Kyndryl: A Strong Consulting Business to Help Drive Adoption of Generation AI (Valuation Update) (KD)

We last covered Kyndryl Holdings, Inc. (NYSE:KD) in February 2022, highlighting its alliance with Nokia Oyj (NOK) for private 5G and edge computing. Despite my Hold position, it is up almost 58% as shown in the chart below, and that’s despite his income in decline every quarter since then.

This is partly due to a higher likelihood that the US central bank will become accommodative next month and also because its financial results beat analysts’ estimates during the fourth quarter of 2024 in May, as shown increase in share price. It later raised guidance when it reported first-quarter 2025 (FQ1-25) results in early August, but the stock fell alongside other enterprise software and IT providers.

The reason seems to be related to investors focusing more on AI infrastructure plays, but things are also changing attention is likely to shift to software and services. In this context, this thesis aims to show that Kyndryl is an opportunistic buy for its consulting and infrastructure businesses, with its sale price remaining undervalued relative to the IT sector.

Beware of moving to software and solutions

As I described recently, ChatGPT is certainly an innovative application that allows people to search for information more interactively, but the problem is that most of the discussion and investment about Gen AI, the technology that drives the intelligent chatbot has focused on chips and hyperscaling (large cloud service providers) implementing them. As a result, companies that are part of the Magnificent 7 have gained more than 70% since the launch of ChatGPT, as investors’ attention has been captivated by semiconductor suppliers such as NVIDIA Corporation (NVDA), whose chips are essential to provide the accelerated computing needed for the formation of LLMs or majors. language patterns. The focus was also on its competitors, AI networking companies and OEMs like Super Micro Computer, Inc. (SMCI), which packages processors and memory into servers before shipping them to data centers.

However, after the semiconductor giant saw a slowdown in growth in its data center segment, which includes the H100 accelerated computing GPUs, its share price took a hit. This may indicate a shift in investor focus from infrastructure builders to developing software and services where AI is actually monetized.

Additionally, for Gen AI to be adopted in the corporate world, IT infrastructure and consulting service providers like Kyndryl are key.

In this regard, in addition to accompanying their clients in their multi-cloud strategies, consultants must now meet the growing demand to modernize corporate processes using Gen AI to leverage data assets in a user-friendly way, through use of interactive chatbots and summary features. . Also, with companies having their data located both within the four walls of the enterprise and in hybrid cloud environments, Kyndryl consultants need to advise on the best way to proceed securely.

Thus, the company has to adapt its product offerings accordingly and has expanded its portfolio of traditional machine learning and analytics services to include Gen AI, namely by working with NVIDIA.

Thinking aloud, we are in the midst of the century-old trend of digital transformation, where the business world is making a step from cloud computing and digitization to AI-based business transformation, but this remains a highly competitive industry, one characterized by disruption as well .

Facing disruptions created by Gen AI and Competition

In this case, it is important to look at what sets Kyndryl apart from others in an IT consulting market itself disrupted by Gen AI. For example, when an employee is looking for a solution to their problems, they can now ask ChatGPT from OpenAI, Alphabet Inc. (GOOG) (GOOGL) Gemini or Perplexity.ai. These come in the form of chat-based interfaces that answer queries in intuitive and interactive ways and with relative ease. In other words, it’s like having a virtual assistant. As such, depending on the complexity of the task, this can reduce the need to hire consultants who typically charge more for tasks such as strategic change, digital transformation and technology consulting.

In addition, weak consumer discretionary spending also affected the financial performance of consulting firms such as Cognizant Technology Solutions Corporation (CTSH), whose revenue declined by -0.67%, as shown below.

Now, in addition to pure consulting, the solutions proposed by the consultancies include IT infrastructure management, application development, systems integration and managed services (or the provision of IT contracting services). As for Accenture plc (ACN), despite its diversification into digital marketing services that enhance customer engagement, its growth slowed from double digits to 1.46%. In turn, International Business Machines Corporation (IBM) also operates cloud services, software, infrastructure, research and security, making it a diversified technology company and not just a consulting firm, but it has still seen growth of revenues of only 3%.

