Psychemedics (PMD) 10-Q 2007 Q2 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

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

For quarterly period endedJune 30, 2007

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

For the transition period from                    to                    

Commission file number 1-13738

PSYCHEMEDICS CORPORATION

(exact name of Issuer as specified in its charter)

Delaware	58-1701987
(State or other jurisdiction of	(I.R.S. Employer
incorporation of organization)	Identification No.)

125 Nagog Park, Acton, MA	01720
(Address of principal executive offices)	(Zip Code)

Issuer’s telephone number, including area code (978) 206-8220

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15 (d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yesþ      Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filero      Accelerated filero      Non-accelerated filerþ

Indicate by check mark whether the registrant is a shell company.

YESo      NOþ

Number of shares outstanding of only class of Issuer’s Common Stock as of August 14, 2007: Common Stock $.005 par value (5,215,584 shares).

PSYCHEMEDICS CORPORATION

		Page No.
Part I FINANCIAL INFORMATION
Item 1	Financial Statements (Unaudited)
	Condensed Balance Sheets as of June 30, 2007 and December 31, 2006		3
	Condensed Statements of Income for the three months ended June 30, 2007 and 2006		4
	Condensed Statements of Income for the six months ended June 30, 2007 and 2006		5
	Condensed Statements of Cash Flows for the six months ended June 30, 2007 and 2006		6
	Notes to Condensed Financial Statements		7-12
Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations		12-17
Item 3	Quantitative and Qualitative Disclosures about Market Risk		17
Item 4	Controls and Procedures		17
Part II OTHER INFORMATION
Item 1A	Risk Factors		17
Item 4	Submission of Matters to a Vote of Security Holders		17-18
Item 6	Exhibits		18
EXHIBIT INDEX			20
SIGNATURES			21
Ex-31.1 Section 302 Certification of the Chief Executive Officer
Ex-31.1 Section 302 Certification of the Principal Accounting Officer
Ex-32.1 Section 906 Certification of the Chief Executive Officer
Ex-32.2 Section 906 Certification of the Principal Accounting Officer

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PSYCHEMEDICS CORPORATION

CONDENSED BALANCE SHEETS

	JUNE 30,			DECEMBER 31,
	2007			2006
	(Unaudited)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	4,231,995		$	4,180,235
Short-term investments		3,775,000			3,683,192
Accounts receivable, net of allowance for doubtful accounts of $283,281 in 2007 and $333,281 in 2006		4,165,934			3,196,384
Prepaid expenses and other current assets		918,817			818,693
Deferred tax assets		444,071			412,486
Total current assets		13,535,817			12,290,990
PROPERTY AND EQUIPMENT:
Equipment and leasehold improvements, at cost		10,678,739			10,376,718
Less-accumulated depreciation and amortization		(9,802,774	)		(9,630,190	)
		875,965			746,528
DEFERRED TAX ASSETS		183,555			183,555
OTHER ASSETS, NET		39,640			39,830
	$	14,634,977		$	13,260,903
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable	$	445,395		$	499,420
Accrued expenses		768,235			865,575
Deferred revenue		363,642			392,403
Total current liabilities		1,577,272			1,757,398
SHAREHOLDERS’ EQUITY:
Preferred stock, $0.005 par value; 872,521 shares authorized; none issued or outstanding		—			—
Common stock; $0.005 par value; 50,000,000 shares authorized; 5,799,381 shares and 5,756,044 shares issued in 2007 and 2006, respectively		28,997			28,780
Paid-in capital		26,226,997			25,609,800
Accumulated deficit		(4,075,598	)		(5,012,384	)
Less — Treasury stock, at cost; 583,797 shares		(9,122,691	)		(9,122,691	)
Total shareholders’ equity		13,057,705			11,503,505
	$	14,634,977		$	13,260,903

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

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PSYCHEMEDICS CORPORATION

CONDENSED STATEMENTS OF INCOME

(UNAUDITED)

