This is my first post on Substack. Here goes nothing!

PharmChem, Inc. is, quite simply, one of the highest-quality tiny companies I know. Year after year, the company records mid-teens revenue growth, earns a healthy operating margin, generates copious cash flow, and does it all with practically zero capital expenditures or invested capital. And yet, PharmChem remains practically unknown.

I should start by explaining exactly what PharmChem is and does. PharmChem sells the PharmChek Sweat Patch drug testing system. PharmChek is a means of testing for illicit drug use, either in one-off scenarios or as part of on-going compliance monitoring. PharmChek received FDA approval in 1990. Sweat patch testing is not as reliable as hair or urine sampling, but it is substantially cheaper and less invasive. PharmChek’s major customers are state, local, and federal criminal justice systems, which use the products for programs like work-release and drug offender monitoring. PharmCheck works well, and customers continue increasing their purchases of both sweat patches and lab testing services. PharmChem is headquartered in Fort Worth, Texas.

PharmChem’s success over the last decade contrasts with the company’s earlier struggles. From the late 80s to the early 2000s, PharmChem operated a lab that performed nearly all drug testing for the Administrative Office of US Courts. But the company lost this contract, resulting in operating losses. In 2004, doubtful that a turnaround would materialize, the company sold what it could, settled its liabilities, and resolved to sell the remaining PharmChek segment and liquidate. But then, a funny thing happened. Finding a buyer for PharmChek proved difficult. The highly-regulated aspect of drug testing services, a few long-term contracts, and some anticipated research and development expenses proved a deterrent to buyers. Meanwhile, PharmChek sales took off! PharmChem began earning meaningful profits and generating cash, and any thoughts of liquidation took a back seat.

In 2014, PharmChem produced revenue of $2.52 million and operating income of $0.47 million. By 2020, revenue had grown to $6.67 million with operating income of $2.14 million, increases of 165% and 355%, respectively. The COVID pandemic hardly touched PharmChem, and in fact benefitted the company in some ways as drug testing shifted from in-person sampling to more socially-distanced solutions like sweat patches. In 2020, revenue rose 20% and operating income was up 31% despite a slow-down in orders from government customers.

Over the entire period, balance sheet cash rose from $1.68 million to $7.85 million. Amazingly, invested capital remained the same over the entire period, from effectively nil in 2014 to….negative $0.34 million at year-end 2020. The company simply does not require investment in physical assets or working capital to grow.

With statistics like these, one would expect PharmChem to be the toast of the market, with a valuation to match. Instead, PharmChem languishes at 8.5x trailing EBIT on an enterprise value basis, and 11x normalized (fully-taxed) earnings, net of excess cash. Why? Get ready, it’s a long list.

• Tiny size and illiquid shares. Depending on how you treat some outstanding options, PharmChem’s market capitalization is $24-28 million. My guess is less than half of the company’s shares are free-floating, making acquiring a meaningful position a challenge.

• Minimal reporting/disclosure. PharmChem deregistered its shares 17 years ago, and has happily avoided SEC reporting ever since. Shareholders are treated to a summary annual report each April, and a mid-year update in advance of the annual shareholder meeting.

• Product and customer concentration. PharmChem’s results depend on a single product system sold to a rather limited set of customers. PharmChem appears to enjoy solid, long-standing relationships with customers and has recently added several new ones, but the risk remains.

• Sub-par capital allocation. Despite steady profits and near zero need for capital expenditures, PharmChem has allowed a substantial amount of cash to accumulate on its balance sheet. The firm has paid occasional dividends and seems committed to raising them in tandem with profit growth, but investors should rightfully question the company’s need to hold onto such a hoard. On the plus side, management has avoided the temptation to plow this cash into dubious acquisitions or empire building efforts.

• Board composition. PharmChem’s upper management and board of directors are, well, not exactly youthful. The three-person board has an average age of 80. Some new blood at the board level could provide some healthy additional perspective and urgency.

• Poor communication. Perhaps related to the board issue, the company does a lackluster job of communicating with shareholders. PharmChem’s annual letters portray a company at risk of plummeting into insolvency at any minute. (Quite unlikely for a company with cash reserves sufficient to cover years of overhead.) Risks are explained, then re-explained. Upcoming expenditures are disclosed. What is rarely discussed is upcoming opportunities, growth targets and goals, long-term strategy, or why the company has been so successful this last decade. Management should do a better job capturing the full picture of the company in its letters to shareholders.

• Possible changes to national policy on drug use. Marijuana usage is growing more and more socially acceptable, and the law is starting to reflect the same. It is possible that if marijuana is federally legalized, the demand for drug testing will decrease. However, it is extremely difficult to imagine hard drugs (methamphetine, PCP, etc.) being legalized, and the need to test for usage of those will remain.

Despite the negatives, I view PharmChem shares as extremely attractive at the current price around $4.00. The company’s many positive characteristics and discounted valuation more than make up for its shortcomings. I know of no other company with as attractive a business model, as positive an outlook, and as robust a balance sheet trading at such a modest multiple.

I have reason to believe investors will take more of a shine to PharmChem in the months and years ahead. First, despite the company’s reluctance to provide forward-looking guidance, the CEO somewhat subtly indicated the company expects continued growth.

“During 2020, we engaged a process improvement consulting firm to define and strengthen our current business processes and to evaluate and select improved technology to develop a customer relationship management (CRM) tool, more efficient operations, and updated financial and operating reporting systems. The review enabled us to identify key processes to initiate and improve customer onboarding, order fulfillment and invoicing to continue our sales growth (emphasis added) while maintaining current staffing. A vendor has been selected and we plan to implement these new systems in 2021.” - PharmChem CEO Joe Halligan in the April 9, 2021 letter to shareholders.

Firms with stagnant or plateauing revenue and dimming prospects do not generally invest in new software systems to streamline customer onboarding and continue sales growth. The language concerning updating financial reporting systems also stands out as it ties into another major company initiative this year: upgrading its reporting status. Due to the SEC’s changes in Exchange Act Rule 15c2-11, so-called “non-reporting” companies such as PharmChem will have to commence providing shareholders with a basic level of financial reporting if they wish to have their shares continue trading in the regular market. PharmChem has indicated it will comply with the rule change and begin publishing sufficient information to maintain its listing.

Investors were somewhat disappointed with PharmChem’s 2020 second half results, mostly due to lighter than expected revenue and operating income, largely due to reductions in government purchasing. These purchases will return as the COVID pandemic fades away. With shares down 20% or so, I think the current price represents an excellent entry point. As PharmChem begins reporting quarterly results this year and the OTC Markets “STOP” sign is removed, I think a new set of investors will check out PharmChem and find lots to like.

Here are a few helpful links for anyone interested in learning more.

Investor Relations

Product Overview

Alluvial Capital Management, LLC holds shares of PharmChem, Inc. for client accounts it manages. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.