Will Big Blue’s New Red Hat be a Good Fit?

Posted on by Nicholas Cagle

On October 28, 2018, IBM announced its plan to acquire software developer Red Hat for $34 billion in cash. If the deal goes through, it will be the second largest in industry history1 and the largest deal in IBM’s 107 years of operation.2

This announcement continues a tremendous winning streak for mergers and acquisitions. The value of 2018’s software M&A sector in the United States reached $138.3 billion as of the end of the third quarter—a record breaking high.3 The IBM/Red Hat deal accounts for nearly a quarter of that value. Globally, the software M&A sector reached a value of $187 billion in the third quarter. 4 In short, 2018 was a big year for merger and acquisition deals, and even among many notable announcements, IBM’s acquisition of Red Hat stands out.

Red Hat is a multinational software company based in Raleigh, North Carolina. The company sells open source software and services. Red Hat is perhaps best known for its program Red Hat Enterprise Linux, a Linux-based operating system intended for commercial use. But it is the company’s cloud service that has been getting the most attention lately, and IBM has focused its attention specifically on Red Hat’s hybrid cloud services. With this acquisition, IBM hopes to revitalize its involvement in the cloud computing sector, which the company had moved away from in recent years. That makes this deal a pivotal moment for IBM, which has been struggling to find its place in a changing industry. IBM CEO Ginni Rometty remarked, “We’ve been reshaping IBM for this moment.” Rometty has not made a lot of significant moves since stepping into her current role, and she seems to be staking her legacy on this deal.5

The deal will likely close in the second half of 2019. When it does, Red Hat will be incorporated into IBM’s hybrid cloud business unit.6 To close the deal, both IBM and Red Hat need approval from their respective board of directors, which each company has already easily secured. Red Hat also needs approval from its shareholders, and the deal will need to be approved by government regulators. Because IBM is paying such a substantial premium for Red Hat stock, approval from Red Hat’s shareholders was considered almost a foregone conclusion when the deal was announced. While Red Hat shareholders have now approved the deal, approval from government regulators is still pending.7 There are not any immediately apparent regulatory red flags and IBM CEO Ginni Rometty has remarked that she sees no regulatory inhibitors to the closing of this deal.8 But this might not be as simple as Rometty suggests. Because Red Hat is a multinational company, the deal will likely require international approval. In addition to regulatory industries such as the United States Department of Justice and the European Commission, the deal might need approval from regulators in China. But Chinese law requires review of a merger only in certain instances, such as if the company makes enough of its revenue in China.9 Given the nature of its business Red Hat believes it will not require Chinese approval.

There is plenty that could happen between now and the second half of 2019. Markets will continue to react, which may affect how each company views this deal. Under current terms, IBM will pay $190 per share in cash to acquire Red Hat.10 That represents a 63 percent premium on Red Hat’s value as of market closing on the Friday before the deal was announced.11 Perhaps it is not surprising the announcement of the merger—and the price IBM will pay—drove up Red Hat’s stock considerably. On Friday, October 26, Red Hat’s stock price was $116.68 per share. The deal was announced that Sunday. The next day, the stock closed at $169.63 per share—a 45% increase in price per share. Clearly this was a good day for Red Hat’s stock. IBM’s premium at $169.63 per share would be 12 percent. As of September 30, 2018, IBM had $11.6 billion in cash.12 IBM will need to finance this deal with both cash and debt.

Some commentators have praised the deal as a great move for Big Blue citing the tremendous potential for synergies. 13 Recently, Cloudera CEO Tom Reilly called IBM’s acquisition of Red Hat’s cloud computing infrastructure, in lieu of trying to build its own, a “brilliant” move.14 Historically, IBM and Red Hat have been competitors in “operating system offerings . . . middleware system offerings . . . cloud technologies . . . services related to the development, deployment and integration of enterprise technologies.”15 The acquisition benefits IBM from both a horizonal and vertical integration perspective. But others have taken a more critical tone and suggested that this move implies IBM is desperate to regain its foothold in a market that has been moving on without it.  Some market commentators have suggested IBM overpaid for Red Hat’s stock.16 IBM has experienced declining revenue for the past five years17 and the size of this deal presents a significant risk for a company that has been struggling. Even so, those critical voices do not necessarily consider a desperate move to be a bad one.18 These critics recognize the potential benefits to the company and most of their concern comes from the nature of the risk and what such a bold move might say about deeper issues with the company’s long-term viability.

