Kyndryl Holdings, Inc. (KD) Earnings Call Transcript & Summary

All right. Good morning. Let's get started. Here we have Kyndryl up next for a fireside chat. My name is Tien-Tsin Huang, I cover IT Services sector. We'll be taking questions from the audience as I get through a few also questions from the portal. We'll be taking questions there, so feel free to submit anything you have there. With us from Kyndryl, we've got Martin Schroeter, CEO and Chairman; and David Wyshner, CFO. And like I said, I've collected a lot of these questions. So hopefully, we'll get through the most relevant stuff, but don't feel afraid to ask. But welcome. Thank you both for being here.

Thanks for the opportunity.

Yes, absolutely. It's always my pleasure. And I guess it doesn't feel like that long ago, Martin, when we were up here getting updates, you're pushing through some of the initiatives you've laid out. So yes, I figured it was a good thing to just kick it off and have you share a progress report on some of your key initiatives.

Sure. Thank you. It feels about like 6 degrees ago maybe because it feels -- it's a little -- I don't know about -- it's pretty cool, but that's okay. It's good. Look, we laid out at the beginning of last year, a strategy for how we were going to return to growth and how we are going to improve profitability. And we shorthanded all of that for those who know the story to 3 As, and we put a plus and a plus on it. And from a progress standpoint, we did a little bit more, but we did everything and maybe a little bit more than what we said we would get done in the first year. And those 3 As are -- I think we've proven those 3 As are the things that can turn this business around. So one of the As, which is Alliances, this is us joining, if you will, the ecosystem that really matters to our customers where we were not part of it before as part of the IBM ecosystem. We were very -- this business was very narrowly focused on IBM. But we said last year at the start, we would sign at least $1 billion of new business with our 3 new hyperscaler partners; Microsoft, Google and AWS. And we ultimately signed $1.2 billion last year. So to me, what it makes us feel really good about is that the nature of what we do, the role that we play in enterprise IT is important enough for the 3 biggest hyperscale cloud companies to want to work with us and to create meaningful businesses. So really good start on Alliances. We laid out what we call Advanced Delivery, which for us is a way to use the intellectual property we have to automate workloads, to reduce the labor content and free up labor to go redeploy into new opportunities. And we said that over the year, we would generate about $200 million in savings from that, and we finished a bit stronger than that. Finished -- I think we finished at [ $275 ] million or so. And then finally, the third A is focus Accounts. So when we were spun out, there are a series of relationships, about 40% of our business, about $8 billion of revenue that are essentially no margin, 0 profit, think of them almost as cost recovery for -- because it was on a different mission. And we set out to improve the profitability of these relationships. And we said we'd get about $200 million done, we'd exit the year with about a $200 million run rate improvement. And I think we finished about $210 million, $220 million. But again, it proved that not only do the partners, the most meaningful partners in IT space want to work with us. And while I only mentioned the 3 hyperscalers, we also have meaningful partnerships and relationships now with Oracle and SAP and Cisco and VMware, et cetera, et cetera. It also proved that our customers really want to stay engaged with us, and they want us to be successful. And they're willing to reimagine, if you will, the relationships we have, because, again, the role we play in their systems. We're running what I would call hearts and lungs, what are commonly referred to as mission critical systems. So those 3 As position us well now over the longer term to capture what we see as about $1.6 billion of gross profit opportunity for our business to improve from our current small loss, if you will, on the pretax line. And then I mentioned earlier the sort of a plus-plus. We said we were going to move much more heavily into advisory, into consulting work. So we created something called Kyndryl Consult. That grew pretty dramatically solid -- very strong double-digit signings growth and revenue growth, and we see that well positioned for the future. And then we started to take steps. The other plus would be to get our spending and our expense levels back to what we view as a competitive level because we were born -- you don't get to pack your own suitcase for this, right? So they put in -- IBM put in and spun us out with, quite frankly, a pretty heavy [ E2R. ] And we're now starting to address that as well. So we announced earlier this year that we took some actions, we'll reduce the [ E2R ] over time as well. So look, for me, I think what we've proven is that our customers really want us to be successful, and they want to work with us. We have the right Alliance partners now that can grow meaningful parts of the business. We can address the accounts. And importantly, from a progress perspective, everything we've put into the backlog since we spun out, everything we put into the backlog now is in that sort of high single-digit profit pool, which is what we see the business can ultimately deliver in the medium term. So we got a lot done in the year. We've laid out now what I'd call an acceleration of all that progress across the 3 As and a continuation of growth in the Alliance business and a continuation of growth in the consulting business. So look, a really good start and certainly on track, maybe even a little bit ahead of what we think this business can deliver.

