FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
                    Washington, D.C. 20549                    

(Mark One)

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

For the quarterly period ended September 30, 2003

OR

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

For the transition period                           to                          

Commission file number 1-11394

                         MEDTOX SCIENTIFIC, INC.                         
(Exact name of registrant as specified in its charter)

Registrant's telephone number including area code:                                    (651) 636-7466

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes       X       No           

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes            No       X     

The number of shares of Common Stock, $.15 par value, outstanding as of October 31, 2003, was 4,983,970.

MEDTOX SCIENTIFIC, INC.

INDEX

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PART I     FINANCIAL INFORMATION
Item 1:      FINANCIAL STATEMENTS (UNAUDITED)

MEDTOX SCIENTIFIC, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share data)
(Unaudited)

See Notes to Consolidated Financial Statements (Unaudited).

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MEDTOX SCIENTIFIC, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
(Unaudited)

See Notes to Consolidated Financial Statements (Unaudited).

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MEDTOX SCIENTIFIC, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

See Notes to Consolidated Financial Statements (Unaudited).

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MEDTOX SCIENTIFIC, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2003

1.     BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of MEDTOX Scientific, Inc. (the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation of financial condition and results of operations have been included. Operating results for the nine-month period ended September 30, 2003 are not necessarily indicative of the results that may be attained for the entire year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Stock-Based Compensation — Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” requires companies to measure employee stock compensation plans and non-employee stock-based compensation based on the fair value method of accounting. However, for stock compensation granted to employees, SFAS No. 123 allows the alternative of continued use of Accounting Principles Board Opinion (APBO) No. 25, “Accounting for Stock Issued to Employees,” with pro forma disclosure of net income and earnings per share determined as if the fair value method had been applied in measuring compensation cost. The Company elected the continued use of APBO No. 25.

Had the Company determined compensation expense based on the fair value at the grant date for its stock options under SFAS No. 123, (as amended by SFAS No.148), the Company’s net income (loss) and earnings (loss) per share would have been changed to the pro forma amounts indicated below:

(In thousands, except per share data)

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New Accounting Standards: In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities.”  FIN 46 addresses consolidation by business enterprises of variable interest entities and significantly changes the consolidation application of consolidation policies to variable interest entities and, thus improves comparability between enterprises engaged in similar activities when those activities are conducted through variable interest entities. The Company does not hold an interest in any variable interest entities.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 was effective for certain contracts entered into or modified by the Company after June 30, 2003. The Company adopted SFAS No. 149 effective July 1, 2003 with no material impact on its results of operations or financial position.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity.  SFAS No. 150 was effective immediately for all financial instruments entered into or modified after May 31, 2003. For all other instruments, SFAS No. 150 was effective at the beginning of the third quarter of 2003. The Company adopted SFAS No. 150 effective July 1, 2003 with no material impact on its results of operations or financial position.

2. SEGMENTS

The Company has two reportable segments: Laboratory Services and Product Sales. The Laboratory Services segment consists of MEDTOX Laboratories Inc. and New Brighton Business Center, LLC. Services provided include forensic toxicology (primarily workplace drugs of abuse testing) and specialty services, which include clinical toxicology, clinical testing for the pharmaceutical industry, pediatric lead testing, heavy metals analyses, courier delivery, and medical surveillance. The Product Sales segment, which includes POC (point of care) disposable diagnostics devices, consists of MEDTOX Diagnostics Inc. Products manufactured include easy to use, inexpensive, on-site drug tests such as PROFILE®-II, PROFILE®-II ER, and VERDICT®-II in addition to a variety of agricultural testing products. MEDTOX Diagnostics Inc. also provides contract manufacturing services in its FDA/GMP facility.

The Company’s reportable segments are strategic business units that offer different products and services. They are managed separately, as each business requires different products, services and marketing strategies.

In evaluating financial performance, management focuses on income (loss) before income taxes as a segment’s measure of profit or loss.

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(In thousands)

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The following is a summary of revenues from external customers for each group of services provided within the Laboratory Services segment:
(In thousands)

The following is a summary of revenues from external customers for each group of products and services provided within the Product Sales segment:
(In thousands)

3. ACQUISITION

On July 1, 2003, the Company completed the acquisition of the forensic drug testing customer list from Cox Toxicology, a full-service, SAMHSA-certified drug testing laboratory and a division of CoxHealth. The purchase price of the transaction is based on varying percentages of the revenue realized from the transitioned business over the next three years. During this period, the Company estimates that revenue from these accounts will total approximately $1.2 million and that the sum of the payments for the acquisition should not exceed 25% of this total. As part of the agreement, the Company paid $50,000 as an initial payment at closing. Per the terms of the agreement, as 50% of the revenue realized from the transitioned business during the third quarter did not exceed the $50,000 initial payment, no other payments were required. The $50,000 initial payment was recorded as a customer list asset and is being amortized on a straight-line basis over a five-year period. Pro forma results related to the Cox Toxicology customer list acquisition are not material to the financial condition or results of operations of the Company.

