Author anujdhwn's blog writes about the upside case for Redhat . $RHT, Red Hat, Inc. / H1 Summary Red Hat is one of the most well-regarded companies in the tech space.The company is a play on open source and subscription, with good growth prospects.The desire to get into cloud and the need to consolidate, along with the possible ownership of a large and well-functioning developer community make RHT a good takeover target.As large legacy markets slow down, companies continue to evaluate buy vs build paradigms. For deep pocket tech companies, Red Hat comes out as a very attractive buy due to its unique positioning in the operating system market and cloud based model. About RHT RHT is a leading provider of open source software solutions. The company’s offerings include operating system, virtualization, management, middleware, cloud, mobile and storage technologies. RHT has over a million developers in its global community, the engine of the company’s open source development. The biggest advantage of the crowd sourced development is that RHT offerings are developed by the users for the users, which helps to enhance acceptance of the offerings and also allows for quick resolution of bugs/issues. The company then takes this software, refines them and then distributes these products under open source licenses. RHT sells these offerings as annual or multi-year subscriptions, which also drives a stream of service revenues. RHT's business segments are as follows: Source: 10K - 2017 1.Infrastructure - related offerings Red Hat Enterprise Linux (RHEL): An operating system for enterprise computing, capable of running applications in hybrid cloud environments. RHEL is customizable and comes with multiple optimization adds ons.Red Hat Satellite (( RHS )): This is a system management tool to ease deployment of RHT infrastructure across hybrid cloud environments.Red Hat Virtualization (RHV): RHV offers virtualization and management tools for servers and desktops. RHV can not only support RHEL, but also Microsoft Windows and application servers supported under Microsoft Windows Server Virtualization Validation Program. 2. Application Development-related and other emerging technology (( ET )) offerings Red Hat JBoss Middleware: This is a suite to develop, deploy and manage applications, data and devices across hybrid cloud environments. Red Hat OpenShift: This is a container-based platform as a service (PAAS) used by developers to develop, host and scale applications in a cloud environment.Red Hat Cloud Infrastructure: This product allows for building and managing a private or hybrid infrastructure as a service (IAAS) cloud.Red Hat OpenStack Platform: This is an IAAS offering that provides an enterprise-ready cloud foundation, optimized for RHEL and RHEV.Red Hat Ansible Automation: This product helps to automate application and IT environment lifecycles.Red Hat CloudForms: This is a hybrid cloud management that allows to manage services across cloud providers and, virtualized and container-based solutions.Red Hat Storage technologies: These are used by enterprises using IAAS and PAAS deployments for their storage requirements.Red Hat Mobile Application Platform: This product is used for mobile application life-cycle management. 3. Consulting services: These range from assessments to deployment and integration support. 4. Training: Revenues are generated from certifications and subscription based learning programs. RHT did revenues of $2.92 billion for F2018 (fiscal year ends in February) and has lowered its guidance by $50 million (due to forex headwinds) for F2019 to $3.375 - $3.410 billion. In 1Q19 and for the rest of the year, the company also expects some weakness in its middleware business. RHT attributes this weakness to a ‘pause’ created due to customers taking stock of their long-term technology plans and trying to extract the maximum out of their existing vendors (“both IBM and Oracle have started giving 98% discounts or whatever it takes to hold on to that tail of the business”). The company has maintained since its analyst day that this is a timing issue, which is likely to take “several quarters” before it resolves. Also, deals done in 1Q18 add to the comps becoming tougher. Significant renewals across product lines due in the latter half of this fiscal are likely to ensure that the broader business momentum for RHT is intact. Market size and competition The management estimates that RHT’s total addressable market (TAM) to reach ~73 billion by 2021. Source: RHT Analyst Day RHT’s main competitors, across markets are: Operating systemStorageMiddlewareCloud & infraVirtualizationPaaSNFV/telco