Good day, and thank you for standing by, and welcome to the Kyndryl Earnings Conference Call. At this time, all participants are in listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised today's conference is being recorded. I would now like to hand the conference over to your first speaker of today, Lori Chaitman, Head of Investor Relations.

Good morning, everyone and welcome to Kyndryl's earnings call for the second fiscal quarter ended September 30, 2023. Before we begin, I'd like to remind you that our remarks today will include forward-looking statements. These statements are subject to the risk factors that may cause our actual results to differ materially from those expressed or implied. These forward-looking statements speak only to our expectations as of today and we are under no obligation to update them. For more details on some of these risks, please see the Risk Factors section of our annual report on Form 10-K for the year ended March 31, 2023. In today's remarks, we'll also refer to certain non-GAAP financial measures. Corresponding GAAP measures and a reconciliation of non-GAAP measures to GAAP measures for historical periods are provided in the presentation materials for today's event, which are available on our website at investor.kyndryl.com. With me here today are Kyndryl's Chairman and Chief Executive Officer, Martin Schroeter; and Kyndryl's Chief Financial Officer, David Wyshner. Following our prepared remarks, we will hold a Q&A session. I'd now like to turn the call over to Martin. Martin?

Thank you, Lori and thanks to each of you for joining us. Last week, we marked our second anniversary as an independent company, and we are delivering progress at an accelerated pace. Today, I want to talk about why we've been able to succeed. Of course, our first half performance reflects continued progress and strong execution positioning us really well for the year as a whole, and we're raising our full year earnings outlook. Our 3 AAAs initiatives centered on alliances and advanced delivery in accounts are paving the way for profitable growth. Kyndryl Consult, Kindel Bridge and our efficiency efforts are also driving our results. And as an organization, we're delivering strong performance that is evident both in our financial metrics and in our customer satisfaction scores. On today's call, David will review our recent financial results, our raised fiscal 2024 outlook and how we're changing Kyndryl's profile for the better. However, let's not lose sight of why this performance is happening. We are vital to our customers' current and future technology needs. Our capabilities align with the powerful secular trends in IT, and this makes us an indispensable partner for our customers. In other words, our progress is being fueled by the leadership position we have in our industry, our new freedom of action we have as an independent company and how that perfectly aligns with the larger forces shaping the evolution of IT. We're helping customers navigate these secular trends, and we're already capturing the growth opportunities they present. And because we're at the heart of these trends, of enabling our customers' IT futures as well as their current operations performing mission-critical work across a broader technology ecosystem, our business is sustainable and important over the long term. That's why we're seeing growth in alliances with our…

Thanks, Martin, and hello, everyone. Today, I'd like to discuss our quarterly results, the outstanding progress we're making on our 3As, the growth in gross profit that we've been building into our contracted book of business and our updated outlook for fiscal year 2024. We have a lot of good news to share. Our second quarter results reflect strong operational execution and continued progress on our key initiatives. In the quarter, revenue totaled $4.1 billion, a 5% decline in constant currency. The year-over-year decline in revenue was anticipated and primarily driven by our intentional exit from negative no and low margin revenue streams within ongoing customer relationships, not by macro factors. We continued to gain momentum in higher-margin advisory services. Kyndryl Consult revenues grew 17% year-over-year in constant currency which highlights how we're growing our share in this higher-margin, higher value-add space. Consult signings grew even faster, increasing 32% year-over-year in constant currency. This performance reflects how the opportunities for growth in Kyndryl Consult services stemming from our new alliances with third-party technology providers are outweighing the macro issues pressuring some other firms. Our Q2 signings were down 3% year-over-year in constant currency. Outside of our core enterprise practice, where we've concentrated on removing pass-through revenue and addressing focus accounts, signings were up in the single digits. Our adjusted EBITDA grew 34% to $574 million. Our adjusted EBITDA margin was 14.1%, a year-over-year increase of 390 basis points. At the risk of being immodest, we view this as remarkable execution. Nearly 4 points of margin expansion is a proof point for our ability to drive meaningful profit growth in our business. Adjusted pretax income was $25 million, a $127 million improvement in profit compared to the prior year quarter. As I'll discuss in a moment, our continued progress on our…

Thank you. At this time, we will conduct a question-and-answer session. [Operator Instructions] please stand by while we compile the Q&A roster. Our first question comes from Divya Goyal from Scotiabank.

