The Ginny Rometty era is over and she will go down as the Jeff Immelt of tech. A CEO who inherited a blue chip colossus and left it an afterthought in the tech world. The great hope of AI tied to Watson failed. Revenues and earnings have been declining for years. Unlike Microsoft, IBM (IBM) had no luck reinventing itself. IBM was uniquely positioned to benefit from the cloud and data center explosion, but whiffed on both. IBM after over a decade of futility has jettisoned its worst business in order to grow again. Investors responded with a resounding yawn.
IBM has continued to founder after the spinoff and its spinoff has done even worse. This makes spinoff Kyndryl (NYSE:KD) the worst of the worst. It is the unwanted segment of a business that has struggled for over a decade with declining revenues and earnings. Who would want such a mess? I am raising my hand with a resounding me.
Background
On November 3, 2021 IBM distributed 1 Kyndryl share for every 5 of IBM. This represented 4.8% of the market cap of IBM at the time of the spinoff, for a business with 20% of the combined revenues. IBM retained 19.9% of Kyndryl stock in the transaction but intends to dispose of that stock over the next year. Kyndryl joined the S&P Midcap 400 on November 5 th and there are about 224 million shares outstanding. It has about 90,000 employees, many of them highly skilled. It prov ides 2 million terabytes of storage and manages 750,000 virtual servers and 270,000 network devices.
Kyndryl was the IT data center services portion of IBM formerly comprising most of IBM Global Technology Services. It traditionally operated and designed datacenters for large corporations and governments. Kyndryl handles most or all IT infrastructure for these corporations. The business is worldwide with 46% coming from the Americas and another 46% from Europe and the Middle East. Customers represent 75 of the Fortune 100 companies.
What is now Kyndryl was a major growth business for IBM in the 1990s into the 2000s as it expanded from its traditional mainframe hardware and software business. This ended about a decade ago when the cloud emerged and many large corporations moved their IT data centers to cloud providers such as Amazon Web Services and Microsoft Azure. IBM also has a cloud division but it has struggled to gain traction as shown in the chart below.
Source: Statista
Financials
Since Kyndryl was just spunoff, there is a lot of noise in the numbers. The last quarter ended September 30, 2021 (pre-spin), showed a $469 million loss. However, $529 million of that is spinoff related costs net of some higher expenses needed to be independent. That indicates a proforma $60 million profit in that quarter. That was 1.3% of the $4.6 billion in revenues that quarter. Revenues were down 5.7% from the prior quarter. In the first 9 months of 2021, revenues totaled $14.1 billion, down 2.2% from the prior year. Management believes the increased revenue decline in the third quarter was due to customer hesitancy for new projects with the business for sale prior to the spinoff announcement. Kyndryl had adjusted free cash flow of $317 million in the first 9 months of 2021. Proforma free cash flow was $794 million in 2020.
The balance sheet has moderate leverage. Tangible net worth was $4.2 billion on September 30, 2021. Total liabilities (I always exclude lease liabilities) were 1.28x tangible net worth on that date. There was only $392 million of interest bearing debt on September 30, 2021. At the time of the spinoff, $3.2 billion in debt was issued in bonds and $2.0 billion in cash was retained on the books. The net debt of $1.2 billion is only 29% of tangible net worth. Interest expense was on investment grade bonds. For example, the 2031 bonds have a 3.15% interest rate and the 2026 bonds are at 2.05%. No debt is due until 2024 and most is due after 2025.
Catalysts
Kyndryl has a recent history of declining revenues. However, it suddenly has a number of catalysts that could improve earnings, revenues and the stock price. These are listed below.
1. Free of poor management – The decade under Ginny Rometty was a disaster. In January, 2020 she was replaced as CEO by Arvind Krishna, the head of IBM’s cloud division. While this sounds good, and copies what Microsoft did, a closer look indicates the new CEO is also problematic. Mr. Krishna had led IBM’s cloud and cognitive software division since 2015. While most other cloud providers are enjoying 20-50% revenue growth, IBM floundered. Their cloud and cognitive software division (primarily cloud) grew only 4.5% in 2019 and 2.1% in 2020. It must be noted that Kyndryl CEO Schroeter like Krishna has been a member of IBM’s executive team, in his case for 7 years.
2. Big increase in TAM – This is probably the most important catalyst. Kyndryl was heavily tethered to IBM in the past. According to a Kyndryl presentation dated October, 2021 being free of IBM increases Kyndryl’s total addressable market (TAM) from $240 billion to $415 billion. That number increases to $520 billion by 2024. Kyndryl is no longer a captive to IBM and can recommend and sell anyone’s products and provide new services. By the way, this will hurt IBM.
3. Growth areas – The IT business is rapidly evolving leading to new opportunities. Kyndryl is positioned to benefit from some. They expect to get growth from areas such as security and resiliency, AI, data and analytics, a hybrid cloud, and intelligent automation. They are now free to recommend non-IBM equipment and services. Kyndryl can expand its consulting and cloud services formerly handled by other parts of IBM.
4. Spinoffs do well – The following is from Investopedia “Historically, spinoffs have been good for investors. On average, both the parent company and the subsidiary outperform the market during the 24-month period following a spinoff. Investors who have been able to withstand the unpredictability of the initial days and weeks have seen nice gains.”
A study of spinoffs by factorinvest.com is shown in the following chart. It clearly shows outperformance to the parent and the stock market. How can this be? Many believe it’s due to management being more focused. I also believe it’s due to management being better incented with compensation including stock and options directly tied to the business. Further, underperforming businesses like this tend to be underinvested in by the parent. Kyndryl is planning to reinvest in the business.
Spinoff & Parent Excess Performance (vs. S&P 500) 1996-2017
Source: factorinvestor.com
5. Largest in its space – Kyndryl is the largest in its space and should be able to take advantage of its scale to get margins as good or better than its peers.
6. Tax loss selling pressure soon gone – Both Kyndryl stock and IBM before it declined significantly in value this year. This is tax loss season when losers are being sold to reduce tax expenses. The chart below shows KD has dropped from $31.50 when issued to $18.63 currently. It actually started trading at $40 prior to that on a when issued basis in late October.
Source: stockcharts.com
7. IBM holders selling pressure soon gone – Many long term IBM holders are selling for various reasons. IBM has long been a big dividend investors stock and Kyndryl currently does not pay one. Kyndryl’s market cap is 4% of IBM’s, making it too small for large cap funds and investors. Kyndryl also has the stigma of being the junk IBM needed to jettison to grow again. All this and tax loss selling should be over soon, removing major headwinds for the stock.
8. Management plans – Management has been somewhat vague to this point on goals for profit margins, cost cuts, and growth initiatives. I expect a detailed presentation within the next 6 months covering all of that. The guidance as to what can be done should help the stock.
9. Dividend initiation – Once the smoke clears and it’s apparent Kyndryl is solidly profitable, a dividend is likely. This will attract a new group of investors. It may take a year or two as management wants to pay down some debt first and reinvest in the business.
10. Insider buying – Three top executives purchased significant shares at the end of November. They are; CEO Martin Schroeter 58,300 shares, Group President Elly Keinan 29,150 shares, and CFO David Wyshner 14,850 shares. These purchases totaled $1.75 million. The most important insiders when it comes to insider trading are the CEO and CFO as they know the most about what is going on. They are buying heavily at the market price.
11. Mergers and acquisitions – Kyndryl has the balance sheet to pursue acquisitions. They will likely do so as that makes it quicker and easier to move into adjacent businesses they couldn’t offer before. There have been no acquisitions since 2016. Also, Kyndryl can now be bought itself. It would be much easier to buy them than to buy IBM.
12. Reduced capital needs – Kyndryl has a very high capital intensive business. However, as it moves to offer more services from the cloud, that will be reduced. That means more free cash flow.
13. ESG- Kyndryl already gets 60% of its data center energy from renewable sources. It expects to increase that to 75% in the medium term. The 10 member Board has 3 women and at least 3 members of color. This is a company that should garner interest from ESG funds and investors.
Other strengths
The balance sheet is relatively strong. Kyndryl upon its spinoff issued $3.2 billion of bonds. Moodys assigned an investment grade rating of Baa2. This will allow flexibility for growth through acquisitions, dividends, and business investment.
Services can be a great business if revenues are recurring. Kyndryl’s revenues are annuity-like in that they are highly recurring and mostly on long term contracts. There is little churn year to year though in recent years those lost were not being replaced fast enough.
While Kyndryl is the worst of the worst (worst part of a bad company) from many stock investors perspective, that is not the case in the IT world. Its professionals are highly trained and highly regarded by their customers. In fact, Kyndryl is still the blue chip in its industry.
Concerns
As I will show below, Kyndryl is currently trading at a 3.7x EV/EBITDA valuation. That is depressed by any measure. There are clear reasons for this.
