Psychemedics Makes The Speculative Buy List

Mar. 27, 2019 2:12 PM ETPsychemedics Corporation (PMD)7 Comments

Summary

  • Psychemedics shares dropped substantially after its future revenues from Brazil were put into doubt.
  • The company offers a superior method for drug testing that could still see substantial growth as more corporations learn of the benefits.
  • The company, with 68% of revenues coming from the U.S., has limited international exposure outside of Brazil, which leaves plenty of room to expand globally.
  • Weighing the risks and growth potential, along with the current depressed valuation, resulted in the company being added to our speculative buy list.

Psychemedics (NASDAQ:PMD) provides drug testing via hair analysis. This is an asset-light business that has resulted in this small-cap generating impressive free cash flow over the years. 2018 marked the third consecutive year of record revenue. Domestic revenue grew by 11%, which is slightly above average. The average annual revenue growth over the last five years was 9.7%.

Product Value Proposition

Most U.S. corporations use drug testing to screen job applicants and employees. The widespread practice of drug testing exists because it has the potential to help corporations avoid serious problems. Drug abuse by employees can cost employers in multiple ways. A Hazelden Betty Ford Foundation survey of over 300 human resources professionals listed absenteeism, reduced productivity, and a negative impact on the company's reputation. Other concerns cited in the study include safety and employee health problems and costs. The Psychemedics 2018 10-K notes that the cost to businesses of employee drug abuse is estimated to exceed $100 billion annually.

Drug Testing to Remain Prevalent as an Essential Component of Hiring

Data from the Centers for Disease Control and Prevention show the U.S. continues to face problems with drug abuse. From 2013 to 2017, drug overdose deaths increased in 35 of the 50 states and DC. The opioid overdose epidemic continues to worsen with increased deaths involving synthetic opioids. The United Nations Office on Drugs and Crime issued its 2018 World Drug Report which gives a similar story. The report notes that the headline figures for drug users have changed little in recent years. Despite this stability, the report notes many changes like increases in the non-medical use of prescription drugs. The report states that the range of substances and combinations available to users has never been wider.

A Market Research Engine Report estimates that the global drug screening market will exceed $9.5 billion by 2024 equating to a CAGR of 9.5%. The need for this screening is further highlighted by a 2018 study from Quest Diagnostics which found drug use by the U.S. workforce increased each year from 2015 to 2017 in five of the 16 major industry sectors analyzed.

Source: 2018 Quest Diagnostics Study

Specific Benefits of Psychemedics's Hair Analysis

Psychemedics distinguishes itself as a provider of hair analysis, which has some important benefits compared to the more common urinalysis drug testing.

  1. It offers a much wider detection window. Per the Psychemedics 10-K, studies published in many scientific publications have indicated that most drugs disappear from urine within a few days. Psychemedics's hair analysis provides a detection window of several months or longer depending on the length of the hair sample.
  2. Errors in drug detection are significantly reduced via the company's hair analysis. Urinalysis is more susceptible to false positives, resulting from passive drug exposure or poppy seeds.
  3. If a result is challenged, it is easier to retest. A retest via urinalysis is not useful, given that the individual is warned and can pass the retest by temporarily discontinuing illicit drug use. The same individual would not easily impact a hair analysis retest, given that the historical drug use remains locked in the hair fiber.
  4. Its FDA-cleared hair testing method uses a patented method of digesting hair that allows for what the company believes is the most efficient release of drugs from the hair without destroying the drugs.
  5. Hair testing is generally seen as more attractive to those being tested because of its less intrusive nature.

Cost Disadvantage

While we feel the benefits highlighted above are genuine benefits, as is so frequently the case with superior products, it comes with a cost. Prices for its tests are usually somewhat higher than prices for tests using urinalysis. While business decisions often come down to costs, the value proposition offered by Psychemedics tests has grown its customer list to include Fortune 500 companies, small to mid-size companies, as well as schools and government entities located in the U.S. and internationally.

Why the Opportunity to Pick Up the Shares at a Discount Exists

Psychemedics Brazil, the company's independent distributor, accounted for 31% of revenue in 2018. This is critical for investors to be aware of, since this revenue stream is now in doubt. Psychemedics Brazil had 55% of its shares acquired by Instituto Hermes Pardini S.A., a provider of medical diagnostic services in Brazil. Psychemedics has stated that it is in discussions with its distributor and its acquirer about the future of its distribution agreement. This agreement may be terminated by either party without prior written notice. In its latest 10-K, the company states that it is unclear if the acquirer can supply the same volume of drug tests as Psychemedics in the near term. Obviously, this was not welcome news, and investors dumped Psychemedics shares on seeing the Q4 report.

