Posts

Low cost, but little long-term value: Insight Enterprises’ plan to acquire PCM Inc.

Insight’s acquisition strategy has led to strong services growth and a successful shift from the legacy VAR model

Insight’s last three acquisitions, of Cardinal Solutions, Ignia and BlueMetal, were all services companies that provided significant differentiation and skilled talent that legacy Insight lacked. The acquisitions were part of the firm’s 2015 digital innovation strategy, an attempt to shift its business model from a typical VAR to a true solutions and services provider. That strategy was largely successful, and Insight’s growth in services (greater than 18% year-to-year for the last five quarters) has outstripped nearly all of the firm’s major competitors, including CDW (Nasdaq: CDW), SHI and Connection (Nasdaq: CNXN). In January 2019 Insight announced the formation of a new practice called Insight Digital Innovation, which unites those three acquisitions under one umbrella, allowing Insight to deploy its 850 developers and architects on new IP and services engagements in a streamlined fashion. TBR believes Insight has been executing its digital innovation strategy extremely well, and the decision to invest in services and more highly skilled employees has been a key differentiator for Insight. Though the company’s overall top line has decreased year-to-year in recent quarters, this is due entirely to declines in product sales, which also face particularly difficult compares from a strong 2017-2018. Insight’s extremely robust double-digit growth in services revenue positions the firm to return to growth in 2H19 to deliver midsingle-digit overall growth for the year. TBR believes the firm’s pivot from its legacy business model is an example for other VARs to follow to combat the continual commoditization of hardware and software.

PCM represents a retreat to scale and a regression for Insight

Even considering Insight’s success in shifting away from its legacy model, the company’s plan to acquire PCM does make some immediate sense. Adding scale can be of significant value in a marketplace dependent upon volume selling, and Insight’s leadership touts PCM’s penetration in the small to midmarket segment, where they believe there is opportunity to upsell Insight’s higher-margin services offerings and in which legacy Insight has very little market share. Essentially, Insight is attempting to buy customers in hopes of increasing stickiness with those clients and continuing its services growth in a new market. Beyond its customer base, PCM has largely done nothing to adapt to the changing marketplace that VARs now face and seems to offer little in the way of differentiation. TBR believes purchasing customers is a dubious strategy at best, as PCM has been consistently declining in revenue over the last two years, indicating stickiness is already an issue with its customer base, and being acquired is likely going to send many employees out the door. Undoubtedly, many of PCM’s customers are loyal to the company due to their relationships with current PCM employees — if those employees become redundant or decide to leave PCM as it joins Insight, many of those customers may choose to follow them.

TBR believes the main benefactor of this planned acquisition is likely to be limited to the organization’s supply chain, given the likely increase in scale and efficiency, as well as the addition of about 1,100 highly skilled services and technical employees. Another interesting piece of this planned acquisition is PCM’s cloud hosting business, which seems to be one of the only offerings from PCM that is not matched by most every other VAR. However, in a special conference call regarding this planned purchase, Insight CEO Kenneth T. Lamneck indicated the cloud hosting business is going to get a very close look to determine if it will remain part of Insight once the acquisition is finalized. Though PCM’s cloud hosting business is relatively small, it seems more likely to provide growth than many other parts of PCM’s business and would allow for more opportunity to bundle additional higher-margin services and solutions. Ultimately, fully capitalizing on what PCM has to offer will be a difficult proposition for Insight considering the typical effects of such a large acquisition and Insight’s apparent strategy for growth.

In June Insight Enterprises (Nasdaq: NSIT) announced plans to acquire PCM Inc. (Nasdaq: PCMI) for around $581 million in June, a deal that would add about $2.2 billion to Insight’s revenue, with about $1.6 billion coming from small to midmarket clients and $260 million coming from the public sector. The planned acquisition appears to be aimed at gaining market share with small to midmarket companies, a segment which Insight historically has not had much success growing organically. PCM also has 40 offices and just over 4,000 employees, which would give Insight a significant boon in terms of scale for both product delivery and sales. However, with 2,700 of those 4,000 employees currently in client-facing roles, TBR notes there are a number of redundancies in locations and employees across the two firms.

