|Shares Out. (in M):||5||P/E||28||0|
|Market Cap (in $M):||90||P/FCF||20||0|
|Net Debt (in $M):||6||EBIT||0||0|
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Psychemedics Corporation is the world's largest provider of hair testing for the detection of drug use. Most drug testing is done through urine testing which explains why Psychemedics is a little known company with a market cap of $88 million. Hair testing does have certain advantages over urine testing and the company's patented process is used by thousands of U.S. and international customers, including over 10% of the Fortune 500 companies, for both pre-employment and random drug testing. Major police departments, Federal Reserve Banks, schools, and other public entities also use Psychemedics services.
The company has embarked on a major expansion into Brasil on the basis of legislation that has been passed but is frozen until further notice. The cost of this expansion puts pressure on the company’s current results. I’ll show that the company is strongly undervalued when looking at current operations ex-expansion costs or when looking at operations taking into account future revenues from the expansion.
The product: Hair testing explained
There has been a great prior write-up dating from 2009 on VIC which covered the company’s technology in a lot of detail, most of the advantages over other methods like urine testing still apply but the company did continue its research & development and announced updates to its technology and new patents.
These are the important characteristics of the product which are important to know about:
1. Superior window of detection
By Hair testing it's possible to detect whether any drugs have been used in the prior months, instead of the prior few days covered by other methods. Hair testing on the other hand does not detect drug use in the days just prior to the harvest of the sample.
2. Less embarrassing collection procedures
The person being tested doesn’t have to piss in front of someone who oversees the process. If the urine testing is not witnessed it’s very easy to cheat.
3. Hair testing is much harder to cheat
Which brings me to the 3rd advantage which is that hair testing is much harder to cheat. It doesn’t work to abstain for a small number of days and it’s hard to submit someone else's hair. Shaving your head doesn’t work because the company can also test on body hair. Claims that hair samples have been contaminated by someone else’s drug use has been deemed an invalid excuse after independent studies and the process held up in 20 years of court cases.
4. Improved accuracy of results
Because Psychemedics' technology is the only one that removes virtually 100% of the drugs from the hair, it is able to provide superior detection; both compared to other hair tests, as well as urine.
Some of the Company's customers have also completed their own testing and found the Company's hair test results favorably compared to other companies' urine test results. When results from the Company's hair testing methods were compared to urine results in side-by-side evaluation, 5 to 10 times as many drug abusers were accurately identified by Psychemedics methods. Detection rate varies by the type of drug. For example, Psychemedics tests detects marijuana users only 4 to 7 times more frequently than urinalysis for example.
5. Re-testing possible
With Psychemedics method of hair testing, the hair sample isn’t lost and testing can be repeated if the result is challenged and or something is screwed up through the process.
Who employs drug tests and why?
Psychemedics results are somewhat tied to the cyclical job market. Most of its revenue is derived from company’s that are hiring and want to do pre-employment or employee testing. As much as 10% of Fortune 500 companies use drug tests supplied by Psychemedics but regional employers, major police forces,Federal Reserve Banks, schools, and a variety of government and medical research programs use their tests as well. Wordwide, thousands of companies rely on the tests.
Psychemedics has obtained FDA clearance on all drug categories and is the only lab to have clearance not limited to head hair (it also has body hair clearances).Labs without FDA clearance claim FDA clearances are unnecessary. In response, the FDA issued an advisory in June, 2005, that clarified the need for workplace screening tests to be cleared by the FDA. This advisory said “When the FDA has not reviewed a test product, consumers and businesses cannot have the same assurance that the results of that test are correct as with an FDA-cleared test. Manufacturers of tests with FDA approval or clearance have provided the FDA with data to assure that their tests generate reliable results for the specimens being tested.”
Customers use the drug tests because it saves money and prevents future problems. If you successfully refrain from hiring or fire a drug abuser this can save a bundle on healthcare costs, lost hours and prevent accidents. Government studies in the 80s and 90s have shown estimates that a drug user costs on average $7K to $10K per year. In todays money the figure would be roughly double that. Meanwhile, the test is relatively inexpensive. It follows that it is more important to be accurate than to save a few dollars on the test.
The global drug abuse testing market is growing because government and non-government organizations increasing awareness of the ill effects of illicit drugs drives a desire to control the damage to society caused (as evidenced by this thesis as you will see later).
In the Gobal Industry Analysis Forecast 2013-2018, Transparancy Market Research forecasts a global CAGR of 5% for urine testing. Urine testing is the dominant method of drug testing. The report also breaks out the CAGR for hair testing and saliva testing but I haven’t been able to get access to those figures because I can’t justify the price of the complete report given the size of my investment. Hair testing has the advantages described above but urine testing tends to be cheaper and it has a larger lobby in place. Hair testing is definitely helped by the overall drug abuse testing market.
