IBM takes a smart but substantial risk with Red Hat play

IBM Red Hat
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IBM can finally lay a claim to the cloud with its Red Hat acquisition, but it’s a financially risky play. The acquisition needs to go well because the $34 billion that IBM is paying in cash will all end up on the balance sheet as debt, taking its gearing to an uncomfortable 66% of assets.

IBM will pay $190 per share to acquire Red Hat which is a premium of 63% over Friday’s (Oct 26) closing share price. Red Hat gives its software away for free but makes a return on that software by offering customizations and services of that software for enterprise customers. This makes Red Hat a good fit for IBM, which is also focused on both the enterprise and services, but calls into question IBM’s historic claims to a major cloud player.

If IBM was a major player in the cloud, arguably it would not need to take the risk of leveraging the balance sheet to this scale. IBM’s cloud claims are mostly based on the fact that it sells a lot of servers for use in the cloud which I don’t think really counts.

However, with Red Hat, IBM gets a foothold – not to challenge Amazon, Alibaba Cloud, Microsoft or Google, but to become their biggest supplier. Hence, this acquisition is about IBM becoming the picks and shovels of the trend to move computing into both public and private clouds.

Red Hat will become a unit of IBM’s Hybrid Cloud division but will continue to operate pretty much independently. This means that there are no tangible synergies to be had, but being owned by IBM should enhance Red Hat’s ability to win business, as well as give IBM’s Hybrid Cloud business greater credibility.

The aim here is obviously to take market share in this fast-growing market, which is badly needed to push IBM’s revenues back into positive territory. IBM’s revenues have been falling since 2012, and even its cloud business is growing far more slowly than the market, signalling that something needed to change.

This change is Red Hat and IBM can now justifiably make the claim that it is a major player in the cloud.

Red Hat is currently growing around 18% YoY with about $3 billion in revenues, but IBM will need to push that up if it wants Red Hat to have a meaningful impact on its circa $80 billion of annualized revenues. This is the challenge that now lies before IBM’s management, as the cost of this acquisition is going to make an indelible mark on the company’s capital structure.

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