IBM is buying Red Hat for $34 billion: The vision and goals behind the mega merger

IBM (NYSE:IBM) and Red Hat announced today that they have closed the transaction under which IBM acquired all of the issued and outstanding common shares of Red Hat for $190.00 per share in cash, representing a total equity value of approximately $34 billion.

The acquisition of Red Hat, an open-source, enterprise software maker, marks the close of IBM's largest deal ever. It's one of the biggest in U.S. tech history. Excluding the AOL-Time Warner merger, it follows the $67 billion deal between Dell and EMC in 2016 and JDS Uniphase's $41 billion acquisition of optical-component supplier SDL in 2000.

IBM is buying Red Hat for $34 billion

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The acquisition is by far IBM's largest deal ever, and the third-biggest in the history of U.S. tech. Excluding the AOL-Time Warner merger, the only larger deals were the $67 billion merger between Dell and EMC in 2016 and JDS Uniphase's $41 billion acquisition of optical-component supplier SDL in 2000, just as the dot-com bubble was bursting.

Red Hat started 25 years ago as a distributor of a particular flavor of Linux, an open-source operating system that is commonly used in server computers that power company data centers. Today, Red Hat is known for distributing and supporting Red Hat Enterprise Linux, as well as other technologies commonly used in data centers. The company, which went public at the peak of the dot-com boom in 1999, earned $259 million on revenue of $2.92 billion in its last fiscal year, which ended Feb. 28. Its revenue grew 21% between the 2017 and 2018 fiscal years.

Open source has been the biggest theme in technology this year. Prior to IBM's purchase of Red Hat, two of the biggest tech deals of the year were Microsoft's $7.5 billion purchase of GitHub, a code-sharing service, and Salesforce's $6.5 billion acquisition of MuleSoft, whose technology stitches together disparate software applications, data and devices. Earlier this month, big-data rivals Cloudera and Hortonworks agreed to merge in a $5.2 billion deal.Both Rometty and Whitehurst, in comments to CNBC, agreed that Microsoft's purchase of GitHub was "irrelevant" to IBM and Red Hat's decision to enter into a deal. While Red Hat has talked for years about potentially selling itself to other companies, including Google, never has anything gotten nearly as serious as the negotiations with IBM, according to people familiar with the matter.

Both companies have already built leading enterprise cloud businesses with consistent strong revenue growth, as they help customers transition their business models to the cloud. IBM cloud revenue for the 12-month period through the first quarter of this year grew to over $19 billion, reflecting a comprehensive range of as-a-service offerings, and software, hardware and services that enable IBM to advise, build, move and manage cloud solutions across public, private and on-premises environments for customers.

IBM acquired all of the issued and outstanding common shares of Red Hat for $190 per share in cash, representing a total equity value of approximately $34 billion. The transaction was funded through a combination of debt and cash, with the incremental debt issued earlier this year. The company will continue its disciplined financial policy and is committed to maintaining its strong investment grade credit ratings, targeting a leverage profile consistent with a mid to high single A credit rating within a couple of years. IBM suspended its share repurchase program at the time of closing. At the same time the company is maintaining its solid and growing dividend.

When IBM bought Red Hat, I thought it was the biggest open-source deal of all time. I was wrong. At $34-billion, it's the biggest software acquisition ever. So, why is IBM spending so much money? The reason is twofold. First, it's about positioning IBM as a cloud power. And, second, it's about investing in open source. The two are intimately connected.

Thirty-four billion is a lot of money, but IBM had to do something big to get back into the game. Public cloud gets all the attention, but hybrid cloud is just now setting up for growth. It was only last year that both Amazon Web Services and Google partnered with VMware on hybrid cloud offerings, so IBM isn't necessarily late to the hybrid cloud game. Both IBM and Red Hat are big believers in hybrid cloud, so this acquisition makes sense and helps IBM compete with Amazon, Google and Microsoft in terms of hybrid cloud.

The deal, which is subject to Red Hat shareholder approval, is expected to close in late 2019. As Bloomberg reports, revenue at Red Hat is expected to top $3 billion this year, but its sales missed analyst expectations last quarter. IBM, meanwhile, has watched its revenue decline in recent years.

