Kendle International Inc.

Case Analysis

MGMT 619 – MW 7:20pm
November 8, 2010

Team Polycom:
Anirvan Das Girish Navalgundkar Jakub Cech Kyle Kaido Prashanth Kalika Vivek 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 UGene 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 Operational Economics of Scope Capability Transfer Leveraging Core Competence Financial Economies of Scope Anticompetitive Economies of Scope Diversification Economies of Scope Restructuring Supports Single Business Acquisition? Yes Yes Yes No Yes Yes Explanation

Leverage Resources and Talent Applying capability (e.g. Knowledge Transfer, Research capabilities...) to a new business Research facilities and full service offerings to the customer None of the companies have significant internal capital to share. Market Power : Combined company after both acquisitions will be sixth largest in Europe New economic market in Europe can help diversify risk. Not enough data.

Exhibit 1b: Synergies Kendle + gmi
Increased geographical presence Full range II to IV services - good in Phase III trials Experience in health economic studies and training programs Higher margins cost/rev=79% compared to 86% that of Kendle Decreased time span between Phase II and Phase II trial 22 days better than industry standard of 6 months to 1

Kendle + U-Gene
Increased geographical presence Phase I facility --> increases Kendle's service offering Full service CRO

Kendle + gmi+ UGene
International presence Full service CRO Emerging leader in skeletal disease, inflammation drugs and various therapeutic areas. Maximize utilization of labor - utilization rate - 6570% Decreased time span between Phase II and Phase II trial 22 days better than industry standard of 6 months to 1

Emerging leader in skeletal disease and inflammation Increased SG&A with access to US markets

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yr Maximize utilization of labor - utilization rate - 6570% Expertise in multiple therapeutic areas

Maximize utilization of labor - utilization rate - 6570% Expertise in multiple therapeutic areas

yr Experience in health economic studies and professional training programs Proprietary software - trial ware for global data collection

Exhibit 1c: Operational Economies of Scope
Value Chain Activity Input/Data Collection Activities Research Activities Sales and Marketing Shared Activities Common: Data collection software, Research facilities for various trials, Regulatory Loop-holes Common: Knowledge Transfer, Data Validations, Best Practices. Common: Promotional activities, cross-selling, pricing systems, marketing depts., distribution channels, sales forces , order processing.

Exhibit 2: Financial Assumptions
Cost of Unlevered Beta =1.25 Rf MRP MRP Ke Ke Cost of Debt (Nations Bank) 1.25 7.1%(30yr Treasury rate) 7.5%(Ibbotson’s) worksheet) = Rf+beta*MRP 16.48% Kendl e gmi 12.49 % 79.00 % No info UGene Credit Line Subordinated debt Wt Avg Kd Kd 6.20% 12% 8.13% = Wt avg*(1-tax) 4.9%

WC/Re v 2%* 2.50% costs/Re 86.00 v % 90% Dep/PP 17.22 No E % info PPE/Re 14.16 v % 2.73% 8.50% * - Based on assumption. This is used as a variable in sensitivity analysis All the values are calculated as historical averages. Stand alone assumptions Revenue Growth Year 1997 Kendle Based on Q1 revenue. gmi & U-Gene Based on Q1 revenue

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1998-99 2000-01 Terminal cost/rev -

Average from historical performance Industry growth < US GDP

Average from historical performance Average from historical performance <GDP due to market uncertainty.

Historic average for each company.

Full synergy assumptions for all acquisition through only IPO First 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 1998-99 growth rate 62% 20002001 20% Perpetual 5% 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. 1998-1999 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. 1998-199 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.

costs/Rev Acquire only U-Gene

0.79

0.79 20002001 25% 0.86

0.79

1998-99 growth rate costs/Rev 62% 0.86

Perpetual 5% 0.86

Acquire both gmi and U-Gene at the same time 1998-99 growth rate costs/Rev 62% 0.79 20002001 30% 0.79 Perpetual 5% 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.

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Share price 11 13 15 Scenario Analysis

Ke SE $33,000 $39,000 $45,000 Debt $9,500 $9,500 $9,500 16.48% 16.48% 16.48%

Kd WACC 4.9% 4.9% 14.2% 4.9% 14.5% Assumptions 13.9% =>used discount rate

Scenario 1No synergy

Revenue Growth 199 200 1998 9 0 47% 47 24 % %

200 1 24%

Termin al 4%

Costs/R ev 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. 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. 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.

