Deep Blue Doo – $IBM 

by Dan June 6, 2016 12:11 pm • Commentary• Trade Ideas

We spend a lot of time on RiskReversal discussing implied event moves. We do this not try to predict the unpredictable, but mostly use it as an input to help gauge the sentiment of investors and the analyst community.  While noting the post event reaction is important relative to the pre-event set up, it’s also interesting to note the outright direction of the post event move.  IBM is a great example of a stock that has been in a massive downtrend since making new all time highs in 2013. The stock at one point this year was down 45% from those levels, and is now down about 30%:

IBM 5 yr chart from Bloomberg
IBM 5 yr chart from Bloomberg

In the 3 years since its all time highs, the stock has declined 11 times out of the 13 days following quarterly earnings reports,with the two times the stock rallied averaging a little less than 1% and the 11 quarterly declines averaging about 5%.  While this data can be diced up anyway you want, one thing is fairly obvious, since topping out in early 2013, the company has routinely disappointed investor expectations immediately after giving results and outlook.  IBM’s eps peaked in 2014 at $16.53, which is 18% below this year’s expected $13.53, while sales are expected to be close to $80 billion this year, more than a 10 year low and 26% below their 2011 annual peak of $107 billion.

What’s shocking about the eps decline is that between 2010 and the end of 2015, IBM spent about $75 billion buying their own shares back, while shedding nearly that amount in market cap from their 2013 peak to the 2016 lows.  

It’s probably about time for IBM’s board to take a page out of Hewlett Packard Enterprise (HPE) CEO Meg Whitman, who last year split the Silicon Valley stalwart in two parts, where she stayed on as the head of the faster growing software and services business from their PC/Server and printer businesses.  And then last month, Whitman again announced another split of HPE in a effort to unlock shareholder value by spinning out (in a tax free manner) the slower part of the faster part of her recently split company into a new entity with competitor CSC to join their services businesses.

Yeah that’s all a bit confusing, but the main take-away is fairly simple. Ms. Whitman knows that she was the steward of a bunch of legacy technology business that were weighing down the value of the whole. She has cut costs, made acquisitions and a bunch of corporate actions that are all culling down HPE to something that people may find invest-able after years of under-performance.  Not too different of a situation than that of IBM.

In my opinion, 2016 is the  year that IBM’s board moves their feet on something other than share buybacks to manage earnings, which could start with a management shakeup.  IBM CEO Ginni Rometty is a 30 year veteran of IBM, and this fall she will have had 4 years, or a full recruiting cycle to right the ship.  Since her appointment, IBM shares are down 20%, vs the S&P 500 (SPX) up about 70%, with almost $50 billion of share buybacks going up in smoke in that time period.

Shares of IBM are actually up this year, threatening new 2016 highs, up 11% ytd, up 8% from its April lows, that came after the stock declined 5.5% after their Q1 results and up a whopping 30% from their 52 week lows made in Feb:

[caption id="attachment_64128" align="aligncenter" width="600"]IBM ytd from Bloomberg IBM ytd from Bloomberg[/caption]

Betting on another disappointing quarter when the company reports Q2 on July 18th seems like a decent bet as we get closer to the print, if just considering the current enterprise spending environment. But given the stock’s recent performance, it seems that downside, without a broad market move lower seems limited to somewhere between 5 to 10%.

But playing for a near term breakout, and potentially a much larger move higher on the heels of some sort of corporate action could be the way to play the stock, especially when you consider how cheap options are in IBM.  30 day at the money implied volatility is at 2016 lows, very near 16%, nearly in half of the 52 week highs made in Jan of 31%:

[caption id="attachment_64129" align="aligncenter" width="600"]from Bloomberg from Bloomberg[/caption]

There are two trades I might consider for two different scenarios.

First, play for some sort of corporate action to unlock shareholder value announced on their Q2 July 18th earnings call:

Trade: IBM ($152.70) Buy July / Aug 160 Call Calendar $1.45

-Sell to open 1 July 160 call at 65 cents

-Buy to open 1 Aug 160 call for 2.10

Break-Even on July Expiration:

Max profit at $160 as the short July call will expire worthless, and the long August call will increase in value as the decay will be offset by pick up in deltas.

Max loss comes in a sharp move higher or lower above strikes of $1.45 or less than 1% of the stock price.

Rationale: the idea for choosing an out of the money strike is to allow for some room for a breakout in the near term, but really to isolate the July 18th earnings event that will fall into August expiration. If the stock were to move towards $160 prior to July expiration I would consider a roll whereby covering the short July call and selling to open a higher strike call in August, making a vertical call spread.


Second, play for a miss and guide down on Q2 earnings:

Trade: IBM ($152.70) Buy July / Aug 145 Put Calendar $2

-Sell to open 1 July 145 puts at $1

-Buy to open 1 Aug 145 puts for $3

Break-Even on July Expiration:

Max profit at $145 as the short July put will expire worthless, and the long August Put will increase in value as the decay will be offset by pick up in deltas.

Max loss comes in a sharp move higher or lower above strikes of $2 or a little more than 1% of the stock price.

Rationale: Sell short dated premium to finance already cheap downside puts for the earnings event. I would look to roll close to strike as we get closer to July expiration if the stock were to work closer to strikes. I would also consider selling a lower strike put in August to make a vertical put spread into earnings.