	THREE MONTHS
	ENDED JUNE 30,
	2007		2006
REVENUE	$	6,497,290	$	6,181,386
COST OF REVENUE		2,387,713		2,331,401
Gross profit		4,109,577		3,849,985
EXPENSES:
General and administrative		1,028,602		836,679
Marketing and selling		807,287		731,607
Research and development		160,699		116,072
		1,996,588		1,684,358
OPERATING INCOME		2,112,989		2,165,627
INTEREST INCOME		101,163		63,493
INCOME BEFORE INCOME TAXES		2,214,152		2,229,120
PROVISION FOR INCOME TAXES		881,800		828,000
NET INCOME	$	1,332,352	$	1,401,120
BASIC NET INCOME PER SHARE	$	0.26	$	0.27
DILUTED NET INCOME PER SHARE	$	0.25	$	0.27
DIVIDENDS DECLARED PER SHARE	$	0.15	$	0.125
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, BASIC		5,172,247		5,169,361
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, DILUTED		5,265,023		5,238,697

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

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PSYCHEMEDICS CORPORATION

CONDENSED STATEMENTS OF INCOME

(UNAUDITED)

	SIX MONTHS
	ENDED JUNE 30,
	2007		2006
REVENUE	$	12,213,896	$	11,248,116
COST OF REVENUE		4,842,194		4,447,550
Gross profit		7,371,702		6,800,566
EXPENSES:
General and administrative		1,861,055		1,600,660
Marketing and selling		1,511,930		1,397,174
Research and development		255,622		228,650
		3,628,607		3,226,484
OPERATING INCOME		3,743,095		3,574,082
INTEREST INCOME		197,568		122,203
		197,568		122,203
INCOME BEFORE INCOME TAXES		3,940,663		3,696,285
PROVISION FOR INCOME TAXES		1,573,400		1,373,000
NET INCOME	$	2,367,263	$	2,323,285
BASIC NET INCOME PER SHARE	$	0.46	$	0.45
DILUTED NET INCOME PER SHARE	$	0.45	$	0.44
DIVIDENDS DECLARED PER SHARE	$	0.30	$	0.225
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, BASIC		5,191,481		5,168,235
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING, DILUTED		5,281,547		5,224,374

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

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PSYCHEMEDICS CORPORATION

CONDENSED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	SIX MONTHS
	ENDED JUNE 30,
	2007			2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	2,367,263		$	2,323,285
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		172,584			145,834
Stock-based compensation expense		86,675			28,930
Deferred income taxes		(31,585	)		(6,494	)
Changes in current assets and liabilities:
Accounts receivable		(969,550	)		(1,114,880	)
Prepaid expenses and other current assets		(100,124	)		(227,706	)
Accounts payable		(54,025	)		(20,910	)
Accrued expenses		(97,340	)		(334,744	)
Deferred revenue		(28,761	)		32,671
Net cash provided by operating activities		1,345,137			825,986
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments		(91,808	)		(1,025,000	)
Purchases of property and equipment		(302,021	)		(69,269	)
Decrease in other assets		190			—
Net cash used in investing activities		(393,639	)		(1,094,269	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Tax benefit associated with exercise of options		37,523			8,982
Cash dividends paid		(1,430,476	)		(1,163,242	)
Net proceeds from the issuance of common stock		493,215			60,100
Net cash used in financing activities		(899,738	)		(1,094,160	)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		51,760			(1,362,443	)
CASH AND CASH EQUIVALENTS, beginning of period		4,180,235			3,352,519
CASH AND CASH EQUIVALENTS, end of period	$	4,231,995		$	1,990,076

See accompanying notes to financial statements and management’s discussion and
analysis of financial condition and results of operations.

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PSYCHEMEDICS CORPORATION

NOTES TO CONDENSED FINANCIAL STATEMENTS

(UNAUDITED)

June 30, 2007

1. Interim Financial Statements

The accompanying unaudited interim financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission for reporting on Form 10-Q. Accordingly, certain information and footnote disclosure required for complete financial statements are not included herein. It is recommended that these financial statements be read in conjunction with the financial statements and related notes of Psychemedics Corporation (the “Company”) as reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of financial position, results of operations, and cash flows at the dates and for the periods presented have been included. The results of operations for the six months ended June 30, 2007 may not be indicative of the results that may be expected for the year ending December 31, 2007, or any other period.

