maximum that
could be borrowed and the amount outstanding under the amended revolving Credit
Agreement were $5,440,000 and $4,576,000, respectively.

During the process of relocating to Texas, we have incurred significant
costs that have been financed through a combination of internal operations,
increased borrowing under our existing and new credit facilities and a
sale-leaseback transaction. We believe these costs are of a nonrecurring
nature and principally relate to the period prior to occupying our new Haltom
City, Texas corporate headquarters, main laboratory and distribution center.
Our laboratory operations and distribution center relocated to the Haltom City
facility in September and October, respectively. As a result of the
restructuring charge and nonrecurring expenses associated with the relocation
to Texas, we were not in compliance with our current ratio, net worth and
capital expenditures covenants. Although we continue to negotiate with our
bank to provide a waiver for the noncompliance with the covenants, the bank has
not yet determined it will grant such a waiver. Accordingly, we have
reclassified $761,000 of our term debt with the bank from long-term debt to
current portion of long-term debt on our balance sheet as of September 30,
2001.

On January 3, 2001, we completed a $2,363,000 financing lease agreement
with a group of lessors to refinance certain modules of ATLAS, our new
laboratory information management system. The lease agreement bears interest
at 8.9% and is payable over 36 to 48 months. On August 8, 2001, we completed a
$1,186,000 financing lease agreement with a lessor to refinance laboratory and
other equipment and additional modules of ATLAS. The lease agreement bears
interest at 8.7% and is payable over 36 to 48 months. The proceeds from both
leases were used to reduce amounts outstanding under our revolving line of
credit and to fund additional capital expenditures. These leases have been
accounted for as capital leases.

On September 14 and September 21, 2001, we closed transactions with three
stockholders resulting in the issuance of subordinated debt in an aggregate
amount of $1,500,000. We issued to the stockholders unsecured subordinated
promissory notes (Notes) in the aggregate amount of $1,500,000 and, in
addition, the stockholders received (without additional consideration) warrants
to purchase an aggregate of 150,000 shares of the Companys common stock.
Interest on the Notes accrue at a rate of 9% per annum and is payable annually
during the term of the Notes. The Notes will mature on September 30, 2003. Our
obligation under the Notes is subordinate in payment and priority to the
indebtedness of the Company due and owing to our bank. The warrants are
immediately exercisable by each stockholder for shares of the Companys common
stock at an exercise price of $3.00 per share and expire five years from the
date of the closing. The warrants also provide each stockholder certain
registration rights for the warrant shares. On the closing dates, the fair
value of each warrant was $2.30 based on the Black-Scholes option pricing
module and using assumptions of a 4.02% risk free rate of return, 5 year life
and a 101% annual volatility of our stock price. The fair value of the
warrants is classified as a discount to the Notes and is being amortized to
expense over a two year period.




|        |                                                                                      
|------- | -------------------------------------------------------------------------------------
|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of
Operations

Forward Looking Statements

Managements Discussion and Analysis of Financial Condition and Results
of Operations contains forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act

11



---



##### Table of Contents



of 1934 and Section 27A of the
Securities Act of 1933, which are subject to the safe harbor created by these
Sections. Our actual future results could differ materially from those
projected in the forward-looking statements. Some factors which could cause
future actual results to differ materially from our recent results and those
projected in the forward-looking statements are described in our Annual Report
on Form 10-K for the year ended December 31, 2000. We assume 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):

