IBM’s $33B Deal For Red Hat Fails 3 Of 4 Tests For Successful Acquisitions

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IBM is shrinking — revenues fell 2.1% in the latest quarter — and its stock is down a whopping 35% since its current CEO took over at the beginning of 2012.

So what better time to make the biggest acquisition in its history? That’s what IBM’s October 29 deal is to pay $33 billion — a 63% premium over its close on October 26 — to acquire open source software maker Red Hat, according to CNBC.

Red Hat provides services for its version of the open-source (free from licensing costs) Linux software operating systems, middleware, storage, virtualization, and management tools. The company reports revenue through two categories: subscriptions, and training and services. The Americas contributed approximately 64% of total revenue in fiscal 2018; Europe, the Middle East, and Africa contributed 23%; and Asia-Pacific contributed 14%, according to Morningstar.

Red Hat is a steadily growing and profitable company that throws off lots of cash. In the last five years, sales have increased at a 17.1% annual rate to $2.92 billion, net income rose at an 11.5% annual rate to $259 million, and free cash flow grew at nearly a 19% annual rate to $821 million, according to Morningstar.

Sadly, Red Hat slipped in its most recent quarter. That’s when it missed badysts’ expectations for sales and its forecast for the current quarter also fell short — investors may have been concerned that Red Hat was losing deals to rivals and that growth might be slowing, according to Bloomberg which noted that Red Hat shares are down 28% percent over the past six months through October 26.

Is this deal a good thing for IBM shareholders? Investors do not love this deal — sending its shares down over 4% on October 29. And I think it fails three of the four tests for successful acquisitions. (I have no financial interest in the securities mentioned in this post).

To be fair, Red Hat competes in an attractive industry. However, the combined companies will not be better off, IBM grossly overpaid, and it will be difficult to integrate the two companies.

Industry Attractiveness: Pbad

Red Hat’s industry — providing service and training for companies that use open source software — is large, growing, and profitable. As Red Hat CEO, Jim Whitehurst, said in an SEC filing, "We believe our total addressable market to be $73 billion by 2021. If software is eating the world – and with digital transformation occurring across industries, it truly is – open source is the key ingredient."

What’s more, IDC reported that with 32.7% of the server operating system market in 2017 — Red Hat lagged only Microsoft. Within the Linux segment, IDC found that Red Hat Enterprise Linux adoption grew by nearly 20% in 2017.

Better Off: Fail

To be sure, IBM and Red Hat touted the deal as a way to compete with Amazon and Microsoft in the so-called hybrid cloud. But IBM’s approach to integrating acquisitions makes it highly unlikely that the combined companies will be able to get their act together to offer customers a better service and gain market share.

For one thing, IBM is famous in its acquisitions for imposing internal requirements on its products — the products must appear to all work together forcing customers to accept a clunky bundle rather than a more focused, efficient solution.

While IBM has been shipping servers with Red Hat for years — and this deal will save IBM from paying Red Hat for that, it remains to be seen how well this deal will result in a cloud service that can boost IBM’s measly 1.9% share of cloud infrastructure revenue in 2017.

What’s more, companies have bought Red Hat products because it was considered vendor neutral. Whitehurst, told CNBC that the combined company would be the largest contributor to open-source software. "We will [also] remain distinct because we want our customers to understand that Red Hat coming in is a neutral sell."

But as part of IBM, Whitehurst will have an insurmountable challenge in trying to explain how Red Hat can be both neutral and not try to make the acquisition pay off by encouraging customers to buy from IBM. This will be especially difficult as he loses control over its product line and go-to-market strategy due to Big Blue’s bureaucracy.

Net Present Value Greater Than Zero: Fail

By paying so much for Red Hat, it will take some heroic badumptions for this deal to generate a positive net present value. IBM has about $80 billion in annual revenue and Red Hat would add a mere 3.8% to Big Blue’s top line.

This is not much but it could end up being worse. After all, it badumes that customers stick with Red Hat once it is owned by IBM. Of course, companies who previously bought from Red Hat because it was perceived as neutral, may decide to switch to a still-independent rival.

Moreover, Red Hat would only add 6% to IBM’s free cash flow. To be sure, I have no doubt that it’s possible to make badumptions that would cause this 63% premium to result in a positive net present value. But I think IBM is overpaying.

Integration: fail

One of the key reasons that mergers fail is because the acquired company can’t retain the best people in the acquired company. One factor causing people to leave is a change in its culture. And Red Hat believes that preserving its culture is critical to its success. According to its latest annual report,

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity and collaboration. As our organization grows, our employees (including remote workers) and our resources become more globally dispersed and our organizational management structures become more complex, we may find it increasingly difficult to maintain these beneficial aspects of our corporate culture. If we are unable to maintain our corporate culture, we may find it difficult to attract and retain motivated employees, continue to perform at current levels or execute on our business strategy. As a result, our business, financial condition, operating results and cash flows could be adversely affected. 

Will this culture survive being acquired by IBM? Given how big the gap is between IBM’s actual culture and the one built by Thomas Watson, I would vote for no. But Rometty told the Wall Street Journal that IBM intends to retain Red Hat’s culture and brand.

To be fair, this is an outstanding deal for Red Hat shareholders who will no doubt enjoy the huge premium IBM paid. Sadly, IBM shareholders are likely to be disappointed by the deal’s failure to pbad the four tests for successful acquisitions.

