IBM acquires Red Hat

IBM nicknamed Big Blue, a hundred-year-old company, is struggling in comparison to younger and nimbler
companies to increase revenues and profit margin. Virginia Rometty, IBM’s Chairman, president and CEO,
is frequently stating strategy to from lower-margin business to new, higher-margin businesses such as
cloud services, AI, security, blockchain and quantum computing. she acknowledges that a bold move is
the need of the hour.

Rometty announced the acquisition of Red Hat on October 28 2018, proclaiming, “Through this acquisition
IBM will become the world’s leading hybrid cloud provider and completely change the cloud landscape.”
James Whitehurst, Red Hat’s President and CEO, said “The combination of two will accelerate the
expansion of the Red Hat’s leading open source portfolio and provide greater value to clients.”

Shift in IT industry
In span of two centuries, world has witnessed four industrial revolutions. We are currently implementing
the Fourth Industrial Revolution. This is characterized by the application of information and
communication technologies to industry and is also known as “Industry 4.0”. It builds on the
developments of the Third Industrial Revolution. Production systems that already have computer
technology are expanded by a network connection and have a digital twin on the Internet so to speak.
These allow communication with other facilities and the output of information about themselves. This is
the next step in production automation. The networking of all systems leads to “cyber-physical production
systems” and therefore smart factories, in which production systems, components and people
communicate via a network and production is nearly autonomous.

The networking of all system requires IT applications. Traditional applications were designed, developed
and built to be operated on premise, hosted and managed end-to-end by the internal IT organization. But
this leads to huge infrastructure and constant upgradation of technology. Cloud-native applications that
are built to run on cloud/as-a-service infrastructure and middleware environments that operate both on
and off premise provides better alternative, which is cost effective and real time data can be assessed
from anywhere anytime.

Cloud-native applications are stateless, technology independent and can be deployed in almost any
context. Cloud-native is today’s choice when designing and deploying applications that are fast (in terms
of deployment and change time), agile and deliver value for money.

Cloud computing is shared pools of configurable computer system resources and higher-level services
that can be rapidly provisioned with minimal management effort, often over the Internet. Cloud
computing relies on sharing of resources to achieve coherence and economies of scale, similar to a public
utility. Third-party clouds enable organizations to focus on their core businesses instead of expending
resources on computer infrastructure and maintenance.

Cloud-computing providers offer their services according to different models, of which the three standard
models are Infrastructure as a Service (IaaS), Platform as a Service (PaaS), and Software as a Service (SaaS).
These models offer increasing abstraction; they are thus often portrayed as a layers in a stack:
infrastructure-, platform- and software-as-a-service.

Hybrid cloud

Hybrid cloud is a composition of two or more clouds (private, community or public) that remain distinct
entities but are bound together, offering the benefits of multiple deployment models. Hybrid cloud can
also mean the ability to connect collocation, managed and/or dedicated services with cloud resources.
Gartner defines a hybrid cloud service as a cloud computing service that is composed of some combination
of private, public and community cloud services, from different service providers. A hybrid cloud service
crosses isolation and provider boundaries so that it can't be simply put in one category of private, public,
or community cloud service. It allows one to extend either the capacity or the capability of a cloud service,
by aggregation, integration or customization with another cloud service.

Varied use cases for hybrid cloud composition exist. For example, an organization may store sensitive
client data in house on a private cloud application, but interconnect that application to a business
intelligence application provided on a public cloud as a software service. This example of hybrid cloud
extends the capabilities of the enterprise to deliver a specific business service through the addition of
externally available public cloud services. Hybrid cloud adoption depends on a number of factors such as
data security and compliance requirements, level of control needed over data, and the applications an
organization uses.

Another example of hybrid cloud is one where IT organizations use public cloud computing resources to
meet temporary capacity needs that cannot be met by the private cloud. This capability enables hybrid
clouds to employ cloud bursting for scaling across clouds. Cloud bursting is an application deployment
model in which an application runs in a private cloud or data center and "bursts" to a public cloud when
the demand for computing capacity increases. A primary advantage of cloud bursting and a hybrid cloud
model is that an organization pays for extra compute resources only when they are needed. Cloud bursting
enables data centers to create an in-house IT infrastructure that supports average workloads, and use
cloud resources from public or private clouds, during spikes in processing demands. The specialized model
of hybrid cloud, which is built atop heterogeneous hardware, is called "Cross-platform Hybrid Cloud". A
cross-platform hybrid cloud is usually powered by different CPU architectures, for example, x86-64 and
ARM, underneath. Users can transparently deploy and scale applications without knowledge of the cloud's
hardware diversity. This kind of cloud emerges from the rise of ARM-based system-on-chip for server-
class computing