|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |      |       | 
|----------------------------- | --------------------------------- | ------------------------ | ------ | -------------------------------- | ------ | ------------------------------- | ----- | ----- | ------ | ---- | ----- | --------------------- | ----- | ---- | ---- | ---- | ----- | ---- | ------ | ------ | ------ | --------------------- | ------ | ------ | ------ |  | ----- | ---- | ----- |  | ---- | ---- | ----- | 
|                              |                                   |                          |        | Three Months Ended September 30, |        | Nine Months Ended September 30,
|                              |                                   |                          |        |                                  |        |                                
|                              |                                   |                          |        | 2001                             |        | 2000                            |       | 2001  |        | 2000 |       | 2001                  |       | 2000 |      | 2001 |       | 2000
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |     
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       | (As a % of net sales) |       |      |      |      |       |      |        |        |        | (As a % of net sales)
|NET SALES:                    |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|                              | Workplace employers               |                          | $      | 3,019                            |        |                                 | $     | 4,469 |        |      |       | 26.0                  | %     |      |      | 37.4 | %     |      | $      | 9,904  |        |                       | $      | 13,297 |        |  |       | 29.2 | %     |  |      | 38.9 | %    
|                              | Criminal justice agencies         |                          |        | 4,640                            |        |                                 |       | 3,808 |        |      |       | 40.0                  |       |      |      | 31.9 |       |      |        | 12,622 |        |                       |        | 10,548 |        |  |       | 37.2 |       |  |      | 30.9 |      
|                              | Drug rehabilitation programs      |                          |        | 301                              |        |                                 |       | 267   |        |      |       | 2.6                   |       |      |      | 2.2  |       |      |        | 811    |        |                       |        | 871    |        |  |       | 2.4  |       |  |      | 2.6  |      
|                              | Domestic products & other         |                          |        | 1,864                            |        |                                 |       | 1,605 |        |      |       | 16.0                  |       |      |      | 13.4 |       |      |        | 5,151  |        |                       |        | 3,868  |        |  |       | 15.1 |       |  |      | 11.3 |      
|                              | Medscreen                         |                          |        | 1,786                            |        |                                 |       | 1,807 |        |      |       | 15.4                  |       |      |      | 15.1 |       |      |        | 5,460  |        |                       |        | 5,560  |        |  |       | 16.1 |       |  |      | 16.3 |      
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|                              |                                   | Total net sales          |        |                                  | 11,610 |                                 |       |       | 11,956 |      |       |                       | 100.0 |      |      |      | 100.0 |      |        |        | 33,948 |                       |        |        | 34,144 |  |       |      | 100.0 |  |      |      | 100.0 | 
|COST OF SALES                 |                                   |                          | 9,907  |                                  |        |                                 | 8,463 |       |        |      | 85.3  |                       |       |      | 70.8 |      |       |      | 28,780 |        |        |                       | 23,711 |        |        |  | 84.8  |      |       |  | 69.4 |     
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|GROSS PROFIT                  |                                   |                          | 1,703  |                                  |        |                                 | 3,493 |       |        |      | 14.7  |                       |       |      | 29.2 |      |       |      | 5,168  |        |        |                       | 10,433 |        |        |  | 15.2  |      |       |  | 30.6 |     
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|OPERATING EXPENSES:           |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|                              | Selling, general & administrative |                          |        | 3,136                            |        |                                 |       | 2,797 |        |      |       | 27.0                  |       |      |      | 23.4 |       |      |        | 11,372 |        |                       |        | 8,515  |        |  |       | 33.5 |       |  |      | 24.9 |      
|                              | Amortization of goodwill          |                          |        | 47                               |        |                                 |       | 47    |        |      |       | 0.4                   |       |      |      | 0.4  |       |      |        | 139    |        |                       |        | 139    |        |  |       | 0.4  |       |  |      | 0.4  |      
|                              | Restructuring charge              |                          |        |                                 |        |                                 |       |      |        |      |       |                      |       |      |      |     |       |      |        | 1,029  |        |                       |        |       |        |  |       | 3.0  |       |  |      | -    |      
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|                              |                                   | Total operating expenses |        |                                  | 3,183  |                                 |       |       | 2,844  |      |       |                       | 27.4  |      |      |      | 23.8  |      |        |        | 12,540 |                       |        |        | 8,654  |  |       |      | 36.9  |  |      |      | 25.3  | 
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|INCOME (LOSS) FROM OPERATIONS |                                   |                          | (1,480 | )                                |        |                                 | 649   |       |        |      | (12.7 | )                     |       |      | 5.4  |      |       |      | (7,372 | )      |        |                       | 1,779  |        |        |  | (21.7 | )    |       |  | 5.2  |     
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|OTHER EXPENSES, net           |                                   |                          | 118    |                                  |        |                                 | 74    |       |        |      | 1.0   |                       |       |      | 0.6  |      |       |      | 233    |        |        |                       | 167    |        |        |  | 0.7   |      |       |  | 0.5  |     
|PROVISION FOR INCOME TAXES    |                                   |                          | 74     |                                  |        |                                 | 172   |       |        |      | 0.6   |                       |       |      | 1.4  |      |       |      | 324    |        |        |                       | 553    |        |        |  | 1.0   |      |       |  | 1.6  |     
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     
|NET INCOME (LOSS)             |                                   | $                        | (1,672 | )                                |        | $                               | 403   |       |        |      | (14.4 | )%                    |       |      | 3.4  | %    |       | $    | (7,929 | )      |        | $                     | 1,059  |        |        |  | (23.4 | )%   |       |  | 3.1  | %   
|                              |                                   |                          |        |                                  |        |                                 |       |       |        |      |       |                       |       |      |      |      |       |      |        |        |        |                       |        |        |        |  |       |      |       |  |      |     

