Kyndryl shares are not worth much compared to IBM, representing less than 5% of the two firms' combined market value.
Rather than maintain such a small position in the spinoff, some IBM investors have likely chosen to dump their new Kyndryl shares and reinvest the money in core positions instead.
Kyndryl's investment proposition is lacking for conservative income investors, too. The firm does not plan to pay a dividend in the near term, and its revenue declined at a mid-single-digit clip in 2019 and 2020 as more on-site IT infrastructure migrated to the public cloud, reducing client-based volumes.
Management expects to direct cash flow towards strengthening Kyndryl's BBB- rated balance sheet and improving its business model as a stand alone company. If everything goes to plan, the firm expects to return to revenue growth in 2025.
With many investors selling their shares, Kyndryl's valuation looks undemanding; we estimate the stock would yield over 7% if it began distributing 50% of its free cash flow as a dividend.
Despite Kyndryl's low expectations and annuity-like revenue stream, conservative investors may prefer to own a company with a stronger long-term outlook as the technology landscape evolves.
For more on Kyndryl's business, please see our October 2020 note that we published after the spin-off was announced last year.
As for IBM's dividend, management has consistently assured investors that "the initial combined dividend of IBM and Kyndryl to be no less than IBM's dividend today."
With Kyndryl not expected to pay a dividend out of the gate, IBM will need to maintain its current dividend for management to keep their word.
We expect IBM to deliver on its promise. While Kyndryl accounted for 25% of sales, this legacy division was responsible for less than 10% of IBM's free cash flow. IT services is a capital-intensive business with low margins.
Given Kyndryl's relatively small contribution to IBM's profits, the company's payout ratio next year is projected to remain at a reasonable level near 60% based on the current dividend rate.
The bigger question is whether IBM's growth rate will improve now that management can focus more exclusively on the firm's hybrid cloud and artificial intelligence initiatives.
Big Blue's cloud and cognitive-software business disappointed again last quarter, but it may take a couple years for the company's hybrid cloud strategy to take hold.
Overall, our thoughts on IBM haven't changed since our January 2021 note:
IBM hasn't shown investors many reasons why it can be a serious cloud competitor, but it may take a few years to assess the success of Mr. Arvind's hybrid cloud strategy.
For now, IBM continues to have the financial health to pay a reliable dividend and work on its turnaround plan. But the company cannot sustain revenue losses forever.
The stock's expectations look low (as usual), but there are no guarantees IBM will successfully adapt its business in the long term, especially if rivals move even further ahead of IBM as cloud demand accelerates.
We will continue monitoring IBM's traction over the coming quarters and provide updates as needed. Given IBM's track record, the stock will probably remain a "show me" story until revenue trends improve.