IBM to buy Red Hat for $33B to catapult cloud efforts

IBM’s $33 billion purchase of Red Hat—the world’s second-largest technology deal ever—is aimed at vaulting the company into the ranks of the top cloud software competitors.

The cash deal, IBM’s largest, boosts the company’s credentials overnight in the fast-growing and lucrative cloud market, and it gives it much-needed potential for real revenue growth. The 107-year-old computer-services giant, once synonymous with mainframe computing, has been slow to adopt cloud-related technologies and has had to play catch-up to market leaders Amazon.com and Microsoft in offering computing and other software and services over the internet.

“We’ve been reshaping IBM for this moment,” Chief Executive Officer Ginni Rometty says. “This is all about resetting the cloud landscape, and this is the inflection point to do it.”

IBM has been positioning itself as a leader in the so-called “hybrid cloud” market, in which companies run programs on both their own internal servers and the big “public” cloud providers—Amazon’s AWS and Microsoft’s Azure. At the same time. Red Hat, which sells software and services based on the open-source Linux operating system, helps companies bridge different platforms.

“Knowing first-hand how important open, hybrid cloud technologies are to helping businesses unlock value, we see the power of bringing these two companies together,” JPMorgan CEO Jamie Dimon said in an emailed statement.

IBM has seen revenue decline by almost a quarter since Rometty took the CEO role in 2012. While some of that has been from divestitures, most is from declining sales in existing hardware, software and services offerings, as the company has struggled to compete with younger technology companies. She has been trying to steer IBM toward more modern businesses, such as the cloud, artificial intelligence and security software with inconsistent results.

In its third-quarter earnings report, IBM disappointed investors who were seeking more progress in those areas after six years of declining sales that had only recently started to show gains. Still, the improvements had been coming largely from IBM’s legacy mainframe business, rather than its so-called strategic imperatives. Cloud revenue grew 10 percent in the period to $4.5 billion, but that was slower than the 20 percent expansion in the second quarter.

The Red Hat deal could signal to investors that IBM wasn’t as well positioned in cloud as it had been claiming, says Jim Suva, an analyst at Citigroup Research. “We expect investor skepticism around the deal given IBM’s messaging that it is well underway in its transformation,” he said.

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The International Business Machines Corp. (IBM) logo is displayed in front of the company's offices in New York, U.S., on Monday, Oct. 14, 2013. Photographer: Craig Warga/Bloomberg

The Red Hat deal represents an admission by Rometty that in-house growth wasn’t going to be enough to keep IBM from falling permanently behind in a market that is growing in importance and size. Acquiring Red Hat makes IBM “a credible player in cloud now,” Bloomberg Intelligence analyst Anurag Rana said. “This gives them an asset that looks forward and not backwards.”

Still, analysts contend that the deal is unlikely to improve IBM’s chances of winning the Pentagon’s $10 billion cloud contract, known as the Joint Enterprise Defense Infrastructure cloud or JEDI. The project is widely seen to favor Amazon because it’s the dominant cloud services provider and already won a major cloud contract from the Central Intelligence Agency.

IBM will pay $190 a share in cash for Raleigh, N.C.-based Red Hat, according to a statement from the companies Sunday, a 63 percent premium over Red Hat’s closing price of $116.68 per share on Friday. Rometty said IBM “paid a very fair price. This is a premium company. If you look underneath, this is strong revenue growth, strong profit strong free cash flow.”

Revenue at Red Hat, is expected to top $3 billion for the first time this year as the company’s Red Hat Enterprise Linux product attracts business from large customers. Last quarter the company reported a record 11 contracts valued at over $5 million each and 73 over $1 million, according to a note from JMP Securities analyst Greg McDowell.

Armonk, New York-based IBM will continue to grow its dividend and neither company will cut jobs after the deal, Rometty said. “This is an acquisition for revenue growth, this is not for cost synergies” she said.