Psychemedics Corp. Annual Report 2014

Plain-text annual report

Dear Fellow Shareholders, 2014 was a year of major accomplishment, investment in the future and continued recognition of our scientific leadership position in the industry. • Record revenues were recorded for the 3rd consecutive year • Our expansion program to double our capacity was successfully completed and the significant investment funded to position us well for future growth • The FBI published a peer-reviewed paper in the Journal of Analytical Toxicology that provides additional validation of the Psychemedics wash protocol (used to exclude the risk of false positives from external contamination) and recognizes our scientific leadership For the third consecutive year, we recorded record revenues. Our new business remains strong. New business accounted for all our growth in 2014 and, in fact, also offset the softness in our base business as existing clients continued to be cautious in their hiring. Earnings for the year were significantly impacted by the increase in our capacity and other costs related to the Brazil opportunity (described below). We estimate the total impact from these projects in 2014 was about $0.25 per share. Without these additional costs, our EPS for the year would have increased 18%. The expansion of capacity was needed to prepare Psychemedics for our expanding business, including a significant opportunity in Brazil. The project included additional lease space and over $7 million of new equipment and leasehold improvements. To finance this expansion, the Company obtained equipment financing of $7 million ($6.2 million of which was outstanding as of December 31, 2014) at a very favorable interest rate of 2.15% for 2014. As I reported in last year’s letter and in our quarterly reports, we believe we have a very exciting opportunity in Brazil. To recap, at the end of 2013, the Brazilian Federal Government announced a new regulation that would require professional drivers in the transportation industry to pass a hair drug test. Testing had been scheduled to begin in July 2014. There also was a bill introduced in the Brazilian Congress that would require professional drivers be drug tested on a more rigorous basis (testing every 2 ½ years vs. every 5 years) than the recently passed regulation. As the year unfolded, the implementation of the regulation was being delayed. It now appears that such delay was done to coordinate with the new proposed law. However, at the beginning of last year, we could not anticipate this and we needed to put our expansion plan in place to be ready for the July 2014 regulation date. We were ready, but the regulation implementation was delayed. This impacted our earnings in 2014 as we indicated. The law has now passed and has been signed by the President and published on March 2, 2015 in Brazil. It stipulates that testing must begin 90 days after publication. That would be June 1, 2015. While earnings in the first half of 2015 will still be negatively impacted by our costs for gearing up for Brazil business, we are very excited about the prospect to compete for Brazil’s professional drivers hair testing business, and believe the potential volume could be substantial. The Brazilian government has taken a real leadership role by utilizing the rigorous hair test to ensure public safety on the roads of Brazil. In addition to our capacity expansion project, we are continually looking at advancing the science of hair testing, which is important to Psychemedics’ strong position and growth. This commitment was reflected in 2014 with a 63% increase in spending on Research and Development over 2013. Psychemedics established its technological and market leadership position in 1987 with the development of the first hair test to detect drugs of abuse. We have continued this leadership role with significant achievements over the last few years, including:    In 2012, we re-established our strong patent position/protection as we received new patents covering the process that releases virtually 100% of the drugs trapped in the hair without destroying the drugs. This is fundamental to all hair testing, because if you can’t get the drugs out of the hair, you can’t measure them. We also developed and received FDA clearance for 5 new custom-designed EIA immunoassays that meet the standards of the robust radioimmunoassays we previously used, which were the gold standard in screening for drugs. This represented a significant technological breakthrough. In 2013, after many years of investing time and research, we came to the market with a hair test to measure alcohol consumption over a period of time. This new alcohol test provides clients with another method to identify substance abuse. In 2014, we were proud to once again be recognized as the industry and scientific leader with the publishing of a peer-reviewed paper by scientists at the FBI in the Journal of Analytical Toxicology. This paper provides additional validation of the Psychemedics extensive wash protocol used to exclude the risk of false positives from external contamination. Our wash protocol plays a significant role in safeguarding our clients and those being tested. We look forward to making further advances in our field in 2015 and beyond, and maintaining our scientific leadership position. The Company’s balance sheet remains strong, with approximately $5.6 million in working capital, and $3.6 million in cash at year end. Our directors share our confidence in the future of Psychemedics and remain committed to rewarding shareholders and sharing the financial success of the Company as we grow. At the end of 2014, the Company had paid 73 consecutive quarterly dividends which is more than 18 years. We are also proud that we have been profitable every year for the last 22 years − since 1993 − through numerous recessions and other challenges. I would like to take this opportunity to express my sincere appreciation to all our clients for the contribution they are making to deter the use of drugs of abuse, to our Directors for their counsel and guidance, and to all my teammates at Psychemedics for their commitment and dedication to excellence in serving our customers. And I want to thank you, our shareholders, for your continued support. Sincerely, Raymond C. Kubacki Chairman, President and Chief Executive Officer UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (cid:2) □ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended December 31, 2014 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 1-13738 PSYCHEMEDICS CORPORATION (Exact Name of Registrant as Speciﬁed in Its Charter) Delaware (State or Other Jurisdiction of Incorporation or Organization) 125 Nagog Park Acton, Massachusetts (Address of Principal Executive Offices) 58-1701987 (I.R.S. Employer Identiﬁcation No.) 01720 (Zip Code) Registrant’s Telephone Number Including Area Code: (978) 206-8220 Securities registered pursuant to Section 12(b) of the Act: Title of Class Name of each exchange on which registered: Common Stock, $0.005 par value The Nasdaq Stock Market L.L.C. Securities registered pursuant to Section 12(g) of the Act: None Indicate by a check mark if the registrant is a well-known seasoned issuer (as deﬁned in Rule 405 of the Securities Exchange Act of 1934). Yes (cid:4) No (cid:2) Indicate by a check mark if the registrant is not required to ﬁle reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1934). Yes (cid:4) No (cid:2) Indicate by check mark whether the registrant (1) has ﬁled all reports required to be ﬁled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to ﬁle such reports), and (2) has been subject to such ﬁling requirements for the past 90 days. Yes (cid:2) No (cid:4) Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such ﬁles.) Yes (cid:2) No (cid:4) Indicate by check mark if disclosure of delinquent ﬁlers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in deﬁnitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (cid:2) Indicate by check mark whether the registrant is a large accelerated ﬁler, an accelerated ﬁler, or a non-accelerated ﬁler. See deﬁnition of ‘‘accelerated ﬁler’’ and ‘‘large accelerated ﬁler’’ in Rule 12b-2 of the Securities Exchange Act of 1934. Large Accelerated Filer □ Accelerated Filer □ Non-Accelerated Filer □ (Do not check if a smaller reporting company) Smaller Reporting Company (cid:2) Indicate by a check mark whether the registrant is a shell company (as deﬁned in Rule 12b-2 of the Securities and Exchange Act of 1934). Yes (cid:4) No (cid:2) As of June 30, 2014, there were 5,375,061 shares of Common Stock of the Registrant outstanding. The aggregate market value of the Common Stock of the Registrant held by non-affiliates (assuming for these purposes, but not conceding, that all executive officers, directors and 5% shareholders are ‘‘affiliates’’ of the Registrant) as of June 30, 2014 was approximately $56.3 million, computed based upon the closing price of $14.16 per share on June 30, 2014. As of February 27, 2015, there were 5,375,061 shares of Common Stock of the Registrant outstanding. DOCUMENTS INCORPORATED BY REFERENCE Part III of this Annual Report on Form 10-K incorporates by reference portions of the Registrant’s deﬁnitive proxy statement, to be ﬁled with the Securities and Exchange Commission no later than 120 days after the close of its ﬁscal year; provided that if such proxy statement is not ﬁled with the Commission in such 120-day period, an amendment to this Form 10-K shall be ﬁled no later than the end of the 120-day period. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Some of the statements under ‘‘Business,’’ ‘‘Risk Factors,’’ ‘‘Legal Proceedings,’’ ‘‘Market for Registrant’s Common Stock and Related Stockholder Matters’’ and ‘‘Management Discussion and Analysis of Financial Condition and Results of Operations’’ and elsewhere in this Annual Report on Form 10-K (this ‘‘Form 10-K’’) constitute forward-looking statements under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements made with respect to future earnings per share, future revenues, future operating income, future cash ﬂows, competitive and strategic initiatives, potential stock repurchases and future liquidity needs. These statements involve known and unknown risks, uncertainties and other factors that may cause results, levels of activity, growth, performance, earnings per share or achievements to be materially different from any future results, levels of activity, growth, performance, earnings per share or achievements expressed or implied by such forward-looking statements. The forward-looking statements included in this Form 10-K and referred to elsewhere are related to future events or our strategies or future ﬁnancial performance. In some cases, you can identify forward-looking statements by terminology such as ‘‘may,’’ ‘‘should,’’ ‘‘believe,’’ ‘‘anticipate,’’ ‘‘future,’’ ‘‘potential,’’ ‘‘estimate,’’ ‘‘encourage,’’ ‘‘opportunity,’’ ‘‘growth,’’ ‘‘leader,’’ ‘‘could’’, ‘‘expect,’’ ‘‘intend,’’ ‘‘plan,’’ ‘‘expand,’’ ‘‘focus,’’ ‘‘through,’’ ‘‘strategy,’’ ‘‘provide,’’ ‘‘offer,’’ ‘‘allow,’’ ‘‘commitment,’’ ‘‘implement,’’ ‘‘result,’’ ‘‘increase,’’ ‘‘establish,’’ ‘‘perform,’’ ‘‘make,’’ ‘‘continue,’’ ‘‘can,’’ ‘‘ongoing,’’ ‘‘include’’ or the negative of such terms or comparable terminology. All forward-looking statements included in this Form 10-K are based on information available to us as of the ﬁling date of this report, and the Company assumes no obligation to update any such forward-looking statements. Our actual results could differ materially from the forward-looking statements. Important factors that could cause actual results to differ materially from expectations reﬂected in our forward-looking statements include those described in Item 1A, ‘‘Risk Factors.’’ i PSYCHEMEDICS CORPORATION FORM 10-K ANNUAL REPORT For the Year Ended December 31, 2014 TABLE OF CONTENTS PART I Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 1A. Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 1B. Unresolved Staff Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 2. Item 3. Item 4. Item 5. Item 6. Item 7. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mine Safety Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PART II Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Management’s Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 7A. Quantitative and Qualitative Disclosures About Market Risk . . . . . . . . . . . . . . . . . . . Item 8. Item 9. Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in and Disagreements With Accountants on Accounting and Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 9A. Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 9B. Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PART III Item 10. Directors, Executive Officers and Corporate Governance . . . . . . . . . . . . . . . . . . . . . . Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 12. Security Ownership of Certain Beneﬁcial Owners and Management and Related Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Item 13. Certain Relationships and Related Transactions, and Director Independence . . . . . . . . . Item 14. Principal Accountant Fees and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PART IV Item 15. Exhibits and Financial Statement Schedules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 1 7 11 11 11 11 12 14 15 19 20 37 37 37 38 39 39 39 39 40 41 ii Available Information; Background PART I Psychemedics Corporation (‘‘the Company’’ or ‘‘Psychemedics’’) maintains executive offices located at 125 Nagog Park, Acton, MA 01720. Our telephone number is (978) 206-8220. Our stock is traded on the NASDAQ Stock Market under the symbol ‘‘PMD’’. Our Internet address is www.psychemedics.com. The Company makes available, free of charge, on the Investor Information section of its website, its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically ﬁled with the Securities and Exchange Commission (the ‘‘SEC’’). Copies are also available, without charge, from Psychemedics Corporation, Attn: Investor Relations, 125 Nagog Park, Acton, MA 01720. Alternatively, reports ﬁled with the SEC may be viewed or obtained at the SEC Public Reference Room in Washington, D.C., or the SEC’s Internet site at www.sec.gov. We do not intend for information contained in our website to be part of this Annual Report on Form 10-K. Item 1. Business General Psychemedics Corporation is a Delaware corporation organized on September 24, 1986 to provide testing services for the detection of drugs of abuse through the analysis of hair samples. The Company’s testing methods utilize a patented technology that digests the hair and releases drugs trapped in the hair without destroying the drugs. This is fundamental to the entire process because the patented method gets virtually 100% of the drug out of the hair, and if you cannot get the drug out of the hair, you cannot measure it. The Company then performs a proprietary custom-designed enzyme immunoassay (EIA) on the liquid supernatant, with conﬁrmation testing by mass spectrometry. The Company’s primary application of its patented technology is as a testing service that analyzes hair samples for the presence of certain drugs of abuse. The Company’s customized proprietary EIA procedures to drug test hair samples differ from the more commonly-used immunoassay procedures employed to test urine samples. The Company’s tests provide quantitative information that can indicate the approximate amount of drug ingested as well as historical data, which can show a pattern of individual drug use over a longer period of time, thereby providing superior detection compared to other types of drug testing. This information is useful to employers for both applicant and employee testing, as well as to physicians, treatment professionals, law enforcement agencies, school administrators, and parents concerned about their children’s drug use. The Company provides screening and conﬁrmation by mass spectrometry using industry-accepted practices for cocaine, marijuana, PCP, amphetamines (including ecstasy) and opiates (including heroin, hydrocodone, hydromorphone, oxycodone and codeine). In addition, in 2013, the Company launched a hair test for alcohol which also looks back on use over a 90 day period, as our hair drug tests do. Testing services are currently performed at the Company’s laboratory at 5832 Uplander Way, Culver City, California. Background on Drug Testing with Hair When certain chemical substances enter the bloodstream, the blood carries these substances to the hair where they become ‘‘entrapped’’ in the protein matrix in amounts approximately proportional to the amount ingested. The Company utilizes a patented drug extraction method followed by a unique enzyme immunoassay (EIA) procedure to identify drugs in the hair. The patented drug extraction method effectively releases drugs from the hair without destroying the drugs — getting virtually 100% of the drug out of the hair. The patented method can be used with a broad range of immunoassay screen techniques and mass spectrometry methods. The immunoassays produced by the Psychemedics R&D team were uniquely designed speciﬁcally to meet and even exceed the standards of radioimmunoassay (‘‘RIAH’’), the original testing method created and utilized by the Company prior to 2013. Because Psychemedics is the only hair testing laboratory that manufactures its own screening assays, it has full control over all aspects of its technology, and that powerful advantage facilitated the Company’s creation of the EIA assays with equivalence to its own previously FDA-cleared radioimmunoassays. 