Description

Kyndryl, which was spun off by IBM in 2021, is the largest managed infrastructure services provider in the world. The company recently provided softer than expected revenue guidance, which has led to a sell-off in the stock. While analysts and investors seemed fixated on KD’s revenue growth rate, their real opportunity lies in improving earnings through cutting costs and renegotiating existing contracts. At the time of the spin Kyndryl was burdened with unfavorable terms regarding contracts with customers, reselling agreements with IBM, and their TSA, but over the next 1-3 years these headwind should cycle through and allow Kyndryl to display meaningful earnings and free cash flow growth. We estimate KD’s normalized earnings to be approximately $3/share, vs. the current stock price of $12.25. 

Business Description:

Kyndryl manages legacy data centers, hybrid cloud environments, and provides services including IT support, cybersecurity, consulting, cloud transitions, and more. The company was spun off from IBM in October 2021 and has been labeled “the bad business within IBM”. Given their orientation towards 1) legacy data center assets and 2) the IBM ecosystem, Kyndryl was responsible for a large portion of the historical revenue decline within IBM, and was spun to position RemainCo as a more profitable and growing business.

Kyndryl’s positioning coming out of the spin has led investors to believe that the company was a melting ice cube. While there is a large element of the business that faces secular headwinds as customers move from on-premise to cloud environments, Kyndryl’s independence has allowed them to at least mitigate this decline by accessing a customer base outside of the IBM ecosystem through partnerships with providers like AWS, Azure, and Google Cloud. In addition, Kyndryl’s legacy customer base is in highly regulated industries – approximately 50% of KD’s revenue comes from the financial services industry. These types of customers will likely always maintain a portion of their business on-prem rather than fully transitioning to a cloud-based model given the heightened needs around data security and integrity. 

As it relates to the recent weak revenue guidance, the majority of the disappointment can be attributed to Kyndryl walking away from reselling IBM products where Kyndryl earns a negative/zero margin.

Relationship with IBM: 

Many spins have had mixed results over the past few years as companies have done a good job of extracting value through the process. This can be seen with SpinCo’s saddled with high debt burdens (LYLT), environmental liabilities (GTX), opaque transactions leading up to the spin (STHO), and more. In Kyndryl’s case, the process of the spin was extremely complex given the relationship between IBM and their customers. 

Kyndryl and IBM have multi-year, multi-component, and multi-million dollar contacts with their customers. IBM provided the hardware and software component, while Kyndryl provided the services. When Kyndryl was a part of IBM, they seemed to be a profitable segment despite their revenue challenges. Ahead of the spin, IBM broke out Kyndryl’s profitability into discontinued operations, showing KD earned >$3bn of pre-tax profit in 2019, and >$2bn in 2020 despite covid disruptions. However, immediately following the spin this went to virtually zero. Most notably, the pre-tax income allocated to discontinued operations differs widely from what KD published as an independent entity following the release of the information statement. 

The way Kyndryl’s CEO has framed the spin process seems to indicate that it was a one-way street where IBM had final say on setting the terms. This matches our conversations with former employees of both IBM and Kyndryl, who felt the only reason Kyndryl was a viable independent entity was due to the negotiating done by Martin Schroeter, KD’s CEO and IBM’s former CFO. 

The ongoing relationship between Kyndryl and IBM is continuing to evolve. KD and IBM’s employee matters agreement recently expired, allowing Kyndryl to begin reducing their headcount. Next, the transition services agreement will expire in October. This step is meaningful enough that Kyndryl has a clock in their offices with the countdown to expiration. 

In addition to the TSA, in some instances Kyndryl serves as a reseller for IBM hardware and software, and the company has indicated that based on the terms dictated by IBM, Kyndryl is forced to resell products at a 0% or even a negative margin. IBM also licenses software to Kyndryl with escalating fees of $200m/yr. 

