Up in the clouds: where next for IBM stock after Red Hat acquisition?

Growth in Red Hat’s Linux subscriptions, the core driver of revenue, is still going strong but looks to be peaking after rising 15% year-on-year for the last two financial years. The Linux business is well-established but (alongside a drag from forex) has spooked investors this year after signs of a severe slowdown in growth. The Enterprise Linux division grew just 8% in the second quarter (Q2) and that had followed the disappointing guidance for revenue growth of 16%-17% this year compared to 21% in the 12 months to the end of February 2018, 18% in 2017 and 16% in 2016.

Revenue and profits are still growing but, like many others in the tech sector, pressure to maintain the high levels of expansion that financial markets have become accustomed to is starting to boil over.

This has pushed Red Hat to develop new products that it has targeted as areas of future growth like cloud computing. Its cloud computing and middleware business (middleware is described as ‘software glue’ that lies between an operating system and the applications that run on it) grew 42% last year, accelerating from the 36% growth reported the year before.

Meanwhile, IBM’s business has stagnated and fallen into decline. IBM’s revenue had contracted for almost six straight years before it managed to briefly install hope that it had returned to growth by posting three-straight quarters of growth. But those hopes were scuppered when IBM’s short-lived run came to an end as revenue declined and missed expectations in the third quarter of the current financial year.

While the acquisition has been based on a long-term view that IBM hopes will shape the next era of its business, Red Hat’s current traction of revenue, profitability and cashflow growth will prove an immediate catalyst for IBM, with all three metrics set to benefit in the first year of ownership.

IBM and Red Hat to create 'world’s number one hybrid cloud provider'

'Open source is the default choice for modern IT solutions, and I'm incredibly proud of the role Red Hat has played in making that a reality in the enterprise. 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.' – Red Hat CEO Jim Whitehurst.

IBM may be the third biggest cloud service provider in the world, but it has lost market share over the past year while smaller rivals like Alphabet's Google and Chinese firm Alibaba have closed the gap and expanded. Still, market-leading growth by the two market leaders that already control half of the worldwide market threatens to make all other players irrelevant over the long term.

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IBM’s purchase of Red Hat will create the 'world’s number one hybrid cloud provider' in the world capable of challenging Amazon and Microsoft, with Linux set to be used as the starting point for any company looking to integrate public cloud services with existing IT systems operated on private clouds or using proprietary software.

Cloud computing and hybrid clouds: a $1 trillion market

Before diving into modern-day cloud computing it is worth starting with the ‘original cloud’: the mainframes that have served governments, banks and other crucial industries maintain their critical-mission systems and digital operations. IBM released its first mainframe in the 1950s and has long dominated the market having held over 90% of the market at one point. Today there is only two other major producers, US firm Unisys and Japanese IT giant Fujitsu.

Cloud computing is often incorrectly regarded as a threat to mainframes on the assumption that companies will not manage or process any of their own digital operations and leave it all to the cloud service providers. It is a misconception that the new development of public cloud computing will make mainframes and private cloud networks – areas where IBM has thrived – redundant.

Mainframes and IBM’s systems are still needed for these types of operations as cloud computing is either unsuitable or yet to prove its ability to handle such tasks. Today, over 90% of all banks and insurers still rely on mainframes to carry out their mission-critical operations: it is simply not acceptable (either because regulation prohibits it or because it is too risky) to outsource control over such vital operations like processing transactions and cash withdrawals to somebody else, or to open access to such sensitive data to third parties. But everything else – like human resource (HR) operations or email – can be moved from private networks (or clouds) and mainframes to public clouds that allow firms to plug into shared computing systems for a more cost-effective way to scale up. Therefore, the combination of IBM’s traditional business and Red Hat’s open source technology being built around cloud computing is justified.

What are the different types of cloud computing?

1. Public cloud: these are owned and operated by cloud service providers that deliver computing resources like storage over the Internet. These providers own all the hardware, software and infrastructure that customers access using the Internet. Examples of public clouds include Amazon Elastic Cloud Compute (EC2), IBM’s Blue Cloud, Microsoft Azure and the Google App Engine. Real-life examples of public clouds in action include file-sharing firm Dropbox and social media platform Facebook, both of which can be accessed remotely by customers
2. Private cloud: these are owned by a single business and often used internally with data and programmes being stored on its servers within its own data centres. However, some companies do pay cloud service providers to host their private clouds (often referred to as ‘managed cloud services’). While many companies using public clouds use them to sell them on as services to their own customers the primary point of private clouds is not to sell as-a-service offerings to customers but to use cloud computing internally. This allows firms to benefit from cloud computing without giving up control or outsourcing security over their own data centres. One company that has spent big developing a private cloud in recent years is US retail giant Walmart, which has kept IT in-house so it can better store and analyse data to boost future sales. The decision to go private over public has been partly driven by the fact that the biggest cloud service provider in the world, Amazon, is a fierce rival of Walmart
3. Hybrid cloud: this a combination of the two that allows data and information to be shared across both public clouds and private clouds. Hybrid clouds are growing in popularity partly because companies are using it to transition from private to public. One example of a hybrid cloud in use is hotel chain Marriott International, which adopted the model in 2016 so it could offer a scalable and faster online service to customers without relinquishing control over sensitive customer data

IBM and Red Hat are banking on hybrid clouds to utilise their respective skill sets and believes the timing of their merger is right, claiming 80% of businesses are yet to make their move to the cloud and complete their digital transformations, claiming adoption has been 'held back by the proprietary nature of today's cloud market'.