2. Stock-Based Compensation

The Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004),Share-Based Payment, (SFAS 123R) effective January 1, 2006. SFAS 123R requires the recognition of the fair value of stock-based compensation as a charge against earnings. The Company recognizes stock-based compensation expense over the requisite service period of the individual grantees, which generally equals the vesting period. Based on the provisions of SFAS 123R, the Company’s stock-based compensation is accounted for as equity instruments. Prior to January 1, 2006, the Company followed Accounting Principles Board (APB) Opinion 25,Accounting for Stock Issued to Employees, and related interpretations in accounting for stock-based compensation. The Company elected the modified prospective transition method for adopting SFAS 123R. Under this method, the provisions of SFAS 123R apply to all awards granted or modified after the date of adoption, as well as to the future vesting of awards granted and not vested as of the date of adoption.

On March 22, 2006 the Company adopted a new stock-based plan (the “2006 Equity Incentive Plan”) for officers, directors, employees and consultants, which was approved by the Company’s shareholders at the 2006 Annual Shareholders’ meeting. Under the 2006 Equity Incentive Plan, the Company is authorized to grant options with terms of up to ten years, grant restricted stock, issue stock bonuses or grant other stock-based awards. As of June 30, 2007, a total of 250,000 shares of common stock were reserved for issuance under the 2006 Equity Incentive Plan.

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The Company also has stock option plans that have expired, but shares can be issued upon exercise of outstanding options that were granted prior to such expiration. Activity for these plans is included in this footnote. Options granted under the plans consisted of both non-qualified and incentive stock options and were granted in each case at a price that was not less than the fair market value of the common stock at the date of grant. These options generally have lives of ten years and vest either immediately or over periods up to four years.

Under the provisions of SFAS 123R, the Company recorded $55,281 and $86,675 of stock-based compensation in the accompanying statements of income for the three months and six months ended June 30, 2007, respectively. The Company recorded $21,286 and $28,930 of stock-based compensation for the three months and six months ended June 30, 2006, respectively. The Company granted 26,700 stock unit awards (“SUAs”) to certain members of management and its directors on May 11, 2006. The fair value of the SUAs was $16.70 per share, which was the closing price of the Company’s stock on May 11, 2006. The SUAs vest over a period of two to four years and are convertible into an equivalent number of shares of the Company’s common stock provided that the awardee remains continuously employed throughout the vesting periods. Of these 26,700 units, 2,000 were cancelled upon employee termination and 7,150 units vested and were issued, net of tax withholdings, on May 11, 2007.

On May 10, 2007 the Company granted 34,000 SUA’s to certain members of management and its directors. The fair value of the SUAs was $18.41 per share, which was the closing price of the Company’s stock on May 10, 2007. The SUAs vest over a period of two to four years and are convertible into an equivalent number of shares of the Company’s common stock provided that the awardee remains continuously employed throughout the vesting periods.

SFAS 123R requires the measurement of the fair value of stock options or warrants to be included in the statement of income or disclosed in the notes to financial statements. The Company has computed the value of options using the Black-Scholes option pricing model.

A summary of stock option activity for the Company’s expired stock option plans for the six months ended June 30, 2007 is as follows:

				Weighted		Weighted
				Average		Average
	Number			Exercise		Remaining	Aggregate
	of			Price Per		Contractual	Intrinsic
	Shares			Share		Life	Value (1)
Outstanding, December 31, 2006		527,858		$	15.79
Granted		—			—
Exercised		(23,800	)		14.00		$	65,234
Terminated		(26,095	)		22.23
Outstanding, March 31, 2007		477,963			15.53	5.8 years	$	1,025,712
Granted		—			—
Exercised		(14,078	)		13.56		$	96,857
Terminated		(1,250	)		13.56		$	8,600
Outstanding, June 30, 2007		462,635		$	15.58	5.5 years	$	1,968,703
Exercisable, June 30, 2007		462,635		$	15.58	5.5 years	$	1,968,703
Available for grant, June 30, 2007		—

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(1) The aggregate intrinsic value on this table was calculated based on the amount, if any, by which the closing market value of the Company’s stock on June 30, 2007 ($20.44) exceeded the exercise price of the underlying options, multiplied by the number of shares subject to each option.

