(Original idea and position entered September 2022 – this is part of a series of old write ups I am making available)
About Kyndryl
An IT infrastructure and services provider, created from the spin-off of IBM's infrastructure services business in November 2021.
Why I am investing.
A beaten down and fairly hated spin-off that swung too low on the downside. It also span near the market top before the recent 2022 bear market, so seemingly felt a double-whammy decline.
Being freed from the behemoth parent, it has many classic traits outlined in Chapter 3 of Greenblatt’s Stock Market Genius:
Widened/new target market through various partnerships that would not have been allowed in IBM. Kyndryl’s addressable market hopes to move from $240 billion to $510 billion by 2024
SpinCo Kyndryl less than 5% of Parent (IBM 100bn+ MCap) = Huge indiscriminate/institutional selling. A 40% drop in first month trading. Now, as of Sept 22, the bathwater is everywhere, trading at sub $9 - a near 70% fall. Sits notably below peer/industry multiples – and even with pessimistic growth/revenue assumptions, it seems very cheap for when profit and free cash flow get into gear (assuming it does!)
The CEO was SVP and CFO at IBM for 13 years. Management compensation nicely aligned with shares/options too.
Free of broader corporate governance and inefficiencies etc etc
Good runway to cull the waste, strengthen revenue trajectory and improve margins; returning to profitability (reducing capital intensity with increased focus on public cloud, data, security etc)
Sizeable insider buying since spin-off
Spun-off with manageable debt (3.2bn) at low interest, with a healthy cash balance (2bn).
Risks or concerns
Kyndryl provide services in decline (mainframe, data centres etc)
I hope greater pivots to public cloud, consulting services and partnerships (e.g. Msft, Google etc) can alleviate a lot of this. Should hopefully be plenty of runway in other services such as cyber etc too. This isn’t a growth story – it’s a cigar-butt that’s been beaten too hard mixed with typical spin-off characteristics that could be favourable.
Turnaround doesn’t turnaround – they often don’t.
Protection through very low valuation and conservative growth/margin estimates. Management have skin in the game.
Valuation
Relative approach:
A relative sector/industry approach can be a good yardstick for Spins ahead of separation – but still serves a useful purpose nearly a year on. Although somewhat of a declining industry in some areas, the closest comparables such as Atos, DXC and Fujitsu hover around 0.5 P/S when normalised. At time of writing, Kyndryl is in the basement at 0.11.
With a very conservative annual revenue estimate of 14bn, re-rating to 0.25 P/S would come to 3.5bn MCap. A 75% upside, from the current Sept 2022 2bn MCap. A more hopeful (realistic?) revenue of 17bn (do note that management proforma/forecast 19bn), using a P/S multiple of 0.3 brings us north of 5bn MCap – 150% upside.
I worry about the overall sector/services being in decline – I also still think general market conditions and multiples are heading south – so my preference is to stick with the lower 3.5bn figure.
An EV/EBITDA approach gives very optimistic numbers, with Kyndryl at 1.25 vs peers at 5. Re-rating a 2.8bn EBITDA to a 2.5 multiple gives 7bn EV. Back out the debt and again we’re around 5bn MCap range. The D and A part of this puzzle though is somewhat convoluted. P/E might be a better fit. August 22 earnings call defined a medium-term pre-tax earnings plan of 2bn. If we tax this and add a dose of pessimism, we could call it 1.5bn. Again with a current MCap of 2bn, that screams cheap if management can execute.
I am in danger of being precisely wrong, rather than broadly correct – but with these relative comparisons the results are positive. Studies have shown that spin offs show strongest outperformance around the 2 year mark, so I’d be hopeful of a re-rate / unlocking value in a 2-3 year period.
Yield and growth approach:
Management define an adjusted 800m FCF. There’s a lot of assumptions and things to go right. This feels a bit finger in the air – but at ~3.5bn Enteprise Value, we can swing at various FCF numbers; 400m (Bear), 600m (Conservative), 800m (Good).
I like Geoff Cannon’s (Focused Compounding) 10-year FCF model… So assuming zero growth, and no multiple re-rating, yields would be 11.4%, 17%, 23% on the above values. I do however think re-rating is part of this story, which could add north of 5% per year to each given such low starting multiples.
Any view on the co's execution since the writeup was written? Feels like they are ahead of schedule.