Value Vector: IBM-Red Hat: End of the Beginning or Beginning of the End?
On October 28, 2018, IBM announced it would acquire Red Hat for $190 a share, approximately $34 billion at a 63% premium to the stock’s closing price. Red Hat had guided revenues of $3.3 billion for its Fiscal Year 19 ending in February, valuing the deal a ~10X revenues. This is a steep multiple for a company that has been growing in the mid-teens, and IBM’s largest transaction to date. IBM intends to leave Red Hat as an independent entity, and work to integrate Red Hat’s offerings across the customer and partner base.
A few observations:
- IBM paid an inordinately high multiple (10X revenues) largely to ensure the deal gets done. In 2009, IBM lost out on buying Sun Microsystems when engaged in negotiations over price when Oracle swooped in and outbid them over a weekend. At $34 billion it’s unlikely there will be a higher bidder. Red Hat shareholders are clearly winners in the deal.
- Strategically the deal does makes sense. From a technology and product standpoint, there’s minimal product overlap, the Red Hat portfolio will enhance IBM’s solution stack and contribute a meaningful recurring revenue component.
- IBM is trying to increase the proportion of annuity revenues (which accounted for 61% of 2017 sales) so Red Hat advances this goal.
- Red Hat’s reputation as agnostic arbiter in the open source community will be tested as part of IBM. Leaving the brand intact is a pragmatic approach, but it’s unclear how sustainable the model will be.
- Large software acquisitions are risky, and failures are legion, hence there’s a lot of reason to be skeptical of the success in retaining key talent, growing the business and realizing a meaningful return for shareholders.
- IBM continues to double down on infrastructure software, platforms, tools and solutions rather than packaged applications. While this approach worked well in the 1990s and 2000s, IBM’s performance trails mega-software competitors Microsoft, Oracle and SAP, which lead with their application businesses.
Why IBM needed to do the deal
IBM has managed transitions in technology over many decades, but the company’s revenues and stock price have struggled over the last several years. For the last two decades, IBM’s core businesses have revolved around infrastructure technology – hardware and software – outsourcing, and services to create solutions, not applications. As such there are a notable deflationary forces that have been eating away at the margins and revenues:
- The ascendance of cloud computing has eaten into IBM’s core hardware and infrastructure sales as companies shift workloads increasingly to lower-priced infrastructure as a service providers. The just-in-time purchasing model impacts server, storage and software sales, while successive layers of automation, security and self-service render more complex outsourcing arrangements impractical.
- Open source software has been creeping up the stack displacing previously proprietary infrastructure software. Linux has steadily eaten away share from UNIX, including IBM’s AIX variant, while open source offerings from database (PostGRES versus DB2 for example) to application servers and middleware (JBoss versus WebSphere) to data integration tools (Talend and others) have evolved to become viable alternatives to proprietary options. Revenues from open source software are far less lucrative than traditional proprietary software, and IBM’s heavy reliance on infrastructure has left it exposed to erosion of growth and margins.
To be fair, IBM embraced open source in the 1990s and has advanced Linux on the mainframe while offering its own BlueMix platform of open source infrastructure, but the advances the company has made with its strategic priorities – Watson, Analytics and its own Cloud offerings have not been able to stanch the challenges. Revenues have declined over 4 years in a row, and the shares are down nearly 20% in 2018. IBM needed to turn to M&A to offset challenges to the business.
Why Red Hat?
Red Hat’s business is based around an open source development model, but the company sells subscription versions of its curated and supported software packages – Red Hat Enterprise Linux (RHEL), Red Hat Enterprise Virtualization (RHEV), OpenShift cloud platform and other products. The company’s business has grown steadily for over 15 years, all subscriptions, with operating margins in the mid-20s comparable with similarly sized enterprise software companies. A key advantage to Red Hat’s model is that the company sources innovations across thousands of open source communities globally, providing significant leverage to R&D spending.
The triumph of the open source model
One of the subtle but important shifts in the technology industry over the past several years has been the shift in leading edge innovations in infrastructure software. In the past, proprietary software vendors vie to be the first to introduce innovations to market; with the rise of cloud computing, the most cutting edge innovations are coming from open source. Google, Facebook, Amazon and even Microsoft have released key projects open source, and innovations such as containers, Kubernetes, and NoSQL databases proliferate rapidly. With the Red Hat deal following Microsoft’s acquisition of GitHub and Salesforce’s acquisition of Mulesoft so far in 2018, multi-billion dollar valuations are validation of the of the strategic value of open source. With Cloudera merging with Hortonworks, this leaves three publicly traded open source companies in the US, the others including Elastic Search and Talend.
Cloud and open source erode proprietary infrastructure sales, compelling M&A
For IBM, the company was faced with the choice of continuing to face erosion of its core business from cloud and open source competition. The Red Hat deal will provide a boost to revenues, growth and operating income, but at steep cost: IBM is expected to take on at least $20 billion in debt, and it’s more than likely that interest on the debt could exceed incremental operating profits for the first couple of years.
Will it work?
The big pushback to the deal comes from justifiable skepticisms about IBM’s ability to retain talent and culture over the longer term, given the mixed record so far. From the perspective of the technology community, Red Hat’s advantages stemmed from being agnostic to vendors as a neutral curator of open source software. It’s not clear how will the goodwill from the open source community will translate to a Red Hat under IBM’s umbrella, though IBM has to its credit been an active supporter of Linux. It’s too early to tell whether the deal will succeed, and the consensus view is skeptical, but regardless the Red Hat acquisition marks an important milestone in the maturing of open source software as foundational to enterprise technology.