Summary
- Company now has a full quarter of Red Hat under its belt.
- Management needs to show deal was worth the high price.
- Stock looking to break out of its range.
One of the more interesting names I'm looking at this earnings season is technology giant IBM (IBM). Big Blue will report on October 16th, and this is an important report since we are now more than three months past the closing of the Red Hat acquisition. As the company looks to cloud growth for its future, management now has a chance to show that the deal was worth it and help push this stock out of its longer term range.
One of the reasons IBM shares have struggled in recent months is the weaker-than-expected guidance given for the year based on the Red Hat deal. Management called for operating EPS this year of at least $12.80, which was a full dollar below street estimates. The deal is expected to add to EPS by the end of 2021, and revenues will obviously benefit in the short term.
The Red Hat deal was closed on July 9th, meaning Wednesday is the 3-month anniversary of the finalization of this major purchase. By the time IBM reports earnings next week, it will have had 14 weeks of Red Hat under its belt, which should give management a good idea of how things are progressing. Investors are likely hoping that the original guidance given was a little conservative, and perhaps the yearly forecast could be raised at the Q3 report.
What I do find interesting is where current estimates stand. Thanks to that weaker than expected forecast, analysts have reduced their Q3 EPS average from $3.53 to $2.67 since the July report, which seems rather logical. However, top line estimates have stayed mostly around $18.3 billion over the past six months, so it almost seems like the street is not counting any contributions from Red Hat just yet. For Red Hat's fiscal year 2019, ending in February, revenue was $3.4 billion, so we're talking about a material boost to IBM revenues from the deal, which closed only a little more than a week into the company's third quarter.
Unfortunately, for IBM, the company saw some bad luck with the timing of the financing of the deal. Back in May, $20 billion of debt was issued to help with the transaction, and by the time the deal closed, most US treasury rates were 50 basis points lower and are another 25-50 basis points lower now. It may not seem like much, but it means an extra $100-150 million or so a year in extra interest in the short term. While not all of the debts have the same maturity, the extra interest costs could end up adding over $1 billion to the Red Hat deal in the long run, especially when you consider prior financing transactions related to the $34 billion purchase.
When we look at IBM shares, the stock has spent most of this year between $130 and $150 as seen in the chart below. If we go back to just after the Q4 2018 report in late January, the stock has had less than a dozen closes outside of those two price points. Excluding dividends, the stock is actually down over the past four years, and even if you include those payments to shareholders, a measly $10 gain is peanuts compared to the roughly 80% gain the NASDAQ 100 has seen over the same time.
