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Will IBM’s Huge Bet on Red Hat Pay Off?

After years of slumping revenues, disappointing earnings, and an underwhelming stock performance, IBM (NYSE:IBM) has made a huge move. It is acquiring cloud player Red Hat (NYSE:RHT) for more than $30 billion. This deal will make or break IBM’s future. Management sees a trillion dollar market opportunity in the hybrid cloud, with Red Hat being a key piece of IBM’s strategy to conquer that market. Red Hat also offers a way to tag along with Microsoft’s (NASDAQ:MSFT) success, as Linux use has been surging within Microsoft’s Azure platform.

Will IBM's Huge Bet on Red Hat Pay Off?

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Needless to say, if IBM made a sound purchase with Red Hat, it will revive the company’s fortunes. But, having paid 10x sales for Red Hat, expectations are high. In recent weeks, IBM has raised debt funding for the purchase and gotten regulatory approval from various government bodies. It’s increasingly likely that the Red Hat purchase will close soon, and with it, IBM will need to start getting results to justify the steep price tag on its purchase.

The Red Hat Deal Adds Tons of Debt

Prior to the Red Hat deal, IBM retained a fairly strong balance sheet. Yes, critics could point to the company’s $50 billion debt load as a clear negative. However, rating agency S&P’s IBM credit rating of A+ reflected the company’s strong financial position. Why didn’t the $50 billion of debt make IBM a riskier proposition?

For one thing, IBM has an extensive credit operation of its own called Global Financing. This division extends loans and other credits to its customers, facilitating more transactions. As of Q1, Global Financing made up nearly $30 billion of the overall debt load, leaving just $20 billion after subtracting that. In theory, many of IBM’s clients could go bust if another steep recession hit or the tech industry faced a wipe-out. Still, most of that $30 billion should be good money, making IBM’s balance sheet much stronger than it first looks.

Still, it is weakening, especially with the Red Hat purchase. In 2017, S&P cut its IBM rating from AA- to A+ on shortfalls in revenues compared to expectations. Last fall, S&P cut its IBM rating again, now to A and has left it on negative outlook for yet another potential downgrade. Bloomberg said that the credit rating could get cut all the way to BBB — near the edge of investment grade — depending on how the Red Hat deal works out.

IBM announced earlier this month that it is issuing $20 billion in debt to fund the Red Hat purchase. This doubles the company’s effective debt load once you back out Global Finance. IBM still has some wiggle room on the balance sheet. But it has used up a lot of its borrowing capacity already.

No More Stock Buyback

That will lead to one immediate potentially negative impact for IBM stock: The stock buyback is halted. IBM has had a monster stock buyback in recent years cutting the share count by a third. In fact, the company has relied on that share buyback to paper over its shortcomings elsewhere.

The company has seen revenues drop 20% in recent years. Even with a rise in margins, it has not been able to offset this in terms of net income. But when you shrink the divisor, the number of shares outstanding, you can still show earnings growth even as the business shrinks. IBM will lose that cushion for at least 2020 and 2021, as it is now planning on spending its free cash flow on the dividend and paying down the Red Hat debt rather than buying its own stock.

The one potential silver lining here is that IBM won’t destroy any further shareholder value buying overpriced IBM stock. IBM’s share price is now below where it has traded for most of this decade. That means IBM paid billions more repurchasing its stock than it is now worth on the open market. Given the business’ struggles, shareholders may be happy that IBM spent money on growth again, rather than buying its stagnant stock.

The Red Hat Deal Has to Work

But whether shareholders end up happy depends almost entirely on execution from this Red Hat deal. This is a huge move for IBM. They are paying $33 billion for Red Hat and IBM’s current market cap is under $120 billion. That means that IBM is spending more than a quarter of its market cap on this purchase. Should it fail to meet expectations, not only would it cause a large write-off, it’d also irredeemably tarnish management’s reputation. This deal is so big that it has to work for IBM to retain its credibility as a leader in tech.

Will it work? There are reasons for skepticism, as there are with most large tech mergers. It’s often hard to retain employees, particularly since people view Red Hat as far more creative than IBM at this point. Plus, Red Hat’s business model was quite different from IBM’s. Still, the company clearly needed to do something. Its main division, Global Technology Services, saw revenues fall nearly 10% this quarter versus the previous year. Meanwhile, even more worryingly, Cloud & Cognitive Software revenues fell by 2%. Cloud is still booming for various other tech companies and is supposed to be the future for IBM as well. They absolutely must get cloud back on track if IBM stock is going to work out for its shareholders. Hence the Red Hat deal.

IBM Stock Verdict

A lot of people, myself included, enjoy receiving the nearly 5% dividend yield from IBM stock. It’s a primary reason to own the stock in fact. IBM has also managed huge rates of dividend increases over the past twenty years. However, Red Hat muddies the picture here as well. The company has shrunk its share count by 25% since just 2012. Theoretically, if a company had 100 shares then, it has only 75 now. If you had a fixed pot of $225 to pay annual dividends, it could pay $2.25 per share in dividends back then. Now it can pay $3 per share simply because the pie is getting split into far fewer slices.

This virtuous cycle stops now that the share buybacks are halted. For IBM to continue its dividend growth, it now needs more net income to drive that lever. As we say this year, IBM gave us its smallest dividend increase in ages. For IBM to get back on track, both in terms of earnings and dividend hikes, the Red Hat deal absolutely has to pay off. Otherwise, IBM stock will be an even worse performer going forward. I personally still own IBM stock, but I have it on a leash. The stock would be a sell if IBM management bungles the Red Hat purchase. For IBM, it’s do or die time.

At the time of this writing, Ian Bezek owned IBM stock. You can reach him on Twitter at @irbezek.

Article printed from InvestorPlace Media, https://investorplace.com/2019/06/will-ibms-huge-bet-on-red-hat-pay-off/.

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