International Business Machines (IBM -0.91%) will be taking on a lot of additional debt when it closes on its $34 billion deal to buy Red Hat. A suspension of the share buyback program in 2020 and 2021 will free up some cash to pay down that debt, but investors are right to be concerned about IBM's balance sheet.
The balance sheet will get a small boost before the Red Hat deal closes thanks to IBM's latest divestitures. The company announced on Dec. 6 that it was selling a set of software products to Indian tech company HCL for $1.8 billion. This sale will not only bolster IBM's cash reserves, but it will also rid the company of products that have been stunting its growth.
Seven of IBM's software products will make their way to HCL as part of the deal. These include:
- Appscan -- secure application development.
- BigFix -- secure device management.
- On-premise Unica -- marketing automation.
- On-premise Commerce -- omnichannel e-commerce.
- On-premise Portal -- digital experience.
- Notes & Domino -- email and rapid application development.
- Connections -- workstream collaboration.
Collectively, these products compete in addressable markets worth more than $50 billion, according to IBM. Some have been a part of IBM for decades. Notes, for example, comes from the 1995 acquisition of Lotus.
IBM is dumping these products for three main reasons beyond raising cash. First, they're largely outside of the key areas IBM has been investing heavily in during its multiyear transformation. IBM has been pouring resources into artificial intelligence, hybrid cloud computing, cybersecurity, analytics, and blockchain. The Red Hat acquisition, for example, is a big bet on hybrid cloud.
Second, these products are increasingly being sold as stand-alone products, according to IBM Senior Vice President John Kelly. One of IBM's strengths is its integrated business model -- its ability to deliver full-scale solutions to its clients. Selling one-off software products strays from that model.
Third, some of these products have been causing trouble for IBM. The company's third-quarter revenue missed expectations, partly due to poor performance from certain legacy software products. The company blamed secular shifts in collaboration, commerce, and talent management for a steep decline in cognitive solutions segment sales.
Put it all together, and selling these products makes perfect sense.
Bolstering the balance sheet
The $1.8 billion IBM will receive from this sale is small potatoes relative to the size of the Red Hat deal, but every little bit helps. At the end of the third quarter, IBM's balance sheet featured $14.7 billion of cash and marketable securities, along with $46.9 billion of debt. Most of that debt is tied to the company's financing business -- only $16.6 billion is nonfinancing debt.
This software sale is expected to close by mid-2019, ahead of the late-2019 closing of the Red Hat deal. Debt reduction will be the name of the game for at least a couple of years after that. The $1.8 billion from the software sale, plus roughly $6 billion to $7 billion over two years freed up by suspending share buybacks, plus whatever portion of its remaining free cash flow IBM decides to throw at its debt will all help the company whip its balance sheet back into shape.
IBM has a history of divesting businesses that no longer work as part of its high-value, integrated business model. This software sale is in the same mold as previous divestitures, and it may not be the last in the run-up to the Red Hat deal.