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

[ James Faucette here ] at Morgan Stanley. Very pleased to have Kyndryl. We'll be speaking with Harsh Chugh, Interim CFO of the company. But before we get started, I do have a disclosure to read. Please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley representative.

So maybe as a preamble, I'm sure that you're well rehearsed in going through this, Harsh. But can you walk us quickly through the SEC matter? What was that issue? And maybe more importantly, what was not an issue for that SEC matter?

Thanks, James, and good morning to all of you. And as you know, in matters like this, it's -- we are very limited in what we can talk about. But I think it's important to talk about a few things, which is -- it's a voluntary disclosure request. We are cooperating. That's number one. And more importantly, the financials are financials for us, like there were no restatements. Important to also talk about that we do have material kind of weakness as we disclosed. And those are around disclosure processes. We do have a remediation plan, and we are working expeditiously. But more importantly for us and the management team is we are focused on our business.

Right. Interesting. And that's an important point, and it seems like we're getting past that. So let's talk about the business this morning, Harsh. First, I guess probably the most common question that we get from investors and maybe is the key question on Kyndryl is, what's lending you confidence in being able to maintain fiscal year '28 targets despite fiscal year '26 coming in a little bit weaker than you had expected? And in particular, what specific parts of the business do you expect to accelerate to bridge the gap? And I guess, how much of that -- of your fiscal year '28 plan depends on some sort of recovery in the discretionary spending component of IT budgets?

Yes. And I think as we talked during the third quarter earnings -- and I specifically talked about it. Like while the sales cycles have extended and the complexity of decisions that our customers are making in the environment is very different with the data sovereignty and AI. But I -- while it might look like a headwind, but you have to think about the opportunity pool that it's creating for us. Like we are not what we used to be at the time of spin. We didn't have much relationship with hyperscalers. Kind of we are -- from a run rate perspective, this is kind of close to a $2 billion business that we have a relationship with Broadcom in terms of the penetration in the private cloud that we are going after. But more importantly, as you look at the types of signing that we are doing. And post-spin, 2026, 2/3 of our signings are post-spin. And as you look at 2027, it's going to be about 80-plus percent. And then as you go into 2028, it's going to be 90-plus percent. If you go underneath the characteristic of the deals that we are signing, the characteristic is a very disciplined approach, like in the new signing we are doing. It's 25%, close to that number in terms of the GP and high single-digit PTI margin, kind of that we have been [ hitting ]. And so that kind of creates an opportunity pool of what we have been signing, and it's kind of growing in terms of the new signing. The other market that I would talk about is the last 12 months of the gross GP dollars that we have booked versus what we have actually built, that's kind of $4 billion that we have booked and $3.3 billion that we actually built, so kind of in terms of the ratio. So we are creating the gross profit dollar kind of pool and the disciplined approach of kind of the new content as well as the signings, which is kind of post-spin, gives us the confidence kind of where we want to get. And by the way, 2 years is a long time. Two years is a long time. And things have changed in terms of our broader relationship in the ecosystem and kind of how we are becoming more relevant across than just being, I would say, at the time of spin, kind of more IBM-centric only business, a broader business.

Got it. So when you think about exactly that and then that broadening, can you talk a little bit about where you expect to see broadening or where you're seeing broadening of opportunity and how you expect that evolution to continue to develop?

Yes. I think if I take a step back, the world is -- and our CIOs and CTOs are going through what I call a change that they have never experienced. And I think I will use one simple example, and that you should try it. Ask any CIO this question, "Do you know where your data is within the enterprise?" That's a very hard question. And on top, you put the regulatory pressure of the regulators asking kind of from a data sovereignty point of view and who owns the data, where is the data residing, what is the IP being used? And that creates what I call the complexity. And with the emergence of agentic AI, it's not challenging the CIOs and CTOs to think about what the future proof of my IT environment should look like. Along with the cybersecurity issues that have always existed, now it kind of gives a bit more edge to the threat actors to kind of have a bit more using agentic AI. They can also use agentic AI. So data sovereignty, agentic AI and security are kind of changing this paradigm, all coming at a rate and pace that humankind cannot keep pace with. So now because many of our customers are in regulated industries. And we have been with them for decades. So the understanding we have with their business. And we're building capability across the broader ecosystem. Kind of more relevant with hyperscalers, like which we were not at the time of spin. Our broadening relationship with Broadcom that's becoming more relevant if you think about VMware from a private cloud, which is reemerging as a new trend. And being very relevant and still very important partner of ours, which is IBM in terms of the largest estate of mainframe that we manage. So think about the across footprint of ecosystem. Having this relevance in the regulated industry and relevance with the broader ecosystem, it puts us in a very unique position with many of these customers to bring our consulting capabilities, the modernization capabilities, that was not as prevalent and relevant kind of 4 years ago. So I think that kind of gives us a business context apart from the financial context I gave in terms of the signings, which are new signings with better margins that we are signing.

