www.zerohedge.com
In what can only be described as a desperation move,
IBM announced that
it would acquire Linux distributor Red Hat for a whopping $34 billion,
its biggest purchase ever, as the company scrambles to catch up to the
competition and boost its flagging cloud sales. Still hurting from its
Q3 earnings,
which sent its stock tumbling to the lowest level since 2010 after Wall
Street was disappointed by yet another quarter of declining revenue...
... IBM will pay $190 for the Raleigh, NC-based Red Hat, a 63% premium
to the company's stock price, which closed at $116.68 on Friday, and
down 3% on the year.
In the statement, IBM CEO Ginni Rometty said that "the acquisition of
Red Hat is a game-changer. It changes everything about the cloud
market," but what the acquisition really means is that the company has
thrown in the towel on organic growth (or lack thereof) and years of
accounting gimmicks and attempts to paint lipstick on a pig with the
help of ever
lower tax rates
and pro forma addbacks, and instead will now "kitchen sink" its endless
income statement troubles and non-GAAP adjustments in the form of
massive purchase accounting tricks for the next several years.
While Rometty has been pushing hard to transition the 107-year-old
company into modern business such as the cloud, AI and security
software, the company's recent improvements had been largely from IBM’s
legacy mainframe business, rather than its so-called strategic
imperatives. Meanwhile, revenues have continued the shrink and after a
brief rebound, sales dipped once again this quarter,
after an unprecedented period of 22 consecutive declines starting in 2012, when Rometty took over as CEO.
While some of the decline has been from divestitures, most is from
declining sales in existing hardware, software and services offerings,
as the company has struggled to compete with younger technology
companies.
The good news for IBM is that the Red Hat purchase, the largest in
the company's history, will give IBM an immediate cloud revenue boost
growth as well as a suite of proven software products to sell through
its global sales force. “We will scale what Red Hat has deeply into many
more enterprises than they’re able to get to,” Rometty told
Bloomberg.
That growth, however, will come at an extraordinary price, one which shareholders may have a tough time justifying.
Furthermore, while Red Hat is expected to report an all-time high $3
billion in revenue as the company’s Red Hat Enterprise Linux product
attracts business from large customers - after booking a record 11
contracts valued at over $5 million each and 73 over $1 million,
according to JMP Securities - even here growth may be stalling out after
last quarter overall revenue missed analysts’ expectations and the
forecast for the current quarter also fell short, "fueling concerns Red
Hat may be losing deals to rivals" according to Bloomberg. While Red Hat
said at the time it believes the slowdown has "bottomed out", its stock
is down 28% over the past six months through Friday.
The bad news is that in its desperation for growth at what amounts to
be any price, IBM is almost certainly overpaying for Red Hat. This was
confirmed by Rometty's preemptive defense, telling Bloomberg that IBM
"paid a very fair price. This is a premium company. If you look
underneath, this is strong revenue growth, strong profit strong free
cash flow" she said, adding that IBM will not cut jobs as a result of
the deal: "this is an acquisition for revenue growth, this is not for
cost synergies."
Perhaps, but the bigger question is what the deal means for IBM's
balance sheet. In the press release, IBM said that "the company has
ample cash, credit and bridge lines to secure the transaction financing.
The company intends to close the transaction through a combination of
cash and debt." In other words, no IBM stock, which is already at the
lowest level this decade.
So let's do the math: IBM ended Q3 with cash of $14.7 billion, and a
record $46.9 billion in debt. Which means that IBM will likely incur at
least $20 billion in additional debt, and as a result IBM's already
shaky A+/A1 rating could soon be downgraded to BBB.
So what is IBM buying for this $34 billion and $20 billion in debt?
According to its LTM financials, Red Hat has $3.2BN in revenue and
$603MM in EBITDA. These numbers are expected to grow to $3.9BN by 2020,
when EBITDA will hit $1 billion. In other words, on an EV basis,
IBM is paying roughly 31x (net of $2.2BN in cash) Red Hat's 2020 forward EBITDA.
Of course, if one assumes continued EBITDA growth for the foreseeable
future, this acquisition could make sense. The problem is that between
the threat of a recession in the next few years, and aggressive
competition from Amazon, Microsoft and others for cloud market share,
this is a very aggressive assumption.
Meanwhile, in exchange for this $1 billion in EBITDA, IBM's net debt will grow from $32.5 billion currently to $52 billion,
almost doubling IBM's net leverage from 1.7x level to a whopping 3.2x, and well on its way to a BBB rating if not worse. Which
is why IBM promise that it will "target a leverage profile consistent
with a mid to high single A credit rating" is, with all due respect,
laughable.
But the worst news for investors may have nothing to do with the
massively overpriced acquisition, and with something that IBM noted deep
inside its press release:
The company intends to suspend its share repurchase program in 2020 and 2021.
Considering that the only factor that has kept the IBM stock price
elevated in the past decade as IBM's diluted number of shares
outstanding declined by 40%, was the company's buybacks...
... most investors may finally have no choice but to bail on "Big Blue" -
which after the Red Hat deal may be renamed "Big Purple" and leaving
shareholders with at least one blackened eye - as the company bets
everything on what may soon prove to be another disastrous gamble.