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4. INVENTORIES

Inventories consisted of the following:
(In thousands)

5.     EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted earnings per common share:
(Dollars in thousands, except per share amounts)

Options and warrants to purchase 1,351,678, 1,705,763, 978,359 and 915,565 shares of common stock were outstanding during the three and nine months ended September 30, 2003 and 2002, respectively, but were not included in the computation of diluted earnings per share as their exercise prices were greater than the average market price of the common shares, or because they were antidilutive in the nine months ended September 30, 2003 due to a net loss.

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6.     INCOME TAXES

At September 30, 2003, the Company had federal and state net operating loss carryforwards (NOLs) of approximately $28.7 and $10.5 million, respectively, which are available to offset taxable income through 2020. For financial reporting purposes, a valuation allowance has been recorded to offset deferred tax assets that, more likely than not, will not be realized based on the Company’s projected future taxable income, the timing of expiring NOLs, and the Company’s tax planning strategies. Section 382 of the Internal Revenue Code restricts the annual utilization of certain NOLs incurred prior to a change in ownership. Although the Section 382 limitation is currently not expected to impair the realization of these NOLs, other factors could, such as projected future taxable income, the timing of expiring NOLs, and the Company’s tax planning strategies.

In the third quarter of 2002, the Company recorded a $10.8 million income tax benefit and reduced its valuation allowance on deferred tax assets.  The reduction in the valuation allowance at that time was based on the available evidence, including the Company’s historical performance, tax planning strategies, and projected future results.  The valuation allowance at December 31, 2002 of $1.4 million represented the portion of the net operating loss (NOL) carryforwards that were expected to expire unused in 2003 and future years.   Should operating results for the remainder of 2003 and possibly 2004 fail to meet expectations, the valuation allowance against the Company’s NOL carryforwards and the related deferred tax asset may require adjustment in future periods.

7.     RELATED PARTY TRANSACTIONS

In March 2001, the Company entered into a 10-year lease of the Burlington, North Carolina production facility for an annual base rent of $197,000, exclusive of operating expenses. This facility has always been owned and leased to the Company by Samuel Powell, a director of the Company. The Company believes it is renting this facility on terms similar to those available from third parties for equivalent premises.

In February 2003, the Company entered into a month-to-month lease for a warehousing and distribution facility in Burlington, North Carolina. The monthly base rent for the facility is $9,400 exclusive of operating expenses. It is the intent that the month-to-month lease shall be converted to a long-term lease within the next several months. This facility is owned and leased to the Company by Samuel Powell, a director of the Company. The Company believes it is renting this facility on terms similar to those available from third parties for equivalent premises.

8.     COMMITMENTS AND CONTINGENCIES

Leases — The Company leases other offices and facilities and office equipment under certain operating leases, which expire on various dates through April 2011. Under the terms of the facility leases, a pro rata share of operating expenses and real estate taxes are charged as additional rent.

Legal — The Company is party to various legal proceedings arising in the normal course of business activities, none of which, in the opinion of management, are expected to have a material adverse impact on the Company’s consolidated financial position or results of operations.

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Item 2:     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT IDENTIFYING IMPORTANT FACTORS
THAT COULD CAUSE THE COMPANY’S ACTUAL RESULTS TO DIFFER
FROM THOSE PROJECTED IN FORWARD LOOKING STATEMENTS

In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, readers of this document and any document incorporated by reference herein, are advised that this document and documents incorporated by reference into this document contain both statements of historical facts and forward looking statements. Forward looking statements are subject to certain risks and uncertainties, which could cause actual results to differ materially from those indicated by the forward looking statements. Examples of forward looking statements include, but are not limited to (i) projections of revenues, income or loss, earnings or loss per share, capital expenditures, dividends, capital structure and other financial items, (ii) statements of the plans and objectives of the Company or its management or Board of Directors, including the introduction of new products, or estimates or predictions of actions by customers, suppliers, competitors or regulatory authorities, (iii) statements of future economic performance, and (iv) statements of assumptions underlying other statements and statements about the Company or its business.

This document and any documents incorporated by reference herein also identify important factors which could cause actual results to differ materially from those indicated by the forward looking statements. The factors that could affect our actual results include the following:

    o        increased competition, including price competition

    o        general economic and business conditions, both nationally and internationally

    o        changes in business strategy or development plans

    o        technological, evolving industry standards, or other problems that could delay the sale of our products

    o        risks and uncertainties with respect to our patents and proprietary rights including:

        o         lack of meaningful protection from claims of any patents issued to the Company

        o         other companies challenging our patents

        o         patents issued to other companies that may harm our ability to do business

        o         other companies designing around technologies we have developed

        o         our inability to obtain appropriate licenses from third parties

        o         our inability to protect our trade secrets

        o         risk of infringement upon the proprietary rights of others

        o         our inability to prevent others from infringing on our proprietary rights

    o        our inability to obtain sufficient financing to continue to expand operations

    o        changes in demand for products and services by our customers

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    o        our failure to obtain and retain new customers and alliance partners, or a reduction in tests ordered
              or specimens submitted by existing customers

    o        adverse results in litigation matters

    o        our ability to attract and retain experienced and qualified personnel

    o        failure to maintain our days sales outstanding levels

    o        losses due to bad debt

The cautionary statements made pursuant to the Private Litigation Securities Reform Act of 1995 above and elsewhere by the Company should not be construed as exhaustive or as any admission regarding the adequacy of disclosures made by the Company prior to the effective date of such Act. Forward looking statements are beyond the ability of the Company to control, and in many cases the Company cannot predict what factors would cause results to differ materially from those indicated by the forward looking statements.

General

MEDTOX Scientific, Inc. (formerly EDITEK, Inc.), a Delaware corporation, was organized in September 1986. MEDTOX Scientific, Inc. and its subsidiaries, MEDTOX Laboratories, Inc., MEDTOX Diagnostics, Inc., and New Brighton Business Center, LLC are referred to herein as “the Company.” The Company is engaged primarily in two distinct, but very much related businesses. The business of forensic and clinical laboratory services is conducted by MEDTOX Laboratories, Inc. at its facility in St. Paul, Minnesota, and the business of manufacturing and distribution of diagnostic devices is executed by MEDTOX Diagnostics, Inc. from its facility in Burlington, North Carolina.

The Company has two reportable segments: “Laboratory Services” conducted by the Company’s wholly owned subsidiaries, MEDTOX Laboratories, Inc. and New Brighton Business Center, LLC and “Products Sales” conducted by the Company’s wholly owned subsidiary MEDTOX Diagnostics, Inc. Laboratory Services include forensic toxicology (primarily workplace drugs of abuse testing) and specialty laboratory services, including clinical toxicology, clinical testing for the pharmaceutical industry (central laboratory services, bioanalytical and pharmacokinetic testing), and analysis of heavy and trace metals. In addition, the Laboratory Services segment provides logistical support, data management and overall program management services. Product Sales include sales of a variety of on-site screening products and contract manufacturing. For financial information relating to the Company’s segments, see Note 2 of Notes to the Consolidated Financial Statements. For the three and nine months ended September 30, 2003, Laboratory Services revenue accounted for 76.6% of the Company’s revenues, compared with 77.5% and 76.3%, for the same periods in 2002. Revenue from Product Sales accounted for 23.4% of the total revenues of the Company for the three and nine months ended September 30, 2003, compared with 22.5% and 23.7% for the same periods in 2002.

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Critical Accounting Policies

The Company has identified the policies outlined below as critical to understanding its business and results of operations. The listing is not intended to be a comprehensive list of all accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by accounting principles generally accepted in the United States of America, with no need for management’s judgment in their application. The impact and any associated risks related to these policies on the Company’s business operations is discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 in the Notes to the Consolidated Financial Statements in Item 15 on Form 10-K for the year ended December 31, 2002. Note that the preparation of this Form 10-Q requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. There can be no assurance that actual results will not differ from those estimates.

The Company’s critical accounting policies are as follows:

Accounts Receivable:
The Company performs ongoing credit evaluations of its customers and adjusts credit limits based upon payment history and the customers’ current credit worthiness, as determined by management’s review of their current credit information. The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses based upon the Company’s historical experience and any specific customer collection issues that have been identified. While such credit losses have generally been within the Company’s historical expectations and the provisions established, the Company cannot guarantee that it will continue to experience the same credit loss rates that have occurred in the past. The Company’s consolidated trade accounts receivable balance as of September 30, 2003 was $8.9 million, net of allowance for doubtful accounts of $0.6 million.

