Morningstar | IBM Doubles Down on Hybrid Cloud Strategy, Announces Acquisition of Red Hat; Shares Undervalued
IBM announced that it had reached a definitive agreement to acquire Red Hat for $190 per share, or $34 billion in enterprise value. We expect the deal to be funded through a mixture of cash and debt while IBM also suspends its stock buyback program for fiscal 2020 and 2021. We see some strategic rationale in favor of IBM's planned acquisition and believe there can be scale-related revenue synergies based on cross-selling opportunities. However, we think IBM has been backed into this position and needed an acquisition of this magnitude and nature to reinvigorate its growth profile and competitive positioning after years of lagging performance versus peers. As the world becomes increasingly cloud-focused, the hybrid cloud boost IBM will receive from the Red Hat acquisition will be supportive and at least give IBM a fighting chance against other cloud providers. We see Red Hat as an open-source sales catalyst for IBM across its own (and competitors) infrastructure-as-a-service, platform-as-a-service, and hosted private cloud environments, but still see IBM as an also-ran versus peers in the infrastructure and platform markets. After incorporating the acquisition into our model, we are lowering our fair value estimate for narrow-moat IBM to $158 per share from $168, as we're concerned about whether IBM will extract enough revenue synergies to justify the deal price. Nonetheless, IBM's shares remain undervalued, in our view.
In terms of the financial aspects of the deal, we view a 63% premium as a bit high compared with recent software deals and above our $145 fair value estimate for narrow-moat Red Hat. The deal is expected to close in the second half of 2019, and we do not foresee any regulatory hurdles. Rumors suggest that IaaS leaders like Microsoft, Google, or Amazon may try to outbid IBM for Red Hat, but we suspect that Red Hat's Enterprise Linux (RHEL) operating system is best served under IBM’s mammoth services divisions.
We are not concerned that Red Hat could change its cloud-neutral stance or "freemium" model, as IBM’s recent announcements have stressed the value in Red Hat being a cloud-neutral Linux OS compared with the likes of Amazon Linux. Ultimately, we think the deal will see synergies from cross-selling, especially in IBM’s private cloud business where IBM would expect to pick up customers by way of Red Hat’s OpenShift container management platform.
IBM expects to fund the deal with cash and debt, and we expect the firm to issue new debt to help close the deal, cover short-term debt, and keep some cash on hand. To help alleviate any potential liquidity issues, IBM also expects to suspend its share buybacks in fiscal 2020 and 2021, which we incorporate in our financial model. After accounting for Red Hat’s financial impact, we now view IBM’s midterm top-line growth rate in the low single digits (2.8% five-year revenue CAGR) as we see Red Hat continuing to grow its revenue in the midteens during this time frame. Further, we expect gross margin accretion in year one of the closing and EPS accretion by the end of year two, according to management commentary on the deal. Red Hat will be funneled into IBM’s Hybrid Cloud division.
On an enterprise value/sales basis, IBM is paying roughly 10 times Red Hat's fiscal 2019 sales, which looks a little high relative to past technology deals and for a company expected to grow at a 15% five-year CAGR. Still, Red Hat is a more mature, and profitable, business as our prior projections for stand-alone Red Hat were for 16.5% GAAP operating margins for fiscal 2019 (24% on an adjusted basis).