IBM andRed Hat

The skeptical reading

Investors and analysts questioned the purchase. IBM's shares fell about 4 percent on the announcement because the all-cash structure would halt buybacks and add debt, and Red Hat's shares closed at $169.63, below the $190 offer, which Fortune read as a sign of Wall Street's doubts (Fortune). Moody's put IBM's rating under review and called the deal “a departure from IBM's historical acquisition philosophy of making small, tuck-in acquisitions.” Citigroup's Jim Suva said the purchase could suggest IBM was less well placed in cloud than it had claimed. Others disagreed. Bernstein's Toni Sacconaghi argued that Red Hat already had a strong foothold in the cloud.

What customers pay for

Red Hat Enterprise Linux is a distribution of Linux, which is open source. Anyone can download the code at no charge. What Red Hat sold was a supported version: tested across a defined set of hardware, patched on a published schedule for a long support window, and certified to work with the commercial applications a bank or hospital runs. The subscription buys accountability and a maintenance commitment.

That position is strong because of work the customer has already done. Consider a hypothetical bank that has certified three hundred applications against one distribution. To move, it would have to repeat that testing for all of them. The cost is counted in engineering years and in the risk of an outage, and it has little to do with the price of an alternative. A supplier whose customers face that cost can sustain a subscription price that the free product alone could not support.

Why IBM bought it

IBM had lost ground in cloud computing to Amazon and Microsoft and had no realistic way to catch them by building. Buying a smaller cloud provider would have been costly without solving the problem. Red Hat's software runs in more than one cloud and in customers' own data centers, so its revenue does not depend on which provider wins.

IBM's chief executive, Ginni Rometty, put it this way in the announcement: “Businesses are starting the next chapter of their digital reinventions,” and “they need open, flexible technology to manage these hybrid multicloud environments.” The release also stated that “IBM preserves Red Hat's independence and neutrality” (joint press release). That commitment is the central one. A buyer paying a 63 percent premium for neutrality is promising to preserve something that its own ownership puts at risk.

The risk the structure creates

Red Hat's neutrality is an asset that IBM can reduce by its own decisions. IBM sells a cloud service. If Red Hat's engineers favor IBM's cloud, or if customers on other clouds believe they do, the reason to choose Red Hat everywhere weakens. The same dynamic ended the Nvidia and Arm transaction in 2022, where licensees objected to an owner with a competing product.

The two cases differ in how the risk shows up. Arm's licensees had a regulator to appeal to. Red Hat's customers have only their own purchasing decisions. What would show whether IBM preserved neutrality is whether Red Hat's products stay fully supported on Amazon's, Microsoft's and Google's clouds, and whether Red Hat's revenue growth, which IBM reports each quarter, holds up among customers that run on those clouds.

What a reader should take from it

The skeptics addressed the cost, and IBM's shares did fall on the announcement. They did not address the mechanism. A buyer of this kind of business should be judged on whether it kept the property that made the asset valuable, and for IBM that means the evidence of neutrality over years and not a single year of results.