mma redhat defence final

8/8/2019 Mma Redhat Defence Final

1/17

Exam Number:

F09115

F09025

F09035

F09080

F09112

Word Count: 2,989

CRANFIELD SCHOOL OF MANAGEMENT

Full Time MBA Programme 2009/10

Part 2

Term 4

MMA Defence Document Microsoft/Red Hat

This assessment/report is all my own work and conforms to the Universitys

regulations on plagiarism

An identical copy of this document has been submitted to the Turnitin system.


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Contents

Rejection of an offer from Microsoft for our company.............................................................1

Microsoft undervalue our business ...........................................................................................2

An acquisition by Microsoft would be very wrong for Red Hat ................................................3

How we can grow without Microsoft ........................................................................................5

Summary of offer options..........................................................................................................8

Microsofts offer ....................................................................................................................8

Red Hats offer .......................................................................................................................8

Appendices.................................................................................................................................9

Appendix 1: Valuation of Red Hat..........................................................................................9

Appendix 2: Strategic group analysis...................................................................................12

Appendix 3: Post acquisition integration approach ............................................................13

Appendix 4: Corporate parenting matrix.............................................................................14


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Red Hats value ...

STRONGPRODUCTBASE

+

INVESTMENTS

(ACQUISITION ANDORGANIC)

+

GROWTHMARKET

+

STRONG CULTURE

=

VALUEWHICH BELONGS TOYOU

(NOT MICROSOFT)


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1

16 July 2010

To the holders of Ordinary Shares,

Dear Shareholders,

Rejection of an offer fromMicrosoft for our company

Firstly, and most importantly, Microsoft fundamentally undervalues our company, they are not

offering a market price, we consistently outperform the market (even in a time of global recession)

as a result of our subscription based business model and we have a diversified product portfolio.

Secondly, Microsoft are the wrong company to acquire us. Underlying their proposal is a cost cutting

mentality (despite their attempt to dress it up as based on knowledge transfer). Further, past

performance suggests that they would discontinue very popular flagship products such as Linux.

A key competitive advantage is the Red Hat culture. This is the culture which continues to generate

above average industry returns for you, our shareholders. Any merger with Microsoft will, almost

certainly, destroy the culture that makes our business a success.

We have a clear growth strategy which can deliver far more value than Microsoft is currently

offering. This can be delivered through:

our continued investment in R&D to secure our future offerings

building upon our recent successes in the Middle East and Asia

continued rapid growth through acquisition, and

growth in subscriptions due to the wider market needing to reduce upfront investment costs.

Recommendation: Your board unanimously recommend you REJECT the Microsoft offer.

In line with this recommendation and indicating that they have no hesitation in rejecting the

Microsoft offer, members of the Red Hat board do not intend to accept the offer in respect of their

own substantial holdings of Ordinary Shares.

1801 Varsity Drive

Raleigh, NC 27606

+1 919 754 3700

www.redhat.com

Yours sincerely,

JimWhitehurstPresident and Chief Executive Officer

CC Holders of Preference Shares

Holders of Share Options


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2

Microsoft undervalue our business

Microsoft are offering US$39.45 per share which constitutes a bid premium of 24. 9%

This premium is pitiful and woefully undervalues our unique business. We are the industry leaders in

our sector and given this strong position are worthy of a much higher price. In March 2010 Novell,

our closest competitor, rejected an offer from a private equity firm with a bid premium of 115%. 1

When Oracle acquired Sun Microsystems in January 2010 they paid a 42% bid premium. 2 Both of

these very recent examples taken from our industry highlight how bad this offer is.

Despite facing the largest global downturn ever in the financial year 2008/09 we have outperformed

the market and continued to increase our sales by nearly 25%.3

Complementing this sales growth

our subscription business model generates a constant flow of cash into the business that enables us

to ride out the rough times. This inherent strength in our earnings makes this business exceedingly

attractive to a potential buyer, unfortunately none of this value has been reflected in Microsofts

bid. We have valued Red Hat at 9.122bn, which is 53 times higher than the current market

capitalisation even after following a rather conservative approach to projecting future cash flows.4

This clearly highlights the fact that Microsoft is undervaluing our business.

To date Red Hat are the only business that is operating simultaneously in the operating system (OS),

middleware and virtualisation markets. We achieved this through consistent and effective

innovation and investment in research and development (R&D). Our R&D ability is well known and

respected throughout the industry, the future value of this capability has simply not been captured

in the current bid.