The major players in the drug abuse testing market are:
These are much larger pharmaceutical companies with larger research departments and sales operations worldwide. Not one is focused on the drug testing market. There are no similar sized pure plays competing with Psychemdics. The oversized set of competitors does introduce the threat of a competitor trying to take over Psychemedics (if it really is significantly undervalued that's not a great outcome for shareholders). Urineanalysis is the dominant competing technology in the drug abuse market at this time but it’s possible this changes if competitors discover breakthrough technology. It’s also possible Urineanalysis is improved to compete even more effectively, although certain fundamental disadvantages like the embarrassing collection method, will be hard to workaround.
From 2004 up to now management has achieved an average annual return on invested capital of 33%. Revenue has grown an average of 5% per year over the past 10 years and EPS has grown by an average of 12% over the same period. The company has been vigilant in returning cash to shareholders, both by the occasional buyback and through its dividend.
It's not surprising that a company with an excellent track record of growth, proprietary technology and a only a small share (~1%) of its potential adressable market, is trading at somewhat higher multiples:
|Market Cap:||$90 Million|
|Enterprise Value:||$91.5 Million|
|PEG Ratio (5 yr expected)||0.89|
|Enterprise value/Revenue (ttm)||3|
|Enterprise value/EBITDA (ttm)||15.4|
On price/sales, price/book, enterprise value/revenue, enterprise value/EBITDA and its trailing P/E Psychemedics trades at multiples that do not immediately inspire to dig deeper. The PEG ratio isn’t too bad but to be honest it’s in none of the screens I use to find ideas. Only judging by the market outlook and the company’s track record of growth and returning cash to shareholders over the past ten years I’d call the above multiples “fair” at best.
Forward P/E shows that there may be something here, and gets me to the heart of the matter:
PMD is in the midst of an expansion into Brasil based on a legislative event which will force demand. Capex and Opex have increased to prepare for this pending demand while the legislation has yet to take effect and additional revenue has yet to materialize.
The balance sheet is not an issue with Psychemedics. I think I’d rather see it lever up a little further than to decrease its debt. Long term debt is $6.25 million on which it paid 2.15% over 2014, the company also holds $3.6 million in cash.
Insiders own shares but not to the extent that I’m really excited about it. Raymond C. Kubaki (CEO since 1991) owns 3.8% of the company and Fred J. Weinert (Board member) 2.8%, other board members and executives own shares as well but less than 1% of the shares outstanding.
Only one sell side analyst is following Psychemedics. It’s a really small company that has been around for quite awhile and not in a overly exciting industry. The one analyst does have a price target of $32 on the company and highly recommends it.
The key development which my thesis revolves around is not necessarily recognized as such by the market, although it has been announced in December 2013 by press release. In that press release the Company announced that the Brasil Federal Government had announced new guidelines that would require professional drivers in the transportation industry to pass a hair drug test when obtaining or renewing their driver's license. Brazilian professional driver licenses are only valid for five years and must then be renewed. The first testing was, at that time, expected to begin on July 1, 2014.
Back then management said:
"We are very excited about this opportunity and believe the potential volume from this Brazilian opportunity could be very substantial. In order to service that potential volume, we need to make significant investments in plant, equipment and people. These investments must be made in the first half of 2014 to be ready for the July 1 start date. During this period, we will not have any revenues from this Brazilian opportunity to offset these costs. Therefore, we would expect earnings in the first half of 2014 to be unfavorably impacted.”
The stock responded to that announcement and traded up. Then the Brazilian legislation got delayed and the company’s financials were affected by the investments made in Brasil and the stock suffered for it.
Meanwhile, things are looking quite good regarding the legislation. Ofcourse, I would have preferred it had the bill been passed last summer as planned.
That original bill required professional drivers in the transportation industry to pass a hair drug test when obtaining or renewing their driver’s license.
That bill has now been deferred until a broader transportation bill has been passed or rejected.
This broader bill includes the requirement that professional drivers be drug tested on a more rigorous basis than the requirements under the prior regulation. Once the bill becomes law, it would go into effect 90 days after the President's signature and official publication.
The implementation of the previous regulation has been delayed to coordinate with the new proposed law. If the bill does not become law, the existing regulation would remain in effect, and would be implemented on a timetable to be determined at that point.
The Brasil government is highly motivated to put this legislation into effect because drug abuse by professional drivers is a real problem in Brasil and a real public hazard. An important abuse I came across in my research is the use of amphetamines by drivers to help them stay awake completing the long hauls across the vast country. A Google search will reveal how interested Brasil is in drug abuse by drivers.
There are a few reasons why this legislation is likely to have an outsized impact on Psychemedics and function as an important driver for its share over the next few years:
Size: The fact that Brasil is a country with over 200 million people. There are millions of professional drivers (more on market size below)
Historic presence: The company has been an active player in the Brazilian market over the past 15 years. Clients of Psychemedics Brasil (independent branded distributor) include many government organizations and Royal Dutch Shell.
