Name That Trade $IBM: A Couple Ways To Play

by Dan July 17, 2014 2:36 pm • Commentary

Earlier today we previewed IBM’s Q2 earnings report due after the bell (below).  To say that we are less than enthusiastic about IBM’s near term prospects for an acceleration in earnings and sales is understatement. The stock’s month to date rally of 7% dramatically raises expectations into the print in our opinion.  Heading into IBM’s Q1 results in mid April, the stock had also experienced a healthy bounce, 7% in the month prior, and 14% in the 2 months prior off of the 52 week lows.

Investing in large cap tech in 2014 has been a bit of a mixed bag with AAPL, CSCO, HPQ, INTC & MSFT leading the out-performance with greater than double digit ytd gains, with notable laggards EMC, IBM & ORCL stuck with single digit gains.

IBM this morning was trading near 196, very near its closing level prior to Q1 results back in April, a level that the stock declined almost 10% from until late last month.   Despite analyst sentiment being very poor, investors appear to be a bit more sanguine, which possibly creates a greater than expected decline in the event of an earnings disappointment.

On the bullish side, Investors seem somewhat giddy since the news of the joint IBM Apple enterprise agreement announced earlier this week, yet we see little reason to extrapolate much from a financial standpoint as the implementation of the agreement should take months if not quarters and the economics of said deal have yet to be discussed.

We wanted to put out our favorite structures in each direction for those that have an opinion into the print.

For those looking to play for disappointment and a move back towards the moving average, we would suggest a very short term, defined risk bearish bet that looks for the stock to decline in line to slightly higher than the implied move:

Hypothetical Bearish Trade: IBM ($194) buy to open July regular (tomorrow) 195/185/175 put fly for 2.80

-Buy 1 July 195 put for 4.40

-Sell 2 July 185 puts at .85 each or 1.7o total

-Buy 1 July 175 put for .10

Break-Even on July Expiration:

Profits: btwn 192.20 and 177.80 of up to 72.0 with max gain of 7.20 at 185

Losses: up to 2.80 btwn 175 and 177.80 and btwn 195 and 192.20 with max loss of 2.80 below 175 and above 195


For those who think IBM goes higher from here, the $200 level seems like something near term that can be leaned on. By selling near term 200 calls one can offset buying farther dated calls for a break out. Ideally with this trade you’d want the stock to have trouble getting through 200 tomorrow but no trouble next week and beyond:

Hypothetical Bullish Trade: IBM ($194) buy to open 1 July/Sept 200 call calendar for 1.65

– sell to open 1 July 200 call at .90

– buy to open 1 Sept 200 call for 2.55




Previous Post July 17th, 2014:  $IBM Q2 Earnings Preview

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.

Options Open Interest:  Total open interest slightly favors puts over calls by a ratio of 1.05 to 1.  However, the average volume over the past month has favored calls over puts by a ratio of 1.2 to 1.  Among short-term options, the Jul19th 195 calls and the Jul19th 185 puts both have over 10k of open interest.  The Jan15 175 calls, Jan15 190 calls, and Jan15 200 calls, as well as the Jan15 150 puts all have over 5000 in open interest, the most among long-term maturities.
Price Action / Technicals:  IBM has traded in a range throughout the past year, frustrating bulls and bears alike:
IBM daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg
IBM daily chart, 50 day ma in pink, 200 day ma in yellow, Courtesy of Bloomberg

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:

IBM weekly chart, Courtesy of Bloomberg
IBM weekly chart, Courtesy of Bloomberg

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:

IBM Price/Cash Flow ratio, Courtesy of Bloomberg
IBM Price/Cash Flow ratio, Courtesy of Bloomberg
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:
30 day implied volatility in IBM, Courtesy of Bloomberg
30 day implied volatility in IBM, Courtesy of Bloomberg
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.