Kyndryl Holdings, Inc.: Form 10-Q for the period ended Jun 30, 2023

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FOR THE THREE MONTHS ENDED JUNE 30, 2023

Overview

(Dollars in millions)

(1) Revenue growth in constant currency and adjusted EBITDA are non-GAAP financial metrics. For definitions of these metrics and a reconciliation of adjusted EBITDA to the most directly comparable financial measure calculated and presented in accordance with U.S. GAAP, see “⸺Segment Results.”

(Dollars in millions)

Organization of Information

Kyndryl Holdings, Inc. was formed as a wholly-owned subsidiary of IBM in September 2021 to hold the operations of the managed infrastructure services unit of IBM’s Global Technology Services segment. On November 3, 2021, Kyndryl separated from IBM through a spin-off that was tax-free for U.S. federal tax purposes. Following the Separation, Kyndryl became an independent, publicly-traded company and the world’s leading managed infrastructure services provider.

Financial Performance Summary

Macro Dynamics

In fiscal year 2023, we saw continuing demand for information technology services, despite declining economic growth, increased geopolitical tensions, inflationary pressures and government efforts to stem inflation. Although the risk of economic slowdowns in certain geographies has increased due to higher interest rates and other factors, most economists, including the International Monetary Fund, expect positive global macroeconomic growth in calendar years 2023 and 2024.

Quarterly Financial Performance

For the three months ended June 30, 2023, we reported $4.2 billion in revenue, a decline of 2 percent compared to the prior-year period. The revenue decline was largely attributable to actions the Company has taken to reduce low-margin components of its customer relationships, as well as currency effects. United States revenue was unchanged, Japan revenue declined 4 percent (but increased in constant currency), Principal Markets revenue declined 2 percent and Strategic Markets revenue decreased 4 percent, in each case compared to the three months ended June 30, 2022. Net loss of $141 million improved by $109 million versus the prior-year period driven by lower transaction-related costs and progress on our key initiatives to drive operating efficiencies and increased margins, partially offset by a $54 million increase in workforce rebalancing charges in the current quarter.

Segment Results

The following table presents our reportable segments’ revenue and adjusted EBITDA for the three months ended June 30, 2023 and 2022. Segment revenue and revenue growth in constant currency exclude any transactions between the segments.

(Dollars in millions)

NM – not meaningful

(1) Revenue growth in constant currency and adjusted EBITDA are non-GAAP financial metrics. See the information below for definitions of these metrics and a reconciliation of adjusted EBITDA to net income (loss).

(2) Represents net amounts not allocated to segments.

We report our financial results in accordance with U.S. GAAP. We also present certain non-GAAP financial measures to provide useful supplemental information to investors. We provide these non-GAAP financial measures as we believe it enhances visibility to underlying results and the impact of management decisions on operational performance and enables better comparison to peer companies.

Revenue growth in constant currency is a non-GAAP measure that eliminates the effects of exchange rate fluctuations when translating from foreign currencies to the United States dollar. It is calculated by using the average exchange rates that existed for the same period of the prior year. Constant-currency measures are provided so that revenue can be viewed without the effect of fluctuations in currency exchange rates, which is consistent with how management evaluates our revenue results and trends.

Additionally, management uses adjusted EBITDA to evaluate our performance. Adjusted EBITDA is a non-GAAP measure and defined as net income (loss) excluding net interest expense, income taxes, depreciation and amortization (excluding depreciation of right-of-use assets and amortization of capitalized contract costs), charges related to ceasing to use leased/fixed assets, charges related to lease terminations, transaction-related costs, pension costs other than pension servicing costs and multi-employer plan costs, stock-based compensation expense, workforce rebalancing charges, impairment expense, significant litigation costs and foreign currency impacts of highly inflationary countries. We believe that adjusted EBITDA is a helpful supplemental measure to assist investors in evaluating our operating results as it excludes certain items whose fluctuation from period to period does not necessarily correspond to changes in the operations of our business. We provide this non-GAAP financial measure as we believe it enhances visibility to underlying results and the impact of management decisions on operational performance, enables better comparison to peer companies and allows us to provide a long-term strategic view of the business.

These disclosures are provided in addition to and not as a substitute for the percentage change in revenue and profit or loss measures on a U.S. GAAP basis compared to the corresponding period in the prior year. Other companies may calculate and define similarly labeled items differently, which may limit the usefulness of this measure for comparative purposes.

The following table provides a reconciliation of U.S. GAAP net income (loss) to adjusted EBITDA:

(Dollars in millions)

* Other adjustments represent pension expense other than pension servicing costs and multi-employer plan costs, significant litigation costs and currency impacts of highly inflationary countries.