And -- so let's talk about free cash flow because I want to come back to margins and some of these other points. But speaking specifically about your fiscal year '28 free cash flow target, does that depend more or less on working capital assumption changes? Or how do you think about the elements that build up to your fiscal year '28 free cash flow targets?

I'm glad you brought this topic. I think there was a conversation on this during our Q3 earnings. If you look at last 2 years, the biggest driver of our free cash flow was what happened to our pretax income and the cash taxes. Working capital is kind of not as a relevant element. Over the longer term, that's what you should expect. Working capital is not the biggest driver or much of the driver. What's important is as business leaders, we still have to manage our working capital. We still have to think about the cash conversion cycle. So quarter-to-quarter, it is a variable that you have to manage. It's a business paradigm. You manage kind of what you're doing with your customers from receivable, what you're doing with your supplier base. So I think this is kind of what I call a disciplined approach in managing your working capital because you want to manage cash conversion. But from a free cash flow perspective, as we look into the future, longer-term perspective is that working capital is something that's not relevant from that perspective.

Right, right. Got it. Got it. So let's go back. And once again, you touched on this just a moment ago, but a couple of times in talking about like the engagements that you're having with your customers and what that development may look like. But how should we be tracking and thinking -- as investors and people outside of the company, how should we be thinking about and tracking forward-looking bookings trajectory and in particular, how those build up to reaching your targets?

Yes. I think it's a good question. I would kind of point you to kind of a few important metrics to think about. And one of the key metric is kind of are we booking from a gross profit dollar perspective more than what we're billing, right? That's an important key indicator. That's kind of one. From a business perspective is our relevancy in terms of what we bring to our customers in terms of the broader ecosystem participation. And in the customer base that we are kind of trying to manage, is this going to resonate? Like modernization as an example. Private cloud is an example, like security as an example. And what agentic AI capabilities we are bringing. Like it might not be as apparent. Our delivery has so much of agentic AI now being built into it. So we are a big consumer. And I will kind of also give you, as a practitioner -- I was -- in my previous role as Chief Operating Officer, I was also doing agentic AI in our procurement process, right? So I think the business relevancy and things that we are doing in terms of -- from a financial metric point of view, are we creating kind of better margin deals in our engagements.

So let's -- I want to parse a couple of things, just so we're clear. When we talk about like improving gross profit bookings relative to revenue or relative to what you're recognizing, just talk a little bit about why we should be tracking gross profit versus most of the time, the quick and easy would be to just track book-to-bill versus revenue. So talk a little bit about why the difference in gross profit matters for you.

Yes. I think if you think about where we were born from, many of our contracts were not profitable, right? So we had account focus. And much of the signing were kind of what we actually inherited. Now it was a more disciplined approach as we were going as to what matters to Kyndryl in terms of our capabilities that we're bringing, in terms of what we are presenting to our customer and what -- and are we getting a fair share of our profit, right. When we began, 0% of signing was from what this management delivered on. Now last year -- or this current year, it's 2/3 of our business is coming from the new signing. And by the time we get into 2027, it's going to be 80%. So is there a disciplined approach of we're getting the right content, the right GP margin. We did talk about IBM as potential kind of where customers are making some choices, where they're going with the CapEx versus OpEx. And some of these ecosystem where we might be acting as a bit of reseller, you don't make much margin. But are you earning the right margin on the broader capability you're bringing? And some of the content may be high margin, and some content might be low. But on a collective basis, are you bringing the right share of profit? And that's why GP dollar is important for us.

Got it. Got it. So I want to also touch on something you mentioned a couple of times. Private cloud, right? Like what is happening with private cloud versus public cloud? I mean it seemed like over the last few years, I mean, even going back maybe the last decade is that there was very much this idea that private cloud eventually would be completely subsumed by public cloud. I know in other parts of the market that we watch very closely, for example, financial services, everybody has been waiting for years to move off of private cloud to public cloud. So what's happening with private cloud? And is the changing technology landscape also adjusting some of the road maps that people had in their minds?

