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Thinking About How Much IBM Is Paying For Red Hat

Morning Markets: While the rest of the technology press was working on the Red Hat-IBM deal yesterday, I was too busy enjoying being folded into United economy class. Regardless, let’s do some digging around the agreement to see how much IBM is paying for the venerable open-source star.

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IBM announced Sunday that it was buying open source shop Red Hat for $34 billion in a massive, $190 per share all-cash deal. It was simply enormous news, for several reasons. First, that IBM was making a play of this size (the deal is widely tipped to be the largest software deal, ever). Second, that it was Red Hat that IBM managed to snag. And, that IBM paid such a staggering premium for the company’s shares.

As CNBC notes, the price of a single share of Red Hat “closed at $116.68 on Friday before the deal was announced.” Doing some quick sums, the $190 per-share price was therefore a 62.8 percent premium. Hot dang.

We’ll leave the strategic reporting to the Ron Millers of the world, as they can do a better job discussing what Red Hat may bring to IBM, and vice versa. But what I wanted to do was peek at Red Hat’s financials, and see what IBM is buying. And for how much. And what that might mean for startups.

Red Hat

In its most recent quarter, Red Hat’s second quarter of its fiscal 2019, the company put up the following points: $823 million in revenue (+14 percent year-over-year), 88 percent of which according to the company was “[s]ubscription revenue.” So, Red Hat is a large business with recurring revenues. Things are good so far, even if its growth rate isn’t quick.

Red Hat managed real profit off its recurring revenue, however. The firm kicked out an operating profit, measured with GAAP tooling, of $135 million. Its GAAP-approved net income was $87 million during the same period. And, during the quarter, Red Hat generated $133 million in operating cash flow.

The company literally demonstrates that it is possible to have quality gross margins (85.5 percent across all revenue) and some at-scale growth, while driving profit.

But what is that worth? Using our above math ($34 billion deal at $190 per share, a 63 percent premium, etc), Red Hat was worth around $21 billion before the deal (a rough number, admittedly). And, today, instead of looking back at its most recent four quarters, we’re going to use the firm’s current forecast.

For its current fiscal year, that is. And, per its most recent quarterly filing, the company expects the following: Revenue between $3.360 and $3.395 billion, and (converting a bit from EPS to net income), $426 million to $433 million in profit.

Now, at $21 billion (give or take), we were looking at a company valued at around (using $3.775 billion as revenue midpoint, and $429.5 million as net income midpoint) 5.6 times revenue (current fiscal year), and 49 times profit for the same expected period.

That seems low in terms of revenue multiples, comparing Red Hat to other subscription software companies that often fetch more value per dollar of revenue, but high in terms of profit multiples. So, Red Hat was cheap and somewhat expensive at the same time, depending on how you want to measure. Then IBM showed up.

$34 Billion

Recall the IBM-Red Hat sale price, $34 billion, is sharply higher than the firm’s prior worth. Though Red Hat is trading for just $169.92 today (the gap between sale price and current share price could be market doubt about the deal’s chances), we’ll use the full $34 billion as it’s the official figure.

Now, recalling our fiscal 2019 projections from Red Hat itself, IBM is paying a far steeper 9 times current-year revenue for the smaller firm, and 79 times its expected profits. That’s a lot!

Now Red Hat only looks expensive. Yes, it has cash and positive cash flow and the like, but at the same time, IBM is paying enthusiastically for the firm. And it’s not like Red Hat will change IBM’s growth profile in the short term.

After all, the larger company put up $18.8 billion in revenue during its most recent quarter, meaning that it was nearly six times as big in the three-month period as Red Hat expects to be in its current fiscal year. The smaller entity notching 14 percent yearly growth isn’t going to move the needle too much for its new parent.

So what have we learned? That IBM is paying quite a lot for Red Hat. The deal is expensive by quick-growth SaaS metrics (though Red Hat isn’t growing very quickly), and it’s an expensive agreement by conventional profit metrics as well.

Perhaps that’s why IBM shares are off nearly 2 percent as of the time of writing, despite the markets being up.

Illustration: Li-Anne Dias