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Does the Red Hat Deal Make IBM Stock Worth Buying?

James Brumley

Late last month, International Business Machines (NYSE:IBM) agreed to pay $34 billion for software company Red Hat (NYSE:RHT), making it not only the biggest deal in Big Blue’s 107-year history, but the biggest software acquisition ever. In the days following the deal, IBM stock retreated, but IBM stock price has since risen, taking the shares back to roughly where they were before the transaction was announced.

Though a struggling International Business Machines needs all the help it can get right now, current and prospective owners of IBM stock are still trying to digest the sheer scope and size of the transaction.

Investors, however, can’t wait too much longer for decisive proof that the acquisition will bear meaningful fruit. The time to pull the trigger on IBM stock — if it’s going to be pulled at all — is now.

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The problem is that while Red Hat undoubtedly brings something to the table, it’s still not likely to be enough to make IBM stock a name to gamble on.

IBM Is Playing Catch-Up

International Business Machines’ backstory isn’t one that needs much retelling. Most investors know all too well that the company mostly missed the beginning of huge tech evolutions like cloud computing and the mobile web, which in turn created industries like the Internet of Things and mobile security.

IBM has since tried to play catch-up on those fronts by launching a highly-focused effort called Strategic Imperatives, and to its credit, the project has enabled it to gain traction. As of the second quarter of this year, the revenue of Strategic Imperatives, which covers areas like AI, social and cloud computing, surged 26%, and accounted for more than half of the company’s top line.

But that was a dubious victory, since IBM’s overall sales were only up 4%, and its net income only grew 5.2%.

Things didn’t get any better during the third quarter either. The company’s revenue fell, as many of its Strategic Imperative products finally hit tougher year-over-year comps. The ongoing weakening of IBM’s legacy businesses has offset much of the success that IBM has been achieving in areas like cloud computing and mobile security

There is one area, however, where IBM has achieved some success that can be built upon: selling products and services for the cloud. That’s where Red Hat, which provides open-source software to enterprises, enters the picture.


Open Source Is Now the Norm

Open-source software is quickly becoming the preferred platform for corporate programmers.

The simple definition of open source is a type of computer program coding that can be seen, tweaked and added to as needed in order to create more customized solutions.

For many years after the mainstreaming of computers back in the 90’s, software companies like Microsoft (NASDAQ:MSFT) worked diligently to keep their computing platforms and applications as closed as possible, in order to protect their revenue. Much has changed within the world of technology though, and embracing open source is no longer seen as a barrier to revenue growth.

Even Microsoft, which arguably has the most to lose by embracing open source, now fully embraces the world’s most popular open-source operating systems. Amazon.com (NASDAQ:AMZN) does too, making sure clients of AWS have all the flexibility and computing options they want. Even IBM has been helping fans and users of open-source technologies for some time now, and has worked closely with Red Hat.

An outright acquisition of the company, however, is an enormous leap for Big Blue.

The question remains: Does this deal ultimately bring the last missing ingredient to the table and make IBM stock worth buying? Will it boost IBM stock price in the future, making the shares very attractive now?

No.

The deal does have some merit. With Red Hat, IBM is instantly able to compete directly with rival cloud-computing platform providers like Amazon and Microsoft. There are also 8 million software developers who know and like Red Hat. Following the deal, those developers will be a bit more apt to steer cloud operators toward IBM hardware. Perhaps best of all, IBM will benefit from Red Hat’s revenue growth, which is on pace to improve 15% this year and repeat the feat next year.

The Bottom Line on IBM Stock

When all is said and done, Red Hat won’t do much to alter IBM’s fiscal stagnation. Synergy is the intended outcome of most acquisitions, and it’s not clear if this deal will create any synergy. And IBM just paid a steep price for a new revenue stream. Specifically, IBM is forking over more than ten times Red Hat’s trailing revenue and more than 40 times Red Hat’s likely earnings for 2019.

Most importantly, the deal may destroy the one thing that has made Red Hat the success it has become.

Science and technology venture fund Siana Capital’s Siddharth Pai wrote, “Red Hat has managed to build many strong ongoing relationships with service providers since it is viewed as an independent. IBM, on the other hand, given the ‘frenemy’ status it has since it both sells to and competes with service providers, has far fewer frictionless relationships.”

Translation: International Business Machines may well find a way to undo what makes Red Hat so great by damaging its relationships with its customers.

And finally, there’s no assurance that the acquisition of Red Hat will enable IBM to do anything it couldn’t do without making the deal.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter, at @jbrumley.

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