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2 November 2018

IBM breaks out checkbook in record $34bn for Red Hat

You will have heard of IBM’s acquisition of Red Hat, priced at a 61% premium over closing share prices. This is either a move to snatch a leader and then aggressively scale it, returning multiple dollars in future business for each dollar spent now, or it’s a big gamble with a lot of risk. Your view will depend on your opinion of IBM leadership, but one wonders the rates one would get sticking that kind of cash in the bank.

To some extent, this is IBM moving to counter Dell EMC and its VMware wing, to shore up core business while it tries to prove that there’s big money to be made in AI and blockchain (the two buzzwords that have thankfully stolen the marketing-term-du-jour title from the IoT).

For sure, there’s heaps of money to be had in open source, as seen in Hortonworks and Cloudera’s merger, which created a $5bn firm, focused on analytics and machine-learning -admittedly a different area to IBM and Red Hat. This has been a very good deal for Red Hat shareholders.

IBM is far from an enemy of open source, but it is not well-liked in the open source community. It has a similar reputation in the rest of the technology world, and you don’t have to scroll far to find disparaging and hostile comments about Big Blue, whenever it is mentioned in the news. CEO Rometty frequently gets it in the neck, and this monster buy will certainly distract attention from the poor performance of the company’s stock under her tenure.

Fears of culture-clash have been addressed by leadership, with Rometty saying “I want to preserve its brand and its culture. It is very clear to us what horizontally stays neutral.”

IBM’s SVP of Hybrid Cloud, Arvind Krishna, said that he had no intention of interfering with the Red Hat roadmap, that there was “no value-add in trying to change that.” Red Hat’s EVP and President of Products and Technologies, Paul Cormier, added that the biggest change will be the much larger sales channels. “We’re still a relatively small company. We can’t ramp up to the full potential of that customer demand.”

It looks like IBM is paying essentially ten-times Red Hat’s annual revenue, which would be a pretty standard multiple in a transaction a couple of orders of magnitude smaller. At this scale, it’s a huge amount of money to pay to simply add a little over $3bn in sales to your sheets, which is indicative of the potential that IBM sees in Red Hat. This is by far the largest IBM acquisition; an order of magnitude larger than Truven ($2.6bn) and The Weather Company ($2bn).

In order to pull this off, IBM needs to be able to take all of the sales channels that Red Hat has fostered, and sell IBM products into them. In turn, IBM will be looking to sell the well-respected Red Hat offerings into its much larger channels. Hopefully, IBM has crunched the numbers, and its projections should provide a big upside.

Our initial response to the price was to wonder how much it would cost to hire enough engineers to replicate what Red Hat was doing with its open source offerings. It would be a fraction of the Red Hat revenues, but of course, it would lack the Red Hat brand – which is definitely worth quite a bit. We wonder if IBM considered SUSE or Canonical, too.

But while IBM promises that Red Hat will continue as a brand, there’s a good deal of hostility out there to Big Blue’s takeover – with rampant fears that it will gut Red Hat, run it into the ground, and drive the key talent away. For what it’s worth, a number of public Red Hat figures have been quite positive about the deal, but then, at that ~61% premium, they would be if they held shares.

So, IBM is planning on sticking Red Hat inside its Hybrid Cloud wing. It will likely come in handy as IBM tries to haul its existing customers into the cloud-era. IBM still makes good money selling mainframe computers, and while many enterprises have experimented with cloud options, adding Red Hat lets IBM better offer a full suite – covering on-premises where needed, public cloud, private cloud, and also the hybrid cloud options that are essentially virtualized private clouds (where some single-tenant private cloud resources are cooperating with public cloud deployments).

To some extent, Red Hat lets IBM get more out of selling digital transformation services to enterprises that are too big to do things internally. IBM made a very big song and dance about its Watson suite, of systems that it says are augmented with its famed AI technologies, but Watson seems to be underperforming. Hybrid Cloud is something that companies need now, while Watson is something they might not want to commit to, yet.

IBM servers running RHEL will soon be a pretty standard offering, and maybe IBM’s Power CPU architecture might become more prominent in the Linux world. But if IBM wanted an operating system to sling with its server racks, it didn’t have to buy Red Hat.

It could have licensed it, and paid for support, taking that burden from end-customers perhaps, or it could have simply tasked engineers with using Fedora or CentOS – the latter of which was bought by Red Hat for around $250mn recently, but which still has an open source version. The biggest addition is OpenStack, a project for which Red Hat is a chief steward, which is an open source management stack that lets vendors serve VMs to customers using pooled resources. Also of note is its OpenShift service, a container management tool for Kubernetes.

Collectively, these tools let it better compete in private and hybrid cloud bids. For public cloud, IBM is still miles behind Amazon’s AWS, Google’s Cloud Platform, and Microsoft’s Azure. However, many decision makers remain very skeptical of multi-tenant public cloud environments, and so that might not be such a pressing inadequacy for IBM. It is happy to play in the private and hybrid world, and ship gargantuan mainframes to those who can’t be persuaded otherwise.

Initial figures show that Red Hat would add around 4.2% to IBM’s total revenues, as well as an extra 8.2% to its free cash. Red Hat’s biggest unit, Infrastructure Software and Support, accounted for $1.95bn in the last full-year earnings (posted in February). The second of the three units, Application Development, accounted for $624mn, and Training and Consultancy billed $346mn. Subscriptions are growing at around 20% annually, and profit for those four quarters was $259mn.

IBM CEO Ginni Rometty said that the acquisition is a game-changer. “It changes everything about the cloud market. IBM will become the world’s number-one hybrid cloud provider, offering companies the only open cloud solution that will unlock the full value of the cloud for their businesses.”

Red Hat CEO Jim Whitehurst said “joining forces with IBM will provide us with a greater level of scale, resources and capabilities to accelerate the impact of open source as the basis for digital transformation and bring Red Hat to an even wider audience – all while preserving our unique culture and unwavering commitment to open source innovation.”