IBM: Damned If You Don’t, Damned If You Do

 

 

 

For years investors have been clamoring for IBM (IBM) to transform their business via acquisition, as tech infrastructure moves to the cloud and away from IBM’s legacy businesses. Despite some very small deals, the company instead opted to buyback stock and pay dividends with its prodigious free cash flow.

To put this capital allocation decision in perspective, consider that between 2010 and 2017 IBM spent $34.4 billion of dividends and repurchased $82.4 billion of stock, for a total of $116.8 billion of profits that were not reinvested in the business over and eight year period. Compare that with IBM’s current equity market value of $110 billion. Wow.

Thew result has been a stagnant business from a numbers standpoint ($15 billion of free cash flow in 2010 versus $13 billion in 2017), and a larger lead for the new age/cloud-based competition.



When we learned yesterday that IBM had agreed to buy Red Hat (RHT) for $34 billion, or $190 per share, a stunning premium of 63% compared with the prior closing price, you could have a few different reactions (or combination thereof). One, “it is about time they make a big move.” Two, “well, oh well, it’s five years too late.” Three, “great move, but why on earth pay such a steep price?”

IBM stock went down yesterday, which makes sense when taking a short term view (the deal is dilutive in the early years), but seems strange with a long term view (could IBM possibly be worth less on a per-share basis with RHT onboard?).

The way I see it is that if IBM was valued at 9x free cash flow without Red hat, it should not be worth less than that with it. But that begs the question, can RHT really make a dent in IBM’s massive business? If IBM’s valuation multiple is going to expand on the heels of this deal, RHT needs to show up in the numbers.

So let’s go through the numbers. RHT adds $3.3 billion of revenue, $650 million of EBITDA, and $775 million of free cash flow to IBM. If we assume IBM uses $10 billion of cash and borrows $24 billion at 5% to fund the $34 billion acquisition, debt costs will rise by roughly $1.2 billion pre-tax. Call it $1 billion annually after-tax. There goes the added free cash flow generation from RHT… completely negated (and more) from the added debt load.



IBM said that they would suspend share buybacks until 2022, so let’s assume they use 100% of free cash flow after dividends (roughly $6 billion per year) to repay 50% of the RHT-related debt in 2020 and 2021. At that point, perhaps the RHT business is generating $1 billion of free cash flow and debt service on the remaining $12 billion of incremental RHT debt is $500 million after-tax. The result in 2022 is a deal that is accretive to free cash flow by $500 million, or roughly 4% vs 2018 financial results ($12 billion free cash flow guidance for 2018).

Does this Red Hat deal add risk to IBM? Unlikely. Does it materially change the growth rate and underlying profits of the business? Unlikely. Does it mean IBM stock should go down? Unlikely. Could it result in a 10x or 12x free cash flow multiple longer term, vs 9x today? Perhaps.

Add in a dividend yield north of 5% and IBM stock around $120 per share seems likely to be able to put in a floor, assuming the RHT deal does not spur competing bids. Given the price being paid, it will likely not result in a surging IBM stock price, but from a risk/reward perspective, I would conclude that IBM is a meaningfully more attractive deep value/income-producing stock with RHT than it was without it.

Full Disclosure: No position in IBM at the time of writing, but holdings may change at any time

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