With $34-Billion Purchase of Red Hat, Grounded Tech Giant IBM Looks Towards a Future in the Cloud
International Business Machines Corporation (“IBM”) announced on October 28th of 2018 its plans to acquire American software company Red Hat, Inc. (“Red Hat”) for $34 billion. (Liana B. Baker and Greg Roumeliotis, Reuters). The deal, which is the software industry’s largest-ever acquisition, is expected to close in the latter half of 2019. Id. IBM is set to pay $190 per Red Hat share — a 63% premium on Red Hat’s closing share price on October 26, 2018. Id. IBM intends to maintain Red Hat’s headquarters, facilities, brands, and practices, as well as retain Red Hat’s management team and Chief Executive Officer Jim Whitehurst after the deal has closed. Id. This post provides an overview of the two companies, the deal, and its anticipated effects.
The details of the deal show how desperate IBM is to compete meaningfully in the cloud computing market. For starters, with a market capitalization of $114 billion, Red Hat’s price tag rings in at nearly a third of IBM’s corporate worth. Id. To finance the deal, IBM took out a loan from JPMorgan Chase & Co and plans to raise the additional funds by suspending its share repurchase program in 2020 and 2021. Id. Despite the large cost, IBM is motivated to see the deal through. IBM Chief Executive Officer Ginni Rometty (“Rometty”) said that IBM chose Red Hat because it is one of few companies in the cloud computing arena that has both revenue growth and free cash flow. Id. Further, while IBM shares have lost almost one-third of their value in the past five years, Red Hat share values increased one-hundred-and-seventy (170) percent during the same time. Id. Rometty explained her company’s hopes for similar growth: “This acquisition we are clearly doing for growth synergies. This is not about cost synergies at all.” Id. In other words, IBM’s primary motivation in partnering with Red Hat is increased growth, not necessarily reduced business expenses.
Founded in 1911, IBM— also known as “Big Blue,” as a reference to its once famous blue computers— is among the oldest players in the technology industry. Id. IBM’s business has historically been focused on computer design and production, although recent initiatives include artificial intelligence designed around Watson, the company’s supercomputer introduced to the world in 2010. Id. While the Red Hat acquisition is its largest yet, it is certainly not IBM’s first attempted foray into the world of software development and cloud computing. Id. For example, IBM acquired Canadian software maker Cognos for $5 billion in 2008, and cloud infrastructure provider Softlayer for $2 billion in 2013. Id. Despite its efforts to invest in these new technologies, IBM has faced declining revenue. (Frank Palermo, Venture Beat). Over the past six years, the company lost over $28 billion in revenue, and it ended FY2017 with only $79.14 billion in revenue, a twenty-year low. Id.
Founded in 1993 and headquartered in Raleigh, North Carolina, Red Hat specializes in bringing customers the Linux operating system, the most popular kind of open source software. (Liana B. Baker and Greg Roumeliotis, Reuters). Linux is a type of computer core operating system that, because it is open source, allows users to make modifications and improvements directly to the code. (Robert McMillan, WSJ). Linux is ideal for today’s companies, which more often rely on the cloud and rent computing power from servers in a third-party facility — servers which thrive on software that is cheap and easily modified. Id. Red Hat bundles Linux with other free programs for customers to install on their servers and PCs, and charges what are essentially “subscription fees” to its corporate customers for custom features and ongoing maintenance and technical support. (Liana B. Baker and Greg Roumeliotis, Reuters).
Given the radically different places these two companies are coming from, many analysts and tech insiders wonder if IBM and Red Hat can come together in any effective way. The open source community was founded largely in opposition to market-dominating large vendors with proprietary computing practices. (John Webster, Forbes). Many at Red Hat likely see IBM as one such large vendor. IBM will have to take care to incorporate the “open source way” of delivering products and services using an open and collaborative business model, or else it may find itself in a counterproductive culture clash with Red Hat. Id.
IBM hopes its $34-billion purchase of subscription-based Linux provider Red Hat will propel “Big Blue” into the future and enable it to compete with major cloud providers such as Alphabet, Amazon, and Microsoft. (Liana B. Baker and Greg Roumeliotis, Reuters). The deal has already begun to cost IBM, and more hits to the company are expected: IBM stock fell 4.2% immediately following the deal’s announcement in 2018, and financing the acquisition will require suspension of IBM’s share repurchase plan for two years. Id. While top executives of both companies remain hopeful that IBM and Red Hat can successfully merge together, others have lingering concerns. One such skeptic, Frank Palermo, Executive Vice President at Virtusa Digital, a global information technology services company, wondered, “There is no doubt that Red Hat gives IBM a much more credible cloud story. But the question really is, is it too late?” (Frank Palermo, Venture Beat).
Despite the criticisms and concerns, as of January 22, 2019, IBM’s Chief Financial Officer James Kavanaugh says the deal is still on track to be completed later this year with “overwhelming” client support. (Lauren K. Ohnesorge, Triangle Business Journal). Not only are clients happy, it would appear that Red Hat is as well, with 99% of Red Hat shareholders recently voting to approve the pending acquisition. Id. Time will tell if shareholder and client satisfaction continues when the deal is finally pushed through in the second half of 2019.