IBM to buy Rational Software for $2.1b

By Siobhan Kennedy and Eric Auchard

NEW YORK: International Business Machines Corp. on Friday said it would buy Rational Software Corp. for about $2.1 billion, expanding IBM's role in the market for tools companies use to make customized software.

IBM, of Armonk, New York, said in a statement it would pay $10.50 cash per share for the Cupertino, California, company -- a premium of about 28 percent over Rational's closing price of $8.17 on the Nasdaq stock market Thursday.

The news sent Rational shares up more than 25 percent. For IBM, the world's largest maker of computers and No. 1 provider of technical services, the deal is its biggest software acquisition since the $3.5 billion purchase of Lotus Notes Corp. in 1995. It is also IBM's latest move away from the computer hardware business that was its trademark for decades.

"It's a very good strategic move as IBM continues its migration into the services and software focus," said Andy Neff, an analyst with Bear Stearns in New York. The deal will dramatically boost IBM's position in the $9 billion market for software development tools, where rival Microsoft Corp. has been gaining ground. In four years the market is expected to grow to about $15 billion, according to International Data Corp estimates.

Rational's products are used by software programmers at tens of thousands of companies to design, develop and test customized programs that can run simultaneously across a variety of different software categories such as Microsoft and UNIX.

Taking aim at Microsoft

"This is largely a shot across the bow at Microsoft," said Scot Sedlacek, managing director at technology investment bank Broadview International, whose firm advised a company Rational acquired recently but who was not involved in this IBM deal. Sedlacek said there was a "holy war" going on between Microsoft, with its .NET Internet platform, and IBM, BEA Systems Inc. and Sun Microsystems Inc., which all favor the Java programming language.

"What IBM and BEA and others found a while ago is that to be successful at selling all the plumbing, you've got to own the developer. And the problem is that Microsoft owns the developer right now," Sedlacek said, noting that 60 percent to 70 percent of all software developers use Microsoft tools. IBM and Rational said their deal should close in the first quarter of 2003, subject to regulatory approvals.

Speaking on a conference call, IBM executives said the deal should reduce the company's 2003 earnings by "a few pennies per share" -- a tiny fraction of the $4.31 per share average forecast among analysts surveyed by Thomson First Call. IBM investor relations vice president Hervey Parke said the deal's impact on results should be neutral in 2004 and "very positive" in 2005.

The impact on IBM finances will not be determined until an independent analysis can be done of likely charges and write-offs for acquisition costs and goodwill write-downs, he said. Rational shares shot up to $10.28 in afternoon trade on the Nasdaq stock market, where Rational was the most active issue. IBM stock fell $1.66, or 2 percent, to $81.40 on the New York Stock Exchange. The deal comes amid consolidation of the market by Rational and rival Borland Software Corp., which recently purchased privately held TogetherSoft, a design tools maker.

Borland Chief Executive Dale Fuller said IBM's purchase of Rational will make his $220 million company the largest independent supplier of software tools for programmers. Rational will now favor IBM software, losing its claim to independence, Fuller argued. "Rational customers are now officially locked in to IBM. They have no choice," he declared. "As a customer, am I going to bet on IBM's mercy and their willingness to support the (software) platforms from their competitors?"

Damian Rinaldi, a software analyst with First Albany Corp., agreed, saying, "There will be a temptation to make IBM servers and IBM databases ... the priority. Rational will have to fight that temptation to maintain their independent reputation."

Shift to software, services

The purchase of Rational is the latest move by IBM to scoop up competitors as it shifts the focus of its business away from mainframe hardware, where sales have slowed, to software and more lucrative computer services.

In October IBM bought the consulting business of PricewaterhouseCoopers for $3.5 billion, expanding its computer services operations. It is in the process of selling its disk-drive business to Hitachi Ltd. for $2.05 billion. IBM Chief Executive Sam Palmisano said in October that software was one of the areas where the company would continue to make acquisitions this year. Software accounts for $13 billion of IBM's $80 billion in annual sales.

IBM was advised by Morgan Stanley and the law firm Cravath, Swaine & Moore. Rational sought advice from Goldman Sachs and the Silicon Valley-based law firm Wilson Sonsini Goodrich & Rosati. Rational, with 3,500 employees, should generate $630 million in revenue in 2002, down from $689 million in 2001, according to analysts polled by Thomson First Call.

(Additional reporting by Jeffrey Goldfarb)

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