By Jonathan Vanian
October 29, 2018

IBM’s plan to buy enterprise software company Red Hat for $34 billion is the biggest acquisition in Big Blue’s history.

The deal, announced Sunday, also marks a major change from the company’s recent high-profile acquisitions under CEO Ginni Rometty. In 2016, IBM bought healthcare company Truven Health for $2.6 billion after paying a reported $2 billion for The Weather Company.

The Truven Health and Weather Company acquisitions centered largely on IBM’s Watson data crunching technology, which Rometty has previously pitched as critical to her company’s long-time turnaround effort. IBM hoped the vast troves of healthcare and weather data would help it train technology to predict rain storms that could keep truck drivers off the road and help doctors better diagnose diseases.

But those data-centered acquisitions have yet to significantly lift IBM’s sales, which fell short of analyst forecasts in the most recent quarter. Furthermore, revenue in IBM’s Cognitive Solutions unit, which include Watson related services, dropped 6% year-over-year to $4.1 billion in the third quarter.

By buying Red Hat, IBM gains a well-established business software company that has revenue today instead of a mere possibility in the future. Red Hat may not be known for cutting edge artificial intelligence technologies, but it does have a reputation as one of the few companies with a successful business built on open source, or free, software—which, in Red Hat’s case, is the Linux operating system used in corporate servers worldwide.

David Holt, an analyst with market research firm CFRA, said that the deal makes sense for both IBM and Red Hat since they were already big partners. Previously, IBM has teamed with Red Hat on consulting and software for running the Linux operating system on IBM’s mainframe computers.

Holt also mentioned that IBM can use its huge sales team and existing relationships with big businesses to sell Red Hat’s hybrid cloud technology to more customers. Red Hat’s business of selling hybrid cloud services, which companies use to manage their apps that run in both internal data centers and cloud data centers, is smaller than its core business centered around paid support for Linux.

Toni Sacconaghi, an analyst with Bernstein Research, said in a research note that the acquisition makes sense for IBM because Red Hat already has a “strong foothold in the cloud.” Red Hat’s Linux OS is used in most cloud computing data centers by customers like Amazon Web Services and Microsoft’s Azure cloud service.

Sacconaghi said that the acquisition is a “huge win” for Red Hat because investors have punished its shares in recent months due to slowing growth in its core Linux business. IBM is offering to pay a 63% premium on Red Hat’s shares based on their closing price on Friday, which is big by tech standards.

But some investors are skeptical that the acquisition, a mix of cash and debt, will happen at all. Red Hat’s shares rose only 45% to $169.63 on Monday, well below the $190 offer price, a telltale sign of Wall Street’s doubts.

Sacconaghi added that IBM’s acquisition of Red Hat may be IBM’s management admitting defeat in its earlier data-focused strategy—or, at least, that it was not lifting the business fast enough. He also noted that Rometty will turn 62 by the time the deal closes, which is older than the retirement age of some previous IBM CEOs like Sam Palmisano and Lou Gerstner.

Rometty’s age and the fact that the deal appears to be a “major pivot” from her current strategy could indicate that she may leave IBM after two or three years, Sacconaghi said. On CNBC on Sunday, Rometty tried to quell rumors about stepping down, saying “I’m still young and I’m not going anywhere.”

Dennis Gaughan, Gartner’s lead analyst on applications, told Fortune in an email that it’s unclear whether the acquisition is a good idea. “It’s hard to say who the winners and losers will be at this point,” he said.

Gaughan explained that IBM is pitching the deal as important to its “hybrid clouds” strategy. The challenge, however, is that all of IBM’s “cloud competitors” like Microsoft and Google, are all pushing a similar strategy, which means that IBM will still face tough competition.

Daniel Ives, an analyst with Wedbush, said in a research note that the deal represents “a major shot across the bow” by IBM against top cloud players such as Amazon (AWS), Microsoft (Azure), and Google (Google Cloud). “There is another player in town that plans to aggressively compete in this massive secular hybrid cloud shift,” Ives said.

Although Ives believes that Amazon and Microsoft will be cloud computing leaders for the coming years, the deal could help IBM gain market share in an industry he expects to be massive.

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A big challenge for IBM will be creating compelling hybrid cloud services that work with competitors like AWS and Azure while also convincing companies to use IBM’s public cloud service, Gartner’s Gaughan noted.

Additionally, IBM challenges other enterprise tech giants like Hewlett Packard Enterprise and Cisco in pitching their own technologies and services for customers to manage corporate infrastructure, whether it be in internal data centers or with cloud providers.

As for whether the IBM’s Red Hat acquisition will work better than its previous data-heavy deals like Truven Health, Gaughan said “Potentially yes, and given the price tag they are paying they absolutely need it to!”

 

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