Kendle International Inc.

Case Analysis

MGMT 619 – MW 7:20pmNovember 8, 2010

Team Polycom:Anirvan Das

Girish NavalgundkarJakub CechKyle Kaido

Prashanth KalikaVivek Durairaj

Kendle’s Corporate Strategy

Kendle is a Contract Research Organization (CRO) that performs clinical research for

pharmaceutical companies looking to outsource their R&D. Its corporate strategy is focused on

growing revenue to keep up with its larger competitors in the CRO industry including Quintiles

and PPD. Kendle sees its best opportunity for revenue growth through the acquisition of a CRO

firm in Europe. Kendle currently only operates in the US, relying on subcontractors to perform

work in international markets. U-Gene and gmi are currently under evaluation as potential

acquisitions to fulfill Kendle’s corporate strategy. Since Kendle’s entire revenue comes from

CRO activity for pharmaceutical companies it has a single business corporate strategy. Acquiring

U-Gene and/or gmi will not change this single business corporate strategy.

Benefits Kendle Creates for a Competitor

Kendle’s strong U.S. presence, broad range of scientific capability, and ability to manage

studies for phases II through IV all provide potential benefits to a competitor through acquisition.

The company is operationally focused, with a high utilization of talented resources that ensures

healthy profit margins. Kendle specializes in a range of therapeutic areas with recent emphasis

on skeletal disease and inflammation drugs. Kendle’s strong relationship with large

pharmaceutical companies, including Searle, offers an additional benefit through acquisition.

Potential Sales Price vs. Economic Value

Firms in the CRO industry are typically valued at 8-10 times EBITDA which equates to a

sales price of $15M for Kendle. We used relative and DCF valuation methods and found the

average economic value for Kendle to be $25.3M. Since Kendle’s estimated sales price is less

than its current economic value, Kendle is undervalued in the market.

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Strategic Benefits from Acquisition

Exhibit 1a provides more information on the methods of value creation resulting from

Kendle’s acquisition of gmi and/or U-Gene. Exhibits 1b and 1c outline expected synergies and

economies of scope achieved through these acquisitions.

Synergies: Synergies resulting from acquisition are reciprocal, benefiting all three firms through

value and cost drivers. Kendle will become the sixth largest player in Europe after acquiring U-

Gene and gmi, meeting its goals of becoming a full service CRO with international presence.

gmi provides a full range of Phase II to IV services, higher margins, and specific expertise in

health economic studies. U-Gene complements Kendle by adding phase I facilities and resources.

U-Gene and gmi will both benefit from Kendle’s ability to decrease time span between phase

trials utilizing “Trial Ware” software and close customer collaboration. U-gene and gmi also gain

access to Kendle’s US market opportunities and productive labor force.

Resources: All three companies have abundant “soft resources”, which include highly talented

engineers, scientists and research capabilities. The extent of redundant resources is low since

different geographic offices will continue to utilize existing resources and best practices after an

acquisition.

Market Conditions: The pharmaceutical industry is growing 10% annually while demand for

CRO services is growing 20% annually. Pharmaceutical firms are looking for a single CRO to

fulfill all their needs including data collection, research, and management of various phase trials.

These conditions result in a low degree of market uncertainty.

Industry Attractiveness Test: Barriers to entry are favorable due to restrictive government

policies (especially in the US), dependency on highly talented scientists and incumbency

advantages. Although the pharmaceutical industry is highly concentrated with a high influence

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on pricing, buyer power is favorable since they require a high level of credibility and technical

skill from CRO firms. Rivalry is high in the CRO industry due to fragmentation and

differentiation of services. Low exit barriers exist due to a dependency on soft resources

compared to more expensive fixed capital resources. Overall, this industry creates a very

attractive acquisition environment.

Cost of Entry Test: We don’t have enough information to determine transaction costs,

integration costs and premium required to entry this industry. We base the cost on entry on the

economic value created by the combined business compared to the individual firms. Based on

our financial analysis, NPV (Kendle, U-Gene, gmi) > NPV(K) + NPV (U) + NPV (gmi).

Therefore these acquisitions pass the cost of entry test.

