IBM has closed the largest procurement in its more than 100-year history. With the purchase of Red Hat announced in October, but materialised in recent weeks, it positions itself as the leading hybrid cloud provider and accelerates IBM's high-value business model.
Baker Tilly International's 34.000M$ that they will pay for the transaction raises the question of whether the price is commensurate with the value that Red Hat can bring them. For this reason, we analyse from the corporate finance point of view the valuation company in the following lines.
Founded in 1993, Red Hat is specialises in Linux operating systemsThe most popular type of open source software and an alternative to software made by Microsoft.
In its early years its business model was based on taking Linux and selling it to its customers, after adapting it to their taste, the basis and hallmark of its current success. In this way it competed directly with Microsoft, making money from the sale of CDs that usually came out every 6 months.
Five years later, it made its debut on the stock exchange, ranking among the best performing companies in that period.
Back in 2002, Red Hat introduced a new operating system (Red Hat Enterprise Linux), which meant a complete change in their business model. At that time they decided to end their previous product and main source of revenue to focus on enterprises and sell under a subscription model.
Red Hat not only sells its operating system, but also offers virtualisation services, cloud management solutions, storage technologies and others.
Today, 90% of Fortune 500 companies use its products.
Red Hat e IBM have been partners for some 20 years now. With the buyRed Hat will become a unit of IBM's Hybrid Cloud division, while maintaining its open source legacy. In this way, the companies said, they will offer a new generation of hybrid multi-cloud platforms that will be based on open source technologies, such as Linux and Kubernetes.
The deal, closed at 34,000 M$, is the largest ever in IBM's history. Agreed at the end of October, it involves a cash payment of $190 for each Red Hat share.
This deal is undoubtedly the best option for IBM, as taking into consideration the low price of its shares, a share offer would have had a dilutive effect on its shareholders. In addition, the low net debt level and the strong free cash flow generation will keep the debt level at reasonable levels.
Before starting with the analysis, it should be noted that Red Hat's financial years close in February, so we can have the financial information for 2019.
Firstly, it is worth noting that the 2019 financial year closed with a quarter in which its sales increased, as has been the case in the previous 68 quarters.
Sales are growing in double digits, as companies are increasingly turning to hybrid cloud infrastructures and open source technologies. This trend is likely to continue over the next few years, although it will eventually slow as adaptation grows. Even so, this increase in sales is evidence of Red Hat's leading position in the industry.
EBITDA continues to grow in line with sales, showing that the company is not incurring excessive expenses. However, a 'slight' increase in 2019 is noteworthy, as a result of the expenses incurred by the IBM acquisition.
The evolution of the net income and ROE shows that Red Hat is highly profitable compared to other comparable companies, which is partly due to the high-margin business it operates and partly due to the efficient structure it has developed.
The balance sheet shows a significant increase as a result of the increase in the company's business figures. Thus, it can be seen how the customer and cash items have increased, accounting for a large part of the increase in assets.
Likewise, liabilities and equity have increased gradually. This, together with a stable level of debt and reasonable growth, shows the robustness of the company's equity structure.
IBM will pay for the deal through cash and debt, along with a halt to share buybacks in 2020 and 2021.
The valuation of $190 per share (for a total of 34,000 M$) is a premium of 63% to the trading price at the time of the announcement (29 October 2018). Compared to other transactions in the sector, this is an excessive premium. The average premium for all transactions last year was around 34%, or 37% for M&A in the technology sector.
In terms of multiples, IBM has acquired Red Hat at 12.3x EV/Sales. A rather high multiple when considering the acquisitions IBM's historical performance and its cautiousness in all of them. The situation worsens when looking at the historical average of software companies, which have sold off around 4.5x according to EY data.
IBM has failed to achieve sales growth in recent years. However, the cloud segment, part of its strategy, is one of the few businesses that manage to grow.
For its part, Red Hat has successfully transitioned to a cloud-based company.
Therefore, as both companies operate in the so-called hybrid cloud aimed at enterprises, the corporate operation makes perfect sense from an operational point of view. However, as indicated above, the price and valuation given seem excessive.