IBM: Take Advantage of Sell-Off After Good Earnings

After Thursday’s close, IBM reported Q3 EPS of $2.40 versus $2.05 and said it expects to have full year results of at least $9.85 /share – up from 2008’s $8.93. You’d think that would have been received well but instead, the shares dropped by $6.34 (-4.95%) Friday to close at $121.64.

2009 will be the sixth consecutive year of improved EPS and Zacks sees another record on tap for 2010. They match the consensus view of about $10.75 /share in 2010. That puts IBM’s multiple at< 12.4x this year’s and about 11.3x next year’s expectation.

Here are IBM’s per share numbers from the past few years as reported by Value Line:

Year	Sales	C/F	EPS	Div.	Avg. P/E	Avg. Yield
2002	47.14	6.53	3.95	0.59	21.4x	0.7%
2003	52.60	7.27	4.34	0.63	19.6x	0.7%
2004	58.52	8.24	5.05	0.70	18.0x	0.8%
2005	57.90	8.71	5.22	0.78	16.1x	0.9%
2006	60.69	9.56	6.06	1.10	13.9x	1.3%
2007	71.31	11.28	7.18	1.50	14.8x	1.4%
2008	77.39	13.28	8.93	1.90	12.3x	1.7%

While it’s unlikely that IBM will bounce back to the high teens multiples of 2002-2004 it does seem logical that 14x earnings might be the new normal as the economy gradually recovers. That would put my one-year target at about $150 /share. Standard and Poors sees things similarly with their 12-month goal of $147.

IBM gets S & P’s top, 5-star ranking and garners Value Line’s A++ financial strength rating along with 95^th and 100^th percentile marks for ‘stock price stability’ and ‘earnings predictability’(with 100^th being best).

The dividend has been increased in each year since 1995 and the well covered $0.55 quarterly payout is now a 1.81% current yield.

The bottom line: After Friday’s drop IBM shares look to be 20 – 25% undervalued.

Here’s a way to play that can provide an even better return with a built in margin of safety that straight share ownership can’t offer.

	Cash Outlay	Cash Inflow
Buy 100 IBM @ $121.64 /share	$12,164
Sell 1 Jan. 2011 $120 call @ $13.40 /sh.		$1,340
Sell 1 Jan. 2011 $120 put @ $13.80 /sh.		$1,380
Net Cash Out-of-Pocket	$9,444

If IBM merely remains above $120 /share on Jan. 21, 2011:

· The $120 call will be exercised.

· You will sell your shares for $12,000.

· The $120 put will expire worthless.

· You will likely have collected at least $275 in dividends.

· You will have no further option obligations.

· You will end up with no shares and $12,275 in cash.

That would be a best-case scenario profit of $2,831/$9,444 = 29.9%

achieved in 15 months on shares that did not have to move up at all from the trade inception price. That’s not a bad annualized rate on a conservative stock.

In a worst case scenario (where IBM finishes below $120 on expiration date):

· The $120 call will expire worthless.

· The $120 put will be exercised.

· You’ll need to buy another 100 shares of IBM.

· You’ll have to lay out an additional $12,000 in cash.

· You will likely have collected at least $275 in dividends.

· You will end up with 200 shares and $275 in cash.

What was that ‘margin of safety’ I was promising on this trade?

Here’s the breakdown:

	Cash Outlays	Cash Inflows	IBM Shares
Original Cash Outlay	$9,444		100
Cash for ‘Put’ Shares	$12,000		100
Dividends Received		$275
Net Cash Outlay	$21,169

You will have put out $21,169 total (after dividends) for the 200 IBM shares for
a net average cost of $105.85 /share.

That’s $15.79 /share under Friday’s closing price of $121.64. IBM could fall by as much as 12.9% without causing a loss on this trade.

Summary: IBM is a low-risk, high-quality issue that appears to be at least 20% undervalued based on even a partial rebound towards its historical valuation metrics.

The dividend is higher than typical and the P/E is among IBM’s lowest in 15 years.

Buying shares plus writing a January 2011 call and put at the $120 strike price will allow for almost a 30% total return over the next fifteen months while also protecting against up to a 12.9% share price decline. Best of all, the 29.9% return will be achieved if the shares go up, stay unchanged, or even if they decline slightly to $120/ share.

If you leave both the shares and the options alone through the January 2011 expiration date you will not need to report any gains (or losses) until you file your 2011 tax year Schedule D in April 2012.

Disclosure: Author bought IBM shares and sold IBM puts Friday.

Comments

[Paul Price:]

Barrons' October 26th issue somes to the same conclusion and pretty much the same projected valuation for IBM that I did.

In a follow-up item they spoke about the latest earnings report and concluded that based on the earnings projections... "the stock could be worth more than $150."

Oct 24 06:43 PM

[Paul Price:]

Party with IBM like it's 1999

Analysts say shares could hit their highest level since the turn of the century.

SAN FRANCISCO (Fortune) -- If you own IBM shares, hold 'em. If you don't, now might still be a good time to get a piece of Big Blue.

Like many tech stocks, IBM (IBM, Fortune 500) has been on a tear lately, up almost 41% since March 9 lows. But even though its shares are knocking on the door of 52-week highs, they still lag the blistering 64% increase overall of the Nasdaq (COMP) and, perhaps more important, the 56% rise of the S&P 500 (SPX) during the same period.

Over the past five years IBM has traded at an average P/E ratio that is about 10% lower than the S&P 500's, according to financial data firm FactSet. With a current P/E just north of 12, IBM now trades at about a 25% discount to the S&P 500. So if IBM reverts to more typical ratios, it has some room to rise.

How much? Barclays Capital analyst Ben Reitzes recently raised his price target on IBM to $140 (that would eclipse the record high of $138 set in 1999). Reitzes sees IBM benefiting from continued strength in its core software and services businesses, but he highlights the long-awaited return of corporate spending on hardware in 2010.

While it accounts for only about 17% of sales, IBM's hardware business has been the hardest hit during the recession, down 12% in the third quarter (margins fell slightly too). IBM has been beating Street estimates on earnings by cutting costs and wringing more margin out of its software and services businesses. Those sectors clearly dominate IBM, but all of IBM tends to do well when its hardware business is on a roll.

That hasn't happened yet. In the third quarter IBM yet again beat analysts' estimate for earnings, posting a 14% increase in net income year-over-year. Revenue, however, fell 7% during the same period (the decline was much smaller than in the previous quarter).

0:00 /3:26Low tech supply? Good sign
IBM didn't show the top-line growth that investors are looking for, in part because of the continued hit its hardware business is taking. Without evidence of a return to revenue growth, IBM shares were punished the day after its third-quarter earnings were announced, dropping 4%.

But the next six months are likely to offer a rosier picture, says Mark Loughridge, IBM's CFO. Loughridge predicts a return to revenue growth in the fourth quarter, driven by improved performance in both its software and hardware business.

"We're not just saying we see an improvement in profitability for our hardware business going from third quarter to fourth quarter," Loughridge told analysts. "We're looking at it and saying that the hardware business ought to be growing profitability at double-digits as we go into the fourth."

Remember, all of IBM does well when its hardware business is humming. So if you start to see an uptick in sales of servers, storage systems, and mainframe computers, you're also likely to see continued upside for Big Blue

Nov 01 12:50 AM