IBM's record offer for Red Hat leaves analysts doubtful, but still speculating on bidding war

Red Hat Inc.’s stock soared Monday after International Business Machines Corp. promised to pay a premium of more than 60% for the open-source software company to boost its hybrid-cloud service. Even with the high price, analysts speculated that a bidding war may be in the works, while also questioning whether the marriage would be beneficial.

Red Hat RHT, +45.90% shares touched an intraday high of $174.48 and recently were trading 43% higher at $166.36 Monday, while IBM IBM, -4.57% shares declined 2.6% to $121.49, after touching an intraday low of $118.30. On Sunday, IBM said Red Hat agreed to be acquired for $190 a share in a cash and debt deal with an enterprise value of about $34 billion, which would reportedly be a record for a software acquisition. On Friday, Red Hat shares had closed at $116.68, giving the company a market cap of $20.54 billion based on 176 million shares outstanding.

Read: Software stocks jump as analysts bet ‘surge of cloud M&A’ could follow IBM/Red Hat

Ginni Rometty, IBM’s chairman, president and chief executive, who called the acquisition “a game-changer” on Sunday and on a Monday morning conference call, said the deal is about “resetting the cloud landscape.”

IBM‘s stock price took a hit after its recent 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.

“We will be the undisputed No. 1 leader in hybrid cloud,” Rometty said. “Our IBM cloud platform is growing like crazy,” Rometty said on the call, referring to hybrid cloud as an emerging $1 trillion market.

In a hybrid-cloud arrangement, a company keeps some of its data in a public cloud service and some of its data on servers on its own premises, often for regulatory reasons, such as in the cases of financial institutions or health-care facilities. Red Hat does not operate a public-cloud service, though, and analysts questioned whether the two companies would even be as powerful combined as they currently are separately.

Jeffries analyst John DiFucci, who has a hold rating and a $190 price target on Red Hat, questioned whether an IBM acquisition might damage Red Hat’s brand.

“In regard to the IBM/Red Hat combination, we question whether this will have a negative effect on Red Hat’s business,” DiFucci said in a note. “As an Operating System vendor first, its neutrality to all hardware vendors was an important characteristic in our opinion. The IBM acquisition certainly calls that neutrality into question.”

In August, research firm Gartner said IBM Cloud ranked fifth in terms of cloud revenue behind Amazon.com Inc.’s AMZN, -7.94% Amazon Web Services, Microsoft Corp.’s MSFT, -4.19% Azure, Alibaba Group Holding Ltd. BABA, -6.92% and Alphabet Inc.’s GOOG, -5.75% GOOGL, -5.66% Google Cloud Platform.

“While IBM has struggled to keep up with Amazon Web Services , Microsoft and Google in the public cloud market, this deal gives IBM a new stronghold in the cloud development platforms market,” Dave Bartoletti, principal analyst at research firm Forrester, said in emailed comments Monday.

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The debt load of the deal prompted ratings firms to reconsider IBM’s credit rating. On Monday, S&P Global Ratings lowered their credit rating on IBM to “A” from an “A+,” and Moody’s put its “A1” rating of IBM on review for a possible downgrade.

Some of the analysts who checked in Monday morning suggested that other companies could make a run at topping IBM’s offer. Cowen analyst Gregg Moskowitz, who has an outperform rating and a $190 price target on Red Hat, said other suitors may arise.

“The substantial premium that IBM is paying for Red Hat might on the surface seem to make it highly unlikely that a superior bid could occur,” Moskowitz said. “However, we believe there is a reasonable possibility that another suitor could emerge.”

If the breakup fee is not too onerous, Red Hat might be wooed away by Cisco Systems Inc. CSCO, -1.92% Google or Oracle Corp. ORCL, -1.39% Moskowitz said.

KeyBanc analyst Alex Kurtz, who has an overweight rating and a $180 price target on Red Hat, said that while there’s “little potential for another takeover offer,” there was an outside possibility that Google or Cisco could enter the fray.

Brad Reback, who downgraded Red Hat to a hold and hiked his price target to $190, said in a note he “would not be surprised if a hyperscale cloud vendor such as Google, Amazon, Microsoft, or Oracle make a competing bid given Red Hat’s strategic position within on-prem datacenters (over 100K customers).”

Microsoft Corp. MSFT, -4.19% , however, recently announced a foray into open-source with its planned $7.5 billion acquisition of GitHub.

Raymond James analyst Michael Turits, who has a market perform rating on Red Hat and does not cover IBM, not only believes a bidding war may be in the near future but it may trigger a buying frenzy for software companies.

Turits said a strengthened IBM Cloud not only poses a threat to Oracle’s Infrastructure-as-a-Service offerings but “forces Microsoft to develop a Linux strategy more independent of current partner Red Hat.”

“So while therefore less likely, potential acquirers in a position to ‘come over the top’ do include both Oracle and Microsoft, as well as Cisco, and HPE HPE, -0.96% ” Turits said.

“We would also point out that especially post the recent pull back in tech valuations, this deal could spark consolidation of other large cap, category leading, ‘at scale’ vendors,” he said, calling out companies like Splunk Inc. SPLK, +1.84% ServiceNow Inc. NOW, -2.37% Atlassian Corp. TEAM, -0.91% Workday Inc. WDAY, +0.60% and Tableau Software Inc. DATA, -0.92% and Nutanix Inc. NTNX, +2.23%

Beyond Red Hat: Here are other cloud companies that could be takeover targets

DiFucci, though, was adamant that a bidding war for Red Hat is unlikely given the premium IBM is offering, and shares staying lower than the $190 price IBM offered suggests the market isn’t buying it.

IBM shares were down 21% for the year as of Monday morning, while Red Hat shares were up 39%, compared with a 0.1% decline in the Dow Jones Industrial Average DJIA, -1.61% a 0.6% slip for the S&P 500 index SPX, -1.31% and a 3.8% advance in the Nasdaq Composite Index COMP, -2.50% in 2018.

Of the 27 analysts who cover Red Hat, 13 have buy or overweight ratings, 12 have hold ratings, and two have sell ratings, and an average target price of $168.92. On Monday, six analysts used the announcement to hike their price targets on Red Hat, while two lowered theirs, according to FactSet.

Of the 22 analysts who cover IBM, eight have overweight or buy ratings, 11 have hold ratings, and three have sell ratings, along with an average price target of $159.63, as three analysts cut price targets on Monday.

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