Name That Trade $IBM – From Zero to Hero in a Month

by Enis January 7, 2014 2:20 pm • Commentary

IBM has been a bull/bear battleground for the past 2 years, a period in which the stock is flat with a lot of gyrations along the way.  Given that IBM is one of the few $200 billion+ market cap stocks in the U.S. market, this stock has tons of eyeballs dissecting each and every piece of the business, macro landscape, financial fundamentals, psychology and technicals.  Even with all of those analytical hours spent, the stock has traded in a relatively tight range since late 2011:

IBM weekly, 50 week moving average in pink, 200 week moving average in yellow, Courtesy of Bloomberg
IBM weekly, 50 week moving average in pink, 200 week moving average in yellow, Courtesy of Bloomberg

The 50 week moving average is downward sloping for the first time since 2009 (now around $193.50), though IBM stock did find support at the 200 week moving average around $175.

Following IBM’s weak earnings report in mid-October, we highlighted some of the longer-term fundamental concerns for the company in a Macro Wrap post, most notably IBM’s financial engineering to continue to grow earnings despite flat sales for the past 5 years.

Dan expanded on that theme in his Morning Word last week:

What I find so interesting is that investors have discounted IBM’s 10% earnings growth in 2013, and clearly see it for what it is, the product of financial engineering, the result of massive share buybacks, lower taxes and cost cutting (earlier this year they announced a restructuring that will eliminate 3300 jobs globally).

The stock’s languishing stock price is the result of declining sales (negative for the last 2 years and expected at just 1% growth next) and earnings growth, despite the tens of billions in share buybacks (lowering share count and raising eps) and job cuts that analysts expect to be half of what it was in 2011 next year at only 8%.

IBM reports earnings in 2 weeks.  Expectations are for 11% year-over-year earnings growth on a 4% year-over-year decline in sales (there’s that theme again).  Now, here’s the thing about IBM’s valuation – it all depends on how you measure it.    

On a P/E valuation basis, the stock looks cheap vs. the past 10 years:

[caption id="attachment_34443" align="alignnone" width="506"]Trailing 12 month P/E, Courtesy of Bloomberg IBM Trailing 12 month P/E, Courtesy of Bloomberg[/caption]

However, on a Price to Free Cash Flow basis, the stock is near the high end of its 10 year range:

[caption id="attachment_34444" align="alignnone" width="504"]IBM stock price to free cash flow, Courtesy of Bloomberg IBM stock price to free cash flow, Courtesy of Bloomberg[/caption]

Moreover, the inability to grow sales is a concern for any large tech company, especially since the tech industry backdrop is so frequently changing.

Yet, IBM’s relative valuation does certainly suggest low expectations in 2014 vs. many of its peers.  The stock has had some legs ever since ORCL’s strong quarterly report in December.

Add it all up, and I am of the view that IBM is unlikely to see much of a rally in 2014, but also unlikely to see a precipitous fall.  With that view in mind, here is a potential trade idea that would require a little patience, but is higher probability than most options structures as a result:

Name That Trade – Hypothetical:  Buy the $IBM ($190.00) Feb 195/185/175 Put Fly for $2.95

Ideally we’d look to enter this trade with IBM around $192 which could serve as near term resistance. At that point the fly should be cheaper and any hopefully could catch February vol at a higher point.

Rationale:  This trade structure goes out to the month that follows earnings, but it is profitable if the stock closes between the 192 and 178 range on Feb expiry, which is a scenario that I view as decent probability given the stock situation we’ve outlined above.  If IBM goes lower from here, which we think is more likely than a rally through 192, we don’t think it will make new lows in the near term, as there seem to be buyers below.  A move higher in the stock is likely to be contained by the significant overhead supply built up over the past 2 years.  We might look to put on this trade closer to earnings in 2 weeks, since the trade is unlikely to appreciate much before then, and as stated above, would like to time the 192 level and higher vol as best as possible.