Big Blue opens its arms, and its wallet, to Red Hat

On Oct. 28, IBM (NYSE: IBM) and Red Hat (NYSE: RHT) executives announced a proposed acquisition ― one that will be the industry’s third-largest acquisition should it gain approval. The deal, valued at $34 billion, would bring Red Hat into IBM’s hybrid cloud team, in its Technology Services and Cloud Platforms (TS&CP) group, where its IaaS (formerly SoftLayer), PaaS (formerly Bluemix) and hybrid management capabilities reside.

Sticker shock fades once you factor in the rest of the numbers

Historically, initial public offerings (IPOs) and sales of more traditional technology and software companies have been valued at around 5x their annual revenue. However, in recent years, as more cloud-native companies with subscription-based business models go public or get acquired, this multiple has steadily shifted upward. As a rather extreme example, Cisco (Nasdaq: CSCO) bought AppDynamics for $3.7 billion, a valuation of nearly 16x AppDynamics’ annual revenue, even though in the week prior to the purchase AppDynamics had been valued at $1.9 billion on an annual revenue of approximately $220 million as the company readied for its IPO.

Much of the speculation around this monstrous deal relates to how IBM can and will fund such a hefty purchase. To put this massive $34 billion figure into perspective, Red Hat’s trailing 12-month revenue for the four quarters ended Aug. 31, 2018, was just shy of $3.1 billion, indicating the deal is valued at 11x Red Hat’s annual revenue. Figure 1 shows that if Red Hat were to stay on its double-digit growth pattern and trajectory*, its revenue and operating income would be projected to more than double by the close of 2021, benefiting from access to IBM’s vast enterprise customer base.

Estimated revenue, year-to-year growth, operating margin and more for 2018 through 2021

These projections help IBM justify the large purchase price. Additionally, it is likely that the purchase price per share was set at least a few weeks ago, when there were more Red Hat shares available and at a higher price. On Oct. 1, Red Hat was trading at $133 a share, compared to the $117 per share price it was trading at on Oct. 26.

Big Blue opens its arms, and its wallet, to Red Hat

Red Hat’s projected growth is enough to justify the hefty purchase price

On Oct. 28, IBM (NYSE: IBM) and Red Hat (NYSE: RHT) executives announced a proposed acquisition ― one that will be the industry’s third-largest acquisition should it gain approval. The deal, valued at $34 billion, would bring Red Hat into IBM’s hybrid cloud team, in its Technology Services and Cloud Platforms (TS&CP) group, where its IaaS (formerly SoftLayer), PaaS (formerly Bluemix) and hybrid management capabilities reside.

While the sheer magnitude of the deal may surprise some, the underlying reasons do not. IBM’s cloud strategy was sorely due for a boost, and Red Hat has been looking for a potential buyer for quite some time. Stefanie Chiras, a 17-year IBM vet, joined Red Hat as the VP and general manager of the Red Hat Enterprise Linux (RHEL) business unit in July, likely to lead that group through the planned acquisition. The potential acquisition would also be aided by portfolio synergies around Linux on IBM hardware and Kubernetes. Additionally, IBM is pervasive in the large enterprise market while much of Red Hat’s revenue is channel-led.

What’s most important is that IBM listened to its stakeholders and the broader market, realizing that while its cloud business was growing consistently at around 20% to 25% year-to-year on a quarterly basis, that was not enough to move the needle materially to more effectively compete in cloud. The company’s recognition that it should not always promote all-IBM solutions is a noteworthy shift. Though IBM has had technology partnerships for some time, there was always the underlying perception that it would push its own solutions ahead of others, regardless of customer needs. Its recent and ongoing focus on hybrid IT enablement has changed this; and now, bringing on an open-source company could change the game for IBM.

Sticker shock fades once you factor in the rest of the numbers

Historically, initial public offerings (IPOs) and sales of more traditional technology and software companies have been valued at around 5x their annual revenue. However, in recent years, as more cloud-native companies with subscription-based business models go public or get acquired, this multiple has steadily shifted upward. As a rather extreme example, Cisco (Nasdaq: CSCO) bought AppDynamics for $3.7 billion, a valuation of nearly 16x AppDynamics’ annual revenue, even though in the week prior to the purchase AppDynamics had been valued at $1.9 billion on an annual revenue of approximately $220 million as the company readied for its IPO.
Much of the speculation around this monstrous deal relates to how IBM can and will fund such a hefty purchase. To put this massive $34 billion figure into perspective, Red Hat’s trailing 12-month revenue for the four quarters ended Aug. 31, 2018, was just shy of $3.1 billion, indicating the deal is valued at 11x Red Hat’s annual revenue. Figure 1 shows that if Red Hat were to stay on its double-digit growth pattern and trajectory*, its revenue and operating income would be projected to more than double by the close of 2021, benefiting from access to IBM’s vast enterprise customer base.