Kyndryl appears to have suffered the most, but there could be a turnaround, namely because of its consulting expertise, which management says is based on “decades of experience” dealing with complex IT environments. Checking the veracity of this claim, it is indeed true, as its consultants previously operated as part of IBM, which already offered AI (Watson) in addition to conventional IT services. Tellingly, a comparison shows that Kyndryl’s consulting services business (Kyndryl Consult) generated $2.5 billion in FQ1-25 and grew by double digits, which is much better than IBM whose consulting fell 0.6% in the first six months of 2024.

In addition, management noted that Kyndryl Consult is valuable not only because of margin gains, but also because it acts as a leader for the managed infrastructure services business that generally accompanies IT modernization projects. Looking in the rearview mirror, one of the reasons why Kyndryl was spun off as an independent company in November 2021 was precisely because of its specialization in managed infrastructure services.

It is worth better based on Kyndryl Consult, but there are risks

So, almost three years later, it looks like this is resulting in new growth opportunities and could unlock value for shareholders, especially at a time when driven by the cost optimization rationale, the managed infrastructure services market is expected to grow at a CAGR of 10.3% from 2023 to 2033 to reach $239.6 billion.

Therefore, based on the 88% ((0.35-2.97)/2.97) undervaluation to IBM, which boasts a price-to-sales of 2.97x, there appears to be considerable upside potential for Kyndryl. However, being moderate, I consider a 17% advantage corresponding to the weight of the Kyndryl Consult business on total sales to be reasonable. Thus, I have a target of $27.71 (23.69 x 1.17) based on the current share price of $23.69.

To explain my moderate position, Kyndryl faces much larger rivals with at least seven times market caps, including its parent company and emerging disruptors using Gen AI to completely change the game. This means they risk seeing their market share come under pressure or having to cut costs to increase sales, in turn impacting margins.

To that end, as seen in the comparison above, its EBITDA margins remain well below peers. Moreover, its debt of $4.1 billion at the end of FQ1-25 exceeds its cash of $1.3 billion, meaning it does not have the freedom to spend money on growth in the same way as competitors with larger balance sheets strong. Now, being unprofitable and loaded with more debt than cash means a greater likelihood of borrowing money, which has resulted in the stock being punished as the Federal Reserve begins aggressive monetary policy tightening starting in March 2022. More recently, it has the opposite, as inflation increased. it has cooled below 3% and there are high expectations for a reduction. Therefore, if for any reason, there is any delay from the Fed, this rate-sensitive stock may suffer from volatility.

Justification of bullish position by margin expansion and Gen AI

However, as part of cost-cutting efforts, the contribution of certain legacy zero-margin and low-margin revenue streams from IBM is reduced, which is expected to increase the adjusted EBITDA margin by 160 basis points for FY-25.

Now, for a company like Kyndryl, it’s important to balance profitability and growth, whether it’s spending money on marketing or liquidating unprofitable assets. Its balanced approach is expected to result in top-line growth in the fourth quarter, breaking the losing streak. To that end, the non-GAAP forward P/E being less undervalued than the P/S, both relative to the IT sector median, as shown below, suggests that investors place more value on its profitability. As such, the 19% understatement of earnings value also justifies my moderately bullish stance of targeting 17% growth.

To further justify the pivot to growth by leveraging Gen AI, firstly, there is a synergy between the consulting business and Kyndryl Bridge, an integration platform that enables corporations to better manage (through improved visibility and control) their core operations using analysis tools. . By doing so, it saves them nearly $2 billion on an annual basis. Now, since one of Gen AI’s goals is to increase productivity by up to 50% according to McKinsey, and depending on the task at hand, it’s easier for consultants to get clients to adopt AI by using Kyndryl Bridge. In the same sense, the collaboration with NVIDIA is timely, as it allows the implementation of NIM tools to accelerate the development of AI models.

Second, the company expanded its partnerships with Microsoft Corporation (MSFT), Amazon.com, Inc. (AMZN) and others to advance their systems integration services for multi-cloud environments and cover aspects such as analytics and data management. To remind us, since LLMs feed on data, it has become a key ingredient to benefit from AI, and in doing so, the company is on track to generate nearly $1 billion in revenue from the hyperscaler, or double the amount obtained in the financial year. -24.

In conclusion, while the investments are not without risk, this bullish thesis is based on the fact that Kyndryl Consult continues to grow in double digits and provides additional impetus to the managed services business. At the same time, there is a balanced approach to growth and profitability to take advantage of Gen AI along its value chain in a sustainable way.