I'm glad you asked this question. I think the reemergence of private cloud has some basic tenets that I think it's important to kind of compare and contrast. The cloud-type experience private cloud could never provide, so from the DevOps perspective and development community perspective and the native creation of application, it was a lot easier experience in hyperscaler versus private cloud. I think VMware or Broadcom and some other players are actually bringing certain new technologies. Like in terms of VMware, they're going from VCF 7 to VCF 8 to VCF 9. It might look a bit more technical, but they're trying to make the private cloud cloud-like experience with the full integration of virtualization all the way to the PaaS layer. Why it's important? That's kind of one. Is there a bit of less difference in the development and application communities to see there's less difference.

Right. So for the developers and the people running it, they may be -- you might be able to get to more parity of features between public and private cloud?

There's still more work to be done to get to that point. But then one of the other biggest driver that's driving this is data sovereignty and AI. And let me explain why. Would you actually want to move data closer to AI? Or would you want to move AI closer to data? And let me explain. If you want to run AI and you have workload and you're in hyperscale environment, your data sits with the hyperscaler and you. Whereas in private cloud, you can bring AI closer to your data. So now this is kind of where the reemergence of this AI war and the data sovereignty war. And this war between hyperscaler and private cloud has actually created an impetus, which is also industry-led, kind of the regulation-led data and AI is creating a new debate that companies didn't worry as much, but now it's becoming real. So that's why you see this reemergence. Even in our customer community, we hear that they actually are now starting to think back, kind of bringing some of the workload back into private cloud environment.

Interesting. Is that -- so like the logic -- and it's an interesting question or point. How much of that is likely to be driven entirely by regulation or legal requirement, like you said, data sovereignty? When you say that, I often think about some of the laws and regulations have been put in place in geographies like Europe versus how much of that is purely strategic decision-making on the part of different parties and saying, "Hey, even if we're not subject to regulation or law, this is still something that we want to do for our own strategic benefit."

Yes. Again, this is a very interesting thesis, and I'll just put myself in the shoes of -- as the Chief Operating Officer when I had -- I was the Chair of our own cyber governance at Kyndryl. That's kind of one side of me. The other one is kind of building agentic AI in my procurement processes. I used to have my CISO with me, talking to the companies who I'm working with to kind of get the domain-specific knowledge in procurement processes. The bigger debate you have to think about is when you have AI models and when you're taking data closer to the AI model, are you actually sharing some of the knowledge from your data and AI models, kind of?

Yes. I was reading an article yesterday in The Wall Street Journal about a guy that just was uploading all his contracts to ChatGPT. And I was like, well, is that a great idea or not, right?

So think about it. Now you are a European business. and you are, let's say, in Germany. Are you willing to send your data to a hyperscale environment? And what do they learn from it, and that becomes an IP that gets used in some other places. It's a debate that's going to evolve. The whole governance around agentic AI is what I call -- I would quote it as late '90s when we were talking about emergence of cloud. And they were saying, "Well, is cloud actually secure?" That debate took 5 or 10 years before that debate went away. Agentic AI and data sovereignty is what I call is in that early stage of governance. Think about you're going to have agents -- sorry, agentic AI coming from different environment. What is the governance principle? Who governs this? And how it gets governed? What are the large language models that are embedded in these and what data elements have been used?

Right. And do you see customers proactively saying -- like already making decisions on that debate saying, "Hey, we're okay with it, so we'll go ahead with our public cloud migration,"? Or do you have customers conversely already saying, "You know what, we've already decided so we're going to reengage on a private cloud strategy,"?

If I take a step back, and I would say most of the customers we deal with are going to be in all 3 environments. What I mean with they're going to be in mainframe. Mainframe offers unique platform kind of capability that none other platform offer, like from a security resiliency and encryption point of view. Private cloud is becoming more relevant because of the regulation and AI, what gets stored where. It's more the data in your control, more AI in your control and hyperscaler from the DevOps perspective, and they're also kind of far ahead in their own AI capability. So most of these companies have investment in all 3. The question is what is the right platform choice for way you keep system of record to system of engagement and how do you bring this data sovereignty and AI and application. There is a bit more governance and maturity that has to evolve from here. But I want to be, as Kyndryl, be relevant in all spaces. So where customer wallet goes, my wallet share follows.

