Kyndryl stock price will be in the cloud by 2025 (NYSE: KD)

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Kyndryl Holdings (NYSE: KD) was a good opportunity when it was separated from IBM. Now it’s even better. Freed from the chains of the Big Blue (IBM), the company can chart its own course, pursue a a much larger market and focus on more profitable opportunities. The setup is asymmetric, with the reward several times greater than the risk.

Kyndryl Opportunity

The price

Kyndryl was separated from IBM in November 2021. In October 2021, the board of directors approved the separation of Kyndryl and distributed 80.1% of its shares to IBM shareholders and retained 19.9% ​​of the share capital of the society.

This opportunity starts in the price action of the last few months and it has been terrible.

Chart
Data by YCharts

The company started trading at around $40 per share and is currently trading at $12. A drop of 70% in 7 months. To put the decline in perspective, the S&P500 is down about 9% over the same period. This is part of a textbook spin-off, where in the first year it comes under sales pressure from the parent’s holders who want nothing to do with the child. In KD’s case, it came under additional pressure as IBM sold 10% of its stake between November and May. The positive part of the picture is that IBM is a price-insensitive seller, which is always good for buyers, they’re just raising millions from the spin-off, which is unusual. Normally, in a demerger, the company sells 100% of the shares of the subsidiary to the parent shareholders, but in this case the parent company has decided to charge a commission of 19.9%.

Deals

KD is one of the largest, if not the largest, IT infrastructure provider in the world. Their business is to design, build and manage secure and responsive private, public and multi-cloud environments to accelerate customers’ digital transformations. Although the business is low margin, the industry is rife with positive secular trends and tailwinds such as increased demand for digital services, covid-19 has even accelerated this trend as businesses need to transform the electronic medium into their IT infrastructure. Every day, more companies are turning to the cloud to take advantage of its flexibility and workload portability. Other megatrends are: increased amounts of data in use, where big data, AI and machine learning play a vital role, and the need for cybersecurity. Future wars and issues will be primarily digital and Kyndryl provides comprehensive cybersecurity services.

Much of the Kyndryl opportunity is not seen by the market as current financials still reflect their days when their business was limited by IBM. Immediately after the spin-off, they have two advantages: 1) they are completely free to pursue their strategies. This is not an empty statement since in the past they were required to work with IBM’s software offerings and had to serve IBM’s customers even if the contract profitability was low or negative because IBM was earning money. money on that customer elsewhere. 2) Their market has expanded to include cloud services and applications and as a result their total addressable market will double from $240 billion to $510 billion.

Market Opportunity Slide

Presentation Kyndryl 4Q2021

Profitability Opportunity Slide

This means that the company can start recruiting new customers who do not use IBM-related software, which is essential to be competitive in the cloud (AWS and Microsoft dominate the cloud) and existing customers can be a source growing income. The other major aspect that shapes Free Kyndryl is cost effectiveness. The business can choose to pursue only profitable accounts and does not have to maintain negative or very low margin accounts. This transformation will not happen overnight but will be incremental overtime.

The value

Kyndryl’s current price puts the company’s market capitalization at $2.8 billion and with net debt of approximately $900 million, the EV company is $3.7 billion. Even compared to current financial statements, this figure is low. Nevertheless, based on the size of the opportunity and the profitability, the company has an action plan to significantly increase its operating profit by 2025 through several initiatives: alliances, advanced delivery, accounts and others. Alliances are the partnerships they enter into with hyperscalers like AWS, Microsoft, and Google, which means they can now offer solutions to their customers based on the offerings of these companies. This new revenue will add $200 million to pre-tax income. Advanced delivery through process automation brings $600 million in cost savings, with $200 million coming in March 2023. The biggest opportunity is in accounts where they will be dealing with substandard margin accounts and will try to improve them with the new offers they have or leave them. All of these initiatives will also lead to better growth practices, expense management and other processes that will add $400 million to pre-tax earnings. On the other hand, their IBM costs will increase to $600 million in the medium term, but the initiatives will more than compensate for this increase. In total, they should add $1,400 million in pre-tax income.

Scenarios (% of $1.4B pre-tax revenue earned by initiatives)

Running Basis (40%) Taurus (75%)
Beneficial power value (millions of dollars) LTM 2025 2025
Revenue 18.317 18.317 18.317
GM Adjusted EBITDA 5.6% 8.7% 14.4%
Adjusted EBITDA 1.029 1.589 2.639
Depreciation 1.575 1.575 1.575
EBIT -546 14 1.064
MG EBIT -3.0% 0.1% 5.8%
Tax @ 21% -115 3 223
Maintenance investments 752 850 850
gain power 392 736 1.566
Multiple PEPS 11 11 11
EPV 4.308 8.097 17.221
Debt 3.004 3.004 3.004
Cash 2.134 2.134 2.134
Intrinsic value 3.438 7.227 16.351
Shares outstanding (millions) 224 224 224
Intrinsic value per share 15.33 32.21 72.88
Upside down 19% 149% 464%
Present Intrinsic Value per Share (@ 12% Hurdle Rate) 15.33 21.47 48.57
Upside down 19% 66% 276%
Safety margin 16% 40% 73%

As mentioned earlier, at the current price, the company is undervalued, based on the last twelve months financial statements, by 20%. But if you consider the transformation the company is going through, the undervaluation is even more significant. The valuation has some assumptions, but the main difference between the base and bull cases is the amount of money the initiatives will add to pre-tax income, while the former will add $560 million, the latter will add approximately $1 billion. dollars. I did not predict revenue growth since the company will not return to revenue growth until 2025. Here is what the CEO said about the company’s Q4 2021 results:

Obviously, this is not where we expect our results once our major initiatives have a greater impact on our P&L and once we return to revenue growth in 2025.

Another important assumption was that depreciation and amortization will remain constant and that capital spending will be guided for 2023. Which is reasonable since Kyndryl tends to be more asset light, so the differential between the depreciation and maintenance expenses should be kept. The earnings power multiple of 11x is conservative to reflect slow growth and low margin in the IT infrastructure business. The bearish and bullish case gives KD a value between $7.2 billion and $16.4 billion, but that’s only in 2025. The value is discounted to today at a minimum rate of 12% is between $4.8 billion and $10.9 billion or between $21 and $48 per share. The upside potential is huge.

The set up

I truly believe that the reward outweighs the risk in this case. From a fundamental perspective, the business becomes less risky after the rotation, with the business’s addressable market doubling and the ability to offer more solutions to its new and existing customers. In fact, the company’s customers were spending more on IT each year, but their ties to Big Blue were preventing them from benefiting. Plus, being an independent business allows them to better manage costs, which they already do. From a market perspective, the company’s stock has been under pressure and the multiple it is trading at is too low. The recent split also helps align the interests of executives, who are much more invested in the company and its stock price. IBM’s 9.9% position could add some selling pressure if they continue to sell, but they would be price-insensitive sellers and their actions should not be taken as an indication of the value of the stock. company.

All in all, we have all the ingredients in the mix for a profitable cake! A falling price due to insensitive sellers, undervalued activity at current prices, a wide margin of safety and a transformation strategy with huge potential and an opportunity with huge potential. At this price, I like the configuration!

Karen J. Nelson