Event: IBM reports Q2 earnings Wednesday after the close. The options market is implying about a 4% move, which is lower than the 4 qtr avg move of 5.25%, and lower than the 8 qtr avg of about 4.75%.
Sentiment: Wall Street is fairly mixed on the stock, with 14 buys, 16 holds, and 1 sell, with an average 12 month price target of ~$220. After a strong run from 2009 to 2012, the stock is close to flat in the past year.
Options Open Interest: Total open interest is slightly skewed towards calls, with 203k calls of vs. 173k of puts. Recent activity has been close to evenly split as well. The largest open interest is in July and Jan14 expiry, with much of the open interest on strikes between 185 and 205 .
Fundamentals: Given recent results from ORCL and ACN, the notion that IT spending is weak from both enterprise and government channels is an understatement. While demand in the U.S. may be stable relative to Europe, China and emerging markets, IBM relies on overseas sales for almost two 3rds of their sales. As with many U.S. multi-nationals the dollar strength in the quarter could have provided a late headwind, and could cause the company to give more cautious than usual guidance for the back half of the year. While IBM is not a particularly expensive stock trading about 12.5x trailing earnings, analysts expect a meaningful earnings deceleration this year and next from the high teens to about 10%. This deceleration is likely to keep IBM’s multiple well below a market multiple which would be at the high end of the stock’s 10 year valuation range.
To put the valuation discussion in a historical context, top ranked hardware Toni Sacconaghi from Bernstein (who rates the shares a Hold with a $225 12 month price target) had the following to add in a note to clients yesterday:
IBM’s stock has underperformed the S&P by 17% year-to-date, and the stock is now trading at 0.77x the S&P 500 on a P/FE basis, placing it in its 5th percentile since the end of 2002
While investors point to IBM’s low revenue growth over time, our analysis reveals that IBM is one of 38 companies in the S&P 500 to average >8% EPS CAGR on less than 5% revenue growth over the last ten years – more importantly, this collective group of stocks have historically traded in line to above a market multiple. Additionally, we note that IBM is currently the second least expensive name among this cohort on a P/FE basis
Given that IBM is currently trading at a ~20% discount to the S&P, its valuation relative to other companies with similar financial models suggests that now may be a good opportunity to add to positions in the stock. We agree that is the case for investors with a longer-term view, but note that IBM’s multiple may remain constrained in the near-term due to weak expected revenue growth for the next few quarters, potential worries about earnings quality, and ongoing weak capital and IT spending.
Price Action / Technicals: The long-term picture in IBM shows a stock that was in a steady uptrend channel throughout 2009 to 2012. However, the stock broke that long-term uptrend convincingly on its last earnings miss, and the stock is near where it closed after that April earnings report:[caption id="attachment_28095" align="alignnone" width="639"] 5 year weekly chart of IBM, Courtesy of Bloomberg[/caption]
On a shorter-term, 1 year chart, the stock has basically been rangebound between 185 and 215 the entire time:[caption id="attachment_28096" align="alignnone" width="640"] 1 year daily chart of IBM, 200 day ma in black, Courtesy of Bloomberg[/caption]
The 200 day moving average (in black) is basically flat, and has been flat for all of 2013. Near term support is around 185, while near term resistance is around the 200 day ma and the psychological level of $200.
Volatility Snapshot: Largely related to the recent selloff in the stock, IV in IBM is higher than in the previous earnings events. Aug vol is about 23 right now and will fall to about 16 following the event, a 30% contraction.[caption id="attachment_28103" align="aligncenter" width="578"] from LiveVol Pro[/caption]
MY VIEW: Given last quarter’s first earnings miss in 8 years, and the stock’s subsequent under-performance (down ~6.5% since April 19th), expectations are not exactly running high, yet as mentioned above, recent results and commentary by peers suggest little potential for revenue upside, despite the company’s ability to massage earnings. From a technical standpoint, the stock has clearly broken the uptrend that has been in place since the lows in late 2008 and continued earnings disappointments would most likely cause a re-test of key support at $180. IBM checks a lot of the boxes for the reasons we remain cautious on the market here, a multi-national with tons of exposure to: strong dollar, emerging markets, China & U.S. govt spending. My assumption would be that an earnings re-set would find buyers below $180, as IBM would once again be viewed as defensive with low multiple, strong balance sheet better than avg dividend yield, monster buyback and lots of recurring revenue from their services business.