Right, right, right. So interesting conversation there. Let's talk about the budgeting and sales cycle in the current environment. You recently noted some lengthening sales cycle across Kyndryl Consult and hyperscale-related revenue. Help us unpack the key drivers behind this elongation, at least from where you sit, and if you've observed any changes of late?

It's no different than what I was struggling with as the Chief Operating Officer. I'm doing agentic AI implementation and procurement processes. And I don't know kind of from a governance point of view, what data is being processed, where is that data? What is the implication of agentic AI? And how do I future-proof my environment? So think about most of the discussions we have with our customer, they are more long term in nature. These are not a 3-month engagement. So they are thinking about how do I future-proof my IT environment, IT architecture? And I'm in a regulated industry, working with Kyndryl as an important service provider. How should I even think about evolution of these things? There are platform choices they have to make, hyperscaler versus private cloud versus mainframe. Kind of what application goes where, agentic AI, what disruption it would create in the application environment. So these discussions are more because the complexity of how do you future-proof because these are longer-term decisions. So you have to be -- you have to create a bit of nimbleness in your IT environment so you can move. What is the level of modernization that is feasible? What is the cost model kind of go forward? And how do you keep the flexibility and keep in mind the data sovereignty, how do you meet the regulatory changes that are coming? Like it's not -- like every 3 months, there is something different. And I'll actually even give you an example. We are actually in the middle of closing an acquisition, Solvinity, that we announced. Just a few months ago, it was not a question, but now it's a debate in Parliament -- in Netherlands Parliament. Because it's talking about a cloud service provider in Netherlands providing support to the government entities, the question in Parliament is, is a U.S. corporation going to have access to that cloud service provider or they're going to become -- so what does it mean, right? Like -- so those questions were not -- kind of 3 months ago, were not as big as they were starting to be. So most of the customers are starting to have this conversation. So it's the regulatory pressure, the data sovereignty and AI. Security was always there, becoming even more complex for them. So the reason I even call it as a tailwind for us, while it might look headwind, the tailwind is, because it's bringing us into more and more complex decisions where I can bring more value because we are already working with these customers in regulated industries because we understand their business. So I'm more interested in getting that incremental scope in the discussion rather than getting a deal signed, which may not be also worthwhile for customers because they haven't future-proofed.

Right, right. Yes, they still have to figure out where they're going, et cetera. Interesting. So I could spend a ton of time on this topic, and maybe we'll circle back to it. But I want to make sure that we hit a couple of other things. And in particular, this once again was a topic that came up in the last call was the relationship with IBM and that revenue model. How is that evolving, particularly between IBM software and hardware and the services that are tied into the IBM ecosystem? And how should we anticipate that changing relationship impacting the financials?

I'm glad you're bringing up this question again. And it's so near and dear to me because at the time of spin, I was appointed as the IBM relationship [indiscernible]. So I have lived through the evolution of our relationship. And most importantly, this is a very important relationship to us. our customers rely on an important platform, which is mainframe, and it's very core to critical systems that IBM provides in terms of their IP and capability. It's very important for customers that we provide the certainty of the uptime on those. So it's very, very joint collaborative engagement in many situations. But I think when -- just going back to the spend conversation that you had. Like at the time of spin, we had about $4 billion of spend. But we also carried -- 40% of contracts that we had at the time of spin, we were not making those kind of no margin to low-margin kind of business. So we actually had an account focus initiative. So many of those engagements, we actually work with customers and IBM to make sure that we could restructure the contracts, make sure that the content, the IBM content can go direct with customers. So that spend evolved over time. I thought we were -- we thought that we were over with this, kind of all the customers because most of our account focus initiative was significantly done at this time. But customers are continuing to make those choices. And let me explain why they are making choices because they have to pick what platform they're going to be on longer term. As you and I talked about mainframe versus private cloud versus hyperscaler. IBM continues to bring their own new innovation, any acquisition they are doing. Customers will also make choices on whether they want to do a CapEx base, meaning they want to sign a big ELA and kind of make a bigger commitment and longer-term commitment with IBM. Or they might want to kind of get that content through us in an operating services base. We do not see that this is a resold capability of IBM that you can command significant margin. Like it's a lower margin kind of business, while it's a high-value business for us in terms of the services we provide and it's high value for IBM and its important content. So I think it's now about $2 billion of business that we have or spent with IBM. It's a customer decision. They will make those choices. What it can have is the revenue could shift because of customer choices, but it's not going to have any material impact on our earnings because it's lower margin to begin with. It's a resold piece of business.

