Description

Summary:

Kendle International (KNDL) is a deeply undervalued business with a poor investor communications track record that has led to a low valuation both on an absolute and relative basis (40% discount to peers).  KNDL is trading for 4.6x our trailing EV/EBITDA estimates, and for 3.8x our normalized EV/EBITDA (and 5.0x our normalized EV / (EBITDA - Capex)) estimates 2 years out.  Analysts have extrapolated poor investor communications to mean that KNDL is an industry laggard in the CRO industry, which itself is currently out-of-favor.  Based on extensive primary research, we believe the street is wrong on both accounts: KNDL is a top-tier, mid-quality operator that has gotten even better with recent management changes, and the CRO industry-while facing short-term challenges-should eventually return to 2007 and 2008 levels.  As these misperceptions are resolved, we expect KNDL to roughly double within the next two years, using a very conservative 7x EBITDA  or ~ 9x EV / (EBITDA - Capex) target.  On more aggressive valuation assumptions in-line with historicals, we believe the stock could triple.

Investor Communications Failures:

On April 20th, KNDL announced that Q1 would come in below their guidance.  The company held a brief conference call and did not take any questions.  Without any guidance from management, investors panicked and sold off the stock, sending it from $21.36 to $10.28, or down 52% in one day.  Analysts and investors were furious.  Calls with analysts following the company reveal just how negative people were: one analyst we spoke with went so far as to call the company "uninvestable."  An analyst report came out entitled: "Anyone left who hasn't been burned?".  A few quick calls to any of the analysts following KNDL will quickly reveal the pessimism on KNDL's near-term prospects.  Although communication efforts have, in our opinion, improved drastically, KNDL is still in the penalty box.  ICLR, which is an analyst darling and receives about 2x the valuation of KNDL, reported a book:bill number in Q3 that was in-line with KNDL's Q2 and Q3 number.  Analysts argued that if you back out their one large cancellation, the book:bill would have been 1.1:1.  KNDL gets none of this treatment: their large cancellation in Q1 was not treated this way, and their last two quarters of in-line performance with the broader industry have continued to be ignored and, most recently, punished (KNDL was down 8% yesterday after reporting numbers we were very happy with).

Because investor communication has no impact on the cash flow stream produced by KNDL, we place no discount on how well or poorly KNDL has managed street expectations.  We would also note that despite the occasional earnings miss, the stock regularly received low teens EBITDA multiples throughout 2007 and the first half of 2008, during which they missed analyst estimates about half of the time.

Poor recent performance: 

KNDL's recent struggles have also been operational, with poor showings in both new business wins and in cancellation rates , especially in Q1. Because of the recent poor results and suspension of guidance, we believe people are taking an overly pessimistic view of what could happen at KNDL, and that anything short of a complete implosion (which we view as very unlikely, especially after recent Q3 results) will result in considerable upside.  Based on our calls, we believe that consensus views on the key issues facing KNDL are incorrect.

Cancellation Rates:

Consensus View:   Majority of those following the company look at cancellation rate as current quarter cancellations divided by new business authorizations in the quarter.  KNDL has worse than peer performance on this metric for the past couple of quarters.  Analysts believe that this is due to their status as a 2^nd tier player that provides less value to pharma than their larger competitors, resulting in higher cancellations and lower business wins.

Our view:  KNDL's cancellations are undergoing a natural ebb and flow exacerbated by a one-off customer issue and recent industry turmoil.  KNDL historically has led the industry in cancellation rates.  We use current quarter cancellations / trailing nine months new business authorizations (TNM) to reflect that cancellations typically occur on business booked in the last 6-12 months. We believe this metric is more accurate than using current quarter cancellations divided by new business booked in the quarter.

Cancellations are a normal part of the CRO business: sponsors generally cancel for reasons having nothing to do with their CRO provider.  Poorly funded pharma companies have been forced to suspend projects; sponsors going through M&A have cut their pipelines to eliminate overlapping drugs; other sponsors have reprioritized their pipelines to focus on drugs that are closest to generating revenue, or by aggressively cutting projects short if initial indications are that the trial is unlikely to yield promising results.  All of these issues have affected all CROs, and happen with some degree of randomness.  In the same way this randomness has in the past caused swings in cancellation rates at different companies (e.g. see ICLR in Q1 2007, PPDI in Q3 2008, PRXL in Q2 2007), we believe these same issues-combined with challenging industry conditions-are causing elevated cancellations at KNDL today.  Numerous calls with competitors and highly placed former employees lead us to believe that KNDL's cancellations are related to industry conditions and not KNDL specific issues.  In Q1 for example, the majority of KNDL's cancellation number came from a small biotech start-up that lost its funding.   In all of our calls we did not hear any reason offered for cancellations that were KNDL specific and that are likely to persist. 