United States

(Dollars in millions)

For the three months ended June 30, 2023, United States revenue of $1.2 billion was unchanged compared to the prior-year quarter. Adjusted EBITDA increased $36 million from the prior-year quarter, primarily driven by increased operating efficiencies and higher margins on recent signings, partially offset by an increase in software costs of $16 million resulting from an amendment of the contract with a software provider that re-allocated costs among our segments.

Japan

(Dollars in millions)

For the three months ended June 30, 2023, Japan revenue of $610 million decreased 4 percent compared to the prior-year quarter, driven by an unfavorable currency exchange rate impact of six points. Adjusted EBITDA decreased

$15 million from the prior-year quarter, primarily driven by unfavorable currency movements that impacted both non-yen-denominated costs and the translation of earnings into U.S. dollars.

Principal Markets

(Dollars in millions)

For the three months ended June 30, 2023, Principal Markets revenue of $1.5 billion decreased 2 percent compared to the prior-year quarter. The revenue decline was largely attributable to actions the Company has taken to reduce equipment sales and other low-margin components of its customer relationships. Adjusted EBITDA increased $67 million from the prior-year quarter, primarily due to a decrease in software costs of $21 million resulting from an amendment of the contract with a software provider that re-allocated costs among our segments, increased operating efficiencies and higher margins on recent signings.

Strategic Markets

(Dollars in millions)

For the three months ended June 30, 2023, Strategic Markets revenue of $935 million decreased 4 percent compared to the prior-year quarter. The revenue decline was largely attributable to actions the Company has taken to reduce equipment sales and other low-margin components of its customer relationships. Adjusted EBITDA increased $37 million from the prior-year quarter, primarily due to increased operating efficiencies and higher margins on recent signings, partially offset by an increase in software costs of $9 million resulting from an amendment of the contract with a software provider that re-allocated costs among our segments.

Corporate and Other

Corporate and other had an adjusted EBITDA loss of $24 million in the three months ended June 30, 2023, compared to a loss of $20 million in the three months ended June 30, 2022.

Costs and Expenses

(Dollars in millions)

NM – not meaningful

Cost of services was 82.3% of revenue in the three months ended June 30, 2023, compared to 85.8% in the three months ended June 30, 2022, driven by increased operating efficiencies and higher margins on recent signings. Selling, general and administrative expenses were 17.2% of revenue in the three months ended June 30, 2023 compared to 16.2% in the prior-year quarter, driven by the impact of currency on revenue compared to our U.S. dollar-denominated expenses. Workforce rebalancing charges were 1.4% of revenue in the three months ended June 30, 2023 versus 0.1% of revenue in the prior-year quarter, due to workforce rebalancing actions in the first quarter of fiscal 2024. Transaction-related costs were 1.0% of revenue in the three months ended June 30, 2023 compared to 2.4% in the prior-year quarter driven by reduced rebranding and employee retention costs. Interest expense was 0.7% of revenue in the three months ended June 30, 2023 compared to 0.5% in the prior-year quarter.

Transaction-Related Charges

The Company classifies certain expenses related to the Separation, acquisitions and divestitures (if any) as “transaction-related costs” in the Consolidated Income Statement. Transaction-related costs include expenditures incurred to prepare for and execute the Separation and establish Kyndryl as a standalone business. These costs include employee retention expenses, information technology costs, marketing expenses to establish the Kyndryl brand, legal, accounting, consulting and other professional service costs required to prepare for and execute the Separation, and other costs related to contract and supplier novation and integration.

Workforce Rebalancing and Site-Rationalization Charges

During the fiscal year ending March 31, 2023, management initiated certain actions to reduce our overall cost structure and increase our operating efficiency. These actions include workforce rebalancing charges, charges related to ceasing to use leased and owned fixed assets, and charges related to lease terminations. Workforce rebalancing charges arise from cost-reduction actions to enhance productivity and cost-competitiveness and to rebalance skills that result in payments to the terminated employees. In addition, we identified certain leased and owned assets that were inherited from IBM as a result of the Separation that we determined will no longer provide any economic benefit to Kyndryl. As a result, we disposed of these assets through abandonment or early termination. During the three months ended June 30, 2023, the Company recognized $58 million in workforce rebalancing charges and $10 million in charges related to ceasing to use leased and owned fixed assets and lease termination charges.