And then speaking about IBM, I want to circle back to a technology-related question. In the last week or so, IBM shares moved on concerns that newer AI tools could reduce the need to modernize legacy COBOL workloads. And given your work with IBM, can you walk us through the specific services you provide to IBM-related environments today? And how do you see AI changing that demand over time? And I guess we're just trying to conceptualize like, okay, are these kinds of AI threats to a lot of this legacy and long time deployed technologies, does that adversely impact you? Does that help you? Just trying to get a better handle there.

One thing I would say is for those -- there is an op-ed Rob Thomas from IBM wrote. I think it's an interesting article, and I ascribe to that article, people should read that, like that's kind of one. But more importantly, COBOL was kind of one of the discussions that came up in this. COBOL actually is in both distributed and mainframe environment. It exists across multiple environments. It also came from the context of modernization. Modernization is a much bigger conversation. It's not just about reading a code which is written in COBOL. The modernization is a discussion about your data architecture, your application architecture, your process flows, your transaction element, how is it connected with your business. What this can do, some of the tools can read the language and can create documentation for what that code is doing. It has what I call -- it has improved the discovery element of what that code is doing. But that's just the initial step of a bigger modernization discussion, which would be what do you want to keep on mainframe versus what application you want to modernize. The silver lining in all this for us as Kyndryl is it has actually lowered the barrier of entry for Kyndryl because we were not in application space. But this has lowered the entry barrier for us because now we can do certain things. And understanding the application environment, that would have required a lot more resources with application capability. We require a lot less capability now. So I think that's the silver lining. So it is -- it creates better relevancy for us from a modernization perspective because we can also now bring a little bit of more application skill set without the size of the application business that we had.

Got it. So let's talk about in the last few minutes here, impact on financials and kind of how to think about a couple of key things. First, margins. How should we think about the sustainability of margin improvement once the benefits from your strategic initiatives are fully realized, especially if sales cycles remain a bit elongated?

Yes. I would kind of bring back to the same conversation I was having. Think about the gross profit dollars that we are guiding. That's kind of number one, kind of $4 billion in the last 12 months. What we built was $3.3 billion. Second, the amount of signing that's post-spin. This year was 2/3, and it's increasing to 80% by next year, and the following year, 90%. And our discipline in making sure that as we are signing new deals, at what margin are we signing, right? The disciplined approach of getting the right mid-20s GP and high single-digit PTI margin. And number of investments we are making like in Consult, as they start to scale, kind of those become what I call a contribution to kind of the margin that we all should expect kind of move upwards.

Got it. Got it. And then capital allocation. Talk and remind us about your capital allocation priorities, mainly as it relates to your existing debt profile. And how we should think about the -- where you're targeting on that debt level and what you want to do with the capital that you are generating?

It's an interesting question, and we always think about capital allocation as a holistic approach. And it's a long-term holistic approach because, number one, we want to keep a strong balance sheet. That gives us the financial flexibility. That then allows us to think about are we making the right investment in a business like Consult, like Kyndryl Bridge. Important for us to also think about tuck-in acquisitions, Solvinity that I talked about. And we continue to kind of think about acquisition that becomes an add-on in terms of shaping our business. And then at the end of last quarter, we had about $350 million of repurchase, buyback authorization still remaining. It will continue to be kind of a holistic approach, and that's how we think about capital allocation.

So Harsh, just to wrap up here. You've come from IBM into Kyndryl, managed relationship, had operational roles. Now you've stepped into the interim CFO role. What's the top 1 or 2 things that you think we, as investors, should be tracking in terms of your path to returning to growth and ultimate acceleration of growth?

Yes. I think it's customer relevancy. Customer relevancy because if you're relevant in the broader ecosystem and we are solving the real customer problems -- and modernization is a good example. And within modernization is kind of the broader ecosystem, like hyperscaler to private cloud to kind of mainframe, we have to be relevant across. And customers will make their choices. Those are going to be driven by what is happening with the business, which market they are in, which country they are in because regulations will define -- is it heavily regulated? And as long as we are deeply embedded with them, with these long-term relationships, that's going to drive -- as their wallet shifts, am I going to shift with their wallet as long as I'm in the broader ecosystem, and I'm able to deliver. I just don't want to be one services only. It's the breadth. And then you follow the customer. And I think wherever the customer wallet goes, we go with them.

Great. We're out of time. Thank you very much, Harsh. I really appreciate you joining us here at the Morgan Stanley TMT Conference. It was fantastic.

Thank you, James. It was nice meeting you.