IBM buys Red Hat for US$ 34 billion in mega-deal

October 29, 2018

IBM announced on 28 October (Sunday) that it would acquire “open source” software company, Red Hat, in an all-cash deal for US$34 billion. Red Hat is one of the most successful pioneers in “open source”, i.e. programming instructions that are open and accessible for anyone to view and edit.

Previously, the cloud market is dominated by cloud-computing giants like Amazon, Microsoft and Alphabet (Google). This all-cash blockbuster IBM-Red Hat deal just made the cloud-computing war more interesting.

Ginni Rometty, IBM’s chairman, president and CEO says, “The acquisition of Red Hat is a game-changer. It changes everything about the cloud market. IBM will become the world’s #1 hybrid cloud provider, offering companies the only open cloud solution that will unlock the full value of the cloud for their businesses.”

Prior to the deal, IBM’s shares have been on a downward trend, with the biggest drop in 4 years in October after missing analysts’ quarterly revenue estimates. Rometty has been trying to turn around the business over the years and reshape itself as a key player in in tech, but progress has been inconsistent.

Why IBM’s Acquisition of Red Hat Makes Sense

While IBM is better known for its mainframe computing and has been too slow in its entry into cloud computing and artificial intelligence, Red Hat is too small to compete with the likes of Amazon or Microsoft. Partly because of the nature of “open source”, Red Hat does not have a full enterprise sales process and sales staff like SAP or Oracle.

With exposure through IBM’s sales staff, IBM can now sell Red Hat’s product portfolio to the CIOs and senior management of large companies. As Rometty explains, ““This is an acquisition for revenue growth, this is not for cost synergies”. 

Rometty adds that currently, many companies are holding back in their cloud transformation due to closed platforms. The acquisition of Red Hat will be a game-changer, propelling IBM to be “the world’s number one hybrid cloud provider, offering companies the only open cloud solution that will unlock the full value of the cloud for their businesses.” 

Is the deal price right?

Bloomberg reports that IBM’s acquisition values Red Hat at 51 times its estimated earnings in the next year, which is among the highest multiples in the software industry.  

The all-cash purchase price of US$ 34 billion (US$ 190 per share) represents about 62 percent premium of Red Hat’s shares (US$116.68) and about two and a half years of IBM’s free cash flow at current levels. 

Based on the official press release from IBM, it says “The company will continue with a disciplined financial policy and is committed to maintaining strong investment grade credit ratings. The company will target a leverage profile consistent with a mid to high single A credit rating. The company intends to suspend its share repurchase program in 2020 and 2021.

Looking at the share price of IBM after the announcement of the deal, it seems that there is little impact of the Red Hat announcement on the optimism of shareholders.

Perhaps the market thinks that Red Hat was overvalued in this deal or investors are not particularly excited about the suspension of the share repurchase program to fund the purchase of Red Hat.

My take is given IBM’s current free cash flow levels, the purchase of Red Hat is definitely a big gamble. However, in today’s changing landscape in the tech scene, IBM is declining in technology relevance and has no choice, but to take risks to compete with tech giants like Amazon, Microsoft and Google. Whether Red Hat is the answer to IBM’s woes, only time will tell.

about author

Lee is currently pursuing a Master’s degree in Finance at INSEAD. Prior to his Master’s, he has worked for about five years in the treasury and accounting space. He graduated from SMU with a double degree in Accountancy and Finance, and is also a Chartered Accountant (Singapore). Other than building Excel spreadsheets and poring through annual reports, he spends his time reading and watching sci-fi movies.