1 The EIA screened positive results are then conﬁrmed by mass spectrometry. Depending upon the length of hair, the Company is able to provide historical information on drug use by the person from whom the sample was obtained. Because head hair grows approximately 1.3 centimeters per month, a 3.9 centimeter head hair sample can reﬂect drug ingestion over the approximate three months prior to the collection of the sample. Another option is sectional analysis of the head hair sample, in which the hair is sectioned lengthwise to approximately correspond to certain time periods, thereby providing information on patterns of drug use. Validation of the Company’s Proprietary Testing Methods The process of analyzing human hair for the presence of drugs has been the subject of numerous peer-reviewed, scientiﬁc ﬁeld studies. Some of these studies were performed with the following organizations: Boston University School of Public Health; Citizens for a Better Community Court, Columbia University; Connecticut Department of Mental Health and Addictive Services; Koba Associates-DC Initiative, Harvard Cocaine Recovery Project; Hutzel Hospital, ISA Associates (Interscience America)-NIDA Workplace Study; University of California-Sleep State Organization; Maternal/Child Substance Abuse Project, Matrix Center, National Public Services Research Institute, Narcotic and Drug Research Institute, San Diego State University-Chemical Dependency Center, Spectrum Inc.; Stapleford Centre (London); Task Force on Violent Crime (Cleveland, Ohio); University of Miami-Department of Psychiatry, University of Miami-Division of Neonatology; University of South Florida-Operation Par Inc.; University of Washington, VA Medical Center-Georgia; U.S. Probation Parole-Santa Ana; and Wayne State University. The above studies included research in the following areas: effects of prenatal drug use, treatment evaluation, workplace drug use, the criminal justice system and epidemiology. Many of the studies have been funded by the National Institute of Justice or the National Institute on Drug Abuse (‘‘NIDA’’). Several hundred research articles written by independent researchers have been published supporting the general validity and usefulness of hair analysis. Some of the Company’s customers have also completed their own testing to validate the Company’s hair test results compared to other companies’ urine test results. These studies consistently conﬁrmed the Company’s superior detection rate compared to urinalysis testing. When results from the Company’s hair testing methods were compared to urine results in side-by-side evaluations, 5 to 10 times as many drug abusers were accurately identiﬁed by the Company’s proprietary methods. In 1998, the National Institute of Justice, utilizing Psychemedics’ previously utilized RIAH hair testing assay, completed a Pennsylvania Prison study where hair analysis revealed an average prison drug use level of approximately 7.9% in 1996. Comparatively, urinalysis revealed virtually no positives. After measures to curtail drug use were instituted (drug-sniffing dogs, searches and scanners), the use level fell to approximately 2% according to the results of hair analysis in 1998. Again, the urine tests showed virtually no positives. The study illustrates the usefulness of hair analysis to monitor populations and the weakness of urinalysis. The Company has received 510k clearance from the Food and Drug Administration (FDA) on seven EIA assays (ﬁve of which are currently being offered) used to test head and body hair for drugs of abuse. As of the date of this document, Psychemedics is the only company to receive FDA clearance for testing of drugs of abuse using both head and body hair for seven drugs of abuse. The Company’s decontamination wash protocol and the effects in eliminating surface contamination were analyzed in a study conducted by scientists at the Laboratory of the Federal Bureau of Investigation and published in August, 2014 in the Journal of Analytical Toxicology. The FBI concluded that the use of an extended wash protocol of the type used by the Company will exclude false positive results from environmental contact with cocaine. In the study, the FBI cited Psychemedics’ studies published in 1993, 2002, 2004, and 2005, and named our lab director Dr. Michael Schaffer and our lab in its acknowledgments. The FBI study also supported the use of metabolites known as hydroxycocaines as evidence of ingestion. These metabolites were ﬁrst identiﬁed in hair by Psychemedics. Advantages of Using the Company’s Patented Method The Company asserts that hair testing using its patented method confers substantive advantages over detection through urinalysis. Although urinalysis testing can provide accurate drug use information, the scope of the information is short-term and is generally limited to the type of drug ingested within a few days of the test. Studies published in many scientiﬁc publications have indicated that most drugs disappear from urine within a few days. 2 In contrast to urinalysis testing, hair testing using the Company’s patented method can provide long-term historical drug use information resulting in a signiﬁcantly wider window of detection. This window may be several months or longer depending on the length of the hair sample. The Company’s standard test offering, however, uses a 3.9 centimeter length head hair sample cut close to the scalp which measures use for approximately three months prior to collection of the sample. This wider window enhances the detection efficiency of hair analysis, making it particularly useful in pre-employment and random testing. Hair testing not only identiﬁes more drug users, but it may also uncover patterns and severity of drug use (information most helpful in determining the scope of an individual’s involvement with drugs), while serving as a deterrent against drug use. Hair testing employing the Company’s patented method greatly reduces the incidence of ‘‘false negatives’’ associated with evasive measures typically encountered with urinalysis testing. For example, urinalysis test results are adversely impacted by excessive ﬂuid intake prior to testing and by adulteration or substitution of the urine sample. Moreover, a drug user who abstains from use for a few days prior to urinalysis testing can usually escape detection. Hair testing is effectively free of these problems, as it cannot be thwarted by evasive measures typically encountered with urinalysis testing. Hair testing is also attractive to customers since sample collection is typically performed under close supervision yet is less intrusive and less embarrassing for test subjects. Hair testing using the Company’s patented method (with mass spectrometry conﬁrmation) further reduces the prospects of error in conducting drug detection tests. Urinalysis testing is more susceptible to problems such as ‘‘evidentiary false positives’’ resulting from passive drug exposure or poppy seeds. To combat this problem, in federally mandated testing, the opiate cutoff levels for urine testing were raised 667% (from 300 to 2,000 ng/ml) on December 1, 1998, and testing for the presence of a heroin metabolite, 6-AM, was required. These requirements, however, effectively reduced the detection time frame for conﬁrmed heroin with 6-AM in urine down to several hours post drug use. In contrast, the metabolite 6-AM is stable in hair and can be detected for months. In the event a positive urinalysis test result is challenged, a test on a newly collected urine sample is not a viable remedy. Unless the forewarned individual continues to use drugs prior to the date of the newly collected sample, a re-test may yield a negative result when using urinalysis testing because of temporary abstinence. In contrast, when the Company’s hair testing method is offered on a repeat hair sample, the individual suspected of drug use cannot as easily affect the results because historical drug use data remains locked in the hair ﬁber. When compared to other hair testing methods, not only are the Company’s assays cleared by the FDA for head and body hair, they also employ a unique patented method of digesting hair that the Company believes allows for the most efficient release of drugs from the hair without destroying the drugs. The Company’s method of releasing drugs from hair is a key advantage and results in superior detection rates. Disadvantages of Hair Testing There are some disadvantages of hair testing as compared to drug detection through urinalysis. Because hair starts growing below the skin surface, drug ingestion evidence does not appear in hair above the scalp until approximately ﬁve to seven days after use. Thus, hair testing is not suitable for determining drug presence in ‘‘for cause’’ testing as is done in connection with an accident investigation. It does, however, provide a drug history which can complement urinalysis information in ‘‘for cause’’ testing. The Company’s prices for its tests are generally somewhat higher than prices for tests using urinalysis, but the Company believes that its superior detection rates provide more value to the customer. This pricing policy could, however, adversely impact the growth of the Company’s sales volume. Hair Alcohol Testing In 2013, the Company launched a test for alcohol using hair. This test measures average alcohol consumption over a period of approximately three months, indicates the level of alcohol use during that time period, and can provide a behavioral indication of excessive use. The test measures the amount of ethyl 3 glucuronide (EtG) in the hair — a trace metabolite of ethanol and a direct alcohol biomarker. The test follows the guidelines determined by the World Health Organization in association with the Society of Hair Testing for measuring consumption. Intellectual Property Certain aspects of the hair analysis method currently used by the Company are covered by US and foreign patents owned by the Company. The Company has been granted a total of eight US patents, including a patent issued to the Company in 2011 that focuses on digesting hair and releasing drugs trapped in the hair without destroying the drugs. This patent can be used with a broad range of immunoassay screen techniques, mass spectrometry methods, and chromatographic procedures. In 2012, the Company received an additional patent that extended the range of the patent received in 2011. Additional patents are currently pending in the U.S. and internationally. The Company also relies on trade secrets to protect certain aspects of its proprietary technology. The Company’s ability to protect the conﬁdentiality of its trade secrets is dependent upon the Company’s internal safeguards and upon the laws protecting trade secrets and unfair competition. In the event that patent protection or protection under the laws of trade secrets is not sufficient and the Company’s competitors succeed in duplicating the Company’s products, the Company’s business could be materially adversely affected. Target Markets Workplace The Company focuses its primary marketing efforts on the private sector, with particular emphasis on job applicant and employee testing. Most businesses use drug testing to screen job applicants and employees. The Hazeldon Foundation survey from 2007 indicated that 85 percent of human resource (‘‘HR’’) professionals believe that drug testing is an effective way to diagnose substance abuse. The prevalence of drug screening programs reﬂects a concern that drug use contributes to employee health problems and costs (as the same study found that 62 percent of HR professionals believe that absenteeism is the most signiﬁcant problem caused by substance abuse and addiction, followed at 49 percent by reduced productivity, a lack of trustworthiness at 39 percent, a negative impact on the company’s external image at 32 percent, missed deadlines at 31 percent, and in certain industries, safety hazards.) It has been estimated that the cost to American businesses is more than $100 billion annually. The principal criticism of employee drug testing programs centers on the effectiveness of the testing program. Most private sector testing programs use urinalysis. Such programs are susceptible to evasive maneuvers and the inability to obtain conﬁrmation through repeat samples in the event of a challenged result. An industry has developed over the Internet, and through direct mail, marketing a wide variety of adulterants, dilutants, clean urine and devices to assist drug users in falsifying urine test results. Moreover, scheduled tests such as pre-employment testing and some random testing programs provide an opportunity for many drug users to simply abstain for a few days in order to escape detection by urinalysis. The Company presents its patented hair analysis method to potential clients as a better technology well suited to employer needs. Field studies and actual client results support the accuracy and effectiveness of the Company’s patented technology and its ability to detect varying levels of drug use. This information provides an employer with greater ﬂexibility in assessing the scope of an applicant’s or an employee’s drug problem. The Company performs a conﬁrmation test of all screened positive results through mass spectrometry. The use of mass spectrometry is an industry accepted practice used to conﬁrm a positive test result from the screening process. The Company offers its clients an expanded drug screen with mass spectrometry conﬁrmation of cocaine, PCP, marijuana, amphetamines (including Ecstasy and Eve), and opiates (including heroin, codeine, hydrocodone, hydromorphone, and oxycodone). In addition, the Company offers a hair test for alcohol which also looks back on use over a 90 day period, as our hair drug tests do. 4 Schools The Company currently serves hundreds of schools throughout the United States and in several foreign countries. The Company offers its school clients the same ﬁve-drug screen with mass spectrometry conﬁrmation that is used with the Company’s workplace testing service. In addition, the Company offers a hair test for alcohol which also looks back on use over a 90 day period, as our hair drug tests do. Parents The Company also offers a personal drug testing service, known as ‘‘PDT-90’’(cid:5), for parents concerned about drug use by their children. It allows parents to collect a small sample of hair from their child in the privacy of the home, send it to the Company’s laboratory and have it tested for drugs of abuse by the Company. The PDT-90 testing service uses the same patented method that is used with the Company’s workplace testing service. Research The Company is involved in the following ongoing studies involving use of drugs of abuse in various populations: Mclean Hospital and Wayne State University. Sales and Marketing The Company markets its corporate drug testing services primarily through its own sales force and through distributors. Sales offices are located in several major cities in the United States in order to facilitate communications with corporate employers. The Company markets its home drug testing service, PDT-90, through the Internet. Competition The Company competes directly with numerous commercial laboratories that test for drugs primarily through urinalysis testing. Most of these laboratories, such as Quest Diagnostics, have substantially greater ﬁnancial resources, market identity, marketing organizations, facilities, and more personnel than the Company. The Company has been steadily increasing its base of corporate customers and believes that future success with new customers is dependent on the Company’s ability to communicate the advantages of implementing a drug program utilizing the Company’s patented hair analysis method. The Company’s ability to compete is also a function of pricing. The Company’s prices for its tests are generally somewhat higher than prices for tests using urinalysis. However, the Company believes that its superior detection rates, coupled with the customer’s ability to test less frequently due to hair testing’s wider window of detection (several months versus approximately three days with urinalysis), provide more value to the customer. This pricing policy could, however, lead to slower sales growth for the Company. The Company also competes with other hair testing laboratories. The Company distinguishes itself from hair testing competitors by emphasizing the superior results the Company obtains through use of its unique patented extraction method (getting drug out of the hair), in combination with the Company’s FDA cleared immunoassay screen. In addition, Psychemedics is the only laboratory with FDA clearance for a ﬁve-drug panel test that is not limited to head hair samples for drugs of abuse. To date, no other laboratory engaged in hair testing has received approval or clearance from the FDA on all of its assays for the testing of both head and body hair samples (two other laboratories have either partial FDA clearance or clearance speciﬁc to head hair samples only). Government Regulation The Company is licensed as a clinical laboratory by the State of California as well as certain other states. All tests are performed according to the laboratory standards established by the Department of Health and Human Services, through the Clinical Laboratories Improvement Amendments (‘‘CLIA’’), and various state licensing statutes. A substantial number of states regulate drug testing. The scope and nature of such regulations varies greatly from state to state and is subject to change from time to time. The Company addresses state law issues on an ongoing basis. 