Note: This stock is a nanocap with limited trading volume, making this idea suitable for personal accounts and small funds. 

PharmChem Inc. (OTC: PCHM) 

PharmChem is a profitable, high ROIC nanocap business ripe for a turnaround in 2024. The sweat-based drug testing company over earned during Covid by delivering a remote solution for criminal justice drug-testing (mail-in sweat patch vs in-person urine testing). A successful activist campaign in 2021 and a pause in buying from its largest customer in 2022 disrupted its operations.  New management hired sales staff and boosted marketing to explore new customer markets, driving down earnings and cutting the stock price in half. Sales recovered in 2023 and PharmChem announced plans to cut spending on new markets in February 2024, setting the company up for earnings growth this year from the twin engines of higher revenue and lower expenses. Meanwhile, the company is aggressively repurchasing shares. We see the stock moving from $2.91 to $4+ this year as investors re-evaluate PharmChem’s prospects. 

Business Description 

PharmChem is a sweat-based drug testing company based in Fort Worth, Texas. It sells patches mostly to criminal justice customers for testing parolees. The patches serve as an alternative to traditional urine-based drug testing, which is a market dominated by the duopoly of Quest Diagnostics and LabCorp. PharmChem occupies a small niche driven by long-term customer relationships and the ability of sales staff to sell this alternative method. 

The primary advantage of the patch testing system over urine or saliva testing systems is they measure drug use over time (7-10 days) rather than at a single point in time for urine tests. This reinforces better habits. Testing can also be done via mail or drop-off without requiring an in-person appointment. They have also recently expanded their offering by including panels testing for fentanyl. PharmChem’s largest customers are in Texas and Missouri. 

The business model is capital light as PharmChem owns the intellectual property and outsources the kit production and testing to an external laboratory. The balance sheet assets are cash ($1.57m), accounts receivable ($636k), and inventory ($392k). Liabilities are accounts payable, accrued expenses, deferred revenue, and smaller items totaling $559k. PharmChem has no debt. 

PharmChem consistently generates gross margins around 65%. Expenses are sales staff, marketing, and buying new testing kits. 

Growth, Activist Takeover, and Disruption 

Starting in 2014, PharmChem’s revenue grew rapidly. Revenue rose from $2.52m in 2014 to reach $6.67 in 2020. Over that period, they registered annual sales growth at rates ranging from 7.4% to 42%. In 2020 as the Covid pandemic diverted Quest and LabCorp testing capacity away from drug testing to covid testing and buyers sought contactless testing, PharmChem grew revenue by 20.3%. 

Activist investors Tice Brown and Tim Eriksen saw an opportunity to accelerate growth and launched a proxy battle in 2021 to takeover the board. The previous management had issued themselves stock options for 16% of PharmChem at low prices (15 cents per share) in 2015/2016 as growth took off and after the company had suspended public reporting to shareholders. This option issuance became a major issue in the proxy contest. 

The activists were successful and bought out the previous management’s options. Sensing the potential for growth, they hired new sales staff and experimented with expanding into new customer markets including private companies testing staff (truck drivers, hospital staff, etc.) and over-the-counter sales via retail channels. The new market efforts failed to gain traction over two years, but the expanded sales staff had success onboarding new customers and growing sales in the core criminal justice segment. 

Starting in August 2023, PharmChem began to shift from the focus on new markets to refocus on the core criminal justice segment. Chairman Tice Brown sold most of his shares to fellow activist Tim Eriksen, who took over as chairman. Eriksen cut spending on the private employer marketing and retail channel. 

2023 Results  

PharmChem grew revenue by 3.5% last year to $6m after two years of revenue declines and earned $723k in net income in 2023. The company’s net income peaked at $1.96m in 2020 on $6.67m in revenue. We expect steady progress this year back toward those levels through sales growth and cost cuts. 

Expectations for 2024 

Chairman Tim Eriksen expects sales growth in 2024 and will decrease spending on underperforming new markets by $300k-$400k, according to his February chairman’s letter. PharmChem is retaining sales staff to grow customers in the core government parole/treatment center segment, which are performing above expectations. 

PharmChem also announced effective March 15 that it agreed to part ways with its CEO Matt Katz and replaced him with board member Thompson Clark. The leadership change will save the company a further $90k annually (the difference between Katz’s $140k salary and Clark’s $50k annual pay). The company would also reverse $194k of stock-based compensation expense if Katz’s options with a $4.40 strike price aren’t exercised by June 15.  

If we forecast 5% sales growth this year and PharmChem achieves the midpoint of $350k in annual operating expense savings, PharmChem should report $1.49m of net income this year. At today’s share price of $2.91, PharmChem trades at 9.1x this year’s net income. 

The P/E multiple comes down to 8x if we exclude the $1.57m of cash on the balance sheet. If PharmChem uses $1m of this year’s cash earnings to buy back shares at an average price of $3 each, it reduces the multiple further to 7.4x earnings. 

Capital Structure 

PharmChem is a share cannibal: capital light and aggressively repurchasing shares. Since activist investors Tim Eriksen and Tice Brown took over the company in 2021, they reduced PharmChem’s share count by one-third via repurchasing shares and options. Chairman Tim Eriksen owns 33.3% of shares through his Cedar Creek Partners and the Jordan family, who bought in the open market prior to the activist takeover, owns a further 13% of shares.  

In 2023, the company repurchased 507k of shares and share options, representing 9.8% of shares outstanding for $1.34m. It's likely they will continue to buy back the 1.77 million shares (38%) that remain as free float today as the most attractive way to return capital to shareholders if prices stay at or near current levels. If shares rise, we expect they will return capital via dividends as they did in early 2023 with a 20 cent per share dividend ($1.03m). 

It’s rare for $13m market cap companies to buy back nearly 10% of their shares and return $1m in dividends within a year. PharmChem ‘s capital light model and cashflow gives it the ability to continue to aggressively reward shareholders going forward. 

Track Record 

Chairman Tim Eriksen has a strong record as an investor/operator. He manages Cedar Creek Partners, which invests in microcaps, and has returned 14.5% annually net of fees over an 18-year period. He also has experience operating small, publicly traded companies. He serves as chief executive of Solitron Devices (OTC: SODI), which he took over in 2016. The company produces power semiconductors for aircraft and radar systems with military applications. Since the start of 2016, Solitron’s stock is up 288%, rising from $4.68 to $18.15.  

Valuation 

If PharmChem can achieve these modest growth and cost-saving targets, while continuing to repurchase shares at a similar pace at somewhat higher prices, we are paying only about 8x this year’s net income to buy PharmChem shares (ex-cash) today.  

We believe that is an attractive price for a company with a capital light business model, investor-friendly leadership, and an aggressive approach to returning free cash flow to shareholders.