networkMicrosoftxxxxxAWSxIBMxxxDocker Inc.xVMwarexxxxHPExxGooglexOraclexxxxxMuleSoftxMirantisxUnisys CorporationxPivotalxxFreely available variantsxx Source: RHT 10K Why is RHT a potential target? RHT has seen strong growth across its portfolio, as evident from the financials. However, it would be worth looking through the different segments of the company to understand what can make it a target. Infrastructure - related offerings RHT has been gaining share from the likes of Microsoft, Oracle, IBM etc. As per a recent IDC report, the company has been growing over the last 5 years. Source: IDC It is interesting to note that RHT has twice the market share of an IBM and possibly a share greater than Oracle and HPE combined. Source: IDC Clearly, the only remaining competitor to Microsoft in the operating systems market is RHT (not considering Apple here, since it more of a consumer play). Virtualization Virtualization is present across 'Infrastructure' and 'Application Development'for RHT. According to a 2016 report on Worldwide Server Virtualization, the market may already have reached its peak due to high levels of adoption. The move to containerization has also been cited as a key reason for the slowdown in virtualization. RHT has been pushing its containers for a while and even showing them to be superior to virtualization. Application Development-related In May 2018, IBM announced that it is "certifying our private cloud platform, IBM Cloud Private; IBM middleware including WebSphere, MQ and Db2; and other key IBM software to run on Red Hat Enterprise Linux via Red Hat’s OpenShift container platform." This partnership is expected to offer official support behind a platform hack its customers had been stitching together themselves. In a June 2018 report on Application Infrastructure and Middleware Market, Gartner notes: The iPaaS segment is still a small part of the overall market, topping $1 billion in revenue for the first time in 2017 after growing over 60 percent in 2016 and 72 percent in 2017. This makes iPaaS one of the fastest-growing software segments. "The iPaaS market is also starting to consolidate, most notably with Salesforce's recent acquisition of MuleSoft," ... "There is still a lot of room for further consolidation, with more than half the AIM market held by vendors outside the top five. This "others" segment is enjoying double-digit growth, which is likely to encourage acquisitions from big players losing market share to challengers." A large middleware player, whose offerings are not as well recommended as that of a smaller player and with below average in customer satisfaction and experience in iPAAS, tying up with the same smaller PAAS based challenger (RHT, who has also been seeing sluggishness in the middleware market) might be the precursor to an imminent consolidation among these two companies. The juice in RHT comes from.. RHT's business has two dimensions: product (server software) and delivery (cloud based). While the product in itself may be slowing, the move to subscription is likely to keep revenue growth healthy. Additionally RHT offers the following: A treasure trove of developers, communities and loyalties: RHT works on the open source model. Most of the company’s product offerings are developed through communities and platforms, where RHT is a significant contributor and participant. Furthermore, the company’s commitment to open source and disdain for proprietary software has made it a well-respected name in the industry.Subscriptions based product: Not only are RHT’s products crafted by subsets of the end users, but also are cloud based. Due to the recurring nature of the model, it helps to grow customer lifetime value. Additionally, the services line also chips in with a neat contribution to the overall revenue.Profitable: The company has been registering a solid growth over the last few years (15-20% across revenue, net income and cash flows) and is expected to continue performing well (although, at a possibly slower rate due to base effect and competition) over the next few years. The cloud-based model is stable and generates good cash. It is also scalable and cost-effective for the customer, thus making it a sought after offering. How much juice are we talking about? Buying RHT is not going to be an inexpensive proposition. Based on the closing price for July 12, 2018, the stock has a market cap of over $26 billion. Based on consensus estimates of F2019 revenue of $3.4 billion, RHT trades at a P/S of 7.8x – not inexpensive by any means. For anyone to buy into RHT, the synergies would have to make sense. As a starting point, we would need to arrive at a more reasonable