Hybrid Cloud market

The report "Hybrid Cloud Market by Component, Service Type (Cloud Management and Orchestration,
Disaster Recovery, and Hybrid Hosting), Service Model, Organization Size (SMEs and Large Enterprises),
Vertical, and Region - Global Forecast to 2023", The global hybrid cloud market size is expected to grow
from USD 44.60 billion in 2018 to USD 97.64 billion by 2023, at a Compound Annual Growth Rate (CAGR)
of 17.0% during the forecast period. The major factors that are expected to drive the growth of the hybrid
cloud market include the growing demand from organizations for agile, scalable, and cost-efficient
computing; rising need of standards for interoperability between cloud services and existing systems;
increasing demand to avoid vendor lock-in; and growing number of digital services and their applications.
The rising need for more computational power and rapidly increasing adoption rate of the hybrid cloud
are expected to open new avenues for the hybrid cloud market.

The demand for hybrid cloud is increasing as organizations are deploying the hybrid cloud solution to
overcome complexities existing in the traditional Information Technology (IT) environment. Moreover,
the hybrid cloud solution offers numerous benefits, such as the reduced Total Cost of Ownership (TCO),
high security, flexibility, agility, and improved economies of scale.

IBM
IBM ranked No. 34 on the 2018 Fortune 500 rankings of the largest United States corporations by total
revenue. For the fiscal year 2017, IBM reported earnings of US$5.7 billion, with an annual revenue of
US$79.1 billion, a decline of 1.0% over the previous fiscal cycle. IBM's shares traded at over $125 per
share, and its market capitalization was valued at over US$113.9 billion in September 2018. IBM is
experiencing decline in revenues since 2014 and trend has continued since then.

Giving up a years-long fight for profits in a highly competitive part of the market for powerful networked
machines, IBM has agreed to sell its x86 server business to Lenovo for $2.3 billion, the companies
announced Thursday.

Shift from competitive market to profitable market.

Red Hat
Founded in 1993, Red Hat, Inc. is an American multinational software company providing open-source
software products to the enterprise community. Company’s revenues have grown over 15% for per year
for past 3 years, accounting to $2.9 billion total revenue in 2018. The company is showing signs of growth
with $259million in net income and $923 million in operating cash flow.

In 2018, Multi-product adoption and expansion across our portfolio helped drive annual subscription
revenue growth of 21% in U.S. dollars. Subscription revenue from our Infrastructure-related offerings,
which include core of Red Hat Enterprise Linux subscriptions, grew 15% in U.S. dollars; while Application
Development-related and other emerging technology offerings, which include our middleware and cloud
technologies, grew 42% in U.S. dollars. Application Development-related and other emerging technology
offerings made up 24% of subscription revenue.

Motivation – Cloud shift

Today the way businesses functions, the way technology impact businesses, the way industry behaves
and the way society lives is changing and each of these elements is getting disrupted.

Through 2022, growth in enterprise IT spending for cloud-based offerings will be faster than growth in
traditional (non-cloud) IT offerings, making cloud computing one of the most disruptive forces in IT
markets since the early days of the digital age.

When organizations are faced with IT spending decisions, the consideration of using cloud services for
new initiatives or replacing existing systems causes a shift in spending from traditional IT solutions to
cloud. This results in an effect we call cloud shift, and it is happening more often due to a “cloud-first”
preference most organizations take when making IT spending decisions
“This cloud-first orientation increases the rate of cloud adoption and, consequently, cloud shift,” said Ed
Anderson, Distinguished Vice President Analyst, Gartner. “The rate of cloud shift varies slightly based on
the dynamics of each market segment.”

For example, Gartner’s latest IT spending forecast shows that spending on data center systems is forecast
to be $195 billion in 2019, but down to $190 billion through 2022. In contrast, spending on cloud system
infrastructure services (IaaS) will grow from $39.5 billion in 2019 to $63 billion through 2021

Post-Merger integration:

IBM acknowledges the fact that business model of RedHat is entirely different. RedHat is known as an
open source software stalwart. Its services are either based on open source code or the company develops
services and then contributes those services to the open source community. IBM understands that it has
to support current endeavors and deals of RedHat or else they will lose the customer base.

