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IBM to Enhance Hybrid Cloud Platform With $34B Red Hat Buy

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International Business Machines Corporation IBM recently entered into a definitive agreement to acquire Red Hat, Inc. RHT for approximately $34 billion in cash.

The company anticipates Red Hat buyout to improve its revenue growth, free cash flow and gross margin within 12 months of completion. IBM also anticipates Red Hat buy to aid it in sustaining robust dividend growth.

With the buyout, IBM intends to provide enterprises with market leading hybrid cloud platform enabling them to shift their business applications seamlessly to the cloud.

In the words of IBM’s chairman, president and CEO, GinniRometty, "IBM will become the world's #1 hybrid cloud provider, offering companies the only open cloud solution that will unlock the full value of the cloud for their businesses.”

Per IBM’s research, “80% of business workloads have yet to move to the cloud, held back by the proprietary nature of today's cloud market.” IBM intends to bridge the space by enabling data portability and data security across multiple cloud platforms on the back of the buyout.

The acquisition is subject to Red Hat shareholders nod and other customary regulatory approvals.

IBM anticipates completion of the deal in the latter half of 2019 through a combination of cash and debt. Consequently, Red Hat shareholders will obtain $190.00 per share in cash, approximately 62.8% premium over the $116.68 price on Oct 26, 2018 after market close.

Following the news, IBM’s shares were down almost 5% in pre-market trade, while that of Red Hat went up approximately 51%. Notably, shares of IBM have lost 17.3% year to date, compared with the industry’s decline of 11.8%.



Analyzing Cash & Debt Position

IBM ended third-quarter 2018 with $14.70 billion in total cash and marketable securities compared with $11.93 billion at the end of second-quarter 2018. Total debt (including global financing) was $46.9 billion, up $1.4 million from the previous quarter.

IBM reported cash flow from operations (excluding Global Financing receivables) of $3.1 billion and generated free cash flow of $2.2 billion in the third quarter.

In the third quarter, the company returned $2.1 billion to shareholders through dividends and share repurchases. At the end of the third quarter, the company had $1.4 billion remaining under current buyback authorization.

Meanwhile, Red Hat does not have any long-term debt. The company reported total deferred revenue balance of $2.4 billion, up 17% year over year at the end of the second quarter of fiscal 2019.

With the agreement announcement, IBM noted that it plans to shelve its share buyback program in 2020 and 2021, and aims to maintain a leverage profile steady with a mid to high single A credit rating.

Major Takeaways

The integration of Red Hat into IBM’s Hybrid Cloud is anticipated to be smooth, given both the companies allegiance to hybrid cloud and Linux. Moreover, both the companies have been partners for the past 20 years.

Post the buyout, IBM noted that Red Hat will join IBM's Hybrid Cloud team as a separate entity. Further, Red Hat will be led by its current CEO, Jim Whitehurst, who will join IBM's senior management team. Under IBM’s umbrella, Red Hat's headquarters, facilities, brands and practices will remain unaltered.

IBM and Red Hat will also continue to enhance Red Hat’s partnerships with the likes of notable cloud providers. These include Amazon’s (AMZN - Free Report) Amazon Web Services, Microsoft’s MSFT Azure, Alibaba Cloud, Alphabet’s Google Cloud, among others, apart from IBM Cloud.

With the closure of the deal, Red Hat is expected to expand its business globally by leveraging IBM’s enterprise IT scale.

Strengthening Hybrid Cloud: A Masterstroke?

IBM’s recent third-quarter financials were mixed. Notably, revenues of $18.76 billion lagged the Zacks Consensus Estimate of $19.10 billion and declined 2.1% on a year-over-year basis. At constant currency (cc), revenues remained flat.

The company’s focus on Watson and mainframe business isn’t paying off at the pace investors anticipate it to. However, IBM Cloud remains the key to winning back investors’ optimism regarding strength in company’s business model.

In fact, in the third quarter, cloud revenues surged 13% from the year-ago quarter to $4.6 billion. The annual run rate for cloud as-a-service revenues increased 24% at cc on a year-over-year basis to $11.4 billion.

We believe IBM’s attempt to bolster its hybrid cloud business is likely to pave the way for the company’s growth prospects. The company estimates the value of its hybrid cloud business at $19 billion.

Notably, the pioneer of the open source development model, Red Hat is leaving no stone unturned to expand its Red Hat Enterprise Linux (“RHEL”) customer base and exposure to hybrid cloud infrastructure. Red Hat noted that its total addressable market (TAM) is more than $66 billion in size, with significant exposure to Middleware, OS and Cloud management.

Red Hat’s OpenStack (uses RHEL to scale infrastructure across hybrid cloud) is a key catalyst. In fact, Red Hat reported revenues of $822.7 million in second-quarter fiscal 2019, which increased 13.7% year over year, primarily driven by strong demand for hybrid cloud technology solutions and aggressive cross-selling.

Apart from the aforementioned factors, Red Hat’s expanding foothold across Asia Pacific is also anticipated to boost IBM’s TAM post buyout.

Conclusion

We anticipate Red Hat’s addition to IBM Hybrid Cloud business to aid IBM to revive its fortunes and pave the way for a robust and secure hybrid cloud infrastructure. Notably, the $34 billion deal is one of the notable software based acquisitions, surpassing Microsoft’s LinkedIn buy for $26.2 billion.

The deal is anticipated to pep up the cloud war since IBM’s Hybrid Cloud is poised well to gain from sturdy business model of Red Hat and its robust capabilities in providing hybrid cloud technology solutions.

Zacks Rank

IBM carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

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