Net salesfor the three months ended September 30, 2001 decreased $346,000
(2.9%) to $11,610,000 in 2001 from $11,956,000 in 2000. We recorded 6.8% lower
domestic laboratory service sales which more than offset a 16.1% increase in
domestic product and non-laboratory sales. Domestic specimen (including
product related analyses) volume decreased 8.5% and average selling prices for
domestic laboratory analyses (including product related analyses) increased
1.8%. The lower domestic laboratory sales reflect a generally sluggish US
economy, a significant reduction of specimen receipts following the September
11 tragedy and logistical and operational challenges encountered during the
relocation of our Menlo Park, California corporate headquarters and main
laboratory to Haltom City, Texas. Our Menlo Park lease terminated on June 1,
2001. Due to construction delays at our new Haltom City facility, we quickly
expanded our Fort Worth, Texas laboratory to accommodate the significant
specimen volume transferred from Menlo Park and, as a consequence, we fell
behind in our specimen processing while the new workforce was being trained. Medscreen, our
London-based subsidiary, reported a decrease in laboratory analyses sales of
$35,000 (2.0%) and a 1.0% decrease in specimen

12



---



##### Table of Contents



volume. Product sales of the
PharmChek® Drugs of Abuse Patch (excluding analysis) increased 138.7% due to a
140.3% increase in volume while sales of the PharmScreen® On-site Screening
Device were unchanged compared to the prior year. Non-laboratory service sales
increased 16.6% compared to the prior year. Under our Premium Comprehensive
Management (PCM®) umbrella of integrated drug testing services, such
non-laboratory services include our web-based specimen collection management
system used by governmental and workplace customers.

Net sales for the nine months ended September 30, 2001 decreased $196,000
(0.6%) to $33,948,000 in 2001 from $34,144,000 in 2000. We recorded 33.2%
higher domestic product and non-laboratory sales which were more than offset by
a 5.6% decrease in domestic laboratory analyses sales. Domestic specimen
(including product related analyses) volume decreased 9.7%, principally by
criminal justice customers. Average selling prices for domestic laboratory
analyses (including product related analyses) increased 4.6%. Medscreens
sales decreased $100,000 (1.8%) due to a 3.1% decrease in specimen volume.

Cost of salesfor the three months ended September 30, 2001 increased
$1,444,000 (17.1%) to $9,907,000 in 2001 from $8,463,000 in 2000. The increase
in cost of sales includes $1,602,000 of nonrecurring costs directly related to
the transfer of production from our Menlo Park main laboratory to our Texas
laboratories. These nonrecurring costs include duplicate payroll, lab
materials, training and transportation. Cost of sales as a percentage of net
sales increased to 85.3% in 2001 from 70.8% in 2000. Gross profit as a
percentage of net sales decreased to 14.7% in 2001 from 29.2% in 2000.
Excluding the nonrecurring charges, the proforma cost of sales and gross profit
as percentages of net sales would have been 71.5% and 28.5%, respectively.

Cost of sales for the nine months ended September 30, 2001 increased
$5,069,000 (21.4%) to $28,780,000 in 2001 from $23,711,000 in 2000. The
increase in cost of sales includes $4,106,000 of nonrecurring costs directly
related to the transfer of production from our Menlo Park main laboratory to
our Texas laboratories. Domestic specimen collection costs increased $668,000
(12.2%) due to an 11.3% increase in managed collection volume and higher rates
charged by our network of collector draw stations. Cost of sales as a
percentage of net sales increased to 84.8% in 2001 from 69.4% in 2000. Gross
profit as a percentage of net sales decreased to 15.2% in 2001 from 30.6% in
2000. Excluding the nonrecurring charges, the proforma cost of sales and gross
profit as percentages of net sales would have been 72.7% and 27.3%,
respectively.

