Retrospective: IBM’s $34 Billion Acquisition of Red Hat

Cloud

27 Sept

Deal Overview

Acquirer: IBM
Target: Red Hat
Total Transaction Size: $34 bn
Closed Date: July 9, 2019

On 28/09/2018 IBM agreed to buy Red Hat at $190 per share of common stock, financed with a combination of cash and debt. This was IBM’s largest acquisition to date and the third largest tech acquisition in US history.

$190 per share was a significant premium, 63%, to the $116 Red Hat was trading at, even relative to the already high tech industry average of 37%. News of the acquisition saw the Red Hat share price climb above $170 by early November. IBM investors, however, were highly sceptical of the deal, IBM shares fell from $104 to $83, a 2 decade low, between the announcement to the end of October. Despite, initial shareholder scepticism, the acquisition of Red Hat predated a sustained rally in the IBM share price in the following years, disrupting a decade long decline for the company, and laid the foundations for IBM’s strategic shift towards Hybrid Cloud.

Company Details: Acquirer - IBM

Founded: June 16, 1911
CEO: Ginni Rometty
Market Cap: $112.8 bn
LTM Revenue: $80.4 bn
LTM EBITDA: $16.6 bn
P/E: 10.60

IBM was founded in 1911 as the Computing-Tabulating-Recording Company (CTR) with the merger of four of the most innovative hardware companies of the late 19th century with each developing and commercialising such technologies as the computing scale, the dial recorder, the Electric Tabulating Machine and industrial time recorders. In 1914 Thomas J. Watson Sr. joined CTR where, 11 months later, he was made President, and he renamed CTR to IBM.

Over the coming decades IBM became one of the leading innovators in the nascent electronic computer industry, culminating in the 1964 release of the IBM System/360, a general purpose mainframe, with its modular architecture revolutionising how businesses were able to scale computing needs. Over the next decade IBM grew to become the dominant player in the massive mainframe market, this was hugely profitable for IBM which became one of the world’s 10 most valuable companies in 1975 with a 62% market share in the mainframe market by 1981.

The 1980s were a more challenging decade for IBM, despite early successes in personal computing and network technologies a series of strategic missteps led to IBM missing these hugely profitable emerging markets, at the same time these same technologies began to erode the value of IBM’s core mainframe business, earnings dropped from a high of $5bn a year in the early 1980s to $3bn in 1989. By the early 1990s IBM was in serious trouble, in 1991 IBM posted a loss of $8.10bn, the highest single-year loss in US history. To stabilize IBM’s trajectory and rebuild its reputation, new CEO Louis Gerstner implemented a new strategy, he divested from Low Margin industries and product lines and built IBM Global Services into a leading provider of IT integration. These actions were successful in reviving IBM’s financial health and diversifying IBM’s revenues over the next 2 decades.

By the mid-2010s, IBM once again faced significant challenges, its earnings peaked in 2012 but this was followed by a steady fall over the coming years. Whilst new(er) technology companies like Amazon, Google and Apple saw explosive growth in this period fuelled by the rise of the internet, cloud and mobile, IBM was still over dependent on its legacy mainframe business and related software sales which provided a less reliable source of revenue than increasingly popular subscription models and which were increasingly threatened by migration towards the cloud, additionally, whilst IBM Global Services had driven consistent earnings growth it was a lower margin and slower growth than the markets pursued by competitor companies. As such IBM leadership again sought to refocus the business, they invested heavily into cloud and IBM’s Watson AI platform which achieved some notable breakthroughs, most notably winning Jeopardy! in 2011, however, commercialisation was a greater challenge than expected with IBM Health losing billions of dollars for the firm before being divested.

IBM entered the public cloud market in the early 2010s seeking to compete with the then dominant player AWS. In 2013 IBM acquired SoftLayer a leading infrastructure-as-a-service company. SoftLayer provided on-demand access to dedicated servers and other resources which enabled client to run applications in a highly scalable and more cost effective manner with a particular focus on bare-metal servers which were highly performant and predictable relative to the virtualized, multi-tenant infrastructure favoured by competitors. SoftLayer’s technology and data centres became the foundation for IBM Cloud. As the cloud industry developed it became clear that most enterprises preferred the more scalable approach of AWS and Azure to the IBM Cloud offering and IBM was unable to match the ecosystems built by AWS and Azure. By 2018 IBM had firmly fallen behind AWS, Azure and Google Cloud Platform to around 5% market share in the public cloud market.

IBM executives recognised that in spite of the failure to become a leading player in public cloud, cloud still presented enormously lucrative opportunities to leverage IBM’s deep institutional trust from enterprises across the world and their deep hardware and software expertise. In 2017 IBM launched IBM Cloud Private which enabled companies to build and manage cloud-native applications on premises, this was enhanced by the release of Cloud Paks in 2018 which allow organisations to deploy and manage workloads across on-premises, private and public cloud environments.

