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IBM and Red Hat – WTF is a Hybrid Cloud?

In our last article on IBM’s activities in the area of blockchain, we talked about how difficult it is to find technology stocks for a dividend growth investing strategy. Why is that the case? It’s because technology stocks are largely growth stocks, and growth stocks can best serve investors by plowing all of their cash profits right back into the company so that it can get bigger and generate even more cash profits. That’s why technology stocks like Nvidia or Illumina don’t pay dividends. They have better uses for all that cash they’re printing – like making acquisitions with it. And that’s exactly what IBM has decided to do by paying almost $34 billion in cash (some of which was borrowed, as they only have ~11 billion on the books last we checked)  to acquire a publicly traded company called Red Hat (RHT).

As shareholders of IBM (IBM), we want someone to explain to us in laymen’s terms what this means for our future dividend streams. None of this complicated accounting mumbo-jumbo that you often read in those verbose Seeking Alpha articles, just a simple explanation as to whether the acquisition makes sense or not from a dividend growth investor’s mindset. The first thing we want to do is understand a bit about what Red Hat does.

What Does Red Hat Do

Before we try and explain what a “hybrid cloud” is, imagine if you will that IBM was able to achieve growth that looked like this:

What every IBM investor has fantasized about for the past decade

What every IBM investor has fantasized about for the past decade

That’s the sort of hockey stick growth that IBM shareholders have been fantasizing about for decades. Whatever Red Hat is selling, people are buying a whole lot of. Turns out it’s something called “open source software”, and Red Hat is the “world’s leading provider of enterprise open source software solutions, using a community-powered approach to deliver reliable and high-performing Linux, hybrid cloud, container, and Kubernetes technologies.” If you’re not familiar with open source software, it’s what everyone in startups uses because it’s free. Then, when these startups graduate and become full-fledged enterprises, they’re glad to pay fees to Red Hat and help “support the community”. There’s a certain code of ethics that surrounds the whole thing, and everyone in the community gets all chummy and loves to spend their free time making it better. It’s every company’s dream to have someone else do all the work for you for free in their spare time, and that’s kind of how open-source software works.

What is IBM Saying About the Merger?

Now that we sort of understand what Red Hat does, let’s take a look at what IBM has to say about the merger. After all, it’s their job to keep us shareholders informed about what they’re spending our future dividend payment raises on. It’s all right there in a big bold exciting press release that says:

The press release describing the acquisition

The press release describing the acquisition

While most of this is just a bunch of buzzwords vomited all over a page by some “investor relations consultant”, there are a few things highlighted in yellow that stand out.

  • Firstly, IBM says they are now the “World’s #1 Hybrid Cloud Provider.” Claiming you are #1 in the world at something is great, but not if you’re the only one doing it. We need to understand what a hybrid cloud is because that’s what the CEO, Ginni Rometty, seems to be getting all excited about when she talks about this “game-changing” acquisition that “changes everything about the cloud market.”
  • Secondly, we need to dig more into this statement they make about the acquisition being “free cash flow and gross margin accretive within 12 months.” Those of you who wasted two years of your life studying for the CFA might know what that means, but us commoners don’t have a clue.

Let’s start by looking at the financial terminology that’s being used in the press release.

Free Cash Flow and Gross Margin Accretive

In the finance world, you might use this term in a large group setting and not everyone will understand what it actually means. That is, they couldn’t explain it simply. However, nobody will ever ask what it means because in finance it’s more important that people think you know what it means. That’s why we’re going to try and explain this as simply as possible – mainly because it’s ridiculously simple. If you’re a dividend growth investor, you understand that the Earnings-per-Share is the pool of money that sends you checks every quarter. That EPS number needs to grow in order for your checks to keep getting bigger. What IBM is saying here, is that as a result of this transaction, EPS will improve in 12 months. But by how much?

Here’s a simple look at these two companies side by side which puts some key numbers into perspective. We’re going to look at the market cap (size), revenues (sales), and Net Income (profits) side by side.

IBM and Red Hat - Side-by-Side

IBM and Red Hat – Side-by-Side

As you can see, IBM completely dominates Red Hat in all three of these key metrics. If we simply just added Red Hat to IBM with everything else remaining constant, IBM’s revenues would increase by +3.7% and EPS would increase by +4.5%. Ms.Rometty has said that the company won’t look to adopt any cost-savings (synergies as they’re sometimes called), but rather the ability for the two companies to work closely together – as they have been over the last two decades – is where the synergies will come from. As we said earlier, one of those stated synergies is that IBM is now the “World’s #1 Hybrid Cloud Provider.”

WTF is a Hybrid Cloud?

According to IT consulting firm Xorlogics, “There is no strict and standardized definition of what the hybrid cloud is” and “each player on the market (consulting firms, hosting companies…) have their own definition.” We’re not off to a very good start if IBM is claiming to be #1 in something that no two people can define the same way. Maybe looking at this picture will help us understand what a hybrid cloud is:

A Hybrid Cloud

A Hybrid Cloud – Credit: Xorlogics

Still confused? So are we. In order to explain what may be going on here, we’ll give you an example we observed in the real world.

Financial services provider MSCI (MSCI) sells risk management tools to various clients. One of their tools is based in the cloud (meaning the applications is on MSCI’s machines in MSCI’s data center) and the other tool they offer which is a bit more antiquated is something you would install on your desktop. The reason that antiquated desktop app still exists is because hedge funds have not been too comfortable about entrusting all their secrets to someone else, regardless of the fact that MSCI is a well-trusted services provider. That’s just how things are. Not all companies feel comfortable stuffing all of their most important technologies into someone else’s cloud. That’s where this notion of a “hybrid cloud” comes into play. Now, the company can build private clouds (using open source software of course) and then easily talk to their public clouds. It’s the best of both worlds. At least everyone seems to agree upon that.

Conclusions

In an article by Bloomberg today, one of their analysts was quoted as saying that this acquisition makes IBM “a credible player in the cloud now.” So what exactly were they before? It’s also a bit disheartening to hear all this talk about a “hybrid cloud” when everyone has a different definition for what that actually means. However, we take solace in the fact that IBM made it a point to talk about how this acquisition will benefit dividend growth investors. But by how much, we don’t know. Watching the “cloud services” segment of their business grow faster over time is what we’ll expect to see from this “accretive acquisition”. None of this malarkey about how “exchange rates moved unfavorably” and wiped out whatever miniscule growth they managed to eke out, but real, solid growth that shows the $34 billion in cash they just spent will help fuel more dividend increases for many decades to come.

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