Initially, the deal did not attract a large number of investors and some worried it would not be able to do so.19 Some of the concerns over the merger were specific to the deal—such as the size of the premium and the need to take on debt to finance the deal—while others are based on external concerns. Recent technology sell-offs coupled with the deal’s long timeline contributed to skepticism.20 Another concern is that the deal might get tied up in China amid a trade war with the Trump administration.21 Considering these risks, the would-be investors need to balance the risk involved with the difference between the market value and the potential payout. But since the deal was announced, investors have started showing up and the stock prices for both Red Hat and IBM have continued to rise. Even Warren Buffet recently purchased stock in Red Hat.22

Red Hat might receive other offers as the time progresses which could reshape or even kill the deal. But there is plenty of incentive for Red Hat to follow through with IBM. The terms of the deal prohibit Red Hat from soliciting any other acquisition proposals. Moreover, filings with the SEC state the breakup fee for the merger as $975 million.23 The breakup fee combined with the already high premium IBM is paying on Red Shares make another offer unlikely, but as the deal continues to look better for IBM, other buyers might begin to show up.

Regarding Red Hat’s future value, there is some concern over whether the company will be able to maintain the culture that has led to its present success. Red Hat is a company of engineers, whereas IBM is more business focused. This potential culture clash may inhibit IBM’s ability to realize the potential synergies of the merger. Red Hat employees, particularly those who previously worked for IBM, have pointed to IBM’s previous acquisitions and expressed concern over what they see as a disappearance of the pre-merger workplace culture in the acquired companies. Leadership in at both Red Hat and IBM have sought to assure Red Hat employees that such concerns are unwarranted.

Potential antitrust issues are something to keep an eye on as the deal moves forward. Both IBM and Red Hat claim their businesses are complementary, not competitive. While IBM acquiring Red Hat in large part because of its hybrid cloud business, IBM had a hybrid cloud business of its own before the merger was announced. In SEC filings, Red Hat has referred to IBM as a competitor in the cloud computing field. But IBM’s hybrid cloud division is a relatively new segment of the company—a factor which regulators will surely consider. Moreover, major companies such as Amazon and Microsoft are already involved in cloud computing and have substantial resources to compete with the likes of IBM.

Despite some early market concerns and a slow start to investor confidence, IBM is moving ahead with excitement. From the onset of this transaction, Rometty has expressed confidence that there is great potential in the cloud-based computing market. In a phone call with analysists and the press, she remarked that only 20 percent of enterprise workloads have currently been moved to the cloud. Rometty believes the value of this market could be as much as 1 trillion by 2020.24 “Red Hat on its own has been a high value company and has done a great job with strong growth, is highly profitable and generates cash. There are not many companies out there that look like that in this area,” remarked Rometty.25 As the deal moves forward, the general outlook from the market has evolved from skepticism to cautious optimism. There are likely to be many twists and turns before this deal is finalized. But because of the size of this deal and the potential industry impact, it is worth keeping an eye on Big Blue’s acquisition of its new Red Hat.

  1. Gerrit De Vynck, IBM’s Rometty Stakes Legacy on Risky $33 Billion Red Hat Deal, Bloomberg (Oct. 30, 2018), https://www.bloomberg.com/news/articles/2018-10-30/ibm-s-rometty-stakes-legacy-on-risky-33-billion-red-hat-deal. ↩

  2. Jordan Novet, Here’s How Red Hat Can Help IBM in the Cloud and Beyond, CNBC (Oct. 29, 2018), https://www.cnbc.com/2018/10/29/heres-how-red-hat-can-help-ibm-in-the-cloud-and-beyond.html. ↩

  3. Nick Ismail, Breaking down the IBM/Red Hat Deal in the Context of the Software M&A Space, Information/Age (Oct. 31, 2018), https://www.information-age.com/ibm-red-hat-deal-123476041/. ↩