Great quarter. David and Martin further to your comments, overall, we can see obviously the company doing the right things, progressing the right way. I wanted to get some color on what are your overall discussions with your clients like, obviously, Kyndryl delivers mission-critical project and does mission-critical infrastructure work. But given the broader macro and geopolitical concerns out there, how are the clients thinking and how do you see that progressing into early part of 2024 and towards the latter part of 2024? And how does that fit in with Kyndryl's continued progress?

Please go ahead. You're on mute.

Sorry, did you hear my question?

We did hear your question. I think they're on mute bear with us one second.

Can you hear me now?

We can, go ahead.

Great, thank's you. So thanks for the question, Divya, thanks for the nice intro to the question as well. What we -- and you said it well, what we experience is driven by the role we play in our customers' environments. We are mission critical. We are the trusted partner as we have been for many of our customers for decades. And so the nature of the discussion, and you see this in some of our charts, the nature of the discussion that we have with our customers is really about the secular trends that they want to take advantage of and [ the work ] that they need to manage. The industry skill -- industry-wide skill shortage is very real for CIOs today. And we see the results of that, and we see the effect of that in how strongly we are able to drive our consulting performance the role we can play in helping them navigate what are obviously very complex infrastructure. We see it in helping them with even the basics, right? When you think about what Kyndryl Bridge helps our customers do, it helps them understand their environments. It helps them keep up with the never-ending best practices that every technology provider is putting out constantly in order to optimize their systems. And so the role we play, I think, makes us a bit different from others. And it -- I guess it's reflective, if you will, of the 2 things are the things we can do for them. One is we can help them save money. That's part of what Bridge helps them do. It helps them optimize their systems, and that's important. And I wouldn't say that saving money today is any more important than it has been in the past. And then we can help them prepare them -- to get themselves prepared to take advantage of the innovation no matter where they see it, which is part of what creates these hybrid environments that we're so good at helping them manage. So we don't see -- again, I think it is unique to us because of the world, we don't see the macro in any of the places in which we operate. We don't see the macro having a profound difference in the nature of the discussions. the discussions for us are still around the secular trends that they want to take advantage of and prepare themselves for whatever the macro is either today or whatever the macro is going to be in a year's time.

Thanks, Martin. Operator next question please.

Our next question comes from David Togut from Evercore.

And good to see the outperformance, especially on advanced delivery and accounts initiatives. Just focusing there, even against your raised targets, you're already at 80% year-to-date of the raised targets for both advanced delivery and accounts with half of the year to go can you flesh out the dynamics around both for the back half of this year? And why wouldn't your targets be even higher given your high attainment so far this year?

Sure, David. Thanks. When you look at our targets for the -- for advanced delivery and for focus accounts, remember that they're cumulative targets. So we started the year started this fiscal year with the progress we made last year, which was around 200 -- over $200 million related to advanced delivery and over $200 million related to the focus accounts. And we've increased each of those significantly. And as you point out, we're at our full year target for accounts. We're within $25 million of our initial target for advanced delivery. And that's really why we raised them each by $100 million. And so with that, that translates into for accounts is about $50 million of incremental progress each quarter in the back half of the year, which is consistent with where we ran last year. And obviously, we overperformed relative to that in the first half of this year. And then on the advanced delivery side, our forecast calls for $125 million of further improvement in the back half of the year, which, again, is pretty consistent with where we've been running other than the really strong performance, the overperformance we had in the first half of this fiscal year.

Appreciate that. And just as a follow-up, given the unique dynamics of your large business in Japan, where you're generating revenue in yen and your cost base is in dollars USD. Is there anything you can do to kind of manage that let's say, currency mismatch on revenue and expenses going forward and sort of limit the headwinds to revenue and earnings?