Red Hat’s OpenShift framework is at the heart of the way the offering will work as it condenses vast amounts of data and processes into smaller parcels known as ‘containers’ that are easier to share across multiple clouds. The concept is that hybrid clouds can help companies make a digital transition rather than sudden transformation that comes with much higher risks. The title of a Red Hat report released in October 2017 sums up the balance between cloud computing and the use of mainframes: 'Cloud Migration Is Actively Embraced, But Not For Everything'. That report suggested companies would have as much as 25% of their digital infrastructure operating on a public cloud by October 2019 compared to 21% late last year to steal share from private clouds, but the latter still manages over 60% of all digital infrastructure (with Software-as-a-Service [SaaS] operating the balance).

There are two other significant benefits that IBM is hoping to secure from its big bet on open source software. The first will be IBM’s ability to offer cloud services without threatening to ‘lock in’ firms, whereby businesses become overly dependent on one tech company that offers proprietary software. Rometty said the battle for cloud computing will be 'open versus proprietary', and she has placed all her backing behind open source. The second is the opportunity to accelerate growth and development of IBM’s artificial intelligence (AI) division Watson (the main component of its ‘Cognitive Solutions’ division), which, despite being the second biggest revenue driver and the highest-margin unit of the entire business, has disappointed investors and drawn criticism for being more suitable for analysing large volumes of data rather than forward-looking AI applications that get the market excited. Open source software like OpenShift will mean IBM’s AI can be rolled-out anywhere and everywhere on the cloud and open it up to Red Hat’s community of developers that can find new applications for it, ultimately driving improved adoption and faster development.

How much is IBM paying for Red Hat?

IBM is paying $190 in cash for each Red Hat share, giving the deal an enterprise value of $34 billion. The price is a 63% premium to the closing price of Red Hat shares prior to the offer being made but this figure is somewhat flattered because the stock had fallen 34% from its peak of $176.27 in mid-June after its first-quarter results contained disappointing guidance that overshadowed continued double-digit growth at both the top and bottom lines and a fresh $1 billion share buyback.

The day before the offer was made Red Hat shares sat at $116.68 - their lowest level in over a year – having erased all its 2018 gains to trade over 3% lower than the start of 2018.

Red Hat shares have since surged almost 50% since the offer was announced, flirting with the all-time high seen earlier this year.

IBM is funding the deal through a combination of cash and debt. At the end of September IBM had $14.70 billion of cash (up from $12 billion at the end of 2017 and $7.80 billion in 2016) versus debt of $16.50 billion (up from $15.40 billion at the end of 2017 and $14.30 billion in 2016). That excludes the $30.40 billion of debt on the balance sheet of the Global Financing division which provides its clients with lease finance and short-term loans to help buy or upgrade equipment.

IBM shareholders must sacrifice buybacks for dividend growth

Although IBM’s balance sheet is capable of handling higher debt levels it is making shareholders sacrifice short-term returns. IBM has been spraying shareholders with returns after nearly $10 billion was dished out last year through dividends and buybacks – taking total returns to around $120 billion over the past decade. But the acquisition of Red Hat means buybacks will be suspended in 2020 and 2021, placing the onus onto its dividend.

Read more: Are share buybacks the fruits of labour or a consequence of short-term focus?

Although IBM’s business has stagnated, the company’s dividend has grown by more than a third since 2014. IBM has said the addition of Red Hat 'will support a solid and growing dividend' but its long-term payout policy will not be changed.

IBM stock: where next for the share price?

IBM shares fell to $113.80 the day after announcing the Red Hat deal - their lowest level since July 2009 and one-third lower than the 2018-high hit in January. Shares have rebounded to roughly the same level as before the announcement was made, but are still 7.8% lower than a week before unveiling the acquisition.

IBM must prove it can keep Red Hat distinct and that hybrid is the future

'IBM will remain committed to Red Hat’s open governance, open source contributions, participation in the open source community and development model, and fostering its widespread developer ecosystem… IBM and Red Hat also will continue to build and enhance Red Hat partnerships, including those with major cloud providers, such as Amazon Web Services, Microsoft Azure, Google Cloud, Alibaba and more.' – IBM and Red Hat.

IBM believes it can maintain the collaborative characteristics embraced by Red Hat that has brought together the development teams of the biggest competitors in the industry, and preserve the 'independence and neutrality' of the business to keep rivals onside. This includes leaving Red Hat’s existing management in place with chief executive Jim Whitehurst reporting to Rometty, and leaving the business headquarters in North Carolina. But it is still going to have a hard time convincing its rivals to help develop and improve technology only for the bottom-line earnings to ultimately end up in IBM’s pockets. This will involve IBM convincing rivals that Red Hat’s importance outweighs any dubious feelings they have over its ownership.

The other debate it will need to have is whether hybrid cloud services is where the long-term growth lies and that it will not simply be used by companies as a stopgap to gradually transition to public clouds. Many believe the public clouds currently dominated by Amazon and Microsoft will be the ultimate winner as their ability to handle increasingly complex and important processes improves, but we are far from throwing away the mainframe that powers the majority of industries around the world. The debate over the future of cloud computing will rumble on but it has become increasingly clear that open source technology has become increasingly important for tech firms both young and old, with Red Hat described by Rometty as a 'prized asset'.

The arrival of cloud computing has often cast doubt over the future prospects of traditional IT giants like IBM but this is not the first time the company has had to reinvent itself to keep up with the fast-changing market, and new technology does not always replace the old but help enhance it. IBM’s mainframes may be nicknamed ‘dinosaurs’ and described by many in the tech space as ‘legacy systems’, but they are far from outdated and the company will be bringing as much to the table as Red Hat as the pair embark on a new journey that is set to revolutionise the cloud computing industry.

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