How IBM Acquisition of Red Hat May Impact the Company

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Introduction

Merger & Acquisition is an important tool for growth and diversity. It tends to happens for strategic reasons to get competitive advantages and increase market share through better distribution of network. In tech industry, acquisitions are more common than initial public offerings. Through acquisition a company can add value to bottom line, quick access to new technology, distribution channels and a way to enhance competitive advantages to gain creative talent.

There are two types of companies’ e.g start-ups and developed companies. Normally the start-up company is acquired by the big company like small fish swallow by big fish. Therefore, to decide whether the acquisition brings fruitful results is a critical thing to analyze by both companies.

Companies choose to merge for several reasons including digital strategy, talent acquisition and entering into new market. The major reason of merger & acquisition is to increase firm’s value to work more efficiently. Mergers and Acquisitions are a key part of a corporate growth strategy. M&A support companies to enjoy competitive advantage and bigger market share and it will also increase firm’s capability through Research and Development. Capability can also be enhanced by buying a unique technology based company that is operating into same business through which Acquirer Company can easily penetrate in the target market at very short time rather than to start it from zero.

MA is also helpful for product and services diversification to gain competitive edge over others. By acquiring a same operating company will cut in cost and increase efficiency. This brings economies of scale where cost is lower and value increases and firm enjoys maximization in profit. Sometimes to grow in the rapid changing market a company has to perform M&A for its survival and existence in the global market.

No company can invent everything even Google and Amazon buy the start-up companies hence either it has to acquire or become partner with other company. Your customer helps you to understand what you need to buy. When you buy a company, you can negotiate everything except strategy and culture. Oracle is master of acquisitions but most of its merger failed due to cultural mismatch and lack of staff integration.

Wave of Technology-driven Mergers & Acquisitions

Tech is no more only for tech companies. A company cannot afford to ignore the impact of tech in their business from supply chains to customer satisfaction.

M&A appear to create waves that changes between the periods of high and low levels of activity. This is true in all industries including tech industry. Over the past 20 years it notices upward swings in M & A activity in tech industry.

The 1st was in the late 1990 and the 2nd in the mid to late 2000 prior to global financial crisis. M&A activity has picked up again over the past years. The recent pick up is even more noticeable when pending as well as completing deals is taken into account. The most important tech sector M&A reason is innovation in technology and future growth. Since 1990 there has been a significant expansion of M&A activity in tech sector. Many companies involved in the small and young set up acquisition. The main driver of acquisition is to acquire innovative skills, competitive technical knowledge and diversification. Large tech companies prefer to buy rather than to build.

Companies are looking for acquisition for future growth, market power and innovation in technology. The biggest driver of acquisition wave is the rapid change of new technologies in the fast-changing markets. Companies acquire knowledge, capabilities and technology to compete with their competitors. Over few years, technology driven merger and acquisition is in practice due to innovation in disruptive cloud, mobile, social and Big Data analytics technologies that comes with billion dollar transaction cost.

In tech industry, M&A activity is booming as companies seek innovative technologies and global expansion. Tech is the top sector for M&A with a year on year increase and second highest volume on record which is also the substantial chunk of the all other sectors. A rise in the tech M&A is considered to have multiple factors. Start-up tech companies are usually more innovative in cloud, wireless and analytics sectors followed by a new wave of innovative technologies. Large tech companies like Microsoft, Cisco and IBM have large amount of cash which enable them to make acquisition to keep them innovative in the long run.

The share of deal involving a tech company is rising very fast and approximately every one out of five deals is linked with tech industry and value of these deals is also greater. In contrast to other industries, where many acquisitions are aimed at market share or cost savings, the purpose of technology driven acquisition is innovation and talent.

Synergy Opportunities

The combined value of two firms is greater than the sum of the separate firm creates synergy. Therefore, synergy is very crucial when the right company merge together.

Operational synergies enhance operating income by achieving higher growth. Operational synergies can be achieved through M&A when two firms have competencies in two different areas such as research and development or marketing and production. It brings economies of scale, greater market share and power by reducing competition, combination of new skills and good product line and most importantly growth in the new markets. Operating synergies are achieved through horizontal, vertical or conglomerate mergers.

Strategic Synergy is used to indicate the added value of shared resources, improved operations and efficiency and new functionalities but more importantly it delivers strategic value to combined organization. Strategic synergy also helps organization to develop strategic perspective in terms of planning for gaining competitive advantages, market leader, increase revenue, deliver good ROI, corporate culture with growth and increase customer satisfaction.

IBM Purchase Motivation of Red Hat

IBM's four years flat share price clearly indicates the reason of acquisition. As per CEO & President of IBM Ms. Rometty” It changes everything about the cloud market”. IBM is new to Cloud and as per Q4 results indicated that IBM's system division sales dropped by 20%. By acquiring Red Hat IBM will be the prime leader in Hybrid Cloud market so this all about growth.

IBM annual revenues are just OK starting from 2015 to following years, IBM made $81.74bn in 2015, $79.92bn in 2016, $79.14bn in 2017 and $79.59 billion in 2018 which is pretty much same flat revenues for the consecutive 4 years while on contrary its competitors like Google starting from zero crossed $110bn over the same 20 years time. Microsoft from $15bn to $110bn and Apple from $6bn to $229bn. IBM is not growing relevant to its competitors like Microsoft Azure, AWS and Google Cloud over a few years due to the failure of IBM Watson.

IBM is not new in acquisitions, it acquired cloud infrastructure provider Softlayer in 2013 for $2 billion, following by the Weather Channel’s data assets for more than $2 billion in 2015 and in 2009 a biggest deal of Canadian business intelligence company Cognos for $5 B however, Red Hat acquisition for $34 billion that will be matured in last of 2019 is largest acquisition in IBM'S history and it's third largest acquisition in US tech history.

IBM needs an injection of innovation to smooth growth. IBM is serious about enhancing its position in the cloud market to remain relevant. Acquisition of Red Hat will opens a new dynamic in cloud wars between IBM, Google, Amazon and Microsoft. Adding Red Hat’s product mix into IBM will accelerate revenue growth for IBM as this is the prime business segment where Red Hat is making most of its revenue.

Together they have huge opportunity in terms of growth, profit and lifting IBM. IBM acquisition of Red Hat is the biggest open source business deal ever. Red Hat gives booster to IBM' efficiency in Open Source and Cloud DNA. Acquisition of two companies will help hybrid cloud and open source synergies. Both companies have a strong track record of creating and developing to OSS Projects but Red Hat is most successful in Linux operating system. IBM is struggling to keep up with Amazon, Microsoft and Google in the public cloud market.

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Companies are moving from OSS to Open Source System therefore IBM is also in need of this survival system for continuous growth. IBM motive of this deal is to gain revenue growth because most of its legacy businesses revenue is flattening. The primarily motive is to make IBM the Number 1 Hybrid Cloud Company which has a projected market of $ 1 trillion by 2020.

Red Hat gains money by charging support, system integration and training with some other premium features. By this acquisition IBM will get a chance to cross sell its product to Red Hat customers and offer Red Hat Cloud system to its existing customers in order to generate revenue synergies.

The investment in Red Hat will open a new chapter for IBM as this is the biggest acquisition IBM ever made in its 100 year dwarfing Microsoft’s 2016 LinkedIn acquisition and Facebook’s takeover of WhatsApp in 2014.

How Red Hat Fits in to IBM Business

IBM is a company of companies which need Red Hat's talent pool. Red Hat acquisition enable IBM to get a strong hold on leading Kubernetes, Hybrid Cloud and Open Source ecosystem that is difficult to achieve separately. IBM is looking to diversify its hardware and consulting business into products and services business.

IBM encourages focusing on positive actions that improve innovation, capability and skills development training. Red Hat is expected to bring four things to IBM High Value business model: The World’s largest portfolio of open source technology. Innovation in hybrid cloud platform. Vast open source developer community. By alignment of both companies business model they can achieve financial goals.

Red Hat has the opportunity of cultural dilution with IBM, a company that been innovative, open source, moves this conglomerate large kind of slow the company. Buying Red Hat fits into IBM business model through support, expertise and technology. Red Hat is spending 2% on Research and Development while IBM only 7% will also provide growth opportunity into IBM business model. Red Hat will remain Red Hat and continue its operations within IBM model as a natural distinctive independent unit to sell across the platforms. IBM is necessary looking to resetting Cloud landscape and Red Hat has always been advance in Cloud computing.

Together with the merger, the both companies can make cross selling to each other’s customers and combination will bring power house that is purely open source where IBM is lacking of. IBM needs competencies and new technology and Red Hat can bring their Linux and other portfolio technologies. Red Hat has the technology but not their own Cloud and IBM is working on Cloud for many years. IBM is also seeking to adopt Red Hat open source culture within IBM. The main focus is that Red Hat will continue to operate independently as a standalone entity within the IBM ownership the culture, company roadmap and day to day operations. As per Red Hat CEO Mr. Jim Whitehurst: “we will keep doing great things but with the financial, marketing, and sales muscle of IBM and IBM is seeking that injection of fresh people, fresh ideas, and fresh technology”.

Deal Financials, Valuation Model & Share Movement

Red Hat is a major market player in Linux and Open Source world with track record of continuous growth in sales and IBM is slow growth company, not doing anything in the space really need this deal.

On 28th October, IBM, which has a market capitalization of $114 billion announced to acquire Red Hat for $34 Billion OR $190.00 per share in cash to Red Hat, the deal price is equal to 7.7 times Red Hat's fiscal 2020 (ends in Feb. 2020). That is a 63% premium on its 20 year partner that makes $116.68 per share. Prior to this deal, Red Hat had a market capitalization of about $20.5 billion. The deal is expected to close in second half of 2019. There is 8.11% deal spread. The company intends to close the transaction through cash, credit and bridge line. The combination will not add to free cash flow immediately. But cost savings are not the point.

IBM is expecting the deal will increase in growth rate by 200 basis points per year for next several years. Its massive amount to pay a company whose annual revenue is $2.9b in 2018. JP Morgan & Stanley is the financer of the deal and the deal is significantly affects IBM capital structure. IBM will borrow $20bn to fund its takeover of open source software pioneer Red Hat. IBM is not rich with Cash like its competitors Google or Apple or Microsoft because it has $12bn in cash and $46bn in debt (that is used to operate global business units). IBM spent $100bn to buy its own shares with the fact that since 20 years IBM is continuously increasing dividend payment which is more than 4% annual yield.

IBM took a massive amount of debt which restricts its future option and makes themselves a risky company for any unseen events like US recession and interest rate deterioration. With such high cost of acquisition IBM will be under pressure to maintain $3 billion per year to meet the required rate of return over next five years. IBM will also suspend to share repurchases in 2020 and 2021 for payments to Red Hat but will not touch dividends. This pause of repurchase is for cautionary measure as the company plans to return to normal leverage into 2 years. According to U.S. Securities and Exchange Commission: If Red Hat accepts a competing offer then its liable to pay a breakup fee of $975 million to IBM and also restricts Red Hat to look for any other acquisition proposals.

There are two valuation models are used for valuation e.g relative and absolute valuation model. The absolute valuation models are used to calculate the true value of dividends, cash flow and growth rate of a company while relative valuation models are used to compare the similar companies by calculating price-to-earnings ratio, dividend ratio and growth ratio.

For target companies valuation of Red Hat relative valuation model will be used. The relative valuation model is used of the lack of absolute financial information.

According to macrotrends statistics the P/E ratio of Red Hat is on highest level $119.84 as of 28th October, 2018 after the deal was announced. That is a 63% premium on its 20 year partner that makes $116.68 per share. This shows how normal it is in tech industries to pay high premium price for their target companies.

Red Hat has a profitable business around $3 billion a year in sales. Company growing at 20% annually by providing software and approximately $1 billion in FCF (free cash flow) making the purchase price 33x FCF. That looks high and a company whose growth rate is 20% doubles its revenue in 3 and half years or over the time so the FCF would most likely be double. As a comparison, IBM has approximately $14.5 billion in cash and short term vehicles on its balance sheet.

According to financial statement of Red Hat has an increasing trend of Earnings before Interest and Tax (EBIT) from past 3 years for an increase of 42% from 2017 to 2018. That clearly indicates that Red Hat is a good target company for IBM for consistent innovation in cloud computing and open source technology that will enhance market share of IBM.

IBM is facing slow growth and decline in share price in the recent years which means company is losing its market position over its competitors. The acquisition is all about hybrid clouds as the cloud segment is growing businesses for IBM. Within recent 5 years IBM shares have lost a third of their value while on contrary Red Hat shares are up 170 percent over the same period.

IBM purchase price 34B is pretty high though but all cash transaction is a good option for IBM because Red Hat share price is 1/3 low in value due to the missing of summer earning and technology sell off. A stock offer will also dilute for shareholders and by considering IBM taking low debt combined with free cash flow will maintain company’s debt on reasonable level. IBM.However, IBM has to prove a fast profitability growth in its cloud environment to justify the huge acquisition cost.

Red Hat share are not exactly at $190 price so this will need regulatory approval before going ahead. Shareholders of both companies already gave their approval in January. After the announcement of the deal came by 29th October 2018, Red Hat share price increased by 47% from ($52.88 to $169.56) that is all time high while IBM’s fell down by over 5% to $119.64. Earnings adjusted for one-time gains are 96 cents per share for Red Hat. That is of $94.5 million.

Conclusion

Although M&A has expanded in recent years but most of their results bring disappointment. The main factor is the complexity of the M&A process and structure, culture of the two companies.

Although the deal is not cheap with risks, execution and cultural difference but still Red Hat acquisition by IBM is a good strategic fit for IBM that could help IBM expand into emerging IT industry and change its struggling phase. This deal is justifiable because the combination will make IBM world's No.1 hybrid cloud provider which has a $1 Trillion emerging market. They will have huge commercial opportunity in terms of new clients, penetrating into new market, earn high profits and it’s all about lifting IBM stagnant growth.

IBM acquisition of Red Hat will indeed be a game changer for IBM. It makes sense because both companies are already not strangers and through this acquisition they established a long-term partnership in hybrid cloud therefore IBM can offer cross selling to Red Hat customers and vice versa. IBM can also strengthen its cloud computing system for enterprises. Red Hat knows how to drive revenue from Open Source System. Tech sector’s M&A involved high level of growth and uncertainty. As the deal is not completed close yet hence for this reason, it is quite difficult to predict future implication of IBM acquisition of Red Hat. Apparently, to compete in the cloud market IBM needs Red Hat for its survival which shows a positive impact on IBM.

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