Description

**PMD is a small and thinly traded ticker, most appropriate for personal accounts or smaller funds**

Summary

PMD is a business with great long term proven ROIC, profitability, and cash return to investors. The business also has multiple long term uptrend drivers. The stock has been pushed down due to two idiosyncratic events but we can already see the business is returning to normal. This is a short lived opportunity to buy PMD at less than half of what it formerly traded for, and is already being strongly bought by management and Peter Kamin of ValueAct fame in his personal account. 

Introduction & History

(Written up previously twice on VIC in previous years)

Psychemedics is the world’s leading company for hair testing to detect drug use. People at PMD have been behind many of the major advances in the field [1] and hold important positions on industry committees[2] that set standards and work with the government to set regulations.

Hair-based drug testing was invented by the founders of Psychemedics circa 1978.  When certain chemical substances enter the bloodstream, the blood carries them to the hair where they become "entrapped" in the protein matrix in amounts roughly proportional to the amount ingested. Benefits of hair testing include detection of drug usage over about a three month window, less embarrassing/invasive sample gathering, and ease of sample handling - remote sites can gather multiple days worth of samples from multiple people and FedEx them all back to the lab in one envelope. Since it takes 5-7 days for newly grown hair to make it to the surface, hair testing is not appropriate for immediate testing due to an accident or suspect behavior - urine, oral fluid, or blood testing will remain the testing of choice immediately after incidents. Thus hair testing is typically used during the hiring process or for occasional random testing.

Federally required mandatory drug testing regulations have been trying to add hair testing for almost 20 years. The US Department of Health and Human Services (HHS) issued a Federal Register notice[3] in 2004 proposing inclusion of oral fluid, hair, and sweat specimens in federal workplace drug testing programs. This proposal came during a contentious and high profile case[4] in Boston where ten police officers who tested positive for drugs on hair tests between 2001 and 2006 contested their firing. They and their union argued that hair testing *could* pick up ambient exposure during law enforcement activities and that urine testing was not done and would have eliminated such possible false positives. The unions made the same arguments to the HHS and instead of adding hair testing to federal drug testing a decade-plus process of proof and challenge validation was started. The government first developed ways of generating proof test (PT) samples[5], then began an extensive blind testing campaign in which labs were sent hair samples they didn’t know anything about and expected to return the correct drug detection results. One result of this was shaking out many labs that didn’t really know what they were doing. Psychemedics demonstrated accurate results, however it turns out that the “exposure” weakness was real - hair dusted with cocaine would come back positive for cocaine even though this exposure doesn’t necessarily imply consumption.

During this time PMD engaged in significant research and pioneered the use of “metabolite” testing - in which hair is tested for the metabolites generated within the body after ingestion of drugs. This eliminates “exposure” based false positives. By 2015 metabolite testing was going strong and industry (for example the trucking industry) badly wanted to be able to use hair testing and lobbied successfully in 2015 for the administration to instruct HHS add hair testing as a drug testing option. HHS worked through a very long process on this and came out with a new proposed rule in 2020 [6]. The rule basically says that hair testing is allowable as the primary detection technique but for any drug detection that isn’t using a unique metabolite, or to which the tested person doesn’t admit drug use based on the hair test, any positive test should be followed up by at least one positive urine/other fluid test before the employee is removed. This is clearly framed specifically to avoid the types of argument put forward in the Boston PD case. Industry has responded acerbically noting that in many cases they will have to keep using hair tests to actually find drug users, but will need to urine test them every 3-4 days to catch them in the act. Trucking companies, in particular, often use hair tests to find drug use that happens on the road away from urine testing at HQ [7] - but are prevented from sharing that information with other trucking companies right now because it isn’t an approved solo test. 

Ultimately the new rules will allow hair testing to increase. There is heavy pressure to allow hair to be the sole test, and HHS is allowing it to be the only needed test as new metabolites are developed that remove exposure arguments. PMD is at the forefront of new metabolite development and is ready to take advantage of years of research as well. 

PMD as a Business

PMD revenue is heavily composed of testing new hires, and they have a broad client base from the Fortune 500 down to small business. The company has had excellent long term financial indicators, keeping good margins and return on invested capital for decades. Most of their moat is not in the basic test; but rather in their certifications, process additions for cleaning and correcting for variability in the test, metabolite development, and expertise providing expert witness and publication support if clients get taken to court over testing (people get aggressive about losing their jobs, even if they were truly caught doing drugs). 

As a shortcut, one can think of PMD as a direct play on hiring in the US with a bit of growth on top as hair test usage expands. Here is a chart of BLS hiring data (the JOLTS HIL series) compared with PMD revenue. That bump of “extra” revenue PMD had from 2016 to 2019 was an entry into and exit from Brazil (more below). 

Figure: PMD revenue (red) has been generally following the JOLTS hiring statistics (blue) plus an upward slope as hair testing slowly takes drug testing share from other techniques. The above-trend bump in the red revenue line is when PMD moved into the Brazilian market then moved out as discussed in the text below. The final red dip is from COVID. Over time, my expectation would be for the revenue line to return to the pre-2014 trend now that PMD is exiting Brazil and as the world recovers from COVID.

