Summary
IBM has made a huge deal with the $34 billion acquisition of Red Hat.
The deal looks very expensive as it does little to boost the organic topline growth rate and is likely to be dilutive on the bottom line (at first).
I am surprised by just a modest negative reaction in the share price of IBM as the premium looks rich.
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Just a week ago, I looked at the prospects for IBM (IBM) after it reported soft third quarter results, which triggered another pullback in its share price. This is another major disappointment which investors have gotten used to by now, as they have seen so many in recent years.
I noted that the increase in sales was short-lived, in part driven by currency headwinds, but driven by further operational weakness as well. I furthermore criticised promotional management, which stresses the good but completely neglects the bad.
That being said, valuations remain very reasonable at just 11 times GAAP earnings and close to 9 times adjusted earnings. At the same time, the balance sheet remains sound. It is this balance sheet which will take a hit as IBM announced the $34 billion purchase of Red Hat (RHT). Given that management has bought back shares at fair higher levels in recent years, it was more or less forced to pay for such a deal in cash. After all, issuance of stock would imply that management would have to admit that it made a huge capital allocation mistake.