5 The Federal Food, Drug and Cosmetic Act, as amended (the ‘‘FDC Act’’) requires companies engaged in the business of testing for drugs of abuse using a test (screening assay) not previously recognized by the FDA to submit their assay to the FDA for recognition prior to marketing. In addition, the laboratory performing the tests is required to be certiﬁed by a recognized agency. In 2002, the Company received 510k clearance to market all ﬁve of its assays utilizing RIAH technology. In 2008, the Company received the ﬁrst CAP (College of American Pathologists) certiﬁcation speciﬁcally including hair testing. In 2011, the Company received ISO/IEC 17025 International Accreditation for a broad spectrum of laboratory testing including drugs of abuse and forensics in hair and urine specimens. ISO/IEC 17025 accreditation provides formal recognition to laboratories that demonstrate technical competency, and maintains this recognition through periodic evaluations to ensure continued compliance. In 2012, the Company received 510k clearance from the FDA to market ﬁve of its assays utilizing the Company’s custom developed EIA technology. In 2013, the Company had received 510k clearance from the FDA to market two additional assays utilizing the Company’s custom developed EIA technology, which have not yet been launched. Research and Development The Company is continuously engaged in research and development activities. During the years ended December 31, 2014, 2013 and 2012, $1,348,496, $825,102, and $825,518, respectively, were expended for research and development. The Company continues to perform research activities to develop new products and services and to improve existing products and services utilizing the Company’s proprietary technology. The Company also continues to evaluate methodologies to enhance its drug screening capabilities. Additional research using the Company’s proprietary technology is being conducted by outside research organizations through government-funded studies. Employees As of December 31, 2014, the Company had 156 full-time equivalent employees, 8 of whom are in R&D. None of the Company’s employees are subject to a collective bargaining agreement. 6 Item 1A. Risk Factors In addition to other information contained in this Form 10-K, the following risk factors should be carefully considered in evaluating Psychemedics Corporation and its business because such factors could have a signiﬁcant impact on our business, operating results and ﬁnancial condition. These risk factors could cause actual results to materially differ from those projected in any forward-looking statements. Companies may develop products that compete with our products and some of these companies may be larger and better capitalized than we are. Many of our competitors and potential competitors are larger and have greater ﬁnancial resources than we do and offer a range of products broader than our products. Some of the companies with which we now compete or may compete in the future may develop more extensive research and marketing capabilities and greater technical and personnel resources than we do, and may become better positioned to compete in an evolving industry. Failure to compete successfully could harm our business and prospects. Increased competition, including price competition, could have a material impact on the Company’s net revenues and proﬁtability. Our business is intensely competitive, both in terms of price and service. Pricing of drug testing services is a signiﬁcant factor often considered by customers in selecting a drug testing laboratory. As a result of the clinical laboratory industry undergoing signiﬁcant consolidation, larger clinical laboratory providers are able to increase cost efficiencies afforded by large-scale automated testing. This consolidation results in greater price competition. The Company may be unable to increase cost efficiencies sufficiently, if at all, and as a result, its net earnings and cash ﬂows could be negatively impacted by such price competition. The Company may also face increased competition from companies that do not comply with existing laws or regulations or otherwise disregard compliance standards in the industry. Additionally, the Company may also face changes in fee schedules, competitive bidding for laboratory services or other actions or pressures reducing payment schedules as a result of increased or additional competition. Additional competition, including price competition, could have a material adverse impact on the Company’s net revenues and proﬁtability. Our results of operations are subject in part to variation in our customers’ hiring practices and other factors beyond our control. Our results of operations have been and may continue to be subject to variation in our customers’ hiring practices, which in turn is dependent, to a large extent, on the general condition of the economy. Results for a particular quarter may vary due to a number of factors, including: • • • • economic conditions in our markets in general; economic conditions affecting our customers and their particular industries; the introduction of new products and product enhancements by us or our competitors; and pricing and other competitive conditions. A failure to obtain and retain new customers, or a loss of existing customers, or a reduction in tests ordered, could impact the Company’s ability to successfully grow its business. The Company needs to obtain and retain new customers. In addition, a reduction in tests ordered, without offsetting growth in its customer base, could impact the Company’s ability to successfully grow its business and could have a material adverse impact on the Company’s net revenues and proﬁtability. We compete primarily on the basis of the quality of testing, reputation in the industry, the pricing of services and ability to employ qualiﬁed personnel. The Company’s failure to successfully compete on any of these factors could result in the loss of customers and a reduction in the Company’s ability to expand its customer base. Our business could be harmed if we are unable to protect our technology. We rely primarily on a combination of trade secrets, patents and trademark laws and conﬁdentiality procedures to protect our technology. Despite these precautions, unauthorized third parties may infringe or copy portions of our technology. In addition, because patent applications in the United States are not publicly 7 disclosed until either (1) 18 months after the application ﬁling date or (2) the publication date of an issued patent wherein applicant(s) seek only US patent protection, applications not yet disclosed may have been ﬁled which relate to our technology. Moreover, there is a risk that foreign intellectual property laws will not protect our intellectual property rights to the same extent as United States intellectual property laws. In the absence of the foregoing protections, we may be vulnerable to competitors who attempt to copy our products, processes or technology. Our business could be affected by a computer or other IT system failure. A computer or IT system failure could affect our ability to perform tests, report test results or properly bill customers. Failures could occur as a result of the standardization of our IT systems and other system conversions, telecommunications failures, malicious human acts (such as electronic break-ins or computer viruses) or natural disasters. Sustained system failures or interruption of the Company’s systems in one or more of its operations could disrupt the Company’s ability to process and provide test results in a timely manner and/or bill the appropriate party. Failure of the Company’s information systems could adversely affect the Company’s business, proﬁtability and ﬁnancial condition. Failure to maintain conﬁdential information could result in a signiﬁcant ﬁnancial impact. The Company maintains conﬁdential information regarding the results of drug tests and other information including credit card and payment information from our customers. The failure to protect this information could result in lawsuits, ﬁnes or penalties. Any loss of data or breach of conﬁdentiality, such as through a computer security breach, could expose the Company to a ﬁnancial liability. Our future success will depend on the continued services of our key personnel. The loss of any of our key personnel could harm our business and prospects. We may not be able to attract and retain personnel necessary for the development of our business. We do not have key personnel under contract other than 3 officers who have agreements providing for severance and non compete covenants in the event of termination of employment following a change of control. Further, we do not have any key man life insurance for any of our officers or other key personnel. There is a risk that our insurance will not be sufficient to protect us from errors and omissions liability or other claims, or that in the future errors and omissions insurance will not be available to us at a reasonable cost, if at all. Our business involves the risk of claims of errors and omissions and other claims inherent to our business. We maintain errors and omissions and general liability insurance subject to deductibles and exclusions. There is a risk that our insurance will not be sufficient to protect us from all such possible claims. An under-insured or uninsured claim could harm our operating results or ﬁnancial condition. Our research and development capabilities may not produce viable new services or products. In order to remain competitive, we need to continually improve our products, develop new technologies to replace older technologies that have either become obsolete or for which patent protection is no longer available. It is uncertain whether we will continually be able to develop services that are more efficient, effective or that are suitable for our customers. Our ability to create viable products or services depends on many factors, including the implementation of appropriate technologies, the development of effective new research tools, the complexity of the chemistry and biology, the lack of predictability in the scientiﬁc process and the performance and decision-making capabilities of our scientists. There is no guarantee that our research and development teams will be successful in developing improvements to our technology. Improved testing technologies, or the Company’s customers using new technologies to perform their own tests, could adversely affect the Company’s business. Advances in technology may lead to the development of more cost-effective technologies such as point-of-care testing equipment that can be operated by third parties or customers themselves in their own offices, without requiring the services of a freestanding laboratory. Development of such technology and its use by the Company’s customers could reduce the demand for its testing services and negatively impact our revenues. 8 We may not be able to recruit and retain the experienced scientists and management we need to compete in our industry. Our future success depends upon our ability to attract, retain and motivate highly skilled scientists and management. Our ability to achieve our business strategies depends on our ability to hire and retain high caliber scientists and other qualiﬁed experts. We compete with other testing companies, research companies and academic and research institutions to recruit personnel and face signiﬁcant competition for qualiﬁed personnel. We may incur greater costs than anticipated, or may not be successful, in attracting new scientists or management or in retaining or motivating our existing personnel. Our future success also depends on the personal efforts and abilities of the principal members of our senior management and scientiﬁc staff to provide strategic direction, to manage our operations and maintain a cohesive and stable environment. Our facilities and practices may fail to comply with government regulations. Our testing facilities and processes must be operated in conformity with current government regulations. These requirements include, among other things, quality control, quality assurance and the maintenance of records and documentation. If we fail to comply with these requirements, we may not be able to continue our services to certain customers, or we could be subject to ﬁnes and penalties, suspension of production, or withdrawal of our certiﬁcations. We operate a facility that we believe conforms to all applicable requirements. This facility and our testing practices are subject to periodic regulatory inspections to ensure compliance. Our business could be harmed from the loss or suspension of any licenses. The forensic laboratory testing industry is subject to signiﬁcant regulation and many of these statutes and regulations are subject to change. The Company cannot assure that applicable statutes and regulations will not be interpreted or applied by a regulatory authority in a manner that would adversely affect its business. Potential sanctions for violation of these regulations could include the suspension or loss of various licenses, certiﬁcates and authorizations, which could have a material adverse effect on the Company’s business. If our use of chemical and hazardous materials violates applicable laws or regulations or causes personal injury we may be liable for damages. Our drug testing activities, including the analysis and synthesis of chemicals, involve the controlled use of chemicals, including ﬂammable, combustible, and toxic materials that are potentially hazardous. Our use, storage, handling and disposal of these materials is subject to federal, state and local laws and regulations, including the Resource Conservation and Recovery Act, the Occupational Safety and Health Act and local ﬁre codes, and regulations promulgated by the Department of Transportation, the Drug Enforcement Agency, the Department of Energy, and the California Department of Public Health and Environment. We may incur signiﬁcant costs to comply with these laws and regulations in the future. In addition, we cannot completely eliminate the risk of accidental contamination or injury from these materials, which could result in material unanticipated expenses, such as substantial ﬁnes or penalties, remediation costs or damages, or the loss of a permit or other authorization to operate or engage in our business. Those expenses could exceed our net worth and limit our ability to raise additional capital. Our operations could be interrupted by damage to our specialized laboratory facilities. Our operations are dependent upon the continued use of our highly specialized laboratories and equipment in Culver City, California. Catastrophic events, including earthquakes, ﬁres or explosions, could damage our laboratories, equipment, scientiﬁc data, work in progress or inventories of chemicals and may materially interrupt our business. We employ safety precautions in our laboratory activities in order to reduce the likelihood of the occurrence of certain catastrophic events; however, we cannot eliminate the chance that such events will occur. The availability of laboratory space in these locations is limited, and rebuilding our facilities could be time consuming and result in substantial delays in fulﬁlling our agreements with our customers. We maintain business interruption insurance to cover continuing expenses and lost revenue caused by such occurrences. However, this insurance does not compensate us for the loss of opportunity and potential harm to customer relations that our inability to meet our customers’ needs in a timely manner could create. 