Management expects total future charges for this program to be approximately $70 million, consisting of $50 million in workforce rebalancing charges and $20 million in charges related to ceasing to use leased and owned fixed assets and lease termination charges. The Company estimates that the program in aggregate will require a cash outlay of approximately $260 million, of which approximately $92 million has been paid through June 30, 2023 (including $11 million of contractual payments toward leased assets we have ceased to use) and approximately $100 million is expected to be paid within fiscal year 2024, and the remainder thereafter. Management expects that these workforce rebalancing and site-rationalization activities will reduce future payroll costs, rent expenses and depreciation of property and equipment by approximately $200 million in fiscal year 2024. There can be no guarantee that we will achieve our expected cost savings. The Company will continue to seek opportunities to improve operational efficiency and reduce costs, which may result in additional charges in future periods. For additional information, see Note 14 – Workforce Rebalancing and Site-Rationalization Charges in the accompanying Consolidated Financial Statements.

Income Taxes

The provision for income taxes for the three months ended June 30, 2023 was $32 million of expense, compared to $45 million of expense for the three months ended June 30, 2022. Our income tax expense for each of the three months ended June 30, 2023 and 2022 was primarily related to taxes on foreign operations and valuation allowances recorded in certain jurisdictions against deferred tax assets that are not more likely than not to be realized.

In assessing the need for a valuation allowance, management considers all available evidence for each jurisdiction, including past operating results, estimates of future taxable income, the reversal of existing temporary differences, and the feasibility of ongoing tax planning strategies and actions. Estimates of future taxable income and loss could change, perhaps materially, which may require us to revise our assessment of the recoverability of the deferred tax asset at that time.

Financial Position

Dynamics

Total assets of $11.0 billion decreased by $477 million (and decreased by $450 million adjusted for currency) from March 31, 2023, primarily driven by: a decrease in cash and cash equivalents of $341 million mainly due to the net loss in the period as well as payments for license agreements, annual incentives and workforce rebalancing liabilities; and a decrease of $33 million in accounts receivable due to lower revenue.

Total liabilities of $9.6 billion decreased by $354 million (and decreased by $379 million adjusted for currency) from March 31, 2023, primarily as a result of: a decrease in accounts payable of $148 million; a decrease in deferred income of $63 million mainly due to lower advanced billings; and a decrease in accrued compensation and benefits of $60 million due to payments of annual incentives; partially offset by an increase in debt of $63 million due to new finance leases. Total equity of $1.3 billion decreased $124 million from March 31, 2023, principally due to our comprehensive loss in the period.

Working Capital

(Dollars in millions)

Working capital decreased $33 million from March 31, 2023. Current assets decreased $310 million (and decreased $300 million adjusted for currency) primarily driven by: a decrease of $341 million in cash and cash equivalents and a decrease of $33 million in accounts receivable. Current liabilities decreased $277 million (and decreased $298 million adjusted for currency) as a result of a decrease in accounts payable of $148 million and a decrease in accrued compensation and benefits of $60 million.

Noncurrent Assets and Liabilities

Noncurrent assets of $6.3 billion at June 30, 2023 decreased by $167 million (and decreased by $150 million adjusted for currency) compared to March 31, 2023, driven by a decrease in deferred taxes of $58 million; and a decrease in deferred costs (noncurrent) of $44 million.

Noncurrent liabilities of $5.1 billion at June 30, 2023 decreased $77 million (and decreased by $82 million adjusted for currency) compared to March 31, 2023, mainly driven by a decrease in deferred tax liability of $30 million; and a decrease in deferred income (noncurrent) of $28 million; partially offset by an increase in long-term debt of $38 million.

Cash Flow

Our cash flows from operating, investing and financing activities are summarized in the table below.

(Dollars in millions)

Net cash used in operating activities was $173 million in the three months ended June 30, 2023, compared to net cash provided of $104 million in the prior-year period. This change was primarily driven by payments toward license agreements, annual incentives and workforce rebalancing liabilities in the current quarter and higher cash flows from receivables in the prior-year quarter.

Net cash used by investing activities was $113 million in the three months ended June 30, 2023, compared to a net cash use of $218 million in the prior-year period due to lower capital expenditures.

Net cash used by financing activities totaled $38 million in the three months ended June 30, 2023, compared to net cash used by financing activities of $41 million in the prior-year period.

Other Information

Signings

The following table presents the Company’s signings for the three months ended June 30, 2023 and 2022.