The main reason is it is in a declining industry. Kyndryl and its peers have revenues declining at low to mid single digits a year right now. The reason is a migration of IT data centers to the cloud. Kyndryl, with its spinoff has an opportunity to go after many customers and businesses it couldn’t pursue before. This includes its own cloud and consulting services formerly handled elsewhere at IBM.
Kyndryl does not currently pay a dividend.
What Kyndryl claims for adjusted EBITDA is way overstated. They include amortization of deferred costs in adjusted EBITDA. For the first 9 months of 2021, they claim adjusted EBITDA of $2.06 billion. After removing amortization, which is almost entirely for deferred costs, adjusted EBITDA was $1.09 billion. Kyndryl defines deferred costs as costs for software, contract setup and other contract costs. While it’s OK for accounting purposes to capitalize and amortize these costs, they should not be added back to adjusted EBITDA. That is because the amortization is offset by cash paid for the initial costs that were capitalized. Cash flow is way overstated. Also, Kyndryl has way more deferred costs than most other companies. I find including amortized deferred costs in adjusted EBITDA very misleading. The good news is even after factoring amortization on deferred costs out of adjusted EBITDA, there is plenty of EBITDA. That is the EBITDA I will use in the valuation section.
The separation from IBM could cost Kyndryl some customers.
IBM plans to sell its remaining 19.9% stake within a year. This could weigh on the stock if it is sold through the open market.
Valuation
IBM’s three purest play competitors are shown in the chart below. All are also facing declining revenues.
Sources: Forms 10-Q, Value Line and Yahoo Finance.
Kyndryl originally traded at $40 on a when issued basis starting on October 24, 2021. As of December 3, 2021 it closed at $18.63 having bounced off a low of $15.45 three days earlier. The bounce occurred immediately after the insider purchases. That is 0.99x tangible book value. DXC (DXC) and Unisys (UIS) are much more profitable on an adjusted basis. I say adjusted because Unisys has huge pension obligations that eat up their profits in many years. DXC is the most profitable of the three peers, but its revenues are declining faster. DXC’s average revenue decline was 5.8% the last four years, but closer to 10% this year. Thus, the lower EV/EBITDA ratio versus the peers. It is a little hard to say exactly what Kyndryl’s revenue decline was under IBM, but I estimate it at about 5% a year the past three years.
Comparing Kyndryl to its peers, it is superior to Unisys with its poor balance sheet and more similar to the other two. It also has significantly superior prospects now that it can go after significant new business it couldn’t offer before. It also has a good balance sheet, and the majority of the largest companies as existing customers to cross sell to. This is partially offset by its current weak profit margin versus peers. However, profits are better than they look as they are understated by depreciation significantly exceeding capital expenses. I believe it should be trading at a similar price to sales as its peers, or at least double its current price. However, it will take time, probably 2-3 years, for Kyndryl to get its profit margin up and its revenue bleed down.
My one year price target is $35, which is 0.42x revenues. That is still below the peer average of 0.50x for price to revenues. Cognizant (CTSH), which trades for a PE ratio of 20 and a price to sales of 2.32x, is a good example of what Kyndryl can be if it is able to take of advantage of the new markets now available to it. That will take some time. In the meantime, Kyndryl is significantly undervalued based on the business and balance sheet its got.
Takeaway
In the medium and long term, the most important thing here is Kyndryl’s opportunity to pursue a whole range of business they couldn’t before. They already have relationships with the majority of the companies those opportunities are with. They already have a highly skilled workforce that can easily move into adjacent businesses. It’s just a matter of if they can execute on it.
In the short term, the stock has been weighed down by tax loss selling and selling by IBM shareholders who want a dividend or a large cap. That headwind should disappear rather quickly. Other short term tailwinds are insider buying and more clarity on management’s plans.
Jeremy Blum
Tipranks.com shows stock returns from my articles have averaged over 32% over a one year period. I was the Credit Manager for a mid-sized publicly traded bank and retired early in 2013. Despite never working in the industry, I took and passed the CFA Level 1 exam. I usually only write about stocks that are my best ideas and I have a position in. I traditionally have invested in and written about small and micro cap deep value stocks. As an investor you can get an edge in researching and talking to management of small and micro cap companies that have little or no analyst coverage. About 50-75% of my portfolio are deep value stocks, primarily microcaps. That is historically where I have had the best returns.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of KD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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