KD - Kyndryl's Mixed Investment Profile: Pros And Cons

2023-09-29 09:33:59 ET

Summary

• Kyndryl Holdings, as the largest provider of IT infrastructure services globally, has a complex investment profile with mixed prospects.
• Despite progress in profitability, the stock's current valuation, with a P/E ratio of around 22x this year's pretax profits, doesn't seem particularly attractive given the declining revenues.
• Kyndryl's challenge lies in convincing customers to pay more in a competitive IT services market while facing the risk of struggling to retain existing customers.

Investment Thesis

Kyndryl Holdings, Inc. ( KD ) is a technology services company and the largest provider of IT infrastructure services globally.

Its underlying thesis is not complicated. The business spun out of IBM ( IBM ) and it holds a lot of unprofitable contracts with customers. The business has to shrink as it either renegotiates smaller and yet more profitable contracts with certain customers, called its Focus Accounts, or to stop servicing those accounts as they become due.

Therefore, Kyndryl is expected to deliver improved profitability, even as its revenues continue to compress with time. That's the bull case.

The bear case is, even as Kyndryl inches towards profitability, I don't find its stock cheap enough to support its valuation. On the other hand, I recognize that Kyndryl has made substantial progress of late in improving its profitability profile.

Simply put, this is a very mixed-bag investment.

Kyndryl's Near-Term Prospects

Kyndryl is a leading global technology services company specializing in IT infrastructure services. With a presence in over 60 countries, they help enterprises adapt to technological changes by designing, building, and managing secure hybrid cloud environments.

Kyndryl offers a wide range of services across various technology domains, including cloud services, core enterprise solutions, data and AI services, and more.

Kyndryl's core strength includes their extensive experience and data insights, enabling them to support clients in achieving their digital transformation goals.

This graphic illustrates what the business is attempting to do. They are seeking to move their Focus accounts, which carry 0% gross profit margins, to similar levels of their Blueprint accounts, which carry mid-20% gross margins. Or at least get something higher than 0% gross profits.

Revenue Growth Rates Don't Inspire Much Hope

As discussed, Kyndryl's business is shrinking. Here's a quote from the Q1 2024 earnings call that explains the dynamics Kyndryl faces:

we remain committed to delivering revenue growth in calendar 2025 and in fiscal 2026. That means that our revenue will bottom out in calendar 2024 or fiscal 2025. And we expect that bottom will be within a few percentage points of our revenues this fiscal year as we retain the substantial majority of our focus accounts and their revenue.

In plain English, this means that next year, calendar 2024, the business will shrink further, before starting calendar 2025, in April, delivering some growth as the comparables improve.

However, we appraise this business, it's not one that's thriving strongly. But one that's simply content to exist. And with that, let's turn to discuss its valuation.

KD Stock Valuation - Not That Cheap

Kyndryl's share price has significantly improved in the past several months as investors saluted the fact that it won't be unprofitable going forward. However, the business is only expected to bring in around $150 million of pretax income.

Even if the goal over time is to make closer to $1 billion of pretax income, I don't believe that investors will be all that patient waiting a number of years to see Kyndryl reach its coveted target.

As it stands right now, the stock is priced at around 22x this year's pretax profits, for a business with revenues that are becoming smaller.

Furthermore, think about the core of what Kyndryl is seeking to do. They are renegotiating their 0% margin contracts with customers. Customers who have been used to paying a low figure for Kyndryl's services are being asked to pay a higher figure. With so much competition in IT services, that's not such an easy task.

Furthermore, Kyndryl faces a few important risks. First, the obvious one, that Kyndryl may struggle to retain existing customers. While customer retention costs could rise as the company seeks growth.

Second, achieving growth relies on Kyndryl having to make investments in its own infrastructure . What Kyndryl declares is that it has a large amount of non-cash intangible amortization and that investors should simply ignore that cost. But this amortization of intangibles, even if they are accounting costs, will in time have to be replaced with better technologies . Otherwise, why would a customer be willing to pay a premium for the same offering?

The Bottom Line

I find Kyndryl to be a rather mixed-bag investment. On one hand, it has a clear strategy of renegotiating unprofitable contracts with certain customers, which could lead to improved profitability over time.

However, its revenues are expected to continue shrinking, and the stock's valuation, with a P/E ratio of around 22x this year's pretax profits, doesn't seem particularly cheap for a business with declining revenues.

Kyndryl's task of renegotiating contracts and convincing customers to pay more in a competitive IT services market poses challenges. Additionally, the risk of struggling to retain existing customers and the need for investments in infrastructure are concerns. Overall, Kyndryl's near-term prospects are uncertain, making it a complex investment choice.

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