$IBM Q1 Earnings Preview

by Dan April 18, 2016 11:56 am • Commentary• Trade Updates

Event: IBM reports Q1 results tonight after the close. The options market is implying about a 4.5% one day move tomorrow, which is about inline with the 4 qtr one day avg move. With the stock about $152.50 hours before the report, the April 22nd weekly 152.50 straddle (the call premium + the put premium) is offered at ~$7. If you bought that, and thus the implied weekly move, then you would need a move above $159.50 or below $145.50 on Friday’s close to just break-even.  

Price Action / Technicals: After 3 consecutive annual declines (the last two of about 14%), with IBM down about 30% from its all time highs made in 2013, the stock is miraculously up 10% so far in 2016 and up 30% from its 52 week and nearly 6 year lows made in late January.  The stock’s January low was 90 cents, or less than 1% from its 2010 low:

[caption id="attachment_62906" align="aligncenter" width="600"]IBM 6 year chart from Bloomberg IBM 6 year chart from Bloomberg[/caption]

What I also find interesting about the chart above is the stock’s recent pause at the downtrend that has been in place since mid 2014, this could signal some exhaustion at technical resistance.

Sentiment: Wall Street analysts remain overwhelmingly cautious on IBM shares with 7 Buy ratings, 15 Holds and 5 Sells  with an average 12 month price target of $138, or about 10% below the stock’s current price.  Short interest sits at about 2.5% of the stock’s float.

Valuation, Expected Growth & Share Buybacks: IBM trades about 10x trailing earnings and about 11x expected 2016 eps that consensus estimates has declining 9% year over year, and 10.7x expected 2017 earnings that consensus has growing  5% yoy.  EPS declines despite some serious buyback activity. Back in late February I had some thoughts on IBM’s share buybacks that actually continued to grow eps from their sales peak in 2011 (around the time the company’s largest shareholder, Warren Buffett started building his stake), and since they have slowed is expected to be flat in 2016 from their 2011 eps print of $13.44:

Since Buffett bought his initial stake in IBM, the company’s annual sales have dropped 23% from $107 billion in 2011 to $82 billion last year, while consensus is calling for a 5% decline in 2016 and its second consecutive 10% eps decline and eps estimate that is expected to match 2011’s $13.45 a share.  The problem is that since 2011 the company has shrunk their float by over 200 million shares, massively aiding that eps number, with most of their operating cash flow going to capital return.

WTF Watson??

If you’re like me, and you watched the final round of the Master’s golf tourney on Sunday, then you were subjected to what might be considered cruel and unusual punishment at the hands of IBM’s marketing team in what amounted to dozens of mind numbing commercials for their talking computer called Watson.  What is Watson you ask? Wasn’t that the thing that won Jeopardy? And why do the marketing peeps at IBM think it is such a big deal?  Well, it’s IBM’s so called cognitive computing engine that the company hopes can be applied to dozens of industries, transforming IBM’s lagging sales of legacy products to businesses, per Bloomberg:

The Watson unit — called cognitive computing — could reach $1 billion in sales in the near-term, he said, without specifying the time frame. Watson is the fastest growing part of International Business Machines Corp.’s analytics business, he said. Those operations brought in about $17 billion in revenue last year, or about 18 percent of sales. Watson is already incremental to the business, Kelly said in an interview.

I guess the main take-away for me is the part where Watson may account for a little more than $1 billion in sales of IBM’s expected $78 billion in total sales in 2016, or less than 1.5% of the expected total. So advances in artificial intelligence is still in its infancy. Meanwhile, IBM is expected to post its 5th consecutive annual sales decline, down 27% from their peak of $107 billion in 2011, and reaching annual levels not seen in more than a decade.

Implied Volatility & Options Open Interest SnapShot:  30 day at the money implied volatility (the price of options, blue line below) is below levels where it was prior to the last three quarters, with realized volatility (how much the stock has been moving over that period, white below) at 2016 lows, down 50% from its 52 week highs made in February, with one of the largest gaps between the two measures in a year:

[caption id="attachment_62908" align="aligncenter" width="600"]from Bloomberg from Bloomberg[/caption]

The three largest strikes of open interest are calls, with 13,400 of the May 155 calls, 10,300 of the Oct 165 calls and 10,200 of the Jan18 200 calls, followed by 8,600 of the Jan17 150 calls and 6,100 of the July 145 calls.

Estimates & Forecasts from Bloomberg:
-1Q adj. EPS est. $2.09 (range $1.99-$2.28); IBM on Jan. 19 forecast $2.025
-1Q rev. est. $18.28b (range $17.69b-$18.77b)
-1Q gross margin est. 48.4% (range 47%-49.9%)
-2016 adj. EPS est. $13.54 (range $13.24-$14.10); IBM sees at least $13.50
-2016 FCF est. $11.51b (range $9.60b-$12.96b); IBM sees $11b-$12b

My View:  You know the drill, strong dollar on yoy basis, weak on a sequential basis will likely be responsible for one of the most important headlines as the company gets more than 55% of their sales outside the U.S.  The U.S. Dollar Index (DXY) is down about 5% since they last gave forward guidance in January, and down about 3.5% over the last year which could offer some favorable comparisons. I mention Watson above because it’s been my view, and that of others (HPE’s CEO Meg Whitman to name one) that the focus on Watson has been slightly disingenuous for near term sales and earnings.  I would also add that recent negative results and commentary from Juniper Networks (JNPR) and Seagate Technology (STX) about U.S. enterprise spending could fairly easily offset any recent gains from US dollar weakness.

So the stock looks cheap relative to its history, and the markets. From a technical standpoint it bounced where it should have in Jan, but could be pausing now at key resistance, options are relatively in line to past moves into the event, and a sales stabilization turning into a ramp could remain allusive given their exposure to a volatile dollar, growth reliance on emerging markets that remain uncertain, slowing legacy products, slow emerging growth in big data analytics like Watson, despite very poor sentiment.

We will follow up with a post with some trade ideas depending on ones current positioning or directional inclination.