In 2012, Red Hat became the first one-billion dollar open-source company, reaching US$1.13 billion in annual revenue during its fiscal year.[40] Red Hat passed the $2 billion benchmark in 2015. As of February 2018[update] the company's annual revenue was nearly $3 billion.[41]

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IBM shares took a hit after this past earnings report as some analysts complained that segments meant to wean Big Blue from its legacy mainframe business, such as Watson AI and IBM Cloud, are not growing fast enough. IBM reported that third-quarter revenue at its technology services and cloud-platform segment, which includes IBM Cloud, was flat at $8.3 billion compared with a year ago, while analysts had expected $8.43 billion.

IBM paid $190 a share for Red Hat in cash, for a total equity value of about $34 billion, the company said in a statement Tuesday. The deal was announced in October. IBM shares were little changed at $139.90 in New York. They have gained about 12% since the deal was announced.

In one fell swoop that is going to cost Big Blue a whopping $34 billion, IBM is going to become a modern software powerhouse in the datacenter that has to be contended with in an entirely different way. We will be spending some time chewing on all of this, as the top brass at IBM and Red Hat no doubt have been doing for quite some time.

Red Hat is on track to close more than $3 billion of business in calendar 2018, which may not seem like a lot but this is by far the largest company that works on open source software and that makes a living selling support contracts for it. Had this been all done with proprietary software with traditional perpetual licenses and annual maintenance fees, Red Hat might be generating $15 billion in revenues a year. But the whole premise of open source is that the code is not proprietary and the value lies in the community that develops the freely available software and the only way to make a living is to sell support services. Red Hat, more than any other company, has wiped out untold tens of billions of dollars in revenue streams that IBM once depended by displacing its AIX Unix and proprietary IBM i and System z machines in so many large enterprises. Even companies that still use IBM platforms tend to have a much larger Linux and Windows footprint, and have had them for decades in many cases.

If some company makes a better offer for Redhat, does Redhat still have to pay the million dollar fee for changing from the IBM deal? A million sounds like a lot to most; but if they get a billion more, the million penalty sounds like small potatoes.

Red Hat, the first billion dollar open source company is one of the strongest players in the containers and the cloud game. IBM has been lagging behind the likes of Microsoft and Google in the trillion dollar cloud market. So to strengthen their position in this field, IBM is acquiring Red Hat.

IBM announced Sunday that it has agreed to purchase Red Hat, one of the first and most prominent open-source server operating system providers, for around $34 billion in a move the companies said would make them the hybrid cloud provider of choice.

Many interesting analyses have been and will be written about whyIBM bought Red Hat, and what it means for open source, Red Hat,Ubuntu, cloud computing, IBM, Microsoft and Amazon, amongst otherthings. But one aspect of the deal people may have missed isthat in an important sense, IBM actually began buying Red Hat 20years ago. After all, $34 billion acquisitions do not springfully formed out of nowhere. Reaching the point where IBM'smanagement agreed it was the right thing to do required a journey.And, it was a particularly drawn-out and difficult journey, given IBM'sstarting point not just as the embodiment of traditional proprietarycomputing, but its very inventor.

When I was writing my book RebelCode: inside Linux and the open source revolution in 2000, Ihad the good fortune to interview the key IBM employees who madethat happen. The events of two years before still were fresh intheir minds, and they explained to me why they decided to push IBMtoward the bold strategy of adopting free software, which ultimatelyled to the company buying Red Hat 20 years later.

Barry, therefore, realized that IBM needed to adopt one of themainstream web servers. IBM talked about buying Netscape. Hadthat happened, the history of open source would have been verydifferent. As part of IBM, Netscape probably would not have releasedits browser code as the free software that became Mozilla. NoMozilla would have meant no Firefox, with all the knock-on effectsthat implies. But for various reasons, the idea of buying Netscapedidn't work out. Since Microsoft was too expensive to acquire,that left only one possibility: Apache.

I am a senior reporter for technology, covering venture capital and startups. I am based out of Forbes' San Francisco bureau, where I previously covered tech billionaires as a wealth reporter, and wrote about artificial intelligence as an assistant editor for technology. I graduated from Duke University, where I spent time as news editor for The Chronicle, the university's independent news organization. Follow me on Twitter at @kenrickcai, on Mastodon at @kenrickcai@journa.host and email me at kcai [at] forbes.com. 2ff7e9595c