A summary of activity for SUAs under the Company’s 2006 Equity Incentive Plan for the six months ended June 30, 2007 is as follows:

	Number			Aggregate
	of			Intrinsic
	Shares			Value (2)
Outstanding, December 31, 2006		26,700
Granted		—
Terminated		(2,000	)
Outstanding, March 31, 2007		24,700
Granted		34,000
Terminated		—
Converted to common stock		(7,150	)
Outstanding, June 30, 2007		51,550		$	1,053,682
Converted to common stock		7,150
Available for grant, June 30, 2007		191,300

(2) The aggregate intrinsic value on this table was calculated based on the closing market value of the Company’s stock on June 30, 2007 ($20.44).

As of June 30, 2007, a total of 712,635 shares of common stock were reserved for issuance under the various stock option and stock-based plans. As of June 30, 2007, the unamortized fair value of awards relating to SUAs was $877,103.

3. Basic and Diluted Net Income Per Share

Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common and dilutive common equivalent shares outstanding during the period. The number of dilutive common equivalent shares outstanding during the period has been determined in accordance with the treasury-stock method. Common equivalent shares consist of common stock issuable upon the exercise of outstanding options and assume the full vesting of all SUAs.

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Basic and diluted weighted average common shares outstanding are as follows:

	Three Months Ended				Six Months Ended
	June 30,		June 30,		June 30,		June 30,
	2007		2006		2007		2006
Weighted average common shares		5,172,247		5,169,361		5,191,481		5,168,235
Common equivalent shares		92,776		69,336		90,066		56,139
Weighted average common shares outstanding, assuming dilution		5,265,023		5,238,697		5,281,547		5,224,374

For the three months ended June 30, 2007 and 2006, options to purchase 97,635 and 194,481 common shares, respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive. For the six months ended June 30, 2007 and 2006, options to purchase 97,635 and 200,919 common shares, respectively, were outstanding but not included in the diluted weighted average common share calculation as the effect would have been antidilutive.

4. Revenue Recognition

The Company performs drug testing as well as provides training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. The revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer. The Company also provides expert testimony, when and if necessary, to support the results of the tests, which is generally billed separately and recognized as the services are provided.

In 2003, the Company adopted Emerging Issue Task Force (“EITF”) Issue No. 00-21,Revenue Arrangements with Multiple Deliverables, which was effective for all transactions entered into subsequent to June 15, 2003. The Company applied the consensus reached under EITF 00-21 and concluded that the testing, training and storage elements are considered one unit of accounting for revenue recognition purposes as the training and storage costs do not have stand-alone value to the customer. The Company has concluded that the predominant deliverable in the arrangement is the testing of the units and has recognized revenue as that service is performed and reported to the customer.

Deferred revenue represents payments received in advance of the performance of drug testing procedures. Deferred revenue is recognized as revenue when the underlying test results are delivered. With respect to a portion of these transactions, there may be instances where the customer ultimately does not require performance. Revenue is then recognized when the Company can reasonably, reliably and objectively determine that it is remote that performance will be required for an estimable portion of transactions. The Company recorded $11,167 of revenue in the results of operations in the second quarter of 2007 and $60,494 for the six months ended June 30, 2007 related to test kits that were sold for which the Company’s obligations to provide service were deemed remote.

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At June 30, 2007 and December 31, 2006, the Company had deferred revenue of approximately $364,000 and $392,000, respectively, reflecting sales of its personal drug testing service for which the performance of the related test had not yet occurred and future obligations were not deemed remote.

5. Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48,Accounting for Uncertainty in Income Taxes(“FIN 48”), an interpretation of Statement of Financial Accounting Standards No. 109,Accounting for Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition and became effective for the Company on January 1, 2007. The Company has adopted FIN48 without material effect in the financial statements. The Company’s evaluation was performed for the tax years ended December 31, 2003, 2004, 2005 and 2006, the tax years which remained subject to examination by major tax jurisdictions as of January 1, 2007.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements(“SFAS 157”). SFAS 157 provides guidance for using fair value to measure assets and liabilities. It also responds to investors’ requests for expanded information about the extent to which companies measure assets and liabilities at fair value, the information used to measure fair value, and the effect of fair value measurements on earnings. SFAS 157 applies whenever other standards require (or permit) assets or liabilities to be measured at fair value, and does not expand the use of fair value in any new circumstances. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company in fiscal 2008. The Company is currently evaluating the effect that the adoption of SFAS 157 will have on its results of operations and financial condition but does not expect it to have a material impact.

In February 2007, the FASB issued SFAS No. 159,The Fair Value Option for Financial Assets and Financial Liabilities(“SFAS 159”) including an amendment of FASB Statement No. 115. SFAS 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings. SFAS 159 is effective for the Company beginning in the first quarter of 2008, although earlier adoption without effect is permitted. The Company is currently assessing the impact of SFAS 159 but does not presently anticipate it will have a material impact on the Company’s results of operations and financial condition.

6. Contingencies

The Company is subject to legal proceedings and claims, which arise in the ordinary course of its business. The Company believes that based upon information available to the Company at this time, the expected outcome of these matters would not have a material impact on the Company’s results of operations or financial condition.

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7. Subsequent Event — Dividends

On August 6, 2007, the Company declared a quarterly dividend of $.15 per share, which will be paid on September 22, 2007 to shareholders of record on September 8, 2007.

Item 2

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FACTORS THAT MAY AFFECT FUTURE RESULTS

From time to time, information provided by the Company or statements made by its employees may contain “forward-looking” information which involves risks and uncertainties. In particular, statements contained in this report which are not historical facts (including, but not limited to, the Company’s expectations regarding revenues, business strategy, general and administrative expenses, marketing and selling expenses, research and development expenses, anticipated operating results, strategies with respect to governmental agencies and regulations, cash dividends, cost savings, capital expenditures and anticipated cash requirements) may be “forward-looking” statements. The Company’s actual results may differ from those stated in any “forward-looking” statements. Factors that may cause such differences include, but are not limited to, employee hiring practices of the Company’s principal customers, development of markets for new products and services offered by the Company, the economic health of principal customers of the Company, financial and operational risks associated with possible expansion of testing facilities used by the Company, government regulation (including, but not limited to, Food and Drug Administration regulations), competition and general economic conditions. With respect to the continued payment of cash dividends, factors include, but are not limited to, available surplus, cash flow, capital expenditure reserves required, and other factors that the Board of Directors of the Company may take into account.

OVERVIEW

Psychemedics Corporation was incorporated in 1986. The Company utilizes a patented hair analysis method involving radioimmunoassay technology and mass spectrometry confirmation to analyze human hair to detect abused substances.

Revenue for the second quarter of 2007 was $6.5 million and was 5% above revenue of $6.2 million for the second quarter of 2006. Revenue for the first six months of 2007 was $12.2 million and was 9% above revenue of $11.2 million for the first six months of 2006. The Company reported net income of $0.25 per share in the quarter ended June 30, 2007 and net income of $0.45 per share for the six months ended June 30, 2007. At June 30, 2007, the Company had $8.0 million of cash, cash equivalents and short-term investments. The Company distributed $0.65 million and $0.78 million, or $0.125 per share and $0.15 per share, of cash dividends to its shareholders in the first and second quarters of 2007, respectively, which represented year to date totals of $1.4

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million, or $0.275 per share. The Company has paid forty-three consecutive quarterly cash dividends.