The board at Red Hat believes that it is unlikely that the proposed acquisition would be allowed to

complete as it ould be anti competitive.

1Taken from: http://www.eweekeurope.co.uk/news/novell-confirms-acquisition-offer-from-hedge-fund-5622

2

Taken from: www.sun.com/third-party/global/oracle3Red Hat annual report 2009.

4See Appendix 1: Valuation of Red Hat.


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3

An acquisition byMicrosoft would be verywrong for Red Hat

While there are many reasons why you should be suspicious of Microsofts offer there are two main

points that need to be noted. The first question that a Red Hat shareholder needs to ask is how the

acquisition of Red Hat fits into Microsofts strategy. It is evident from Microsofts acquisitions in

2009 that they are focused on obtaining application software which enhances the user experience 5

(examples being BigPark, Powerset, Greenfield Online etc). Red Hat, as a pure play open source

enterprise software development organisation, seems to be out of place within the kind of

companies mentioned earlier.

Red Hat shareholders also need to examine the value creation logic proposed by Microsoft. 6 While

Microsoft has primarily projected knowledge based value creation logic, it is evident from the

proposed bid that the driver behind the acquisition is cost savings rather than transfer of knowledge.

This can be seen through the fact that Microsoft have mentioned in the bid that they are planning to

utilise the current Red Hat customer base to cross sell their products,7 while there is no mention of

how the combined organisation would utilise the resources to sell Red Hat solutions to existing

Microsoft customers.

Microsofts CFO has publicly stated that they specifically look for companies that would bolster their

position in categories where they have a presence but are not a dominant player. 8 Keeping this in

mind the Red Hat Shareholder should refer to Figure 3 in the bid document. This competitive

landscape shows that Microsoft is a strong player in the operating systems domain and a small

player in the virtualisation world. This, in conjunction with the CFOs statement and the fact that

Microsoft has traditionally stripped assets from the acquired companies to include into the

Microsoft products,9 suggests that that Microsoft would retain the R&D talent from the virtualisation

division of Red Hat but will ignore the remaining divisions like Linux operating system development.

Moreover, Red Hat shareholders should also remember that when Microsoft acquired GeCAD itpromptly discontinued GeCADs Linux antivirus product.10

5Bid document, page 8.

6See Appendix 3: Post acquisition integration approach.


8

http://www.forbes.com/2009/05/17/microsoft-acquisitions-strategy-technology-paidcontent.html9http://www.readwriteweb.com/archives/acquisitions_an.php

10http://www.pcworld.com/article/111123/linux_version_of_acquired_antivirus_product_doomed.html


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Further, Microsoft has proposed all cash offer to buy out Red Hat.11

The deal has been structured as

an all cash offer in order to prevent the dilution of earnings per share for Microsoft share holders as

Microsofts price earnings ratio12 is lower than that of Red Hat13 by at least five times. The all cash

offer also indicates that Microsoft wants to gain complete control and does not want the Red Hat

share holders to be part of the combined future of the companies.

Red Hat shareholders should also be aware that Microsoft had entered into a joint venture with

Novell in 2006.14

This joint venture was undertaken to monitor the interoperability between Linux

and Windows. This joint venture is still operational as can be evidenced by the recent (June 2010)

press releases released by Microsoft.15 The shareholders would be surprised to know that Microsoft

has not addressed this joint venture in its bid document and how this relationship would be handled

post the proposed merger with Red Hat. Without a clear guideline on the Microsoft / Novell joint

venture it is a valid risk that a merger of Red Hat and Microsoft may result in all the intellectual

capital built up over the years by Red Hat being passed to Novell.

Moreover, the culture of both the companies is quite different.16 While Microsoft has promised to

retain the open culture which Red Hat has developed, in order to attain any synergies from the

combined entity, the dilution of the corporate culture of one of the organisations will be necessary.

Microsofts culture has changed a lot from their initial days when the company was innovative.

