How to profit from the war on drugs

The drugs problem isn't going away - but there's a way you can make money out of controlling it.

According to the 2005 World Drug Report, 200 million people that's 5% of the world's population aged 15 to 64 abuse drugs. In the US, UK and Spain, the figures are more like 10%, and in prisons the situation is even worse: within Europe's prisons, it is believed that more than one in three inmates are regular users. The street value of the drugs comes to around $320bn. But the cost to global society is a great deal more than that.

These things are hard to compute, but in the US the additional cost to an employer of taking on habitual drug users is estimated to be about $10,000 a year, thanks to lower productivity and absence. In the UK, the social and economic cost in terms of crime, absenteeism and sickness is estimated to be over £20bn a year, and Government expenditure on the Home Office's Drugs Interventions Programme will be not be far off £500m a year by the end of 2007.

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This is a horrible situation and it is clearly in everyone's interest that governments around the world keep cracking down on it. But how? One answer is to test people for drug use and to treat those in trouble as quickly as possible: for every £1 spent on drug treatment, the Home Office tells us that at least £9.50 is saved in health and criminal justice costs, so it's no wonder that the drug-testing industry is expanding at speed.

The US is at the forefront of this movement it already accounts for more than 50% of the $1.3bn global drug-testing market but the rest of the world is also beginning to understand the benefits of catching drug abuse early. Only last month a new policy was introduced among the Metropolitan Police, which means that all officers can now be tested for evidence of the abuse of everything from cannabis and cocaine to heroin and ecstasy.

But it isn't just public employees who get tested these days. Businesses are also increasingly testing potential employees before they hire, and even introducing random, compulsory drug testing. They are able to do this largely thanks to improved methods of testing.

In the past, to test for the various drugs doing the rounds, firms would have had to ask for either a urine or blood sample, and then send it for laboratory analysis, a process that is both costly and intrusive. Today, things are simpler. While many of the bigger firms in the business still offer these rather old-fashioned tests, a number of smaller businesses have developed portable "point of care" (POC) detection kits, offering a quick, simple and round-the-clock alternative to laboratory-based testing.

Many of these kits use saliva for testing purposes, making them much more convenient, to say nothing of being less intrusive. As well as their commercial applications, they're useful for the police, who can use them quickly to test erratic drivers on the roadside, for example; according to Brake, the UK road safety charity, more than one in seven young drivers aged 17 to 25 admit that they have put lives at risk by driving after taking illegal drugs.

The POC drug-testing sector is currently estimated to be worth around $100m globally, but given all the factors outlined above, there is clearly huge scope for growth as those groups using traditional blood and urine tests switch over, and those doing no testing get started. In 2003, according to Frost & Sullivan, more than 50% of US companies tested employees for drugs, while only 5%-10% of those in the UK implemented such tests.

One of the main reasons for this has long been the confused legal position on testing. In the US, drug-testing policies are largely accepted and considered practical, whereas in Europe there are still lingering perceptions that testing is an invasion of privacy. Still, however valid one may think those concerns are, I suspect that the gap between the US and Europe will soon close, thanks to the success of US testing programmes, the ongoing introduction of tighter regulation in Europe (such as the 2005 Drugs Act) and the fact that we just can't keep ignoring the effects the drug problem is having on productivity.

All this puts a very strong tail wind behind the industry. And the good news for investors is that not only is POC a high growth area, but it is also under-researched, which suggests there may be opportunities out there that the City hasn't spotted yet. I've trawled through all the players in the sector looking for the best way for us to get in. My aim was to find a financially secure business with high exposure to the market, with a good and securely patented technology, strong customer reference sites, a broad geographic reach, and which had clear potential for growth. My ideal candidate also had to be priced at an attractive valuation compared to the rest of the market. This was a demanding list of criteria, but I think I've found one, and I look at it in more detail in the box below.

How to profit from the clean-up operation

My favourite stock in the drug-testing sector is Cozart (CZT, 33p). The UK-based firm develops, produces and sells point-of-care (POC) testing products, laboratory services and forensic testing kits to the criminal justice, medical and workplace markets in the UK and abroad.

