Kendle International Aces Value Test

In December 2003 this column recommended shares of one research specialist: Pharmaceutical Product Development (PPDI). They've since gained 160%, more than triple the S&P 500 index's increase. Today we'll look at a smaller company, based on both sales and name length, whose shares are climbing even faster. Kendle International (KNDL) has increased sixfold in value during that same period. Its shares still look like a bargain. They turned up recently in our Small-Cap Value screen.

Small companies tend to grow faster than large ones, an advantage amply rewarded in recent years. Over the past decade the S&P Small Cap 600 index has outperformed its big brother, the S&P 500, by four percentage points a year. That's a bigger lead than normal; long-term studies suggest small-company returns tend to top large-company ones by two percentage points a year. Given the trend, small caps are not the underdogs they used to be. The S&P 600 index now trades at about 20 times forecast 2007 earnings, vs. 16 times earnings for the S&P 500.

Our screen is designed to find promising small companies with cheap shares. It looks for fast sales and earnings growth, but also for share prices that are low on two counts: relative to the company's annual revenue and to the earnings it's expected to produce over the next several years. That's another way of saying the screen looks for low price/sales and PEG ratios. There are other search criteria. See our recipe for all of them and use our stock screener anytime to run the search yourself. Eight companies recently made the cut from a starting database of 8,000.

Cincinnati-based Kendle runs drug trials from the start of human testing ("phase 1") through after-launch surveillance ("phase 4"). Its contracts are mostly fixed-price, with only a few services reimbursed by customers as they're incurred. That subjects Kendle to the risk of cost overruns, which are taken as losses if and when they're identified as likely. On the whole, though, the company seems to have little trouble producing profits. Since 2004 its earnings have tripled on a 73% increase in sales.

Kendle focuses primarily on five health threats it says will represent 70% of drug research spending by 2009: heart disease, cancer, viruses, nervous system disorders and arthritis. Over the past year it has produced $429 million in sales. That puts it at roughly half the size of competitor Parexel International (PRXL) and a third of the size of Covance (CVD) and Pharmaceutical Product Development. It also competes, of course, against the in-house research teams of big customers like Pfizer (PFE). The company is winning plenty of business. Profits this year are expected to increase by more than half. But shares have stalled since late last year, largely because the company has missed Wall Street's quarterly earnings targets twice, each time by 10% or more.

Much of the shortfall seems related to a 2006 acquisition that Kendle has had trouble digesting. It bought the Phase 2 through 4 operations of Charles River Laboratories (CRL) last August for $215 million. Management says it got a good deal at 2.1 times annual sales. Investors seem to believe otherwise. Since the deal was announced on May 9, 2006, Kendle shares have dipped 6% while Charles River has gained 14%. Analysts cite order delays and systems integration snags as the biggest issues.

Bookings still look strong, tough. In Kendle's first quarter its backlog swelled to $700 million, a 105% increase vs. a year ago. The stock now seems underpriced, according to Jefferies analyst David Windley, who on Friday lifted his rating to Buy from Hold. "The company is actively winning new contracts, and backlog pressure continues to build," he wrote in the upgrade note. "While our upgrade is not a confirmation of a complete and successful integration of [Charles River], we think the worst is behind KNDL."

Shares fetch 21 times forecast 2007 earnings. The company is expected to increase its earnings by 27.5% a year, on average, over the next five years, according to Reuters Research. Those two numbers make for a PEG ratio (price/earnings divided by long-term earnings growth rate) of 0.8, suggesting a discount of half to the broad market and a third to competitors.