Stock of the week: International Business Machines

Summary:

• IBM announced huge acquisition on Sunday

• Deal may help company boost its struggling cloud business

• Competition is growing in the cloud computing industry

• Fourth quarter is the best for IBM according to seasonality

International Business Machines (IBM.US) surprised public on Sunday with announcement of huge acquisition. There were rumours earlier this year that the deal may be made but it seems that no one anticipated it to happen so fast. In this analysis we will take a look at the details of the deal as well as examine the latest IBM’s earnings report.

IBM experienced negative revenue growth in the past few years and impending acquisition may help change things around. Source: Bloomberg, XTB Research

International Business Machines (IBM.US), one of the most famous US tech companies, announced on Sunday that it will acquire Red Hat (RHT.US), including its debt, in a $34 billion deal. Red Hat is the US software company specializing in open-source software products for enterprises. This is important for IBM as it is one of the pioneers in the hybrid cloud sphere, the next stage of cloud computing, where open-source solutions are said to be playing a key role. During the conference call on Monday morning Ginni Rometty, CEO of IBM, said that so far just 10-20% of IBM’s clients moved their workloads to cloud and expansion into hybrid cloud could be more successful due to improved features for clients. However, there is going to be fierce competition in the cloud computing area as companies like Salesforce.com, Microsoft or Dell also made some expensive acquisitions in the past three years.

While IBM struggled with revenue growth in the past couple of quarters Red Hat did not experience similar problems. Moreover, Red Hat also has less volatile profit margins than IBM. A significant drop in earnings visible on the charts in the Q4 2017 for IBM and Q1 2018 for Red Hat is due to one-off factors associated with the US tax overhaul. Source: Bloomberg, XTB Research

Apart from that, there is a number of juicy facts concerning Red Hat that make IBM especially interest in this deal. Most importantly, Red Hat is one of the few companies operating in the open-source software business that is able to constantly improve its sales and provide positive free cash flow. While IBM was experiencing quite solid free cash flows it struggled with revenues in the past couple of years. After the deal is completed (second half of 2019 is the expected deadline) Red Hat will continue to operate as one of IBM’s business segments. However, IBM said that it wants Red Hat to keep its headquarters, brands and practices. As we mentioned before numerous companies decided to acquire smaller entities operating in the cloud industry. Companies other than IBM were also said to be interested in acquiring Red Hat and that may be the main reason for significant premium offered by IBM. IBM announced on Sunday that it will buy Red Hat for $190 per shares, implying a 63% premium over Friday’s closing price. In turn the deal is worth aforementioned $34 billion and is the second biggest acquisition of technology company (Dell acquisition of EMC was worth $67 billion).

Technology Services & Cloud Platforms segment accounts for roughly a half of the IBM’s revenue. Red Hat deal can help put the segment back on the growth path. Source: Bloomberg, XTB Research

IBM released its earnings report for the third quarter of the fiscal year on 16 October. The company managed to provide minor beat with EPS ratio at $3.42. On the other hand, revenue came in at $18.756 billion against expected $19.085. Looking at particular segments Technology Services and Cloud Platforms, IBM’s biggest business segment, generate 2% smaller revenue on the annual basis. This is a worrying sign but planned acquisition of Red Hat may help this segment get back on the growth track. Other major segment - Cognitive Solutions - also experienced a YoY drop in revenue while Global Business Services and Systems segments managed to increase sales on the annual basis. However, the fourth quarter is usually the most busy one for IBM and this time will be no different due to deals with Economical Insurance, ExxonMobil or Novis.

IBM (IBM.US) share price plunged severely following the release of the latest earnings report. As lacklustre revenue in cloud business was one of the major reasons behind a drop the Red Hat acquisition may help boost sentiment towards the company. Source: xStation5