Adding a new position in Imaflex, Selling Psychemedics
I added a new position in a company called Imaflex this week. Imaflex trades on the Canadian market. They produce polyethylene films for packaging, garbage bags and, most recently, agricultural products. I’ll do a more detailed write-up but for now the thesis is:
- this is a small company ($65 million market capitalization)
- they just reported strong growth (32% year over year revenue growth in the second quarter)
- they are ramping up a new product called Shine N’ Ripe that uses a thin film wrap around plants to increase sunlight and deter insects
- that product is gaining traction, having generated $2.1 million of orders in the second quarter on top of $3.3 million in the first quarter, and is driving growth
The company trades at a fairly reasonable valuation of 14x free cash flow based on the trailing twelve month numbers. Focusing on more recent history, they trade at only 8x free cash flow if you annualize the last quarter results. This is a small position for me so far, at 0.5%.
Its also in Canada, which means I don’t have to worry about currency, the bane of my existence the last few months.
A second trade, after much consideration, was to sell Psychemedics. As the stock rose back to the $21 level I decided I did not have the conviction to wait and see if it would go back into the teens.
Psychemedics didn’t have the best quarter in Q2. The main culprit was gross margins, which declined from 52% in the first quarter to 48% in the second quarter. In the last two quarters of 2016, the company had gross margins of 59%. Historically, margins have been around 50%.
Unfortunately Psychemedics doesn’t give a conference call so we are left with only what they have written to understand the significance of the decline.
What the company said in the second quarter press release was:
In the past quarter, we have made a number of strategic decisions and are implementing a number of strategic initiatives that we believe are in the best long-term interests of the company. Our market share remains strong and we have taken further strategic actions to solidify and strengthen our long-term position in the market. In addition, we now have established a wholly-owned subsidiary in Brazil and have brought on a Country Manager, a Brazilian national to manage our business in Brazil and work with our distributor. We believe in the long-term attractiveness of this market and are willing to make short-term investments and sacrifices.
In the 10-Q they said that “the decrease in margin was attributable to a mix of business, the inclusion of Brazil sales taxes and additional depreciation from equipment placed in service.”
I have been worried that Psychemedics had lost market share in Brazil to a competitor, Omega, that had just started operating in Brazil 3 months ago. Omega stated on their website that they have achieved 25% market share in Brazil in the first 3 months of operations there.
But after talking to management I got the impression that Omega’s press release may have been optimistic and that while they are now a competitor in Brazil, they have not scaled to the degree they are suggesting. There was a lawsuit between Omega and (indirectly) Psychemedics earlier this year. There is clearly no love lost between the two companies.
Still, the rising costs/shrinking margins bother me, particularly given the valuation. I am uncomfortable that Psychemedics is trading at over 10x EBITDA when they are having trouble maintaining margins and there is some uncertain level of increased competition in the Brazil market. And I can’t help but look at the long-term stock chart and note that it wasn’t that long ago that the stock traded at $10. It shouldn’t trade at $10 again, but a motivated seller in a crappy market and I think $15 is not impossible.
On the other hand its entirely possible that the market looks past the second quarter, the stock continues to trade at this level for a while, and then we get an upside surprise in the third quarter and its back to the mid-$20’s. I’ll accept the risk I miss out on that. If I had a bit more confidence, ie. if I hadn’t just been smacked down by an incessantly strong Canadian dollar, I might be more willing to take the risk. But given the strength in the Canadian dollar, and my suspicion that the US dollar weakness is not a temporary event, if I am going to own a US stock, it needs to be a lopsided bet. Psychemedics doesn’t feel like that right now, so I’m out.