This past August I wrote an analysis piece on PharmChem, Inc. (PCHM). Since then PharmChem has become a part of my portfolio and I am happy with the write-up. I wrote an analysis before I had this blog so I am going to put it below (in italics). After which I have provided some updates. Nothing about the company’s business materially changed since I initially wrote the analysis which is why I am not going to write a brand new one. But I am including updates about the proxy fight and 2021 earnings, as those are important.
PharmChem, Inc. is a microcap company trading over the counter, that has delivered some seriously impressive operating results in the last decade. The company has steadily increased its revenue and earnings growth and maintained good margins, all while generating lots of cash flow. Most impressively of all though, PharmChem has done all of this without the addition of almost any capital expenditures. PharmChem’s business is a very simple one, they sell drug testing systems in the form of their ‘PharmChek Sweat Patch’ testing product. They sell their drug testing solutions mostly to state and federal criminal justice systems. They compete with other companies who make drug testing solutions, most of which test with hair or urine sampling. PharmChem is an interesting player in this space because they offer sweat patch testing systems, which are a little less reliable than hair/urine sampling but are much cheaper and less invasive.
The results of this business model have proven to be very successful, in 2014 PharmChem’s revenue was $2.52 million, and their operating income was $0.47 million. In 2020, revenues were $6.67 million, and operating income was $2.14 million. Since 2014, balance sheet cash has risen from $1.68 million to $7.85 million, and invested capital has decreased from around nothing in 2014 to negative $0.34 million this year. PharmChem just does not need investments in additional tangible assets or working capital in order to grow. PharmChem’s 2020 revenue and operating income were up 20% and 31% each, despite the COVID-19 Pandemic. In some ways, the Pandemic helped PharmChem as customers looked to use drug testing solutions that were less invasive and more suited to the socially distanced operations required during the pandemic. The numbers and results are clearly very impressive, but PharmChem is actually trading at a very cheap valuation despite all of this. With shares currently trading for around $4.5, PharmChem is being valued by the market at about only 8x EBIT and 10x net income.
There are of course lots of risks that come with over-the-counter microcaps, including liquidity and disclosure concerns among others that should be considered. PharmChem is no exception to any of these concerns, but I want to focus on some interesting developments that I think are worth looking at regarding the company. Earlier this month the company responded to a proxy statement by investors at Cedar Creek Partners who are trying to replace the board of directors and CEO. These investors claim that although the operational management and results of the company have been superb, the current non-operational management and board has hurt shareholders as they are hoarding insane amounts of cash that should be either returned to shareholders or reinvested into the company. PharmChem has of course released an opposition statement, that I found honestly rather weak. Currently, the annual meeting is set to be held on August 31st where we will learn what the shareholders have voted to do. I believe that the Shareholders will vote for the board and non-operational staff to be replaced, as the proxy statement and the accusations are very accurate and reasonable. I’m not sure how management could have used the cash to reinvest in the company, as I don’t know enough about what options they have looked at/exist, but it is strange that the company hasn’t used the cash to buy back shares or distribute any dividends.
I believe that when the board and non-op management is replaced, (assuming they get enough votes), the company will either buy back shares or distribute at least a special one-time dividend, if not announce a recurring one. I think it’s most likely they decide to buy back shares, but regardless this should increase shareholder value. Additionally, I think new management will be better at communicating with shareholders and will more frequently disclose information. I believe it is likely that PharmChem would start to disclose quarterly results, not just an interim and annual report.
Looking forward, I think it’s unlikely that 2021 results are going to be as good as they were in 2020. Simply put, I think COVID-19 benefited 2020 results in a way that isn’t repeatable this year, even with the pandemic. In their statement to the opposition, PharmChem made it sound like this won’t be the case and that results are currently looking just as good, but I don’t put a lot of weight into this, because I think it’s just a move to please shareholders and help them get a few more votes. Additionally, the current legal battle between PharmChem and the opposition behind the proxy statement will likely add one-time legal expenses that will bring down 2021 earnings. Regardless though, I think the company looks attractive at current valuations and is well set to continue to grow in the future, even if 2021 ends up being a year of stagnation, particularly if the proxy goes through, and more value is returned to shareholders.
It is now March and time for an update: indeed the activists won the proxy contest and took control of the board. Staying true to their word, new management immediately set out to deploy all of the excess cash into reducing PharmChem’s share count. They successfully repurchased 90k shares in the 3rd quarter as well as 900k in the money options. In the 4th quarter, PharmChem continued to buy back shares, purchasing 659k shares. In total, the company reduced its share count by 23.6% for a cost of around $5.8m.
2021 earnings were down as expected (-5%), some of this was due to non-recurring expenses such as litigation fees for the proxy fight. Additionally, the company announced it had invested significantly in improving its sales force. The hope is this will lead to more revenue growth in the future. It will take time to see if PharmChem’s investments end up paying off but I believe they remain an attractive bet at this time. PharmChem is asset-light, their position in the industry is strong, and when adjusting earnings for the one-time expenses the stock looks attractively priced.
As of writing, PharmChem makes up ~ 8% of my portfolio. Thanks for reading!