PharmChem : 8.31.2022 Shareholder Meeting Q&A

Shareholder Meeting Q&A

08/31/2022

CEO

What was the Board's rationale for appointing Matt Katz as CEO?

The decision to appoint Matt Katz as CEO was motivated by a bigger picture evolution of PharmChem's strategy. The Board believes that growth will come from not only greater market share in the core criminal justice business, but also through the targeting of new customer segments and new product formulations. Matt brings a strong background in product development and corporate strategy. Having worked over a decade in healthcare, he understands the challenges of a highly regulated business with long sales cycles. His educational credentials include graduating in the top 5% of his MBA class at Wharton.

What is the compensation structure of the new CEO and what sort of goals and incentives are built into his contract?

Matt's base salary is $140,000. His primary form of compensation is in stock options, which as previously disclosed, vest over a four-year period. These options have a strike price of $4.60, incentivizing him to grow the company as well as reflecting our view of the potential value of PharmChem as it grows. He is not currently scheduled to receive any other form of variable compensation for this performance year.

The board continues to monitor his performance and has emphasized gross profit growth as a key measure of success.

Board compensation and strategy

Are any of the Directors receiving compensation for their roles?

As we have previously disclosed, the Chairman and the Board are taking no compensation for their positions. Zero dollars of cash and zero shares, options, RSUs, or other equity compensation. They solely stand to make economic returns from their personal stockholdings which were purchased in the open market.

What conditions would lead you to resume open market share repurchases?

When we are confident that internal cash flows exceed attractive internal uses of cash, and cash on the balance sheet is adequate for growth spending, we could consider open market share repurchases again.

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Sales team impact

What is the growth opex on salesforce?

Sales team compensation represents roughly $400k in additional SG&A spend on an annual basis.

The team is compensated through a mixture of base salary and commissions, in line with industry rates.

How is the Board evaluating the ROI on new salesforce?

The Board is actively monitoring the ROI of the sales team and expects a high IRR for it to be judged a success.

Kerri, our Chief Revenue Officer, has built the sales organization from the ground up over the past year, and we believe they are only now really starting to hit their stride. This is a nuanced product competing in an industry with long sales cycles. As noted in the Q2 shareholder letter, we continue to see quarter over quarter new sales revenue growth and will continue to watch that closely.

Importantly, we are taking a multi-year perspective on the value created by this new salesforce by looking at CLV. Many of our largest customers started as small accounts that grew over time as they became comfortable with the sweat patch technology and processes. Analysis of historical sales data has confirmed that the present value of each new customer is significantly higher than year-one gross margin, so we are also measuring the number of new customers, not just revenue.

Our YTD new customer count has already matched 2021 and exceeds our historical full-year average by 50%.

Are there plans to expand the sales staff beyond current levels?

We do not have explicit plans to expand the sales team in the near-term future, but we continue to explore options to improve overall customer support and account management capabilities.

Lab partnership

How is relationship with current testing lab?

We continue to have a strong and collaborative relationship with our lab partner. A recent example is the development and rollout of a new Fentanyl add-on test that became available to our customers in April. The lab worked with us to directly address a stated need from our customers, and we have seen great early uptake.

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We have an evergreen contract with our existing lab partner which renews automatically on an annual basis and we look forward to continuing to evolve the relationship.

Inventory

Are there any concerns with the significant increase in inventory?

Supply chain and Covid-related headwinds, created two challenges:

1. Increased manufacturing lead times
2. Uncertainty around raw material pricing

Taking advantage of the long shelf-life of the patch, we partially hedged our risk by increasing our order size and holding more inventory. Moving to fewer, but larger, orders has also allowed us to lower manufacturing costs.

The unexpected slow down in sales from the large customer discussed in the Q2 shareholder letter will impact the speed of inventory sell-down, but we anticipate an increase in pre-emptive product purchases in the last quarter and do not anticipate any write-offs.

Customers

How have customers responded to previous price increases?

Can you offer insight into your pricing power / ability to pass along cost increases?

Many of our customers are government entities with budgetary constraints, making them highly price sensitive. We also face the challenge of competing against urine testing, which has a significantly lower unit cost. Despite that, we have been able to maintain a consistent gross margin rates over the past five years. This speaks to the value our product brings to our customers, and our continued emphasis on communicating the unique benefits of the sweat patch.

Recently, we have made efforts to lower operational expenses to minimize cost increases for our customers and have benefited from strong collaboration with our manufacturing partner to find creative solutions.

Do we expect to get the business back on the 10% customer referenced in Q2 letter?

Though we cannot offer any specific guidance, we are optimistic that we will be able to get at least some of the business back. The decision for them to discontinue use in Q3 was largely driven by budget constraints they are facing. We anticipate having a clearer picture when the customer's budget year resets in early Q4.

Beyond the large customer referenced in the Q2 Shareholder level, how concentrated is the business?

The large federal customer referenced in our shareholder letter is an outlier in both size and the fact that they represent a single end user. No other customer is a double-digit share of revenue

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and most of our other large clients are resellers who work with multiple criminal justice end users, mitigating the risk of a sudden large drop.

What are recent trends on customer retention and dormant accounts?

The addition of the sales team has improved our ability to manage and grow existing customer accounts, as well as re-engage dormant accounts. In 2020, we did not have the infrastructure in place to handle the surge in new customers, and as a result many of them were not fully onboarded and cultivated. A key metric we are now monitoring is whether customers are submitting screens to the lab within 60 days of their first patch purchase. Customers who are not actively using the patch by that time are far less likely to become repeat purchasers.

Another benefit of the expanded sales team is the ability to communicate and influence a broader range of decision makers. Turnover within the operations and leadership of our customers can present a challenge if new individuals are not familiar with sweat testing. We are proactively building awareness through training sessions and communications to decrease customer knowledge bottlenecks, which we expect to result in improve retention.

Product

What IP protections do you have in place?

In addition to the FDA 510(k) clearance for the sweat testing patch, much of PharmChem's protection comes from proprietary business knowledge and processes. Within the criminal justice segment, we have established legal precedent in over 20 states, giving us a defensibility that a new entrant would struggle to replicate.

Is PCHM looking at external research as a source of new opportunities?

We believe that there are additional applications for the patch that have not been fully explored due to our historical focus on drugs of abuse testing within the criminal justice segment. We will continue to explore opportunities to leverage our proprietary sweat testing capabilities to address new use cases and/or market segments, but do not have specific updates at this time.

DISCLAIMER

This letter contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933 ("Forward-looking Statements"), which are subject to the "safe harbor" created by these Sections. Forward-looking statements are statements about future financial results, future products or services and other events that have not yet occurred. These forward-looking statements contain words such as, but not limited to, "expect", "anticipate", "estimate", "believe", "will", "may" or "might". Investors should be aware that actual results may differ materially from our expressed expectations because of risks and uncertainties about the future. We will not necessarily update the information in this letter if any forward-looking statement later turns out to be inaccurate.

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