IBM Sees Red Hat Accelerating Growth, but Earnings Will Take a Hit This Year

International Business Machines (NYSE: IBM) expects its $34 billion acquisition of software provider Red Hat to deliver significant benefits in the long run, but the deal will weigh on the company's results this year. In an investor briefing on Aug. 2, the company lowered its 2019 earnings guidance due to transaction-related costs. IBM now expects adjusted earnings per share of $12.80, down from previous guidance of $13.90.

The financial impact

The Red Hat acquisition is expected to have a negative impact on IBM's adjusted earnings through 2020, finally boosting the bottom line in 2021. The dilutive impact of the deal is mostly due to noncash costs related to the transaction itself.

For this year, IBM expects equity and retention costs tied to the acquisition to have a $0.25 negative impact on per-share earnings. The suspension of the share buyback program, which will help IBM lower its debt, will have a negative impact of about $0.10 per share.

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Image source: IBM.

The biggest negative item is deferred revenue adjustment, which will reduce earnings by $0.85 per share in 2019. When a company collects up-front payment for products or services, like in the case of a software subscription, that payment is registered on the balance sheet by increasing cash on the asset side and increasing deferred revenue on the liability side. Over the course of the subscription, revenue is recognized on the income statement, and deferred revenue on the balance sheet is reduced.

When a company is acquired, that company's assets and liabilities are generally recognized on the acquirer's balance sheet at fair value on the acquisition date. For deferred revenue, fair value is not the amount of revenue that would eventually be recognized if not for the acquisition, but instead related to the cost of delivering the product or service. For a software subscription, the cost of delivering can be minimal.

Red Hat had $2.8 billion of deferred revenue on its balance sheet when the acquisition closed. IBM is taking a $2.2 billion charge to reduce that deferred revenue balance to just $0.6 billion. In this case, the fair value of Red Hat's deferred revenue was just about 20% of its preacquisition value.

While these charges will hurt IBM's earnings this year, the company maintained its guidance for free cash flow. It continues to expect free cash flow of around $12 billion in 2019. In 2020 and 2021, IBM sees a $0.5 billion and $1 billion positive impact from Red Hat, respectively.

Faster revenue growth

With Red Hat in the fold, IBM now expects to produce mid-single-digit constant currency revenue growth in 2020 and 2021, up from IBM's previous long-term model of low-single-digit growth. Pre-tax income is expected to grow at a high-single-digit rate, up from previous expectations of mid-single-digit growth.

Beyond simply adding Red Hat's revenue base to IBM's, the company sees a big opportunity to cross-sell products and services. Among IBM's largest clients with little or no Red Hat spend, the company sees a $1 billion annual opportunity for every 5% that adopt Red Hat. IBM also plans to expand Red Hat in around 30 countries where it has little or no presence currently.

IBM also expects to sell more IBM software by making it available on Red Hat's OpenShift container platform, which supports private and public clouds, including Amazon Web Services, Microsoft Azure, and Google Cloud. The company sees more than $50 billion of strategic new workloads now up for grabs thanks to this hybrid cloud strategy.