Some of the Company’s laboratory services revenues for certain types of tests are billed to third-party payors including insurance companies, state Medicaid and Medicare agencies. These payors pay for such services at established amounts, which are typically lower than gross amounts billed by the Company. However, the tests are sometimes billed directly to patients or other parties and paid at the gross amount billed for these tests. In addition, billings for the tests are occasionally re-billed to alternative payors in situations where incorrect billing information was submitted to the Company by the customer. The Company estimates an aggregate discount on the billings for these tests, and recognizes revenue and related accounts receivable at a net amount after discount in order to state revenue and accounts receivable at the amount expected to be paid. While the Company believes that estimated discounts and the related net revenue and net accounts receivable from these testing services are materially correct, there can be differences in amounts ultimately paid compared to estimated amounts. These differences are recorded upon payment and may affect previously recorded amounts. The Company considers historical discounts when estimating future discounts on a quarterly basis.

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Off-Site Supplies Inventory:
Off-site supplies represent collection kits and forms located at collections sites throughout the United States used by Laboratory Services’ customers to submit specimens for testing services. At September 30, 2003, off-site inventory was $0.6 million. The process for valuing off-site inventory involves significant assumptions regarding the average time that a collection site uses the inventory, as well as the amount of inventory expected to be scrapped.

Goodwill and Other Intangible Assets:
Effective January 1, 2002, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets”. SFAS No. 142 requires that goodwill and other intangible assets be tested for impairment within six months of adoption of SFAS No. 142 and then on a periodic basis thereafter. During the first half of 2002, the Company completed impairment testing and determined that there were no impairment losses related to goodwill and other intangible assets. In the fourth quarter of 2002, the Company updated its impairment testing and determined that there was no impairment. In assessing the recoverability of goodwill and other intangible assets, projections regarding estimated future cash flows and other factors are made to determine the fair value of the respective assets. If these estimates or related projections change in the future, the Company may be required to record impairment charges for these assets. During the nine months ended September 30, 2003, no circumstances occurred that required an impairment charge.

Accounting for Income Taxes:
As part of the process of preparing the consolidated financial statements, the Company is required to estimate income taxes in each of the jurisdictions in which it operates. This process involves estimating actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities. The Company must then assess the likelihood that deferred tax assets will be recovered from future taxable income and tax planning strategies, and to the extent management believes that recovery is not likely, the Company must establish a valuation allowance. To the extent the Company increases or decreases the valuation allowance in a period, the Company must include an expense or benefit within the tax provision in the consolidated statement of operations.

Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and any valuation allowance recorded against net deferred tax assets. The Company’s deferred tax assets primarily consist of certain net operating losses (NOLs) carried forward. The valuation allowance is based on management’s estimate of taxable income, the period over which NOLs will be recoverable, and tax planning strategies. In the future, subsequent revisions to the estimated net realizable value of these deferred tax assets could cause the provision for income taxes to vary significantly from period to period, although the Company’s cash payments would remain unaffected until the benefit of the NOL is completely utilized or expires unused.

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Results of Operations

Total revenues for the third quarter of 2003 were essentially flat with the third quarter of 2002. Gross margin improved over the third quarter of 2002, reflecting improvement in Laboratory Services gross margin. Operating expenses as a percentage of sales were slightly higher in the third quarter of 2003, reflecting the continued investment in research and development. Other expense was also higher than last year due to reduced rental income from the Company’s building rental activities. In the third quarter of last year, the Company recorded a $10.8 million non-cash tax benefit as part of net income. The following table sets forth the percentages of total revenues represented by certain items reflected in the Company’s Consolidated Statements of Operations:

Three Months Ended September 30, 2003 Compared to Three Months Ended September 30, 2002

Revenues

Revenues of $13.6 million for the three months ended September 30, 2003 were flat with the third quarter of 2002. Although Laboratory Services revenues declined 2%, this impact was mitigated by a 3% improvement in Product Sales revenues.

Laboratory Services revenues were impacted by a decline in the average price per testing specimen for workplace drugs of abuse testing. The lower pricing was aimed at attracting new business to offset the impact of the reduced specimen volume from existing workplace drug testing clients experienced in the first two quarters of 2003. In the third quarter, specimen volume from the Company’s occupational health and corporate clients increased 5%, reflecting the Company’s continued success in acquiring new client relationships and gaining market share, despite the continued softness in new business employment. In addition, revenues from the Company’s specialty laboratory services increased 2% in the quarter.