  4. Id. ↩

  5. Giles Turner, Why Red Hat’s Open-Source Cloud Is IBM Game Changer, Bloomberg (Oct. 29, 2018), https://www.bloomberg.com/news/articles/2018-10-29/why-red-hat-s-open-source-cloud-is-ibm-game-changer-quicktake. ↩

  6. Caroline Donnelly, The IBM and Red Hat Mega-Merger: Who Stands to Benefit Most?, ComputerWeekly (Nov. 1, 2018), https://www.computerweekly.com/news/252451840/The-IBM-and-Red-Hat-mega-merger-Who-stands-to-benefit-most. ↩

  7. Kurt Pollet, Red Hat Merger: Good Deal for Investors with Time Frames Under 10 Years, Seeking Alpha (Feb. 20, 2019), https://seekingalpha.com/article/4242391-red-hat-merger-good-deal-investors-time-frames-10-years. ↩

  8. Avi Salzman, Red Hat Stock Points to Wall Street’s Worries Over the IBM Deal, Barron’s (Oct. 30, 2018), https://www.barrons.com/articles/red-hat-shares-point-to-wall-streets-worries-over-ibm-deal-1540920513. ↩

  9. Id. ↩

  10. Benjamin Horney, 3 Firms Steer IBM’s $34B Red Hat Acquisition, Law360 (Oct. 28, 2018) https://www.law360.com/articles/1096434/3-firms-steer-ibm-s-34b-red-hat-acquisition. ↩

  11. Ron Miller, Assessing IBM’s $34 Billion Red Hat Acquisition, TechCrunch (Oct. 29, 2018), https://techcrunch.com/2018/10/29/assessing-ibms-34-billion-red-hat-acquisition/. ↩

  12. Salzman, supra note 7. ↩

  13. Bill Zettler, No, IBM Did Not Overpay for Red Hat, Seeking Alpha (Nov. 5, 2018), https://seekingalpha.com/article/4218401-ibm-overpay-red-hat. ↩

  14. Jonathan Vanian, Cloudera CEO Talks Hortonworks Merger, IBM Acquiring Red Hat, and A.I. Hype, Fortune (Feb. 15, 2019) http://fortune.com/2019/02/15/cloudera-hortonworks-ibm-redhat-ai/. ↩

  15. United States Securities and Exchange Commission, Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, Red Hat, Inc., https://www.sec.gov/Archives/edgar/data/1087423/000119312515153023/d836093d10k.htm. ↩

  16. See Mark Albertson, Straight takes: Ray Wang weighs in on IBM, Red Hat, Salesforce, Google and Amazon, SiliconANGLE (Feb. 25, 2019 3:30 P.M.), https://siliconangle.com/2019/02/25/straight-takes-ray-wang-weighs-in-on-ibm-red-hat-salesforce-google-and-amazon-think2019-guestoftheweek/. ↩

  17. De Vynck, supra note 2. ↩

  18. Eric Jhonsa, IBM’s $34-Billion Deal for Red Hat Is a Calculated Swing for the Fences, TheStreet (Oct. 29, 2018), https://www.thestreet.com/opinion/ibm-deal-for-red-hat-swing-for-the-fences-14761008. ↩

  19. See David McLaughlin & Joshua Fineman, IBM-Red Hat Deal Leaves Steep Premium as Merger Funds Stay Away, Bloomberg (Oct. 29, 2018), https://www.bloomberg.com/news/articles/2018-10-29/ibm-red-hat-deal-leaves-steep-premium-as-merger-funds-stay-away. ↩

  20. Id. ↩

  21. Id. ↩

  22. See Crystal Kim, Warren Buffett’s Berkshire Hathaway Sells Oracle Stock, Buys Red Hat, Cuts Apple, Barron’s (Feb. 14, 2019 5:53 P.M.), https://www.barrons.com/articles/warren-buffetts-berkshire-hathaway-still-hearts-apple-51550184810. ↩

  23. Dina Bass, IBM Acquisition of Red Hat Has $975 Million Termination Fee, Bloomberg (Oct. 29, 2018), https://www.bloomberg.com/news/articles/2018-10-29/ibm-acquisition-of-red-hat-has-975-million-termination-fee. ↩

  24. Miller, supra note 10. ↩

  25. Id. ↩

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