RESULTS OF OPERATIONS

Revenue was $6,497,290 for the three month period ended June 30, 2007 as compared to $6,181,386 for the comparable period of 2006, representing an increase of 5%. Revenue was $12,213,896 for the six month period ended June 30, 2007 as compared to $11,248,116 for the comparable period of 2006, representing an increase of 9%. The increase in revenue for the second quarter of 2007 was due to an increase of 3% in testing volume from both new and existing clients, while the average revenue per sample increased by 2% as compared to the comparable period of 2006. The increase in revenue for the six months ended June 30, 2007 was due to an increase of 8% in testing volume from both new and existing clients, while the average revenue per sample remained relatively constant as compared to the comparable period of 2006.

Gross margin was 63% of revenue for the three month period ended June 30, 2007, as compared to 62% for the comparable period of 2006. Gross margin was 60% of revenue for both of the six month periods ended June 30, 2007 and June 30, 2006. Increased direct costs were primarily due to increased labor costs and expenses related to laboratory supplies.

General and administrative (“G&A”) expenses were $1,028,602 for the three month period ended June 30, 2007 as compared to $836,679 for the comparable period of 2006, representing an increase of 23%. G&A expenses were $1,861,055 for the six month period ended June 30, 2007 as compared to $1,600,660 for the comparable period of 2006, representing an increase of 16%. The increase in general and administrative expenses for the three month period ended June 30, 2007 as compared to the comparable period of 2006 was due primarily to an increase in personnel related costs, CFO severance cost and higher than normal legal fees. The increase in general and administrative expenses for the six month period ended June 30, 2007 as compared to the comparable period of 2006 was due primarily to expenses related to the cost of staffing as well as higher legal costs. As a percentage of revenue, G&A expenses were 16% and 14% for the three month periods ended June 30, 2007 and June 30, 2006, respectively, and 15% for the six months ended June 30, 2007 from 14% for the comparable period of 2006.

Marketing and selling expenses were $807,287 for the three month period ended June 30, 2007 as compared to $731,607 for the comparable period of 2006, an increase of 10%. Marketing and selling expenses were $1,511,930 for the six month period ended June 30, 2007 as compared to $1,397,174 for the comparable period of 2006, an increase of 8%. The variation in marketing and selling expenses for both the three month and six month periods ended June 30, 2007 as compared to the comparable periods of 2006 was due primarily to higher staffing expenses and higher commissions. Total marketing and selling expenses represented 12% of revenue in all periods presented.

Research and development (“R&D”) expenses for the three month period ended June 30, 2007 increased by $44,627 from the comparable period of the prior year to $160,699, an increase of 38%. Research and development (“R&D”) expenses for the six month period ended June 30, 2007 increased by $26,972 from the comparable

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period of the prior year to $255,622 representing an increase of 12%. The increase for the period ending June 30 was due to the cost of supplies for several new scientific research projects. R&D expenses represented 3% of revenue for the three month period and 2% for the six month period ended June 30, 2007 as compared to 2% of revenue for the three month and six month periods ended June 30, 2006.

Interest income for the three month period ended June 30, 2007 increased by $37,670 and increased by $75,365 for the six month period ended June 30, 2007 as compared to the comparable periods of 2006 and represented interest and dividends earned on cash equivalents and short-term investments. Higher average investment balances along with an increase in the yield on investment balances in 2007 as compared to 2006 caused the increase in interest income.

During the three months ended June 30, 2007 and June 30, 2006, the Company recorded tax provisions of $881,800 and $828,000 representing effective tax rates of 39.8% and 37.1% for the respective periods. During the six months ended June 30, 2007 and June 30, 2006, the Company recorded tax provisions of $1,573,400 and $1,373,000 representing effective tax rates of 39.9% and 37.1%, respectively.

LIQUIDITY AND CAPITAL RESOURCES

At June 30, 2007, the Company had approximately $8.0 million of cash, cash equivalents and short-term investments. The Company’s operating activities provided net cash of $1,345,137 in the six months ended June 30, 2007. Investing activities used $393,639 in the six month period while financing activities used a net amount of $899,738 during the period.

