A Deal Creates a Trading Opportunity
It was big news when it was announced that IBM plans to pay $190 a share for Red Hat in what IBM said would be its largest acquisition ever. IBM plans to use cash and debt to make the acquisition. At the end of the third quarter, it held $14.7 billion in cash.
IBM is paying an unusually large premium in the deal, at 63% above Red Hat’s closing stock price of $116.68 on Friday. IBM said that the deal, including debt, is worth $34 billion. Using Red Hat’s most recently disclosed number for shares outstanding, the equity value of the deal is just under that.
The stock price jumped to reflect the deal’s value.
A Good Fit for IBM
Founded 25 years ago, Red Hat has grown into the dominant provider of the Linux operating system to corporations. While Linux is available free of charge, Red Hat sells a version of Linux that contains software enhancements and the high level of technical support that corporations require. The company reported $2.9 billion in revenue for its most-recent fiscal year, which ended in February 2018.
“IBM has deep, deep customer expertise…in a way that can dramatically accelerate our business,” Red Hat CEO Jim Whitehurst said in an interview.
For IBM, Red Hat’s Linux and other software assets represent an opportunity to sell products to corporate software developers who are building complex applications that can run on both cloud-computing platforms such as Amazon and Microsoft as well as in-house data centers.
“I think this is a very good and strategic move for IBM,” said Crawford Del Prete, chief operating officer with the industry research firm International Data Corp. “Red Hat has done a fantastic job over the last few years becoming relevant to developers and helping developers not only with Linux, but also with the tools on top of Linux.”
Red Hat, based in Raleigh, N.C., will operate as a distinct unit within IBM’s Hybrid Cloud team. And IBM intends to retain all of Red Hat’s roughly 12,600 employees, Ms. Rometty said. IBM currently has just under 370,000 employees.
As companies move more of their computing to the cloud, they’re choosing multiple cloud providers—Amazon and Microsoft for cloud-infrastructure, for example, and Salesforce.com Inc. and Workday Inc. for applications. Ms. Rometty is betting that Red Hat will help IBM offer software and services to help companies bridge those technologies with applications that run in their own data centers.
“Already they can see what I would call cloud sprawl, and they have to have a way to manage it,” Ms. Rometty said.
Open-Source Software is Key…
Because it eases customers’ ability to move their computing among various cloud providers and from their own data centers.
The challenge for IBM is that rivals have raced ahead in the business. In the world-wide cloud-infrastructure market, IBM had 1.9% share of revenue in 2017, according to market-research firm Gartner Inc. Market leader Amazon took 51.8% of the market. IBM also trailed Microsoft, Alibaba Group Holding Ltd. and Alphabet Inc.’s Google.
Red Hat provides IBM with its flagship operating system, Red Hat Enterprise Linux. The software company has focused its resources on a new product called OpenShift, which lets corporate software developers build programs that run on specialized software, called containers, which can in turn be run either in corporate data centers or on the cloud.
Having Red Hat’s Linux and container software in its product portfolio will help IBM remain relevant to corporate developers who are looking to leverage cloud computing, said Mr. Del Prete of IDC.
That means there is a high probability the deal will go through and shares of RHT will drfit towards the deal price over time. In the meantime, traders can benefit from low risk opportunities in RHT.
A Trade for Short Term Bulls
As with the ownership of any stock, buying RHT could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for RHT
For RHT, the November 16 options allow a trader to gain exposure to the stock.
A November 16 $175 call option can be bought for about $0.50 and the November 16 $180 call could be sold for about $0.25. This trade would cost $0.25 to open, or $25 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $25.
The maximum gain on the trade in RHT is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in RHT the maximum gain is $4.75 ($180 – $175 = $5.00; $5.00 – $0.25 = $4.75). This represents $475 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $25 to open this trade.
That is a potential gain of about 1,900% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.