In 2018 IBM had one of the most diverse product offerings of any technology company. Arranged into 3 core business areas, Hardware, Software and Consulting, IBM products included the aforementioned cloud solutions, in addition to IBM Watson it’s AI platform, business intelligence software, database software, IBM servers and storage solutions, security solutions and IBM Global Business Services their consulting division. Through IBM’s expertise across these core business areas, it sought to assist enterprises with the challenges of storing, processing and utilizing data at scales which were only becoming realisable towards the end of the decade. IBM executives aimed to further boost their depth of technical talent and intellectual property portfolio to enable them to achieve this transformation through strategic acquisitions.

Company Details: Target - Red Hat

Founded: 1993
CEO: Jim Whitehurst
Market Cap: $34 bn
LTM Revenue: $3.3 bn
LTM EBITDA: $644 m

Red Hat was founded in 1993 by Marc Ewing. It sold Linux and Unix software accessories. In 1994 Ewing developed Red Hat Linux, a Linux distribution which provided a number of advantages for small businesses and consumers over the standard Linux kernel. From the beginning, Red Hat was dedicated to open-sourcing its software, this strategy set Red Hat Linux apart from proprietary competitors like Windows and Unix systems and allowed for greater cost savings and flexibility for users and for collaboration on Red Hat Linux and future products by a global community of developers. Through the decade Red Hat Linux grew in popularity and in 1999 Red Hat went public on the NASDAQ raising $84 million in its IPO. Despite Red Hat’s success, the proprietary software model dominated this era with the industry leaders, including Microsoft, Oracle and SAP, rigidly adhering to a closed-source approach to software development.

In 2000, Red Hat launched Red Hat Enterprise Linux, RHEL, another Linux distribution which this time was suitable for workloads which were core to enterprise functions, these tasks required highly secure and reliable software which RHEL provided with Red Hat generating revenue through a subscription-based support model. In 2003, Red Hat ended its development of Red Hat Linux, it is now part of the Fedora project which provides community development and support. By 2005, RHEL has begun to dominate the enterprise Linux market, it was supported by Dell, IBM, HP and Oracle and in December 2005 CIO Insight magazine ranked Red Hat #1 in its annual “Vendor Value Survey”.

Through the late 2000s Red Hat continued its strong growth, in 2008, it was the first company which primarily developed open-source software to surpass $500 million in annual revenue. In 2006, Red Hat expanded beyond its core competency of Linux distributions through the acquisition of JBoss, a provider of open source middleware (middleware is software which allows different applications to interact regardless of the underlying infrastructure), for $420 million.

In 2010, Red Hat launched OpenShift a containerization platform for cloud native development. This followed the launch of AWS Elastic Compute 2, EC2, and Simple Storage Services, S3, in 2006, Google App Engine in 2008, and Microsoft Azure in 2010. Containers are software which allow developers to run applications across a variety of computing environments, a challenge which had plagued application developers since the dawn of computing, and unlike Virtual Machines, they shared the host computer’s operating system thus making them smaller and faster to run. As cloud became the dominant computing paradigm Containers offered several features which enhanced the innate benefits of cloud including improved scalability and elasticity, since containers can be started, stopped and replicated, and so became widespread as developers increasingly built cloud native applications. Containers also improved portability across cloud environments (different cloud providers, private and public cloud, and different regions), thereby allowing organisations to follow multi-cloud strategies. OpenShift was built on Kubernetes, a platform that automates the management, deployment and sailing of containerized applications, offering all core functionality whilst extending the number of features through additional tools, automation and security, thereby tailoring Kubernetes for enterprise customers.

Red Hat achieved incredible growth through the 2010s spearheaded by their flagship products, Red Hat Enterprise Linux, and Open Shift. In 2015 once again set a record for open-source software companies, becoming the first to reach $2 billion in annual revenue.

Motivation

Strategic repositioning to Cloud + hybrid cloud

In 2018, IBMs traditional business lines faced structural decline, however, the value of cloud was clear, the strength of AWS had propelled Amazon to become the world’s 4th largest company by market cap, in Q1 2018, AWS generated $1.4 billion in operating income, a margin of 26%, relative to Amazon’s total net income of $1.9 billion, margin of less than 1%, Azure was leading a revival at Microsoft, and cloud based companies like Salesforce were seeing huge revenue growth. However, IBM could not directly compete with the major public cloud providers, earlier in the decade they had pursued technical directions with IBM cloud which had not borne fruit commercially and by 2018 IBM has sub-4%, and shrinking, market share.

