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Psychemedics Corp (PMD) is the world’s largest provider of testing services for detecting abused substantces through its proprietary and patented hair sample analysis system. The company trades at a P/E ex-cash of 14x, and P/B of 4.4x, making it appear to be fairly valued (or even overvalued), but for a variety of reasons, I believe the company presents a decent value opportunity (though, I am waiting for a bigger discount before I make a move).

First, the company’s revenues are largely tied to the economy, in that its customers demand drug testing of new hires (head hair grows 1.3cm/month, so using a 4cm sample allows PMD to test for three months’ worth of drug use, compared with urinalysis, only good for a few days, maximum, and usually used in the case of specific instances). The company hit a five year bottom for revenue in 2009 and has been regaining since then, as the economy continues to expand and hiring begins again.

Second, the company has competitive advantages. Its testing process has been patented (though, some of these patents expire in the next few years), and it is the only company FDA approved for its full 5-drug panel test that is not limited to head hair. This has allowed the company to continuously earn strong returns on equity (35% average over the last five years).

Third, this company isn’t going anywhere. It has zero debt, has a long history of strong profits and returns on equity (5-year avg profit margin of 16% and ROE of 35%, including the recession!), and produces strong free cash flows due to its low capital demands.

As a bonus, the company pays a strong dividend (just under 5.5-6%) that isn’t in danger anytime soon.

Treating the company as a no-growth perpetuity using normalized margins, I calculate EPV to be in the $10 range. Thus, today’s prices don’t represent the biggest discount, but given the company’s historical performance I believe this is a strong candidate in the future. I’ve added it to my watchlist and hope to initiate a position at prices closer to what we saw in December.

Author Disclosure: No position.

Source: Psychemedics Corp: Value in Hair Analysis