Quick Thoughts: Big Blue Puts on a Red Hat

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October 29, 2018

Quick Thoughts: Big Blue Puts on a Red Hat

  • IBM’s $33.4B deal for RHAT is an expensive (63% premium) acquisition that greatly expands IBM’s play in hybrid enterprise cloud solutions, and better positions its cloud platform for the future.
  • The all-cash deal will eat about 2 years of operating cash flow. IBM will pause its share buybacks but sustain its dividend. Management expects accretion in 12 months.
  • Cloud demand is shifting toward traditional enterprise IT, which demands hybrid solutions to help transition in-house datacenter applications to public platforms and to help manage usage across multiple cloud hosts.
  • There are significant strategic synergies in the deal. IBM will have the most complete platform of software and services for hybrid cloud customers and could use that strength to better position its hosting platform and infrastructure software.
  • This keeps RHAT away from rivals, particularly AMZN, who lack IBM’s credentials as a hybrid solutions provider. The addition of RHAT’s expected 15% topline growth and sales synergies should also tip IBM into sustainable revenue growth.

IBM’s CEO Ginny Rometty broke out the checkbook on Sunday to pick up enterprise software and services company Red Hat. This combination has a lot to speak for it. IBM’s strength remains levering its huge existing customer list with solutions that help transition to a public cloud future. It sells cloud hosting, hosted infrastructure software platforms, AI APIs, SaaS applications, and most prominently, IT consulting services to move the process along. Still, most of IBM’s sales and profits remain tied to its proprietary premises-based hardware and software products, which are on a long slow decline to oblivion.

Red Hat expands IBM’s cloud products and expertise to the growing world of open source software, where the money is made from the support services, higher level software functions based on the open source code and from hosting. IBM’s huge sales operation and longstanding customer relationships become assets to introduce Red Hat’s capabilities to a much broader audience. Classic sales synergies with yet undisclosed cost savings to boot. IBM and Red Hat had already been partners to push an open source technology called containerization. Containers allow enterprises to breakup their computing loads to small pieces and shift them easily between multiple cloud hosts, looking for best performance at the lowest costs. This technology will be key for most traditional enterprises, who are gradually moving applications from their internal datacenters onto public cloud hosting platforms and are loath to be locked in. The combined IBM/Red Hat will be a clear leader in this area and an obvious partner for many enterprises contemplating a cloud move to Microsoft Azure, Amazon Web Services, Google Cloud Platform or even IBM’s own SoftLayer. Indeed, we suspect that this will be a considerable shot in the arm for those existing IBM cloud services.

We also think that it is important that IBM kept Red Hat out of the hands of those rivals. Its only real advantage in the enterprise cloud is its expertise and willingness to work in a messy, heterogenous solution, bridging enterprise datacenters to public platforms and helping enterprises manage multiple cloud partners. Microsoft plays in these areas, specifically where heterogenous means Microsoft proprietary platforms, like Windows or SQL, combined with open source. Google has technical strength in containerization and a commitment to open source but is not well positioned with most traditional enterprises or particularly familiar with their problems. Its increasingly close partnership dance with Salesforce might give it a better play someday, but right now it is not playing in IBM’s sandbox. Amazon is dominant with web-based businesses, but the incremental cloud demand is coming from traditional enterprises where it is not well positioned. We thought this was the most likely future home for Red Hat, but Big Blue stepped in.

Consensus forecasts have IBM sales down $460M and Red Hat sales up about $500M in 2019. Presuming some bit of sales synergy between the two, it seems a good bet that this deal is the one that finally pushes IBM across the line to sustainable growth. (N.B. We would be a bit more optimistic than that.) It also may be IBM’s best chance yet to establish itself as a bona fide player in the public cloud market, rather than just a waystation on the route to an Amazon-Microsoft-Google dominated future.

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