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IBM Stock Is Only Scratching the Surface With the Red Hat Deal

Two big events took place in July for investors in International Business Machines (NYSE:IBM). On July 9, the company closed its $34 billion acquisition of Red Hat. And on July 17, IBM reported better-than-expected Q2 earnings. As a result, IBM stock gained nearly 10% during the month of July, but it has given back those gains and then some through August.

IBM Stock Is Only Scratching the Surface With the Red Hat Deal

Source: Shutterstock

Even after a 1.39% pop on Friday — when International Business Machines stock closed at $133.76 — it’s down 11% from the start of August and off 3% compared to where it started in July. Why has the boost from the finalization of the company’s Red Hat acquisition been so short-lived?

Why Red Hat Is a Big Deal

The Red Hat acquisition is a big deal for IBM in every way. First is the sheer scale of the purchase. At $190 per share, it was valued at $34 billion, making it the largest acquisition in IBM’s history, and the second-largest ever technology deal. The combined companies made IBM one of the biggest players in cloud computing, immediately putting it in contention with Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT).

Red Hat’s hybrid cloud Linux software is used in data centers by 90% of Fortune 500 companies, and the company reported 2018 revenue of $2.9 billion (up 21% compared to the previous year). Investors may have been uncertain about the deal — IBM stock took a hit after it was announced last October — but the Red Hat purchase positioned IBM to take advantage of the growing cloud computing market. Anything that looks to the future is a positive for a tech giant that has struggled to compete in a rapidly changing IT world.  

That Red Hat acquisition officially closed on July 9 and the speed with which the deal cleared regulatory hurdles likely contributed to investor enthusiasm, helping to give International Business Machines stock a short-term boost.

Q2 Earnings Recap

IBM’s Q2 earnings were better-than-expected, but that doesn’t mean they were all good news for investors. Earnings-per-share came in at $3.17, beating estimates of $3.07 and its cloud computing division delivered revenue of $5.65 billion for 3.2% growth. While the company’s largest revenue division — Global Technology Services — saw its revenue decline to $6.8 billion, this was actually positioned as a positive. IBM says gross profit margin increased, as it is in the process of exiting from less profitable client relationships. Several segments saw double-digit revenue declines in the quarter, resulting in overall revenue of $19.2 billion being off 4.2% compared to last year.

So there was some good news in there that contributed to the July IBM stock price gains, but also some causes for concern once investors had time to digest the details.

Red Hat Expected to Pay Off in 2020 for IBM Stock

Despite the fact that the immediate boost from the closure of its Red Hat acquisition appears to have worn off, long-term prospects for IBM stock are stronger as a result. 

On Aug. 2, the company held an investor briefing where the impact of Red Hat to IBM’s bottom line was detailed, and it looks good. Here’s how the company summed up its expectations of what Red Hat will do to help growth, starting in 2020:

“Bringing all of this together, IBM expects an acceleration in its financial results in 2020 and 2021 – across revenue, operating pre-tax profit and free cash flow. The company expects mid single-digit revenue growth at constant currency. This will be led by the Cloud and Cognitive Software segment, which will accelerate to double-digit growth at constant currency in 2020 with the addition of Red Hat, and an improving services revenue growth profile while continuing to drive margin expansion. All of this is accomplished while the company maintains a strong balance sheet, reducing its debt levels and continuing its commitment to a growing dividend.”

Despite its August slump, the IBM stock price has still seen near 18% growth in 2019. And if its record-setting acquisition of Red Hat pans out the way IBM expects it to, that trend should continue in 2020 and beyond. 

As of this writing, Brad Moon did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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