KD - Kyndryl Q4 Earnings: Why The Stock Is Dropping

2023-05-18 11:04:43 ET

Summary

• Kyndryl's guidance points to yet another year of shrinking revenues, although that was always the investment thesis.
• What wasn't the investment thesis was that Kyndryl's free cash flow profile would be smaller in fiscal 2024 than in fiscal 2023.
• The stock is not expensive at around 11x forward free cash flows. But I believe it's far from cheap either.
• Kyndryl has just started fiscal Q1 2024. So keep in mind that Kyndryl's fiscal and calendar years are misaligned.

Investment Thesis

Kyndryl ( KD ) is a large independent infrastructure services company servicing the IT sector. The business spun off from IBM ( IBM ) and is in the process of cleaning up its revenue stream.

The investment thesis consists of cutting out some low-margin customers, which impacts its revenue growth rate trajectory.

The idea here is that Kyndryl should in time be a smaller, but meaningfully more profitable on a free cash flow basis, company.

But investors are struggling to buy into this story. Should you buy into this story?

Why Kyndryl? Why Now?

Kyndryl is the world's largest IT infrastructure service. 75% of the Fortune 100 use Kyndryl's IT infrastructure services. Accordingly, Kyndryl's operations are used by the biggest and best blue-chip companies.

The business is in the process of transition, which is best illustrated in the graphic below.

As a reminder, Kyndryl has just started fiscal Q1 2024. So keep in mind that Kyndryl's fiscal and calendar years are misaligned.

Kyndryl is seeking to reduce services to low margin "Focus Accounts", by either upselling those contracts or stopping servicing them. Simply put, the goal is to move its "Focus Accounts" to a gross margin profile that's closer to its "Blueprint Accounts".

Moving on, Kyndryl's investment thesis is not straightforward. In the first instance, this is a huge business with global customers. In practice, this means that currency headwinds are significant. Particularly with the USD showing such strength.

The graphic above is a reminder of the exposure that Kyndryl has to other markets, outside of just the US.

Secondly, the overall story is just not "Wall Street-clean". It requires a lot of nuance, and I don't believe investors have any patience for a turnaround story, particularly when the guidance ahead is less than compelling near-term.

Revenue Growth Rates Don't Inspire Much Hope, And Yet...

The graphic above is a frustrating reminder that Kyndryl isn't yet stabilizing its growth rates. More specifically, Kyndryl's guidance for the year ahead points to negative 6% y/y revenue growth rates, at the high end.

Along these lines, allow me to highlight a quote from Kyndryl's earnings call ,

I can say confidently that we have laid a solid foundation and this year our fiscal 2024 will be a year of acceleration. We will continue to execute our strategy, deliver on cost optimization, and serve even more of our customer's needs.

Would you say that negative 6% y/y revenue growth rates are aligned with a narrative of "a year of acceleration"? It is not. That's what I contend, there's little congruence between Kyndryl's narrative and its financial results. And so, investors are losing patience.

Indeed, let's get to the next section, where the whole bull case is expounded upon.

Profitability Profile Not Moving in the Right Direction

As noted already throughout, the bull thesis is that yes, Kyndryl's revenues will be shrinking from fiscal 2023 to 2024, but Kyndryl's underlying profitability should be improving .

However, what the graphic above shows is the opposite of that narrative.

Furthermore, for those that follow Kyndryl closely, they'll remember that Kyndryl had consistently maintained that in fiscal 2024, it would be reporting around $500 million of free cash flow.

In fact, that had been the whole reason why I previously invested in the company. And yet when management was grilled about their free cash flow outlook for fiscal 2024, management was noticeably guarded when they were once highly confident in their outlooks for fiscal 2024.

Here's what Kyndryl stated on the earnings call,

In fiscal 2023, we were able to generate significant positive adjusted free cash flow despite having an adjusted pretax loss.

And we did that in part by having a favorable gap on CAPEX and depreciation and then making a lot of progress on working capital. And as we go into fiscal 2024, we're not going out with a free cash flow guide or outlook but the key pieces in there will be our pretax income or loss.

[...] And then the biggest opportunities for us are the gap between CAPEX and depreciation that I mentioned earlier, and we estimate that to be in the $100 million favorable range.

Kyndryl went on to declare that working capital gains of $500 million in fiscal 2023 was the main reason why Kyndryl was able to report $350 million of free cash flow in fiscal 2023.

But that looking ahead to fiscal 2024, investors should not expect working capital cash flow to be as significant. It may turn out that working capital may end up providing around $100 million of cash flows.

Meaning that if we take Kyndryl's guidance of an adjusted pretax margin of 0% to negative 1% and add back around $200 million for the gap between depreciation and capex requirements plus working capital as a source of cash, it's very likely that in Kyndryl's free cash flow in fiscal 2024 could be around $250 million. Although, probably less.

The Bottom Line

Kyndryl is not an expensive stock by any stretch. The business is priced around 11x this year's free cash flows.

But the problem here is that with its free cash flows moving in the wrong direction, plus the fact that revenues are shrinking, investors are going to rapidly become disenchanted with this name.

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