The corporate culture of Microsoft can be considered to be one of win at all costs as espoused on

their company website; We are driven to make an impact at work, in our communities, on the

world.17. At the moment Microsoft,18 just like any big conglomerate, concentrates on identifying

opportunities to cut costs and use resources more effectively. Microsofts business model itself is

predicated to developing, manufacturing, licensing, and supporting a wide range of software

products and services for many different types of computing devices.19

Red Hats culture can

summed up in the following statement We don't want to kill our competitors. We just want to be

the best.20 Red Hat believes in democratizing content and making it available for everyone's


12http://finance.yahoo.com/q?s=MSFT

13http://uk.finance.yahoo.com/q?s=RHT

14http://www.microsoft.com/presspass/press/2006/nov06/11-02MSNovellPR.mspx

15http://www.microsoft.com/Presspass/press/2010/jun10/06-

01HybridHPCPR.mspx?rss_fdn=Press%20Releases16

See Appendix 4: Corporate parenting matrix.17

https://careers.microsoft.com/careers/EN/US/lifeatmicrosoft.aspx18

Microsoft FY 2009 Annual Report.19Microsoft FY 2009 Annual Report.

20http://www.redhat.com/about/culture/topten.html


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benefit.21

As mentioned in Red Hats 2009 annual report, diluting the open corporate culture of Red

Hat will result in a loss of the innovation, creativity and teamwork with the company and

consequently a loss of value for the Red Hat business.

Howwecan growwithout Microsoft

Red Hat can continue to maintain its position as a leading open source services and solutions

company. We have more than 70% share of the world wide Linux subscriptions.22

The majority of IT

companies have, in the last twelve months, had to take drastic measures to counter recession Red

Hat is an exception. We have weathered the recession quite nicely due to our emphasis on offerings

that are high value and low upfront cost. In the first quarter of 2010 we have reported an 11% year

over year increase in revenues23

with 85% amounted by subscription revenues. In the next quarter

we have projected the increase of revenues by 12%24 which we aim to achieve by enhancing our

offerings to fully suit the customer needs.

The foray into virtualisation and middleware applications from being an enterprise Linux vendor has

helped Red Hat to position itself as a one stop shop for enterprise applications. 25 The business

proposition of Red Hat, which involves a combination of the licensing model along with advanced

platform tools, has helped customers to make large cost savings.26 Red Hat has successfully faced

competition from IBM and Microsoft/Novell partnership mainly because our product completely

satisfies the customer needs and is well known for its quality and reliability. This continued focus on

high value low cost offerings will help Red Hat stifle competition in coming years.

Red Hat will continue to focus on operating systems, Cloud computing, virtualisation and

middleware for future growth. We intend to increase our market share globally by bringing out new

technology and service offerings (such as messaging and high performance computing), improving

our infrastructure and capitalising on existing strategic relationships, for example with IBM.27

Realising that virtualisation is where the world is heading to we have taken a conscientious effort to

enhance our offering in this area. We have recently expanded our relationship with Cisco for

21http://www.redhat.com/about/culture/topten.html

22http://www.redhat.com/about/companyprofile/history/

23http://www.internetnews.com/bus-news/article.php/3840776

24http://www.internetnews.com/bus-news/article.php/3840776

25See Appendix 2: Strategic group analysis.

26http://www.builderau.com.au/program/linux/soa/Red-Hat-Enterprise-Linux-5/0,339028299,339275059-

2,00.htm27http://www.linux-foundation.org/weblogs/jzemlin/2009/02/18/congratulations-to-ibm-and-red-hat-on-

their-10th-anniversary/


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technology integration. The integration of the Cisco network with Red Hat Enterprise Virtualisation

will enable customers to enjoy higher performance, control and lower cost of ownership.28

In the

middleware sector we will continue to invest in R&D to launch new products to maximise our

position. We believe that the open source approach that we follow in Cloud computing allows inter

operability between products of different vendors which would in turn benefit our customers

leading to retention as well as acquisition of new customers.

We will continue our strong focus in R&D for product and technology development. In 2009 we

invested $130mn, an increase of 32% from 2008. 29 In 2010 we aim to focus our R&D investment on

adding and improving the functionality of our offerings needed by Global 2000.30 We intend to

encourage the development of applications by third party developers which are compatible with our

software by providing them with open source tools so that our products will continue to remain

competitive.

In order to address our lack of scale we would be looking at acquiring companies that complement

our product offerings, such as Jboss which we acquired in 2006. We are keen to establish a strong

foothold in Systems Management market.31 Diversification into this sector promises higher returns

in the future as organisations will be looking for efficient and cost effective software which will allow

them to deploy applications anywhere and anytime as well automate their Linux environments. We

have looked at improving our competitiveness by investing in EnterpriseDB an open source database

vendor.32 This would strengthen our position as we would be able to move away from Oracle which

is our current back end database. Such a move would decrease our reliance on Oracle, one of our

major competitors.

