Description

We believe Psychemedics Corporation (PMD) shares represent an opportunity to invest in a company with a proven proprietary product, a significant competitive advantage and earnings that will recover strongly as corporate America expands its payroll. The company's customers include 10% of the fortune 500 and six Federal Reserve Banks. In addition, the company has historically been extremely shareholder friendly and has paid a substantial portion of its earnings in dividends. The shares have been driven down by the recent bear market and we believe they are now an attractive long term purchase.

Psychemedics (PMD), organized in 1986, is not a new technology company with an unproven product. PMD is in the business of abused drug testing, but instead of using conventional urine samples to detect illegal substances it used hair samples. As it turns out, hair testing has a significant advantage over urine testing. As professional athletes well know, abstinence for a few days before testing can render urine drug tests useless, but this is not the case with hair testing. Hair retains an individual's drug use history and pattern for several months and even longer depending on an individual's hair length. Hence, hair testing will detect substantially more drug users than urine testing. As a hiring company screening job applicants, which testing method would you rather use?

The company's drug test information is useful to employers for both applicant and employee testing, as well as to physicians, treatment professionals, law enforcement agencies, school administrators, parents concerned about their children's drug use and other individuals or entities engaged in any business where drug use or potential drug use is an issue. The company provides commercial testing and confirmation by mass spectrometry using industry-accepted practices for cocaine, marijuana, PCP, methamphetamine (including Ecstasy, which is difficult to detect in urine due to sporadic use patterns and rapid clearance from the body) and opiates (including heroin, hydrocodone, hydromorphone and oxycodone).

We hate to burden you with the science behind the product, but in this case it's important for understanding the investment merits. The application of unique radioimmunoassay procedures to the analysis of hair was initially developed in 1978 by the founders of the company. They demonstrated that 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's patented drug testing procedure involves direct analysis of liquefied hair samples by radioimmunoassay procedures utilizing certain chemicals and antibodies. The antibodies detect the presence of a specific drug or drug metabolite in the liquefied hair sample by reacting with the drug present in the sample solution, as well as an added radioactive analog of the drug. The resulting antibody-drug complex is precipitated and analyzed. The amount of drug present in the sample is inversely proportional to the amount of radioactive analog in the precipitate. Positive results are then confirmed by Mass Spectrometry. Depending upon the length of head hair, PMD is able to provide historical information on drug use by the person from whom the sample was obtained. Since head hair grows approximately 1.3 centimeters per month, a 3.9 centimeter head hair sample can reflect drug ingestion over the approximate several months prior to the collection of the sample. Another testing option involves sectional analysis of the head hair sample. In this procedure, the hair is sectioned lengthwise to approximately correspond to certain time periods. Each section corresponds to a time period, which allows PMD to provide information on patterns of drug use. 

The process of analyzing human hair for the presence of drugs using PMD's patented method has been the subject of numerous peer-reviewed, scientific field studies. Results from the studies that have been published or accepted for publication in scientific journals are generally very supportive of the company's technology. Several hundred research articles written by independent researchers have been published supporting the general validity and usefulness of hair analysis for abused drugs. Some of the PMD's customers have also completed their own testing to validate the company's hair testing method as a prelude to purchasing PMD's services. These studies have consistently confirmed the company's superior detection rate relative to urinalysis testing. When results based on the PMD's patented hair testing method were compared to urine results in side-by-side evaluations, 4 to 10 times as many drug abusers were accurately identified by the company's method. In addition to these studies, the company's proprietary method is validated through the services it offers to the thousands of clients for whom it has performed testing.

The company offers the following specific example to further support the significant advantage of its method.  In 1998, the National Institute of Justice, utilizing PMD's hair testing, completed a Pennsylvania Prison study where hair analysis revealed an average prison drug use level of approximately 7.9% in 1996. On the other hand, 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.

Let's list the advantages of PMD's hair drug testing method:

• 1) 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 journals have indicated that most drugs disappear from urine within a few days. In contrast to urinalysis testing, hair testing using PMD's patented method can provide long-term historical drug use data resulting in a significantly longer "window of detection." This "window" may be several months or longer depending on the length of the hair sample.