Scenario 2 – Median Synergy(Base ) Scenario 3 Full synergy

55%

55 %

27 %

27%

5%

83%

62%

62 %

30 %

30%

6%

79%

Exhibit 3: Valuation Analysis
Kendle Baselin e Multipl e Sales $12,95 9 2.35 $30,45 4 EBITD A $1,505 16.53 $24,87 0 $20,37 3 Gmi Baselin e Multipl e Sales $6,996 2.35 $16,44 1 EBIT DA $1,50 5 16.53 $24,8 70 $15,0 57 UGene Baseli ne Multipl e EBITD Sales A $12,5 08 $1,617 2.35 $29,3 94 16.53 $26,7 21 $9,44 7

EVA

EVA

EVA

DCF DCF DCF Net Net Net Avg $25,23 Avg $18,7 Avg $21,8 EVA 2 EVA 89 EVA 54 *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

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Cost of capital = cost of equity Cost structure=100% equity Going IPO before acquisition might result in a lower valuation. An unsuccessful IPO might not only affect the acquisitions of the two companies but also any future acquisitions. This is not a productive way of using the capital with highest cost 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 debt Cost 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 debt Cost 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 Cash offer to U$ Gene 14,000 $ Equity to gmi 2,800 $ Equity to U-Gene 1,600 $ Cash Cushion 14,600 $ 39,000 $ 14,000 $ 2,800 $ 1,600 $ 20,600 $ 45,000 $ 14,000 $ 2,800 $ 1,600 $ 26,600

Exhibit 6: Scenario Analysis for Option 3
Scenario Summary 1998-99 rev growth 2000-01 rev growth Terminal growth Costs/Reven ue Result Cells: Scenario 1 - No Synergy 62% 20% 4% 86% Scenario 2 Base 55% 27% 5% 83% Scenario 3 -Full Synergy 62% 30% 6% 79%

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NPV of Kendle Scenario Summary 1998-99 rev growth 2000-01 rev growth Terminal growth Costs/Reven ue Result Cells: NPV of gmi Scenario Summary 1998-99 rev growth 2000-01 rev growth Terminal growth Costs/Reven ue Result Cells: NPV of Ugene Total NPV Synergetic value created

$26,178.51 Scenario 1 - No Synergy 32% 32% 4% 79% $19,041.69 Scenario 1 - No Synergy 21% 21% 4% 90%

$38,304.77 Scenario 2 Base 55% 27% 5% 83% $19,472.12 Scenario 2 Base 55% 27% 5% 83%

$67,298.43 Scenario 3 - Full Synergy 62% 30% 6% 79% $32,997.34 Scenario 3 - Full Synergy 62% 30% 6% 79% 411.0727044 $65,644.58 $165,940.34

$11,778.83 $56,999.03

$41,107.27 $98,884.17

$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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K n le ed W /R v C e $ 38 5 ,30 13.50% $ 13.75% $ WC AC 14.00% $ 14.25% $ 14.50% $ 14.75% $ 15 % $ 1% 4 3,84 4 4 2,40 0 4 1,03 8 3 9,75 1 3 8,53 3 3 7,37 9 3 6,28 4 $ $ $ $ $ $ $ 2% 4 2,02 1 4 0,63 1 3 9,32 0 3 8,08 1 3 6,90 9 3 5,79 9 3 4,74 5 $ $ $ $ $ $ $ 3% 4 98 0,1 3 62 8,8 3 02 7,6 3 12 6,4 3 85 5,2 3 18 4,2 3 06 3,2 $ $ $ $ $ $ $ 4% 38,375 37,093 35,884 34,742 33,662 32,638 31,667

U ee -G n W /R v C e $ 19 5 ,32 13.50% $ 13.75% 14.00% 14.25% 14.50% 14.75% 15 % $ $ $ $ $ $ 1% 2 3,10 4 $ 2 2,35 8 2 1,65 5 2 0,99 0 2 0,36 1 1 9,76 5 1 9,20 0 $ $ $ $ $ $ 2% 2 1,81 7 $ 2 1,10 8 2 0,43 8 1 9,80 6 1 9,20 8 1 8,64 0 1 8,10 2 $ $ $ $ $ $ 3% 2 31 $ 0,5 1 57 9,8 1 22 9,2 1 22 8,6 1 54 8,0 1 16 7,5 1 05 7,0 $ $ $ $ $ $ 4% 19,244 18,607 18,005 17,437 16,900 16,391 15,908

WC AC

$

WC AC

19 2 ,47 13.50% 13.75% 14.00% 14.25% 14.50% 14.75% 15 %

$ $ $ $ $ $ $

g i m W /R v C e 2% 5% 3 3,07 1 $ 3 0,11 3 3 2,02 6 $ 2 9,15 1 3 1,04 0 $ 2 8,24 4 3 0,10 9 $ 2 7,38 7 2 9,22 7 $ 2 6,57 5 2 8,39 2 $ 2 5,80 6 2 7,59 9 $ 2 5,07 6

$ $ $ $ $ $ $

1 0% 2 84 5,1 2 61 4,3 2 84 3,5 2 50 2,8 2 55 2,1 2 97 1,4 2 73 0,8

$ $ $ $ $ $ $

1 5% 20,255 19,570 18,923 18,313 17,735 17,188 16,669

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