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In the Product Sales segment, sales of substance abuse testing products, which incorporates the PROFILE®-II, PROFILE®-II ER, PROFILE®-II A and VERDICT®-II on-site test kits and other ancillary products for the detection of abused substances, increased 3% to $2.7 million in the third quarter of 2003. The improvement was driven by strong sales of the PROFILE®-II ER device, an on-site, nine drugs-of-abuse panel, targeted at hospital laboratories for emergency response screening in drugs-of-abuse overdose situations. Sales of PROFILE®-II devices to existing workplace and occupational clients were down from last year and continue to be impacted by the reduction in nationwide hiring; additionally, some customers are alternatively purchasing the PROFILE®-II A device, which screens for the same five drugs of abuse, but also includes a patented lateral flow test strip to screen for the five most common adulterants. Sales within the VERDICT®-II product line to government clients for probation, parole and rehabilitation continue to trend slightly below last year. The economic uncertainty and budget constraints that the Company’s government clients are experiencing resulted in lower purchasing levels among these clients. The Company anticipates that the government sector will continue to be a challenging environment, and will continue to pursue new sales efforts that the Company believes will improve this portion of its business going forward. Principally, during the second quarter, the Company introduced a proprietary value added service called DARS™ (drug abuse recognition system) that it believes will increase sales in the government market place.

Product sales from agricultural diagnostic products were flat due to level purchases from the U.S. Department of Agriculture (USDA) for the Company’s products. The USDA’s needs for the Company’s products vary from year-to-year and sales to the USDA are expected to fluctuate accordingly. Sales of contract manufacturing services, microbiological and associated products increased 13% to $0.4 million and were positively impacted by the timing of orders from existing clients.

Gross Profit

Consolidated gross margin increased to 40.2% of revenues for the three months ended September 30, 2003, compared to 39.2% of revenues for the same period in 2002, reflecting improvement in Laboratory Services gross margin, partially offset by a decline in Product Sales gross margin.

Laboratory Services gross margin was 34.5% of revenues for the three months ended September 30, 2003, up from 32.7% of revenues for the same period in 2002. The margin improvement was a result of labor savings due to staffing reductions, partially offset by a decline in the average price per testing specimen. Gross margin from Product Sales declined to 59.0% of revenues for the three months ended September 30, 2003, from 61.6% of revenues in the comparable period of 2002. The lower gross margin was impacted by unabsorbed overhead resulting from lower than anticipated production activity.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $4.2 million, or 30.6% of revenues in the third quarter of 2003, compared to $4.1 million or 30.4% of revenues in the third quarter of 2002. During the first and second quarters of 2003, selling, general and administrative expenses were 34.2% and 33.9% of sales, respectively. The improvement during the third quarter of 2003 reflects savings from steps taken during the second quarter to reduce expenses, including staffing reductions. In the third quarter of 2003, the Company also initiated three significant LEAN projects with the objective of further reducing expenses in the Laboratory Services segment.

Research and Development Expense

Research and development expenses were $0.4 million, or 3.0% of revenues in the third quarter of 2003, compared to $0.3 million, or 2.4% of revenues in the third quarter of 2002. The increase was primarily due to increased development activity associated with new product configurations and assays and other new product research in the Product Sales segment, which is expected to continue through the remainder of 2003.

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Other Income and Expense

Other income and expense consists primarily of interest expense and the net expenses associated with the Company’s building rental activities. These expenses increased 17% to $0.4 million in the third quarter of 2003. The increase was primarily due to reduced rental income as a result of higher vacancy rates. While the Company is actively seeking additional tenants for the building, there can be no assurance it will be able to lower overall vacancy rates during the remainder of 2003. This increase was partially offset by a reduction in interest expense due to lower interest rates.

Income Before Income Taxes

During the three months ended September 30, 2003, the Company recorded pre-tax income of $0.5 million, consistent with the prior year period.

Laboratory Services income of $0.2 million for the three months ended September 30, 2003 was flat with the prior year period. Although gross margin increased, this improvement was offset by a slight reduction in revenues and higher net expenses associated with the Company’s building rental activities.

Product Sales income of $0.3 million for the three months ended September 30, 2003 was also consistent with the prior year period. The increase in revenues was offset by a decrease in gross margin and higher research and development expenses.