Perhaps most meaningful is the fact that Kyndryl is still subject to contracts struck while under the IBM umbrella, and a large portion of these contracts are outright unprofitable. Given the averagecontract  term of 3-5 years, the company is now beginning to cycle ~50% of the pre-spin contracts. 

Path to Earnings Improvement: 

Despite the fact that investors and analysts heavily focus on Kyndryl’s top-line, their biggest opportunity has little to do with their headline revenue figures. Kyndryl has laid out their strategy for improving earnings in what they call the “Three A’s”: Alliances, Advanced Delivery, and Accounts. In addition they have identified a “Plus” category which is a catch-all for other opportunities. 

Accounts: Starting with the most important, KD’s Accounts initiative is focused on repricing and/or restructuring unprofitable business. At the time of the spin, 40% of Kyndryl’s sales ($8bn) had an average Gross Margin of 0%, while the remaining 60% of their business generated Gross Margins in the low/mid 20% range. This profitable section of their business supports their entire G&A structure and interest burden and gets the company to roughly breakeven. Any improvement with the problematic contracts, labeled “Focus Accounts”, should lead to a meaningful improvement in Gross Profit and Earnings. 

Kyndryl’s Focus Accounts strategy can be thought of similar to a retailer undergoing a store rationalization plan. A retailer may have a chunk of unprofitable stores and look to either close, merge, re-locate, or remodel them in order to improve EBITDA or at least walk away from loss-making operations. Similarly, Kyndryl is looking to re-price existing business, add complementary services, remove unprofitable services (such as reselling IBM products at a loss), or just end the customer relationship when allowable. So far Kyndryl hasn’t had to pull that lever given the services they provide tend to be mission critical, and Kyndryl’s competitors are unlikely to step in and operate at sub-optimal margins just to displace KD. 

Notably, KD has been signing new business that looks more like a “Blueprint” account than a “Focus” account. Margins on new signings have gotten progressively better since the spin, reaching mid 20% Gross Margins and high single digit EBT margins. 

Alliances: This initiative involves moving outside of the legacy IBM ecosystem to partner with other technology and cloud providers in order to access a wider customer base. Since their spin, KD has signed partnerships with a range of providers from Nokia to AWS and has booked >$1.2bn of new signings in the past year. Importantly, margins on these signings are in-line with the new business wins KD has disclosed: Gross Margins are in the mid 20% range while EBT margins are in the high single digits. 

Advanced Delivery: Another focus point for KD has been reducing their cost to serve their clients. This comes through automation, which they term ‘advanced delivery’. Former senior employees of KD and IBM highlighted this as an area with particularly low-hanging fruit. One former employee was shocked at the lack of automation within KD, but felt this was a large opportunity going forward to reduce their cost structure. Automation includes everything from password reset to using technology to monitor the alerts generated by KD’s servers to identify which require intervention, which can be predicted, etc. As more processes become automated, KD can either reduce their headcount or re-position employees towards efforts that may generate more growth.

Plus: Kyndryl’s last category, Plus, serves as a catch-all for everything else. This includes G&A savings and growth in adjacent lines of business such as consulting. On the G&A side the company recently announced a real estate optimization plan which should generate $50m of pre-tax savings on a run-rate basis. Meanwhile KD’s Consulting singings (~10% of the business) were up >30% in the most recent year.

Valuation: 

Putting the benefits from all of KD’s initiatives together alongside expected headwinds from IBM software costs, KD could earn >$4/share in EPS. However, the business is continuing to decline organically, so if we assume that 20% of the core profitable “Blueprint” business rolls off over the next ~3 years, that takes earnings down to about $3/share. At 8-12x EPS, KD could be worth $24-36/share, or more than double current levels of $12.25.

Outside of any improvement in earnings, there is a chance KD is an interesting acquisition target once they reach the second anniversary of their spin. The most logical buyer would probably be Google. Google has lagged in the cloud race, and acquiring KD would be a fairly cheap way to access a huge customer base which for the most part has yet to undergo a cloud transition. 

Catalyst

Cost Cuts / Contract Renegotiations