Mike & Mark: IBM Turning The Corner?

by Mike Khouw January 9, 2017 3:48 pm • Trade Ideas

International Business Machines Turning The Corner (IBM)?

International Business Machines Corporation (IBM) commonly referred to as “Big Blue” is one of the oldest and biggest information technology companies that sells its products and services the world over. IBM has largely been a disappointment for investors as the share price peaked in Q1-2013. From that time to Q1-2016, IBM investors have been left out of the overall stock market rally. Even as the share price rebounded over 45% from the 2016 low, IBM shares have not reached their old highs.

For a time, many argued that IBM’s best days were behind it. It seem investors are focused on the shrinking revenue picture of the past. Revenues peaked in 2011 at about $107 billion the company has seen its revenues fall for the past 5 years. One of the reasons the top line shrank is a result of the restructuring. The company sold a number of legacy businesses. Most notably, the company sold its “chip-making” business in 2014, which was a very important core business at one time…

Other core business units like the Global Technology Services, Global Business Services division that offers consulting and systems integration services for large enterprises are no longer growth engines for the company. This should not surprise anyone, as these activities along with the software, hardware and data storage businesses are mature and tend to suffer in slow global economy. Even as the company restructures itself, the company remains very profitable. Over the last 4 quarters, the company generated $80 billion in revenues and generating $11.8 billion in earnings (or $12.26/share).

We expect revenues and earnings growth to come from innovation. The Workforce division, which gives companies the ability to connect people and processes in large organizations, seems to be the place where that is taking place. This group developed a product called “Watson.” Watson is a clever application that allows the user to interact with it in natural language. It is capable of process big data, and can learn from interactions with people, data and other computers. At this point, IBM applies the Watson to the growing Healthcare industry to improve patient outcomes. There are certainly other applications for this technology which large enterprises are sure to use to optimize production and marketing processes. We think the “Internet of Things” also hold great promise. The Internet of Things will connect every device we come in contact with every day (phone, radio, internet, refrigerator, oven, home HVAC and security, etc.) is an enormous opportunity that is just getting started. One can see the day, when everything in ones home, office and car work together seamlessly to help people manage their lives and IBM is putting itself in a position to be a dominant player in this field.

Technically, the company’s share price action is very positive. After a 3-year selloff, the share found support at just under $120 per share. From that point forward, the price rallied and ultimately broke out into a new uptrend in Q2-2016. The share price has been moving higher ever sense. The MACD suggests that bullish price action is slow and steady. The RSI confirms that behavior and suggests the share price has room to run before becoming overbought.

We like the valuation of this company. It trades at a PE of14 based on trailing 12 months earnings and 12 based on analyst expectation of forward looking earnings. EV to EBITDA is middle of the road at 11.4. The firm generates an impressive 7.4% return on assets. We think these valuation metrics are modest for a blue chip company that services the worlds best companies and one that is also poised to capitalize on advanced uses of AI and the Internet of Things.

If you agree with this thesis, investors might consider taking a long position in this stock if it fits into their portfolio and longer-term strategy. Since the stock had a sharp bounce in 2016, the share price could pause and trade sideways for a time before moving higher. If you believe that this is a more likely scenario, you might consider an alternative income oriented strategy. That alternative strategy is to buy the stock outright and sell a call against it for additional income. With the share price trading at $169.53, the market prices of the Feb 17, 2017 175.00 strike call is $2.05 per share equivalent.

The cash cost of this trade structure is $16,748 per 100 shares of stock and one short call. Selling the Feb Call should allow the investor to collect 1 dividend payments estimated to be $140 each in addition to the option premium. The breakeven level is $166.08 (including dividends), which is about 2% lower that the current price. A random walk suggests there is a 55% chance this trade succeeds. Naturally, we think the odds are better than that, for all the reasons discussed above.


Mike Khouw and Mark Guthner are co-authors of The Options Edge (available on Amazon).

Michael Khouw is a 20 year veteran of the financial services industry with broad experience as a strategist, analyst, portfolio manager and proprietary trader of equities, commodities and equity and index derivatives for both buy-side and sell-side firms. (follow on Twitter)

Mark W. Guthner is a veteran of the financial services industry. His skills and experience stretch across multiple disciplines including trading, portfolio and risk management, securities analysis and valuation, investment banking and financial technology as well. (follow on Twitter)