9 Agreements we have with our employees, consultants and customers may not afford adequate protection for our trade secrets, conﬁdential information and other proprietary information. In addition to patent protection, we also rely on copyright and trademark protection, trade secrets, know-how, continuing technological innovation and licensing opportunities. In an effort to maintain the conﬁdentiality and ownership of our trade secrets and proprietary information, we require our employees, consultants and advisors to execute conﬁdentiality and proprietary information agreements. However, these agreements may not provide us with adequate protection against improper use or disclosure of conﬁdential information and there may not be adequate remedies in the event of unauthorized use or disclosure. Furthermore, we may from time to time hire scientiﬁc personnel formerly employed by other companies involved in one or more areas similar to the activities we conduct. In some situations, our conﬁdentiality and proprietary information agreements may conﬂict with, or be subject to, the rights of third parties with whom our employees, consultants or advisors have prior employment or consulting relationships. Although we require our employees and consultants to maintain the conﬁdentiality of all proprietary information of their previous employers, these individuals, or we, may be subject to allegations of trade secret misappropriation or other similar claims as a result of their prior affiliations. Finally, others may independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets. Our failure or inability to protect our proprietary information and techniques may inhibit or limit our ability to compete effectively, or exclude certain competitors from the market. Risks Related to Our Stock Our quarterly operating results could ﬂuctuate signiﬁcantly, which could cause our stock price to decline. Our quarterly operating results have ﬂuctuated in the past and are likely to ﬂuctuate in the future. Our results are impacted by the extent to which we are able to gain new customers, both domestically and internationally, and on the hiring practices of our existing customers, which are, in turn, impacted by general economic conditions. Entering into new customer contracts can involve a long lead time. Accordingly, negotiation can be lengthy and is subject to a number of signiﬁcant risks, including customers’ budgetary constraints and internal reviews. Due to these and other market factors, our operating results could ﬂuctuate signiﬁcantly from quarter to quarter. In addition, we may experience signiﬁcant ﬂuctuations in quarterly operating results due to factors such as general and industry-speciﬁc economic conditions that may affect the budgets and the hiring practices of our customers. Due to the possibility of ﬂuctuations in our revenue and expenses, we believe that quarter-to-quarter comparisons of our operating results are not necessarily a good indication of our future performance. Our operating results in some quarters may not meet the expectations of stock market analysts and investors. If we do not meet analysts’ and/or investors’ expectations, our stock price could decline. Our stock price could experience substantial volatility. The market price of our common stock has historically experienced and may continue to experience extensive volatility. Our quarterly operating results, the success or failure of future development efforts, changes in general conditions in the economy or the ﬁnancial markets and other developments affecting our customers, our competitors or us could cause the market price of our common stock to ﬂuctuate substantially. This volatility may adversely affect the price of our common stock. In the past, securities class action litigation has often been instituted following periods of volatility in the market price of a company’s securities. A securities class action suit against us could result in potential liabilities, substantial costs and the diversion of management’s attention and resources, regardless of whether we win or lose. Payment of a dividend could decline or cease. Because we have historically paid dividends, any cessation of our program or reduction in our quarterly dividend could affect our stock price. We have paid dividends on our common stock for 73 consecutive quarters. It is our intent to continue this practice as long as we are able. However, if we are forced to cease this practice or reduce the amount of the regular dividend, due to operating or economic conditions, our stock price could suffer. Further, if the Company ceases its future dividends, a return on investment in our common stock would depend entirely upon future appreciation. There is no guarantee that our common stock will appreciate in value or even maintain the price at which stockholders have purchased their shares. 10 The general economic condition could deteriorate. Our business is dependent upon new hiring and the supply of new jobs created by overall economic conditions. If the economy deteriorates, leading to a downturn in new job creation, our business and stock price could be adversely affected. Item 1B. Unresolved Staff Comments Not applicable. Item 2. Properties The Company maintains its corporate office and northeast sales office at 125 Nagog Park, Acton, Massachusetts; the office consists of 3,971 square feet and is leased through February 2018. The Company leases two facilities for laboratory purposes in Culver City, California. The ﬁrst is 13,900 square feet of space with an additional 9,600 feet of storage space. This facility is leased through December 31, 2015 with an option to renew for an additional two years. In 2014, the Company added a second facility of 16,000 square feet of space. This facility is leased through March 14, 2017 with an option to renew for an additional two years. The Company also leases an additional 5,400 square feet of space in Culver City, California for customer service and information technology purposes. This office space is leased through December 31, 2015 with an option to renew for an additional two years. Item 3. Legal Proceedings The Company is involved in various suits and claims in the ordinary course of business. The Company does not believe that the disposition of any such suits or claims will have a material adverse effect on the continuing operations or ﬁnancial condition of the Company. Item 4. Mine Safety Disclosures Not applicable. 11 PART II Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the NASDAQ Stock Market under the symbol ‘‘PMD’’. As of February 27, 2015, there were 180 record holders of the Company’s common stock. The number of record owners was determined from the Company’s stockholder records maintained by the Company’s transfer agent and does not include beneﬁcial owners of the Company’s common stock whose shares are held in the names of various security holders, dealers and clearing agencies. The Company believes that the number of beneﬁcial owners of the Company’s common stock held by others as or in nominee names exceeds 3,000. The following table sets forth for the periods indicated the range of prices for the Company’s common stock as reported by the NASDAQ Stock Market and dividends declared by the Company. Fiscal 2014: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . First Quarter Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fiscal 2013: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . First Quarter Second Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Third Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fourth Quarter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . High Low Dividends $18.76 17.47 15.39 15.46 $12.48 12.03 13.40 14.90 $14.41 14.06 12.42 13.06 $10.76 10.55 10.75 12.00 $0.15 0.15 0.15 0.15 $0.15 0.15 0.15 0.15 The Company has paid dividends over the past eighteen years. It most recently declared a dividend on February 10, 2015, which will be paid on March 6, 2015. The Company’s current intention is to continue to declare dividends to the extent funds are available and not required for operating purposes or capital requirements, and only then, upon approval by the Board of Directors. Issuer Purchases of Equity Securities During 2014, the Company did not repurchase any common shares for treasury. Unregistered Sales of Equity Securities and Use of Proceeds There were no unregistered sales of common stock of the Company during 2014. 12 EQUITY COMPENSATION PLAN INFORMATION The following table provides information as of December 31, 2014, with respect to shares of the Company’s common stock that were issuable under the Company’s 2006 Incentive Plan (the ‘‘2006 Incentive Plan’’). The table does not include information with respect to shares subject to outstanding options granted under other equity compensation plans that were no longer in effect on December 31, 2014. Footnote (2) to the table sets forth the total number of shares of common stock issuable upon the exercise of options under such expired or discontinued plans as of December 31, 2014, and the weighted average exercise price of those options. No additional options may be granted under such other expired or discontinued plans. Plan Category Number of Securities to Be Issued Upon Exercise of Outstanding Options, Warrants and Rights (a) Weighted Average Exercise Price of Outstanding Options, Warrants and Rights (b) Number of Securities That Remained Available for Future Issuance (c) Equity compensation plans approved by security holders(1)(2) . . . . . . . . . . . . . . . . . . . . . . . . . 121,625 Equity compensation plans not approved by security holders . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . — 121,625 $0.00 — $0.00 146,885 — 146,885 (1) Consists of the 2006 Incentive Plan. (2) This table does not include information for the Company’s 2000 Stock Option Plan (discontinued on May 11, 2006). As of December 31, 2014, a total of 136,050 shares of common stock were issuable upon the exercise of outstanding options under the foregoing discontinued plan. The weighted average exercise price of outstanding options under such plan is $14.40 per share. No additional options may be granted under the 2000 Stock Option Plan. 13 Performance Graph COMPARE 5-YEAR CUMULATIVE TOTAL RETURN AMONG PSYCHEMEDICS CORPORATION, NASDAQ COMPOSITE INDEX AND RUSSELL 2000 INDEX 300 250 200 150 100 50 0 2009 2010 2011 2012 2013 2014 PSYCHEMEDICS CORPORATION RUSELL 2000 INDEX NASDAQ COMPOSITE INDEX Psychemedics Corporation . . . . . . . . . Russell 2000 Index . . . . . . . . . . . . . . NASDAQ Composite Index . . . . . . . . 2009 100.00 100.00 100.00 2010 114.19 126.34 116.91 2011 133.55 119.52 114.81 2012 163.40 135.22 133.07 2013 223.47 185.26 184.06 2014 237.53 191.80 208.71 Calculated by the Company using www.yahoo.com/ﬁnance historical prices (1) The above graph assumes a $100 investment on December 31, 2009, through the end of the 5-year period ended December 31, 2014 in the Company’s Common Stock, the Russell 2000 Index and the NASDAQ Composite Index. The prices all assume the reinvestment of dividends. (2) The Russell 2000 Index is composed of the smallest 2,000 companies in the Russell 3,000 Index. The Company has been unable to identify a peer group of companies that engage in testing of drugs of abuse, except for large pharmaceutical companies where such business is insigniﬁcant to such companies’ other lines of businesses. The Company therefore uses in its proxy statements a peer index based on market capitalization. (3) The NASDAQ Composite Index includes companies whose shares are traded on the NASDAQ Stock Market. Item 6. Selected Financial Data The selected ﬁnancial data presented below is derived from our ﬁnancial statements and should be read in connection with those statements. Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross proﬁt . . . . . . . . . . . . . . . . . . . . . . . . . . Income from operations. . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . Working capital . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity . . . . . . . . . . . . . . . . . . . . Basic net income per share . . . . . . . . . . . . . . . Diluted net income per share . . . . . . . . . . . . . . Cash dividends declared per common share . . . . 2014 $29,205 15,138 4,690 3,206 24,078 6,980 12,837 0.60 0.60 0.60 14 2011 2013 As of and for the Years Ended December 31, 2012 (In Thousands, Except for per Share Data) $24,090 $25,224 $26,870 14,473 14,252 15,394 5,800 4,936 5,706 3,489 2,980 3,805 13,801 14,121 16,550 9,217 7,491 6,998 11,035 11,223 12,277 0.67 0.57 0.72 0.67 0.57 0.72 0.48 0.60 0.60 2010 $20,109 12,042 4,414 2,614 11,766 8,566 9,748 0.50 0.50 0.48 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read together with the more detailed business information and ﬁnancial statements and related notes that appear elsewhere in this annual report on Form 10-K. This annual report may contain certain ‘‘forward-looking’’ information within the meaning of the Private Securities Litigation Reform Act of 1995. This information involves risks and uncertainties. Actual results may differ materially from the results discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed in ‘‘Item 1A — Risk Factors.’’ Overview Psychemedics Corporation is the world’s largest provider of hair testing for drugs of abuse, utilizing a patented hair analysis method involving digestion of hair, enzyme immunoassay technology and conﬁrmation by mass spectrometry to analyze human hair to detect abused substances. The Company’s customers include Fortune 500 companies, as well as small to mid-size corporations, schools and governmental entities located in the United States and internationally. During the year ended December 31, 2014, the Company generated $29.2 million in revenue, while maintaining a gross margin of 52% and pre-tax margins of 16%. At December 31, 2014, the Company had $3.6 million of cash. During 2014, the Company had operating cash ﬂow of $4.5 million and it distributed approximately $3.2 million or $0.60 per share of cash dividends to its shareholders. In addition, the Company spent approximately $7.6 million on equipment, leasehold improvements and software development which was primarily ﬁnanced with a loan of $7.0 million. The additional equipment purchased, as well as additional lease space, more than doubled the Company’s capacity for anticipated growth, including an opportunity in Brazil. To date, the Company has paid seventy-three consecutive quarterly cash dividends. The following table sets forth, for the periods indicated, the selected statements of operations data as a percentage of total revenue: Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross proﬁt Total operating expenses Operating expenses: General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . Marketing and selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income (expense) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Year Ended December 31, 2013 100.0% 42.7% 57.3% 2014 100.0% 48.2% 51.8% 2012 100.0% 43.5% 56.5% 15.3% 15.8% 4.6% 35.7% 16.1% -0.2% 15.9% 4.9% 11.0% 15.5% 17.5% 3.1% 36.1% 21.2% 0.4% 21.6% 7.4% 14.2% 15.6% 18.0% 3.3% 36.9% 19.6% 0.0% 19.6% 7.8% 11.8% Results for the Year Ended December 31, 2014 Compared to Results for the Year Ended December 31, 2013 Revenue increased $2.3 million or 9% to $29.2 million in 2014 compared to $26.9 million in 2013. This increase was due to an increase in volume from new and existing clients. The increase in volume was primarily driven by new customers which is a result of our recently expanded sales force and several sales initiatives. Average revenue per sample remained the same between 2014 and 2013. Gross proﬁt decreased $256 thousand to $15.1 million in 2014 compared to $15.4 million in 2013. Direct costs increased by 23% from 2013 to 2014, driven by the Company’s capacity expansion project and higher volume. The capacity expansion costs within cost of sales was approximately $1.3 million and included; $0.5 million for hiring and training of additional personnel, $0.5 million for building related costs, and $0.3 million for information technology and other one-time project costs. The gross proﬁt margin decreased from 57% in 2013 to 52% in 2014. 15 General and administrative (‘‘G&A’’) expenses were $4.5 million in 2014 compared to $4.2 in 2013, an increase of 8%. In 2014, G&A costs included approximately $0.2 million related to the Company’s capacity expansion project. As a percentage of revenue, G&A expenses were 15.3% and 15.5% for 2014 and 2013, respectively. Marketing and selling expenses were $4.6 million in 2014, compared to $4.7 million in 2013, a decrease of 2%. Total marketing and selling expenses represented 15.8% and 17.5% of revenue for 2014 and 2013, respectively. Research and development (‘‘R&D’’) expenses were $1.3 million in 2014 compared to $0.8 million in 2013. R&D expenses increased from additional personnel and supplies used to develop new tests for drugs of abuse as well as process improvements. R&D expenses represented 4.6% and 3.1% of revenue for 2014 and 2013, respectively. Other income (expense) represented $57 thousand of other expenses for 2014 compared to $92 thousand of other income for 2013. The expense in 2014 was driven by interest expense related to long term debt incurred in 2014, while the income in 2013 represented a one-time insurance reimbursement of legal expenses. During the year ended December 31, 2014, the Company recorded a tax provision of $1.4 million, representing an effective tax rate of 30.8%. During the year ended December 31, 2013, the Company recorded a tax provision of $2.0 million, representing an effective tax rate of 34.4%. The change in tax rate was driven by R&D tax credits from higher R&D spending and from a California R&D tax credit which was not previously taken. We expect the tax rate to be from 32% to 34% for the foreseeable future. Results for the Year Ended December 31, 2013 Compared to Results for the Year Ended December 31, 2012 Revenue increased $1.7 million or 7% to $26.9 million in 2013 compared to $25.2 million in 2012. This increase was due to an increase in volume from new and existing clients. The increase in volume was primarily driven by new customers which is a result of our recently expanded sales force and several sales initiatives. Average revenue per sample decreased 2% between 2013 and 2012. The revenue per sample decrease was driven primarily from by the mix of customers, with a larger percentage of the business coming from lower priced customers. Gross proﬁt increased $1.1 million to $15.4 million in 2013 compared to $14.3 million in 2012. Direct costs increased by 5% from 2012 to 2013, driven by the higher volume. The gross proﬁt margin remained the same at 57% in 2013 and 2012. General and administrative (‘‘G&A’’) expenses were $4.2 million in 2013 compared to $3.9 in 2012, an increase of 5%. As a percentage of revenue, G&A expenses were 15.5% and 15.6% for 2013 and 2012, respectively. Marketing and selling expenses were $4.7 million in 2013, compared to $4.5 million in 2012, an increase of 4%. Total marketing and selling expenses represented 17.5% and 18.0% of revenue for 2013 and 2012, respectively. Research and development (‘‘R&D’’) expenses were $0.8 million in 2013 and 2012. R&D expenses represented 3.1% and 3.3% of revenue for 2013 and 2012, respectively. Other income increased approximately $90 thousand to approximately $92 thousand for 2013 compared to $2 thousand for 2012. The increase was from an insurance reimbursement of legal expenses. During the year ended December 31, 2013, the Company recorded a tax provision of $2.0 million, representing an effective tax rate of 34.4%. During the year ended December 31, 2012, the Company recorded a tax provision of $2.0 million, representing an effective tax rate of 39.7%. The change in tax rate was driven by a new allocation method for calculating income tax in California. This new calculation requires income tax to be paid only on the sales made within California. The old method taxed all income produced in California, and as the Company has only one laboratory, which is located in California, 100% of the income had been subject to California income tax. The rate also beneﬁted from an R&D tax credit from 2012 which was recognized in 2013. We expect the tax rate to be approximately 34% for the foreseeable future. 