Yes, David, there are things we can do there. And part of it is our starting point where we started with the software contract that we did and the customer contracts that we did, and as we go forward, there are things we can do to increase the matching between those. So it's provisions that we build into our customer contracts that will help protect us more going forward. That becomes the most immediate step. Second, when we actually get to negotiate the software contract, we'll look to not have it all be dollar-denominated. So that's part of it as well. And then there's intra-year, there's some -- there's hedging that we do to mitigate the impact, but that only helps -- that only mitigates it and really only for a limited period of time. And then the last thing we look at and we'll look at going forward is broader asset liability matching. And we started off with our debt all being dollar-denominated and going forward, I think I'd like to see a little bit better mix, a little bit different mix of our debt. It's more aligned with where our assets are, where our embedded equity is around the world. So that's an opportunity for us as well. And then lastly, just going back to your prior question, I think the -- on the -- with respect to the 80% and where we stand already, I think we should make it really clear that if we achieve -- when we achieve the expected benefits from any of the initiatives we're not standing down. We're going to keep powering ahead. And so there are opportunities to overperform, over deliver on the initial targets we laid out 2 years ago. We're actually -- we're actively going to look to take advantage of those.

Our next question comes from Tien-Tsin from JPMorgan.

This is Brendan on for Tien-Tsin. Congratulations on the results. Great job. So question for me on just quantification of like the revenue related to tick up in the revenue midpoint. So you guys obviously outperformed on the accounts initiative to the tune of $100 million per quarter in the first half. But the revenue moves up a tick. So I think, obviously, there's Kyndryl Consult outperformance going on there. But could you help us understand the puts and takes on the revenue line if there's anything we're kind of missing aside from those main drivers of accounts initiative in Kyndryl.

Sure. I think on accounts and advanced delivery there on the 3As, the impact on revenue there ends up being fairly limited. But we obviously, we are making significant progress there in the earnings contribution. So when we look at our -- the revenue raise the narrowing to the favorable half of the range, I would say that Kyndryl Consult is very much the biggest driver of that. That's an area where we're outperforming and the outperformance there is probably even a little bit greater than maybe apparent because we've been more aggressive in stepping away from pass-through revenue from OEM type revenue and are still are nonetheless able to narrow to the upper half of the range. So we're very much holding on to accounts. We're optimizing them and taking out content that doesn't make sense. We're growing Kyndryl Consult, which tends to be a higher-margin revenue. And all of that is helping us really drive more income at a revenue that was -- that is fairly consistent, but in the upper half of the range we initially went out with.

And I'll jump back in the queue with another question.

Thanks, Brendan. Operator, I believe there's one more question in the queue.

And our last question comes from Jamie Friedman. Jamie, you're live on stage. Please go ahead.

Jamie you there? Did Brendan -- operator, did Brendan rejoin the queue with another question.

He has, I can bring him to stage.

Well, you said he had another question. So we give -- maybe Jamie can work on a technical challenge, and we'll keep moving.

So yes, my question number 2 is on visibility into this gross profit backlog. So love to hear that it's above 1 because that's how you guys are obviously managing the business and that makes sense as a sensible target. To me, I'm curious just to think about because of the kind of lengthyness of some of these deals, what are -- what, if any, variables you guys think about still being out there in between booking those gross profits and realizing them, whether that's potentially something like wage inflation? Or just how should we think about any variables outstanding there?

