Event: IBM reports Q2 earnings today after the close. The options market is implying about a 3.25% move, which is below both the 4 qtr avg move of 3.75%, and the 8 qtr avg of about 4.5%.
Sentiment: Wall Street analysts are not positive on IBM, with only 9 buys, 21 holds, and 3 sells, and an average 12 month price target around $196. Short interest in IBM is around 2.75% of the float, slightly lower than 3 months ago but still near 5 year highs. The stock is up 2.5% so far in 2014.
IBM tested the $171-$172 support area on several occasions in late 2013 / early 2014, but bounced from there in February. The stock then tested the high end of the range around $198.50, never touching the $200 level in April. After another weak earnings report in mid-April, IBM sold off again, only to rally into the earnings number for the 3rd straight quarter.
On the weekly chart, we can see that IBM is trading only slightly above where it was exactly 3 years ago:[caption id="attachment_43011" align="alignnone" width="600"] IBM weekly chart, Courtesy of Bloomberg[/caption]
The 1 year range is marked on the chart, but the stock has essentially been flat for 3 years. A lot of speculation, but no progression.
Fundamentals / Valuation: We’ve discussed the many accounting tricks that IBM has played over the past few years to sustain EPS growth even as the overall business has struggled and sales have been flat. Stanley Druckenmiller highlighted those same concerns in yesterday’s speech at the Delivering Alpha conference, summarized by Business Insider:
Druckenmiller said, “Let me give you a few shocking statistics. IBM’s sales are where they were six years ago. Despite the increase you saw in sales, industrial production and corporate customers, they’ve had no increase in sales whatsoever.”
Over that time, Druckenmiller said, IBM has tripled their debt load to buy back stock instead of invest in their business.
Buying back stock is a way that companies can improve their earnings per share, as it reduces the number of shares outstanding, thereby reducing the denominator when computing earnings per share — a company’s net income divided by its shares outstanding.
Much of Druckenmiller’s critique is made against the backdrop of what he sees as harmful Fed policy that is encouraging companies to engage in financial engineering rather than invest in their business.
IBM has used financial leverage quite aggressively. In addition, the company uses acquisitions instead of R&D, which helps keeps its expenses lower than they otherwise would be.
In any case, value investors have pointed to the relatively cheap valuation (11.5x P/E) as pricing in the business stagnation. Our concern is that the EPS number is not a good indication of the underlying business. For example, on a Price/Cash Flow basis, IBM is near its most expensive in the past decade:[caption id="attachment_43014" align="alignnone" width="600"] IBM Price/Cash Flow ratio, Courtesy of Bloomberg[/caption]
- We remain skeptical on the stock as an investment. IBM has been rangebound for several years despite these concerns, but there are likely much better investments in other large cap names.
- Volatility Snapshot: 30 day implied volatility in IBM is relatively low ahead of the earnings report:
- [caption id="attachment_43012" align="alignnone" width="600"] 30 day implied volatility in IBM, Courtesy of Bloomberg[/caption]
- As long as the stock remains in the range, it’s hard to see implied volatility getting above the 2 year high near 25. Given the low volatility backdrop, options traders are likely to reprice 30 day options back down to the 12-13 area after the event.
- Our View: Fundamentally, we don’t favor IBM, for all the reasons discussed above. Technically, the stock has been in neutral mode for some time. As it approaches the high end of its 1 year range, we have considered a bearish structure. Dan made a triple on an earnings trade last quarter, but lower implied volatility ahead of this earnings report makes such a structure less attractive. We don’t anticipate a new trade on the name today, but will post if we find something we like.