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Morningstar | IBM Bids To Acquire Red Hat To Boost Hybrid Cloud Division; We See Synergies From the Deal

On Oct. 28, IBM announced it will acquire Red Hat for $190 per share in cash, at an enterprise value of $34 billion. We are not surprised at the deal’s target given IBM’s 20-year partnership history with Red Hat and ongoing collaboration between IBM Private Cloud and Red Hat’s OpenShift container management platform. We believe IBM's price is a good deal for Red Hat shareholders, compared with our $145 fair value estimate for Red Hat prior to the announcement and the high premium being paid for stock. Rumors suggest that IaaS leaders like Microsoft, Google, or Amazon may try to outbid IBM for Red Hat, but we think the chances of a higher bid are low. We will raise our fair value estimate for Red Hat to $173 per share, which equates to the $190 deal price discounted back one year, as the deal is expected to close in the latter half of 2019.

IBM’s bid values Red Hat at a 63% price premium to its closing price of $117 on Oct. 26. This premium is a bit higher than recent software deals. However, Red Hat’s stock price has taken a hit in the last five months since it released first-quarter earnings in June, when the stock was at a high of $178 prior to results. The stock fell after management announced a reduced fiscal 2019 outlook as traditional middleware suffered from reduced spending and its emerging technologies business decelerated. Still, we think this premium is relatively fair for Red Hat shareholders, given IBM had little choice but to seek nonorganic growth to remain competitive in the hybrid cloud space. The proposed deal represents a 31% premium in comparison with our $145 fair value estimate.

On an enterprise value-to-sales basis, IBM is paying roughly 10 times Red Hat's fiscal 2019 sales, which we project to be $3.39 billion. The multiple is slightly higher than the Microsoft-LinkedIn mega-merger in software, even though LinkedIn was a faster grower at the time (35% revenue growth in fiscal 2015), but we note that RedHat is a more mature and profitable business as our prior projections for standalone Red Hat were for 16.5% GAAP operating margins for fiscal 2019 (24% on an adjusted basis).

There are currently no other bidders in the running to acquire Red Hat, and we believe 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.