Is IBM’s Acquisition of Red Hat the Biggest Acquihire of All Time?

Estimated Reading Time: 11 minutes

Internally, Amalgam Insights has been discussing why IBM chose to acquire Red Hat for $34 billion dollars fairly intensely. Our key questions included:

  • Why would IBM purchase Red Hat when they’re already partners?
  • Why purchase Red Hat when the code is Open Source?
  • Why did IBM offer a whopping $34 billion, $20 billion more than IBM currently has on hand?

As a starting point, we posit that IBM’s biggest challenge is not an inability to understand its business challenges, but a fundamental consulting mindset that starts with the top on down. By this, we mean that IBM is great at identifying and finding solutions on a project-specific basis. For instance, SoftLayer, Weather Company, Bluewolf, and Promontory Financial are all relatively recent acquisitions that made sense and were mostly applauded at the time. But even as IBM makes smart investments, IBM has either forgotten or not learned the modern rules for how to launch, develop, and maintain software businesses. At a time when software is eating everything, this is a fundamental problem that IBM needs to solve.

The real question for IBM is whether IBM can manage itself as a modern software company.

Outcomes from Recent IBM Acquisitions and Products

As the starting point for exploring this hypothesis, let’s take a look both at some of IBM’s software acquisitions as well as some recent in-house developed products. On the acquisition side, I’m thinking of solutions such as Kenexa, Clarity, and Emptoris while on the in-house side, I’m thinking of some of IBM’s modern design products such as Verse, Watson Analytics, and Planning Analytics.

In the case of the acquisitions, these software investments died on the vine as IBM struggled to develop ongoing support and product enhancement for these products across sourcing, HR, and financial management leading to deprecation, lower adoption, and/or the need to push these products off to partners over time.

For  products developed in-house, IBM has a very different problem. In general, the Design with these products is thought out well and in line with modern SaaS standards, but IBM struggles to launch them as products that can be purchased, trialed, and then managed and scaled as standalone businesses.

The Problem With Watson

Part of the challenge is that IBM has been too aggressive with the Watson brand, using it so ubiquitously that it is then all but impossible to really figure out whether Watson represents a product, a platform, an approach, a consulting project, or  simply an umbrella term for any data, analytic, or algorithmic solution or service coming out of IBM. Although insiders and experts could tell you the difference between the Watson product that was demonstrated on Jeopardy, the consulting efforts that were driven through vertical specific approaches, the products that came from specific aspects of the larger Watson platform, and the pieces of Watson that were available as APIs, this nuance never quite resonated with the market at large.

Because individual products struggle to shine, it was difficult to differentiate between IBM products, even those that were significantly different for each other in technological, business use case, or service aspects. At a time when customers are looking for Best-in-Breed Solutions and product names that differ from each other for each use case supported, the Watson umbrella was a significant hindrance.

Compare this to, say, Amazon Web Services, which is careful to always provide a specific brand name for each new product that comes out so that customers know how to identify and buy it from the get-go. Although Amazon still does not have the pure enterprise credibility that IBM has, Amazon has mastered scale-out technology, the willingness to compete against itself, and the ability to get technologies directly into end-users’ and customers’ hands.

IBM Developer and R&D Efforts

Also, despite IBM’s considerable size, its developer team is relatively small compared to the company at large in comparison to many of the technology companies that it takes head-on. From a percentage perspective, IBM’s ratio of developers to sales and marketing staff differs significantly from those of Google, Facebook, Microsoft, and Amazon. At a time when the standard tech investment in R&D is roughly 15%, IBM has been spending closer to 5 or 6%. Given the extraordinary pace of technological advancement and the breadth of IBM’s technology portfolio, this does not seem to be sustainable.

The current IBM metrics are indicative of a company treating its products as cash cows rather than as ongoing investments. I’d argue that based on the numbers, IBM looks like it is only staffed to support innovation on roughly half of its revenue base, give or take, based on how you would split technology revenue vs. service revenue. As much as Wall Street may hate investing in people and operational costs, these numbers stand out to me as a key difference between IBM and many of its peers in tech that have been growing rapidly.

The strange part about this phenomenon is that it’s not that IBM is not creating good products, at least ones where IBM is putting significant resources into a product. And it is not that IBM lacks talent. And it is not that IBM lacks enterprise customers who want to buy its products to solve big problems. For instance, when IBM comes out with something like the z14, a hardened Mainframe to handle large workloads, the money came in because it was an evolutionary improvement in that product category. If IBM had used Softlayer to create an industrial and military-grade security Cloud for the biggest companies in the world and then paired it with an acquisition or partnership with something like Blackberry’s security for a rock-solid mobile cloud ecosystem, it probably would have sold well.

Software Purchasing Habits Have Fundamentally Changed

But here’s a significant challenge. Nowadays, employees and customers want technology that solves their small problems. The likes of Facebook, Google, and Salesforce originated from solving relatively simple problems in the cloud that were able to expand over time as these applications became indispensable to the users. If IBM is seen as a company that cannot solve small problems, then it will continue to struggle in launching new applications and technologies.

For existing products, customers now expect flawless, agile, and frequent development cycles. For some products, IBM does a fantastic job of doing so through expert product managers. But IBM drops the ball with a number of its legacy products, which has led to products that have not been well supported and have not been able to maintain market growth over time. IBM needs to regain a culture of maintenance and contribution that is consistent across its software portfolio for IBM to regain its mojo in the software space and to have software that matches up with IBM’s services and hardware capabilities with the assumption that no software product is a pure cash cow.

