International Business Machines (NYSE:IBM) is swinging for the fences in its attempt to restart growth and shore up IBM stock. Apparently, it wants to do this through a massive acquisition: buying Red Hat.
Without a buyout at this scale, IBM has too few options available. Its growing units are too small to add meaningfully to the company’s total revenue. The mature businesses still bring in profits and do not need to be sold. How will Red Hat fit in IBM’s strategy?
IBM is acquiring Red Hat to transform its offerings and services that lead to higher value. With Red Hat already in a strong position in the cloud, the unit is instrumental for positioning IBM as a leader in hybrid-cloud. On paper, the deal makes sense because out of the $1 trillion market opportunity in hybrid-cloud, IBM has $19 billion of it today.
Integrating Red Hat with IBM should not have too many bumps. The company already built on Kubernetes containers on its IBM Cloud Platform. Together with the Linux platform growing at a rapid pace, adding Red Hat will fit naturally.
IBM invested and supported Linux for the last 20 years at a cost of about $1 billion, but having Red Hat’s expertise will accelerate that growth in this environment. Red Hat open source is used by an estimated 8 million developers. It also gives IBM access to the reported 90 percent of the Fortune 500 companies using Red Hat.
IBM Shares Fall
After IBM announced the deal, the stock traded at around $131. But shares also topped $150 a few weeks before that and before the company reported disappointing quarterly results.
Most recently, the $119 share price is a big drop that signals investor lack confidence in the deal. IBM is paying $190 a share, or $34 billion, paying all cash and financing the deal through cash and debt. Currently, the company has a debt/equity of 2.37 times, so adding more debt to the balance sheet will put its cash flow growth at risk.
IBM’s stock yields a dividend of 5.36 percent. And any deterioration in the business, plus extra costs in integrating Red Hat, if any, may send shares to new yearly lows.
Upside to Deal
IBM and Red Hat worked together for several years and probably share the same customer base. That overlap will lower the usual friction and integration costs normally associated with takeovers. If it is managed properly, the combined unit may potentially take more market share in the open source development space.
It would also be in a better position to compete against Microsoft Corporation (NASDAQ: MSFT), Amazon.com Inc. (NASDAQ: AMZN), and Alphabet Inc. (NASDAQ: GOOGL). It is worth noting that the stock price for all of these companies is also down but with one big difference here: IBM’s stock trades in the single-digit P/E multiples.
IBM’s successful integration of Red Hat depends on a number of things that are already evident between the two firms. Both companies are dedicated to working with developers. Investments in the open source community will continue even after the acquisition. And IBM-Red Hat have a tailwind with the growing uptake of open source solutions.
Stronger cybersecurity, just to name one of many features, in the hybrid multi-cloud will come naturally as the talent from both companies works more closely together.
AI, private cloud, and middleware will also get better for the customer. All the while, IBM may scale its offering because it will have a bigger, more efficient services team. From the aspect of a bigger distribution, it may also cross-sell solutions to more customers.
Valuation and Your Takeaway on IBM Stock
Investors are pricing in the heavy risks associated with integrating such a large company. With debt levels going up at a time when interest rates are rising, investors have no appetite for holding IBM stock.
Despite the market’s negative reaction, IBM trades in value territory and could have around 20% upside if the Red Hat unit adds positively to results in the next few quarters.
Disclosure: The author does not own shares in any of the companies mentioned.