16 Liquidity and Capital Resources At December 31, 2014, the Company had $3.6 million of cash, compared to $4.0 million at December 31, 2013. The Company’s operating activities generated net cash of $4.5 million in 2014, $6.0 million in 2013 and $3.1 million in 2012. Investing activities used $7.8 million in 2014, $1.8 million in 2013 and $2.3 million in 2012. Financing activities generated $3.0 million in 2014, used $3.3 million in 2013 and used $3.2 million in 2012. Operating cash ﬂow of $4.5 million in 2014 primarily reﬂected net income of $3.2 million adjusted for depreciation and amortization of $1.1 million, stock compensation expense of $0.6 million, and an increase in net deferred tax liabilities of $1.4 million. This was affected by the following changes in assets and liabilities: a decrease in accounts receivable of $0.3 million, an increase in accounts payable of $0.3 million, a decrease in accrued expenses of $1.2 million, and an increase in prepaid expenses (and other current assets) of $1.2 million. The decrease in accrued expenses was driven by a $1.2 million reduction in the liability for equipment purchases which were paid for in 2014. The change in deferred tax liabilities and other current assets was driven by bonus depreciation on new assets purchased as part of the tax extender bill passed in December 2014. Operating cash ﬂow of $6.0 million in 2013 primarily reﬂected net income of $3.8 million adjusted for depreciation and amortization of $0.9 million, stock compensation expense of $0.5 million, and an increase in net deferred tax liabilities of $0.4 million. This was affected by the following changes in assets and liabilities: a decrease in accounts receivable of $0.3 million, a decrease in accounts payable of $0.2 million, a decrease in accrued expenses of $0.1 million, and a decrease in prepaid expenses (and other current assets) of $0.4 million. The increase in operating cash ﬂow of $2.9 million over 2012 was primarily driven by higher net income and a reduction of income tax receivable. Operating cash ﬂow of $3.1 million in 2012 primarily reﬂected net income of $3.0 million adjusted for depreciation and amortization of $0.6 million, stock compensation expense of $0.5 million, and an increase in net deferred tax liabilities of $0.4 million. This was affected by the following changes in assets and liabilities: an increase in accounts receivable of $0.1 million, a decrease in accounts payable of $0.3 million, a decrease in accrued expenses of $0.4 million, and an increase in prepaid expenses (and other current assets) of $0.5 million. Investing cash ﬂow principally reﬂected the purchase of capital expenditures. Capital expenditures were $7.6 million, $1.5 million, and $2.2 million in 2014, 2013 and 2012, respectively. In 2014, the expenditures related principally to laboratory equipment, computer equipment, new software, and leasehold improvements for the Company’s new facility. Capitalized patent costs were $0.2 million, $0.2 million, and $0.1 million in 2014, 2013, and 2012, respectively. During 2014, 2013 and 2012, the Company did not repurchase any shares of common stock for treasury. The Company has authorized 750,000 shares for repurchase since June of 1998, of which 250,000 shares of common stock were authorized in March of 2008 for repurchase. Since 1998, a total of 550,684 shares have been repurchased. The Company also distributed $3.2 million of cash dividends to its shareholders in 2014, 2013 and 2012. At December 31, 2014, the Company’s principal sources of liquidity included approximately $3.6 million of cash and $500 thousand of available credit under its equipment ﬁnancing arrangement. See Note 10 — Debt and Other Financing to the Financial Statements for further detail on the equipment ﬁnancing arrangement. Management currently believes that such funds, together with future operating proﬁts, should be adequate to fund anticipated working capital requirements, including debt obligations, and capital expenditures in the near term. Depending upon the Company’s results of operations, its future capital needs and available marketing opportunities, the Company may use various ﬁnancing sources to raise additional funds. Such sources could include joint ventures, issuance of common stock or debt ﬁnancing, lines of credit, or equipment leasing, although there is no assurance that such ﬁnancings will be available to the Company on terms it deems acceptable, if at all. The Company has paid dividends over the past seventy-three quarters. It most recently declared a dividend in February 2015 which will be paid in March 2015 in the amount of $806 thousand. The Company’s current intention is to continue to declare dividends to the extent funds are available and not required for operating purposes or capital requirements, and only then, upon approval by the Board of Directors. There can be no assurance that in the future the Company will declare dividends. 17 Contractual obligations as of December 31, 2014 were as follows: Contractual Obligation Less Than 1 Year 1 − 3 Years Payments Due by Period 4 − 5 Years (Amounts in Thousands) Greater Than 5 Years Operating leases . . . . . . . . . . . . . . . . . . . Loan Obligations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total $ 999 $1,400 $2,399 $ 764 $2,800 $3,564 $ 31 $2,048 $2,079 $— $— $— Total $1,794 $6,248 $8,042 Purchase Commitment Operating leases consist of rent obligations for the company’s facilities. The Company has no signiﬁcant contractual obligation for supply agreements as of December 31, 2014. Signiﬁcant Customers The Company did not have any individual customers that exceeded 10% of revenue for the years ended December 31, 2014, 2013 and 2012, or accounts receivable as of December 31, 2014, 2013 and 2012. Critical Accounting Policies The Company’s signiﬁcant accounting policies are described in Note 2 to the ﬁnancial statements included in Item 8 of this Form 10-K. 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 recognizes revenue in accordance with Accounting Standards Codiﬁcation ‘‘ASC’’ 605, ‘‘Revenue Recognition.’’ In accordance with ASC 605, the Company considers testing, training and storage elements as 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 recognizes revenue as the service is performed and reported to the customer, since the predominant deliverable in each arrangement is the testing of the units. 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. 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, long-lived asset lives, income tax valuation 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. Capitalized Development Costs We capitalize costs related to signiﬁcant software projects developed or obtained for internal use in accordance with U.S. generally accepted accounting standards. Costs incurred during the preliminary project work stage or conceptual stage, such as determining the performance requirements, system requirements and data conversion, are expensed as incurred. Costs incurred in the application development phase, such as coding, testing for new software and upgrades that result in additional functionality, are capitalized and are amortized using the straight-line method over the useful life of the software for 5 years. Costs incurred during the post-implementation/operation stage, including training costs and maintenance costs, are expensed as incurred. We capitalized internally developed software costs of approximately $403,000, $715,000 and $794,000 during the years ended December 31, 2014, 2013 and 2012, respectively. The software development 18 is for primarily for two projects. Determining whether particular costs incurred are more properly attributable to the preliminary or conceptual stage, and thus expensed, or to the application development phase, and thus capitalized and amortized, depends on subjective judgments about the nature of the development work, and our judgments in this regard may differ from those made by other companies. General and administrative costs related to developing or obtaining such software are expensed as incurred. Allowance for Doubtful Accounts The allowance for doubtful accounts is based on management’s assessment of the ability to collect amounts owed to it by its customers. Management reviews its accounts receivable aging for doubtful accounts and uses a methodology based on calculating the allowance using a combination of factors including the age of the receivable along with management’s judgment to identify 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. The Company had net deferred tax liabilities in the amount of $2.4 million at December 31, 2014, which primarily relate to timing differences. There was an increase of $1.4 million from 2013 which was primarily driven by bonus depreciation as part of the tax extender bill passed in December 2014, for equipment purchases in 2014. In 2014, the Company’s tax rate was reduced as a result of two R&D tax credit items. The ﬁrst was a California R&D tax credit which had not been previously taken and the Company recognized the beneﬁt of prior years as well as 2014 in the current year. The second impact came from the increase in spending in R&D which increased both the California and Federal R&D tax credit. 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. Interest and penalties related to income tax matters are recognized as a general and administrative expense. The Company did not have any unrecognized tax beneﬁts and did not have any interest or penalties accrued as of December 31, 2014 or 2013. The Company does not expect the unrecognized tax beneﬁts to change signiﬁcantly over the next twelve months. 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. Recent Accounting Pronouncements There were no new accounting pronouncements issued or effective during the ﬁscal year which have had or are expected to have a material impact on the Financial Statements. See Note 2 — Accounting Policies, to the Financial Statements for further detail on applicable accounting pronouncements that were adopted in 2014. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Not Required. 19 Item 8. Financial Statements and Supplementary Data (a) Financial Statements: Report of Independent Registered Public Accounting Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance Sheets as of December 31, 2014 and 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Statements of Income and Comprehensive Income for the Years Ended December 31, 2014, 2013 and 2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Statements of Shareholders’ Equity for the Years Ended December 31, 2014, 2013 and 2012 . . . . . Statements of Cash Flows for the Years Ended December 31, 2014, 2013 and 2012 . . . . . . . . . . . . Notes to Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Page 21 22 23 24 25 26 20 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders Psychemedics Corporation Acton, Massachusetts: We have audited the accompanying balance sheets of Psychemedics Corporation (the ‘‘Company’’) as of December 31, 2014 and 2013 and the related statements of income and comprehensive income, shareholders’ equity and cash ﬂows for each of the three years in the period ended December 31, 2014. These ﬁnancial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁnancial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁnancial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over ﬁnancial reporting. Our audits included consideration of internal control over ﬁnancial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over ﬁnancial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁnancial statements, assessing the accounting principles used and signiﬁcant estimates made by management, as well as evaluating the overall ﬁnancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the ﬁnancial statements referred to above present fairly, in all material respects, the ﬁnancial position of Psychemedics Corporation at December 31, 2014 and 2013 and the results of its operations and its cash ﬂows for each of the three years in the period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America. /s/ BDO USA, LLP Boston, Massachusetts February 27, 2015 21 PSYCHEMEDICS CORPORATION BALANCE SHEETS Current Assets: ASSETS Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable, net of allowance for doubtful accounts of $95,525 in 2014 and $144,921 in 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses and other current assets . . . . . . . . . . . . . . . . . . . . . Income tax receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Current Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Property and equipment: Computer software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Office furniture and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . Laboratory equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less − accumulated depreciation and amortization . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Assets LIABILITIES AND SHAREHOLDERS’ EQUITY Current Liabilities: Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Current portion of long-term debt Total Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities, long-term . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commitments and Contingencies (Note 9) Shareholders’ Equity: Preferred stock, $0.005 par value, 872,521 shares authorized, no shares issued or outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Common stock, $0.005 par value; 50,000,000 shares authorized 6,043,191 shares issued in 2014 and 5,981,896 shares issued 2013, 5,375,061 shares outstanding in 2014 and 5,313,766 shares outstanding in 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less − Treasury stock, at cost, 668,130 shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated deﬁcit Total Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Liabilities and Shareholders’ Equity . . . . . . . . . . . . . . . . . . . . . . December 31, 2014 December 31, 2013 $ 3,612,153 $ 3,970,512 4,078,133 689,995 1,819,743 376,529 10,576,553 2,361,388 1,068,264 13,297,548 1,801,482 18,528,682 (5,788,551) 12,740,131 761,025 $ 24,077,709 4,368,864 769,269 554,828 292,795 9,956,268 1,958,780 779,891 8,047,840 439,414 11,225,925 (5,175,722) 6,050,203 543,345 $ 16,549,816 $ 845,071 1,351,333 1,399,925 3,596,329 4,848,158 2,796,666 11,241,153 $ 510,550 2,447,920 — 2,958,470 — 1,314,221 4,272,691 — — 30,216 29,454,023 (10,081,789) (6,565,894) 12,836,556 $ 24,077,709 29,910 28,888,712 (10,081,789) (6,559,708) 12,277,125 $ 16,549,816 The accompanying notes are an integral part of these ﬁnancial statements. 22 PSYCHEMEDICS CORPORATION STATEMENTS OF INCOME AND COMPREHENSIVE INCOME Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross proﬁt Operating Expenses: General & administrative . . . . . . . . . . . . . . . . . . . . . . Marketing & selling . . . . . . . . . . . . . . . . . . . . . . . . . Research & development . . . . . . . . . . . . . . . . . . . . . . Total Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income (expense) . . . . . . . . . . . . . . . . . . . . . . . . Net income before provision for income taxes . . . . . . . . . Provision for income taxes . . . . . . . . . . . . . . . . . . . . . . Net income and comprehensive income . . . . . . . . . . . . . . Basic net income per share . . . . . . . . . . . . . . . . . . . . . . Diluted net income per share . . . . . . . . . . . . . . . . . . . . . Dividends declared per share . . . . . . . . . . . . . . . . . . . . . Weighted average common shares outstanding, basic . . . . . Weighted average common shares outstanding, diluted . . . 2014 $29,204,818 14,066,652 15,138,166 Year Ended December 31, 2013 $26,870,297 11,476,263 15,394,034 2012 $25,223,534 10,971,886 14,251,648 4,474,654 4,625,375 1,348,496 10,448,525 4,689,641 (56,576) 4,633,065 1,426,984 $ 3,206,081 $ $ $ 0.60 0.60 0.60 5,355,367 5,376,998 4,157,597 4,704,970 825,102 9,687,669 5,706,365 92,273 5,798,638 1,993,428 $ 3,805,210 $ $ $ 0.72 0.72 0.60 5,299,060 5,315,463 3,946,844 4,543,598 825,518 9,315,960 4,935,688 1,889 4,937,577 1,957,948 $ 2,979,629 $ $ $ 0.57 0.57 0.60 5,260,320 5,272,542 The accompanying notes are an integral part of these ﬁnancial statements. 