Income Taxes

In the third quarter of 2002, the Company recorded a $10.8 million income tax benefit and reduced its valuation allowance on deferred tax assets.  The reduction in the valuation allowance at that time was based on the available evidence, including the Company’s historical performance, tax planning strategies, and projected future results.  The valuation allowance at December 31, 2002 of $1.4 million represented the portion of the net operating loss (NOL) carryforwards that were expected to expire unused in 2003 and future years.  The Company recorded a provision for income taxes for the three months ended September 30, 2003 that reflects the anticipated effective rate for the full year. Should operating results for the remainder of 2003 and possibly 2004 fail to meet expectations, the valuation allowance against the Company’s NOL carryforwards and the related deferred tax asset may require adjustment in future periods.

Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002

Revenues decreased 2% to $39.2 million for the nine months ended September 30, 2003, reflecting a $0.4 million decline in Laboratory Services revenue and a $0.3 million decrease in Product Sales revenues.

Laboratory Services revenues were impacted by a decline in the average price per testing specimen for workplace drugs of abuse testing. The lower pricing is part of the Company’s strategy to attract new business to offset the impact of the reduced specimen volume experienced in the first half of 2003. For the nine months ended September 30, 2003, specimen volume from the Company’s occupational health and corporate clients was up 2% from the prior year period, reflecting the Company’s continued success in acquiring new client relationships and gaining market share, despite the continued softness in new business employment. Revenues from the Company’s Specialty Laboratory Services increased 6% for the nine months ended September 30, 2003.

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In the Product Sales segment, sales of substance abuse testing products, which incorporates the PROFILE®-II, PROFILE®-II ER, PROFILE®-II A and VERDICT®-II on-site test kits and other ancillary products for the detection of abused substances, declined 5% to $7.8 million in the first nine months of 2003. The decline is primarily attributable to lower sales within the VERDICT®-II product line to government clients for probation, parole and rehabilitation. The economic uncertainty and budget constraints that the Company’s government clients are experiencing resulted in lower purchasing levels among these clients. The Company anticipates that the government sector will continue to be a challenging environment, and will continue to pursue new sales efforts that the Company believes will improve this portion of its business going forward. Principally, during the second quarter, the Company introduced a proprietary value added service called DARS™ (drug abuse recognition system) that it believes will increase sales in the government market place. Sales of PROFILE®-II devices to existing workplace and occupational clients were also down from last year and continue to be impacted by the reduction in nationwide hiring; additionally, some customers are alternatively purchasing the PROFILE®-II A device, which screens for the same five drugs of abuse, but also includes a patented lateral flow test strip to screen for the five most common adulterants. Sales of the PROFILE®-II A have increased 82% over the same period last year.

Product sales from agricultural diagnostic products increased 16% to $0.3 million primarily as a result of increased purchases from the U.S. Department of Agriculture (USDA) for the Company’s products. Sales of contract manufacturing services, microbiological and associated products increased 8% to $1.1 million and were positively impacted by the timing of orders from existing clients in the second and third quarters of 2003.

Gross Profit

Consolidated gross margin declined to 38.9% of revenues for the nine months ended September 30, 2003, compared to 40.5% of revenues for the same period in 2002, reflecting declines in both Laboratory Services and Product Sales gross margin.

Laboratory Services gross margin was 33.3% of revenues for the nine months ended September 30, 2003, down from 33.7% of revenues for the same period in 2002. The margin shortfall was primarily attributable to the impact of the high fixed costs nature of workplace drugs of abuse testing combined with a decline in the average price per testing specimen. This impact was partially offset by labor savings associated with staffing reductions. Gross margin from Product Sales declined to 57.3% of revenues for the nine months ended September 30, 2003, from 62.6% of revenues in the comparable period of 2002. The lower gross margin was primarily the result of the impact of fixed type costs on lower production levels associated with the decline in sales, as well as increased spending in quality control.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $12.9 million, or 32.9% of revenues in the first nine months of 2003, compared to $12.2 million or 30.4% of revenues in the same period of 2002. The increase was primarily due to severance costs associated with staffing reductions made in the second quarter, increased bad debt expense and higher business insurance expenses.

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Research and Development Expense

Research and development expenses were $1.2 million, or 3.1% of revenues in the first nine months of 2003, compared to $0.9 million, or 2.3% of revenues in the same period of 2002. The increase was primarily due to increased development activity associated with new product configurations and assays and other new product research in the Product Sales segment, which is expected to continue through the remainder of 2003.

Other Income and Expense

Other income and expense consists primarily of interest expense and the net expenses associated with the Company’s building rental activities. These expenses increased 14% to $1.2 million in the first nine months of 2003. The increase was primarily due to reduced rental income as a result of higher vacancy rates. While the Company is actively seeking additional tenants for the building, there can be no assurance it will be able to lower overall vacancy rates during the remainder of 2003. This increase was partially offset by a reduction in interest expense due to lower interest rates.