Virginia Rometty announced that, “Red Hat will join IBM's Hybrid Cloud team as a distinct unit, preserving
the independence and neutrality of Red Hat's open source development heritage and commitment,
current product portfolio and go-to-market strategy, and unique development culture. Red Hat will
continue to be led by Jim Whitehurst and Red Hat's current management team. Jim Whitehurst also will
join IBM's senior management team. IBM intends to maintain Red Hat's headquarters, facilities, brands
and practices”.

Therefore, IBM is looking forward to take slow path of integration to make acquisition a success.

Exhibit

Table 1. Worldwide Public Cloud Service Revenue Forecast (Billions of U.S. Dollars)

2017 2018 2019 2020 2021

Cloud Business Process Services (BPaaS) 42.2 46.6 50.3 54.1 58.1

Cloud Application Infrastructure Services (PaaS) 11.9 15.2 18.8 23.0 27.7

Cloud Application Services (SaaS) 58.8 72.2 85.1 98.9 113.1

Cloud Management and Security Services 8.7 10.7 12.5 14.4 16.3

Cloud System Infrastructure Services (IaaS) 23.6 31.0 39.5 49.9 63.0

Total Market 145.3 175.8 206.2 240.3 278.3

Exhibit 2: Annual Income Statement for Red Hat (Actuals & Forecasts)
Figures(in Thousands of USD) 2015 2016 2017 2018 2019E 2020E 2021E 2022E Expected Growth rate
Revenue
Total Revenue 1789489 2052230 2411803 2920461 3438420 4048241 4766217 5611529 18%
Cost of Revenue 273199 309629 354378 431797 502975 585886 682465 794963 16%
Gross Profit 1516290 1742601 2057425 2488664 2935445 3462354 4083752 4816566 15.17%
Rev Growth 14.68% 17.52% 21.09% 17.74% 17.74% 17.74% 17.74%
Cost of Revenue growth 13.33% 14.45% 21.85% 16.48% 16.48% 16.48% 16.48%
Gross Profit Growth 14.93% 18.07% 20.96% 17.95% 17.95% 17.95% 17.94%
Operating Expenses
R&D 367856 413322 480668 578330 672713 782500 910204 1058750 16.32%
SG&A 898440 1041231 1244512 1437892 1683772 1971696 2308857 2703671 17.10%
Total Op Exp 1266296 1454553 1725180 2016222 2356485 2754197 3219061 3762421 16.94%
14.87% 18.61% 16.87% 16.88% 16.88% 16.88% 16.88% 17.10%
Operating Income 249994 288048 332245 472442 578960 708158 864691 1054146
Operating Income Growth 15.22% 15.34% 42.20% 22.55% 22.32% 22.10% 21.91% 22.22%

Operating Income 249994 288048 332245 472442 578960 708158 864691 1054146
Interest Income 8336 11673 13921 18493 18493 18493 18493 18493
Interest Expense(-) 9394 23121 23822 24569 24569 24569 24569 24569
Other Income(Expense) 6562 -1735 -2164 8335 0 0 0 0
Operating Income Before Taxes 255498 274865 320180 474701 572884 702082 858615 1048070
Tax 75297 75500 66477 215898 176591 216417 264668 323067
Net Income 180201 199365 253703 258803 396292 485665 593947 725002
Interest coverage ratio 26.61 12.46 13.95 19.23 23.56 28.82 35.19 42.91
Working Capital 315502 549410 313256 424629 829538 790638 930861 1095954 1290327 23%
Working Capital / Revenues 31% 15% 18% 28% 23% 23% 23% 23%

Assumptions
Revenue growth is projected in line with the previous CAGR @18% YOY
Costs, R&D Expenses and SGA Expenses are projected based on previous growth rates i.e. CAGR of 16%, 16.32% & 17.1% respectively
Interest income has been kept constant for the projections assuming there is no change in the Financial investments structure
Interest Expense is kept constant assuming the debt structure remains constant
Other income has been exempted from the estimates for conservative purposes and to analyse organic cash flows
Working capital has been estimated as a percentage of revenues, using an average value from the actuals data. The NWC/Revenue ratio is 0.23

Exhibit 3: Ratios and Metrics for Valuation

Rf 2.70%
Rm 8.70%
Market Premium 6.00%
Beta Market 0.93
COE(ke) 8.28%
Terminal Growth 5.00%
Beta Asset 0.95
WACC 8.06%