23 PSYCHEMEDICS CORPORATION STATEMENTS OF SHAREHOLDERS’ EQUITY Common Stock Treasury Stock Shares BALANCE, December 31, 2011 . . . . . . . . . 5,903,552 37,006 Shares issued − vested . . . . . . . . . . . . . . . Tax withholding related to vested shares from — employee stock plans . . . . . . . . . . . . . . — Stock compensation expense . . . . . . . . . . . — Cash dividends declared ($0.60 per share) . . . Net income . . . . . . . . . . . . . . . . . . . . . . — BALANCE, December 31, 2012 . . . . . . . . . 5,940,558 36,988 Shares issued − vested . . . . . . . . . . . . . . . 4,350 Exercise of stock options . . . . . . . . . . . . . Tax withholding related to vested shares from employee stock plans . . . . . . . . . . . . . . Stock compensation expense . . . . . . . . . . . Excess tax beneﬁt from stock-based — — — compensation plans . . . . . . . . . . . . . . . — Cash dividends declared ($0.60 per share) . . . Net income . . . . . . . . . . . . . . . . . . . . . . — BALANCE, December 31, 2013 . . . . . . . . . 5,981,896 52,046 Shares issued − vested . . . . . . . . . . . . . . . Exercise of stock options . . . . . . . . . . . . . 9,249 Tax withholding related to vested shares from employee stock plans . . . . . . . . . . . . . . Stock compensation expense . . . . . . . . . . . Excess tax beneﬁt from stock-based — — — compensation plans . . . . . . . . . . . . . . . — Cash dividends declared ($0.60 per share) . . . Net income . . . . . . . . . . . . . . . . . . . . . . — BALANCE, December 31, 2014 . . . . . . . . . 6,043,191 $0.005 par Value $29,518 185 Paid-In Capital $28,095,946 (185) — — — — 29,703 185 22 (93,164) 458,167 — — 28,460,764 (185) 20,817 Shares 668,130 — — — — — 668,130 — — Cost Accumulated Deﬁcit $(10,081,789) $(7,009,046) $11,034,629 — Total — — — — — — — (3,156,592) — 2,979,629 (7,186,009) — — (10,081,789) — — (93,164) 458,167 (3,156,592) 2,979,629 11,222,669 — 20,839 — — (154,522) 538,304 — — — — — — (154,522) 538,304 — — — 29,910 260 46 23,534 — — 28,888,712 (260) 32,722 — — — 668,130 — — — — — (3,178,909) — 3,805,210 (6,559,708) — — (10,081,789) — — 23,534 (3,178,909) 3,805,210 12,277,125 — 32,768 — — (147,378) 608,645 — — — — — — (147,378) 608,645 — — — $30,216 71,582 — — $29,454,023 — — — 668,130 71,582 (3,212,267) 3,206,081 $(10,081,789) $(6,565,894) $12,836,556 — — — (3,212,267) — 3,206,081 The accompanying notes are an integral part of these ﬁnancial statements. 24 PSYCHEMEDICS CORPORATION STATEMENTS OF CASH FLOWS Cash ﬂows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,206,081 $ 3,805,210 $ 2,979,629 Year Ended December 31, 2014 2013 2012 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . Stock compensation expense . . . . . . . . . . . . . . . . . . . . . . Changes in operating assets and liabilities: Accounts receivable Prepaid expenses, other current assets and income tax . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050,281 1,398,711 608,645 872,171 416,684 538,304 586,968 437,720 458,167 290,731 251,904 (129,792) receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash provided by operating activities (1,185,641) 334,521 (1,246,096) 4,457,233 353,389 (159,239) (126,876) 5,951,547 (547,895) (292,055) (406,011) 3,086,731 Cash ﬂows from investing activities: Increase in long-term assets; capitalized patent costs . . . . . . . Purchases of property and equipment and capitalized software (243,704) (226,130) (121,375) development costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash used in investing activities . . . . . . . . . . . . . . . . . . . . (7,564,676) (7,808,380) (1,531,632) (1,757,762) (2,214,048) (2,335,423) Cash ﬂows from ﬁnancing activities: Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax withholding related to vested shares from employee stock plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from equipment ﬁnancing . . . . . . . . . . . . . . . . . . . Payments of equipment ﬁnancing . . . . . . . . . . . . . . . . . . . . Net cash provided by (used in) ﬁnancing activities . . . . . . . . . . Net increase (decrease) in cash and cash equivalents . . . . . . . . . Cash and cash equivalents, beginning of year . . . . . . . . . . . . . . Cash and cash equivalents, end of year . . . . . . . . . . . . . . . . . . (3,212,267) (3,178,909) (3,156,592) (43,028) 6,999,626 (751,543) 2,992,788 (358,359) 3,970,512 $ 3,612,153 (110,149) — — (3,289,058) 904,727 3,065,785 $ 3,970,512 (93,164) — — (3,249,756) (2,498,448) 5,564,233 $ 3,065,785 Supplemental disclosures of cash ﬂow information: Cash paid for income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,167,920 $ 1,233,000 $ 1,715,000 Cash paid for interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 77,046 $ — $ — Non-cash investing and ﬁnancing activities: Issuance of restricted stock awards . . . . . . . . . . . . . . . . . . . . . Exercise of stock options . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of equipment through accrued liabilities . . . . . . . . . . $ $ $ 260 32,722 $ $ 185 20,817 149,509 $ 1,161,255 $ $ $ 185 — 497,696 The accompanying notes are an integral part of these ﬁnancial statements. 25 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 1. Nature of Business and Basis of Presentation Psychemedics Corporation (the ‘‘Company’’) is the world’s largest provider of hair testing for drugs of abuse, utilizing a patented hair analysis method involving digestion of hair, enzyme immunoassay technology and conﬁrmation by mass spectrometry to analyze human hair to detect abused substances. The Company’s customers include Fortune 500 companies, as well as small to mid-size corporations, schools and governmental entities located in the United States and internationally. 2. Summary of Signiﬁcant Accounting Policies Risks and Uncertainties The Company is subject to a number of risks and uncertainties similar to those of other companies, such as those associated with the continued expansion of the Company’s sales and marketing network, technological developments, intellectual property protection, 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 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. Estimates The preparation of ﬁnancial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates, including those related to bad debts and income tax valuation, 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. Changes in estimates are recorded in the period in which they become known. Cash Equivalents All highly liquid investments with original maturities of 90 days or less are considered cash equivalents. These consist of cash savings and U.S. government reserve money market accounts. While the money market account contains U.S. federal government backed issues, the account itself is not federally insured. As of December 31, 2014, there were no investments classiﬁed as cash equivalents. Fair Value Measurements The Company follows the provisions of Accounting Standards Codiﬁcation (ASC) 820, Fair Value Measurements and Disclosures (‘‘ASC 820’’), which deﬁnes fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements and expands disclosures regarding fair value measurements. Fair value is deﬁned under ASC 820 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the ﬁrst two are considered observable and the last unobservable, that may be used to measure fair value which are the following: Level 1 — Quoted prices in active markets for identical assets or liabilities. Level 2 — Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 — Unobservable inputs that are supported by little or no market activity and that are signiﬁcant to the fair value 26 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 2. Summary of Signiﬁcant Accounting Policies − (continued) A ﬁnancial instrument’s level within the fair value hierarchy is based on the lowest level of any input that is signiﬁcant to the fair value measurement. In accordance with ASC 820, the Company’s ﬁnancial assets that are measured at fair value on a recurring basis as of December 31, 2014 and 2013 are cash equivalents. Cash equivalents are measured using Level 1 inputs. At December 31, 2014, the Company did not have any investments classiﬁed as cash equivalents. At December 31, 2013, the Company had $0.4 million of Level 1 cash equivalents. Inventory The Company typically expenses consumables such as chemicals, antibodies and tubes as purchased. Property and Equipment Property and equipment are stated at cost. Depreciation and amortization are provided over the estimated useful lives of the assets, using the straight-line method. Repair and maintenance costs are expensed as incurred. The estimated useful lives of the assets are as follows: Computer software Office furniture and equipment Laboratory equipment Leasehold improvements 3 to 5 years 3 to 7 years 5 to 7 years Lesser of estimated useful life or estimated lease term The Company recorded depreciation and amortization related to property and equipment and capitalized software of $1,024,257, $844,093 and $573,712 in 2014, 2013 and 2012 respectively. Capitalized Software Development Costs We capitalize costs related to signiﬁcant software projects developed or obtained for internal use. Costs incurred during the preliminary project work stage or conceptual stage, such as determining the performance requirements, system requirements and data conversion, are expensed as incurred. Costs incurred in the application development phase, such as coding, testing for new software and upgrades that result in additional functionality, are capitalized and are amortized using the straight-line method over the useful life of the software for 5 years. Costs incurred during the post-implementation/operation stage, including training costs and maintenance costs, are expensed as incurred. In accordance with Company policy, during the years ended December 31, 2014 and 2013, we capitalized internally developed software costs of $403,000 and $715,000, respectively. Amortization expense related to software development costs was $223,568, $145,251, and $98,301 in 2014, 2013, and 2012, respectively. Determining whether particular costs incurred are more properly attributable to the preliminary or conceptual stage, and thus expensed, or to the application development phase, and thus capitalized and amortized, depends on subjective judgments about the nature of the development work, and our judgments in this regard may differ from those made by other companies. General and administrative costs related to developing or obtaining such software is expensed as incurred. Other Assets Other assets primarily consist of capitalized legal costs relating to patent applications. The Company amortizes these costs over the lesser of the legal life or estimated useful life of the patent from the date of grant of the applicable patent. The typical life is twenty years. As of December 31, 2014, 2013, and 2012 the Company had capitalized legal costs relating to outstanding patent applications of $656,438, $497,857 and $299,389, respectively. Amortization expense was $26,024, $28,078 and $13,256 in 2014, 2013 and 2012, respectively. The amount of amortization related to patent applications is expected to remain below $50,000 per year for the next ﬁve years. 27 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 2. Summary of Signiﬁcant Accounting Policies − (continued) Revenue Recognition The Company is in the business of performing drug testing services and reporting the results thereof. The Company’s services include, drug testing, 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 recognizes revenue under ASC 605, ‘‘Revenue Recognition’’ (‘‘ASC 605’’). In accordance with ASC 605, the Company considers testing, training and storage elements as 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 recognizes revenue as the service is performed and reported to the customer, since the predominant deliverable in each arrangement is the testing of the units. 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. Research and Development Expenses The Company expenses all research and development costs as incurred. Income Taxes The Company accounts for income taxes using the liability method pursuant to ASC 740, ‘‘Income Taxes’’. Under this method, the Company recognizes deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year the differences are expected to reverse. The Company evaluates uncertain tax positions annually and considers whether the amounts recorded for income taxes are adequate to address the Company’s tax risk proﬁle. The Company analyzes the potential tax liabilities of speciﬁc transactions and tax positions based on management’s judgment as to the expected outcome. Concentration of Credit Risk and Off-Balance Sheet Risk The Company has no signiﬁcant off-balance-sheet risk such as foreign exchange contracts, option contracts, or other foreign hedging arrangements. Financial instruments that potentially subject the Company to concentrations of credit risk are principally cash and accounts receivable. The Company places its cash and cash equivalents and short-term investments in highly rated institutions. These include money market accounts holding U.S. federal government reserve securities. While the underlying securities are federally issued, the account itself is not insured. Concentration of credit risk with respect to accounts receivable is limited to certain customers to whom the Company makes substantial sales. To reduce risk, 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. The Company does not require collateral. Signiﬁcant Customers The Company did not have any individual customers that exceeded 10% of revenue for the years ended December 31, 2014, 2013 and 2012 or accounts receivable as of December 31, 2014, 2013 and 2012. Comprehensive Income The Company’s comprehensive income was the same as its reported net income for the years ended December 31, 2014, 2013 and 2012. 28 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 2. Summary of Signiﬁcant Accounting Policies − (continued) Stock-Based Compensation The Company accounts for equity awards in accordance with ASC 718, ‘‘Compensation — Stock Compensation’’ (‘‘ASC 718’’). ASC 718 requires employee equity awards to be accounted for under the fair value method. Accordingly, share-based compensation is measured at the grant date based on the fair value of the award. It also requires the measurement of compensation cost at fair value on the date of grant and recognition of compensation expense over the service period for awards expected to vest. The Company uses the straight-line method to recognize share-based compensation over the service period of the award, which is generally equal to the vesting period. Under ASC 718, the Company recorded $608,645, $538,304 and $458,167 of stock compensation expense in the accompanying statements of income for the years ended December 31, 2014, 2013 and 2012, respectively. Stock compensation expense by income statement account is as follows: Cost of revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . General & administrative . . . . . . . . . . . . . . . . . . . . . . . Marketing and selling . . . . . . . . . . . . . . . . . . . . . . . . . Research and development . . . . . . . . . . . . . . . . . . . . . . Total stock compensation . . . . . . . . . . . . . . . . . . . . . 2014 $114,795 372,325 103,798 17,727 $608,645 2013 $112,348 339,098 77,789 9,069 $538,304 2012 $ 91,118 282,375 81,819 2,855 $458,167 See Note 7 for additional information relating to the Company’s stock plans. Basic and Diluted Net Income per Share Basic net income per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income available to common shareholders by the weighted average number of common shares and dilutive common stock equivalents outstanding during the period. The number of dilutive common stock equivalents 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 the unvested portion of stock unit awards (‘‘SUAs’’). Basic and diluted weighted average common shares outstanding are as follows: Weighted average common shares outstanding, basic . . . . Dilutive common equivalent shares . . . . . . . . . . . . . . . . Weighted average common shares outstanding, assuming 2014 5,355,367 21,631 2013 5,299,060 16,403 2012 5,260,320 12,222 dilution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,376,998 5,315,463 5,272,542 For the years ended December 31, 2013 and 2012, options to purchase 152,650 and 191,597 common shares, respectively, were outstanding but not included in the dilutive common equivalent share calculation as their effect would have been anti-dilutive. There were no options to purchase shares that were anti-dilutive for the year ended December 31, 2014. Financial Instruments Financial instruments include cash and accounts receivable/payable. Estimated fair values of these ﬁnancial instruments approximate carrying values due to their short-term nature. The Company has 29 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 2. Summary of Signiﬁcant Accounting Policies − (continued) outstanding equipment loans which have an interest rate of the 30-day LIBOR rate + 2.00%. As there is a market interest rate on the loans, the carrying amount is fair value. Segment Reporting The Company manages its operations as one segment, drug testing services. As a result, the ﬁnancial information disclosed herein materially represents all of the ﬁnancial information related to the Company’s principal operating segment. Most of the Company’s revenues and all of the Company’s assets are in the United States. Subsequent Events The Company evaluated all events and transactions that occurred after December 31, 2014 through the time of ﬁling with the Securities and Exchange Commission of the Company’s annual report on Form 10-K for the year ended December 31, 2014. On February 10, 2015, the Company declared a quarterly dividend of $0.15 per share for a total of $806 thousand, which will be paid on March 6, 2015 to shareholders of record on February 23, 2015. Recent Accounting Pronouncements In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which supersedes nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reﬂects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 deﬁnes a ﬁve step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. The standard is effective for annual periods beginning after December 15, 2016, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reﬂecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our ﬁnancial statements and have not yet determined the method by which we will adopt the standard in 2017. 