Yes. So look, the estimates we provide, Brendan, capture our view today of the things you had like how much we're going to have to invest in our teams and all that stuff. So we have -- we have a view of the contract, the longer the contract, the more conservative we tend to be on the view because we know that we're going to want to maintain the best workforce in this space in the world, et cetera, et cetera. So we have a series of assumptions around how we have to invest in our workforce. We have a series of assumptions around where, for instance, deals include other people's IP, what those price rises are going to be. So all of that gets captured. And I'll point out that our -- what we would shorthand to the did versus bid, right, how did -- what did we actually get versus how we bid is very close to what we're showing in our data now for what's going in the backlog. So we're realizing, if you will, what we are assuming. That's one of the reasons we're so comfortable with sharing the data this way. It represents what we have been realizing. Now the big execution element is not really all the assumptions around how we're going to invest in our people and the skills they have to bring, et cetera, et cetera, et cetera, those are important, and we get those right. We have to keep delivering, right? The 80-plus thousand Kyndryl out of the 80-plus thousands, 2/3 of us every day are delivering in front of customers. And we're really, really good at it. And that's why our customer SAT scores are so high, that's why customers love what we do for them, and that's quite frankly why they trust us. So when we get comfortable with sharing what we put into the backlog, it's driven by the confidence that we're getting from that we're actually delivering those over time. And importantly, we just have to keep the organization executing on delivering every day, which is, again, what we've been good at and what, in fact, we've been getting better at and things like Bridge help us with that as well. So we're very comfortable that we can deliver the margins that we have, the assumptions are robust enough and well proven by now enough that we are delivering those and then we have opportunities, obviously, to keep getting even better at it by using Bridge and more customers. As we said a couple of months ago, we had Bridge in about 500 customers. And by the end of the year, we'll have it in 1,000 customers. So the assumptions are robust. Our delivery is phenomenal. The future for us is even more robust with things like Bridge with our ways of working, et cetera, et cetera. So I think you should assume that we'll keep delivering the margins that we're putting in the backlog.

I believe Susquehanna is back in the queue. Operator.

Yes, please stand by. Jamie, you're on stage, please go ahead.

Okay. Sorry about my technical difficulties there, Lori. So congrats on the good execution. Had 2 questions, maybe 1 for Martin and 1 for David. So first, in terms of free cash flow expectations in the second half, could you help us unpack what you're thinking about if there's anything that we need to remember from last year, or call outs from the first half. That's one thing. And then, David, I'd be interested in understanding your perspective on which of the new service lines and new signings are the most accretive to market. Now I understand everything is probably accretive to margins, but if you just would help unpacking a couple of these is what you feel are the most strategic or the most margin accretive that I think would be insightful.

Sure. Let me go first on your second question, and I'll ask David to unpack if he has anything to unpack cash flow. So look, the -- I think you're right, everything is accretive to margins. And in fact, part of the reason that we want to make sure we're sharing everything that's going in the backlog is because it's representative of each of the pieces as well. As we start to think about more or less on a relative basis, right? On an absolute basis, all accretive, all looking quite good and all consistent with where we want to be in the medium term as more of our P&L is defined and reflects, as we covered in our prepared remarks, more of it reflects what we put in the backlog as opposed to what we inherited. We're hitting that inflection point. There is a difference. We see a difference already. And I think the difference exists in the marketplace between the margins we can earn in our consult business and the margins we earn in our run business. I don't know if that persists forever. But we do see higher margins in the consult business right now than we do in the run business. Now the opportunity for us in the consult business is obviously to keep it growing, which we expect it will. And the opportunity for us is to make sure that we keep our skills and our people at the forefront of all those secular trends that they're sitting at the forefront of today. There is an opportunity for us in the run side of the business to continue to improve margins as well. And Kyndryl Bridge is a great example of how we'll continue to drive margin improvements in the run business. So right now, on a relative basis, I would point to our consult business. As we see in the market, the consult business drives slightly higher margin profile for us, and we'll see how that changes over time. But right now, it's slightly better than our run business. David, do you want to cover?

Sure. I do on free cash flow for the full year, we expect our adjusted free cash flow to be positive with the year-to-date number being slightly negative, certainly that implies that the second half will be stronger and that's what we would expect, in particular, because some of the working capital and cash flow seasonality that we have. You may remember that in the first quarter, we have a disproportionate amount of our software license payments which get amortized over the course of the year, or in some cases, over the course of many years in -- We also have annual incentive payments that are -- where all the outflows in Q1 and the accrual happens over the course of the year. So it's natural for our seasonality to be skewed more towards the last 3 quarters of the year and toward the back half. And as a result, we expect stronger cash flow in the second half of the year. The other point I'd make is that the composition of our free cash flow will probably flip a little bit. In the first half of the year, we've been underrunning our full year run rate on capital expenditures and working capital has worked against us. Capital expenditures should pick up a little bit. We're targeting to get to about $700 million of net CapEx for the year. So that will be a little bit more of a use of cash and working capital we expect will be more of a source of cash in the second half of the year as we get to positive for the year overall. And then what I really want to highlight is that as we go forward, and grow earnings, we expect free cash flow growth to coincide with our adjusted pretax earnings growth with strong conversion of our adjusted pretax income to free cash flow over time.

