Is IBM Really Resetting the Cloud Landscape With Its Red Hat Acquisition?

Assuming it passes muster -- and there's no reason to expect it won't -- IBM's (IBM -8.25%) announced purchase of Red Hat (RHT) for $33 billion will make it the third-largest M&A deal in the U.S. tech space ever. So even for a legacy giant, this is serious business. And at $190 a share, it's paying a 63% premium from where the target closed Friday. So for investors, the obvious question is: What is it about this particular deal that makes it so vital for IBM?

To explain what's up, MarketFoolery host Mac Greer has analysts Emily Flippen and Jason Moser join him for this podcast to review the competitive situation in the cloud, talk about the ways the Red Hat acquisition will enhance IBM's offerings, and consider how this linkup could play out.

A full transcript follows the video.

This video was recorded on Oct. 29, 2018.

Mac Greer: IBM making a big deal. On Sunday, IBM agreeing to buy Red Hat for $33 billion or $190 in cash per share. That's a 63% premium to where Red Hat closed on Friday. That sounds like a lot, right?

Emily Flippen: It is.

Jason Moser: It sounds like a lot.

Greer: Not bad. IBM CEO Ginni Rometty says the deal is all about, "resetting the cloud landscape." Emily, I want to get into that here in a minute. The press release announcing the deal describes Red Hat as "the world's leading provider of open source cloud software." When you look at the deal, shares of Red Hat up around 47% today. IBM, down a little. A good deal for IBM?

Flippen: I think it's a necessary deal for IBM. It's an interesting deal for Red Hat. For a little fun fact, this is actually the third largest deal in the U.S. history for tech.

Greer: That's kind of fun.

Flippen: It's a fun fact. That is to say that, you'll notice that Red Hat shares are not exactly at that $190 price. That's attributable to the fact that this will need regulatory and shareholder approval before it moves forward. I would expect that to happen.

It's an exciting deal for IBM. IBM has been posting really stagnant growth over the past few years. They needed to do something. They were losing out horribly to competitors like Amazon and Microsoft in this space. This acquisition for them is an attempt to control every part of the cloud ecosystem for an enterprise. If you're an enterprise, and you have a lot of physical assets, in terms of traditional information storage, and you're looking to move toward a cloud environment, what they do is, they have an inter-between phase where you're operating in a hybrid cloud environment. This deal is going to allow IBM to get in on the hybrid cloud environment space and help companies transition to that cloud environment. They're using Red Hat to do that.

Moser: I think she hit the nail on the head there. It was a necessary deal for IBM. We've been talking about IBM sort of just sitting there doing nothing over the past decade, more or less, as every other tech company we discus seems to be flying right past it. Typically, with big tech companies like this, that are a little bit more based on legacy success, you have to go in there and make a big deal like this. That's why it's such a premium, I think. IBM really wants this. They don't want Red Hat to go shopping around and see if someone wants to up the ante a little bit. So, they're paying a very heavy premium today.

It more than likely goes through. Perhaps there's some scrutiny there. But when I looked at the two companies, I think this really tells you everything you need to know. When you look at the companies, you note the disparity in the research and development line item on their income statements. If you look at R&D as a percentage of revenue, for Red Hat, it's about 20%. They're plowing a lot of the money they make back into the business because they need to keep relevant and keep advancing. IBM's around 7%, and they're basically doing that just to tread water. And that's what they've been doing for a long time now.

To see them make a big deal like this isn't surprising. I think Red Hat's a good business. The fundamentals are sound. Whether IBM actually does anything really good with it remains to be seen.

Greer: When you look at IBM the stock, it hasn't even been treading water. You look over the last five years. Emily, we were talking about this before the show. Shares are down. You have lost money on IBM over the last five years. That's pretty tough to do in this market.

Moser: Yeah, it had the reputation for the longest time of, if you couldn't really figure out what kind of market it was and how you should be investing, you could always just buy shares of IBM and no one would hold that against you because of its standing in the tech space. But obviously, tech has changed so much in just the recent years, and IBM hasn't really been spearheading that change.

Greer: I want to talk more about this idea of resetting the cloud landscape. IBM's CEO says that big companies have moved around 20% of their work to the cloud. Let's just take that as our starting point. That leaves around 80% that all of these different companies are competing for. IBM and Red Hat can go after that 80%. But we've got a few competitors. Let's just review some of the names in that space. Amazon, Microsoft, and Alphabet.

Flippen: What's interesting about Red Hat is they are focused on open-sourced platforms. When a person goes out uses Red Hat as a provider, they're not actually buying any type of material software. All the code is already out there. If they wanted that, they could quite literally go onto GitHub and copy and paste it. What they're doing is, they're buying Red Hat support -- the technology, the expertise that's needed to implement that. It's going to be really interesting to see how they compete. You'll notice that a lot of their competitors actually use Red Hat.

What IBM is trying to do is saying, "Hey, we're not going to be the big cloud provider that is Amazon Web Services. But, we can at least be the system which Amazon Web Services is operating on." Red Hat's most widely subscribed product is Red Hat Enterprise Linux. It's the operating system that all this technology is running on. What they're trying to do is get in on the base level of that and try to be a player in the space without necessarily directly competing.

We mentioned earlier the culture around IBM, how it's been a slow growth company, not doing much in this space. I think that's where the controversy for this deal comes from. A lot of people see Red Hat as an innovator, completely open-source. Any company that can make $2 billion selling something that's free is a good company in my book.

Moser: [laughs] That's a good point!

Flippen: So, the opportunity there for a cultural disillusion, as this company that's been such an innovator, that's been open-source, moves to this conglomerate, this large, slow tech company, it could be a hard pill to swallow for some employees. But IBM definitely needs the growth.

Greer: The old culture clash. We've heard that story before. I think back to AOL and Time Warner. We will see how the deal shakes out.