In my last article on International Business Machines (NYSE:IBM), I explained a trading strategy that goes into playing earnings reports. Unfortunately, that strategy would have failed for Q4 earnings, which disappointed IBM stock holders. However, IBM and the tech sector are on the rebound, causing investors to ask whether now is the time to buy (or buy more) IBM.
Notwithstanding the clear statistical basis for shorting IBM into Q1 and Q2 earnings, I'm pro IBM. I've been asked to present how I would play IBM as a dividend stock. If you're going for dividends, here's how I would play IBM.
Why IBM Is a Great Dividend Stock
If you're not already convinced that IBM is a great dividend stock, let me convince you. The bullish case for IBM relies partly on the company's status as a dividend aristocrat. It's raised dividends consistently since 1995:
The increase in dividends has matched an increase in stock price for most of IBM's history. Because the stock price increase has outpaced the dividend increase, most of the time, IBM could be considered expensive for the dividend. Only in a brief year-long period of 2008 to 2009 was the stock considered cheap in this regard:
We are now seeing another one of these "cheap" periods. From 2015 to present, IBM has fallen. This is one of those rare times to get IBM during a true dip.
What has caused this fall in stock price? Poor earnings for one. But the opacity of IBM's earnings reports and financials have left many fundamental investors worried about the company.
Another issue is the CEO Virginia Rometty, who has led IBM to underperform since taking leadership. Oddly enough, IBM recently announced a $4.5 M performance bonus for her lack of performance.
Yes, it is absurd to reward a CEO for letting tens of thousands of US talent go, outsourcing to India to cut costs and therefore losing many of their clients due to service issues. And it's also absurd that the CEO already sold roughly $4 M worth of IBM stock back when it was trading above $190 a share. But the world is not fair. As an investor, you should just see this as a cut to the free cash flow.
Realize that this bonus is only 0.34% of IBM's free cash flow. The dividend is still being paid. The CEO cannot stop IBM's continued dividend increases.
It's time to stop looking at IBM as a growth stock until management changes. For now, just look at the financials. Important questions for now should relate to IBM's dividend.
Also realize that IBM has been running buyback programs, making each share you own worth a bigger portion of the company. Today, the outstanding shares of IBM are at their lowest number. The buybacks and dividend increases are making each share of IBM literally worth more than ever before, despite management issues:
The steady increase in the dividend, the fall in outstanding shares, and the recent stock price drop have all acted as catalysts for IBM's yield. The yield is at a relative high. Again we see a 2008-like pattern:
The next image shows why IBM dividend investors should not care about falling financials. IBM's income is dipping but still way above what it needs to be to safely pay out and increase dividends. Yes, the last year has been hard, but we have seen an income drop in IBM before, followed by a quick comeback:
In 2003, we also saw the percent of income paid as dividends rise to a previously unseen high. But history repeats itself. I expect the same length for this spike; we should be dropping back to the 20 to 30% region in 2016:
Free cash flows are still high:
As a running average, FCF is looking good. IBM has plenty of cash on hand:
Looking at IBM's dividend from this regard shows us that IBM is no different now than it has been in the past five years. IBM is still paying roughly 40% of its cash to shareholders as dividends. This is in addition to consistently buying back shares:
So overall, IBM's dividend is safe. And that's all dividend investors should worry about. After all, the point of a dividend is to give money to shareholders because the company itself cannot invest the money better than its shareholders - this is true for an IBM under the management of Rometty.
My IBM Dividend and Options Strategy
Still, the yield is not high for a dividend stock. The dividend is safe. But it's not high.
Let's see what we can do about that. Clearly IBM is on the fall. This will naturally increase the yield.
To date, the yield is 4.3%. This is the best IBM has seen in recent memory. But we can make it better by opening collars on IBM.
If you're not familiar with collars, just know that they constitute a protective options strategy that combines covered calls and puts. Covered calls can help you increase your income on a dividend stock. In addition, we buy puts on the stock because, as I showed in the previous article on IBM, buying puts before earnings can be a profitable strategy for IBM.
Thus, we are combining three income strategies for a single, slightly complex way of investing in IBM:
- Holding IBM for dividends
- Selling calls for income
- Buying puts to gain exposure to earnings report gains
What follows is my recommended collar strategy:
- For every 100 shares of IBM you have, sell a slightly OTM call four months out.
- One month prior to an earnings release, buy an ITM put four months out.
Played to June 2016, the following collar would give you $260 in dividends and $388 in theta income (from the covered call):
- Hold: IBM 100 shares
- Sell: IBM JUL16 130 Call @3.88
- Buy April 1, sell May1: IBM AUG16 (x + 10) Put
Thus, you essentially double your IBM dividend. This is in addition to the money you get after Q1 and Q2 earnings reports from your put options. In the above, "x" is the price of the stock at the time.
The ideal outcome is that IBM stays below $130 by July's option expiration date. In this case, you would receive the $648 in income and $500 in stock price gain. The put you opened before April should pay off, statistically, with a $2.5 drop in the stock price, which gives us an addition $200 from the put option. In total, the ideal situation gives roughly $1350 gain in four months on 100 shares of IBM.
What could go wrong? IBM could rise above $130, in which case, you would buy the covered call back at expiration. In this case, you only gain $500 + $260 in dividends = $760.
Alternatively, IBM could trend sideways or fall, in which case you only gain the covered call income and dividends: $648.
If IBM miraculously pulls off a good earnings report, the put option could lose a lot of value. But because we are buying the put option four months out, it still retains a lot of time value and can be sold back at a small loss. If you're worried about this or suspect a good earnings report, you can forgo the put and/or buy back the covered call to allow for more gains in the stock (the covered call limits our stock gains at $500 per 100 shares).
Honestly, not much can go wrong with this strategy. There are no extra tax implications because we are not touching the actual stock. If you're currently holding IBM or considering buying IBM, consider this strategy for a safer source of income.
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Disclosure: I am/we are long IBM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.