A key aspect of Amazon and Microsoft’s strength in cloud came from their huge CAPEX. CAPEX allows public cloud companies to meet the computing and storage demanded at hyper-scales. Higher CAPEX means more potential customers, economies of scale and advanced hardware options like GPUs, CAPEX has been the best predictor of market positioning since the dawn of cloud computing. In 2017, IBM had $4 billion in CAPEX, in the same year Amazon and Microsoft had $20 billion and $12 billion in CAPEX respectively. Amazon, Microsoft and IBM all primarily financed CAPEX through reinvestment of free cashflow. AWS had long reinvested its strong cash flows generated by AWS, $18.46 billion in 2017, at the time Amazon did not pay a dividend. Microsoft generated free cashflow of $31.3 billion in 2017, it paid dividends totalling $12 billion and repurchased $10.2 billion in shares of common stock. IBM generated $13.9 billion in free cash flow in 2017, it paid dividends totalling $5.5 billion and repurchased $4.3 billion in shares. It was clear the IBM could not compete with Amazon and Microsoft on CAPEX, this was a decisive factor in its inability to compete in public cloud.

Competing with AWS and Microsoft in public cloud was not viable for IBM, however, not being a player in the cloud market was not an option at a time when enterprise software profits were dominated by those generated by cloud.

At the end of 2017, 43% of corporate data was stored in the cloud, a 23% increase from 2016, but many companies had concerns, particularly relating to security and regulatory issues, preventing further adoption. In 2017 over a quarter of companies that had performed cloud migrations moved some of their systems back on-premises with 6 in 10 of these citing needing better control over security and compliance. Hybrid cloud, which created connected systems combining public and private cloud with on-premises systems, offered a perfect solution to these concerns. In early 2018 hybrid cloud was still very much in its infancy with Red Hat OpenShift being the lead player in enabling effective hybrid cloud solutions. A hybrid cloud first strategy seemed the perfect solution for IBM - an under provisioned market with a huge potential customer base and Red Hat with its market leading platform was the perfect acquisition target for this new strategy.

Financials

IBM’s acquisition of RedHat was predicted to be free cash flow and gross margin accretive within 12 months, additionally, Red Hat’s 18% year-on-year revenue growth was expected to reverse the trend of declining revenues at IBM. The Red Hat deal offered IBM the opportunity to expand its revenue generated from subscription fees rather than one-off purchases, a trend which had been common across the technology industry as subscription fees provided more stable and predictable cashflow than the large purchases associated with IBM’s legacy hardware businesses and proprietary software. Software businesses where the majority of their revenue is generated through subscription fees typically trade at a 30% to 50% premium to those generating their revenue primarily from one-time sales.

Motivation for Red Hat

By 2018 Red Hat had become the poster child for the success of open-source software, however, it was limited by its relatively small size. The acquisition by IBM would allow Red Hat to bolster its strong sales growth by leveraging IBM’s sales network. In 2018 IBM served 95% of Fortune 500 companies and had developed decades of institutional trust, knowledge and connections across its 3 service lines, an asset which Red Hat could not hope to acquire on its own but which would be invaluable for continuing to grow sales of Red Hat software.

Doubts

There were several doubts relating to the acquisition, these were primarily focused on: questions surrounding the viability of a significant market for hybrid cloud products, cultural differences, and the acquisition value.

The primary doubt around the acquisition was related to questions surrounding the viability of a significant market for hybrid cloud products. In 2017, Microsoft had launched AzureStack and it was, at the time, the most advanced truly hybrid cloud product from a public cloud provider, however, within only a matter of months, Microsoft refocused on extending Azure services into customer data centres. Additionally, OpenShift was simply one of many Kubernetes distributions (AWS, Azure, and GCP all had their own) some of which offered a broader range of functionality. The unique selling point of OpenShift was that one could run containers on-premises or in the cloud, however, many doubted that this was a competitive offering to public cloud providers whose vast array of services were increasingly available both on-premises and in the cloud. Many commentators, particularly in the tech industry, questioned IBM’s definition of hybrid cloud with angel investor Charles Fitzgerald describing it as “the kitchen sink”. IBM estimated the potential size of the hybrid cloud market to be $1 trillion (the global IT market in 2018 was $3.65 trillion). The combination of these factors led many to ask if hybrid cloud was truly a market large enough to stem IBM’s gradual decline and provide an opportunity for growth or if it was simply an opportunity for the large public cloud providers to expand their services to on-premises servers along with some supporting tools offered by smaller companies.

Red Hat had developed a culture deeply rooted in openness, collaboration, and meritocracy centred around its open-source business model. Over the years it had become renowned for its culture and many industry leaders and Red Hat employees believed that it had played a central role in its success. By contrast, IBM, one of the oldest and largest technology companies, was corporate, hierarchical, and slow moving. Culture clashes is one of the leading causes of M&A failure with past acquisitions, like AOL’s acquisition of Time Warner in 2000, providing cautionary tales. Many doubters believed that this acquisition would harm the unique culture that they believed had been the bedrock of Red Hat’s innovation and which had driven Red Hat’s impressive growth.