IBM’s Need to Purchase Red Hat

This is where the Red Hat acquisition comes in. In some ways, Red Hat may end up being the largest acquihire in the history of technology. Although Red Hat has about 3 billion dollars in annual revenue and a billion in annual cash flow, Red Hat has very little in the way of IP or other assets, making its people and culture the true asset being acquired.

But even Red Hat, with its 12,000 employees, will get overwhelmed by IBM without an active effort to prevent Red Hat’s culture from being subsumed into the greater IBM behemoth of 400,000 employees. Although Red Hat will provide a short-term boost both to IBM’s growth and to its current abilities to support software when and if the acquisition closes in late 2019, Red Hat will struggle to provide a long-term impact on IBM unless IBM is committed to truly changing from a cultural perspective to match the current expectations of technology company that is in perpetual research, development, and innovation cycles.

Embracing Moonshots and Tech Investment

I would also caution that IBM may be learning the wrong lesson from Watson. Although Watson has not been an absolute success, IBM would be wrong to think that the answer is to avoid moonshots. Watson was ahead of its time and provided IBM with a first-mover advantage in Enterprise AI. Part of the challenges in any new market is that it does not immediately provide billion dollar gains, even in AI. Even the top AI vendors of 2018 would struggle to assign multi billion-dollar revenue numbers to their direct AI products.

The real lessons that IBM should hopefully learn from Watson are how to launch other innovative and new products and to have a realistic time frame of how to launch emerging products that will eventually be vital to the Enterprise but are still at an early adopter stage. Hopefully, these lessons are being put into efforts such as IBM Blockchain and IBM Quantum Computing, the latter of which is frankly still at least 5-10 years away from a commercial product that will provide any impact to IBM’s income statement.

Key Recommendations for IBM

IBM has a long and storied history as one of America’s great companies. With the acquisition of Red Hat, IBM has a chance at another resurgence, but it will not be easy. For the Red Hat acquisition to ultimately walk work, both industry and financial analysts will likely be looking at the following key issues.

Be developer friendly. Open source can be quite lucrative because there are significant external resources to help with product development and contributions as long as vendors associated with that technology are seen as friendly. Red Hat is currently seen as friendly. This friendliness is a key component of Red Hat’s value. Although IBM has made great strides in this regard, Red Hat is a Gold Standard in terms of maintaining and supporting a loyal developer community. IBM needs to embrace Red Hat’s developer-friendly culture to maintain its own software capabilities.

In today’s Customer-For-Life culture, support and upgrades are seen as a necessary cost of doing business for any software provider. Any significant deprecation or inability to deliver on prolonged customer demands is seen as a default market exit that will be “rewarded” by leaving the product within a few years. In 2018, there are no more pure cash cows in software or technology at the scale that IBM is competing at.

IBM needs to increase R&D spend to develop software and technology innovation at-scale that are proportionately in line with its key competitors. The key metric here is ultimately not simply patents that can be monetized, but creating products that go-to-market and impact top line growth. This is going to be a formidable task, as it is not easy to simply add a few billion+ in R&D spend on an annual basis.

This spend will also improve IBM’s ability to take big shots and big bets in areas where capital and marketing and product investment are needed to fully build out IBM’s story. For instance, IBM is noticeably missing from the deep learning conversation, despite the billions poured into the Watson brand that should make IBM a go-to brand for all things Artificial Intelligence. The Internet of Things, although a cliched buzzword in some respects, is still very much a market in flux where IBM still has the opportunity to be the top player in a many billion dollar industry. And, of course with Red Hat, hybrid cloud middleware is potentially IBM’s for the taking. But all of these areas require investment as IBM’s competitors all are pushing hard in these areas and will require a restructuring on IBM’s current cost structure.

IBM needs to treat each software product as a discrete product and business that solves a business problem. As mentioned before with Amazon, the new world of software is based on creating personas and use cases that can be easily adopted and then expanded over time. Look at how Salesforce has made their product line extremely simple by literally naming each product line after functional capability that they support: Sales Cloud, Marketing Cloud, Service Cloud etc. Although brand names don’t have to be that literal, they do need to be more differentiable than “IBM Watson X, IBM Watson Y, IBM Watson Z”.

Ultimately, as my colleague Tom Petrocelli pointed out, the real question for IBM is whether IBM can manage itself as a modern software company. IBM obviously has the DNA to support large and capital-intensive enterprise projects. And it has the DNA currently to support enterprise services and Consulting. But IBM’s long-term health and growth is dependent on fully embracing a modern approach to technology from a research, deployment, go to market, and community building perspective, all of which are areas where IBM still has room to improve. If IBM works with Red Hat with the intention of embracing modernization and the cutthroat world of having your customers and allies always at risk of leaving or more attractive technology environments, Red Hat will be a phenomenal acquisition and a bargain for IBM. Alternatively, if IBM simply treats Red Hat as a cash cow that is initially a standalone team in IBM Cloud for a couple of years but ultimately subsumed into IBM, this acquisition will be a failure.

For the sake of one of America’s most historic and influential companies, we hope that this acquisition goes through with the right intentions, right goals, and the willingness for IBM to embrace change.

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