Fiscal Second Quarter 2027 Earnings Conference Call - KYNDRYL HOLDINGS INC

Financial Performance:

• Q2 fiscal 2027 revenue was $3.65 billion, down 1.9% year-over-year (down 1.9% in constant currency); U.S. revenue grew 9% year-over-year.
• Adjusted EBITDA reached $699 million with margins expanding 190 basis points to 19.1%.
• Adjusted pre-tax income was $150 million, reflecting 80 basis point margin expansion to 4.1%.
• Gross margins improved to 22.5% in the first half (vs. 21.4% prior year), driven by business mix shifts and operational efficiencies.
• Amortization expense is elevated at $323 million for Q2 (vs. $306 million prior year) due to increased prepaid software; full-year fiscal 2027 expected at ~$1.3 billion.
• Free cash flow for the first half was a use of $434 million, primarily due to $447 million in seasonal working capital outflows (vendor payments and prepaid software); full-year FCF outlook reaffirmed at $400–$500 million.
• Net leverage remains below 1.0x adjusted EBITDA, with cash balance of $1.7 billion and total available liquidity of $4.8 billion.
• Completed $1 billion senior notes issuance ($600M due 2029, $400M due 2032) to refinance maturing debt, extending maturities through 2041.
• Established a commercial paper program to diversify short-term working capital funding.

Guidance and Future Outlook:

• Full-year fiscal 2027 revenue guidance remains flattened to down 2% in constant currency.
• Fiscal 2027 adjusted pre-tax income guidance reaffirmed at $600–$700 million, inclusive of ~$200 million workforce rebalancing charges and savings.
• Fiscal 2028 objectives remain on track, targeting $400–$500 million annualized operating expense savings from workforce rebalancing.
• The "Blueprint" focus account initiative has largely completed, contributing to margin expansion with a long tail of legacy contracts; no further dramatic margin uplift expected from this specific driver.
• $1 billion adjusted free cash flow target for fiscal 2028 remains intact despite the removal of the specific number from recent decks.
• Expect strong FCF conversion in H2 2027 driven by higher earnings and working capital benefits.
• Anticipate revenue mix improvement with Kindred Consult and alliances growing while overall revenue flattens.

Business Segments and Product Lines:

• Kindred Consult: Signings exceeded revenue over the last 12 months; growth driven by AI modernization, cyber preparedness, and hyperscaler demand. First half constant currency growth high single-digits, expected to accelerate in H2.
• Alliances & Hyperscalers: Strong momentum in public and private cloud modernization; expanded Broadcom relationship offers end-to-end VMware Cloud Foundation consulting.
• Kindred Bridge: AI platform deployed to govern and orchestrate agents; foundation for new co-developed solution with ServiceNow announced for next week.
• AI & Innovation: Expanded AI innovation labs to Dallas and Luxembourg; introduced differentiated sovereignty solution to address data residency and regulatory concerns.
• Acquisitions: Completed acquisition of Healthcare IT Leaders to expand application implementation and managed services in the clinical and operational sectors.
• Segment Realignment: Transitioned India from "Principal Markets" to "Strategic Markets" to better reflect operational management.
• Deal Mix: 43 deals >$50M and 154 deals >$10M signed in last 12 months; one-third of large deals included scope expansions or new logos.

Market and Competitive Landscape:

• Key market drivers include AI adoption, modernization delays (98% of delayed organizations faced negative impacts), and sovereign data requirements.
• Customers seek "AI-led modernization" to integrate agentic AI across infrastructure, applications, and workflows while maintaining security and compliance.
• Competitive advantage leveraged through deep operational knowledge of mission-critical systems, "running and modernizing" simultaneously, and proprietary data insights.
• Significant growth opportunities identified in U.S., Spain, and Latin America; Europe showing signs of recovery despite slower decision-making cycles.
• Hyperscalers remain critical partners for mission-critical workload modernization and data residency architecture design.

Risks and Challenges:

• Sovereignty and Geopolitics: Ongoing customer debate regarding data sovereignty and AI provider selection is slowing large deal closures, particularly in Europe.
• Macroeconomic/Commercial: Workforce rebalancing charges incurred in H1 to be offset by savings in H2; potential volatility in Q3 due to difficult comparisons.
• Working Capital: Seasonality of vendor payments and prepaid software subscriptions continues to impact quarterly free cash flow dynamics.
• Customer Decision Cycles: Extended timelines for large, multi-year commitments due to the need to align AI strategies with board-level governance.

Management Commentary and Tone:

• Tone is confident and focused on long-term strategic execution, emphasizing the transition from "running" systems to "modernizing" them with AI.
• Management expressed strong conviction that Q2 represented the low point for constant currency growth in the year, with acceleration expected in H2.
• CEO Martin Schroeder highlighted the successful completion of workforce rebalancing and the strategic pivot toward high-value AI and modernization services.
• CFO Ellen Johnson emphasized the alignment of the balance sheet with investment-grade targets and the robustness of the FCF outlook despite near-term cash uses.
• Management stressed that the company is "reimagining" relationships to drive productivity, with a focus on sharing savings with customers while reinvesting in innovation.

Analyst Questions and Answers:

• Fiscal 2028 FCF Target: Confirmed that the $1 billion FCF target for fiscal 2028 remains on track, noting that current 2027 dynamics are expected to normalize in the following year.
• Gross Margin on Signings: Explained that while 12-month average gross margin on signings is ~25% (down from prior years due to mix), this is structural and sustainable, supporting the high single-digit pre-tax margin profile.
• Consult Growth Trajectory: Addressed the deceleration in Q2 growth (6% vs. 11% in Q1); management views Q2 as the low point, with full-year growth expected in the high single to low double digits.
• EBITDA Margin Guidance: Clarified that the 19.1% margin is driven by gross margin expansion and operational efficiencies, with amortization and other factors factored into the full-year view.
• Europe Sovereignty: Noted that while sovereignty discussions are challenging, the company plans to announce a specific solution next week to address these concerns, expecting deal flow to recover.
• Blueprint Initiative: Stated the initiative is largely complete; future growth will rely on new capabilities (e.g., ServiceNow partnership) rather than further reimagining of existing focus accounts.
• Healthcare Acquisition: Confirmed integration is progressing well, aimed at moving up the value stack in a highly regulated sector with expected synergies.
• Commercial Matter: Clarified that the $3M benefit from a commercial matter resolution is excluded from guidance but does not alter the overall financial outlook.

Other Key Points:

• ServiceNow Partnership: Next week will see an announcement combining ServiceNow's AI workflows with Kindred Bridge data for IT estate context and orchestration.
• New Solution: A differentiated sovereignty solution will be introduced to help customers navigate data residency and regulatory demands.
• Workforce Rebalancing: Savings from H1 charges are expected to fully offset the impact in H2, with annualized run-rate savings of $400–$500 million by fiscal 2028.
• Capital Allocation: Priorities remain focused on liquidity, strategic growth investments, and maintaining investment-grade credit ratings.