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IBM is shrinking — revenues fell 2.1% in the latest quarter — and its stock is down a whopping 35% since its current CEO took over at the beginning of 2012.

So what better time to make the biggest acquisition in its history? That’s what IBM’s October 29 deal is to pay $33 billion — a 63% premium over its close on October 26 — to acquire open source software maker Red Hat, according to CNBC.

Red Hat provides services for its version of the open-source (free from licensing costs) Linux software operating systems, middleware, storage, virtualization, and management tools. The company reports revenue through two categories: subscriptions, and training and services. The Americas contributed approximately 64% of total revenue in fiscal 2018; Europe, the Middle East, and Africa contributed 23%; and Asia-Pacific contributed 14%, according to Morningstar.

Red Hat is a steadily growing and profitable company that throws off lots of cash. In the last five years, sales have increased at a 17.1% annual rate to $2.92 billion, net income rose at an 11.5% annual rate to $259 million, and free cash flow grew at nearly a 19% annual rate to $821 million, according to Morningstar.

Sadly, Red Hat slipped in its most recent quarter. That’s when it missed badysts’ expectations for sales and its forecast for the current quarter also fell short — investors may have been concerned that Red Hat was losing deals to rivals and that growth might be slowing, according to Bloomberg which noted that Red Hat shares are down 28% percent over the past six months through October 26.

Is this deal a good thing for IBM shareholders? Investors do not love this deal — sending its shares down over 4% on October 29. And I think it fails three of the four tests for successful acquisitions. (I have no financial interest in the securities mentioned in this post).

To be fair, Red Hat competes in an attractive industry. However, the combined companies will not be better off, IBM grossly overpaid, and it will be difficult to integrate the two companies.

Industry Attractiveness: Pbad

Red Hat’s industry — providing service and training for companies that use open source software — is large, growing, and profitable. As Red Hat CEO, Jim Whitehurst, said in an SEC filing, “We believe our total addressable market to be $73 billion by 2021. If software is eating the world – and with digital transformation occurring across industries, it truly is – open source is the key ingredient.”

What’s more, IDC reported that with 32.7% of the server operating system market in 2017 — Red Hat lagged only Microsoft. Within the Linux segment, IDC found that Red Hat Enterprise Linux adoption grew by nearly 20% in 2017.

Better Off: Fail

To be sure, IBM and Red Hat touted the deal as a way to compete with Amazon and Microsoft in the so-called hybrid cloud. But IBM’s approach to integrating acquisitions makes it highly unlikely that the combined companies will be able to get their act together to offer customers a better service and gain market share.

For one thing, IBM is famous in its acquisitions for imposing internal requirements on its products — the products must appear to all work together forcing customers to accept a clunky bundle rather than a more focused, efficient solution.

While IBM has been shipping servers with Red Hat for years — and this deal will save IBM from paying Red Hat for that, it remains to be seen how well this deal will result in a cloud service that can boost IBM’s measly 1.9% share of cloud infrastructure revenue in 2017.

What’s more, companies have bought Red Hat products because it was considered vendor neutral. Whitehurst, told CNBC that the combined company would be the largest contributor to open-source software. “We will [also] remain distinct because we want our customers to understand that Red Hat coming in is a neutral sell.”

But as part of IBM, Whitehurst will have an insurmountable challenge in trying to explain how Red Hat can be both neutral and not try to make the acquisition pay off by encouraging customers to buy from IBM. This will be especially difficult as he loses control over its product line and go-to-market strategy due to Big Blue’s bureaucracy.

Net Present Value Greater Than Zero: Fail

By paying so much for Red Hat, it will take some heroic badumptions for this deal to generate a positive net present value. IBM has about $80 billion in annual revenue and Red Hat would add a mere 3.8% to Big Blue’s top line.

This is not much but it could end up being worse. After all, it badumes that customers stick with Red Hat once it is owned by IBM. Of course, companies who previously bought from Red Hat because it was perceived as neutral, may decide to switch to a still-independent rival.

Moreover, Red Hat would only add 6% to IBM’s free cash flow. To be sure, I have no doubt that it’s possible to make badumptions that would cause this 63% premium to result in a positive net present value. But I think IBM is overpaying.

Integration: fail

One of the key reasons that mergers fail is because the acquired company can’t retain the best people in the acquired company. One factor causing people to leave is a change in its culture. And Red Hat believes that preserving its culture is critical to its success. According to its latest annual report,

We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity and collaboration. As our organization grows, our employees (including remote workers) and our resources become more globally dispersed and our organizational management structures become more complex, we may find it increasingly difficult to maintain these beneficial aspects of our corporate culture. If we are unable to maintain our corporate culture, we may find it difficult to attract and retain motivated employees, continue to perform at current levels or execute on our business strategy. As a result, our business, financial condition, operating results and cash flows could be adversely affected. 

Will this culture survive being acquired by IBM? Given how big the gap is between IBM’s actual culture and the one built by Thomas Watson, I would vote for no. But Rometty told the Wall Street Journal that IBM intends to retain Red Hat’s culture and brand.

To be fair, this is an outstanding deal for Red Hat shareholders who will no doubt enjoy the huge premium IBM paid. Sadly, IBM shareholders are likely to be disappointed by the deal’s failure to pbad the four tests for successful acquisitions.