The acquisition price of $190 a share was a 63% premium over Red Hat’s market cap. The total deal size of $34 billion made this the largest software acquisition at the time and added $20 billion in new debt to IBM’s balance sheet. In 2018 the bulk of Red Hat revenues were still generated from Red Hat Enterprise Linux, a product which was increasingly being threatened by Linux distributions offered for free by AWS, Azure and Google Cloud Platform. Red Hat had missed Wall Street estimates for 2 straight quarters at the time the acquisition was announced. The combination of the high premium paid, the large debt burden and concerning trends at Red Hat raised doubts amongst analysts, this was reflected by a 20% fall in IBM’s share price.

Integration

The process of integrating Red Hat into IBM sought to maintain Red Hat’s unique culture whilst effectively augmenting IBM’s hybrid cloud strategy and allowing Red Hat to leverage the benefits of IBM’s sales network.

Red Hat became an independent subsidiary of IBM retaining its own brand and leadership. Red Hat CEO Jim Whitehurst continued in his role until April 2020 when he became President of IBM. Despite IBM reassuring Red Hat employees that Red Hat would maintain its open-source focus, this was met with scepticism by some with several employees and executives departing and Whitehurst himself resigned as President of IBM in July 2021.

IBM continued to allow Red Hat to serve clients using competing cloud clients thereby allowing Red Hat to maintain its credibility as a vendor-neutral service provider.

IBM leveraged its global sales force to cross-sell Red Hat products to its wide network of enterprise customers. IBM provided training to IBM sales and consulting teams on Red Hat products and offered new bundles of Red Hat products and IBM’s exiting hardware and software products.

Outcome

Since the acquisition was finalised in 2019 Red Hat has continued to see double-digit revenue growth, by the end of 2024 it had generated over $34 billion in revenue for IBM since the acquisition (the price paid for Red Hat in 2019). Red Hat has continued to lead in open-source software development, with a NPS score of 41 in 2024 reflecting continued customer satisfaction with Red Hat services, and employee reviews on Glassdoor reflecting a culture which has maintained its unique qualities.

IBM has worked hard to realise its hybrid cloud strategy, placing Red Hat Open Shift at the centre of its efforts. In August 2019 IBM launched Cloud Paks, these are pre-integrated software bundles built on OpenShift which combine IBM Middleware, AI-powered tools, Security, automation and data management services, they are vendor neutral and run across on-premises, private cloud and public cloud. Cloud Paks have played a key role in IBM’s hybrid cloud strategy and have seen particularly successful adoption by highly regulated industries including financial services and healthcare companies. In 2023, IBM’s hybrid cloud revenues passed $22 billion.

Once considered a vanguard of the closed source software model, since the acquisition of Red Hat, IBM has embraced open source development. IBM has become a leading contributor to major open source projects including Linux and PyTorch, and it was one of the co-founders of the AI Alliance which is intended to advance open AI development. It has open sourced many of its AI models. It has also sought to adopt the subscription based revenue model of Red Hat with most of its major new releases being subscription based services including both Cloud Paks and WatsonX.

After nearly a decade of seeing its Market Cap decline, since the Red Hat acquisition, IBM has seen solid growth in its stock price reaching an all-time high in 2025 of $255, up from $104 when the deal was announced. Due to the Kyndryl spin off in November 2021 revenue and profit figures are difficult to compare.

The House View

Since the acquisition in 2019 Red Hat has gone from strength to strength and the high price IBM paid for Red Hat seems to have been worthwhile when viewed in isolation. However, it cannot be viewed in isolation, since 2019 IBM has successfully turned around a long decline in its competitiveness in the tech industry, as reflected by its market cap, supported by innovative new product releases in hybrid cloud and AI. Whilst leaving Red Hat as an independent subsidiary of IBM was successful in maintaining Red Hat’s culture, IBM seems to have adopted many of the best practises of Red Hat whether it be embracing open source, building a revenue model more biased to subscription income or becoming a smaller, more focused organisation through spin offs or redundancies (70,000 fewer employees at the end of 2023 than 2019). How IBM achieved this is undoubtedly more complex than simply through acquiring Red Hat, notably Arvind Krishna the IBM’s new CEO was the one who spearheaded this deal at IBM, however, Jim Whitehurst’s elevation to the role of President of IBM leaves few doubts over how Red Hat inspired IBM to model itself in its image.

The story of IBM’s acquisition of Red Hat is one of excellent execution of a strategic plan spearheaded by acquisition and the benefits of recognising the value of a target company and not only allowing that company the independence to continue to foster the unique aspects of its culture which made it successful, but also embracing those changes to improve your own business.