The company had also paid a reliable dividend for over 20 years. With a consistent and profitable business and a reliable dividend the stock has spent most of the last 10 years at prices from $10-$20. 

So why the current discount? Two negative events have piled onto each other, and both can be analyzed and understood to be ending. First, in 2015 they made an entrance into Brazil in response to new legislation requiring hair based drug tests for all professional drivers there. In 2014-2015 they had lower financial performance while spending to enter the market [8]. Afterward, they had an increase in revenue but lower margins as it turned out that Brazil did not require significant certifications, high performance, or legal expertise, PMD’s primary moat elements. Ultimately their independent distributor in Brazil got into legal trouble[9] and then was acquired by PMDs primary competitor in the country [10]. In my forecasts I attribute zero value to the Brazil operations, although in reality it is supplying cash flow as it declines. The company is now leaving the Brazil market, just servicing some occasional profitable opportunities that happen to arise there.

Just as the bad news was rolling through from Brazil, COVID hit. Since drug testing was considered “nonessential” by most companies and requires close contact, COVID in 2020 hit PMDs revenue (and thus margins) hard. PMD had kept both profitability and the dividend through even the 2009 crash, but COVID resulted in them turning off the dividend after 94 straight quarters of paying one [11].

I have prepared a narrative chart of gross and net margins versus revenue over the years to help visualize the ebb and flow of the company’s business through the events above as well as earlier events:

(Overcomplicated looking) Figure:  The blue and red lines are the gross and net margin of PMD plotted against revenue on the x-axis. Here the red line shows that profit efficient scale was reached in the 1990s and margins stayed broadly consistent for decades of revenue growth afterwards (data points generally evolving to the right). We can see the revenue increase then decrease due to Brazil, followed by COVID. The orange “Expectation” line was drawn in January before we started building a position. The little green triangle on the upper “Expectation” line is annualized Q1 results reported May 10th - the situation is unfolding just as expected and the company is returning to its long term stable margins. (I did not put a Q1 dot for net margin because their net numbers were artificially good due to stimulus payments.)

Valuation and Catalyst

Short term

This is not an investment that requires a dozen spreadsheet pages to justify valuation. The primary and highly cautious valuation case is simply that COVID will go away and the Brazil business will no longer be weighing on the company as they are shedding any business in Brazil that doesn’t have good fiscal metrics [12]. If we simply model them as returning to their pre-Brazil 2013 performance (which is pessimistic since they have continued organic growth), they can easily support returning to a ~60 cent dividend and will be turning in profits that would make the P/E ratio on the current share price below 10 with a dividend yield of ~10%. Even in this highly pessimistic case a reliable earner at this scale would push the shares up, based on historical valuations, to the $15 range.

There is no significant debt load, thus the valuation uncertainty seems mostly a matter of timing. Will it take one year or two to return to long term trends? 

There is also a longer term catalyst

The existence of a government Proof Testing program to certify testing processes and the new rules allowing hair testing as a primary means of workplace monitoring are a positive tailwind for PMD. Trucking companies are already using hair testing even though they can’t make it the single “official” drug test - it turns out such companies really don’t want to deal with accidents by drug-using drivers. It also turns out that the majority of people caught by hair testing don’t lawyer up to fight it and instead voluntarily depart or undergo treatment. As “metabolite” testing methods, where PMD is a leading researcher, gain more traction the use of hair testing is expected spread significantly - mechanisms for this are in the published HHS rules and do not require a new rulemaking cycle. 

On an upside valuation we can talk about gaining business testing federal employees and even eventually testing truck drivers in the USA. These markets could add 1-3 million tests per year (over the next ~3-5 years perhaps). PMDs main competition is Quest Diagnostic (LabCorps looks like a competitor but they actually use PMD behind the scenes to perform the advanced hair testing [13] ), so we might reasonably estimate PMD gets half that market growth. The revenue added per test is not a single number: the testing can actually be done initially via immunoassay in batches, then per-sample tests for batches that register as positive, then per-sample mass spectrometry verification for any single person for whom they register a positive. PMD then charges corporate customers a blended number based on how much of each of those testing steps are needed over time. Still, the number of tests we’re talking about adding would more than double PMD revenue. This is a long term change and since we don’t really need such speculative numbers to arrive at a valuation suggesting gains over 100% I’m not going to try to dangle some speculative earnings impact beyond, “very nice future market path on top of the current discount.”

It would seem insiders agree with these scenarios. After generally being sellers of stock historically through mid 2019, every insider transaction since then has been a buy. The last two months of 2020 alone saw more insider purchase transactions than the preceding 4 years in total, and this activity culminated in Peter Kamin (of ValueAct fame) revealing a personal investment of  5.9% of PMD Dec 30th 2020. Kamin’s MO is to buy legacy cash flow businesses with moats and turn them into free cash flow machines. That appears very likely to happen here.