We do not by any means want to play down the impact of this sudden change. Brazil was an important growth driver for the business. Brazil is expected to implement a change in 2019 for legally-mandated testing for professional drivers. Under the new law, drivers would be required to renew their license every two and a half years. This is down from the prior time span of 5 years. Psychemedics estimated this would almost double its market size in the country.

What Could Trigger a Reversal in the Shares?

The shares declined some 20% on the day of the Q4 report and are down almost 30% for the last 12 months. This decline seems to largely price in a loss of all of Psychemedics's revenue attributed to Brazil. Any agreement with the acquirer or extension of the contract could reverse at least some of the decline in the shares. The company merely stated it is exploring additional options in the country in its press release.

International expansion could still offer a huge growth opportunity for the country which so far has only generated substantial revenue from the U.S. and Brazil. Drug testing is needed around the world. Most international drug testing is still performed by urine collections like in the U.S. Given the benefits of Psychemedics's hair analysis outlined above, the company's tests have potential to gain traction and market share.

Expanding internationally may require a beefed-up sales force. This is one reason Psychemedics could be a potential takeover target. Many of its competitors have market caps that dwarf that of Psychemedics. While this means they have more funds for research and marketing to compete against Psychemedics, it also means they may view the company as an acquisition target. The reason such an acquisition would make sense is because these companies already have the international presence that would allow them to more easily distribute the hair analysis. The synergies gained from such an acquisition seem substantial, given the current minimal international exposure.

Risks

The reason we consider Psychemedics a speculative buy is because there are real risks investors should understand before making an investment. The company basically offers a single product. If another company creates a product that obsoletes that of Psychemedics, it's not as if there is a diverse set of products or services to fall back on. Therefore, we view this lack of diversity in offerings as the main risk to an investment in the shares.

Additionally, the company faces larger competitors with greater financial resources that also offer a broader range of products. Some of the key players providing drug testing are listed below.

Source: Yahoo Finance

Valuation

At the time of this writing, Psychemedics stock was priced at $14.64, which we believe offers about a 20% discount to intrinsic value based on a conservative discounted cash flow analysis. We considered a five-year timeframe and used a PE in year five of 17.63. This is equal to the current multiple and well below the midpoint for the last five years, 25.94. Over the last five years, the company's PE has ranged from 15.56 to 36.32. We assumed that dividends would grow at the same rate as earnings. The average annual EPS growth rate used in the model was 10%. While this is below the average analyst estimate of 20%, it is above the actual annual average EPS growth rate of the last five years of 2.9%. The company would need to grow its earnings by at least five percent a year, keeping all other inputs the same, to justify the current price. We think the company has the potential to exceed our growth estimates via top-line growth by international expansion and gaining market share in the U.S. The multiple given to the company by the market could also see room to the upside if serious expansion plans are provided.

The company has a solid balance sheet with minimal long-term debt. The profitability metrics are also respectable as seen in the table below.

Source: Reuters

Final Thoughts

Psychemedics's share price has been cut by about 30% over the last twelve months. We feel this largely accounts for losing all revenue from Brazil, which is a worst-case scenario but a possible one. However, the company operates in a growing industry, provides a superior method for drug testing, and has the opportunity to grow internationally as well as domestically. The company generates impressive free cash flow thanks to the low capital requirements of its business and also offers an attractive dividend yield of almost five percent. Investors should understand the risks outlined in the article before making a purchase. Given the growth potential, attractive valuation, as well as the risks, we have added Psychemedics to our Speculative Buy List.

This article was written by

Visit our website: Wall Street for Main StreetAll articles/comments are provided for informational and educational purposes and should not be considered as personalized investment advice. Perform your own due diligence and make your own decisions. Be advised and aware that buying and selling financial instruments involves risk.On the long side, I search for equities trading below their intrinsic value with bright prospects.For the short side, I identify companies burning cash with unattractive business models.Software Engineer Education: - Business Administration (MBA) - BS, Electrical Engineering

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PMD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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