Last November, IBM (IBM 0.08%) completed its spin-off of Kyndryl (KD 1.40%), the managed infrastructure services segment of its Global Technology Services segment. Each IBM shareholder received one new share of Kyndryl for every five shares of IBM they held.
IBM still retained 20% of Kyndryl's outstanding shares following the spin-off, but it plans to sell that entire stake this year. Presumably, the separation would enable IBM to dump its slowest-growth legacy business to focus on expanding its higher-growth hybrid cloud and AI businesses.
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Kyndryl's stock opened at $31.50 on Nov. 3, but it now trades at about $17 per share. During that same period, IBM's stock advanced about 4%. That divergence wasn't surprising, since IBM framed the spin-off as a way to jettison its weakest businesses to invest in more promising markets.
But are investors overestimating IBM's turnaround potential while ignoring Kyndryl's ability to expand without being tethered to Big Blue? Let's take a fresh look at both companies to decide.
IBM's turnaround plan
Arvind Krishna, IBM's former cloud chief, succeeded Ginni Rometty as IBM's CEO in 2020. Krishna focused on expanding Red Hat (which IBM acquired for $34 billion in 2019) as the foundation of its hybrid cloud and AI business, then orchestrated Kyndryl's spin-off to accelerate that transformation.
In previous decades, IBM helped large companies manage their on-site data centers. But that market was turned upside down by public cloud infrastructure platforms -- like Amazon's (AMZN 0.31%) Amazon Web Services (AWS) and Microsoft's (MSFT -0.17%) Azure -- which let companies remotely access data storage and computing services.
IBM's failure to keep pace with Amazon and Microsoft, as well as the sluggish growth of its legacy IT services, software, and hardware segments, caused its revenue growth to stagnate over the past decade. However, Krishna believes that IBM can still grow by providing more hybrid cloud services, which process the data that flows between the private and public clouds.
By leveraging Red Hat's open source software, it plans to provide AI-powered hybrid cloud services that are cross-compatible with AWS, Azure, and other public cloud platforms. IBM believes that flexible transformation will enable it to grow its annual revenue by the mid-single digits and its annual free cash flow (FCF) by the high single-digitsfrom 2022 to 2024.
However, IBM might also eventually cut its dividend, which currently boasts a high forward yield of 4.9%, to free up more cash for that expansion. If that happens, IBM will lose its status as a Dividend Aristocrat of the S&P 500.
Kyndryl's vision of a future without IBM
Kyndryl serves over 4,000 customers, including half of the Fortune 500, and operates in 63 countries with a workforce of about 90,000.
On its own, Kyndryl's growth rates look dismal. Its revenue fell 7% in 2019, declined 5% in 2020 as the pandemic disrupted large enterprises, and dropped another 2% year over year in the first nine months of 2021. It was also unprofitable throughout all three periods -- but it generated a slim profit on a pro forma basis after excluding the spin-off costs.
Most of IBM's investors likely looked at those numbers, remembered why Big Blue was so eager to divest the struggling business, and immediately sold their new shares of Kyndryl. Yet Kyndryl believes the spin-off will actually more than double its total addressable market (TAM) from $240 billion to $510 billion by 2024, since it will no longer be tethered to IBM and be allowed to pursue new deals with Big Blue's direct competitors.
Kyndryl is still the largest player in the managed infrastructure and implementation services space, and it generates roughly twice as much revenue as its top competitor, DXC Technology (DXC 0.71%). Without IBM holding it back, Kyndryl could leverage that market-leading position to aggressively expand and start growing its revenue again.
Kyndryl is led by Martin Schroeter, who previously spent more than a decade at IBM. Some investors might find Schroeter's experience reassuring, but Kyndryl might need to hire an outsider with fresh ideas to turn around its massive business. Kyndryl also doesn't pay a dividend yet, since its operations only generated a low single-digit percentage of IBM's FCF in previous years.
The valuations and verdict
Analysts expect IBM's revenue to decline 15% in 2022 as it laps its divestment of Kyndryl. But in 2023, they expect its revenue to rise 4% as its streamlined business gradually grows again. However, they expect Kyndryl's revenue to continue to decline in both 2022 and 2023 as the company attempts to stabilize its business and gain new customers.
IBM's stock trades at 16 times its earnings and two times its sales for fiscal 2022. Those low valuations could limit its downside potential as it gradually transforms its business. Kyndryl can't be valued by its earnings yet, but the stock looks dirt cheap at 0.2 times its 2022 sales.
I believe IBM's profitability, dividends, and clearer plans for the future make it a better buy than Kyndryl right now. If Kyndryl can actually secure more customers by breaking free of IBM's legacy ecosystem, it might be deeply undervalued right now. However, investors shouldn't touch the stock until they actually see some green shoots in its upcoming earnings reports.
Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Leo Sun owns Amazon. The Motley Fool owns and recommends Amazon and Microsoft. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy.