IBM Corp. (IBM, Financial) announced it is buying Red Hat (RHT, Financial), a major distributor of open-source software and technology, in an all-cash deal valued at $34 billion.
The deal, which is IBM's biggest ever, is CEO Ginni Rometty's attempt to revive growth and boost revenue while leveraging on the growing demand for cloud space. In addition, the 107-year-old computer giant will go head head with the likes of Amazon (AMZN, Financial) and Microsoft (MSFT, Financial), who have made great forays into the cloud space.
Red Hat will become a unit of IBM’s Hybrid Cloud division. Jim Whitehurst, the company's CEO, will continue to lead the business as well as become part of IBM’s senior management.
While IBM’s stock had suffered a 1.5% decline at the time of writing, shares of Red Hat surged nearly 48%.
While some investors may question the immensely high premium paid for the company, Rometty said Red Hat’s tech tools will help businesses split their competing work among multiple data centers and be a game changer in the segment. It will be using Red Hat’s enhanced version of the Linux operating system to help companies bridge data centers with cloud computing.
The main concern, however, is IBM’s late entry into the market. Market leaders, including Amazon, Microsoft and Alphabet (GOOGL, Financial), all have a head start. Red Hat’s market positioning, however, does provide IBM with enough leverage to achieve strong revenue growth numbers.
Moreover, while free cloud offerings are available, they are generally rigid and do not provide users with the flexibility to use them across different platforms. This is where Red Hat differentiates itself, providing a standard version of Linux that runs on commonly available clouds as well as a business' own data center for a small fee.
Since Rometty become CEO in 2012, the company has witnessed steep revenue declines. It has been competing with new-age companies in the existing hardware, software and services segments. Rometty, however, seems to be embracing the change as she tries to expand IBM’s service offering to modern businesses to leverage the growing demand for artificial intelligence and cloud computing.
In regard to earnings, the company disappointed investors in the third quarter as revenues fell 2.1% to $18.8 billion, shy of analyst expectations of $19.1 billion. As a result, shares suffered the biggest decline in four years. Regardless, given the latest deal, the outlook seems rather convincing.
Looking ahead, Rometty believes that despite multiple players in the space, the anticipated demand won’t be filled even after IBM comes to full capacity.
While certain industry estimates suggest total spending in the cloud infrastructure services market was up an estimated 45% from last year, the industry scenario still seems rather appealing. Not to mention, astronomical growth rates can’t go on forever.
Coming to valuation, IBM seems to be trading at a relatively attractive level currently. It floats a price-earnings ratio of 19.8 as compared to the industry median of 27.75. Moreover, its forward price-earnings ratio makes it look grossly undervalued at 8.93. The industry median is 25. The company also has an operating margin of 16.23%, above the industry median of 5.13%.
All told, while investors are worried about the price tag of the deal, Red Hat’s competitive advantages are expected to help position IBM as a strong player in the cloud segment.
Disclosure: I do not own any of the stocks mentioned.
Read more here:
