Did IBM Buy Red Hat at a Fair Price?

Introduction

On October 23, 2015 I wrote an article titled “Retirees: I Did Not Buy IBM to Sell; It’s about the Dividend Income Stupid.”  At the time I published the article, I was long International Business Machine (IBM) and remain long today.  With the article I attempted to illustrate why I was including IBM in retirement portfolios.  As the title so brashly stated, it was about the dividend income.  Stated more directly, I was investing in IBM to augment the yield of my dividend growth portfolio based on the company’s quality and financial strength.

Moreover, I talked about the many varied investing strategies that investors could implement.  Specific to my IBM investment, it’s important to emphasize that I intended to hold the company for many years to come, and still do.  Therefore, I am not too concerned about short-term price volatility simply because I have no intention of selling anyway.  Additionally, I had, nor do I have, any delusions about IBM generating significant short-term capital gains.  In fact, I was confident that I would have to be patient on the capital appreciation front, but as I stated in the article:

A Growing Dividend Income Stream Was My Purpose for Investing In IBM

I have been and continue to be aggressively adding IBM into retirement portfolios. However, even upon my first foray into the company, I was never expecting substantial capital appreciation, at least over the short to intermediate term. Instead, my attitude about investing in this company was based solely on the opportunity to receive a safe, above-average and growing dividend yield. On that basis, IBM has proven to be a resounding success because, as I expected, IBM’s dividend income has steadily increased.”

Here I would also add that dividends are paid on the number of shares I own and not based on the current market price.  This is simply another reason why I am not too concerned with price volatility.  It will be many years from now before I decide that it is time to sell IBM, unless I truly come to believe that their financial strength has deteriorated to the point where I can no longer trust their dividend.  However, at this point I have no indication that this might be happening.  In fact, I believe the Red Hat (RHT) acquisition gives me confidence that fundamentals may actually grow again at some point in the future.

IBM’s Financial Strength

Moreover, in addition to my dividend growth objective, my contentment to continue to hold IBM was also predicated on its financial strength.  Simply stated, I considered and still consider IBM a company of formidable resources and immense financial strength.  I understood the company has been struggling adapting to the current revolution in technology, but I felt strongly that the company would both survive and endure.  The following excerpts from the 2015 article illustrates my confidence:

“Additionally, when it comes to determining the safety associated with investing in a stock, determining whether it possesses superior financial strength is an obvious and commonly utilized approach. However, there are additional important safety measurements that are subtler, less understood and often either ignored or their importance not given the credit deserved.”

These subtler safety measurements are an above average, but sustainable, current dividend yield and sound valuation, or better yet, significant undervaluation.  This last point is critically important because I believe any issues that IBM has are already (and have been for some time) priced into the stock.  Stated more directly, I believe that IBM is trading at a significant discount to its intrinsic value.  Moreover, I believe that even if IBM continues to grow at low rates, it is still undervalued.  Because, even a company with no growth is worth more than IBM with its significant resources is currently trading at.  Consequently, and to expand on why I am not worried about the short-term or current low stock price, is simply because I do not believe in selling anything – common stock or otherwise – for less than I believe it’s worth.  Therefore, I do expect IBM to provide me substantial at best, and more than adequate at worst, long-term capital appreciation.  Therefore, as long as the dividend continues to grow, I am more than willing to patiently wait for future capital appreciation to occur.

“IBM’s Financial Strength

IBM was founded in 1910 and incorporated in the state of New York in 1911. The company took on the iconic IBM name in 1924. Consequently, IBM has been an American technology stalwart even before technology became cool. As such, IBM has been long renowned as a blue-chip dividend growth stock. So much so that legendary investor Peter Lynch once quipped “no one ever gets fired for buying IBM.”

As a side note, several people commented on my recent article on IBM suggested that I misused the above quote.  They corrected me by stating that Peter Lynch said that no IT manager ever got fired for purchasing IBM.  That may be true, however, my quote was referencing what Peter said on page 44 in his best-selling book “One up on Wall Street” as follows: “there is an unwritten rule on Wall Street: you’ll never lose your job losing your clients money in IBM.”

IBM Credit Rating Downgrades – Remain Investment Grade

Credit rating agencies have recently been evaluating IBM’s credit ratings.  However, IBM continues to receive investment grade ratings as follows:

S&P, based on the Red Hat acquisition announcement, lowered IBM’s credit rating one notch from A+ to A.

Moody’s rates IBM A1 with a possible downgrade alert as of October 29, 2018

Did IBM Buy Red Hat at A Bargain Valuation?

From my contrary perspective on IBM, my belief in the company’s formidable financial strength was validated by their announcement of the Red Hat merger/acquisition.  Most pundits and many investors suggest that IBM dramatically overpaid for Red Hat.  I disagree that they overpaid, and later in the video associated with this article I will offer a case that the acquisition was made at a fair or reasonable valuation.  This is important to me because it also validates my original reason for purchasing IBM – it was all about the growing dividend!  The following excerpt from the press release on IBM’s website contributes to back my confidence that IBM’s management team will continue to support and grow their dividend (emphasis added is mine):

“Financial Details

The acquisition of Red Hat reinforces IBM’s high-value model. It will accelerate IBM’s revenue growth, gross margin and free cash flow within 12 months of closing. It also will support a solid and growing dividend.

The company will continue with a disciplined financial policy and is committed to maintaining strong investment grade credit ratings. The company will target a leverage profile consistent with a mid to high single A credit rating. The company intends to suspend its share repurchase program in 2020 and 2021.

At signing, the company has ample cash, credit and bridge lines to secure the transaction financing. The company intends to close the transaction through a combination of cash and debt.

The acquisition has been approved by the boards of directors of both IBM and Red Hat. It is subject to Red Hat shareholder approval. It also is subject to regulatory approvals and other customary closing conditions. It is expected to close in the latter half of 2019.”

FAST Graph Analyze out Loud Video: Why I Believe IBM Paid a Fair Price for Red Hat

Summary and Conclusions

I am a long-term investor, and I am an investor that invests according to meeting specific goals and objectives.  I am not a short-term trader, I am not obsessed about beating the market, I am not trying to time the market, and I am not concerned about short-term price volatility.  Instead, I am very concerned about fundamental attributes and financial strength.

More importantly, I am not attempting to convince anyone that they should be investing in IBM.  Instead, with all the articles I’ve written on the company, I simply have been sharing why I personally have been investing in this blue-chip stalwart.  It’s about earning a predictable, safe and growing dividend income stream off the shares of IBM that have been purchased.

Moreover, I have no intention of selling the stock, so as previously stated, I’m not really interested in what the price is currently doing short-term.  On the other hand, I am concerned about what the price might be 5 or 10 years in the future when either I or perhaps my heirs may be desirous of selling the stock.  In the meantime, I’m very content to watch my dividend income grow and expect that to continue into the foreseeable future.  Long IBM for its dividend growth.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

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6 thoughts on “Did IBM Buy Red Hat at a Fair Price?

  • Chuck,

    Very interesting point on RHT valuation. It sure looks like Price to EBIT is the right historical metric. Thanks for your input. I was pursuaded last night to look harder and today put my toe in the water on IBM. If it doesn’t move too far away from the current price, when I have some more cash available next month, I’ll buy some more. Just wondering what you think about the opportunity to make money in Red Hat over the next year, given how far below the $190 offer price it’s currently trading. Based on your valuation numbers, even in the unlikely event that IBM’s offer didn’t come to fruition, owning RHT at $170 cost looks ok. Do you agree?

  • Correction to the above comment. I meant to say EBITDA which the price has tracked very tightly over many years as Chuck points out.

  • Hi Chuck, Thanks you article and video, they help. Getting ready to retire next year so my time horizon is shorter and income is more important.

    I am researching this IBM decision right now. IBM does look like it is oversold and I am thinking of buying more shares, but I have mixed emotions about their ability to leverage RHT.

    I struggled with the same question on T with the TWX and ultimately bought more T, not sure that was wise, but on the income side my average cost per share is decent and a 7% dividend matters. Alternately with GE I ultimately dumped it early last year because I lost faith in their direction.

  • Greetings Chuck,

    Thanks for your excellent work, Chuck!
    You are right more often than you are wrong.
    I have purchased IBM some years ago and and happy with your expressed optimism with the RHT buy out.

    Please give us your comments on OMI. I purchased that at $20 and suffered through to-day’s flame-out. Luckily I got out at $10 this am.
    The Fastgraphs analysis missed this fiasco I believe. I had been buying it all the way down in the $15 range, based upon what I interpreted as fairly sound fundamentals. In the interest of learning from my mistakes, what was i missing?

    Sincerely,

    Gerhard

  • Chuck, I have held IBM a few times, but don’t now due to it lack of growth. Red Hat may seem great, but I have no faith the culture at IBM will fit with the Red Hat Culture. Hope it works out, but I will pass. Chuck, keep up your excellent work as it is first class. Cheers

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