IBM Spends $2 Billion To Improve Its Offense … And Defense

By Stephen D. Simpson, CFA | June 05, 2013 AAA

There aren't any full-time two-way players in football anymore (players that can play both offense and defense), but the concept still works in business. IBM's (NYSE:IBM) purchase of SoftLayer seems to be just that sort of situation – an acquisition that will allow the company to grow its cloud business (offense), while also offsetting some of the potential risks that public clouds represent to its mature hardware business (defense). While it's a logical deal (and at a seemingly fair price), IBM is already pretty well-regarded by the Street in terms of stock valuation.

Buying SoftLayer For Hard Dollars
On Tuesday, IBM announced that it was acquiring privately-held SoftLayer. While the company's press release did not include financial information, various news outlets and sell-side analysts claimed that the price of the deal was $2 billion. Upon closing, SoftLayer will be combined with IBM's existing SmartCloud business.

SEE: Analyzing An Acquisition Announcement

Bringing Amazon Into Its Sights
SoftLayer is one of the largest providers of public cloud infrastructure, with about 21,000 customers and an estimated $400 million in revenue. If that revenue figure is close to the mark, IBM is paying about five times sales to acquire SoftLayer; a multiple above where Rackspace (NYSE:RAX) now trades after some significant declines (more than 50% from the peak), but not out of line with the larger cloud space.

Public clouds have been getting a lot of attention recently, particularly with the success of Amazon's (Nasdaq:AMZN) Amazon Web Services (AWS) and the expectations for Google's (Nasdaq:GOOG) public cloud efforts. These clouds could represent a major IT outsourcing option for businesses, and have already begun to loom as threats to hardware manufacturers in markets like servers, storage, and networking equipment. Not incidentally, IBM has significant presences in the server and storage areas.

This deal makes sense for IBM on multiple fronts. Thinking about it from an offensive perspective, moving further into the public cloud market gives IBM the opportunity to benefit from what could be a multi-billion dollar market with above-average growth characteristics for many years. Competing in the emerging cloud and platform as a service (PAAS) markets requires an integration of hardware, software, and services, and that certainly fits in with what IBM has structured its business to do.

There is also the defensive aspect to consider. Analysts have already begun to assert that the emergence of AWS and other cloud providers is impacting hardware demand, and a greater trend towards outsourcing does not point to good times for IBM's already iffy hardware business. While competing head to head with Amazon, Google, and Rackspace in public clouds doesn't guarantee anything for IBM, it beats the alternative of not participating in the market and watching the hardware business struggle if or when this evolution in enterprise IT occurs.

SEE: Is Cloud Computing An Investible Trend?

Still More On The Way
It's difficult for me to imagine that companies like Cisco (Nasdaq:CSCO), Oracle (Nasdaq:ORCL), or IBM are ever going to be finished with M&A. Specifically in the case of IBM, management laid out a road map to 2015 that included $20 billion in M&A spending. Assuming the $2 billion price for SoftLayer is accurate, this brings the company up to about $14 billion since that road map was laid out for investors. That leaves at least $6 billion to be spent, and given the rising price of growth tech companies (witness the $2.5 billion that Salesforce.com (NYSE:CRM) just paid for ExactTarget (NYSE:ET)), that won't be hard for IBM to spend.

The Bottom Line
Although IBM is not going to be a torrid growth story again, it's hard not to like how the company is structured to address the IT market. While the hardware business is looking a little ragged these days, the company's software business (particularly middleware) is quite strong, and the company is one of the best-positioned players in services.

The downside to the story is that all of this is pretty well known and factored into the share price. Most sell-side analysts and investors regard IBM as a future winner (or at least significant survivor) no matter where the IT market goes, and the shares are no particular bargain today. By no means would I sell the shares if I owned them, but there are cheaper quality names in tech to consider with new money.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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