Yes. No, the performance has been great. I think if I look back at the prior fiscal year, revenue did outperform. So as we look to fiscal '24, I know you're guiding to revenue down 6% to 8%, that's mostly low margin, no margin revenue runoff as part of the plan. So talk to us about the visibility of that runoff and this trade-off between revenue and margin.

Yes. Look, it's an important -- a good question. It's also an important question. So a few things about our business, I think, just to make sure, again, we've said them before, I just remind though, everybody. And you know this well. But when we enter a year, about 85% of our revenue is coming out of the backlog we started the year with. So the in-year signings and the in-year activity is really only about 15%. We also know -- by the way, we know about 2/3 of what's happening in 2 years' time. About 2/3 of that's already in the backlog at the 2-year start to prior. And that's important. I'll come back to why that's important in a second. So we start this year with about 85%. And we know that as we've laid out in our earnings discussion, that backlog that we were born with, the backlog that we inherited is down a couple of points. And that's okay because we're trying to get through that anyway. We also said that 5 to 6 points -- as you said, about 5 to 6 points of revenue decline driven by our actions to either improve focus accounts, sometimes that means taking content out, which recasts the relationship in a much more economically viable long-term position. And so some of it's focused -- half of that's focus accounts. The other half is just what we've called in the past, this kind of -- this OEM pass-through revenue. So again, this business on a different mission was focused very heavily on revenue, and we're focused very heavily on margin at this point. We'll get back to revenue growth, as we said, in calendar 2025. So some of the -- some of this year's impact due to the backlog coming down, which we're happy about. Some of it's driven by actions. Obviously, we're pretty keen. And remember that, Tien-Tsin, to your question on margin, the OEM pass-through, that's kind of in our control, right? We just -- we don't -- we won't sign up to do anymore. And therefore, it will run off. And this is sort of a big year for that to get that low-margin content out. And then the third element, which is growing, as I mentioned earlier, for that -- the $1.2 billion that we signed with our alliance partners last year. We said this year, we'll convert into at least $300 million of revenue. And we said Kyndryl Consult, our advisory business, will continue to grow as well. So this year, we have somewhat some unique dynamics that are going on, really focused on us trying to get low-margin content out, but a lot of that is in our control. So I'm not worried about the margin side of this, because we'll just stop doing OEM -- the OEM resale stuff. Now the reason I go through all of that is because where that positions us at the end of the year in I think a fundamentally different spot, i.e., this year is somewhat unique. The backlog, which is down -- that we inherited is down, it has a smaller and smaller effect on us over time. It's logical. Plus the things we're putting, the signings that we're putting into the backlog, we added a bit over $12 billion of new signings last year. As I mentioned, those are now in the kind of mid-20s GP, which is a good high single-digit PTI. So everything we're putting in the backlog has the margin profile that we like. And we'll have another year of that behind us as well. So the backlog that we inherited will continue to diminish in our P&L. And even if we don't grow at all in signings, we'll still double, right? We'll still double the impact that all the good stuff has in the following year. The OEM will be behind us, and Kyndryl Consult and the Alliance activity will also then punch at another year's worth of weighting in our overall P&L. So this year becomes a very unique year, and it sets us up for a much different construct for the following year, again, as we get back to growth in calendar 2025. So those are all the pieces. Anything you would add?

No.

Okay. But it is -- this year is a very unique year for us, different from what we see going forward.

No. Understood. So using the KPIs that we have -- and I recognize signings are difficult to look at because we're cycling through the old with the new, which is higher quality, but just headline-wise, signings are down 8%. And we looked at book-to-bill as an important metric for the group. So to get to calendar year '25, when might we expect book-to-bill to be equal to or greater than 1? Is that something we should be looking for as a guide for...