Although KNDL has experienced slightly elevated levels compared to peers, we note that in Q3 all industry participants started to converge with their cancellation experiences.  KNDL has also noted positive trends in cancellations through the 1^st month of Q4-if these trends continue book:bill could return above 1 as soon as next quarter.  Recent calls we did with industry contacts also suggest an industry slowdown in cancellations the last 2-3 months.

New Business Authorizations:

Consensus View: KNDL is a notch below its larger publicly traded competitors, and is rarely on pharma's preferred provider lists.  It's smaller size in comparison to other publicly traded competitors disadvantages it from winning large global studies and strategic relationships with sponsors.  KNDL handles overflow work and lower priority projects, and lacks the scale to compete effectively for global studies, which are an increasingly large part of total projects, and carry the most lucrative margins.

Our View: Although smaller than its publicly traded comps, KNDL is widely considered one of the top 5-10 CROs.  KNDL may not have the scale to win the sort of long-term strategic deals 100m+ deals like the one that CVD has won with Eli Lilly, but they are frequently on preferred provider lists of large pharma, and have the scale to compete effectively on most large global studies.  We have heard that KNDL sales woes, particularly in Q1, stem from pricing mistakes and organizational challenges, both of which have since been resolved.  In Q1, an abnormal number of RFPs requested regional pricing.  KNDL's policy had been to quote prices by region using the highest rates charged in individual countries within a region, rather than by creating a blended price for the region as a whole and quoting that number.  KNDL priced itself out of many deals this way, and has since resolved this issue.   This is an issue that management alluded to at a recent investor conference and one we confirmed with our industry contacts.

KNDL also had some turmoil in their sales organization, and our checks reveal that changes to address these issues have been positive.  In particular, KNDL recently brought in industry vet Steve Cutler, who was SVP of Global Project Management at Quintiles, and our checks reveal that  he is very highly thought of by his peers.  A former colleague described him as "brilliant...A huge gain for KNDL and a huge loss for Quintiles."  Another industry expert seconded Cutler's reputation, and speculated that he is being groomed for the CEO role when Candace eventually retires.  We were impressed with Cutler in our meeting with him.  As a senior leader at Quintiles, Cutler is bringing a wealth of relationships with top pharma decision makers, and is currently making a tour of Europe meeting with customers and assuring them that he is bringing Quintiles quality operations to KNDL.

Forward looking indicators of NBAs, released at a recent investor conference and on the latest conference calls, particularly RFPs and RFIs (Request for Information) continue to be very positive, on par with those experienced in 2008.  Unfortunately, RFPs continue to be pulled and delayed, so the actual conversion to awards industry-wide remains depressed.  Once the economy, M&A activity, and healthcare legislation settle down, delays should decrease, resulting in more RFPs converting to NBAs in the industry.

Book to Bill Ratio:

Consensus View:  KNDL's book to bill ratio will continue to lag peers, and is a function of their sales and cancellation challenges.

Our View: KNDL's book to bill ratio has generally been in line with competitors with the exception of Q1 and Q2 2009.  The Q1 numbers were abysmal, but Q2 looked much better, and is more in-line with what we expect over the next couple of quarters as sales and cancellations bottom out (author note: this was originally written before Q3, and Q3 KNDL results were in line with peers).  As a function of cancellation & new business in relation to backlog, we believe that the book : bill ratio will improve as the aforementioned issues abate.  On the Q3 call, management noted that cancellations were trending in line with the lower cancellation levels experienced in August & September.  If this continues, cancellations could drop below $30M next quarter, and book : bill would come in above 1, which we think would be a big positive for the stock short-term.

