by Brenon Daly
The recent rout of technology stocks didn’t actually provide much of a discount in Big Blue’s big bet on Red Hat. In the largest-ever software acquisition, IBM is valuing the open source software provider at its highest price since its dot-com-era IPO. Essentially, Big Blue had to make up Red Hat’s recent stock decline with a very generous premium. (Subscribers to 451 Research can look for our full analysis of the transaction and its implications on our website later today.)
Ahead of the announcement, shares of Red Hat had shed about one-quarter of their value just since mid-September. The stock bottomed out last week at about $117, its lowest level in a year. Under terms, IBM is paying $190 for each Red Hat share, which works out to a premium of more than 60% from the prior close. That’s about twice as rich as the typical premium in a significant software acquisition.
However, looking at the terminal value of a company relative to the market value of a company doesn’t make too much sense unless we also factor in the state of the overall market. Stock prices change every day, particularly for high-beta stocks like Red Hat. It just so happens that in recent sessions on Wall Street, virtually all of the changes have been marked in red.
In the case of Red Hat, it was riding high last summer, with shares peaking at about $177. At that level, IBM is paying a scant 7% premium on Red Hat’s market value. (That fact hasn’t been lost on plaintiff lawyers, who have already revved up their strike-suit machine to target this deal.)
Rather than comparing how IBM is valuing the company to how public market investors value the company, it’s more useful to look at how IBM is valuing Red Hat’s actual business. And by that measure, this is a pricey pairing.
IBM, which trades at less than 2x trailing sales, is valuing Red Hat at more than 10x trailing sales. That’s substantially higher than the average multiple of 6.6x trailing sales for the 10 largest software acquisitions recorded in 451 Research’s M&A KnowledgeBase.