IBM lays a US$34 billion bet on Red Hat to win

Friday, November 02 2018

IBM is making a US$34 billion bet on Red Hat transforming its business amid sustained investor pressure to return the company to strong and consistent growth. It has reported only three quarters of growth in the last seven years, as it exited x86 servers and semiconductor fabrication, and focused investment on big data, analytics, artificial intelligence and cloud. These initiatives have yet to deliver strong enough results, especially in public cloud infrastructure services, where it trails Amazon AWS, Microsoft Azure and Google Cloud. IBM has increased its focus over the last 12 months to enabling customer’s hybrid and multi-cloud environments rather than directly competing with these hyper-scalers. It has launched a range of new software and tools including IBM Cloud Private and IBM Multi-cloud Manager to complement its existing middleware platforms. This presents growth opportunities for its professional services practice to modernize and migrate customer’s existing applications, as well as develop and manage new digital workloads. The move for Red Hat aims to accelerate this latest initiative. But at such a high cost, IBM will be under intense investor pressure and scrutiny to deliver a quick return on its investment.

IBM gains a growing and predictable subscription business, but it needs more

The acquisition of Red Hat will be IBM’s largest ever and the biggest software merger and acquisition in the technology sector to date. It is expected to close in the second half of 2019, dependent on regulatory approval. Key details of the deal include:

  • IBM is paying a premium of more than 60% over Red Hat’s closing share price of US$116.68, as of Friday 26 October
  • It intends to finance the deal with a combination of cash plus debt, funded in part by an unsecured bridge loan facility of up to US$20 billion
  • Red Hat will operate as an autonomous unit within IBM’s Hybrid Cloud business
  • Red Hat will have to pay US$975 million to IBM if it decides to terminate the deal

IBM is paying a high price for Red Hat, approximately 10 times its expected revenue of US$3.4 billion for fiscal year 2019. Red Hat’s revenue though has grown for 66 consecutive quarters. Revenue for fiscal Q2 ending 31 August increased 14% to US$823 million. Growth was driven by steady performance in its core infrastructure software business, with its Enterprise Linux and middleware offerings. Results were also boosted by strong uptake of its application development and emerging technologies, particularly Red Hat OpenShift for hybrid and multi-cloud, and Ansible for automation. Its training and consulting services are also gaining traction, as customers need support with OpenShift and Ansible implementations. Red Hat is winning larger deals in its core verticals of financial services and government. In total, it closed 73 deals worth over US$1 million in Q2, up 11% year-on-year. This includes 11 deals worth more than US$5 million and one exceeding US$10 million. Importantly, Red Hat’s core business has become more predictable over the last three years with subscriptions accounting for 88% of total revenue. This is the result of customer migration to multi-year deals, so that its salesforce can focus on net new accounts and cross-selling.

However, Red Hat’s revenue in the latest quarter came in at the low-end of its guidance. Growth slowed from an average of 21% over the previous four quarters and is expected to be in the range of 13% to 14% next quarter. Unfavorable exchange rates and the loss of a large account to a price aggressive competitor were key contributing factors. Consequently, its full year outlook has been lowered by US$100 million compared to its original forecast. In terms of profitability, Red Hat’s net income for the first six months of fiscal year 2019 increased 16% to US$200 million. Overall, Red Hat’s financials remain strong. The high acquisition price and termination fee indicates other suitors were interested. Nonetheless, IBM is paying a premium, even though Red Hat’s share price has fallen from a peak of US$176.26 in June. It is taking on a lot of debt and will be under pressure to pay it off. But it will be manageable based on current free cash flow and the planned pause in its share repurchase program from 2020. IBM needs to scale the business fast to justify the US$34 billion investment, but Red Hat’s current trajectory will not be enough by itself, especially if it continues to operate as an independent unit.

Culture is everything

Red Hat is uniquely positioned as an enterprise software vendor with an open source development model. This has enabled it to drive innovation and gain influence in a large developer community. Red Hat’s culture is key to how it operates. Preserving it will be important, but this is also going to be a major challenge for IBM. It has repeatedly stated its intentions to maintain Red Hat as an autonomous business, but it is hard to envision Red Hat remaining so as it becomes a more integral part of IBM’s core offerings. For example, IBM and Red Hat have a long-standing relationship around Linux, which was expanded earlier in May to focus on hybrid cloud and Power Systems. The two companies are already well underway in terms of combining offerings, which raises the question of why IBM is spending US$34 billion to own the technology. It must see Red Hat as crucial for its future and could not risk it being purchased by a competitor.