Estimates for revenue, year-to-year growth, operating income and more for 2018 through 2021

These projections help IBM justify the large purchase price. Additionally, it is likely that the purchase price per share was set at least a few weeks ago, when there were more Red Hat shares available and at a higher price. On Oct. 1, Red Hat was trading at $133 a share, compared to the $117 per share price it was trading at on Oct. 26.

Synergies make the acquisition possible; success will come down to execution

Organizational structure

The proposed acquisition poses significant integration challenges for IBM if approved. Though the company has been successful in the past with integrating software acquisitions, it has yet to make a purchase this large, and this is the first major software acquisition since the company reorganized and brought software subgroups across its various business units a couple of years ago, eliminating a dedicated software business unit. Additionally, none of the formerly acquired companies have run as stand-alone units as Red Hat is expected to be.

Red Hat’s proposed position as a stand-alone unit in TS&CP could have varying results. IBM Services’ culture and cumbersome processes could stifle Red Hat’s software-led mindset, culture and innovation. Alternatively, Red Hat’s products could be pulled through in an unprecedented number of Services engagements the company has yet to see due to its much smaller size and scale. This second scenario, however, would only be possible if IBM Services and consultants can differentiate from Red Hat’s existing systems integration partners to maintain IBM’s status as the largest services provider around Red Hat and Linux. Whether or not those partnerships will stay at the strategic levels they are at today, or at all, remains unclear.

Red Hat CEO Jim Whitehurst would report to IBM CEO Ginni Rometty. While it is very likely he would stay with IBM for the year or so required and then retire, there is the possibility, and this is pure speculation, that IBM could be priming him to be a contender for the position of IBM CEO should Rometty look to retire soon.

Go to market

Undoubtedly, IBM has set its sights on reaching more midmarket customers as its large enterprise customer base is slower and more resistant to move to cloud. Red Hat’s prevalence in the midmarket will surely help open the doors to cross-sell IBM solutions and services to these companies, if pricing is adjusted for smaller companies. Additionally, IBM will gain access to a Red Hat developer community of more than 8 million. On the other side of this, Red Hat also can bring its solutions upmarket to IBM’s largest enterprise customers.

Much of IBM’s focus as of late has been on helping customers link on- and off-premises environments and sharing data across truly hybrid environments. Its large Services arm and broad portfolio set have helped offset some legacy software and services revenue erosion in past quarters. While Linux is already relatively pervasive across the market and OpenStack has yet to garner significant demand or traction, Kubernetes is the open-source solution of choice at the moment and will be in coming quarters. IBM continues to update its IBM Cloud Private portfolio centered on Kubernetes, which can also run on OpenShift, presenting an area of immediate portfolio synergy between the two companies. The incorporation of additional open-source technologies into the mix as well as Red Hat’s interoperability with third-party cloud and software solutions only help position IBM as an increasingly technology-agnostic hybrid enabler.

Peer implications

Despite the size of the acquisition and the attention it is garnering, IBM’s cloud competitors will not face substantially altered challenges should the deal go through. Amazon Web Services (AWS) and Microsoft (Nasdaq: MSFT) will continue to dominate the public cloud IaaS and PaaS market. The two have increasingly embraced open-source technology integrations in their proprietary ecosystems, only enabling them to get bigger as they can also work with RHEL customers.

We believe that if this acquisition were to materially impact any single company, it could be Google (Nasdaq: GOOGL) and/or Oracle (NYSE: ORCL). Google struggles to compete at scale with AWS and Microsoft and does not yet have the same permission to play in the large enterprise segment. With IBM, Red Hat would gain that permission almost immediately. Oracle’s Linux offerings are based on RHEL, which could complicate a competitive relationship between IBM and Oracle. While Oracle may have more pressing areas to focus on and invest in, such as Kubernetes in tandem with its peers, the company could, should it choose not to work closely with IBM when Red Hat is integrated, look to acquire another Red Hat-like company with expertise and capabilities in open source and Linux in particular, such as Canonical or SUSE, which was just sold by Micro Focus (NYSE: MFGP) to private equity firm EQT for $2.5 billion.