Editor’s note: Cassandra Mooshian is Senior Analyst at Technology Business Research.
HAMPTON N.H. – No lazy Sunday preparing for game five of the World Series for many IBM and Raleigh-based Red Hat executives, it was all business as they came together to announce the industry’s third largest acquisition (pending approvals).
While the sheer magnitude of the deal made by IBM Chair and CEO Ginny Rometty can take you by surprise, the underlying reasons do not.
The deal, valued at $34 billion, will bring Red Hat square into IBM’s hybrid cloud team, in its Technology Services and Cloud Platforms (TS&CP) group where its IaaS (formerly SoftLayer), PaaS (formerly Bluemix) and hybrid management capabilities reside.
IBM’s cloud strategy was sorely due for a boost and Red Hat has been looking for a potential buyer for quite some time now. Longtime IBMer (since 2001) Stefanie Chiras joined Red Hat as the VP and GM the Red Hat Enterprise Linux (RHEL) business unit in July, likely brought on specifically to lead that group through the transition phase into IBM. Additionally, there are portfolio synergies around Linux on IBM hardware and Kubernetes as well as the fact that IBM is pervasive in the large enterprise market, yet struggles to gain recognition in the midmarket, while much of Red Hat’s revenue is channel-led and not so much large enterprise focused.
IBM’s CEO defends $34B deal for Red Hat but Wall Street is lukewarm (+ video)
What’s most important is that IBM listened to its stakeholders and the broader market, realizing that while its cloud business was growing consistently around 20-25% year-over-year on a quarterly basis, that was not enough to move the needle materially to more effectively compete in cloud. The company’s recognition that it should not always promote all IBM solutions is a noteworthy shift. Sure, IBM has had technology partnerships for quite some time, but there has always been the perception that it will push its own solutions ahead of others despite customer needs. Its recent and ongoing focus on hybrid IT enablement has changed this and now, the idea of bringing on an open source company is changing the game for IBM.
Red Hat shares surge 44% on news IBM is buying Raleigh software firm for $34B
The deal has a lot of potential to be very mutually beneficial to both companies, but if and only if IBM executes well and nurtures Red Hat’s open source philosophy. Otherwise, it will be a lot of money spent only to exacerbate IBM’s internal and go-to-market challenges (HPE’s acquisition of Autonomy comes to mind here).
Sticker shock fades once you factor in the rest of the numbers
Earlier in this decade, IPOs and sales of more traditional technology and software companies have been valued at around five times their annual revenue. However, in recent years as more cloud-native companies with subscription-based business models go public or get acquired, this multiple has steadily shifted upward. As a rather extreme example, Cisco bought the company for $3.7 billion, a valuation of nearly 16x, despite its valuation of $1.9 billion on an annual revenue of approximately $220 million in the weeks prior to this purchase as it readied to IPO.
Much of the speculation around this monstrous deal relates to how IBM can and will fund such a hefty price tag. To put this massive $34 billion figure into perspective, Red Hat’s trailing twelve-month revenue for the four quarters ended August 31, 2018, reached just shy of $3.1 billion, indicating the deal is valued at 11x revenue. If Red Hat is to stay on its double-digit growth pattern and trajectory, by the close of 2021, Red Hat’s revenue and operating income are slated to more than double from 2017 levels, benefitting from access to IBM’s vast enterprise customer base.
This helps IBM justify the large purchase price. Additionally, it is likely that the purchase price per share was set at least a few weeks ago, when there were more Red Hat shares available and at a higher price. Four weeks ago, on October 1, Red Hat was trading for $133 a share, compared to the $117 per share price it was trading at this past Friday (Oct. 26).
There are enough synergies to make this work, but it will all come down to execution.
Organizational structure
Internally for IBM going forward, again, pending the acquisition’s approval, this poses significant integration challenges for IBM. Though the company has been successful in the past with integrating software acquisitions, it has yet to make a purchase this large and this is the first major software acquisition since the company reorganized and brought software subgroups across its various business units a couple of years ago, no longer touting a dedicated software business unit. Additionally, none of the formerly acquired companies have run as standalone units as Red Hat is expected to be.
The idea of Red Hat being brought into TS&CP as a standalone unit could go one of two ways. The first is that IBM Services culture and cumbersome processes could stifle Red Hat’s software-led mindset, culture and innovation. The second is far more positive for Red Hat in the sense that Red Hat products could be pulled through in an unprecedented amount of Services engagements the company has yet to see due to its much smaller size and scale. This second scenario, however, will only be possible if IBM Services and consultants can differentiate from Red Hat’s other existing SI partners to remain the largest services provider around Red Hat and Linux. Whether or not those partnerships will stay at the strategic levels they are at today, or at all, remains unclear.
Red Hat CEO Jim Whitehurst will report to Ginny Rometty. While it is very likely he will stay with IBM for the year or so required and then retire, there is the possibility, and this is pure speculation, that IBM could be priming him to be a contender for the position of IBM CEO should Ginny look to retire soon.
Go-to-market
Undoubtedly, IBM has set its sights on reaching more midmarket customers as its large enterprise customer base is slower and more resistant to move to cloud. Red Hat’s prevalence in the midmarket will surely help open the doors to cross sell IBM solutions and services in to these companies, if pricing is adjusted accordingly for smaller companies. Additionally, IBM will gain access to the 8+ million strong Red Hat developer community. On the other side of this, Red Hat also can bring its solutions upmarket into IBM’s largest enterprise customers.
Much of IBM’s focus as of late has been on helping customers link on- and off-premises environments and sharing data across truly hybrid environments. Its large Services arm and broad portfolio set have helped offset some legacy software and services revenue erosion in quarters past. While Linux is already relatively pervasive across the market and OpenStack yet to garner significant demand or traction, Kubernetes is the open source solution of choice at the moment and will be in coming quarters. IBM continues to update its IBM Cloud Private portfolio centered around Kubernetes, which also can run on OpenShift, presenting an area of immediate portfolio synergies between the two companies. Incorporating additional open source technologies into the mix as well as Red Hat’s interoperability with third-party cloud and software solutions only help position IBM as an increasingly technology agnostic hybrid enabler.
Peer implications
Despite the size of the acquisition and the attention it is garnering, in terms of implications to IBM’s cloud competitors, this will not move the needle all that significantly should the deal go through. AWS and Microsoft will continue to dominate the public cloud IaaS and PaaS market. The two have increasingly embraced open source technology integrations in their proprietary ecosystems, only enabling them to get bigger as they can also work with RHEL customers.
If this acquisition were to materially impact anyone, it is our assessment that it could be Google and/or Oracle. Google struggles already to compete at scale with AWS and Microsoft and does not yet have the same permission to play in the large enterprise segment as the other two have. With IBM, Red Hat will gain that permission almost immediately. Oracle’s Linux offerings are based on RHEL, which could complicate a competitive relationship between IBM and Oracle. While Oracle may have more pressing areas to focus on and invest in, such as Kubernetes in tandem with its peers, the company could, should it choose not to work closely with IBM when Red Hat is integrated, look to acquire another Red Hat-like company with expertise and capabilities in open source and Linux in particular, such as Canonical or SUSE, which was just sold by Micro Focus to private equity firm EQT for $2.5 billion.
(C) TBR
