By Orlando Poraqi (Bocconi University) 09/11/2018 |
Overview of the deal
Acquirer: IBM
Target: Red Hat
Estimated value: $34 bn
Announcement date: 28/10-18
IBM Advisers: Lazard, Goldman Sachs, JPMorgan Chase
Red Hat Advisers: Guggenheim Partners, Morgan Stanley
The transaction is IBM’s biggest purchase in its 107-years history and an all-time third in the USA IT industry. Astonishingly, it currently represents a quarter of the total value of tech M&A in the US this year. It comes after Microsoft, Salesforce, Cloudera and Broadcom acquired data platform and cloud industry players in 2018, for a total of almost $40 bn. Throughout this last merger wave, the NY-based company shares have lost 30% of their value in the past 5 years, while Red Hat stocks are up 170% over the same period of time.
IBM agreed to pay $190 cash per each Red Hat share, representing a 63% premium to Friday’s $116.68 closing figure. The high premium paid surpasses the average 30-days premium for 2018 deals of 34% and the even higher 37% premium paid in tech M&A, which caused IBM stock price to plummet as much as 5% on the first trading day after the deal announcement.
"Knowing first-hand how important open, hybrid cloud technologies are to helping businesses unlock value, we see the power of bringing these two companies together, and are honored to advise IBM and commit financing for this transaction" -JPMorgan CEO Jamie Dimon.
Company details (International Business Machines Corporation)
International Business Machines Corporation (IBM) is an American information technology company. Its major inventions span from the barcode to magnetic stripe cards and RDBMSs, floppy disks and the first DOS-run Microsoft PC.
- Founded in 1911, headquartered in Armonk, NY, USA
- CEO, Chairman and President: Virginia Rometty
- Number of employees: 380,300
- Market Cap: $112.8 bn - EV: $141.7 bn
- LTM Revenue: $80.4 bn - LTM EBITDA: $16.6 bn
- LTM EV/Revenue: 1.76x - LTM EV/EBITDA: 8.54x
Company details (Red Hat, Inc.)
Red Hat is an American company, leading provider of open-source software solutions. It leverages a community-powered approach to offer cutting-edge cloud, middleware, Linux, storage and virtualization technologies. It also pioneers the hybrid cloud industry, where it develops solutions to integrate private, public, proprietary and third-party management information systems.
- Founded in 1993, headquartered in Raleigh, North Carolina, USA
- CEO: Jim Whitehurst
- Number of employees: 12,212
- Market Cap: $30.7 bn - EV: $29.4 bn
- LTM Revenue: $3.3 bn - LTM EBITDA: $633 mn
- LTM EV/Revenue: 8.9x - LTM EV/EBITDA: 46.5x
Projections and assumptions
Short-term consequences
Subscriptions fees generate 85% of Red Hat’s revenues, whereas its heaviest operating costs are marketing and R&D (60% and 30% respectively). It certainly stabilizes IBM cash flows in the next future, especially under the rapid growth cloud computing industry is experiencing. Red Hat 4% QoQ revenue growth since 2016 and constant revenue increase throughout the latest 64 quarters are only some of the financial pills IBM is paying for healing its worsening financial statements.
The deal comes almost six months after IBM’s Joint Venture with Red Hat was established and after 20 years of Partnership. Its goal has been to maximise customer benefits by stitching together customers’ current data centres with innovative cloud services known as “hybrid clouds”. Following the acquisition, two major enterprise application platforms will be brought together: Red Hat OpenShift Container Platform and IBM Cloud Private. IBM Cloud Private provides containers, logging, auditing and encryption services, easily portable and compatible with many public cloud platforms. It will be integrated with Red Hat’s broad portfolio of enterprise-grade, cloud-native, and hybrid cloud infrastructure solutions. The rationale of the deal followed the strengthening trend of customers, using enterprise software, seeking to save money by consolidating their vendor relationships.
Long-term upsides
Enterprises are slowed by the proprietary nature of current cloud products, preventing portability of applications and data across different clouds, data security in a multi-cloud environment and consistent cloud management. IBM management objective is the transaction to help it catch up with Amazon, Google and Microsoft in the rapidly expanding cloud business. More than 90% of Fortune 100 companies and +$100 bn mission-critical transactions each day run on IBM systems. The deal’s long-term value is going to arise, as confirmed by Virginia Rommetty, from growth synergies instead of cost synergies and cuts. Two of the biggest drivers of integration will be Red Hat Enterprise Linux OS for servers and its OpenShift cloud platform, used by big businesses to update their current IT infrastructure.
Upon closing of the transaction, Red Hat will join IBM's Hybrid Cloud team as a distinct unit, in order to preserve the independence and neutrality of its open source development heritage and commitment, product portfolio and strategy, and unique development culture. Red Hat will continue to be led by the full current management team, with the CEO reporting directly to IBM CEO. Red Hat's headquarters, facilities, brands and practices are also unchanged.
Risks and uncertainties
On Monday the 29th of October, only 19% ~ 35 mm of Red Hat’s outstanding stocks traded that day, around $170 (from $116.68 the trading day before), implying market participants show some concerns on whether the deal will go through. This 11% spread between the deal price and the stock price could lie on different scenarios that can happen before the second half of 2019 when IBM expects the deal to close. Credit rating agencies worry about the debt IBM is taking on, in a situation where it could have disposed of the $11.6 bn of cash at hand. To boost repayments, it suspended its share buybacks in 2020-21. Moreover, investors worry about the unpredictable Chinese and US regulator’s behaviour.
IBM is currently in litigation with the Pentagon for concerns raised, together with Microsoft and Oracle, on the winner-take-all approach used by the U.S. Defense Department to award the mandate for its 10-years JEDI project, worth about $10 billion to the winning firm. Amazon is the most favoured candidate, given its 2013 $600 mn cloud contract with CIA and its 44% of the current cloud infrastructure market. The JEDI contract - short for Joint Enterprise Defense Infrastructure - calls for transitioning some of the department’s technology needs to a commercial cloud. In addition, major applications will need to be reconfigured to be compatible with the provider’s technical requirements. Red Hat has been among the nine potential contractors, together with Amazon, Microsoft, Oracle, IBM, DELL and many others. IBM and Red Hat lobbies merged have higher chances to make the Pentagon consider the possible security risks and innovation stifle for the U.S. Defense Department arising by awarding the mandate to a single company. On the other hand, Red Hat has technologies in place with almost all JEDI’s candidate companies, implying its solutions are not going to change depending on which cloud company will be selected, easing IBM future involvement in the deal.
"IBM also believes that the hybrid cloud market is about a $1 trillion market by the year 2020" and the Linux operating system "is the dominant platform across the entire cloud marketplace“ -Charles Fullwood, senior director at Force 3, IBM and Red Hat partner
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