Description

Financially Engineered Value Trap

SUMMARY

I expect a turning point in the perception of Kyndryl (KD US) from a self-help spin-off value case to a secularly declining levered outsourcer where headline KPIs do not accrue to shareholders. I believe the post-spin turnaround of Kyndryl has been boosted by financial engineering due to the complex and discretionary nature of accounting policies in the IT outsourcing business. At an 8x FCF multiple with an optimistic underlying margin profile assumption, I see 60% downside. Additionally, Kyndryl’s financial leverage is misunderstood – should Kyndryl use its working capital financing facilities less aggressively and align its DSOs with industry standards, investors will miss out on 7 years of expected cash flows. Lastly, I consider Kyndryl’s playbook coincidentally similar to the paths of its two main competitors in the market – DXC Technology (DXC US) and Atos (ATO FP). I recommend shorting KD US on the expectation that investors will be disappointed by underlying cash flow generation, lack of drop-through from outperformance in management’s initiatives to cash flow, and business growth profile. Short interest is low (2% of float). The cost to borrow is GC. 5 sell-side analysts are covering the stock, all with Overweight recommendations. The setup is attractive following a significant stock price increase on the back of the latest earnings result where I believe the market mistook accounting-driven profit growth for underlying business improvement. First ever discretionary insider sale in Kyndryl’s history, made by Kyndryl’s SVP & Global Controller in June 2024 (former regional CFO at IBM), supports my views.

BACKGROUND

Corporate spin-offs often create value for shareholders when a quality asset is freed from a larger bureaucratic parent entity and can focus on its own niche business, provided management incentives are appropriate. Kyndryl is an IT infrastructure outsourcing business that was carved out from IBM Global Technology Services in 2021. As one of the largest global IT outsourcers, with 80,000 employees and generating $16bn in revenues in FY2024, the company has a significant market presence. IBM's decision to separate the outsourcing unit was driven by a desire to concentrate on its core business and enhance its growth and margin profile, given the drag from outsourcing unit declines over the years. This move allowed Kyndryl to focus exclusively on its managed infrastructure service contracts and their profitability, a shift from its previous role as a unit within Big Blue that may have prioritized software and hardware relationships at the expense of outsourcing service profitability. With the potential to reinvigorate growth by expanding Kyndryl’s capabilities with non-IBM skills and improve margins through better commercial discipline in its contracts, Kyndryl saw significant opportunities for earnings power improvement.

Headed by Martin Schroeter, former IBM’s Senior Vice President Global Markets in 2018-2020 and CFO in 2014-2017, Kyndryl outlined 3 main initiatives (called ‘3 As’) to create value – Alliances (upskill talent and create new ecosystem partners to provide more options to clients and grow revenues); Advanced Delivery (transform service delivery through automation to improve cost structure and margins); Accounts (restructure legacy contracts with lower margins and improve contracting discipline to improve margin profile). Since the spin in 2021, management’s execution has been nothing short of tremendous on a reported basis, with multiple incremental partnerships, upgraded Advanced Delivery potential profit contribution from $600m to $800m, upgraded Accounts contribution from $800m to $1bn, and adjusted EBIT margin turnaround from negative -2% in FY22 to positive +2% in FY24, with positive +4% guided EBIT margins in FY25 and reported high-single-digit margins on post-spin contracts.

The market has rewarded Kyndryl’s execution progress. Since IBM’s stake was wholly disposed of in August 2022, the stock has appreciated by +150%. Kyndryl has attracted several prominent value investors with strong track records to its shareholder register.

INVESTMENT THESIS

1. 2% FY2024 realized EBIT margin is negative adjusted for accounting benefits.

In FY2022, when Kyndryl was spun off and 98% of revenues came from legacy pre-spin contracts, the company reported negative -1.6% adjusted EBIT margins. Negative margins stemmed from ‘focus accounts’ which Kyndryl targeted to turn around via upselling new content (for example, via upskilling its talent and selling new services to clients), having better price discipline in the organization, and replacing low-margin third-party content (frequently – IBM content) with capabilities with new non-IBM partners. In FY2024, when 33% of revenues came from post-spin contracts, adjusted EBIT margins improved to positive +1.8%.

Source: Kyndryl FY2024 presentation.

Kyndryl’s adjusted EBIT is subject to a number of assumptions where management has discretion:

A) Depreciation useful life assumptions. IT outsourcing is a capital-intensive business due to investment requirements associated with hosting data centers and servicing IT infrastructure assets for clients. In FY2022, Kyndryl had $2.8bn PP&E and depreciated $1.2bn. In FY2024, Kyndryl had $2.7bn PP&E (or just 6% lower than FY2022) but depreciated only $0.8bn (34% lower).

