When it was announced last October, IBM's (NYSE:IBM) acquisition of open-source software provider Red Hat shocked the tech world. It was the largest deal in IBM's storied history, and one of the largest tech acquisitions of all time.
IBM's plan to complete the acquisition in the second half of 2019 has gone off without a hitch. The company announced on July 9 that the deal had officially closed, positioning IBM to reap nearly the full benefit of Red Hat's results in the second half.
Boosting growth and earnings
Red Hat generated $3.4 billion of revenue in fiscal 2019, and it's been growing revenue at a double-digit pace. Adding Red Hat's revenue to IBM will provide a one-off boost to IBM's growth rate over the next year, and Red Hat's revenue growth and cross-selling opportunities will continue to contribute to IBM's growth beyond that. Over the next five years, IBM expects the deal to boost its revenue growth rate by about 2 percentage points annually.
Because Red Hat is a profitable company, the acquisition will immediately benefit aspects of IBM's bottom line. Both gross margin and cash flow are expected to get a boost in the first year, while non-GAAP (adjusted) earnings per share will get a boost starting in the second year. Red Hat generated close to $1 billion in annual free cash flow as a stand-alone company.
The Red Hat deal required IBM to take on some debt, and the company will be focused on reducing that increased debt load over the next few years. IBM plans to refrain from share buybacks in 2020 and 2021 to free up some cash for debt repayment, although it remains committed to growing its dividend.
Red Hat will operate as a distinct unit within IBM, reporting as part of the company's cloud and cognitive software segment. Current Red Hat CEO Jim Whitehurst and his management team will continue to lead the company.
Betting on the hybrid cloud
IBM's annual cloud revenue has grown to $19 billion, representing about 25% of total revenue. While IBM is a minor player in the public infrastructure-as-a-service market, which is dominated by Amazon and Microsoft, the company is a leader in the hybrid cloud market.
Large companies with complex IT environments are unlikely to move wholesale to the public cloud. Managing the complexity of using multiple public clouds along with on-premise infrastructure, a hybrid multicloud environment, is where IBM sees itself making an impact. The opportunity is large: IBM sees the total hybrid cloud opportunity reaching $1 trillion by 2020.
For this acquisition to succeed, Red Hat needs to remain a neutral industry player. The worst thing IBM could do is have Red Hat favor its own platforms. Thankfully, the company plans to maintain that aspect of Red Hat's strategy. IBM SVP Arvind Krishna explains in a Q&A about the deal:
Red Hat is going to stay platform neutral. Let's be extremely clear about that. For this to be successful, it is key that products can run anywhere that clients want them to see. Guaranteeing access to the broadest possible ecosystem is what enables true choice for customers. It's in everyone's interest to let Red Hat be Red Hat.
After returning to revenue growth in 2018 thanks to a strong mainframe refresh cycle, IBM is once again reporting revenue declines. Currency is having a large negative impact, but revenue is still slumping on a constant-currency basis.
The Red Hat deal will provide some much-needed growth for IBM, and the company may be able to accelerate Red Hat's growth through cross-selling opportunities. IBM's results will get a boost in the second half of this year thanks to the acquisition, and it will get the full benefit of the deal in 2020. A new mainframe is also likely sometime in 2020, providing an additional boost in revenue.
IBM is set to report its second-quarter results after the market closes on July 17. Analysts are expecting another revenue decline, as well as a small decrease in per-share adjusted earnings. With the Red Hat deal now officially in the books, expect IBM to update its full-year guidance to account for the acquisition.