value for RHT. This can be done by valuing RHT at the starting year value of the Bessemer Venture Partners Cloud Index, a P/S of 6x. (I am looking at a cloud multiple, since it is the most sought after tech, ahead of virtualization, operating systems and middleware). On a consensus F2019 revenue basis, this implies an intrinsic equity value of $20.4 bn. Now to the impact of synergies and the value of those synergies: I assume that the advantage of synergies will be primarily in increase of revenue. (Any benefits of cost will have to be seen in context of possible restructuring and thus are likely to be practically zero on a net basis). Thus, I build out the following scenarios of volume and pricing growth due to M&A and its impact to the value of the company: Growth in clients due to M&AAverage pricing increase due to M&A5.0%10.0%15.0%20.0%25.0%100.0%2.1x2.2x2.3x2.4x2.5x150.0%2.6x2.8x2.9x3.0x3.1x200.0%3.2x3.3x3.5x3.6x3.8x250.0%3.7x3.9x4.0x4.2x4.4x300.0%4.2x4.4x4.6x4.8x5.0x Source: RHT Financial Model A reasonable expectation for an acquirer would be a ~3x impact to revenue. Thus, the value of the synergy would be ~2x or ~$40 billion in market cap terms. In terms of the price it would imply ~$60 billion or 0.8x P/TAM, a relatively acceptable price given the market exuberance. The big question would be, on how much of this will the buyer be willing to share with RHT shareholders. % synergy shared with existing RHT shareholders20.0%40.0%60.0%80.0%100.0%Implied upside to RHT's stock30.7%61.4%92.0%122.7%153.4% Source: RHT Financial Model Assuming that the acquirer could share between 20-40% of the synergies, would imply an upside of 31-60% from the closing price on 12 Jul 18. Who wants / can buy RHT There have been speculations in the market for a while. However, who wants and who can would be determined by a bunch of factors, not limited to financial strength. In the table below, I examine some of the possible suitors: Potential acquirer Rationale for the acquirerAcquirer's net cash /(debt), last reported in $ mnPossibilityMicrosoft (MSFT)-Competes with RHT virtually across all its verticals-Has recently acquired GitHub to further its opensource ambitionsAn acquisition would give MSFT a virtual monopoly in the operating system market with a share of over close to 80%.55,113 (Mar 31, 2018)Very HighIBM (IBM)-Recently tied up with RHT for at the middleware level; RHT expects middleware to remain slow for a while-Far behind in terms of operating system market share; IBM's share has been falling while RHT has been growing shareAn acquisition would allow for both companies to benefit - IBM becomes a major challenger to MSFT in the operating system market with over 11% share and together the combined entity is likely to weather the middleware sluggishness much better.-33,545 (Mar 31, 2018) Very HighVMware (VMW)-Competes with RHT across many of its verticals-Can benefit from the added scaleHowever, VMW has the backing of EMC and Dell, which make it an integrated play on storage. Also, VMW's virtualization solutions are ranked the best in the industry. Thus, there may be limited interest.8,394 (May 4, 2018)LowGoogle (GOOG)-Has limited presence in storage technologies-Been actively hiring RHT and Vmware executivesHowever, the recent alliance with CRM (and CRM had bought Mulesoft), will bring into question GOOG's focus if such an acquisition were to happen.97,902 (Mar 31, 2018)LowOracle (ORCL)-Competes in most areas as RHT-Needs to re-invent itself to stay relevantRHT could just be that fresh breath of air that ORCL needs. Not only could RHT's acquisition make relevant in the operating system market again, but also can help strengthen ORCL's middleware offerings. 6,642 (May 31, 2018)HighCisco (CSCO)-More of a wildcard entry, based on a suggestion made by a CISCO employee -RHT could be a strategic fit for CSCORHT could give CSCO's portfolio a significant uplift from an complete offering standpoint - RHT portfolio could do most of the software piece and CSCO portfolio could manage most of the hardware pieces across networking, server and hybrid cloud capabilities.Any interest from CSCO could spark a lot of interest from many more security players.26,359 (Apr 28, 2018)Medium Source: 10Qs, 10Ks, Industry analysis, Company product portfolio analysis RHT's market position and a subscription based model make it a strong company. Whether an IBM can muster the kind of money needed scoop up RHT or MSFT makes an offer RHT shareholders cannot refuse, remains to be seen. However, what is clear is the likely alignment of RHT with one of the big boys. This makes RHT a medium-term investment, with a good upside potential.