3. Accounts Receivable The Company maintains an allowance for uncollectible accounts receivable based on management’s assessment of the collectability of its customer accounts by reviewing customer payment patterns and other relevant factors. The Company reviews the adequacy of the allowance for uncollectible accounts on a quarterly basis and adjusts the balance as determined necessary. Write-offs are recorded at the time a customer account is deemed uncollectable. The following is a rollforward of the Company’s allowance for doubtful accounts: Provision for (recoveries of) doubtful accounts Balance, beginning of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Write-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance, end of period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2014 $144,921 44,178 (93,574) $ 95,525 2013 $121,583 82,332 (58,994) $144,921 30 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 4. Accrued Expenses Accrued expenses consist of the following: Accrued payroll and employee beneﬁts . . . . . . . . . . . . . . . . . . . . . Accrued bonus expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued vacation expense Accrued hair collection expense . . . . . . . . . . . . . . . . . . . . . . . . . Accrued audit and tax consulting . . . . . . . . . . . . . . . . . . . . . . . . . Accrued payable for equipment purchases . . . . . . . . . . . . . . . . . . . Accrued payable for building maintenance . . . . . . . . . . . . . . . . . . Other accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Accrued Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2014 $ 208,252 300,008 319,118 147,787 104,615 — 85,283 186,270 $1,351,333 2013 $ 185,937 251,700 267,080 119,587 144,018 1,161,255 142,340 176,003 $2,447,920 5. Income Taxes The income tax provision consists of the following: Current − Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred − Federal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income Tax Provision . . . . . . . . . . . . . . . . . . . . 2014 2013 2012 $ 155,602 (127,329) 28,273 $1,499,400 77,344 1,576,744 $1,196,926 323,302 1,520,228 1,363,093 35,618 1,398,711 $1,426,984 406,116 10,568 416,684 $1,993,428 346,974 90,746 437,720 $1,957,948 A reconciliation of the effective rate with the federal statutory rate is as follows: Federal statutory rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . State income taxes, net of federal beneﬁt . . . . . . . . . . . . . . . . . . Permanent differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stock based compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective tax rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2014 34.0% 1.1% -4.3% 0.0% 30.8% 2013 34.0% 1.1% -0.7% 0.0% 34.4% 2012 34.0% 5.5% 0.1% 0.0% 39.6% The permanent difference is primarily from research and development (R&D) tax credits from Federal and California. These R&D tax credits consist of $74 thousand from Federal for 2014, $35 thousand from California for 2014, and $99 thousand from California from prior years. There are no tax credit carryforwards. 31 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 5. Income Taxes − (continued) The components of the net deferred tax assets included in the accompanying balance sheets are as follows at December 31: Deferred tax assets: Stock-based compensation . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for doubtful accounts . . . . . . . . . . . . . . . . . . . . . Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . R&D tax credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liabilities: Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Excess of tax over book depreciation and amortization . . . . . . 2014 2013 $ $ 168,926 33,585 89,212 84,806 376,529 $ $ 160,850 48,578 83,367 — 292,795 (44,565) (2,752,101) (2,796,666) — (1,314,221) (1,314,221) Net deferred tax liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . $(2,420,137) $(1,021,426) The change in deferred tax liabilities was driven by bonus depreciation on new assets purchased as part of the tax extender bill passed in December 2014. These amounts are shown on the balance sheets as follows: Deferred tax asset short-term . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax liability long-term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net deferred tax liabilities 2014 $ 376,529 (2,796,666) $(2,420,137) 2013 $ 292,795 (1,314,221) $(1,021,426) ASC 740 contains a two-step approach to recognizing and measuring uncertain tax positions (tax contingencies). The ﬁrst step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on an audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax beneﬁt as the largest amount which is more than 50% likely of being realized upon ultimate settlement. The Company considers many factors when evaluating and estimating the Company’s tax positions and tax beneﬁts, which may require periodic adjustments and which may not accurately forecast actual outcomes. 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. Interest and penalties related to income tax matters are recognized as a general and administrative expense. The Company did not have any unrecognized tax beneﬁts and did not have any interest or penalties accrued as of December 31, 2014 and 2013. The tax years ended December 31, 2011 through December 31, 2014 remain subject to examination by all major taxing authorities. 6. Preferred Stock The Board of Directors has the authority to designate authorized preferred shares in one or more series and to ﬁx the relative rights and preferences without vote or action by the stockholders. The Board of Directors has no present plans to designate or issue any shares of preferred stock. 32 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 7. Stock-Based Awards The 2006 Incentive Plan initially adopted in 2006, and amended and restated in 2011 (the ‘‘2006 Incentive Plan’’), provides for grants of options with terms of up to ten years, grants of restricted stock or stock unit awards (SUAs), issuances of stock bonuses or grants other stock-based awards, covering up to 500,000 shares of common stock, plus cash based awards, to officers, directors, employees, and consultants. Such shares are issuable out of the Company’s authorized but unissued common stock. As of December 31, 2014, 146,885 shares remained available for future grant under the 2006 Incentive Plan. The fair value of the SUAs is determined by the closing price on the date of grant. 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 employee receiving the award remains continuously employed throughout the vesting period. The Company records compensation expense related to the SUAs on a straight-line basis over the vesting term of the SUA. Employees are issued shares upon vesting, net of tax withholdings. The Company granted 44,575 SUAs on May 8, 2014. The fair value of the SUAs was $14.97 per share, which was the closing price of the Company’s stock on that date. 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 period. In addition, 9,879 SUAs were withheld for taxes in 2014, in conjunction with the vesting of SUA’s granted in prior years, and consequently, added back to the shares available for future grant. The Company granted 56,500 SUAs on May 23, 2013. The fair value of the SUAs was $11.45 per share, which was the closing price of the Company’s stock on that date. 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 period. In addition, 13,362 SUAs were withheld for taxes in 2013, in conjunction with the vesting of SUA’s granted in prior years, and consequently, added back to the shares available for future grant. The Company granted 65,000 SUAs on May 22, 2012. The fair value of the SUAs was $9.79 per share, which was the closing price of the Company’s stock on that date. 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 period. In addition, 9,619 SUAs were withheld for taxes in 2012, in conjunction with the vesting of SUA’s granted in prior years, and consequently, added back to the shares available for future grant. The Company also has stock option plans that have expired or been terminated, but shares can be issued upon exercise of outstanding options that were granted prior to such expiration or termination. Such shares are issuable out of the Company’s authorized but unissued common stock. No additional grants of options or other stock based awards may be made under such expired or terminated plans. 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 contractual lives of ten years and they are all fully exercisable. 33 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 7. Stock-Based Awards − (continued) A summary of stock option activity for the Company’s stock option plans is as follows: Outstanding & exercisable, December 31, 2011 . . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding & exercisable, December 31, 2012 . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding & exercisable, December 31, 2013 . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Exercised . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding & exercisable, December 31, 2014 . . . . . Number of Shares 221,239 — — (21,401) 199,838 — (14,988) (7,900) 176,950 — (40,900) — 136,050 Weighted Average Exercise Price per Share 13.62 — — 13.61 13.62 — 8.58 13.75 14.04 — 12.84 — $14.40 Weighted Average Remaining Contractual Life Aggregate Intrinsic Value(1) $ 53,636 $157,897 .4 years $102,038 (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 December 31, 2014 ($15.15) exceeded the exercise price of any of the underlying options, multiplied by the number of shares subject to each such option. For value on the exercised stock, the calculation is based on the amount the Company’s stock price at exercise exceeded the exercise price. A summary of stock unit award activity for the Company is as follows: Outstanding & Unvested, December 31, 2011 . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Converted to common stock* . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding & Unvested, December 31, 2012 . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Converted to common stock* . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding & Unvested, December 31, 2013 . . . . . Granted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Converted to common stock* . . . . . . . . . . . . . . Cancelled . . . . . . . . . . . . . . . . . . . . . . . . . . . . Outstanding & Unvested, December 31, 2014 . . . . . Number of Shares 119,100 65,000 (46,625) — 137,475 56,500 (50,350) (4,650) 138,975 44,575 (61,925) — 121,625 Available for grant, December 31, 2014 . . . . . . . . . 146,885 Weighted Average Period to Vest Aggregate Intrinsic Value(2) $1,083,810 $ 458,211 $1,477,856 $ 577,321 $2,041,543 $ 922,330 2.7 years $1,842,619 34 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 7. Stock-Based Awards − (continued) (2) The aggregate intrinsic value on this table was calculated based on the closing market price of the Company’s stock. The price at year end was $15.15, $14.69, $10.75, and $9.10 for the years ended December 31, 2014, 2013, 2012 and 2011, respectively. For value on the converted stock, the price used is the price on the grant date. Includes 9,879 shares in 2014, 13,362 shares in 2013, 9,619 shares in 2012, and 8,406 shares in 2011 withheld to cover income taxes. * As of December 31, 2014, a total of 404,560 shares of common stock were reserved for issuance under the various stock plans. As of December 31, 2014, the unamortized fair value of awards relating to SUAs was $1,057,142 to be amortized over a weighted average period of approximately 2.7 years. During 2014 and 2013, the total tax beneﬁt related stock compensation was $125 thousand and $44 thousand, respectively. 8. Employee Beneﬁt Plan The Psychemedics Corporation 401(k) Savings and Retirement Plan (the 401(k) Plan) is a qualiﬁed deﬁned contribution plan in accordance with Section 401(k) of the Internal Revenue Code. All employees over the age of 21 are eligible to make pre-tax contributions up to a speciﬁed percentage of their compensation. Under the 401(k) Plan, the Company may, but is not obligated to, match a portion of the employees’ contributions up to a deﬁned maximum. Matching contributions of $151,955, $141,661, and $147,360 were made in the years ended December 31, 2014, 2013 and 2012, respectively. 9. Commitments and Contingencies Commitments The Company leases certain of its facilities and equipment under operating lease agreements expiring on various dates through February 2018. Total minimum lease payments, including scheduled increases, are charged to operations on the straight-line basis over the life of the respective lease. Rent expense was approximately $908 thousand, $605 thousand and $555 thousand in 2014, 2013 and 2012, respectively. At December 31, 2014, minimum commitments remaining under lease agreements were approximately as follows: Years Ending December 31: 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amount (000’s) $ 999 537 227 31 $1,794 Contingencies The Company is subject to legal proceedings and claims, which arise in the ordinary course of its business. The Company believes that although there can be no assurance as to the disposition of these proceedings, 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. 10. Debt and Other Financing Arrangements On March 20, 2014, the Company entered into an equipment ﬁnancing arrangement with Banc of America Leasing & Capital, LLC (the ‘‘Lender’’), which it amended on August 8, 2014, including a Master Loan and Security Agreement and related documentation (collectively the ‘‘Equipment Loan Arrangement’’) which provided the Company with the ability to ﬁnance, at its option, up to $7.5 million of new and used 35 PSYCHEMEDICS CORPORATION NOTES TO FINANCIAL STATEMENTS December 31, 2014 10. Debt and Other Financing Arrangements − (continued) equipment purchases. Each such purchase ﬁnanced under the Equipment Loan Arrangement is documented by the execution of an equipment note. Each note has a maturity date of 60 months from the applicable loan date, and bears interest at the then current 30-day LIBOR rate + 2.00%. Principal and interest are payable over the 60-month repayment period and principal is repayable without premium or penalty. Borrowings under the Equipment Loan Arrangement are secured by a ﬁrst priority security interest in the equipment acquired with the proceeds of the equipment notes. Under the Equipment Loan Arrangement, the Company is subject to a maximum quarterly funded debt to EBITDA ratio and a minimum ﬁxed charge coverage ratio. The Company was in compliance with all loan covenants as of December 31, 2014. Under the Equipment Loan Arrangement, the Company executed notes on March 24, 2014, May 22, 2014, June 13, 2014 and August 8, 2014 in the amounts of $1,052,943, $1,935,241, $3,011,816 and $999,626, respectively, for total borrowings of $7.0 million, of which $752 thousand was repaid during 2014. The interest rate for these notes for the year ended December 31, 2014 was 2.15%, and represented $81,877 of interest expense. As of December 31, 2014, the interest rate was 2.16%. There was no long term debt for the same period in 2013. The annual principal repayment requirements for debt obligations as of December 31, 2014 are as follows: 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2018 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less current portion of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total long-term debt, net of current portion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,399,925 $ 1,399,925 $ 1,399,925 $ 1,399,925 $ 648,383 $ 6,248,083 $(1,399,925) $ 4,848,158 11. Selected Quarterly Financial Data (Unaudited) The following are selected quarterly ﬁnancial data for the years ended December 31, 2014 and 2013: Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross proﬁt Income from operations . . . . . . . . . . . . . . . . . . Net income and comprehensive income . . . . . . . . Basic net income per share . . . . . . . . . . . . . . . . Diluted net income per share . . . . . . . . . . . . . . . Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross proﬁt . . . . . . . . . . . . . . . . . . . . . . . . . . Income from operations . . . . . . . . . . . . . . . . . . Net income and comprehensive income . . . . . . . . Basic net income per share . . . . . . . . . . . . . . . . Diluted net income per share . . . . . . . . . . . . . . . Quarter Ended (000’s Except Share Amounts) March 31, 2014 $7,045 3,796 1,168 756 0.14 0.14 June 30, 2014 $7,694 3,891 1,320 857 0.16 0.16 September 30, 2014 $7,704 3,970 1,244 917 0.17 0.17 December 31, 2014 $6,762 3,482 958 676 0.13 0.13 Quarter Ended (000’s Except Share Amounts) March 31, 2013 $6,432 3,487 1,202 822 0.16 0.16 June 30, 2013 $6,899 4,079 1,732 1,063 0.20 0.20 September 30, 2013 $7,055 4,176 1,739 1,052 0.20 0.20 December 31, 2013 $6,484 3,652 1,033 868 0.16 0.16 36 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Disclosure Controls and Procedures The Company maintains disclosure controls and procedures (as deﬁned in Exchange Act Rules 13a-15(e) and 15d-15(e)) that are designed to ensure that information required to be disclosed in reports ﬁled with the SEC are recorded, processed, summarized and reported within the time period speciﬁed by the SEC’s rules and forms and that such information is accumulated and communicated to our management, including to our Chief Executive Officer and our Vice President — Finance, as appropriate, to allow for timely decisions regarding required disclosure. As required by Rule 13a-15 under the Exchange Act, the Company’s management, with the participation of the Company’s Chief Executive Officer and its Vice President — Finance, has evaluated the effectiveness of its disclosure controls and procedures as of December 31, 2014. Based on this evaluation, our Chief Executive Officer and Vice President — Finance concluded that the Company’s disclosure controls and procedures were effective for ensuring that information required to be disclosed by the Company in the reports that it ﬁles or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods speciﬁed in the SEC’s rules and forms, and that its disclosure controls and procedures were also effective to ensure that information required to be disclosed in the reports that it ﬁles or submits under the Exchange Act is accumulated and communicated to management, including the Company’s principal executive and ﬁnancial officers, to allow timely decisions regarding required disclosure. Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over ﬁnancial reporting that occurred during the Company’s last ﬁscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over ﬁnancial reporting. Management’s Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over ﬁnancial reporting (as deﬁned in Rules 13a-15(f) and 15d-15(f) under the Exchange Act). Under the supervision and with the participation of management, including our Chief Executive Officer and Vice President — Finance, the Company conducted an evaluation of the effectiveness of our internal control over ﬁnancial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 1992. Based on the Company’s evaluation under the framework in Internal Control — Integrated Framework, the Company’s management concluded that our internal control over ﬁnancial reporting was effective as of December 31, 2014. This annual report does not include an attestation report of our independent registered public accounting ﬁrm regarding internal control over ﬁnancial reporting. Management’s report was not subject to attestation by our registered public accounting ﬁrm pursuant to rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report. Inherent Limitations on Effectiveness of Controls The Company’s management, including its Chief Executive Officer and its Vice President, Finance, does not expect that the Company’s disclosure controls and procedures or the Company’s internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives for the control system are met. Further, the design of a control system must reﬂect the fact that there are resource constraints, and the beneﬁts of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues, misstatements, errors and instances of fraud, if any, within our company have been or will be prevented or detected. Further, internal controls may become inadequate as a result of changes in conditions, or through the deteriorations of the degree of compliance with policies or procedures. Item 9B. Other Information None 37 PART III Item 10. Directors, Executive Officers and Corporate Governance Following is a list that sets forth as of February 27, 2015 the names, ages and positions within the Company of all of the Executive Officers of the Company and the Directors of the Company. Each such director has been nominated for reelection at the Company’s 2015 Annual Meeting, to be held on April 29, 2015 at 2:00 P.M. at the The Seaport Hotel, 200 Seaport Boulevard, Boston, Massachusetts. Name Raymond C. Kubacki Neil Lerner James Dyke Michael I. Schaffer, Ph.D. Harry Connick Walter S. Tomenson, Jr. Fred J. Weinert Age 70 47 50 70 89 68 67 Position Chairman, Chief Executive Officer, President, Director Vice President, Finance Corporate Vice President, Sales & Marketing Vice President, Laboratory Operations Director, Audit Committee member, Compensation Committee Member, Nominating Committee member Director, Audit Committee member, Compensation Committee Member, Nominating Committee member Director, Audit Committee member, Compensation Committee Member, Nominating Committee member All Directors hold office until the next annual meeting of stockholders or until their successors are elected. Officers serve at the discretion of the Board of Directors. Mr. Kubacki has been the Company’s President and Chief Executive Officer since 1991. He has also served as Chairman of the Board of the Company since 2003. He is a director of Integrated Environmental Technologies, LTD. From 2007 until 2012, he served as a director of Protection One, Inc. and from 2004 to 2007 he served as a director of Integrated Alarm Services Group, Inc. He is also a trustee of the Center for Excellence in Education based in Washington, D.C. and holds an Executive Masters Professional Director Certiﬁcation, their highest level award, from the American College of Corporate Directors, a public company director education and credentialing organization. Mr. Kubacki has been a director of the Company since 1991. Mr. Lerner has served as Vice President, Finance and Treasurer since May 2011. From October 2010 until May 2011, he served as Vice President, Controller. Prior to joining the Company, he served as Director of Operational Accounting at Beacon Rooﬁng Supply, Inc., Corporate Controller with Atlas TMS, Divisional Controller with Mastec, Inc, and multiple roles with Johnson & Johnson, including plant controller in the Netherlands. Mr. Lerner is a Certiﬁed Public Accountant and has a Masters degree in International Management. Mr. Dyke joined the Company as Corporate Vice President, Sales and Marketing in 2010. Prior to joining the Company, he worked as a Strategic Sales Consultant and held a variety of Vice President of Sales/Sales & Marketing and General Management positions with Pitney Bowes Inc. in Canada, the United Kingdom and United States. Dr. Schaffer has served as Vice President of Laboratory Operations since 1999. From 1990 to 1999, he served as Director of Toxicology, Technical Manager and Responsible Person for the Leesburg, Florida laboratory of SmithKline Beecham Clinical Laboratories. From 1990 to 1999, he was also a member of the Board of Directors of the American Board of Forensic Toxicologists. Dr. Schaffer has been an inspector for the Substance Abuse and Mental Health Services Administration’s National Laboratory Certiﬁcation Program since 1989. 38 Mr. Connick served as District Attorney for Orleans Parish (New Orleans, LA) from 1974 to 2003. In 2002, Mr. Connick received from Drug Czar, John P. Walters, the Director’s Award for Distinguished Service in recognition of exemplary accomplishment and distinguished service in the ﬁght against illegal drugs. Mr. Connick has been a director of the Company since 2003. Mr. Tomenson was a founding partner of Integro Ltd. He retired from the ﬁrm in 2012. Prior to joining Integro, Mr. Tomenson was Managing Director and Chairman of Global Client Development at Marsh, Inc. from 1998 until 2004. From 1993 to 1998, he was Chairman of FINPRO, the ﬁnancial services division of Marsh, Inc. Mr. Tomenson is a director of the Trinity College School Fund, Inc. He also serves on the Board of Trustees of the Inner-City Scholarship Fund in New York City. In addition, he is the Vice-Chairman of the Foundation Board of Directors of the Achievement Centers for Children and Families in Delray Beach, Florida. Mr. Tomenson holds an Executive Masters Professional Director Certiﬁcation, their highest level award, from the American College of Corporate Directors, a public company director education and credentialing organization. As a result of these and other professional experiences, Mr. Tomenson possesses particular knowledge and experience in marketing and distribution and human resources that strengthen the Board’s collective qualiﬁcations, skills and experience. Mr. Tomenson has been a director of the Company since 1999. Mr. Weinert is an entrepreneur whose current activities are concentrated in commercial real estate, new business development and environmental consulting. He has served on the Business Advisory Council for the University of Dayton for over 20 years. From 1973 until 1989, Mr. Weinert held various executive positions in the Finance and Operations groups of Waste Management, Inc. and its subsidiaries, including 6 years as the President of Waste Management International, Inc. Mr. Weinert has been a director of the Company since 1991. The information required by Item 405 of Regulation S-K will be set forth in the Proxy Statement of the Company relating to the 2015 Annual Meeting of Stockholders to be held on April 29, 2015 and is incorporated herein by reference. The Company has a code of ethics that applies to all employees and non-employee directors. This code satisﬁes the requirements set forth in Item 406 of Regulation S-K and applies to all relevant persons set forth therein. The Company will mail to interested parties a copy of the Code of Ethics upon written request and without charge. Such request shall be made to our General Counsel, 125 Nagog Park, Acton, Massachusetts 01720. The information required by Item 407 of Regulation S-K will be set forth in the Proxy Statement of the Company relating to the 2015 Annual Meeting of Stockholders to be held on April 29, 2015 and is incorporated herein by reference. Item 11. Executive Compensation The information required by this item will be set forth in the Proxy Statement of the Company relating to the 2015 Annual Meeting of Stockholders to be held on April 29, 2015 and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneﬁcial Owners and Management and Related Stockholder Matters The information required by this item will be set forth in the Proxy Statement of the Company relating to the 2015 Annual Meeting of Stockholders to be held on April 29, 2015 and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions and Director Independence The information required by this item will be set forth in the Proxy Statement of the Company relating to the 2015 Annual Meeting of Stockholders to be held on April 29, 2015 and is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this item will be set forth in the Proxy Statement of the Company relating to the 2015 Annual Meeting of Stockholders to be held on April 29, 2015 and is incorporated herein by reference. 39 Item 15. Exhibits, Financial Statement Schedules PART IV (a) (1) Financial Statements required by Item 15 are included and indexed in Part II, Item 8. (a) (2) Financial Statement Schedules included in Part IV of this report. Schedule II is omitted because information is included in Notes to Financial Statements. All other schedules under the accounting regulations of the SEC are not required under the related instructions and are inapplicable and, thus have been omitted. (a) (3) See ‘‘Exhibit Index’’ included elsewhere in this Report. 40 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 27, 2015 By: /s/ RAYMOND C. KUBACKI PSYCHEMEDICS CORPORATION Raymond C. Kubacki Chairman, President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ RAYMOND C. KUBACKI Raymond C. Kubacki /s/ NEIL LERNER Neil Lerner /s/ HARRY CONNICK* Harry Connick /s/ WALTER S. TOMENSON, JR* Walter S. Tomenson, Jr. /s/ FRED J. WEINERT* Fred J. Weinert * By: /s/ RAYMOND C. KUBACKI Raymond C. Kubacki Chairman, President and Chief Executive Officer, Director (Principal Executive Officer) Vice President, Finance (Principal Financial and Accounting Officer) February 27, 2015 February 27, 2015 Director Director Director Attorney-in-Fact February 27, 2015 41 Exhibit Number 3.1 3.2 4.1 10.2.1 10.2.2 10.2.3 10.2.4 10.2.5 10.2.6 10.2.7 10.3* 10.4* 10.5* 10.6* 10.7* 10.8* 10.9* EXHIBIT INDEX Description Amended and Restated Certiﬁcate of Incorporation ﬁled on August 1, 2002 — (Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended September 30, 2002). By-Laws of the Company — (Incorporated by reference from the Registrant’s Annual Report on Form 10-K for the ﬁscal year ended December 31, 2001). Specimen Stock Certiﬁcate — (Incorporated by reference from the Registrant’s Registration Statement on Form 8-A ﬁled on July 31, 2002). Lease dated October 6, 1992 with Mitchell H. Hersch, et. al with respect to premises in Culver City, California — (Incorporated by reference from the Registrant’s Annual Report on Form 10-KSB for the ﬁscal year ended December 31, 1992). Security Agreement dated October 6, 1992 with Mitchell H. Hersch et. al — (Incorporated by reference from the Registrant’s Annual Report on Form 10-KSB for the ﬁscal year ended December 31, 1992). First Amendment to Lease dated with Mitchell H. Hersch, et.al California — (Incorporated by reference from the Registrant’s Annual Report on Form 10-K for the ﬁscal year ended December 31, 1997). Second Amendment to Lease dated with Mitchell H. Hersch, et.al. California — (Incorporated by reference from the Registrant’s Annual Report on Form 10-K for the ﬁscal year ended December 31, 1997). Third Amendment to Lease dated December 31, 1997 with Mitchell H. Hersch, et.al. California — (Incorporated by reference from the Registrant’s Annual Report on Form 10-K for the ﬁscal year ended December 31, 1997). Fourth Amendment to Lease dated May 24, 2005 with Mitchell H. Hersch, et.al. California — (Incorporated by reference from the Registrant’s Annual Report on Form 10-K for the ﬁscal year ended December 31, 2005). Fifth Amendment to Lease dated November 22, 2011 with Mitchell H. Hersch, et.al. California 2000 Stock Option Plan, — (Incorporated by reference from the Registrant’s Quarterly Report on Form 10-Q for the Quarter ended September 30, 2002). 2006 Incentive Plan, as amended — (Incorporated by reference from the Registrant’s Current Report on Form 8-K ﬁled on May 26, 2011). Form of Stock Unit Award used with employees and consultants under the 2006 Incentive Plan — (Incorporated by reference from the Registrant’s Current Report on Form 8-K ﬁled on May 26, 2011). Form of Stock Unit Award used with non-employee directors under the 2006 Equity Incentive Plan — (Incorporated by reference from the Registrant’s Current Report on Form 8-K ﬁled on May 26, 2011). Change in control severance agreement with Ray Kubacki dated March 2013. (Incorporated by reference from the Registrant’s Current Report on Form 8-K ﬁled March 8, 2013). Change in control severance agreement with Michael Schaffer dated March 2013. (Incorporated by reference from the Registrant’s Current Report on Form 8-K ﬁled March 8, 2013). Employment offer letter dated April 7, 2010 with James V. Dyke (incorporated by reference from Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010) 42 Exhibit Number 10.10* 10.11* 10.12 10.13 23.1 24 31.1 31.2 32.1 32.2 Description Change in Control Severance Agreement with James V. Dyke dated April 7,2010 (Incorporated by reference from Registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2010) Employment offer letter dated October 25, 2010 with Neil Lerner (incorporated by reference from Registrant’s Quarterly Report on Form 10-Q for the year ended December 31, 2010) Lease dated March 12, 2014 with Bristol-Culver Associates, LLC and Mountain Organic Farms, LLC with respect to 6100 Bristol parkway premises in Culver City, CA — (Incorporated by reference from the Quarterly Report on Form 10-Q for the quarter ended March 31, 2014) Loan agreement dated March 20, 2014 with Banc of America Leasing and Capital, LLC — (Incorporated by reference from the Quarterly Report on Form 10-Q for the quarter ended March 31, 2014) Consent of BDO USA, LLP, Independent Registered Public Accounting Firm Power of Attorney Certiﬁcation of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Certiﬁcation of Vice President — Finance Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 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 Certiﬁcation of Vice President — Finance Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 * Management compensation plan or arrangement 43

Continue reading text version or see original annual report in PDF format above