Findings from our primary research paint a picture that is vastly different from what the street believes.  We expect cancellation rates to normalize for KNDL, and for new business authorizations to return to 2007 levels as recent management changes and an improved industry environment take effect.  Much of the pessimism in the industry revolves around M&A activity and pipeline reprioritization.  While these are issues that may hinder growth in R&D at its historical teen growth rates, our base assumption merely rely on a return to 2007 levels of new business.  For this to happen, project delays and pipeline reprioritization activity would need to return to historical levels: we do not need substantial R&D growth for book : bill ratios to rebound and for our thesis to play out.

Financial Model & Valuation:

Base Case Scenario:  Our base case scenario assumes that KNDL revenues continue to decline through 2010 due to the lower NBAs from 2009, but that operating metrics including NBAs and cancellations begin to inch back towards 2007 levels.  We assume cash goes to buy back convert debt at 90% of face, which management has now done the last two quarters and which we expect to continue.  We assume currency rates at today's levels (weaker dollar improves EBITDA).

Revenue Assumptions:  The heart of our model is our revenue assumptions and algorithm.  We have made assumptions for NBAs, Cancellations, and % of backlog recognized as revenue going forward.  These assumptions feed into our forward backlog estimates, which drive the revenue model.  We assume on more rough quarter through FY09 for cancellations, and then a very slow recovery through 2010 and into 2011.  In most cases, our assumptions for all three variables are below the average rates achieved in 2007.  We have run our assumptions by several well-positioned industry experts and believe they are very conservative: two in particular commented that they believe these were likely a "worst-case" scenario.  KNDL's natural backlog throughput to revenue results in a decline in revenue in 2010, followed by a strong improvement in 2011 as a result of improved net bookings. 

Scenario Assumptions:

We ran three scenarios with different assumptions.  Numbers included thus far are from our base case scenario.  In a more optimistic but still very reasonable scenario where KNDL receives an 8x EV/EBITDA multiple, and business metrics improve to somewhere slightly below 2008 averages by 2011, we get a stock price of $43.50 (180% upside) by the end of 2011.  In our disaster scenario, we assume that the business barely improves from its current depressed levels.  We assume very minor increases in NBAs $3M per quarter that eventually settle below 2007 levels, and extremely high cancellations rates for another 3 quarters (eventually leveling off at 2x their prior rates).  We assume an EV/EBITDA multiple of 6.5x, which gets us a stock price of $16, or pretty much where the stock is trading now.  So we view the risk reward as very favorable.

Key Risks:

**KNDL has a very disperse group of customers: there are often multiple decision makers, making it tough to have 100% confidence in our call findings.  It is possible that real business risk exists that our research has not uncovered which will result in continued depressed levels of NBAs and elevated levels of cancellations, but we view this as unlikely.

**The industry landscape recently has been hostile to CROs.  Pharma has cut back on much of it's pipeline, and recent M&A activity has resulted in further cuts and has the potential to further disrupt relationships CROs have with their customers.  The uncertainty around the health care debate in the US could also negatively impact the industry.  Although these are issues currently, we believe that concerns are overblown.  We analyzed R&D budgets for the largest 50 pharma companies and found an average R&D decline of 3.5% YoY in Q2 2009.  We expect this will eventually reverse itself as pharma worries about the impending patent cliff, and also believe that KNDL will benefit from increased outsourcing, as well as the capture of market share from smaller CROs that are getting squeezed as more sponsors require large CROs with a global footprint.  But industry consolidation, government action, and fewer drugs in development going forward remain potential risks.

**Sponsors are increasingly moving towards having a smaller number of CRO vendors serve their projects.  Sponsors that typically had 7 CROs on their preferred provider lists are in some cases narrowing that down to 3 or 4.  If KNDL gets left off of more of these lists than they are left on, they could lose share.  Although we have no indication that this is likely, this was an item that was difficult to research and could be negative.

Catalyst

**KNDL's discount to peers gradually reduces as they get removed from the "penalty box"

**Net book : bill could jump above 1 as soon as next quarter

**Continued in-line performance with peers

**New COO and recent management changes helps to improve operational performance and street reputation

**Pace of pipeline rationalization and project delays declines: high proportion of RFPs convert to new business accross the industry

**Patent cliff concerns at some point overwhelm economic factors currently delaying new trials

**Continued debt buybacks at ~90% of face