Psychemedics (PMD)
- Mike Tango
- Aug 22, 2018
- 5 min read
About Company:
Psychemedics Corporation is the world’s largest provider of hair testing for the detection of drugs of abuse. Clients include big names like General Motors, BMW, Kraft Foods, and Sunoco. The company has been profitable every year since 1993.
Thesis: In spite of increasing competition, PMD will benefit from the expanding Brazilian market. Furthermore, there is a potential for the US domestic market to also expand as a result of new rules which are being considered by regulators.
The Trade: Go long on PMD, with an FX hedge against the potential further depreciation of BRL against USD. Given the FX risks and the increasing competition in the Brazilian market, I would not be comfortable allocating more than 1% of my capital to this trade.
Price: $19.82 (Aug 21, 2018)
Financials:
2017 EPS doubled versus 2014 EPS and almost quadrupled versus 2015.
Stable dividends. 2017 dividend of $0.60
Book value per share increased from 2.55 to 3.14 from 2016 to 2017
FCF increased from 3mm to 7mm from 2015 to 2016
Working capital increased from 6mm to 10mm from 2016 to 2017
P/E of 18.2
Management:
CEO is 73 years old and has had an almost 28y tenor at the firm. During the financial crisis, the company made quick decisions to address the decline in revenue (e.g. eliminated its 401K plan and everyone took salary cuts).
Market share and competitors:
The CEO estimated its market share is less than 10 percent.
Competitors include Quest Diagnostics (DGX) and LabCorp. Quest is also active on the Brazilian market.
Key ratios against competitors:
Ratio PMD DGX
P/Earn. 18 19
P/B 6 2.9
P/S 2.6 2
P/CF 11.8 13
Div Y 3.3 1.7
2Q 2018 results:
Total revenue up 11% yoy
Domestic revenues up by 15% yoy. Largely due to Transportation and Oil and Gas market segments.
International business (primarily Brazil) was up 4%. International revenue would have been up 16% for the quarter compared to the same period in 2017 and total revenue would have increased 15%, if the exchange rate had remained the same.
My own note: it is unclear how changes in the FX had such a large impact in the USD-denominated revenue, given BRL only lost 13% of its value against the USD from Q2 2017 to Q2 2018.
In addition, the Company’s effective tax rate decreased from 47% in the second quarter of 2017 to 43% in the current quarter.
The Brazilian market opportunity:
The testing for the Brazilian legally-mandated hair drug testing program began in March 2016, after the law was published in 2015. PMD made several local investments in anticipation of this opportunity, which led the firm to take on some long term debt.
In a Jan 2016 court ruling against the Brazilian distributor of PMD, it was stated that with the 2015 law, the number of hair tests in Brazil is expected to increase from 4,500 per year to 2,000 tests per day.
I would expect this expected number of tests to decline after professional drivers or their employers have complied with the regulatory requirements. 2000 tests per working day corresponds to 522,000 tests/drivers in one year.
The price of the test varies, but if one is to assume 220 BRL per test (or 54 USD), that corresponds to a market worth between USD 28.2MM and USD 32.4MM, depending on whether we assume 522k or 600k truck drivers in Brazil. This estimate is likely to be too conservative, given the law applies not only to truck drivers but to all professional drivers. In 2017, PMD's Brazilian revenues were USD 13.1MM. It is not clear how the Brazilian revenue is shared between PMD and the local distributor.
The Brazilian Truck Drivers Association is one of the largest unions and it claims to represent 600,000 drivers.
Expected expansion of the Brazil market in 2018 when professional drivers are required to renew their licenses every 2 1/2 years instead of the current 5 years. This expansion is by law and would virtually double the market size, according to PMD. This law will be enacted in Sept 2018.
The Brazilian market represented 33% of 2017 total revenues and 34% of total revenue for 2016. There were no customers that exceeded 10% of revenue for the year ended December 31, 2015.
In PMD's latest annual report, they recognised that the Brazilian market is subject to price pressures as new competitors enter the market.
Quest set-up a JV with the Brazilian company Labet a few years ago, and this year they have set-up a large laboratory in the state of Sao Paulo, Brazil.
In 2017, PMD enhanced its presence in Brazil by establishing a wholly owned subsidiary with the goal of potentially opening a laboratory in the country. This may lead to an increase in CapEx, especially given the increased competitive pressure from Quest.
Outlook for Brazilian Real versus USD:
Given the large proportion of Brazilian sales in PMD's total revenue, and the lack of any FX hedging by the Company, it is important to analyse historical fluctuations in the value of the Brazilian Real (BRL) versus the US Dollar (USD).
BRL is currently at a 15-year low against the USD. BRL has lost value against USD since Jan 2016 as a result of (i) declining Brazil central bank interest rate, (ii) increasing US Fed rate, (iii) sluggish Brazilian GDP growth, (iv) strong US GDP growth.
After two years of negative GDP growth, Brazil achieved in 2017 a 0.97% GDP growth rate (yoy).
Timing of a potential hedge against further depreciation of BRL against USD is important. If the timing is not right, the hedge can generate losses, even if the BRL depreciated against the dollar during PMD's reported financial quarter/year.
Potential catalyst in the domestic market:
The Trucking Alliance, will promote congressional passage of a new drug testing law, to require all people who apply for a safety sensitive job in the US trucking industry to verify no opioid addiction or illegal drug use for at least 30 days prior to employment. Opioids are not accurately detected by urine tests.
If enacted into law, this rule would allow trucking companies to choose between urine and hair follicle testing for their DOT-mandated pre-employment drug tests. Currently, urine is the only federally approved drug testing method. For these companies, the move towards DOT-approved hair testing would create a cost savings for them as they’d only need to conduct one pre-employment drug test on each new driver.
David Kidwell, a Virginia-based research scientist, said his experience shows hair testing is unfair because it measures exposure to drugs rather than use.
The 2015 FAST Act required the Department of Health and Human Services (HHS) to set the guidelines for drug testing by December 2016, but it has yet to do so.
Recent litigation:
In Jan 2017, Psychemedics Brazil, the distributor, was ordered by a court to compensate Omega Laboratories USA for anticompetitive practices in hair drug testing market.
The ruling also indicated that there may be further investigation of Psychemedics Brazil and O. Brazil by Brazil's Administrative Council for Economic Defense (CADE). It is important to note that PMD Brazil is independently owned and it is not a subsidiary of PMD.
Jan. 26, 2017, PMD traded at a price of $26.47 per share. Just five days later, though, the court decision was announced, and the price plummeted back down to $18.87
Websites:
https://seekingalpha.com/pr/16727559-figueira-hong-amaral-bertoni-advogados-landmark-legal-ruling-orders-psychemedics-brazil
http://cache-internet.tjdft.jus.br/cgi-bin/tjcgi1?MGWLPN=SERVIDOR1&NXTPGM=tjhtml122&ORIGEM=INTER&CIRCUN=1&SEQAND=112&CDNUPROC=20160110655585
https://www.psychemedics.com/blog/2018/05/trucking-alliance-supports-more-effective-drug-testing-of-us-truck-drivers/
https://www.foleyservices.com/news/hair-testing-one-step-closer-becoming-dot-drug-testing-method/
https://www.exametoxicologico.com.br/precos/
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