Impact: Slowing depreciation over the last 2 years resulted in a 2.1pp EBIT margin benefit compared to FY2022. It appears there is even more to come in FY2025 (more on this below).

B) Capitalization of internally developed software costs. In FY2022, Kyndryl did not capitalize its own software development costs. However, since Q1 FY2023, the company’s capitalization of these costs has ramped precipitously, with $125m costs on the balance sheet at the end of FY2024. According to schedule disclosures, Kyndryl amortizes internally developed software costs over approximately 4 years.

Impact: Annual net capitalization in FY2024 resulted in a 0.4pp EBIT margin benefit compared to FY2022.

C) Capitalization and amortization of prepaid software and contract costs. At the beginning of an IT outsourcing contract, an outsourcer would pay various Y1 incentives to the customer, transition, install, and set up various IT systems (for free or discounted), and buy third-party software for use in a multi-year contract. The outsourcer has discretion over expensing many of these costs in the income statement or capitalizing them on the balance sheet. There is also discretion over amortization rates of these costs when capitalized. In FY2024, Kyndryl invested $1.6bn in these contract costs. As % of signings, contract cost capitalization rose slightly from 12.3% in FY2022 to 12.6% in FY2024.

Impact: Volatility in capitalization and amortization of prepaid software and contract costs makes the EBIT margin a poor approximation of contract cash flows.

D) Adjustments. Due to secular declines in several legacy pockets of IT infrastructure outsourcing (e.g. mainframe services), outsourcers have seen the need to re-skill their talent and reduce overall headcount. While this is industry-wide rather than Kyndryl-specific, it continues to represent an ongoing cash cost.

Impact: Higher workforce restructuring adjustments resulted in a 0.9pp EBIT margin adjustment benefit in FY2024 compared to FY2022.

In summary, whereas one can applaud the company’s operational progress since the spin-off, margin expansion has come mostly from accounting adjustments thus far. With limited profitability improvement adjusted for these changes, I suspect the excess profit contribution of ‘3 As’ initiatives has been eaten up by faster-than-expected business decline and only partial ability to pass through inflation in contract prices due to market competition. It comes as no surprise as Kyndryl’s outsourcing peers have been experiencing the same pressures. 

2. FY2025 EBIT margin guidance beat thanks to hardware useful life changes.

In May 2024, Kyndryl guided for a positive +3.6% implied adjusted EBIT margin in FY2025. In addition to being a beat vs consensus (the street had expected +3.5%), management noted it would stop adjusting out workforce rebalancing costs from its adjusted profitability. With $100m guided workforce rebalancing costs, the guidance implied +4.3% margins with the prior definition, an even bigger beat vs consensus. Sell-side analysts unanimously called out continued outperformance of expectations and a cleaner profile of Kyndryl’s earnings.

As a side note in prepared remarks for the earnings call and a quick remark in the notes to financial statements, Kyndryl mentioned that ‘its teams have been working to make the compute and storage hardware last longer. As a result, Kyndryl is now able to extend the depreciable lives of these assets from 5 years to 6’ (Source: CFO prepared remarks, Q4 FY2024 earnings call). In financial statements, Kyndryl estimates the lower depreciation rate assumption would result in a $180m benefit to its earnings in FY2025.

Whereas one can once again applaud the opportunity of having compute and storage hardware last longer, one also wants to see underlying improvements. Without the effects of lower depreciation and no workforce restructuring adjustment, adjusted EBIT margins would have been guided to be just +3.1% despite half of revenues already coming from post-spin contracts.

Impact: A longer useful life assumption is a non-cash benefit to EBIT, thus guided FCF in FY2025 with the prior definition missed by 21-32% (21% vs Bloomberg and 32% vs CapitalIQ consensus).

3. Unclear path from FY2025 EBIT margins to high-single-digit margins in mid-term.

The bull thesis centers around convergence between a 4% EBIT margin in FY2025 (50/50 pre-spin and post-spin contract revenue contribution mix) to high-single-digit margins when all legacy pre-spin contracts are behind us. Given that most of the business comes from existing clients, this is equal to assuming that pre-spin existing client relationships that earned negative -2% margins on average in FY2022 can turn into high-single-digit margin relationships.

While, based on my research, Kyndryl successfully increased content in many of its pre-spin contracts to improve overall profitability, the magnitude of the assumed margin turnaround is too optimistic. Kyndryl was spun off with a $51bn backlog of contracts. Post-spin Kyndryl had $32bn singings and recognized $42bn revenues. I estimate since the spin, Kyndryl has lost a $3bn backlog due to FX changes. This would result in a $38bn backlog at this point, however, the company reported a $33bn backlog at the end of FY2024, which implies $5bn lost business (10% of backlog at the spin-off), meaning that approximately a quarter of ‘focus accounts’ have canceled contracts altogether instead of renewing at a better price or better scope.