It was set up in 1993 by two of its current directors, Dr Christopher Hand and his brother Philip Hand. It made its commercial breakthrough in 2001 when it won a £500,000 contract with the Home Office to supply the Government's Drugs Intervention Program (DIP) with its state-of-the-art testing device, the Cozart RapiScan (a saliva-based system that can test for five different drugs and give results in minutes).

Cozart then listed on Aim in July 2004 at 30p a share, raising £5.3m as it did so. Today, around 50% of the shares are still held by the management, with the remainder largely owned by institutional investors (encouragingly, Philips NV, the Dutch technology giant, picked up a 4.8% stake last month).

So why should you think about joining this list of shareholders? The first reason is that the RapiScan is a clear success. In October 2005, the Home Office extended its contract with Cozart through to April 2007. Then, a month later, it expanded the scope of the DIP to encompass all arrestees, rather than just those solely charged with offences such as burglary.

The Home Office anticipates that the number of tests performed, and therefore the number of Cozart cartridges used (you need a new cartridge every time you do a new test), will more than double and perhaps even triple. In the six months up to November 2005, the DIP consumed 59,300 cartridges, so it is entirely possible that within a few years more than 300,000 a year will be being used. The list price of each cartridge is approximately £8, while an electronic reader sells for £2,000, which suggests that this contract alone could deliver well over £2m a year of ongoing revenue.

However, Cozart is not resting on its laurels. Not wanting to become too dependent on revenues from one product, customer, or country, it has recently used part of its cash pile (it still has £400,000 left) to buy two European businesses: Medib, which operates in the Scandinavian drug-testing market for £400,000, and Spinreact, for £8.8m. Spinreact makes its money from a diverse range of diagnostic testing and sells mainly in continental Europe and South America.

Cozart is also making sure that it keeps growing internally too. It is soon to launch a new drug-detection system that should cut the waiting time for test results down from the current 12 minutes to five minutes, making it ideal for roadside testing. In addition, it's recently signed a development agreement with Philips aimed at providing police forces with a lightweight, hand-held saliva drug-testing kit, which is as speedy and easy to use as roadside alcohol Breathalysers.

This deal is particularly encouraging as it represents a stamp of approval on Cozart's technology from an industry heavyweight and means the firm has an excellent chance of winning roadside-supply contracts in the UK. And that could really move the firm into the big time. In 2001, there were 624,000 roadside breath tests conducted in England and Wales. If these drivers were also screened for illegal drugs, using Cozart's kit, the firm could make even more from this than from its current contract with the DIP.

So far so good, but what about valuations? If you look at things very conservatively (assuming the DIP programme is rolled out as planned, but that an extra £500,000 of research and development investment is required in 2007 and that no new large contracts such as the roadside contract are won), the shares are trading on a forward p/e of 23 times this year.

Although this is slightly higher than the rest of the healthcare sector, I think that these assumptions are far, far too miserly, given the company's excellent growth credentials. The gross margins in this industry are excellent, so if Cozart were to sign just one new deal of a similar size to the DIP programme, a good 1p would be added to earnings per share (which are currently forecast to be 1.45p this year), which could lead to a 20p (60%) increase in the share price (or push the p/e down to 13 times).

In light of Cozart's current roadside trials in Italy and France, its relationship with Philips, its management's strong historical track record, and possible future licensing deals of the Cozart RapiScan technology in the US, I believe the likelihood of clinching such a new contract is more than a distinct possibility.

There are risks, of course. As a small firm, Cozart carries a higher level of risk than it would were it larger and more diversified. It also has no real foothold in the US, the world's largest drug-testing market, and makes a good part of its revenues from the Government which comes with all the usual risks of delay and contract cancellation. And given the directors hold so many of the firm's shares, should they sell a lot of their shares in the future, the overall share price could be pushed down.

Still, none of this is putting me off. I have great faith in the firm. Even if its own management turns out not to deliver, one of Cozart's larger competitors may well take it over. So I have recently put my own money where my mouth is and have bought shares at 28.5p, which I intend to hold for two to five years.

Paul Hill is MD of PMH Capital