A few weeks ago we laid out (below) our bearish thesis on IBM. We have written a lot of late about the disturbing trend of large cap U.S. multi-nationals with little to no revenue growth managing earnings through share-buybacks (here, here, here). We think this trend is likely to come to an end, either where sales growth accelerates and lean U.S. companies starting seeing a greater contribution to the bottom line vis a vis demand for their products and or services, or what we believe will be a continued malaise in global growth. IBM has been a top short target for us for the better part of the last year and we are now going to go back to the well. IBM is scheduled to report their Q3 results on Oct 16th, we think this event should serve as the catalyst to send shares back towards technical support at $180 (green line below, also the late June low).
Thesis below, but here is the trade:
TRADE: IBM ($191.70) Bought to Open Oct 192.50/182.50 Put Spread for 2.95
-Bought IBM Oct 192.50 Put for 3.90
-Sold IBM Oct 182.50 Put at .95
Break-Even on Oct Expiration:
Profits: between $189.55 and $182.50 make up to 7.05, max gain of 7.05 below 182.50
Losses: between $189.55 and $192.50 lose up to 2.95, max loss of 2.95 above $192.50
Rationale: We chose a slightly in the money put spread as we are looking to keep a tight stop to the upside (near $195, purple line above). Heading into the Q3 print in mid Oct if the spread was out of the money, we would likely look to cut our loses as we do not love the idea of taking long premium out of the money spreads into a potentially volatile event. If the spread is in the money, and our thesis still stands we like the idea of defining our risk into the event with a pre-determined stop at technical resistance.
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Previous Post – Aug 28th, 2014: Name That Trade – $IBM: We’re On To You Big Blue
IBM has been at the top of our list of large cap stocks where earnings have been massaged for years while the business has remained stagnant. The bull/bear debate between a cheap valuation and a declining business / poor accounting has not been resolved, as IBM has remained in a tight range of $180 to $195 for much of the past year:
The stock has hardly delivered inspiring earnings results over the past year. The general trend for IBM has been to appreciate into earnings, and then gap lower on a poor result and fall after a weak earnings result.
The second quarter report in July was a bit better compared to the prior dismal reports, and IBM was unchanged on the day after earnings. However, analysts have modeled in better numbers for the second half of 2014 (-1% sales decline and 10% EPS growth), raising the bar for IBM. The GS analyst noted that management has guided significant improvement in the software segment (around 30% of total sales):
We were encouraged that IBM reported modest revenue upside and generally in-line profits, but there were also signs of continued challenges. While the Americas performed well and China improved meaningfully during 2Q, much of the rest of Asia-Pacific (ex. Japan) is still weakening, and overall growth markets—which are key to IBM’s future earnings growth—declined. Additionally, the weak reported signings suggest that our previously discussed concerns regarding the services business may be becoming more severe. While the software segment was disappointing, IBM is calling for a sharp recovery in the back half of the year. However, if this rebound doesn’t happen, it will add more risk to the company’s cash flow trajectory.
IBM has not had a 2%+ move higher on earnings since January 2013, as the company has clearly lost market share across its business lines in the past 2 years. Given that history, we remain skeptical about IBM’s ability to reach those higher targets.
Aside from the recent business weakness, the fact that the majority of EPS growth in IBM over the past 5 years has come from stock buybacks is a concern as well. Famed short seller Jim Chanos has been vocal on this point (and we think he’s short IBM as a result. A January WSJ article detailed his view:
By his count, for instance, the recent return on IBM’s buybacks is about 6.5%. Not a terrible number. But IBM’s return on what he dubs its “net business assets”—actual stuff used in actual business—is far better. It is 18.1%.
Wouldn’t this be a sign to immediately raise investment and shrink buybacks?
Maybe IBM has concluded there is no better place to put its money. Or that it is simply doing what stockholders want. It is hard to tell. “Our capital allocation model drives reinvestment in the business through R&D, capital expenditures, and acquisitions, it pays the dividend every quarter since 1916, and it returns excess capital to shareholders through share repurchase,” said IBM spokesman Michael Fay. “We can do both, invest and return cash, and we do.”
…
“Corporate CEOs, with their massive share-buyback programs are in effect investing in the stock market rather than in expanding business opportunities at their companies,” said Mr. Chanos. “Either they expect higher returns from the market, or lower returns in their business, or some combination of both. Given their questionable track record in timing the market, this may be a cause for concern.”
The buyback program is likely part of the reason why IBM volatility has been quite low over the past couple of years.
Implied volatility recently hit a 2 year low in IBM:
[caption id="attachment_44844" align="alignnone" width="600"]
30 day implied volatility in IBM, courtesy of Bloomberg[/caption]
However, the low level of options pricing is directly due to the lack of movement in IBM stock in August. 10 day realized volatility is also near a 2 year low:
[caption id="attachment_44845" align="alignnone" width="600"]
10 day realized volatility in IBM, courtesy of Bloomberg[/caption]
Add to that the fact that IBM remains well within its 1 year range, and it’s no surprise that options market makers have priced options quite cheaply.
Having said that, the October earnings report should be important not just for the Q3 results but also for the crucial Q4 guidance. While short-term volatility might not be a good buy, Oct18th options that capture the next earnings event are valuable.
Given that backdrop, here is the trade that I considered:
Hypothetical Trade: IBM ($191.80) Buy the Sept20th / Oct18th 190 Put Calendar for $2.20
-Sell IBM Sept20th 190 Put at $1.45
-Buy IBM Oct18th 190 Put for $3.65
Break-Even on Sept20th Expiration: This trade does best if IBM is at $190 on Sept20th expiration. If IBM is substantially above or below $190 on Sept20th expiration, the put calendar is going to lose value between now and then.
Rationale: This trade offsets the short-term decay in the Oct18th 190 puts by selling the Sept20th 190 puts against them. The thought is that IBM is unlikely to make a big move with no catalyst over the next 3 weeks, but the Q3 earnings report scheduled for October 16th will be a crucial event for IBM. The put calendar sets up for owning the option that catches that event.