Description

KNDL is a contract research organization serving the pharma and biotech industries. the company carries out clinical trials, with a focus on phase II and III (phase I less than 10% of revenues). The summary here is that the company is going through a turnaround, with two quarters of improved results now behind it, a strong backlog and a pristine balance sheet. Moreover the stock is very cheap, whether you exclude the net cash or not.

Other companies in the space (PPDI, PRAI, etc.) trade at 20x-23x multiples. Even PRXL, which has lower growth than KNDL and which just missed expectations, trades at 21x. KNDL can be bought today for 15x my estimate for this year, and less than 12x if you back out the net cash on the balance sheet & 10x my F06 estimate. Revenue growth is 20% for this year, backlog is up over 30%, orders have been strong the past several quarters with a book:bill of about 1.4:1.

The macro environment appears solid as many major pharmaceutical companies have suggested they will cut SG&A to bolster R&D and KNDL's backlog specifically appears strong. In addition, this space should be relatively well-insulated from the economic softening that is impacting many companies and the stock market in recent weeks.

The two underlying drivers here are 1) the reduction in customer concentration (which should lead to a more in-line multiple with the group) and 2) the reorganization of the company's cost structure. On the first issue, KNDL has historically been accorded a discounted multiple because it used to have high customer concentration, with LLY about 60% of revenues. It has gradually worked its customer concentration down and in the most recently reported quarter, the top 5 customers accounted for about 35-40% of revenues. On the second count, KNDL has benefited from an improved cost structure thanks to headcount reductions and facilities that have been rationalized. The company is also only taking business that meets industry standard margins, which are low double digit OMs. Admittedly, the robust environment for CRO services is providing the environment for KNDL to be selective.

The past two quarters have witnessed that improvement in GMs and OMs and, given that margins in the backlog are even higher, that KNDL gets excellent incremental OMS (25-30%), and given industry peers which have those low double digit OMS, it seems reasonable to assume that KNDL's OMs will be heading steadily higher through the year. Here is my model:

2003 2004 1Q05A 2005E 2006E
net svce revs: 156M 172M 47.8M 208M 240M
gross margin 65M 76M 22.0M 96M 113M
GM% 41.7% 44.2% 46.0% 46.2% 47.1%
SG&A/DD&A 61M 69M 19.0M 79M 86.6M
Op Inc 3.6M 7M 2.9M 17M 26.4M
OM% 2.3% 4.1% 6.1% 8.2% 11.0%
int./other net: 1.5M 1.2M (0.5) (1.0)M 0.0M
pretax 2.1M 5.8M 3.4M 18.0M 26.4M
aftertax: .6M 3.4M 2.2M 11.2M 16.4M
eps $0.04 $.21 $0.16 $.81 $1.18


note that 1q05 revenues grew 17% and that management has guided to the upper end of a range of 200-210M for the year. The company's backlog is 256M, up 30%+ versus $194M. Note also, KNDL's incremental OMs in 1q were over 27%.

there is almost $8/share in book value, which should limit the risk somewhat and a net cash position of about $2/share.

risks:
reversal in pharma/biotech spend patterns from recent robust levels
healthcare regulation/FDA policy changes

Catalyst

greater awareness of successful turnaround
sell-side upgrade possible (the one analyst who covers has a hold)
additional coverage