Better-Off Test: Kendle, U-Gene and gmi are all better off after this acquisition primarily due

to an increase of full service capability (phase I to IV) and end-to-end program management. All

three firms increase their international presence and economies of scope.

Financial Analysis

We conducted a three stage DCF valuation for Kendle since it is in a high growth phase

and a two stage model for gmi and U-Gene as they are in a stable growth phase. We generated

pro forma income statements for a five year period with a constant growth model after the fifth

year to determine the NPV of free cash flows. See Exhibit 2 for a list of assumptions used in our

financial analysis. Our valuation analysis in Exhibit 3 further assumes all equity and funding of

acquisitions is through an IPO only. We estimated full synergy valuation of the combined

company based on different acquisition options: only gmi, only U-Gene, acquiring both. This

analysis shows that both gmi and U-Gene offer significant synergetic benefits to Kendle. The

overall valuation of this combined business far exceeds the values of the companies before

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acquisition. Therefore, all three companies are assumed to be better off after the acquisition.

Acquiring both companies also offers a far better economic valuation than acquiring only one

company due to inter-company synergic benefits. It is evident that gmi offers more synergetic

value than U-Gene when acquired separately.

Recommendation: Since acquiring both gmi and U-Gene together offers the highest synergistic

value, we analyzed the following three options: 1) IPO first, then complete acquisitions 2)

acquire before IPO and 3) acquire gmi first, IPO, then acquire U-Gene. Our analysis (refer

Exhibit 4) results in a recommendation of option 3. Kendle should have a more successful IPO

after acquiring gmi because of increased cash flow, resulting in a higher valuation after

acquisition. Since gmi is willing to accept equity of about $2.8M, Kendle requires less funding

through debt. Kendle can also learn from this first acquisition and leverage this experience for

acquisition of U-Gene, potentially decreasing integration costs. This option allows Kendle to

build a considerable cash cushion, enabling future growth (see Exhibit 5).

Scenario Analysis: After choosing option 3, we performed a financial analysis for three

scenarios: no synergy, moderate synergy (base scenario) and full synergy. Moderate synergy is

considered the most likely event, which determines an estimated valuation of the combined

company of $98.8M and synergetic value creation of $41.8M (see Exhibit 6).

Sensitivity Analysis: We used two variables, Weighted Average Cost of Capital (WACC) and

Working Capital/Revenue ratio (WC/Rev), to perform a sensitivity analysis on our base scenario.

This analysis displays possible outcomes of the acquisition values under these variable

conditions (see Exhibit 7). This sensitivity analysis can be used by each firm to determine its

“most likely” NPV. Since WACC is affected by equity value, Kendle can also use this sensitivity

analysis to determine how many shares to issue in an IPO.

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Exhibit 1a: Methods of Value Creation

Method of Value Creation Supports Single Business Acquisition?

Explanation

Operational Economics of Scope Yes Leverage Resources and TalentCapability Transfer Yes Applying capability (e.g. Knowledge

Transfer, Research capabilities...) to a new business

Leveraging Core Competence Yes Research facilities and full service offerings to the customer

Financial Economies of Scope No None of the companies have significant internal capital to share.

Anticompetitive Economies of Scope

Yes Market Power : Combined company after both acquisitions will be sixth largest in Europe

Diversification Economies of Scope

Yes New economic market in Europe can help diversify risk.

Restructuring - Not enough data.

Exhibit 1b: Synergies

Kendle + gmi Kendle + U-Gene Kendle + gmi+ U-Gene Increased geographical presence Increased geographical presence International presenceFull range II to IV services - good in Phase III trials

Phase I facility --> increases Kendle's service offering

Full service CRO

Experience in health economic studies and training programs

Full service CRO Emerging leader in skeletal disease, inflammation drugs and various therapeutic areas.