With a strong focus on new product development, as well as acquisition of companies that offer

complementary products, we will be able to maintain our strong position in the software market.

We envisage our open source approach to product development as a distinct competitive edge

empowered by a strong international community of users and developers to supplement our own

employees. This enables us to bring product enhancements to market early and at lower costs than

other vendors. As a result, our key strategy for growing market share will continue to involve

28http://www.redhat.com/promo/cisco/

29Red Hat Annual Report 2009.

30Red Hat Annual Report 2009.

31

http://www.mspmentor.net/2010/06/21/red-hat-looking-at-systems-management-market/32http://blog.internetnews.com/skerner/2009/10/red-hat-investing-in-enterpris.html


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stressing the cost savings for users. One of our big initiatives for 2010 is to increase the rate of

adoption of our for-fee products from prospective customers still using for-free versions of our

software (like Fedora), a process it only started in late 2008. Enterprises often find it expensive to

support themselves and we are getting better at convincing the customers to move to subscription

offerings.33 As western economies make their way out of recession, budgets continue to be tight,

and we are likely to benefit more than our competitors as we move from free to fee accounts.

Our FY2010 annual subscription revenue of $639 million was up 18% year-over-year.34

Our routes

to market will continue to build on our traditional distribution channels such as reseller, third party

OEM, ISV and channel partner networks on a global basis. In order to expand our customer base, we

are enhancing relationships with the systems integrators to tap customers who follow system

integrators advice and recommendations for technology purchases. We are also looking at gaining

better value from our professional services and support to make direct marketing more effective but

we still believe that letting community drive the products approach does work well in long term as

proved by our expanding market share.

We operate our business in three geographic regions: The Americas, EMEA (Europe, Middle East and

Africa), and Asia Pacific. In the 2010 financial year, approximately 43.4% of our revenue was

generated outside the United States compared to 40.9% for the 2009 financial year. Our

international operations are expected to continue to grow as our international sales force andchannels become more mature and as we enter new locations or expand our presence in existing

locations.35

In terms of new markets, we are exploring telecom and public sectors, 36 especially in

countries with phenomenal growth like India. Most of the large e-governance programmes are built

on open source platforms and huge projects like Unique Identification (UID) offer tremendous

opportunity which we have already started working on with MindTree Ltd. In addition, we have

generated lot of excitement with considerable savings offered by cloud computing for educational

institutions and SMEs in India and expect orders flowing in soon. The telecoms sector has always

been at the forefront of the open source revolution and we are expecting solid growth in investment

in this area across India and other emerging economies.

33http://news.cnet.com/8301-13505_3-10224781-16.html accessed on 20/07/2010.

34

Red Hat Annual Report 2010.35Red Hat Annual Report 2010.

36http://insurance-technology.tmcnet.com/news/2010/07/12/4894523.htm accessed on 20/07/2010.


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Summary of offer options

Microsofts offer

Microsoft are offering an inadequate premium of 24.9%.

This is an all cash offer so there is no chance for you to share in the future success of this business;

Microsoft will keep all future profits for themselves.

Microsofts track record of acquisition is one of stripping out the useful assets out of companies and

destroying what they dont need.

Red Hats offerUnder the current management Red Hat have outperformed the index and continued to grow during

a severe recession.

We are recognised as the market leaders in our industry with a reputation to match.

We have increased revenues 25% from 2008 to 2009, with a profit margin of 84%.

We have invested nearly $300m in R&D over the last 3 years and are in a strong position to maintain

our growth over years to come.

This is an all cash offer. If you sell your shares in Red Hat you will still need to find another form of

investment for this cash. As a market leader in a growing industry that has bucked the recession we

believe that we offer the best investment in the current market.

Dont let Microsoft buy our company on the cheap.


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Appendices

Appendix 1: Valuation of Red Hat

From the Valuation of Red Hat using discounted cash flows, it can be seen that Red Hat is worth

9.12bn which is 52 times the current market capitalisation.

Source: http://investors.redhat.com/financials-keyRatios.cfm

Assumptions made:

Sales projected to increase by 30% for the next five years

EBIT which is currently 16% of the sales is projected to rise to 21%of sales.