Risks

1. Risk: Fiscal irresponsibility – If PMD takes the benefits of recovery and doesn’t replace the dividend [14], instead taking the profits and perhaps using it for buybacks while also issuing shares internally, they could fritter away the value investors would see. We note the long history of dividends (even through the recession of 2009) and history of fiscal discipline. Peter Kamin’s involvement also seems to reduce the likelihood of irresponsibility. 

2. Risk: Delayed federal adoption of hair testing – Adoption could easily be delayed. This risk is mostly a timing question, and applies only to the additional growth beyond the conservative case. Personally, I think the most likely case is a slow and steady growth of hair testing over the scale of years as PMD comes up with more metabolite developments that eliminate questions about ambient exposure and improves their normalization across hair melanin levels. It’s interesting to note that as the industry makes these advances it is likely to have a consolidating effect of driving more business to PMD as they are the ones more able to handle complicated testing.

3. Risk: Company gets bought by Quest Diagnostics or similar player – Quest is the other major player in the US. If the federal market starts to grow significantly, and especially if DOT allows hair testing for truck drivers, the value of PMDs market position grows dramatically. At that point the amount of revenue starts to matter even to the big players and one of them might buy out PMD. I would expect that to happen at a price more than 2x today’s, but it might mean only getting a two or three bagger. One of my real worries is that PMD gets bought out “only” 100%-200% above current valuation.

4. Risk: Changes in drug testing preferences -- More workplaces seem to be getting to be “okay” with marijuana use, but marijuana testing has yet to decrease. Even if marijuana testing decreases, that is the specific test that PMD has the lowest share of because it is relatively easy. Meanwhile testing for prescription pain medications or meth are increasing and are more aligned with PMDs expertise. 

Summary

PMD is a company with a large current discount driven by two easily understandable and clearly temporary events. The bad news has reduced the price of the stock, but the business has decades of demonstrated highly desirable performance that has not changed. As the temporary bad news recedes we can expect a 100+% gain in stock price. Additionally, there is a major medium to long term catalyst that should dramatically improve revenues and barriers to competitor entry simultaneously, providing a large potential gain in the longer term. I expect a one bagger within 12-24 months and three bagger within 3-5 years. This is a very small market cap (for now) so buying in took us some time. We have taken on a sizable position a bit below the mandatory filing threshold and intend to make contact with management as well. Feel free to come along for the ride if you like.

Usual Disclaimers

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities and may buy or sell at any time without posting here.

Endnotes

[1] Dr. Werner A. Baumgartner, the company founder and a long time (but now former) head of research filed the original patents on drug testing via hair in 1987

[2] The Drug Testing Advisory Board, a part of the Substance Abuse and Mental Health Services Administration, is the primary industry/government advisory group. PMD’s vice president of laboratory operations is on that board

[3] 69 FR 19673

[4] scholar.google.com/scholar_case?case=8020459821720889177&q=psychemedics+corporation

[5] RTI international has an interesting side business making test samples for blind testing drug detection labs

[6] https://www.federalregister.gov/documents/2020/09/10/2020-16432/mandatory-guidelines-for-federal-workplace-drug-testing-programs

[7] https://www.freightwaves.com/news/carriers-pressure-fmcsa-to-act-on-drug-hair-test-exemption-request

[8] one example in 10-K 2014 ("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.", discussed as "capacity expansion project"), visible in growth of Total Assets.

[9]  https://www.prnewswire.com/news-releases/figueira-hong-amaral-bertoni--advogados-landmark-legal-ruling-orders-psychemedics-brazil-to-compensate-omega-laboratories-usa-for-anticompetitive-practices-in-hair-drug-testing-market-300398834.html  - Note: "Psychemedics Brasil is an independent distributor of Psychemedics" ...  "Psychemedics Corporation is not involved in the lawsuit"

[10] See the 2019 Q1 report: “Psychemedics Brasil, our independent distributor in Brazil, has had 55% of its shares acquired by Instituto Hermes Pardini S.A., a provider of medical and diagnostic services in Brazil, including reference laboratory services.  We are continuing our discussions with our distributor and its acquirer about the future of our distribution agreement”

[11] 2020 10-K: “As of March 31, 2020, the Company had paid dividends on our common stock for ninety-four consecutive quarters. We currently expect to pay quarterly dividends in the future, although such payments are at the discretion of our Board of Directors,”

[12] e.g. 2020 10-K shows international revenue down 2x US revenue (%) and a 13% increase in average revenue per sample - Brazilian market pays less per sample

[13] "At LabCorp there are additional and expanded hair test panels available due to LabCorp working with partner laboratories United States Drug Testing Laboratories (USDTL) and Psychemedics."

https://www.nationaldrugscreening.com/blogs/which-labs-perform-hair-drug-testing/

[14] They have already mentioned wanting to bring the dividend back, e.g. 2020 10-K “We currently expect to pay quarterly dividends in the future, although such payments are at the discretion of our Board of Directors,”

Catalyst

Short term: return to usual revenues and margins, return of the dividend

Long term: Increased hair testing share due to beneficial recent regulations