IBM’s New Battle in the Cloud

Dedication from Mohan Subramaniam: Bala Iyer, my research collaborator and a dear friend of many years, sadly passed away recently. I would like to dedicate this article to his memory.

IBM’s purchase of Red Hat is the largest acquisition in the history of software. According to The Wall Street Journal, this $33 billion acquisition is expected to shore up IBM’s position in cloud computing services. Yet, this is an expensive bet to seek parity with other cloud service providers like Amazon, Google, and Microsoft. Just a few years back, IBM was betting the farm on artificial intelligence through its Watson platform. That strategy has yet to deliver promised results. Is it going to be any different this time with Red Hat?

First, it’s important to look at the appeal of this acquisition. Red Hat’s business model is built on the Linux operating system, which came to the fore in the 1990s. Over the years, Linux has emerged as a stable and reliable OS that supports a vast ecosystem of software developers that meets most computing needs of users and enterprises, spanning all kinds of industries across the globe. In addition to its popularity and widespread use in computing devices (from desktop to mobile to smart devices and household appliances), Linux is open source software, available for free.

So why did IBM place such a big bet on free software? Why is this any different from its earlier bet on AI-driven Watson?

To understand the change in IBM’s expectations, it’s important to understand the modern IT industry stack. This stack has three layers — infrastructure (consisting of hardware, operating systems, and middleware), applications, and a newly emerging AI and analytics layer. An AI engine that resides in this new layer is designed to solve specialized problems based on transactional data in the applications layer. For example, H&R Block’s applications layer may automate taxpayer information, calculate returns, file returns with the IRS, and prepare clients for refunds. Watson’s AI engine, with its intelligence on millions of tax codes, can identify unique tax saving opportunities or inadvertent errors that the standard algorithms in the applications layer may have missed. In doing so, it complements the applications layer in unique and specific ways.

IBM expected to see an exponential growth in the demand for such specialized, complementary add-ons to all kinds of applications. It hoped to benefit from an IT spend on AI similar to that of the applications layer. That reality did not pan out, as IT spend on AI remains a fraction of what companies spend for their applications layer.

By contrast, IBM’s investment in Red Hat is a bet for expanding into cloud infrastructure. Red Hat’s heavy investments in cloud services and the Linux OS connect to the infrastructure layer. With the acquisition of Red Hat, IBM can expect demand for its infrastructure solutions to grow and to make inroads into the cloud services sector by shoring up its position in cloud computing.

Migrating to cloud-based services has become a mainstream effort among enterprise companies, as the cloud offers many benefits:

• Freedom from lock-in. Companies can switch cloud providers to suit their needs without fear of being locked in to a permanent hardware solution.
• Accessibility and self-service. Cloud services can be accessed from differing devices and platforms globally, and companies have the ability to scale up or down services when needed.
• Service and workflow plug and play. This supports a suite of cloud services and workflows that allow the realization of business processes and functions within a cloud-type environment.
• Increased transparency. Enterprises have the ability to verify and manage the history, location, and application of their data in the cloud for traceability purposes and compliance issues.

Although these benefits are well-known, only 20% of companies worldwide have moved to a cloud-based infrastructure. However, further growth is inevitable, and IBM estimates this market will grow to $1 trillion in value. Going back to IBM’s recent acquisition, it’s important to note that Linux, Red Hat’s main investment, controls over 95% of the infrastructure software market, and this number is rising. This gives IBM ownership of the largest percentage of software used in the infrastructure layer.

With this acquisition, IBM is initiating a new battle that while emanating from the cloud is likely to have more widespread aftereffects. An immediate consequence may be more intense confrontations for market share vis-à-vis key competitors in the multi-cloud environment, especially Amazon, Google, and Microsoft. IBM may aggressively go after more market share in cloud computing, given that Red Hat provides a more seamless interaction of its cloud infrastructure and an edge over its rivals. Given that a bulk of Red Hat’s software is open source and will continue to be available to all competitors, the degree of advantage for IBM here remains to be seen. Nonetheless, IBM now has the opportunity to benefit from a built-in community of approximately 8 million developers on the Linux platform, which also gives them the opportunity to influence and incentivize the community to better integrate middleware and apps with the Linux OS.

Another consequence may be farther off but could have an outsize impact in the cloud-computing market. Because of its dominance in the infrastructure layer, every cloud player — including market leaders Amazon, Google, and Microsoft — has to interact with Red Hat whenever they introduce a new application or service above their infrastructure layers. Red Hat consequently becomes a sensor for IBM, helping it to not only sense and interpret competitive moves in the cloud, but to acquire early signals for the kinds of applications or services that are trending or growing in demand from global users. Thus, IBM takes its battle with its key competitors not just to the infrastructure layer but to the layers above as well. Red Hat offers the opportunity for IBM to consolidate its competitive strength in all its layers, including the one where Watson’s AI platform sits.

The competitive asymmetry mushrooming from the Red Hat acquisition will soon be evident (if it’s not already) to IBM’s competitors. They will plan their own countermoves — whether in the cloud or in the other layers remains to be seen. A strategic competitive battle has just begun, and while it started in the cloud, it is inevitably going to impact all layers of the modern IT stack.