(Dollars in billions)

Signings decreased by $145 million in the three months ended June 30, 2023, or 5%, compared to the prior-year quarter due to the Company’s efforts to reduce certain low-margin revenues. We believe that the estimated values of signings provide insight into the Company’s potential future revenue and are a tool to monitor trends in the business, including the business’ ability to attract new customers and sell additional scope into our existing customer base, and we believe signings are helpful information for investors. There are no third-party standards or requirements governing the calculation of signings. We define signings as an initial estimate of the value of a customer’s commitment under a contract. The calculation involves estimates and judgments to gauge the extent of a customer’s commitment, including the type and duration of the agreement and the presence of termination charges or wind-down costs. Contract extensions and increases in scope are treated as signings only to the extent of the incremental new value. Signings can vary over time due to a variety of factors including, but not limited to, the timing of signing a small number of larger outsourcing contracts as well as the length of those contracts. The conversion of signings into revenue may vary based on the types of services and solutions, customer decisions and other factors, which may include, but are not limited to, the macroeconomic environment or external events.

Liquidity and Capital Resources

We believe that our existing cash and cash equivalents and the Revolving Credit Agreement entered into in October 2021, will be sufficient to meet our anticipated cash needs for at least the next twelve months.

Senior Unsecured Notes

In October 2021, in preparation for our Spin-off, we completed the offering of $2.4 billion in aggregate principal amount of senior unsecured fixed-rate notes as follows: $700 million aggregate principal amount of 2.05% Senior Notes due 2026, $500 million aggregate principal amount of 2.70% Senior Notes due 2028, $650 million aggregate principal amount of 3.15% Senior Notes due 2031 and $550 million aggregate principal amount of 4.10% Senior Notes due 2041 (the “Notes”). The Notes were offered and sold to qualified institutional buyers in reliance on Rule 144A under the Securities Act and to non-U.S. persons in reliance on Regulation S of the Securities Act. The Notes are subject to customary affirmative covenants, negative covenants and events of default for financings of this type and are redeemable at our option in a customary manner.

In connection with the issuance of the Notes, we entered into a registration rights agreement with the initial purchasers of the Notes, pursuant to which we completed a registered offering to exchange each series of Notes for new notes with substantially identical terms during the quarter ended September 30, 2022.

Term Loan and Revolving Credit Facility

In October 2021, we entered into a $500 million three-year variable rate term loan credit agreement (the “Term Loan Credit Agreement”). In November 2021, we drew down the full $500 million available under the Term Loan Credit Agreement.

In October 2021, we entered into a $3.15 billion multi-currency revolving credit agreement (the “Revolving Credit Agreement” and, together with the Term Loan Credit Agreement, the “Credit Agreements”) for our future liquidity needs.

In June 2023, we amended the Credit Agreements by replacing the London Interbank Offered Rate (“LIBOR”) as the interest rate benchmark for U.S. Dollar borrowings with the Secured Overnight Financing Rate (“SOFR”). The first repricing date using SOFR will be in July 2023.

The Revolving Credit Agreement expires, unless extended, in October 2026, and the Term Loan Credit Agreement matures, unless extended, in November 2024. Interest rates on borrowings under the Credit Agreements are based on prevailing market interest rates, plus a margin, as further described in the Credit Agreements. As of June 30, 2023, there were no borrowings under the Revolving Credit Agreement.

We may voluntarily prepay our debt without premium or penalty, subject to customary “breakage” costs. The Company is in compliance with all of its debt covenants for all periods presented.

Transfers of Financial Assets

The Company has entered into agreements with third-party financial institutions to sell certain financial assets (primarily trade receivables) without recourse. The Company has determined these are true sales. The carrying value of the financial asset sold is derecognized, and a net gain or loss on the sale is recognized, at the time of the transfer. The first agreement, which was executed in November 2021 and subsequently amended, enabled us to sell, at any one time, on a revolving basis, our trade receivables with payment terms from three to nine months in the amount of up to $1.0 billion, and trade receivables with payment terms of less than three months with no defined limit, contingent on the approval of the counterparty. The initial term of this agreement was 18 months, and the agreement automatically resets to a term of 18 months after every six months, unless one of the parties elects not to extend. The second agreement was executed in June 2022 with a separate third-party financial institution, in which the sale of receivables is contingent on the approval of the counterparty with no defined facility limit. The initial term of this agreement is twelve months, and was extended for an additional year.

The net proceeds from these agreements are reflected as cash provided by operating activities in the Consolidated Statement of Cash Flows. Gross proceeds from receivables sold to third parties under such programs were $1.2 billion and $613 million for the three months ended June 30, 2023 and June 30, 2022, respectively. The fees associated with the transfers of receivables were $16 million and $8 million for the three months ended June 30, 2023 and June 30, 2022, respectively. The year-over-year change was due to the aforementioned amendments.