Income (Loss) Before Income Taxes

During the nine months ended September 30, 2003, the Company recorded a loss before income tax benefit of $0.1 million, compared to pre-tax income of $2.0 million in the same period of 2002. The change in performance was caused primarily by lower revenues and gross margin, as well as higher operating expenses in both the Laboratory Services and Product Sales segments.

Laboratory Services loss before income tax benefit was $0.5 million for the nine months ended September 30, 2003 compared to pre-tax income of $0.5 million in the same period of 2002. The decline was primarily attributable to a decrease in revenues, lower gross margin, increased selling, general and administrative expenses, as well as higher net expenses associated with the Company’s building rental activities.

Product Sales pre-tax income was $0.4 million for the nine months ended September 30, 2003, compared to $1.5 million for the same period of 2002. This shortfall was primarily caused by a reduction in revenues and gross margin and increased operating expenses.

Income Taxes

In the third quarter of 2002, the Company recorded a $10.8 million income tax benefit and reduced its valuation allowance on deferred tax assets.  The reduction in the valuation allowance at that time was based on the available evidence, including the Company’s historical performance, tax planning strategies, and projected future results.  The valuation allowance at December 31, 2002 of $1.4 million represented the portion of the net operating loss (NOL) carryforwards that were expected to expire unused in 2003 and future years.  The Company recorded a tax benefit for the nine months ended September 30, 2003 that reflects the anticipated effective tax rate for the full year. Should operating results for the remainder of 2003 and possibly 2004 fail to meet expectations, the valuation allowance against the Company’s NOL carryforwards and the related deferred tax asset may require adjustment in future periods.

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Liquidity and Capital Resources

The working capital requirements of the Company have been funded primarily by cash received from bank financing.

Net cash provided by operating activities was $1.9 million for the nine months ended September 30, 2003 compared to $2.5 million in the same period of 2002. The decrease was primarily due to lower income before income tax benefit as well as a reduction in accounts payable and accrued expenses, partially offset by a reduction in accounts receivable and inventory.

Accounts payable and accrued expenses decreased $2.0 million during the first nine months of 2003 compared to an increase of $0.2 million for the same period of 2002. The significant reduction in the current year period was primarily the result of the more timely payment of outstanding invoices.

Accounts receivable increased $0.3 million during the first nine months of 2003 compared to an increase of $2.4 million for the same period of 2002. The significant increase in accounts receivable in the prior year period was primarily the result of an increase in receivables due from third-party payors such as insurance companies and Medicaid state agencies. Payment cycles from such payors can be lengthy, and in certain cases, were adversely affected in 2002 by incomplete or incorrect billing information provided to the Company by its customers. In 2003, the Company has been able to shorten the payment cycle for such payors through a better understanding of the insurance claim filing requirements and by converting manual billings to an electronic format for certain Medicaid state agencies.

Net cash used in investing activities, consisting of capital expenditures, was $2.1 million for the nine months ended September 30, 2003 compared to $3.2 million in the same period of 2002. The increased spending for equipment and capital improvement expenditures in the 2002 period reflected equipment purchases to improve efficiencies and reduce operating costs.

Net cash provided by financing activities was $0.4 million for the nine months ended September 30, 2003 compared to $1.5 million in the same period of 2002. The decrease was primarily the result of a reduction in the use of the revolving credit facility in 2003. During the nine months ended September 30, 2003, the Company also received proceeds from long-term debt of $1.6 million to finance capital equipment purchases, offset by payments on long-term debt of $2.0 million.

The Company has a Credit Security Agreement (the Wells Fargo Credit Agreement) with Wells Fargo Business Credit, Inc. (the Bank). The Wells Fargo Credit Agreement, as amended, consists of (i) a term loan of $3.185 million bearing interest at prime + 1.25% and (ii) a revolving line of credit, payable on demand, of not more than $8.0 million or 85% of the Company’s eligible trade accounts receivable bearing interest at prime + 1%; and (iii) a capex note of up to $3.5 million for the purchase of capital equipment bearing interest at prime + 1.25%. According to the terms of the agreement the capex note may be amended, supplemented or restated from time to time and is generally done so on an annual basis. During the third quarter an amendment to the capex note was required in order to allow further borrowing. The amendment was not completed in the quarter and no funding from the note was available in the quarter. The Company and the Bank are in the process of amending the note to allow future borrowing for the purchase of capital equipment.