Capital expenditure is 10%of the sales

Net working Capital which is currently 16% of sales projected to rise to 17%

WACC for discounting future cash flows =8.45%

WACC Calculation

beta 1.39

Rf 3%

Rm-Rf 4

Cost Of Equity 8.56

Tax 0.3

Interest rate 500%Cost of Debt 3.5

Total Equity 1.1bn

Total Debt 24.08m

Equity% 0.98

Debt% 0.02

WACC 8.45


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Forecasts for 2011 onwards (mn) (mn) (mn) (mn) (mn) (mn)

2010 2011 2012 2013 2014 2015

Sales 748.2 972.66 1264.458 1643.795 2136.934 2778.014

Sales Growth 0.3

EBIT 121.67 204.2586 265.5362 345.197 448.7561 583.383

EBIT% 0.16 0.21 0.21 0.21 0.21 0.21

NWC at Feb 2010

Receivables 139.44

Payables (16)NWC 123

NWC% 0.16 0.17 0.17 0.17 0.17 0.17

NWC 123 169.5746 220.447 286.5811 372.5554 484.322

Change in NWC (47) (51) (66) (86) (112)

Capital Expenditure 0.1 74.82 97.266 126.4458 164.3795 213.6934 277.8014

Change in Capex (22) (29) (38) (49) (64)

CASHFLOW FORECAST FOR Valuation

EBIT 121.67 204.26 265.54 345.20 448.76 583.38

Depreciation 45.86 45.86 45.86 45.86 45.86 45.86

Tax 0.3 (37) (61) (80) (104) (135) (175)

Change in NWC (47) (51) (66) (86) (112)

Capex (22) (29) (38) (49) (64)

FCF 119.82 151.68 183.43 224.70 278.35

NPV of 5 years at 8.45% 731.24

Growth after 5 y ears 6%

Terminal Value 0 0 0 0 12043.05

NPV of te rmi nal v al ue 8,027.65

Enterprise Value 8,758.89


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Market Capitalisation as of 21/07/2010 = 5.97bn37

Therefore total Value of Red Hat Linux is 9.122bn which is 53 times the current market capitalisation.

Source for 2010 figures: http://investors.redhat.com/financials-statements.cfm

37http://uk.finance.yahoo.com/q?s=RHT

Debti n balance sheet

cash -388.12

Short Term Debt 0.87

Long term 24.08

Net Debt (363) 363

Total Value 9,122.06


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Appendix 2: Strategic group analysis38

We currently have a strong presence in all three domains, which we are constantly strengthening

through strategic acquisitions of complementary companies in each domain, thereby enriching our

product set further. Examples include JBoss (middleware), Amentra (consulting), C2Net (internet

software). Microsoft being restricted primarily to operating systems domain might not provide the

expected growth to middleware and virtualisation domains.

38Microsoft offer document.

In the figure above the bubble size represents the revenues and the number in parenthesis

represents the annual expected growth across these three major segments Operating systems,

Virtualisation and Middleware.


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Appendix 3: Post acquisition integration approach

Table 1: Post acquisition integration approach

Organisations engaging in M&A activity need to be clear about the motives of the merger is it

achieving strategic goals (eg: domain strengthening, domain extension) or transferring capabilities

(eg: resource sharing)? These motives could be different from what has been announced publicly

and drives the questions of how much autonomy is required for the independent firm to retain its

unique selling point and how much strategic independence might be required to create maximum

value for the firm. The answer to these questions will drive the style of the post merger integration

approach.39

Microsofts offer has suggested both a cost and knowledge based approach. As mentioned in the

post acquisition integration approach matrix, this is possible. What is not shown is how difficult it is

to achieve both of these outcomes at the same time, particularly in light of the cultural differences

between the organisations. Further, the degree of autonomy granted to Red Hat will need to be

high, something which we suspect Microsoft is unlikely grant.

39Extended review: human resource management implications of mergers and acquisitions Laura Empson,

The International Journal of Human Resource Management, Sep 1994.

Degree of strategic interdependence

High Low

Degreeof

autonomygranted H

igh

Symbiosis integration

(rationalise knowledge and cost

based strategy)

Preservation integration

(retain knowledge based strategy)

Low Absorption integration

(replace cost based strategy)

[Holding integration]

(governance based strategy)


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Appendix 4: Corporate pa

Figure 1: Corporate parenting matrix41

When considering the corporat

a value trap business to Micr

However, their culture is irreco

value destruction.

40

Image of the Corporate Parentin41Image of the Corporate Parentin

amended by Cranfield Red Hat defe

14

entingmatrix40

fit between Microsoft and Red Hat, we believ

soft. Microsoft may be capable of adding val

ncilable with Red Hats. As a result there is a

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Red Hat represents

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strong likelihood of

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