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IBM chases Amazon into cloud with US$33b Red Hat purchase

The cash deal, IBM's biggest ever, gives it much-needed potential for real revenue growth

The Red Hat deal represents an admission by IBM's chairperson and CEO Ginni Rometty that in-house growth wasn't going to be enough to keep the computer-services giant from falling permanently behind in a market that is growing in importance and size.

New York

INTERNATIONAL Business Machines Corp's (IBM) purchase of Red Hat Inc is a US$33 billion bid aimed at catapulting the company into the ranks of the top cloud software competitors.

The cash deal, IBM's biggest ever by far, boosts the 107-year-old computer-services giant's credentials overnight in the fast-growing and lucrative cloud market - and gives it much-needed potential for real revenue growth. The company once synonymous with mainframe computing has been slow to adopt cloud-related technologies and has had to play catch-up to market leaders Inc and Microsoft Corp in offering computing and other software and services over the Internet.

"The acquisition of Red Hat is a game-changer. It changes everything about the cloud market," said Ginni Rometty, chairperson and chief executive officer of IBM, in a statement on Sunday.

IBM has seen revenue decline by almost a quarter since Ms Rometty, 61, took the CEO role in 2012. While some of that has been from divestitures, most is from declining sales in existing hardware, software and services offerings, as the company has struggled to compete with younger technology companies. She has been trying to steer IBM toward more modern businesses, such as the cloud, artificial intelligence and security software with inconsistent results.

In its third-quarter earnings report, IBM disappointed investors who were seeking more progress in those areas after six years of declining sales that had only recently started to show gains. Still, the improvements had been coming largely from IBM's legacy mainframe business, rather than its so-called strategic imperatives. Cloud revenue grew 10 per cent in the period to US$4.5 billion, but that was slower than the 20 per cent expansion in the second quarter.

The Red Hat deal could signal to investors that IBM wasn't as well positioned in cloud as it had been claiming, said Jim Suva, an analyst at Citigroup Research.

"We expect investor scepticism around the deal given IBM's messaging that it is well underway in its transformation," he noted.

Investors have grown impatient. The stock is down 19 per cent this year and 31 per cent over the last five years, giving IBM a market value of US$114 billion.

Warren Buffett virtually gave up on IBM last year. His conglomerate, Berkshire Hathaway Inc, cut its stake in the company by 94 per cent, while increasing its investment in Apple Inc.

The Red Hat deal represents an admission by Ms Rometty that in-house growth wasn't going to be enough to keep IBM from falling permanently behind in a market that is growing in importance and size.

Acquiring Red Hat makes IBM "a credible player in cloud now," Bloomberg Intelligence analyst Anurag Rana said. "This gives them an asset that looks forward and not backwards."

IBM will pay US$190 a share in cash for Raleigh, North Carolina-based Red Hat, according to a statement from the companies on Sunday, confirming an earlier Bloomberg News report. That's a 63 per cent premium over Red Hat's closing price of US$116.68 per share on Friday.

Ms Rometty said IBM "paid a very fair price. This is a premium company. If you look underneath, this is strong revenue growth, strong profit strong free cash flow," she added.

Revenue at Red Hat, which sells software and services based on the open-source Linux operating system, is expected to top US$3 billion for the first time this year as the company's Red Hat Enterprise Linux product attracts business from large customers.

Last quarter the company reported a record 11 contracts valued at over US$5 million each and 73 over US$1 million, according to a note from JMP Securities analyst Greg McDowell.

At the same time, sales last quarter overall missed analysts' expectations and the forecast for the current quarter also fell short, fuelling concerns Red Hat may be losing deals to rivals and growth may be slowing. The company said at the time it believes the slowdown has "bottomed out".

Red Hat's stock is down 28 per cent over the past six months through Friday, according to data compiled by Bloomberg.

Armonk, New York-based IBM will continue to grow its dividend and neither company will cut jobs after the deal, Ms Rometty said. "This is an acquisition for revenue growth, this is not for cost synergies," she added.

JPMorgan Chase & Co and Goldman Sachs Group Inc and Lazard Ltd advised IBM on the deal. Morgan Stanley and Guggenheim Partners were financial advisers to Red Hat, while Skadden Arps Slate Meagher & Flom provided legal advice.

"Knowing first-hand how important open, hybrid cloud technologies are to helping businesses unlock value, we see the power of bringing these two companies together," JPMorgan CEO Jamie Dimon said in an emailed statement. BLOOMBERG

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