Hair testing quality advantages: Hair testing has a number of advantages over urine testing and is more effective. The legislator is likely to prefer quality testing so its measure has maximum effect in increasing safety. A urine test will only show the driver didn’t use any drugs in the prior days which is not going to be very effective at weeding out abusers.
Price indifference: The legislator is not very well incentivized to keep the costs of this testing low. The truck drivers who probably end up paying for the tests may have very little choice as to accept prices and additionally the price of a test is small in comparison to the cash flow gained from being allowed to drive a truck.
Renewal: In Brasil professional drivers have to renew their driver’s license every five years which creates a continuous demand for drug testing.
Number of professional drivers: There are no official statistics of the number of professional (truck)drivers in Brasil. That complicates the investment case but may also be the reason the market is underestimating the opportunity. I’ve tried to gain insight into this market by deriving data from various corporate and media various sources.
I got to an estimate of between 3 million and 5.5 million professional drivers who would be required to take a government-imposed hair test every 5 years. Brazilian professional driver licenses are only valid 5 years and must then be renewed. I didn’t take into account the fact that a % of drivers will fail test and will be retaking them later, both to keep estimates conservative and because I’m not sure what the % would be.
If tests are sold at $60 that equals the creation of a government imposed market of between $36 million and $66 million for annual drug tests.
Compare that to the $28 million in annual sales PMD does.
Given Psychemedics has been active in Brasil over the past 15 years, through Psychemedics Brasil, and the fact that the company is the world’s largest provider of hair testing for the detection of drugs abuse; it’s realistic the company will grab a large % of market share of this new mandatory business.
It’s possible the entire market will go to one supplier (if a contract is awarded on the state level) or it’s possible, the market will become fragmented. In the former scenario the event will have a binary outcome with PMD either grabbing nothing or hitting the jackpot, although there may be some pressure on pricing from such a large buyer. In the latter example PMD will have to acquire marketshare office by office but pricing pressure will not be strong.
In the past the company communicated investment into a new lab in Brasil was contingent on growth and adoption of hair test by the Brazilian marketplace. Because the company has now sunk $7 million into a Brasil based lab it appears management is anticipating strong adoption.
If PMD manages to grab 50% marketshare this could add between $18 million and $33 million of revenue, an increase of between 66% and 129% of its current revenue.
Management also said the additional equipment purchased and additional lease space it has added more than doubled the Company’s capacity, in anticipation of growth and referring explicitly to Brasil.
Short term pain
Psychemedics last reported record revenues, so its product is selling well. Its gross margin is the lowest it has been in the past 10 years but still a very respectable 52.9%. Historically, this margin has been quite stable but there have been ups and downs of 5% between years.
Currently, the company is incurring significant costs because of the Brasil expansion, including payroll expenses and the expenses from setting up the additional facility. Because of the expansion the company’s EBITDA isn’t tracking revenue growth like it historically did. If it wasn’t for this expansion the company would also be showing record EBITDA.
TTM CapEx amounts to $8 million, while I estimate maintenance CapEx to be around $1 million. If you look at the underlying existing business (ex-Brasil expansion) you are looking at around $9 million in EBITDA-maintenance CapEx against an Enterprise Value of $88 million. TEV/Ebitda - maintenance CapEx = 9.7
You can also look at the business and estimate how it will look after the Brazilian legislation has taken effect and PMD’s revenue is boosted. Taking 50% market share as a base case (What market share Psychemedics takes is uncertain and admittedly a weakness of the case but possibly also the source of misvaluation) this could result in Ebitda - maintenance CapEx figures between $14.6 million and $20.9 million, Implying a forward TEV/Ebitda - Capex of 5.9 and 4.16.
Suddenly, Psychemedics looks like a bargain.
Risk / Negatives
The biggest risk of this investment is that this is basically a single product company or at least a single product line company. Naturally, that makes the company vulnerable to innovation by competitors or others. I don’t want to play this risk down, with so little in terms of tangible assets, investors will not be left with very much if the business fails even though the company has a pretty clean balance sheet.
The Brazilian government could be viewed as a risk or negative as well. Because the bill has already passed, the risk appears to be limited to causing further delays. Waiting for the legislator to move on is not pleasant but I think it’s worth it in this case.
At a glance Psychemedics appears fairly valued or even expensive. Only when temporary heightened CapEx and OpEx are removed from the equasion it becomes clear the current ongoing operations are undervalued. In addition I estimate the opportunity in Brasil can have an outsized effect on the company’s operations. If the Brasil expansion utterly fails, this is still a solid investment. If it is a success, the investment is an easy double.
The Brazilian government passed legislation that forces the country's truck drivers to test for drugs using hair tests every 5 years. The legislation is deferred until a larger bill is passed or rejected. When that happens, legislation goes into effect and demand is likely to increase strongly.
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