IBM - Kyndryl Holdings: Improving But Still Climbing An Uphill Battle

2024-01-12 03:41:57 ET

Summary

• Kyndryl Holdings' shares have shown signs of improvement, trading at $21 per share after falling to $10 post its spin-off.
• The company reports a continued decline in sales and operating losses with net debt gradually ticking up.
• Despite efforts to shift towards higher-margin businesses, Kyndryl's profitability and growth prospects remain uncertain.

Shares of Kyndryl Holdings (KD) have recently shown some signs of life again. The former IBM Global Technology services (IBM) business was spun off from its parent in the fall of 2021. At the time, a $40 stock fell rather dramatically and quickly to the $10 mark by spring of 2022.

Ever since, shares of Kyndryl have mostly traded in a $10-$20 range, now trading around the very high end of the range at $21 per share. This is driven by improvements in adjusted earnings, whose margins remain tiny and very adjusted, creating a tough battle as revenues continue to shrink.

Creating Some Perspective

The reason for IBM spinning off Kyndryl mostly had to do with the fact that these were assets and businesses which had an impaired growth and margin profile, creating a tough set-up for Kyndryl as a standalone business when it spun-off, as IBM was looking to get rid of activities which caused a drag on the shares.

The business designs, builds, manages and modernizes complex and mission-critical information systems. Services offered to a more than 4,000 global customer base includes cloud solutions, core enterprise, digital workplace, application, network & edge and security & resilience.

The scale of its operations is huge as the business employs over 90,000 workers (at the time of the separation), with operations in over 60 countries and over 25,000 SAP and Oracle systems being managed. Despite all the trends in the technology space, including of course cloud solutions, AI, bring-your-own device, ever-increasing workloads, and need to access growing databases in a faster manner, Kyndryl believes it remains very relevant.

Despite the size of the business, Kyndryl operated with just 224 million shares post the spin-off and as these shares quickly fell to the $10 mark post the spin-off, as a market value of $2 billion and change was small in relation to the workforce. This was furthermore the case as the business was posting about $19 billion in sales and EBITDA margins of 15%, resulting in dirt-cheap valuations on these metrics. This comes in part as the business is quite asset heavy, with adjusted operating profits seen around the flat line.

What Happened?

Forwarding to August 2022, the company posted its first quarter results for the fiscal year 2023. The company posted a 10% decline in first quarter sales to $4.3 billion, with GAAP operating losses reported at $205 million, as a net loss of $250 million worked down to GAAP losses of $1.11 per share. Even the adjusted numbers showed an operating loss of $50 million, worrisome as the company torched along a $1.3 billion net debt load.

For the year ending in March 2023, the company guided for sales to fall to a midpoint of $16.4 billion, driven by operational weakness and dollar strength. Adjusted pre-tax profits were seen between flat and positive 1% of sales.

Forwarding to May 2023, the company posted its 2023 results. Revenues were down by about 7% to $17.0 billion, quite a bit better than originally guided for. The company posted a GAAP loss of $1.37 billion, with adjusted operating losses of $217 million being worse than originally guided for. While a $2.0 billion EBITDA number looks decent, the D&A component is quite heavy as the company continues to post realistic losses here.

Worse, the $217 million loss comes after adjusting for a $113 million stock-based compensation expense, making for realistic losses of $330 million, or even more if one does not agree with the other adjustments made as well.

The fiscal 2024 outlook was not convincing either with revenues seen down further to a midpoint of $16.2 billion in sales, with adjusted operating profits seen between flat at best and minus 1%, comparing to a negative 1.3% sales number in 2023.

Improvements Are Seen

In August, Kyndryl posted a mere 2% fall in first quarter 2024 sales to $4.2 billion. Adjusted pre-tax profits came in at $47 million (versus a $50 million loss in the same quarter a year before), resulting in flattish adjusted net earnings. This is needed as continued losses resulted in a net debt load of $1.8 billion by now. While the full year sales guidance was left unchanged, the company now sees adjusted annual pre-tax profits of at least $100 million.

Second quarter sales fell by just over 2% to nearly $4.1 billion, with adjusted pre-tax profits of $25 million improving by $127 million over the year before. While this looks encouraging, GAAP losses were still reported at $142 million, painting a dicey picture for real margins, let alone growth.

And Now?

The 229 million shares grant equity of the company a $4.8 billion valuation at $21 per share, a valuation which increases to $6.6 billion if we factor in net debt. This makes that a 0.1-0.2 times sales multiple at the time of the spin-off has risen quite a bit with revenues trending closer to $16 billion here, for a 0.4 times sales multiple.

While that still looks pretty reasonable, the issue is the lack of profitability. In fact, it is not just that profits are not reported, but that losses remain substantial and that growth prospects are hard to find, in fact not to be found here.

While the company believes that adjusted pre-tax profits for the year are seen at $140 million, or more, that is in line with the adjusted profits reported in the first half of the year. This is pretty much in line and disappointing, as adjustments are big enough to still result in substantial losses here.

Despite this stagnation in the cold hard numbers, the company claims progress under its Alliances, Advanced Delivery, Accounts Initiatives program, as the business shift towards higher margins businesses. While the talk is great, this is still really now showing up in the numbers.

The reality is that while the potential is there if management can execute, I fear that the business has a too tough of a competitive battle to win, with Kyndryl still disappointing here. While I have no position and certainly feel no need to get involved after a recent run higher to the $20s, I recognize that a (partial) successful transition could be painful for shorts as well, making me rate the stock as a hold.

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