Cloud Leaders Shrug at IBM’s $34B Red Hat Deal

Xconomy New York — 

In some ways, the biggest software acquisition of all time could be a yawner.

IBM’s planned $34 billion deal to acquire open-source software maker Red Hat is a hefty price to pay to give its cloud computing business a shot in the arm. But even if the purchase ultimately boosts IBM’s bottom line, some cloud technology executives and investors are wondering whether it will have any transformative effects on the sector.

Scooping up Raleigh, NC-based Red Hat (NYSE: RHT) could make IBM (NYSE: IBM) more competitive with bigger cloud players such as Amazon, Microsoft, and Google, says Michael Skok, a partner with Underscore VC, a Boston venture firm that invests in startups in cloud infrastructure and open-source software, among other sectors.

Skok says the deal, which hasn’t closed yet, also makes sense for Armonk, NY-based IBM given the current state of the cloud computing market, which is primarily focused on serving businesses in a “hybrid cloud” environment. Many enterprises are still in the process of migrating their data storage, applications, and other IT operations to cloud-based servers. A lot of them are using a hybrid approach that involves some combination of apps and IT systems running on the company’s own on-site hardware; on remotely located servers that are owned by a third-party vendor but managed privately by the company; and “public” cloud systems running on remote servers, in which the company shares a pool of virtualized computing resources with the cloud vendor’s other clients.

Many companies choose to operate at least some of their IT operations on their own on-premises hardware because they believe it will let them maintain more control and potentially increase security, Skok says, although he claims that’s debatable. And for older businesses, some of their legacy software programs would be difficult or nearly impossible to run on a cloud-based server, he says.

“If you’re the size of IBM, you need to play to where the market is” today, Skok says, referring to the popularity of hybrid cloud setups.

But he believes businesses should—and eventually will—abandon their on-premises hardware and switch to IT operations running entirely on remote servers owned by cloud vendors. He says that approach makes it faster, easier, and cheaper for businesses to launch and operate apps and other software.

Thus, if IBM wanted to make a bolder move with an eye toward leading the future of cloud technology development—and prove to frustrated shareholders that Big Blue can return to the kind of business growth it enjoyed in its heyday—it should be focused more on apps and systems built “natively” in the cloud, Skok argues.

It’s worth noting that Red Hat does help clients develop cloud-native applications, and the acquisition announcement says that IBM and Red Hat plan to continue that work. But the emphasis was clearly on the hybrid cloud strategy.

Skok argues that trend is just “a transition.”

“It’s basically like [having] one foot on the bank and one foot on the boat while the river keeps going—it’s difficult to manage,” Skok says. “The next great companies are not going to be hybrid cloud players,” he continues, referring to cloud storage providers, cloud management and services firms, and the businesses they all serve. “They’re going to be cloud-native, and they’re going to innovate on the latest cloud technologies.”

Of course, IBM’s leaders think it has the right strategy. In the press release announcing the deal, CEO Ginni Rometty says it will change “everything about the cloud market.” And she sees plenty of opportunity in focusing on hybrid cloud services.

“Most companies today are only 20 percent along their cloud journey, renting compute power to cut costs,” she says in the announcement. “The next 80 percent is about unlocking real business value and driving growth. This is the next chapter of the cloud. It requires shifting business applications to hybrid cloud, extracting more data, and optimizing every part of the business, from supply chains to sales.” (Rometty is pictured above with Red Hat CEO Jim Whitehurst.)

Businesses use Red Hat’s software to build and manage infrastructure and applications for IT operations in the cloud. The 25-year-old company is perhaps best-known for its enterprise tools for Linux operating systems.

Since the software is open source, IBM isn’t gaining a technological advantage by acquiring Red Hat, says Scott Crenshaw, a former Red Hat executive who now leads the private clouds business at San Antonio, TX-based Rackspace, an IBM competitor that has formed partnerships with Red Hat.

Donning Red Hat, which generated $2.9 billion in revenue and a $258.8 million profit last year, should give IBM’s business a lift. But Crenshaw says those financial metrics “are not game-changers” for IBM, a company with a market value that exceeds $100 billion.

“It’s hard to see this having any material impact on IBM’s trajectory unless they do something outside the box here,” Crenshaw argues.

If IBM successfully takes advantage of Red Hat’s assets, then it would have a “very strong” hybrid cloud portfolio, Crenshaw says. One of Red Hat’s strengths is that it has been viewed as a sort of Switzerland in enterprise cloud technology—a “neutral vendor” of open-source software tools, he says. It won’t be easy, but he thinks the key to this deal for IBM could be harnessing Red Hat’s culture and using it as a catalyst to enhance the whole corporation’s culture.

“That is the only justification I can see for that valuation,” Crenshaw says.

After the deal closes, Red Hat will operate as a distinct unit within IBM’s hybrid cloud business, and IBM says it intends to preserve Red Hat’s “unique development culture” and “the independence and neutrality of Red Hat’s open-source development heritage and commitment.” The question is whether that’s how things play out.

“It’s going to be challenging to maintain that neutrality or the perception of that neutrality now that they’re tied to IBM,” Crenshaw says.

That could open the door for other independent cloud management firms “to step in and fill this heterogeneous and trusted advisor role,” says Dan Phillips. He’s a veteran tech executive who co-founded Boston-based cloud management and analytics startup CloudHealth Technologies, which was recently acquired by VMware (NYSE: VMW), a large seller of virtualization software and cloud tools and services. Phillips’s candidates to fill the void left by Red Hat include Nutanix (NASDAQ: NTNX), ServiceNow (NYSE: NOW), New Relic (NYSE: NEWR), Datadog, and, of course, VMware. (Phillips was CloudHealth’s chairman at the time of the acquisition, but he says he no longer holds a position there or at VMware, and he doesn’t own stock in the combined company.)

Phillips says he thinks the Red Hat purchase is a “great deal” for IBM, even if the final verdict ends up being that Big Blue overpaid.

“It feels like IBM woke up,” Phillips says in an e-mail message. “It makes them relevant in the cloud management market. I hope it’s a great deal for Red Hat and the market in general.”

One effect of the deal could be more mergers and acquisitions involving open-source software companies, Crenshaw says, citing Suse and Canonical as two firms that might receive interest from suitors. It’s already a banner year for open-source software deals, Skok points out—see Microsoft’s $7.5 billion acquisition of GitHub, Salesforce’s $6.5 billion purchase of MuleSoft, the $5.2 billion merger of Cloudera and Hortonworks, and Elastic’s initial public stock offering.

But beyond more deal-making, Crenshaw is skeptical the IBM-Red Hat tie-up will have significant ripple effects, at least for now.

“In the short and medium term, it’s hard to see that this changes the game much,” Crenshaw says. “In the long term, there’s a possibility.”