Yes. Look, I think for pieces of our business, book-to-bill is really important. Kyndryl Consult, as an example, has been at a book-to-bill greater than 1. And we'll continue all throughout this year to be at a book-to-bill greater than 1, because we are relying on that for growth. And that will continue to reweight in our overall revenue stream. Now as we bring revenue down, having Kyndryl Consult reweight because you're working on the denominator as well, not -- but even after we stabilize and we start to grow again, I still see the advisory business, Consult, growing. So the focus we have on Kyndryl Consult's book-to-bill is really important. And I think investors should look at that as, how is Kyndryl Consult traveling for the long term? Similarly, our Alliances business where, again, we signed $1.2 billion, we'll book a bit more than at least $300 million in revenue. We will also obviously be focused on growing signings, but that book-to-bill should be greater than 1 for the -- for a long time to come, not only because of the role we play in the world, but we have a lot to catch up here, right? We had, again, a mission that was very focused on the IBM Cloud, no relationships with the 3 hyperscalers. And now we've -- again, we've proven that we play a really important role with our customer base here. So the book-to-bill on Kyndryl Consults should be looked at as something that should be over 1 and keep growing. The book-to-bill on the Alliances' activity should be well over 1 and keep growing. And then as you said, the rest of the business is going to take 1.5 years or so until we can sort out enough of that low-margin, no-margin content to get out before it really becomes important to us as an element of growth. So even if we don't have a book-to-bill greater than 1 this year in total, I don't worry about it. I don't worry about it at all, because we still see growth in calendar '25 with the other dynamics going on. After that, once we get back to growth in calendar 2025, then we'll all be talking about a total book-to-bill, still looking at the elements as well, but the total will also be more important to continue to drive growth. We're just not at that point of the turnaround.

And fiscal '23 was a great example of that, where book-to-bill was below 1, but our revenue growth was solid, flat to up 1%. And so you can really see that over the near term, we may have a bit of a disconnect between what's going on with our revenues and our signings over time. Over the long term, that book-to-bill becomes important. But over the next 12 or 18 months, it's really -- as Martin was saying, the components that matter.

Got it. All right. So we've talked about revenue, signings, a little bit of margin as well, which you feel good about. Free cash flow. So how does this all translate down to free cash flow? I know the quality of the bookings is improving, the sizing is improving. What about the capital intensity on some of the deals. What can you tell us on free cash?

Yes, absolutely. On the margin front ends up being a big part of the cash flow story as well. And so when we look at our margins last year, EBITDA margin was 11.6%, adjusted pretax was minus 1.3%. And our targets over the medium term are really for EBITDA to move up to the high teens, and we've been consistent about that, which would be roughly a 7-point increase from where we were this past year. And we're looking for adjusted pretax income to move up by that much or even a little bit more into that -- ideally, the 7% to 9% range where we've been signing business over the last 12 months. And that could be a 9-point increase associated with that. And to your point about free cash flow, we've always said we expect pretax margin to expand by a little bit more than EBITDA as we become asset-lighter. And depreciation and amortization expense have less of an impact. And so that margin growth is where over a longer period of time, we expect the free cash flow growth to come from. This past year, we were able to generate free cash flow even though we had an adjusted pretax loss because of how we manage CapEx and working capital. And we'll continue to do that this year getting benefits from working capital and having CapEx under-run depreciation. And then over time, our expectation and our goal and what we need to do is have more and more free cash flow come from the adjusted pretax income that we're generating. And as we move adjusted pretax income up in a positive territory and then ideally up to the mid and then upper single digits, the opportunity for free cash flow to really accelerate becomes pronounced.

Good. So let's dig into some of the details, and then I'm happy to take questions. So let's definitely talk about Kyndryl Consult. That's been a positive surprise from our side. I think signings, I wrote down, what, up 30%, now 13% of revenue. What percent of revenue do you think Kyndryl Consult should represent for the total company? And Martin, what kind of work actually is hot right now?

