A year after the announcement of IBM’s acquisition of Red Hat, we examine IBM’s stock price development before and after the announcement.
First they ignore you, then they laugh at you, then they fight you, then you win.
This quote by Mahatma Gandhi appeared in a famous commercial by pioneering open-source software company Red Hat. Years ago, people still remembered it. When technology giant IBM announced its acquisition of Red Hat in 2018, this quote reappeared in ironic form, in which then you win was replaced by then they buy you.
But let’s just forget about romantic ideas about David and Goliath for a moment and focus on everyday reality. IBM’s stock is a generic example of blue-chip stock. Many people around the world have IBM’s shares in their investment portfolios either directly or through investment funds. What happens to IBM’s share price matters.
IBM’s structure of ownership is highly diversified. It is a publicly-traded company and it has many, many shareholders. But have you ever wondered who is the larges one? Who owns more of IBM than anyone else? Well, it used to be Warren Buffett’s Berkshire Hathaway, but not anymore. As of now, the largest institutional shareholder is The Vanguard Group. The largest provider of mutual funds in the world.
So what happens when a company like that makes a biggest transaction in its history? Let’s look at the numbers.
In the above chart, you can see IBM’s common stock price around the time acquisition of Red Hat was announced. The date of the announcement of the acquisitions is highlighted by the orange line. You can zoom in on the chart by holding the left mouse button and selecting the area you wish to zoom into. If you look at the price development around the time the acquisition was announced, you will see that the price started to decline before it already.
We should investigate, whether it was widely known, that the acquisition is going to be announced and whether that was maybe the cause of the price drop occurring early. Maybe also the stock market believed that this acquisition is a bad decision and investors started to sell IBM’s shares, thus causing a drop in price.
We can look at the number of searches for the phrase “IBM Red Hat” on Google trends.
There is a clear peak at the date of the announcement, but before this date, only a few people searched for this phrase.
NASDAQ-100 technology sector index (NDXT) which is a market index calculated based on prices of companies such as Apple, Cisco or Alphabet (parent company of Google) captures the development in the whole industry. If we compare IBM’s stock price to NDXT index we can see a similar drop occurring roughly at the same time.
IBM’s stock price is influenced by many factors. Some of these influence the industry as a whole. So if we want to have an accurate picture of the impact of the acquisition, we need to somehow separate the fluctuations which are industry-wide and which are IBM specific. Luckily, there is a statistical methodology to do just that. It is called the Capital Asset Pricing Model (CAPM).
This model takes into account economy and industry-wide phenomena and a so-called risk-free rate of return and enables us to capture how well is particular stock doing in comparison. The risk-free rate is a rate of return on a risk-free investment. It is a theoretical concept, but for the sake of simplicity, we will assume that risk-free investment is an investment in US government bonds. It is not completely unreasonable to assume that the US government will not fail on meeting obligations to its debtors and therefore that the investors bear no risk (almost). Using CAPM with NDXT index value and US treasury bond yields will enable us to calculate a measure called Alpha of IBM’s stock. Alpha measures the excess return of investment into IBM’s stock above the risk-free rate and NDXT return. In the figure below, the development of Alpha in time is depicted in blue and the date of the acquisition is again highlighted by orange-like. Positive values of Alpha mean, that IBM’s stock was doing well compared to the industry at that time and negative values mean the opposite. Again use the zoom-in function to examine the plot. You can also use the pan button in the top right corner to move around the timeline.
If you’ve looked closely you might have noticed periodically concurring sudden changes in Alpha. Occurrences of these changes are highlighted by gray lines. One of these, a sudden drop, occurred just before the announcement. It is not difficult to figure out the cause of these changes. They occur at the exact dates IBM published its quarterly earnings. If the expected earnings were higher, the value of Alpha drops. If IBM exceeds the expectations of investors, Alpha increases.
We can also calculate overall Alpha for the period before and after the anon cement.
The alpha year before the announcement was
-0.0007589475
Alpha year after the announcement was
-0.0002015524
Both values are negative, meaning IBM is not doing so well compared to other technology companies, but the Alpha calculated for the period after the announcement is actually higher. So maybe the acquisition of Red Hat was not viewed as such a bad decision even though it almost doubled IBM’s indebtedness. Red Hat is a big bite, but IBM has been acquiring other companies for decades. Acquiring another vendor and then selling its product using the huge sales network and synergies that emerge from integration with other IBM products is a core part of IBM’s business model. Only time will tell how much this particular acquisition will be a successful one.
Feature photo by bert sz on Unsplash.
Comments are closed.