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Is Red Hat the Right Medicine for IBM?

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International Business Machines Corp. (IBM) is showing some conflicting signals right now, as the company expects an earnings hit in its July 17 report, within an otherwise solid outlook. Paradoxically, the hit will likely come from IBM’s biggest piece of good news: the recent close of its Red Hat, Inc. (RHT) acquisition.

First, some background. Last year, IBM bid $34 billion to acquire Red Hat, the open source cloud company. The deal has been completed as of this week, with IBM paying $190 per share for Red Hat’s existing stock. The deal was closed in cash, and IBM issued a bond series to cover $20 billion of the purchase price. The added debt pushes Big Blue’s total borrowed liabilities over $60 billion, and the company will be suspending share buybacks for the next two years.

On the plus side, bringing Red Hat on board offers real advantages to IBM. It makes Big Blue the world’s largest hybrid cloud provider, adding services to a business that already brings in $19 billion annually for IBM. Red Hat will function as a distinct division within the larger company, staying focused on its current core business of open source software. IBM’s CEO, Ginni Rometty, says that with this acquisition, “IBM will offer companies the only open cloud solution that will unlock the full value of the cloud for their business.”

Putting on a New Hat

As for Red Hat (RHT), company CEO Jim Whitehurst said of the deal, “Joining forces with IBM will provide us with a greater level of scale, resources and capabilities to accelerate the impact of open source as the basis for digital transformation and bring Red Hat to an even wider audience – all while preserving our unique culture and unwavering commitment to open source innovation.”

Specifically, the Red Hat brings to IBM the ability to tap into the large customer base of companies that are not yet all-in on cloud computing. According to IBM’s research, some 80% of the potential market is reluctant to fully enter cloud computing, mainly due to the proprietary nature of the systems. Red Hat’s open source software offers a viable alternative.

More importantly, as far as IBM is concerned, Red Hat generates nearly $1 billion in free cash flow annually. This is of major importance, as is Red Hat’s $3.4 billion in fiscal 2019 revenues, considering the debt load that IBM took on to complete the acquisition.

Short Term Pain, Long Term Gain

It’s a bright vision of the future, and it may well come true. Accounting rules, however, will require in the short term that IBM report the acquisition costs against the bottom line.

According to Evercore analyst Amit Daryanani, the negative impact could be as much as 80 cents per share for 2019 and 1 dollar per share in 2020. This puts Daryanani’s EPS estimate for FY2019 at $13.10 to $13.90, with the upper end in line with company guidance.

Daryanani explains, “Although Red Hat's revenue profile is fairly substantial, with strong levels of profitability, we note that purchase accounting treatment of the target company's deferred revenue will make IBM unable recognize a meaningful portion of Red Hat's deferred revenue as it converts to actual revenue; this is while IBM will have to incur 100% of Red Hat's operating expense.”

Despite predicting an earnings hit on the way, Daryanani still sees IBM as a long-term gain for investors. He gives the stock an outperform rating and a price target of $150, basing his positive outlook on the combination of IBM’s 23% ytd gains and Red Hat’s solidly profitable bottom line.  His price target suggests an upside of 6.7% for IBM shares. IBM reports earnings on July 17, and we’ll see then how this forecast matches up with reality.

Stifel’s David Grossman believes it will. He sees IBM in a more traditional light, describing the stock as “a defensive holding with two potential catalysts, namely continued improvement in its core infrastructure services business and demonstrated success in leveraging Red Hat.” His price target, $169, clearly shows his confidence in IBM’s prospects – it implies an impressive 20% upside for the stock.

Overall, IBM holds a moderate buy rating from the analyst consensus. The average price target of $157 gives an upside of 12% when compared to the $140 current trading price.