Cash provided by operating activities of $1,345,137 reflects net income of $2,367,263 adjusted for depreciation and amortization of $172,584, offset by an increase in accounts receivable along with a decrease in accrued expenses and a lesser increase in prepaid expenses. The increase in prepaid expenses was due primarily to the purchase of chemicals and supplies for inventory.

Capital expenditures in the first six months of 2007 were $302,021. The expenditures primarily consisted of new equipment, including laboratory and computer equipment. The Company believes that within the next two to five years it may be required to expand its existing laboratory or develop a second laboratory, the cost of which is currently believed to range from $2 million to $4 million, which the Company expects to fund primarily through its operating cash flows.

During the six months ended June 30, 2007, the Company distributed $1,430,476 in cash dividends to its shareholders. The Company did not repurchase any shares for treasury during the six months ended June 30, 2007. The Company has authorized 500,000 shares for repurchase since June of 1998, of which 466,351 shares have been repurchased.

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Contractual obligations as of June 30, 2007 were as follows:

	Less Than		1-3		4-5		After 5
	One Year		Years		Years		Years		Total
Operating leases	$	490,000	$	982,000	$	696,000	$	150,000	$	2,318,000
Purchase commitment		294,000		—		—		—		294,000
	$	784,000	$	$982,000	$	696,000	$	150,000	$	2,612,000

Purchase Commitment

The Company has a supply agreement with a vendor which requires the Company to purchase isotopes used in its drug testing procedures from this sole supplier in exchange for variable annual payments based upon prior year purchases. Purchases amounted to $293,982 for the six months ended June 30, 2007 as compared to $271,916 for the comparable period of 2006. The Company expects to purchase approximately $294,000 for the remainder of 2007. In exchange for exclusivity, the supplier has provided the Company with the right to purchase the isotope technology at fair market value under certain conditions, including the failure to meet the Company’s purchase commitments. This agreement does not include a fixed termination date; however, it is cancelable upon mutual agreement by both parties or six months after termination notice by the Company of its intent to use a different technology in connection with its drug testing procedures.

At June 30, 2007, the Company’s principal sources of liquidity included an aggregate of approximately $8.0 million of cash, cash equivalents and short-term investments. Management currently believes that such funds, together with cash generated from operations, should be adequate to fund anticipated working capital requirements and capital expenditures in the near term. Depending upon the Company’s results of operations, its future capital needs and available marketing opportunities, the Company may use various financing sources to raise additional funds. Such sources could potentially include joint ventures, issuances of common stock or debt financing, although the Company does not have any such plans at this time. At June 30, 2007, the Company had no long-term debt.

CRITICAL ACCOUNTING POLICIES

Management believes the most critical accounting policies are as follows:

Revenue Recognition

The Company is in the business of performing drug testing and reporting the results thereof. The Company’s drug testing services include training for collection of samples and storage of positive samples for its customers for an agreed-upon fee per unit tested of samples. The revenues are recognized when the predominant deliverable, drug testing, is provided and reported to the customer. The Company also provides expert testimony, when and if necessary, to support the test results, which is generally billed separately and recognized as the services are provided.

In 2003, the Company adopted Emerging Issue Task Force (“EITF”) Issue No. 00-21,Revenue Arrangements with Multiple Deliverables, which was effective for all

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transactions entered into subsequent to June 15, 2003. The Company applied the consensus reached under EITF 00-21 and concluded that the testing, training and storage elements are considered one unit of accounting for revenue recognition purposes as the training and storage costs are de minimis and do not have stand-alone value to the customer. The Company has concluded that the predominant deliverable in the arrangement is the testing of the units and has recognized revenue as that service is performed and reported to the customer.

Deferred revenue represents payments received in advance of the performance of drug testing procedures. Deferred revenue is recognized as revenue when the underlying test results are delivered. With respect to a portion of these transactions, there may be instances where the customer ultimately does not require performance. Revenue is then recognized when the Company can reasonably, reliably and objectively determine that it is remote that performance will be required for an estimable portion of transactions. The Company recorded $60,494 of revenue for the six month period ending June 30, 2007, of which $49,327 was related to the quarter ending March 31, 2007 and $11,167 was related to the quarter ending June 30, 2007. This revenue was related to test kits that were previously sold for which revenue had not been recognized and the Company’s obligations to provide service was deemed remote.

Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates, including bad debts and income taxes, and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based on management’s assessment of the collectibility of its customer accounts. Management reviews its accounts receivable aging for doubtful accounts and specifically identifies accounts that may not be collectible. The Company routinely assesses the financial strength of its customers and, as a consequence, believes that its accounts receivable credit risk exposure is limited. The Company maintains an allowance for potential credit losses but historically has not experienced any significant losses related to individual customers or groups of customers in any particular industry or geographic area. Bad debt expense has been within management’s expectations.

Income Taxes

The Company accounts for income taxes using the liability method, which requires the Company to recognize a current tax liability or asset for current taxes payable or refundable and a deferred tax liability or asset for the estimated future tax effects of temporary differences between the financial statement and tax reporting bases of assets and liabilities to the extent that they are realizable. Deferred tax expense (benefit) results from the net change in deferred tax assets and liabilities during the year. A deferred tax valuation allowance is required if it is more likely than not that all or a portion of the recorded deferred tax assets will not be realized.

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The Company operates within multiple taxing jurisdictions and could be subject to audit in these jurisdictions. These audits may involve complex issues, which may require an extended period of time to resolve. The Company has provided for its estimated taxes payable in the accompanying financial statements.

The above listing is not intended to be a comprehensive list of all of the Company’s accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States, with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Sensitivity. The Company maintains a short-term investment portfolio consisting principally of money market securities, Taxable Auction Rate Preferred, 7 and 28 day Dutch Auction securities and securities issued by the U.S. Government that are not sensitive to sudden interest rate changes.

Item 4. Controls and Procedures

As of the date of this report, our Chief Executive Officer performed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer concluded that the Company’s disclosure controls and procedures are effective in ensuring the reporting of material information required to be included in the Company’s periodic filings with the Securities and Exchange Commission. There were no significant changes in the Company’s internal controls over financial reporting or in other factors that could significantly affect these internal controls over financial reporting subsequent to the date of the most recent evaluation.

PART II OTHER INFORMATION

Item 1A. Risk Factors

There have been no material changes in our risk factors from those disclosed in our 2006 Annual Report on Form 10-K.

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

The Annual Meeting of Shareholders of Psychemedics Corporation was held on May 10, 2007 for the purpose of electing a board of directors. Proxies for the meeting were solicited pursuant to Section 14(a) of the Securities Exchange Act of 1934 and there was no solicitation in opposition to management’s solicitations.

Description and tabulation by the Company’s transfer agent of each matter voted upon at the Annual Meeting of Shareholders of Psychemedics Corporation held on May 10, 2007:

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All of management’s nominees for directors, as listed in the proxy statement, were elected with the following votes:

Election of Directors:

	Number of Shares
	For		Withheld
Raymond C. Kubacki, Jr.		4,598,334		281,053
Harry F. Connick		4,597,641		281,746
Walter S. Tomenson, Jr.		4,599,002		280,385
Fred J. Weinert		4,449,019		430,368

Item 6. Exhibits

See Exhibit Index included in this Report

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SIGNATURES

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

	Psychemedics Corporation
Date: August 14, 2007	By:	/s/ Raymond C. Kubacki, Jr.
	Raymond C. Kubacki, Jr.
	Chairman and Chief Executive Officer
	(principal executive officer)
Date: August 14, 2007	By:	/s/ Thomas M. Harty
	Thomas M. Harty
	Accounting Manager
	(principal accounting officer)

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PSYCHEMEDICS CORPORATION
FORM 10-Q
June 30, 2007

EXHIBIT INDEX

		Page No.
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		21
31.2	Certification of Principal Accounting Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002		23
32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		25
32.2	Certification of Principal Accounting Officer Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002		26

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