International Business Machines's (IBM) $34 billion move to acquire the Raleigh, North Carolina-based Red Hat (RHT) in the largest software acquisition ever, is a shot across Amazon's (AMZN) bow in cloud computing.
The 107-year-old company's slide to a nine year low this morning might offer investment opportunity to traders bullish on its ability to compete in this potentially $1 trillion market.
IBM's cloud business currently accounts for $19 billion of the company's revenue, about 25% of the company's overall revenue. The percentage has been steadily growing in recent years.
"IBM could potentially be a new sheriff in town," Keybanc Capital Markets senior analyst Arvind Ramnani wrote in his take on the deal. "With this elevated profile in the cloud landscape, IBM now offers a more compelling alternative to Amazon, Microsoft (MSFT) , and Alphabet (GOOGL) ."
He set a $140 per share fair value estimate for the company, adding that he expects IBM to integrate Red Hat relatively seamlessly into its overall business.
Yet, the price tag is stoking some skepticism.
The $34 billion, the biggest software acquisition ever, sets a $190 per share price on Red Hat which offers a significant premium on the company's Friday close of $116.68. The price tag is equivalent to about one third of IBM's current market cap.
Though IBM has said the deal will be free cash flow and gross margin accretive within 12 months, company pronouncements following the deal suggest some belt tightenting ahead.
For one, share buybacks that have tallied into the billions in recent years will be suspended in 2020 and 2021 as a result of the acquisition.
Additionally, the company will need to focus on debt reduction in order to assuage credit rating agencies that have taken a dim view of the company's blockbuster deal.
S&P has downgraded the company's debt from "A" to "A+", while Moody's has slated a review for a potential downgrade.
The acquisition would lead to a "substantial increase in leverage pro-forma the close of the Red Hat acquisition and represent a departure from IBM's historical acquisition philosophy of making small, tuck-in acquisitions that limit integration risk," Moody's Senior VP Richard Lane said in a statement.
Analysts have proposed that the high price point was necessary to stave off a bidding war with the like of Alphabet, but the market seems to feel the price is too rich given the slide in pre-market hours.
That said, the market size for cloud computing and the grandfather of computing's desperate need to expand into the burgeoning market makes it a logical one for analysts.
"Pragmatically, IBM can closely tie and enhance its cloud business with Red Hat's OpenShift/OpenStack solutions (SoftLayer/Bluemix) and raise its stature with developers through Red Hat's open-source stature," Oppenheimer managing director Ittai Kidron wrote on Sunday.
He held his outperform rating and a $165 price target, noting his belief that the deal will help provide shareholder value in the longer term.
Company executives will look to explain their pragmatic path to competition with the mega-cap companies dominating cloud computing this morning.
A conference call explaining the transaction will be broadcast here at 8:30 a.m. ET.
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