Employee retention will be critical. Canalys estimates approximately 10% of current Red Hat employees have worked for IBM previously. This can be argued as a positive, as many Red Hat personnel have prior experience and understanding of IBM’s processes and culture. This can also be seen as negative, if personnel who chose to leave IBM now face the prospect of coming back. IBM will also need to retain Red Hat’s culture so it does not lose relevance with developer communities. Traditionally, IBM has had most success with C-level executives, IT operations and solution architects, but it failed to adequately influence developers and other non-IBM centric technology influencers. This is one factor in its failure to keep pace with the leader hyper-scalers.

Capitalizing on growing hybrid and multi-cloud requirements

Red Hat has key assets that will become core to IBM’s hybrid cloud proposition, especially as the industry converges on Docker and Kubernetes. IBM’s bet is based on the premise that only 20% of workloads have migrated to the cloud, which means the remainder will need to be modernized. Application development is shifting to a micro services architecture and a DevOps continuous delivery model. Docker for creating, deploying and running applications in containers and Kubernetes for container orchestration are being adopted on a large scale. Red Hat is well positioned to capitalize on this trend with its OpenShift Container Platform, which runs Docker containers in production at scale, and enables management of Kubernetes. This combined with its Red Hat JBoss Middleware provides developer tools to create and deploy container-based applications. Red Hat’s primary value proposition is that OpenShift can be used to deploy applications in any public cloud environment and data center that uses Red Hat Enterprise Linux. All the major public cloud providers, including Amazon AWS, Microsoft Azure and Google Cloud offer Red Hat Enterprise Linux instances.

Red Hat OpenShift gives enterprises a consistent enterprise-ready platform for application portability. Its cloud agnosticism is crucial for customers, which use it for container application development and management, and move workloads between different private and public cloud environments. This gives large enterprise customers leverage to negotiate with multiple providers to help manage costs, especially for large commoditized applications. IBM’s Multi-cloud Manager is similar, in terms of enabling control of Kubernetes clusters over different clouds and data centers, but it is primarily optimized for IBM Cloud. Red Hat OpenShift has deeper integrations with more public cloud providers, for example support of .NET Core 2 in Azure and native integration of AWS services. The key question is whether this is worth US$34 billion. The purchase is being positioned as a cloud-move, but it is more about application and workload management across any infrastructure. However, Red Hat will be challenged to retain its neutrality among these cloud providers given IBM Cloud is also a direct competitor. This could result in cloud providers working closer with other container management and orchestration vendors. It could also trigger acquisitions of similar vendors, such as Docker, Mesosphere Mirantis and Platform9.

IBM must be clear on its channel strategy for the future

While IBM has stressed Red Hat will remain a separate legal entity and will keep its brand, both sets of channel partners will be interested to know how IBM will leverage synergies and drive cross-adoption of the respective portfolios. IBM and Red Hat have been alliance partners for many years and some partners (particularly the global systems integrators such as Accenture and Atos) have long been sourcing technology from both vendors. For those partners, this acquisition will not change anything in the short term. Their account management systems, deal registration portals and day-to-day engagements will stay the same. In the long run, though, there are potential opportunities and challenges of which both companies should be aware.

The balancing act between maintaining Red Hat’s valuable brand and vendor agnosticism while also leveraging the Red Hat channel to increase the market share of IBM Cloud will be a fine one. Partner program elements such as joint certifications or simplified joint training modules, specific incentives, enablement to support cross-portfolio sales, and some unified account management may be necessary to simplify partner engagement. Even building a page within the respective partner portals, to outline potential joint use cases and product sourcing availability may be required at some point in the future, However, even this can become a major re-building project that requires a clear direction from both vendors and consultation with partners on both sides. The obvious reference model is the relationship between Dell Technologies and VMware. While the two are separate companies, and VMware has its own partner program and go-to-market strategy, the collaboration between the two at a technological level is a key factor in their joint success.

There are key groups of partners on both sides that will be looking for different answers during this phase before the acquisition closes. ISVs on both sides, Red Hat’s CCSP partners, IBM’s reseller partners, and global systems integrators will all be keen to see greater choice and integration between certain complementary products, such as Red Hat’s OpenShift and Ansible (application platform and management software) with IBM’s cloud and analytics products. Security will also be an important message. For partners of all kinds, a robust and unified strategy for building security into all joint go-to-market initiatives will enable them to cross-sell more easily, using a message that will resonate with end-customers. The distributors will be key to solving some of these problems. Both Tech Data and Arrow ECS are global distributors for IBM and Red Hat. Red Hat will see more attention paid to its solutions by distributors due to greater financial backing, but the distributors will see an opportunity to add value in managing joint go-to-market solutions for specific use-cases. In this way, independence between the two companies could be maintained while leveraging their shared distribution channels to provide billing services, training, marketing and partner management.


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