Selling, General & Administrative (SG&A)expenses for the three months
ended September 30, 2001 increased $339,000 (12.1%) to $3,136,000 in 2001 from
$2,797,000 in 2000. The increase principally reflects $259,000 of nonrecurring
costs associated with the relocation of our Company from California to Texas.
These nonrecurring costs include significant relocation, travel and subsistence
expenses. In addition, we continued our investment in sales, marketing,
customer service and information systems. SG&A expenses as a percentage of net
sales increased to 27.0% in 2001 from 23.4% in 2000. Excluding the
nonrecurring charges, the proforma SG&A expenses as percentage of net sales
would have been 24.8%.

SG&A expenses for the nine months ended September 30, 2001 increased
$2,857,000 (33.6%) to
$11,372,000 in 2001 from $8,515,000 in 2000. The increase principally reflects
$1,761,000 of nonrecurring costs associated with the relocation of our Company
from California to Texas. These

13



---



##### Table of Contents



nonrecurring costs include significant
relocation, travel and subsistence expenses and our continued investment in
sales, marketing, customer service and information systems. SG&A expenses as a
percentage of net sales increased to 33.5% in 2001 from 24.9% in 2000.
Excluding the nonrecurring charges, the proforma SG&A expenses as percentage of
net sales would have been 28.3%.

Restructuring Chargeof $1,029,000 was recorded in the current years
second quarter in accordance with a plan approved by our Board of Directors to
provide for costs associated with closing our former headquarters, main
laboratory and distribution center in Menlo Park, California. The charge
consisted of $330,000 for severance and related benefits costs of a workforce
reduction and $699,000 for repairs, clean-up and professional services.

Provision for Income Taxesfor the three month and nine month periods
ended September 30, 2001 was $74,000 and $324,000, respectively, compared to
$172,000 and $553,000, respectively for the same periods in 2000. The current
years provision for income taxes reflects Medscreens provision on its income.

Net lossfor the three months ended September 30, 2001 was $1,672,000 or
$0.29 per common share compared to net income of $403,000 or $0.07 per diluted
common share in 2000. Excluding the impact of the $1,861,000 in nonrecurring
costs related to the Companys relocation, proforma net income for the three
months ended September 30, 2001 would have been $189,000 or $0.03 per diluted
share. Net loss for the nine months ended September 30, 2001 was $7,929,000 or
$1.36 per common share compared to net income of $1,059,000 or $0.17 per
diluted common share in 2000. Excluding the impact of the $5,867,000 in
nonrecurring costs and $1,029,000 restructuring charge related to the Companys
relocation, proforma net loss for the nine months ended September 30, 2001
would have been $1,033,000 or $0.18 per common share.

Liquidity and Capital Resources

Our operations during the nine month period ended September 30 used cash
of $3,340,000 and provided cash of $1,392,000 in 2001 and 2000, respectively.
The decrease in cash flow from operations between 2001 and 2000 principally
reflects a $8,988,000 decrease in income which more than offset reductions in
accounts receivable and higher accounts payable. As of September 30, 2001, we
had $1,040,000 in cash and cash equivalents. During the nine months ended
September 30, 2001, we used approximately $4,544,000 in cash to purchase
property and equipment, principally for ATLAS, our new laboratory information
system under development, new laboratory confirmation analyzers and leasehold
improvements and other expenditures for our new Haltom City, Texas facility.

We have a revolving line of credit agreement (Credit Agreement) with a
bank. The Credit Agreement provides for borrowings under the revolving line of
credit limited to 85% of qualified accounts receivable (up to a maximum of
$6,000,000) and is secured by a lien on substantially all of our assets
(excluding computer software and certain other assets). The Credit Agreement
contains certain financial covenants, which, among others, require PharmChem to
maintain certain ratios of working capital and net worth.

On April 17, 2001, our Credit Agreement was amended to provide an
additional $600,000 of short term financing to be used to finance construction
of our new Haltom City, Texas facility. The note

14



---



##### Table of Contents



carried interest at the prime
rate and $423,000 was outstanding as of September 30, 2001. The note was
repaid in full on October 31, 2001. On May 25, 2001, our Credit Agreement was
amended to change the revolving maturity date to May 31, 2002, reduce the
interest rate to the banks prime rate and reduce the commitment fee to 0.1%
from 0.25% of the maximum line of credit.

