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Stock Analyst Update

IBM Announces Acquisition of Red Hat

We are lowering our fair value estimate for the narrow-moat firm and think shares remain undervalued.

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 IBM (IBM) announced that it had reached a definitive agreement to acquire Red Hat for $190 per share, or $34 billion in enterprise value. We expect the deal to be funded through a mixture of cash and debt while IBM also suspends its stock buyback program for fiscal 2020 and 2021. We see some strategic rationale in favor of IBM's planned acquisition and believe there can be scale-related revenue synergies based on cross-selling opportunities. However, we think IBM has been backed into this position and needed an acquisition of this magnitude and nature to reinvigorate its growth profile and competitive positioning after years of lagging performance versus peers. As the world becomes increasingly cloud-focused, the hybrid cloud boost IBM will receive from the Red Hat acquisition will be supportive and at least give IBM a fighting chance against other cloud providers. We see Red Hat as an open-source sales catalyst for IBM across its own (and competitors) infrastructure-as-a-service, platform-as-a-service, and hosted private cloud environments, but still see IBM as an also-ran versus peers in the infrastructure and platform markets. After incorporating the acquisition into our model, we are lowering our fair value estimate for narrow-moat IBM to $158 per share from $168, as we're concerned about whether IBM will extract enough revenue synergies to justify the deal price. Nonetheless, IBM's shares remain undervalued, in our view.

In terms of the financial aspects of the deal, we view a 63% premium as a bit high compared with recent software deals and above our $145 fair value estimate for narrow-moat Red Hat. The deal is expected to close in the second half of 2019, and we do not foresee any regulatory hurdles. Rumors suggest that IaaS leaders like Microsoft, Google, or Amazon may try to outbid IBM for Red Hat, but we suspect that Red Hat's Enterprise Linux (RHEL) operating system is best served under IBM’s mammoth services divisions.

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Andrew Lange does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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