The world is buzzing about the software industry’s largest acquisition ever. This “game changing” IBM acquisition of Red Hat for $34 billion eclipses Microsoft’s $26.2 billion of LinkedIn, which set the previous record. And it’s the third largest tech acquisition in history behind Dell buying EMC for $64 billion in 2015 and Avago’s buyout of Broadcom for $37 billion the same year.
Wall Street certainly gets nervous when it sees these lofty price tags. IBM’s stock was down 4.2 percent following the announcement, and there are probably more concerns over a broader IBM selloff around how much IBM is paying for Red Hat.
This sets the stage for massive expectations on IBM to leverage this asset as a critical turning point in its history. Given that IBM’s Watson AI poster child has failed to create sustainable growth, could this be their best opportunity to right the ship once and for all? Or is this mega merger a complicated clash of cultures and products that will make it hard to realize the full potential?
Big Blue’s been in big trouble
When the chips are down, it’s time to go all in. Big Blue certainly shocked the technology world when it announced it would do its biggest deal ever and purchase Red Hat for a huge 11x premium. The reality is that Red Hat was not necessarily looking to be acquired, so overpaying was the only viable option. And if IBM didn’t pay, Google, Amazon, VMWare or even Alibaba would have.
Desperate times call for desperate measures. IBM has been struggling to demonstrate growth in new markets for quite some time. Before 2018, it had 22 straight quarters of revenue decline. And it has lost over $28 billion in revenue over the past six years. Its revenue at the end if 2017 was $79.14 billion, the lowest in 20 years and the worse annual number since 1997, when IBM revenues were $78.51 billion, excluding inflation.
In early 2018, IBM was able to produce three consecutive quarters of revenue growth, but that was mainly due to the introduction of a new line of IBM Z mainframe computers.
IBM has been a business in decline for many years. It’s hard to sustain a business with shrinking sales.
Too old to grow?
IBM is more than 100 years old and certainly suffers from comparisons to younger and nimbler companies such as Amazon, Google, Facebook, and Apple that have posted record growth in recent times. Amazon’s recent profits have surpassed $2 billion, for example.
If you contrast IBM to Microsoft, another old world software company, it’s startling to see the difference in how Microsoft has been able to reposition itself as growth company based on the cloud.
In 1990, when Microsoft release Windows 3.0, IBM had revenues of $69 billion (only $10 billion shy of what it has today), while Microsoft had around $800 million. Microsoft surpassed IBM in revenue in 2015 and crossed the $100 billion annual revenue mark in 2018.
Over the past several years, as IBM’s revenue shrank, Microsoft invested in its “commercial cloud” business that encompasses Azure, Office 365, and Dynamics 365, bringing in over $23 billion in new revenues. Microsoft has recently been firing on all cylinders while IBM experienced growth stalls.
Slow to get to the cloud
IBM’s success in the hardware business, specifically it’s Z-Series mainframes, forced it to protect its turf and distracted it from seeing the future impact of cloud. AWS began offering public cloud services back in 2006. As late as 2011, IBM was barely mentioning the word “cloud” in its annual reports or earnings calls. The company finally realized in 2013 that cloud computing was the future and made a hail-Mary purchase of SoftLayer to bridge the gap, paying $2 billion and then investing an additional $1 billion to integrate the platform.
It’s hard to establish significant market share when you’re late to the party. Softlayer’s worldwide market share continues to be a distant fifth behind AWS, Microsoft, Google, and even fresher newcomer Alibaba, which exceeded IBM’s cloud revenues in June of 2018.
IBM made several other cloud-related acquisitions, including Gravitant (a cloud brokerage and management software), Bluebox (a private cloud as a service platform based on OpenStack), Sanovi (a hybrid cloud recovery and migration software), Lighthouse and CrossIdeas (both cloud security platforms), and CSL International (a cloud virtualization platform).
Despite these acquisitions in the cloud market, IBM has failed to truly monetize those products and gain market share in the cloud.
The company has failed to capitalize on innovations before: Watson AI was at the top of its game when it debuted on Jeopardy in 2011 to beat human contestants but quickly fell behind Amazon, Google, and Microsoft.
Will Red Hat be the savior?
Red Hat is the world’s largest provider of open-source enterprise software solutions. Red Hat’s bread and butter Linux business continues to deliver growth especially as it powers many modern AI and analytics workloads. Its model has evolved from purely on-premise to a healthy subscription business used on public cloud platforms such as Amazon Web Services (AWS), Microsoft Azure, and Google Cloud Platform (GCP).
Red Hat has also expanded into open middleware solutions such as OpenStack, a cloud infrastructure platform, and OpenShift, a platform for managing application containers. OpenShift has long been a well-kept secret as Cloud Native Computing Foundation (CNCF) has grabbed most of the headlines with its Kubernetes container orchestration platform. IBM has an opportunity to leverage its marketing and global reach to encourage mainframe and legacy clients to adopt OpenShift. These platforms have been highly leveraged in private and hybrid cloud deployments, especially in industries like telecommunications.
There is no doubt that Red Hat gives IBM a much more credible cloud story. But the question really is, is it too late?
The acquisition is certainly good news for enterprises looking to shift classic container-based applications and virtual machines to the cloud. However, Amazon has already captured a significant part of that market.
While the acquisition of Red Hat gives IBM a strong position in the hybrid-cloud market, which will be popular for enterprises that are not taking the time to decommission or re-architect legacy applications, the fast-growing public cloud market will be the battleground of the future.
Will the integration get messy?
IBM has had a spotty record when it comes to integrating and capitalizing on large acquisitions.
While the majority of IBM’s M&A has been in the area of software, revenue in the segment has been disappointing. Perhaps what is concerning is that adjusting for acquisitions, IBM’s software business continues to decline — mostly due to the fact that these large acquisitions have become part of the IBM fabric and business as usual.
Can IBM integrate something as big as Red Hat without interfering with its core value proposition? Many fear that Big Blue will attempt to “blue wash” their platform of choice.
And there’s the question of whether these two different corporate cultures can come together – IBM, a slow growth company not making much progress in the cloud space, and Red Hat, an innovative, open source company that is building foundational components for operating in the cloud.
We’ve seen culture clashes derail many other high profile mergers such as HP/Compaq, HP/Autonomy, Microsoft/Nokia, AOL/Time Warner, Sprint/Nextel and Alcatel/Lucent. IBM will need to embrace the open source community and strategy.
The joint company will face critical platform decisions on the cloud front. IBM has a public cloud that competes with AWS and Microsoft. But developers use Red Hat’s Linux on many public clouds. While that multi-cloud approach will help IBM bring in revenue across the public clouds, it will create conflict with its own Softlayer cloud offering. IBM has struggled to manage this type of channel and product conflict successfully in the past.
And then there is the future of IBM’s own AIX operating system vs. Linux — not to mention the SCO-IBM Unix lawsuit still lingering in the courts.
Also to note are the lesser known Red Hat storage products like Red Hat Ceph (an object file storage) and Red Hat Gluster (a NAS product). As Red Hat integrates into IBM’s hybrid cloud group, these storage products will be separated from IBM, which could create confusion and conflict.
So while IBM certainly faces a lot of opportunity with the acquisition, there is no guarantee this big bet will pay off. IBM needed a bold move. But in the short term, we are unlikely to see any sudden movement of IBM’s position in the public cloud space. All eyes will be on its ability to catapult into the hybrid cloud market. For that, the company will need to make sure it doesn’t get in its own way.
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