On July 18, 2001, our Credit Agreement was amended to provide an
additional $600,000 of short-term borrowing capacity under the revolving line
of credit. On September 12, 2001, the Credit Agreement was amended to, among
other items, waive our noncompliance with covenants for the period ending June
30, 2001, modify our existing covenants and provide for the issuance of
subordinated debt. As of September 30, 2001, the maximum that could be
borrowed and the amount outstanding under the amended revolving Credit
Agreement were $5,440,000 and $4,576,000, respectively.

On January 3, 2001, we completed a $2,363,000 financing lease agreement
with a group of lessors to refinance certain modules of ATLAS, our new
laboratory information management system. The lease agreement bears interest
at 8.9% and is payable over 36 to 48 months. On August 8, 2001, we completed a
$1,186,000 financing lease agreement with a lessor to refinance laboratory and
other equipment and additional modules of ATLAS. The lease agreement bears
interest at 8.7% and is payable over 36 to 48 months. The proceeds from both
leases were used to reduce amounts outstanding under our revolving line of
credit and to fund additional capital expenditures. These leases have been
accounted for as capital leases.

On September 14 and September 21, 2001, we closed transactions with three
stockholders resulting in the issuance of subordinated debt in an aggregate
amount of $1,500,000. We issued to the stockholders unsecured subordinated
promissory notes (Notes) in the aggregate amount of $1,500,000 and, in
addition, the stockholders received (without additional consideration) warrants
to purchase an aggregate of 150,000 shares of the Companys common stock.
Interest on the Notes accrue at a rate of 9% per annum and is payable annually
during the term of the Notes. The Notes will mature on September 30, 2003. Our
obligation under the Notes is subordinate in payment and priority to the
indebtedness of the Company due and owing to our bank. The warrants are
immediately exercisable by each stockholder for shares of the Companys common
stock at an exercise price of $3.00 per share and expire five years from the
date of the closing. The warrants also provide each stockholder certain
registration rights for the warrant shares. On the closing dates, the fair
value of each warrant was $2.30 based on the Black-Scholes option pricing
module and using assumptions of a 4.02% risk free rate of return, 5 year life
and a 101% annual volatility of our stock price. The fair value of the
warrants is classified as a discount to the Notes and is being amortized to
expense over a two year period.

During the process of relocating to Texas, we have incurred significant
costs that have been financed through a combination of internal operations,
increased borrowing under our existing and new credit facilities and a
sale-leaseback transaction. We believe these costs are of a nonrecurring
nature and principally relate to the period prior to occupying our new Haltom
City, Texas corporate headquarters and main laboratory. Our laboratory
operations and distribution center relocated to the Haltom City facility in
September and October, respectively. As a result of the restructuring charge
and nonrecurring expenses associated with the relocation to Texas, we were not
in compliance with our current ratio, net worth and capital expenditures
covenants. Although we continue to negotiate with our bank to provide a waiver
for the noncompliance with the covenants, the bank has not yet determined it
will grant such a waiver.
Accordingly, we have reclassified $761,000 of our term debt with the bank from
long-term debt to current portion of long-term debt on our balance sheet as of
September 30, 2001. We anticipate the existing cash

15



---



##### Table of Contents



balances, amounts
available under existing and anticipated credit agreements, including a
sale-leaseback transaction and a credit agreement with Medscreens bank,
savings from a 15% workforce reduction announced in October 2001, and funds to
be generated from future operations will be sufficient to fund operations and
forecasted capital expenditures through the foreseeable future.

Impact of Recent Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board (FASB) issued
SFAS No. 144 (SFAS 144), Accounting for the Impairment or Disposal of
Long-Lived Assets.SFAS 144 supercedes SFAS 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,
in that it removes goodwill from its impairment scope and allows for different
approaches in cash flow estimation. However, SFAS 144 retains the fundamental
provisions of SFAS 121 for (a) recognition and measurement of the impairment of
long-lived assets to be held and used and (b) measurement of long-lived assets
to be disposed of. SFAS 144 also supercedes the business segment concept in APB
Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions,in that it permits
presentation of a component of an entity, whether classified as held for sale
or disposed of, as a discontinued operation. SFAS 144 retains the requirement
of APB Opinion No. 30 to report discontinued operations separately from
continuing operations. We are required to adopt the provisions of SFAS 144 no
later than January 1, 2002. We believe the implementation of this standard
will not have a material effect on our results of operations and financial
position.

