Psychemedics Remains Undervalued Even After Run-up

Four months ago I wrote an article titled Psychemedics Corp. on Cusp of Significant Revenue Growth. This time it worked out:

Psychemedics (PMD, Financial) did go on to enjoy spectacular earnings growth in 2016 because hair tests for truck drivers are now mandatory by law in Brazil. Truck drivers need to pass a hair drug test every five years to extend their license. In anticipation of the effect of the law, Psychemedics heavily invested in an expansion to its lab capacity. In addition the company is exceptionally well positioned to take market share in Brazil with a sales organization, Psychemedics Brazil, that has been present for something like 15 years.

Back in April I wrote:

Assuming Psychemedics grabs something like 50% market share, even when I am very conservative in my calculations, Psychemedics could very well increase revenue by between $18 million and $33 million. Given the company does about $26 million in annual sales, the potential impact is enormous.

Today this still looks fairly realistic reviewing the latest quarterly numbers. The testing is still in the ramp-up phase. Several states within Brazil require more time to implement the law, and it takes time to process tests on the vast numbers of truck drivers.

To grasp just how profound the effect is now the testing is finally under way just review the latest quarterly filings. This is the first quarter there is any effect because before that the story could be described in three words: delays, delays and delays.

If you will, pay attention how revenues jumped about $2.7 million against the same quarter last year. This is almost entirely the result of the Brazilian testing. Even better is how gross profit jumped up by almost $2 million. That means the additional revenue is generated at terrific margins. Meanwhile, G&A and marketing expenses did hardly budge (crucial lines bolded by me):

It is remarkable how the extra revenue improves the operating income. If you take into account Psychemedics has invested heavily into additional lab expansion and additional personnel in anticipation of the event that got delayed and delayed it starts to make more sense. The recent numbers have been artificially depressed due to these investments.

I’m still surprised the operating income came through this strong while it is still early innings. If we would take this last quarter operating income as a run-rate number it would very roughly translate into something like $2 of annualized operating income per share. Just on that basis the shares still don’t look that expensive at $21 per share.

It stands to reason operating income will increase further as the Brazil rollout gains traction, not to mention the company has historically relied at least partially on revenue coming from the oil and gas industry where drug testing is a common practice. With hiring in this segment of the market still depressed due to the low oil prices that’s another source of growth.

I’m holding my Psychemedics shares even after it has run up strongly as I expect $30 or more within the next four months is an entirely reasonable share price development given the catalyst at play here.

Disclosure: Long PMD.

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