Critical Accounting Estimates

The application of U.S. GAAP requires us to make estimates and assumptions about certain items and future events that directly affect our reported financial condition. There have been no changes to our critical accounting policies and estimates as described in our Annual Report on Form 10-K for the fiscal year ended March 31, 2023 for more information; we refer to the Annual Report on Form 10-K for the fiscal year ended March 31, 2023 as the “Form 10-K”.

Cautionary Note Regarding Forward-Looking Statements

This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact included in this report, including statements concerning the Company’s plans, objectives, goals, beliefs, business strategies, future events, business condition, results of operations, financial position, business outlook and business trends and other non-historical statements in this report are forward-looking statements. Such forward-looking statements often contain words such as “will,” “anticipate,” “predict,” “project,” “contemplate,” “plan,” “forecast,” “estimate,” “expect,” “intend,” “target,” “may,” “should,” “would,” “could,” “seek,” “aim,” “believe” and other similar words or expressions or the negative thereof or other variations thereon. Forward-looking statements are based on the Company’s current assumptions and beliefs regarding future business and financial performance. The Company’s actual business, financial condition or results of operations may differ materially from those suggested by forward-looking statements as a result of risks and uncertainties which include, among others:

• risks related to the Company’s spin-off from IBM;
• failure to attract new customers, retain existing customers or sell additional services to customers;
• technological developments and the Company’s response to such developments;
• failure to meet growth and productivity objectives;
• competition;
• impacts of relationships with critical suppliers and partners;
• inability to attract and retain key personnel and other skilled employees;
• impact of local legal, economic, political, health and other conditions;
• a downturn in economic environment and customer spending budgets;
• damage to the Company’s reputation;
• inability to accurately estimate the cost of services and the timeline for completion of contracts;
• its implementation of a new enterprise resource planning system and other systems and processes;
• service delivery issues;
• the Company’s ability to successfully manage acquisitions, alliances and dispositions, including integration challenges, failure to achieve objectives, the assumption of liabilities, and higher debt levels;
• the impact of our business with government customers;
• failure of the Company’s intellectual property rights to prevent competitive offerings and the failure of the Company to obtain necessary licenses;
• the impairment of our goodwill or long-lived assets;
• risks relating to cybersecurity and data privacy;
• risks relating to non-compliance with legal and regulatory requirements;
• adverse effects from tax matters and environmental matters;
• legal proceedings and investigatory risks and potential indemnification obligations;
• impact of changes in market liquidity conditions and customer credit risk on receivables;
• the Company’s pension plans;
• the impact of currency fluctuations; and
• risks related to the Company’s common stock and the securities market.

Additional risks and uncertainties include, among others, those risks and uncertainties described in the “Risk Factors” section of our Form 10-K, as such factors may be updated from time to time in the Company’s periodic filings with the SEC. Any forward-looking statement in this report speaks only as of the date on which it is made. Except as required by law, the Company assumes no obligation to update or revise any forward-looking statements.

Website and Social Media Disclosure

The Company may use its website and/or social media outlets, such as Facebook, LinkedIn and Twitter, as distribution channels of material company information. Financial and other important information regarding the Company is routinely posted on and accessible through the Company’s website at https://investors.kyndryl.com, its Facebook page at https://www.facebook.com/kyndryl, its LinkedIn page at https://linkedin.com/company/kyndryl and its Twitter account (@Kyndryl) at https://twitter.com/Kyndryl. We may also use our Investors Relations website, https://investors.kyndryl.com, as means of disclosing material non-public information and for complying with our disclosure obligations under Regulation FD. In addition, you may automatically receive email alerts and other information about the Company when you enroll your email address by visiting the “Investor Email Alerts” section under the “Resources” section at https://investors.kyndryl.com.

For our disclosures about market risk, see the information under the heading “Quantitative and Qualitative Disclosures About Market Risk” in the Form 10-K. There have been no material changes to the Company’s disclosure about market risk in the Form 10-K.

The Company’s management evaluated, with the participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.

Changes in Internal Control over Financial Reporting

During the quarter ended June 30, 2023, we completed the initial phase of a new SAP enterprise resource planning system implementation, which we expect will enhance our transactional processing and financial reporting. The implementation included changes to certain financial processes impacting key controls related to our internal controls over financial reporting. We believe we have maintained appropriate internal control over financial reporting during the implementation and will continue to monitor the impact of the implementation on our processes, procedures and internal control over financial reporting. There have been no other changes in the Company’s internal control over financial reporting (as such term is defined in Rule 13a-15(f) of the Exchange Act) that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

For a discussion of our potential risks and uncertainties, see the information under the heading “Risk Factors” in our Form 10-K for the year ended March 31, 2023. There have been no material changes with respect to the risk factors disclosed in the Form 10-K.