Higher margins cost/rev=79% compared to 86% that of Kendle

Emerging leader in skeletal disease and inflammation

Maximize utilization of labor - utilization rate - 65-70%

Decreased time span between Phase II and Phase II trial 22 days - better than industry standard of 6 months to 1 yr

Increased SG&A with access to US markets

Decreased time span between Phase II and Phase II trial 22 days - better than industry standard of 6 months to 1 yr

Maximize utilization of labor - utilization rate - 65-70%

Maximize utilization of labor - utilization rate - 65-70%

Experience in health economic studies and professional training programs

Expertise in multiple therapeutic areas

Expertise in multiple therapeutic areas

Proprietary software - trial ware for global data collection

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Exhibit 1c: Operational Economies of Scope

Value Chain Activity Shared Activities Input/Data Collection Activities Common: Data collection software, Research facilities

for various trials, Regulatory Loop-holesResearch Activities Common: Knowledge Transfer, Data Validations, Best

Practices.Sales and Marketing Common: Promotional activities, cross-selling, pricing

systems, marketing depts., distribution channels, sales forces , order processing.

Exhibit 2: Financial Assumptions

Cost of Equity Cost of Debt (Nations Bank)Unlevered Beta =1.25

1.25 Credit Line 6.20%Rf 7.1%(30yr Treasury

rate)Subordinated debt 12%

MRPMRP

7.5%(Ibbotson’s) worksheet)

Wt Avg 8.13%Ke = Rf+beta*MRP Kd = Wt avg*(1-tax)Ke 16.48% Kd 4.9%

Kendle gmi U-Gene WC/Rev 2%* 12.49% 2.50%costs/Rev 86.00% 79.00% 90%Dep/PPE 17.22% No info No info

PPE/Rev 14.16% 2.73% 8.50%* - Based on assumption. This is used as a variable in sensitivity analysisAll the values are calculated as historical averages.

Stand alone assumptions

Revenue GrowthYear Kendle gmi & U-Gene

1997 Based on Q1 revenue. Based on Q1 revenue

1998-99Average from historical performance Average from historical performance

2000-01 Industry growth Average from historical performanceTerminal < US GDP <GDP due to market uncertainty.

cost/rev - Historic average for each company.

Full synergy assumptions for all acquisition through only IPOFirst year growth rate is assumed to be individual company growth rate to adjust for the integration costs in the first year.Cost of Equity is used as the discount rate.Acquire only gmi We assume the margins of the

combined company will be as that of gmi and the growth rate would mirror of Kendle. The terminal growth is better than stand alone due to market diversification.

1998-99 2000-2001 Perpetualgrowth rate 62% 20% 5%

costs/Rev 0.79 0.79 0.79

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Acquire only U-Gene 1998-1999 growth rates to mirror that of kendle.The 2 year growth in 2000-01 is assumed to be better than industry growth due to the offering of full range of services and decrease in lost opportunities to perform international trials.The terminal growth is better than stand alone due to market diversification. Based on the synergies, we assume the margins of the combined company will be as that of Kendle as it is operationally focused.

1998-99 2000-2001 Perpetualgrowth rate 62% 25% 5%

costs/Rev 0.86 0.86 0.86

Acquire both gmi and U-Gene at the same time 1998-199 growth rates to mirror that of kendle.The 2 year growth in 2000-01 is assumed to be better than industry growth due to the offering of full range of services and decrease in lost opportunities to perform international trials.The terminal growth is better than stand alone due to market diversification.

1998-99 2000-2001 Perpetualgrowth rate 62% 30% 5%

costs/Rev 0.79 0.79 0.79

Assumptions for option 3: Acquire gmi through debt and U-Gene through IPO

A debt of 9.5 Million is assumed as the gmi is willing to get the rest in share when Kendle goes IPO. We assumed a current share price estimate of $13 and later did a sensitivity analysis to see the valuation with a better share price due to increased cash flow from gmi. WACC was calculated as shown below.

Share price SE Debt Ke Kd WACC11 $33,000 $9,500 16.48% 4.9% 13.9%13 $39,000 $9,500 16.48% 4.9% 14.2% =>used discount rate15 $45,000 $9,500 16.48% 4.9% 14.5%

Scenario Analysis Revenue GrowthCosts/Rev

Assumptions1998 1999 2000 2001 Terminal

Scenario 1- No synergy

47% 47% 24% 24% 4% 86% Same assumptions as Stand alone. The numbers shown in the table are the weighted average growth rate for the three companies based on their revenue.

Scenario 2 – Median Synergy(Base)

55% 55% 27% 27% 5% 83% Assumptions same as that for the No equity, full synergy except the terminal growth is better to market diversification and availability of the cash cushion for future growth.