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The Wells Fargo Credit Agreement requires the Company to comply with certain covenants and maintain certain quarterly financial ratios as to minimum debt service coverage and maximum debt to book net worth, which are established annually. It also sets minimum quarterly net income and book net worth levels, which restrict the payment of dividends. As of September 30, 2003 the Company was in compliance with the financial covenants of Wells Fargo Credit Agreement.

In the first nine months of 2003, the Company entered into a Credit and Security Agreement with Wells Fargo Equipment Finance, Inc. for the acquisition of various pieces of equipment. In connection with the agreement, the Company signed notes payable for $2.0 million, payable in monthly installments over 3.5 years. Interest is payable at a variable rate of 1.25% over prime. The note is secured by the equipment purchased with the proceeds of the loan.

The Company is relying on expected positive cash flow from operations and its line of credit to fund its future working capital and asset purchases. The amount available on the revolving line of credit is based primarily on the receivables of the Company and, as such, varies with accounts receivable, and to a lesser degree, the inventory of the Company. As of September, 2003, the Company had total borrowing capacity of $6.2 million on its line of credit, of which $5.1 million was borrowed, leaving a net availability of $1.1 million and a cash balance of $0.6 million.

In the short term, the Company believes that the aforementioned capital will be sufficient to fund the Company’s planned operations through 2003. While there can be no assurance that the available capital will be sufficient to fund the future operations of the Company beyond 2003, the Company believes that future profitable operations, as well as access to additional capital through debt or equity financings, will be the primary means for funding the operations of the Company for the long term.

The Company continues to follow a plan which includes (i) aggressively monitoring and controlling costs, (ii) increasing revenue from sales of the Company’s existing products and services (iii) developing new products and services, as well as (iv) continuing to selectively pursue synergistic acquisitions to increase the Company’s critical mass. However, there can be no assurance that costs can be controlled, revenues can be increased, financing may be obtained, acquisitions successfully consummated, or that the Company will be profitable.

Impact of Inflation and Changing Prices

The impact of inflation and changing prices on the Company has been primarily limited to salary, laboratory and operating supplies and rent increases and has historically not been material to the Company’s operations. In the future, the Company may not be able to increase the prices of laboratory testing by an amount sufficient to cover the cost of inflation, although the Company is responding to these concerns by refocusing the laboratory operations towards higher margin testing (including clinical and pharmaceutical trials) as well as emphasizing the marketing, sales and operations of the Product Sales business.

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Seasonality

The Company believes that the laboratory testing business is subject to seasonal fluctuations in pre-employment screening. These seasonal fluctuations include reduced volume in the summer months, year-end holiday periods, and other major holidays. In addition, inclement weather may have a negative impact on volume thereby reducing net revenues and cash flow.

Impact of New Accounting Standards

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities.”  FIN 46 addresses consolidation by business enterprises of variable interest entities and significantly changes the consolidation application of consolidation policies to variable interest entities and, thus improves comparability between enterprises engaged in similar activities when those activities are conducted through variable interest entities.  FIN 46 is effective for variable interest entities created after January 31, 2003 and to any variable interest entities in which an enterprise obtains an interest after that date. The Company does not hold an interest in any variable interest entities.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 was effective for certain contracts entered into or modified by the Company after June 30, 2003. The Company adopted SFAS No. 149 effective July 1, 2003 with no material impact on its results of operations or financial position.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards on the classification and measurement of certain financial instruments with characteristics of both liabilities and equity.  SFAS No. 150 was effective immediately for all financial instruments entered into or modified after May 31, 2003. For all other instruments, SFAS No. 150 was effective at the beginning of the third quarter of 2003. The Company adopted SFAS No. 150 effective July 1, 2003 with no material impact on its results of operations or financial position.

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Item 3:     QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
                 MARKET RISK.

There have been no material changes in our market risk during the quarter ended September 30, 2003. For additional information refer to Item 7A of our 2002 Annual Report on Form 10-K.

Item 4.     CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls Procedures.

As of the end of the period covered by this report, the Company conducted an evaluation under the supervision and with the participation of the company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, regarding the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rules 13a-15(b) of the Securities Exchange Act of 1934 (the “Exchange Act”). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information that is required to be disclosed by the Company in reports that it files under the Exchange Act is recorded, processed, summarized and reported within the time period specified in the rules of the Securities Exchange Commission.

Changes in Internal Controls.

There were no changes in the Company’s internal control over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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SIGNATURES

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

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EXHIBIT INDEX

MEDTOX SCIENTIFIC, INC.

FORM 10-Q FOR QUARTER ENDED SEPTEMBER 30, 2003

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