Margin improvement in mid-term must also come from the return to revenue growth (as guided in Q1 CY2025) and associated SG&A leverage. With declining business, an outsourcer can only cut so much SG&A before running into issues of system underinvestments and low employee morale. However, the recent development of Kyndryl’s backlog (including 2-year backlog) has been at odds with the revenue turnaround outlook.

Source: Kyndryl financial statements.

Source: Kyndryl FY2024 presentation.

Kyndryl’s first 2 competitors mentioned in its reports are Atos and DXC Technology. In CY2023, Atos made a 3.1% adjusted EBIT margin in its Tech Foundations division. In FY2024, DXC made a 4.5% adjusted EBIT margin in its Global Infrastructure Services division, adjusted for the allocation of corporate costs between divisions. With business exposure similarities of Kyndryl, Atos and DXC and continuous margin pressure experienced in the industry, high-single-digit EBIT margins are somewhat optimistic.

Impact: I believe Kyndryl’s margins are much more likely to converge with industry standards than with elusive long-term targets.

4. Cash generation from financing facilities and one offs.

Kyndryl targets 100% cash conversion of its post-tax earnings. In FY2023, the company generated $352m of adjusted FCF, and in FY2024, $291m. Headline cash conversion has been healthy and consistently exceeded adjusted earnings. In FY2025, based on guidance, management targets $285m (or $385m before payment for workforce restructuring costs). The market expects a rapid improvement in cash generation, with $287m expected in FY2025, $406m in FY2026, $827m in FY2027 (Bloomberg), or $420m in FY2025, $662m in FY2026, $827m in FY2027 (CapitalIQ). In FY2027, the market estimates Kyndryl will be able to generate 5.2% FCF margins.

However, the market does not appear to appreciate the sources of Kyndryl’s recent cash generation:

A) Factoring and reverse factoring. While inside Big Blue, Kyndryl used to access IBM’s working capital financing facilities. Kyndryl’s main factoring line was amended in Q4 CY2022 to provide that Kyndryl may sell an additional amount of trade receivables with payment terms of less than 3 months. In June 2022, Kyndryl opened a new factoring line with a separate third-party financial institution. Gross proceeds from factoring increased from $2.2bn in FY2022 to $3.6bn in FY2024. $3.6bn in FY2024 is not too far from the market cap Kyndryl used to have not long ago. Kyndryl’s heavy (and increased) usage of factoring facilities has resulted in its DSOs standing at less than half of industry standard DSOs. In addition, in FY2024, Kyndryl entered a new reverse factoring facility for its suppliers. The company described reverse factoring amounts as immaterial.

Source: Kyndryl, DXC, Atos, HCL Tech, Infosys, TCS, Wipro financial statements.

Impact: Kyndryl would need to spend 7 years of underlying FCF generation (or $2bn) to unwind its heavy factoring utilization and converge with industry standard DSOs.

B) Net capital investments. Kyndryl has consistently outperformed on its net capital investment targets. For example, entering FY2024, Kyndryl projected $750m in net capital expenditures. In FY2024, net capital expenditures were $513m (partially thanks to better disposal proceeds and lower gross capex). IT outsourcers have had volatile net capital investment ratios from one year to another, however, over time, the capital intensity of the sector has remained consistent. Furthermore, as part of the separation, IBM committed to providing Kyndryl at no cost $265m of upgraded hardware over 2 years. In FY2023 and FY2024, IBM’s commitments were entirely fulfilled. In the future, Kyndryl would have to pay for such upgrades.

Impact: Non-recurring free IBM upgrades constituted 41% of Kyndryl’s cumulative adjusted FCF in FY2023 and FY2024.

C) Adjustments. Adjusted FCF of $352m in FY2023 dropped to a -$61m reported FCF burn (due primarily to separation payments and other adjustments) and to a $285m increase in net debt. Adjusted FCF of $291m in FY2024 dropped to a -$59m reported FCF burn (due primarily to workforce restructuring payments and other adjustments) and to a $311m increase in net debt. Kyndryl has not yet been shown to be able to generate sustainable underlying cash flows. 

Impact: Now that FY2025 cash flow generation is guided to be clean, I expect the market to get increasingly surprised by the gap between reported FCF generation and changes in Kyndryl’s net debt.

