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Posts from the ‘Psychemedics (PMD)’ Category

Sep 2

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:

  1. this is a small company ($65 million market capitalization)
  2. they just reported strong growth (32% year over year revenue growth in the second quarter)
  3. 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
  4. 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.

Selling Psychemedics

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.

Jun 3

2 Comments

Psychemedics: A reasonably Priced Gamble

I got the idea for Psychemedics from Mike Arnold, who mentioned the stock a couple of months ago.

 

I don’t think Mike owns the stock.  Mike believes in portfolio concentration.  Diversifying to 2 or more companies would be seen as a dilutive exercise to him. 😉

I, on the other hand, can’t have enough stocks in my portfolio.  I think this one is worth a buy.  Here is the deal.

Psychemedics provides alcohol and drug testing via hair samples.  They have a patented technology that digests the hair and then releases any residual drug trapped in it.   They then use a proprietary enzyme immunoassay on the liquid mixture to evaluate the presence and level of drug residual in the sample.  Its based on knowledge that blood will carry chemicals, including some that are markers of drug or alcohol use, to the hair follicles, where they become trapped in the protein mixture.

Using hair to test for drugs is a somewhat new, at least in terms of being an accepted alternative to urinalysis.  But it does have advantages.

First, its not nearly as easy to trick the process.  With urinalysis, you can replace the sample or tamper with the sample using chemicals.

Second, urinalysis is only testing for drug and alcohol use in the recent history, usually 3-5 days, hair sampling is testing for a far longer period.  Most tests that Psychemedics performs are looking back 90 days.  The chemicals are deposited in the hair soon after ingestion, so theoretically you can look back as far as the hair has grown for.

Because its harder to game the system air testing typically gives more positives than urinalysis.  In their 10-K Psychemedics notes that when compared to urinalysis “in side-by-side evaluations, 5 to 10 times as many drug abusers were accurately identified by the Company’s proprietary methods.”

The downside is that hair testing can’t be used for to test for-cause, like in the case of a drunk driver.  Drug ingestion does not appear in the hair above the scalp for 5-7 days after use.  Hair testing is also priced “somewhat higher” than urinalysis (from the company, I don’t have specific numbers).  And there are some concerns that hair can become contaminated from the environment or that different hair colors are more susceptible to accumulating chemicals, but I didn’t get the feeling that these were wide spread concerns.

Hair sampling appears to be gaining acceptance.  The Psychemedics process is used for testing by 10% of Fortune 500 companies.  And in 2016 Brazil mandated a hair testing hurdle for professional drivers.

The Brazil requirements created a step change in the results of the company.  Prior to the legislation the company operated at roughly a $7 million revenue rate per quarter.  Since the testing has been mandated, that level has stepped up to $10 million.  You can see how that step change occurred in the second quarter of last year:

Brazil also has room to grow further.  In September 2018 a second phase of the Brazilian law will be enacted that will reduce the number of years between testing from 5 to 2.5.

Note that there were some problems in Brazil earlier this year when their Brazilian distributor, Psychemedics Brazil, lost a court case for uncompetitive practices.  A SeekingAlpha short piece came out shortly after to drum up some fear about the event.  The company clarified that the Brazilian distributor was not owned by Psychemedics and that they expected no interruption in Brazilian revenues as a result.  I read through the court document and thought it probably wouldn’t have much of an effect on their results.

The second potential growth area is the United States.  This is where it really gets interesting.  In the United States the federal government hasn’t recognized hair as a reliable sample for federally regulated employees and programs.  However, there was a bill passed in 2015 that changed that, as it would allow for hair testing of Federal employees as well as for workers needing to meet Federal requirements.

While the bill past some months ago, its implementation is being held up by Health and Human Services (HHS), which has so far yet to issue standards on the tests.  In March the American Truckers Association (ATA) called on the HHS to hurry up and give some guidance.

ATA spearheaded efforts to allow carriers to use hair testing as an alternate test method to traditional urinalysis in the most recent highway bill, but to date HHS has yet to issue the necessary standards to allow those tests to go forward. This week, the HHS agency responsible for developing those standards, the Substance Abuse and Mental Health Services Administration, holds its Drug Testing Advisory Board meetings to consider hair testing, putting HHS well behind its congressionally mandated deadline.

“Many trucking companies are using urinalysis to meet federal requirements, while also paying the additional cost to conduct hair testing,” Spear said in his letter. “We are frustrated that the previous administration failed to meet the statutory deadline and believe your leadership will finally see a resolution to this long-standing and important safety rule.”

The opposition to hair testing seems to come from the Democrats, while the Republicans are in favor of it.  I have no idea what the reasons behind the divide are but I bet they have more to do with constituencies and political support than the value of hair testing.  Neverthless, with a Republican controlled everything right now, I would think the odds are that it is resolved in Psychemedics favor.

I have to admit I haven’t found any source to quantify the size of the opportunity if the HHS issues guidelines and the bill takes effect.  My assumption is that it’s material.

The nice thing about Psychemedics is that you have this growth optionality that really doesn’t seem to be baked into the price.

The market capitalization of the stock is $122 million.  The company has roughly the same amount of cash as debt, with neither being substantial.  Free cash flow for the past 12 months was $11.5 million.  EBITDA was a little over $15 million.  So the stock trades at about 11x free cash flow and 8x EBITDA.

Its not amazingly cheap but also its not particularly expensive.  I like the idea on the basis that we see further revenue growth from Brazil and maybe an announcement in the United States that takes things to another level.  It’s worth a bit more than a starter position for me.