Thank you both for the detailed response. If I could just follow up with -- on the Slide 22. If you -- this is the one that breaks out the services by revenue. If you wouldn't mind sharing how you think of what this will look like in the future, like at the end of your guidance and if that's too specific, if at least qualitatively, you could share like which of these are going to get bigger or smaller? And why I think that would be helpful context.

Sure. Let me take a swing and then David has something he wants to add to it, we'll certainly give him a chance. For us, the secular trends we see in the marketplace, as we had in an earlier chart, around cloud and hybrid cloud, around the need to be -- the need to manage in that world around skill shortages, et cetera. To us suggest applications data and AI -- to us suggest that our cloud practice, our security and resiliency practice, our network and edge practice, our applications and data and AI practice all become really strong high single-digit kind of getting close to double-digit kind of growers. I think that's the market in which they sit, and I see a long-term secular arc that we are part of that is going to drive those. And so they'll mix a bit stronger in our signing streams and therefore, over time, in our revenue streams. Digital workplace is a practice for us that it is a grower. It's in a growing space, but probably not at the same rate as those other 4 practices that I mentioned. And then over time, look, core enterprise and Z Cloud because of the role we play -- because of the role we play and the scale and the magnitude of the skills that we have. While this is probably a market that's declining, I would expect this could still represent a growth opportunity for us once we get through getting the hardware and the software content as much as possible out of our revenue streams. Our labor piece of this market and our labor piece of our business is growing. And I would expect over time, given the skills challenges that our customers have that they express around the teams that they're relying on and how do they get more, et cetera, et cetera. I would expect over time, even the core enterprise and Z Cloud business for us could be the labor component could be and should be and will be a growth opportunity, although in a declining market because of the nature of where customers are going with cloud and multi-cloud, et cetera, et cetera, et cetera. So I see the mix shifting a bit because I see very high -- really good high growth in the secular trends. But every one of our practices, I think, still sits in an area, sometimes it's unique to us. Every one of our practice sits in an area where we can continue to drive growth for each of them, even if it's just the labor piece. But we can drive growth in each of the practices. But that will cause us a remix, if you will, of the revenue weighting over the kind of time frames that you're talking about. David, anything you need to add?

I'd just add that the other axis is really important to us is the growth in consult, which really runs across the practices, but as you know, we started off with consulting around 10% of our revenue. It's grown to 14%. Our target is to move it up to 20%. And again, this really plays across the practices and highlights the fact that we expect to grow our share in consult and advisory work in advisory and implementation work as well. And so that's an important part of how we think about each of the practices.

Thank you. Thanks, Jamie, for your question. Thanks, everyone, for joining us today.

Thank you, Lori. So look, again, thanks, everybody, for joining. I am really proud of the progress that we made again this quarter and the team, as you can tell us just executing very, very well. And bear in mind that we only had our second birthday last weekend, right? So this is a company that has made a ton of progress and delivered a ton and well ahead, I think, of what many thought we could in a pretty short period of time. I'd also encourage you to have a look at the corporate citizenship report. Our first -- and again, this was just before our second birthday, we published it back in September. So we weren't even 2 years old yet. We published what I think is just a phenomenal example of how we're building this business the right way. So we're delivering on our business goals, and we're also having an impact on how the world works. And so as we head into our third year as an independent company, I remain more excited as excited or more excited than I have ever been about where we're going. I see how our teams are moving toward where our customers are going and supporting them on their journeys on these really important secular trends and helping them prepare and we're building the capabilities that allow all of that to happen within those mission-critical workloads, which is the role we've always played. So thank you again for joining, and we look forward to talking with you in a few months. Thank you, operator, we're done.

Thank you for your participation in today's conference. This concludes the program. You may now disconnect.