Why I don't like this move at all (from an IBM shareholder perspective).
I think this has been a really bad news for IBM shareholders and a very good one for Red Hat ones. From my point of view all turns around the valuation. For me Red Hat is worth nowhere near the 34B$ figure (190$ for each share of Red Hat).
It's clear that IBM lost the cloud battle way behind AWS (Amazon), Azure (Microsoft) and GCP (Google), and I think that trying to catch up whit overpriced acquisitions hoping to gain a bit more of market share and some new clients is a fool's game. They are bringing nothing new to the market, just buying what is already available for an unreasonable amount of shareholders' money (wasting it). I would have rather preferred them to use that money to fund research programs and come up with something new on their own, standing up from the cloud crowd.
34 billions is a huge figure, just imagine how many new projects you can finance and lead with that money! How many start-ups, how many innovative and cutting-edge new research programs, how many high-skilled new employees. If you couldn't find anything than overpaying for other companies, then just return the cash to shareholders as dividends or stocks buybacks.
Acquiring another company is a much more easy and effortless task than trying to generate a better internal ROI by building the cool stuff by yourself. That would face uncertainty, difficulties, thinking at the project, leading it and waiting years before getting organic long-term earnings to the bottom line.
At the 34B market cap you are valuing Red Hat in the same league of companies such as Occidental Petroleum, Canadian Pacific Railway, Monster Beverage, Credit Suisse Group, Brown-Forman, General Mills, Ferrari, the entire Yum! Brands (Taco Bell, KFC, Pizza Hut, WingStreet and Yum China together), HP, Electronic Arts, Southwest Airlines, AutoZone, Fiat Chrysler Automobiles, MercadoLibre...
Taking up billions of debt and buying another company at that valuation to fake a bit of growth is clearly an easier task, but the easy task is definitely not what I expect from the CEO of a 120B company with a base salary of 1.6M (and much more including her stock plan).
But let's go deeper to understand how much is IBM actually paying for Red Hat at 190$/share looking at the Red Hat FY2019 financial report.
Red Had reports for FY2019 an EPS of 2.33$, implying a P/E on buy price of more that 80. Yes, you didn't read it wrong, it's 80! Meaning that if the EPS were to stay the same for the years to come and got totally returned to shareholders you'd need 80 years to get your money back.
If we were to look at a more realistic 20 P/E, we were looking at a 75% loss, with a fair price north of 50$/share. To justify the current price it would have to have 4x its current EPS.
I would value Red Hat nowhere near 80 times its earnings, would you? Do you think Red Hat is so disruptive, innovative and fast growing to deserve that massive multiple? Let's not forget that its revenues growth Y-o-Y is a mere +15%, comparing that with the 80 P/E it seems to me a really poor result, totally incapable of justifying that lofty valuation.
Moreover, their profit margin is near 14%, which doesn't impress me either as we are talking about the software and services industry.
If I wouldn't buy Red Hat at that valuation in the first place, I don't want the companies that I'm invested in to do that as well, so I decided to sell the long position I had in IBM.
For updates, insights or suggestions, feel free to post a comment below!
All the information and data expressed in this essay are for informational purposes only and are not to be intended as a financial advice. They may be or prove wrong, with the real possibility of capital and money loss, use them at your own risk.