IBM is preparing to close its $34 billion acquisition of Red Hat, but Wall Street has 'real question marks' after its 'mediocre' quarter (IBM, RHT)

Ginni Rometti

IBM missed Wall Street's revenue expectations when it announced earnings on Tuesday, but analysts are paying close attention to its upcoming acquisition of Red Hat, which will close later this year.
IBM saw declines in its cloud and cognitive-software unit, and analysts say this is a sign that IBM is struggling to compete in artificial intelligence, one of IBM's flagship offerings, against other cloud vendors.
IBM has been betting on Red Hat to improve its hybrid cloud, but analysts say Red Hat alone won't turn IBM around, and the company will have to do more work in both technical integrations and cultural adjustments.
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Analysts say that IBM delivered a "mediocre" quarter, but now all eyes are on its forthcoming $34 billion acquisition of Red Hat and whether IBM's big bet will pay off.

On Tuesday, IBM announced it generated $18.18 billion in revenue this past quarter, missing analysts' expectations of $18.51 billion. The following day, IBM's stock was down 4%.

IBM's multibillion-dollar acquisition got the company a lot of attention, but it hasn't resolved fundamental questions about its big-picture vision and strategy.

"IBM today, they go to a hockey game wearing a football uniform," Marty Wolf, the founder and president of the mergers and acquisitions advisory firm Martinwolf, told Business Insider. "They're growing slower, their margins are less. Their business model is too complicated. They need to deconsolidate. Our belief is, they're looking like a rhino in a field of cheetahs."

As IBM prepares to close its Red Hat acquisition in the coming quarters, the company has the benefit of a "wait and see" attitude from investors, Katy Ring, a research director for IT services at the 451 Group, said.

Namely, IBM is betting on hybrid cloud, which allows companies to run their workloads both on the public cloud and on on-premise data centers. While Red Hat might be an important part of doubling down on this strategy, that alone won't help IBM secure the cloud business, analysts say.

"I think IBM has got to make hybrid cloud work as a strategy in order to remain technically relevant in the longer term," Ring said. "It understands large enterprise IT better than any other cloud provider, and so, could potentially emerge as a much stronger 21st century service provider by taking open source software to its big blue heart."

'Everything in the kitchen sink'

IBM said its cloud business grew 10% year-over-year, generating revenue of $19.5 billion. However, analysts say that when IBM reports cloud business, it can also lump in other aspects that are not necessarily cloud applications and cloud services but are related to cloud, such as consulting and hardware.

And the growth still lags the performance of other cloud providers: Microsoft Azure grew 76% from a year ago, and Amazon Web Services grew 45%.

"They have an 'everything in the kitchen sink' approach to cloud," Andrew Bartels, vice president and principal analyst at Forrester, told Business Insider. "They toss everything that might be related to cloud into that bucket. There's a lot of ambiguity and probably misdirection which is in their cloud numbers."

IBM's cloud and cognitive-software unit itself was down 2%, generating revenues of $5 billion, and analysts say this is because IBM is facing fierce competition from other cloud providers, even in artificial intelligence.

"I think this shows that companies like Microsoft and Google and Amazon are gaining more cognitive solution business," Maribel Lopez, the founder and principal analyst at Lopez Research, told Business Insider. "I think IBM needs to get ahead of that trend and make sure they don't lose that marketplace to the other big cloud providers."

Investing.com senior analyst Haris Anwar said IBM's turnaround strategy "remains very much a work in progress," as all its segments either declined or were flat.

"That was a little disappointing for investors," Anwar told Business Insider. "They were expecting they will see some clear improvements, but that's obviously not the case. They're still struggling to compete in this cloud-computing segment in which Amazon and Microsoft had a great run."

That being said, this lack of growth might not necessarily be specific to IBM, Bartels said. On the downside, it could be reflective of the market as a whole as other tech companies report earnings this month.

"It could well be that IBM is a harbinger of disappointing earnings to come of other vendors in the coming weeks," Bartels said.

And there's still some positives, John Roy, UBS's lead analyst, said. He expects cloud and cognitive services at IBM to grow, and the company will also benefit from getting rid of underperforming assets of the company that slow down the business.

"They are doing more work in artificial intelligence and hopefully I'll hear more about that," Roy said.

'Real question marks'

Analysts say the coming quarters will be crucial for IBM as it closes its acquisition of Red Hat. Analysts predict this will help IBM generate revenue.

Once the deal closes, IBM can focus on technical integrations and creating a product portfolio that includes Red Hat's offerings — not to mention that there will be a cultural adjustment.

Wolf said he has "real question marks" about this.

"Lots of people who work at Red Hat are not going to be that excited to work at IBM," Wolf said. "There's a combination thing. Red Hat looks like a small piece of IBM's business. Some of the reasons people like working at Red Hat is because it's not a big conglomerate."

However, analysts say, the question is whether the IBM salesforce can sell Red Hat and if IBM services can benefit from Red Hat being part of the company. It might take at least two quarters for that to happen.

Ring believes the market sentiment toward IBM is still positive, but the company will need to make "some bold moves."

"The Red Hat acquisition could be very good for IBM if it takes on board the open source culture that the business brings to IBM and its customers," Ring said. "It could be a disaster if IBM does not adapt its culture quickly enough to pull through this benefit for enterprise buyers."

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