WACC - CCF 8.10%

COA 8.40%

Market Value Book Value

Debt 768000 768000
Equity 20624356.8 1470230
Stock Price(Oct 26) 116.68 -
D/E 0.522
Interest Rate(Kd) 3.20%
D/V 0.036 0.343
E/V 0.964 0.657
Shares O/S 176760 (in Thousands)
Assumptions
Major assumption is that the Market Value of Debt = Book Value of Debt
Market Beta and Asset Beta has been obtained and calculated using DJIA as reference
Terminal Growth of the company would be 5%
The Stock price quoted for calculation is Oct 26 2018. This date captures the lowest point of Red Hat valuation in the previous year and is incidentally a day before the date of announcement
The Selection of stock price has been checked for any abnormal behavior prior to acquisition. It also captures recent investor apprehensions on future growth
Cost of Debt has been calculated using the book value of debt

Exhibit 3: Valuation of Red Hat using Free Cash Flow Method (FCF)
Figures(in Thousands of USD) 2015 2016 2017 2018 2019E 2020E 2021E 2022E Expected Growth rate
Net Income 180201 199365 253703 258803 396292 485665 593947 725002
Effective Tax Rate 29.50% 27.50% 20.80% 45.50% 30.83% 30.83% 30.83% 30.83% 30.83%
Interest Expense*(1-Tax) 6623 16763 18867 13390 16996 16996 16996 16996
Depreciation & Amortization 76263 76088 85309 97138 103195 109629 116465 123727 6.24%
Amortization on Debt Discount and
Transaction Costs 8227 21003 21691 22401 22401 22401 22401 22401 28.46%
Net Amortization of Bond Premium 9314 12169 12623 8405 8405 8405 8405 8405
Capex(-) 0 0 0 0 0 0 0 0
Change in NWC(-) 233908 -236154 111373 404909 -38900 140224 165093 194373

FCFF 46720 561542 280820 -4772 586189 502872 593121 702158

Terminal FCFF 24076419.46
NPV $ 1,51,27,030.33

Exhibit 4: Valuation of Red Hat using Capital Cash Flow Method (CCF)
Figures(in Thousands of USD) 2015 2016 2017 2018 2019E 2020E 2021E 2022E Expected Growth rate
Net Income 180201 199365 253703 258803 396292 485665 593947 725002
Effective Tax Rate 29.50% 27.50% 20.80% 45.50% 30.83% 30.83% 30.83% 30.83% 30.83%
Interest Expense*(1-Tax) 6623 16763 18867 13390 16996 16996 16996 16996
Depreciation & Amortization 76263 76088 85309 97138 103195 109629 116465 123727 6.24%
Amortization on Debt Discount and
Transaction Costs 8227 21003 21691 22401 22401 22401 22401 22401 28.46%
Net Amortization of Bond Premium 9314 12169 12623 8405 8405 8405 8405 8405
Capex(-) 0 0 0 0 0 0 0 0
Change in NWC(-) 233908 -236154 111373 404909 -38900 140224 165093 194373

CCF Method 49491 567900 285775 6407 593762.277 510446 600694 709731
Terminal CCF 24057967.99
NPV $ 1,51,18,102.55

Exhibit 5: Valuation of Red Hat using Equity Cash Flow Method (FCFE)
Figures(in Thousands of USD) 2015 2016 2017 2018 2019E 2020E 2021E 2022E Expected Growth rate
Net Income 180201 199365 253703 258803 396292 485665 593947 725002
Effective Tax Rate 29.50% 27.50% 20.80% 45.50% 30.83% 30.83% 30.83% 30.83% 30.83%
Interest Expense*(1-Tax) 6623 16763 18867 13390 16996 16996 16996 16996
Depreciation & Amortization 76263 76088 85309 97138 103195 109629 116465 123727 6.24%
Amortization on Debt Discount and
Transaction Costs 8227 21003 21691 22401 22401 22401 22401 22401 28.46%
Net Amortization of Bond Premium 9314 12169 12623 8405 8405 8405 8405 8405
Capex(-) 0 0 0 0 0 0 0 0
Change in NWC(-) 233908 -236154 111373 404909 -38900 140224 165093 194373

FCFE 40097 544779 261953 -18162 569193 485877 576125 685162

Terminal FCFE 21933542.94
NPV FCFE $ 1,36,78,453.72

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