So a few things on -- let me start with where you finished. So when we created Kyndryl and we described the types of capabilities we would build, we did those obviously in conjunction with our customer base to make sure that we sort of hit that Venn diagram between where they're growing and where they give us what I'll call brand permission to operate, right? So that's why we have a practice on cloud. That's why we have to practice on data applications, in AI, security and resilience, network and edge, digital workplace, et cetera, et cetera, et cetera. So we created the practices with this idea that our customer base, now that we're independent, now that we can bring the sort of the best of that they would be willing to basically expand -- allow us to expand our wallet share with them. And so we've been growing in all those spaces that are growing. So our security resilience business, our network and edge business within Kyndryl Consult data applications and AI business, all of these represent not only places where we have near-term growth opportunities, but I'm sure as the participants in the conference, these are the long arc journeys that every enterprise customer is on. So we are seeing really good growth around each of the practices that we're -- that either we're still building in some case, but we've built and continue to build. And again, the good news is -- the additional good news is, not only is this a long-term growth opportunity from a revenue perspective, the margin for us is a bit higher than the average. So what we showed in our earnings presentation was everything that went into the backlog, delivering 9% -- I think it was 10% last 6 months. PTI, which -- think of that as like a 25%, 26% kind of a GP. And we're seeing consult margins a few points higher than that still again. So we've got great long-term opportunities. As you said, we're at 13%. We've said that we think this can get to be at least 15%, but I've got to tell you, when we look at others, they're far, far bigger than that still. So we're still -- look at our heart. When we were born advisory, which is a little bit different than exactly what we're doing. It was run differently. It was 10% of the overall business, 90% of this business is [ run. ] And run is very sticky and run as really good relationships and run is how you build trust. So our Consult business will still be a preface to the run business. But I do think it has a good long-term trajectory here, where we can continue to see good growth in the practices where we have brand permission.

Yes. So I have to ask, right? When people -- investors think about the Consulting business and it just performed very, very well for you, it is believed to be more cyclical. So -- and tip of the spear to drive some of the run business as you just described there, Martin. So I'm curious -- I'm sure you hear this question throughout the days sort of the cyclicality of the business overall, cyclicality of the Consult business I've heard you say heart and lungs as well. So talk to us about the cyclicality.

Yes. I think -- look, a couple of things about -- again, about the nature of what we do. Regardless of the economic environment, a credit card company, for instance, couldn't decide to run its infrastructure for 6 days to save money. It doesn't work that way, right? An airline can't decide to take down its infrastructure for a few hours just because they have fewer passengers flying. So the nature of what we do again, hearts and lungs is -- sits at the core of sort of -- I wouldn't say we're entirely insulated from the macro, because there is some of our business that is volume-dependent. We saw that in very strong seasonality in the third quarter -- our third fiscal quarter last year, the December quarter, which tends to get driven by what happens in the retailers we run, et cetera, et cetera. So there is some volume business, but by and large, the nature of the work we do insulates us from the extremes. Similarly, because our advisory business, because our consult business is focused on positioning companies to survive and thrive in whatever the economic environment is, infrastructure still sits at the heart of that. And again, our advisory, our consult business is focused on infrastructure still. Now on top of all of that, because we are, in many ways, late to the game and building some of these practices. We still have a lot of catching up to do. So the thorniest problems that our customers have, the things that either they tried and couldn't get done or they didn't even want to tackle, because we were narrowly focused on IBM and they didn't see that as part of their future. They are starting to tackle some of those things because now, we show up with Microsoft in the lobby. Now show up with Google cloud and AWS and Oracle and others. So we still have a -- we sit in a unique spot in what we do. And then on top of that, we have a unique opportunity to catch up, which I think is still a few years before we really have caught up in how important the cloud management business is to us relative to others and how important we are to the data architect work that has to happen as new innovation finds its way on cloud. So we have, I think, 2 different levels of sort of unique opportunity here, the role we play already and then how much opportunity we have just to catch up to what others are already doing.

Yes. And 1 year, 1.5 years ago, when we said we wanted to get consult revenues to 15% of our aggregate revenue, we're starting at 10% and going from 10% to 15%, at 50% growth there felt like a lot and a good ambitious goal. And I didn't expect us to be at 13% a year into that. And that really highlights the amount of catch-up, the amount of Kyndryl-specific opportunity that we have almost regardless of the macro environment out there, because it's infrastructure, because it's catch-up for us. So this is really exciting, particularly when you lay around the higher margin associated with these sorts of revenue.

Yes. No doubt. So staying with the catch-up theme here, I know Alliances -- when you were here last year, you talked a lot about hustling to get partnerships and hustling to get a lot of certified people in, and it's worked. So you had $1.2 billion in signings, you're 20% above the target as you said in the beginning. So same question, what's next? Is there still a lot more room to go in terms of getting the certifications and getting the people in place to do the work? Because I know there's always debate around where we are with cloud and the whole journey, but I'd love to hear your thoughts on that.