In June 2001, the FASB issued Statement No. 143 (SFAS 143), Accounting
for Asset Retirement Obligations.SFAS 143 requires liability recognition for
obligations associated with the retirement of tangible long-lived assets and
the associated asset retirement costs. We are required to adopt the provisions
of SFAS 143 no later than January 1, 2003. We currently analyzing the effect,
if any, the adoption of this standard will have on our financial statements.

In July 2001, the FASB issued Statement No. 142 (SFAS 142), Goodwill and
Other Intangible Assets.SFAS 142 will require that goodwill and intangible
assets with indefinite useful lives no longer be amortized, but instead tested
for impairment at least annually in accordance with the provisions of SFAS 142.
This Statement will further require intangible assets with definite useful
lives be amortized over their respective estimated useful lives to their
estimated residual values, and reviewed for impairment in accordance with SFAS
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of.SFAS 142 is effective January 1, 2002. Upon
adoption of SFAS 142, we will be required to reassess the useful lives and
residual values of all intangible assets acquired in purchase business
combinations and make any necessary amortization period adjustments by the end
of the first interim period after adoption. Any impairment loss will be
measured as of the date of adoption and recognized as the cumulative effect of
a change in accounting principle in the first interim period. On an ongoing
basis, the amortization of goodwill noted in the Statements of Operations will
be eliminated beginning January 1, 2001. At this time, the adoption of the
impairment provisions of SFAS 142 is not expected to have a material effect on
our consolidated financial position or results of operations.

16



---



##### Table of Contents



Quantitative and Qualitative Disclosures About Market Risk

We are subject to market risk with respect to our debt outstanding and
foreign currency transactions. Our revolving credit agreement and installment
note carry interest at the prime rate. As the prime rate increases, we will
incur higher relative interest expense and similarly, a decrease in the prime
rate will reduce relative interest expense. Despite recent changes 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 our international operations, certain transactions are conducted in
foreign currencies. Medscreens transactions are denominated approximately 84%
in pound sterling and 16% in US currency. During the nine month periods ending
September 30, 2001 and 2000, Medscreens net sales represented 15.4% and 16.1%,
respectively, of our 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, we do not intend to engage
in significant hedging transactions.




|         |                  
|-------- | -----------------
|PART II. | Other Information




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

None.




|        |                                 
|------- | --------------------------------
|Item 6. | Exhibits and Reports on Form 8-K



| | (a) |  | Exhibits:
| | --- |  | ---------

| |  |         |  |                                                                                                                                                 
| |  | ------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 10.45 - |  | Lease Agreement between PharmChem, Inc. and
First American Commercial Bancorp, Inc. for the lease of
software and equipment dated July 25, 2001.



| | (b) |  | Reports on Form 8-K:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | --- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |     |  | We filed a Form 8-K dated September 4, 2001, to announce our Board
of Directors amended our Rights Agreement between the Company and
ChaseMellon Shareholder Services, L.L.C.. The amendment was adopted
in contemplation of the possibility of the Company entering into
agreements for the issuance of subordinated debt. The amendment
permits persons previously excluded from Acquiring Person status, as
defined, until they acquired 27 percent of the Companys outstanding
common stock to retain their exclusion up to a 30 percent ownership
level.
|
| |     |  | We filed a Form 8-K dated September 12, 2001, to announce (i)
closing of transactions with three stockholders resulting in the
issuance of subordinated debt in an aggregate amount of $1,500,000
and the issuance of warrants to purchase an aggregate of 150,000
shares of the Companys common stock and (ii) an amendment to our
Loan and Security Agreement and Limited Waiver with our bank.                                                                                                                                                            

17



---



##### Table of Contents






Signature

Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.



| | PharmChem, Inc.
(Registrant)
| | ----------------------------



|Date: November 12, 2001 | By: | /S/   DAVID A. LATTANZIO
|----------------------- | --- | ------------------------

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

18



---



##### Table of Contents






EXHIBIT INDEX

|        |  |                                                                                                                                                 
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                                 
|Number  |  | Description                                                                                                                                     
|        |  |                                                                                                                                                 
|10.45 - |  | Lease Agreement between PharmChem, Inc. and
First American Commercial Bancorp, Inc. for the lease of
software and equipment dated July 25, 2001.