5. Management is incentivized to deliver on its adjusted metrics.

In a spin-off, a new company can set a new set of financial incentives for the management team based on the new company’s performance instead of the former parent’s performance. Ideally, incentives should be aligned with long-term value creation for shareholders.

I believe Kyndryl’s performance incentives are only partially aligned with long-term value creation:

A) Kyndryl’s annual cash bonus is based on a mix of revenue, adjusted EBITDA and ESG targets, subject to strategic adjustments. The FY2023 bonus was based on 60% EBITDA, 30% revenue, and 10% ESG weightings as the Board committee decided to reduce the weight of revenue to reflect the focus on profitability. Additionally, FY2023 targets were adjusted for the loss of contracts not novated in the spin-off and material changes to commercial agreements driven by a change in the strategies of IBM. Given Kyndryl’s accounting complexities and the exclusion of amortization of deferred costs from adjusted EBITDA (which makes the EBITDA metric even more subjective than adjusted EBIT), the 60% EBITDA weighting may incentivize the wrong metric.

B) Kyndryl’s LTI performance-based component is based on a mix of adjusted CFFO, signings, and relative TSR. For the 2022-2025 period, the mix was 50% adjusted CFFO, 25% signings, and 25% relative TSR. The mix is healthy. However, the 50% CFFO weighting may explain that factoring and reverse factoring facilities have rapidly ramped up since the spin-off.

6. IT infrastructure outsourcing case studies.

Today, Kyndryl’s state appears similar to DXC’s history in 2018 and Atos’s in 2019.

Headed by Michael Lawrie, former CSC’s CEO in 2012-2017, DXC Technology was formed (and listed) in 2017 as a merger between HPE’s Enterprise Services business and Computer Sciences Corporation. Similarly to Kyndryl, DXC saw numerous margin expansion opportunities over time and a potential return to revenue growth ‘3 years out’. Margin expansion opportunities were mainly based on automation and efficiencies (‘Workforce and delivery optimization’ by DXC and ‘Advanced delivery’ by Kyndryl). Return to revenue growth was primarily predicated on the growth of 1 main engine (‘Digital offerings’ by DXC and ‘Consult’ by Kyndryl). DXC reported slowing organic revenue declines and profit growth thanks to improving margins for the first several years as a public company. In the meantime, DXC used creative profit adjustments due to the complexities of IT outsourcing contract accounting. DXC’s FCF benefitted from factoring facilities and replacing capital investments with capital lease originations.

This did not end well at some point in late 2018. Costs were cut too much, corporate culture and employee morale were destroyed, and leverage was too high. Organic declines continued, primarily due to continued declines at the Global Infrastructure Services division. While new management teams (several of them over the past several years) have made efforts to clean up earnings profile, reduce usage of factoring facilities, and scale back capex financing, there is still work to be done, even in 2024.

Atos has followed a similar path and has been trying to recapitalize the business over the past year.

The problem for DXC, Atos and Kyndryl is the secular decline of traditional IT infrastructure outsourcing. On renewal, clients ask for price cuts and new efficiencies with reduced traditional workloads as they migrate to cloud infrastructure. Traditional outsourcers are not the first (or second) candidate vendors for cloud-based services and thus lose market share in the IT market over time. Cost-cutting focus and financial engineering have worked in delivering quarterly margin expansion and cash flow but have not worked in making a sustainable business (yet). 

VALUATION

I assume Kyndryl’s business declines would stabilize at approximately $14bn in revenues. I believe 4.5% mid-term adjusted EBIT margins align with today’s corresponding DXC’s margins (the best margin out of DXC, Kyndryl, and Atos peer group today). With $100m in ongoing workforce rebalancing costs, a $125m interest expense run-rate and a 25% tax rate, I get to $1.40/share in cash flow potential. At 8x FCF multiple there is a 60% downside. If Kyndryl begins to unwind its working capital financing measures, I see additional downside.

UPSIDE RISK

In May 2024, Kyndryl guided for the return to revenue growth exiting FY2025 (in Q1 CY2025). The market is comfortable with Kyndryl being a low-single-digit grower thereafter. Assuming 8% adjusted EBIT margins in mid-term (based on high-single-digit reported margins on signings), $100m in ongoing workforce rebalancing costs, a $125m interest expense run-rate and a 25% tax rate yields a $3.30/share cash generation engine. The current share price implies an 8x multiple, which bulls consider conservative. 10x FCF multiple would result in a 25% upside. Bulls consider 10x FCF multiples more appropriate given the shift of Kyndryl’s equity story away from struggling DXC and Atos towards peers with sustainable revenues. 

Catalyst

1) Misses on FCF expectations

2) Rising gap between reported progress on financial initiatives and cash flows

3) Revenue growth disappointment