Scenario 3 - Full synergy

62% 62% 30% 30% 6% 79% Median values between No synergy and Full synergy. This is most expected scenario accounting for integration costs, transportation costs and possible loss of human resources due to acquisition.

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Exhibit 3: Valuation AnalysisKendle Sales EBITDA Gmi Sales EBITDA U-Gene Sales EBITDABaseline $12,959 $1,505 Baseline $6,996 $1,505 Baseline $12,508 $1,617 Multiple 2.35 16.53 Multiple 2.35 16.53 Multiple 2.35 16.53

EVA $30,454 $24,870 EVA $16,441 $24,87

0 EVA $29,394 $26,72

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DCF $20,373 DCF $15,05

7 DCF $9,447 Net Avg EVA $25,232

Net Avg EVA

$18,789

Net Avg EVA

$21,854

*Sales and EBITDA are considered most important in this valuation method so other multiples not included.   

Exhibit 4: Option Comparison Detail

Option 1: IPO before Acquisitions Option 2: Acquisitions before IPO Option 3: Acquire 1 Company before Acquisition and another after IPO

Cost of capital = cost of equityCost structure=100% equity

Going IPO before acquisition might result in a lower valuation. An unsuccessful IPO might not only affect the acquisitions of thetwo companies but also any future acquisitions.

This is not a productive way of using the capital with highestcost of capital.

With two acquisitions at the same time, Integration costs might be higher.

No cash cushion for future growth.

Cost of capital = cost of debtCost structure = Debt for 30 Mil

Due to the interest expense the net income might be negative in initial years.

With high debt and almost no equity IPO might not be successful as expected.

If the synergies with the acquired companies are not achieved in a short period, IPO might have to be delayed to get a better valuation and there is also a risk of losing the IPO window.

This would hamper any future growth and any future acquisitions.

With two acquisitions at the same time, Integration costs might be higher.

A small cash cushion for growth.

Cost of capital = weighted avg of cost of equity and cost of debtCost structure = Debt + Equity.

Acquire the company that offers the maximum synergy first with debt.This will improve the free cash flow.

With better cash flows and diversification in different markets, it will get a better valuation. This will increase the chances of a successful IPO compared to other options.

This option will also result in a lower cost of capital compared to option1.

With some time difference between the two acquisitions, Kendle would be able to handle integration problems better than the two other options.

Highest cash cushion for growth.

Exhibit 5: Cash cushion for Option 3

Cash Cushion Calculation Cash from IPO $ 33,000 $ 39,000 $ 45,000 Cash offer to U-Gene $ 14,000 $ 14,000 $ 14,000 Equity to gmi $ 2,800 $ 2,800 $ 2,800 Equity to U-Gene $ 1,600 $ 1,600 $ 1,600 Cash Cushion $ 14,600 $ 20,600 $ 26,600

Exhibit 6: Scenario Analysis for Option 3

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Scenario Summary Scenario 1 - No Synergy Scenario 2 - Base Scenario 3 -Full Synergy1998-99 rev growth 62% 55% 62%2000-01 rev growth 20% 27% 30%Terminal growth 4% 5% 6%Costs/Revenue 86% 83% 79%Result Cells: NPV of Kendle $26,178.51 $38,304.77 $67,298.43

Scenario Summary Scenario 1 - No Synergy Scenario 2 - Base Scenario 3 - Full Synergy1998-99 rev growth 32% 55% 62%2000-01 rev growth 32% 27% 30%Terminal growth 4% 5% 6%Costs/Revenue 79% 83% 79%Result Cells: NPV of gmi $19,041.69 $19,472.12 $32,997.34

Scenario Summary Scenario 1 - No Synergy Scenario 2 - Base Scenario 3 - Full Synergy1998-99 rev growth 21% 55% 62%2000-01 rev growth 21% 27% 30%Terminal growth 4% 5% 6%Costs/Revenue 90% 83% 79%Result Cells: 411.0727044NPV of U-gene $11,778.83 $41,107.27 $65,644.58

Total NPV $56,999.03 $98,884.17 $165,940.34 Synergetic value created

$41,885.13 $108,941.31

* Assumes no time lag between events: First acquisition, IPO, second acquisition.

Exhibit 7: Sensitivity Analysis

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