• 2) Hair testing not only identifies more drug users, but it may also uncover patterns and severity of drug use (information which is very helpful in determining the scope of an individual's involvement with drugs), while serving as a deterrent against the use of drugs.

• 3) Hair testing employing PMD's 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.

• 4) Hair testing using PMD's 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% on December 1, 1998 and testing for the presence of a heroin metabolite was required. These requirements, however, effectively reduced the detection time frame for confirmed heroin down to several hours after drug use. In contrast, the metabolite is stable in hair and can be detected for months.

• 5) In the event that a positive urinalysis test result is challenged, a test on a newly collected urine sample is not usually a viable option. 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 his hair fiber.

• 6) When compared to other hair testing methods, not only are the company's tests cleared by the FDA, they also employ a unique patented method of enzyme digestion that PMD believes allows for the most efficient release of drugs from the hair without destroying the drugs. PMD's method of releasing drugs from hair is a key advantage and results in superior detection rates.

• 7) Although other laboratories have begun offering hair testing, PMD 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. Currently, 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). Additionally, several of these laboratories that claim to test hair samples use a method that PMD presumes includes the use of a form of immunoassay procedures. The company, however, does not believe that immunoassay testing of hair samples is as effective on a commercial basis without using the company's unique patented method, which allows for the efficient release of drugs from the hair through enzyme digestion without destroying the drugs.

Here are the disadvantages of PMD's hair testing method:

• 1) Because hair begins 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.

• 2) The company's prices for its tests are generally somewhat higher than prices for tests using urinalysis, but PMD 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.

• 3) The "urine testing lobby" in Washington has worked aggressively to maintain urine testing as the standard for the Federal government drug testing despite the fact that hair testing is a significantly superior method.

Financial Performance

Before the current Great Recession, the company had been consistently profitable with growing revenues, earnings and dividends over the past eight years. Earnings peaked at $1 per share in 2008, but will probably come in at about $.10 this year.

Unfortunately, a significant portion of the company's revenues are driven by hiring volume. As companies stop hiring, the volume of drug testing obviously falls significantly. On the positive side, once the economy begins to recover and employers begin to interview job candidates PMD's revenues and earnings will expand materially.  In addition, the number of new customers is continuing to grow, as they discover the advantages of  hair testing. The company is highly confident that we will see record earnings once the hiring cycle begins in earnest 

Second quarter results for the quarter ending June 30, 2009 were poor with sales down to $3.9 million versus $6.2 million last year, but the company remained profitable and paid its 52^nd consecutive dividend. The dividend was cut during the quarter, though, from $.17 per share to $.12 per share. Gross margins fell from 61% last year to 54% in the current quarter.

The balance sheet remains pristine with $5 million in cash ($.95 per share), no debt and a current ratio of 7.7. The company's cash balance has been reduced over the past year as the company has continued to pay a significant dividend that has been well in excess of its earnings. The company has demonstrated a strong commitment to its shareholders and confidence in its future, but without a recovery the dividend will have to be reduced further or eliminated.  Given the recent indications of an imminent economic recovery, it appears that this may not be necessary.

Management holds about 10% of the company's outstanding shares. Wayne Huizenga holds over 11% of the company's outstanding shares. Other notable holders include Lord, Abbott with 8% and Carolina Asset Management with 9%.

Valuation

At its current share price of about $6.40 per share, PMD sells for about six times recovery earnings of about $1 per share which we can conservatively expect in 2011. The shares also yield about 7.5% at their current share price. The shares sell for about two times their current highly depressed sales per share. 50% sales growth would be a conservative estimate from the current annual sales level of about $16 million. This 50% growth would assume no new customer growth and no international expansion. We believe this to be highly unlikely and would expect sales growth to exceed 50% driven by new customers.

Conclusion

PMD is a company that has a proven proprietary product with limited direct competition. The company has demonstrated outstanding revenue and earnings growth and has rewarded shareholders with a consistent and growing dividend stream over an eight year period. The shares have recently collapsed because of a short term cyclical issue, providing an excellent entry point for long term investors. The shares can be purchased today at six times a conservative 2011 earnings estimate.

Catalyst

1) Economic recovery

2) Growing Sales, Earnings and Dividends