The insurance business can be a good business as long as you understand the risks you are underwriting. After following IBM (NYSE:IBM) for about nine months, we believe that whatever IBM is worth - and that is an open question considering the uncertainty surrounding its revenue picture - it's worth more than its present market value.
Value investors using options as directional tools (rather than speculative instruments) can take advantage of opportunities like this by writing covered calls or, in the case of our recently-published suggestion, by selling cash-secured puts.* In this case, the value investor acts as an insurance company that indemnifies other investors' downside risk in the stock and receives a premium in return.
While many investors transact in covered calls/short puts, few investors really understand how to use these investment tools in the most efficient way. Here's a brief article detailing some of the mistakes people make in writing covered calls.
In graphical terms, our strategy looks like this:
Figure 1. Source: CBOE, YCharts, IOI Analysis.
In figure 1, the cone-shaped region represents the option market's estimate of the future price of IBM (see this video to learn more). The geometric shapes to the right represent IOI's estimated valuation range for IBM. Overall, the figure shows that the valuation range that we consider most likely for IBM is above the present price of the stock and that the option market is materially overstating the downside risk to IBM (which means it is overpaying for downside protection).
Indemnifying downside risk can seem daunting unless you understand the risk you are insuring. We control risk by having a disciplined, repeatable method for assessing value.
This valuation method hinges on understanding three key drivers of valuation: revenue generation, profitability and medium-term growth.
Of the three factors that affect valuation, this driver has the most influence on our fair value estimate for IBM - which we have brought down slightly since picking up coverage last July. (Here's an article which explains our change in valuation.)
Even analyzing IBM's financial statements, listening to the earnings conference calls, and combing through industry news, we still have a hard time getting a handle on what IBM's near-term best-case and worst-case revenue scenarios might be. Three issues complicate the matter:
- IBM's business is changing. It is selling off non-core software product lines and completely restructuring its service offering. It's tough for anyone outside the company (or even inside the company, most likely) to know what the extent and timing of these actions will be.
- IBM's nominal revenues are affected by foreign exchange fluctuations. This is a bookkeeping issue rather than an economic one as I explain in this article (the article discusses General Electric (NYSE:GE), but the points regarding foreign exchange are applicable to IBM as well), but it does make forecasting tricky.
- IBM is shifting some software products to the cloud. Cloud revenues cannot be "recognized" all at once, but instead are "ratable" as I explain in this article (relates to Oracle (NASDAQ:ORCL), but applies to IBM's cloud revenues as well). Due to an accounting rule, this switch ends up depressing nominal revenues and boosting IOI's favored profit metric, Owners' Cash Profits (OCP) (which is similar to Buffett's "Shareholder Earnings").
Because we do not have any better than anecdotal evidence for what IBM's revenues will be in the near term, we have plugged in the high and low revenue estimates of Wall Street analysts for our valuation model's Year 1 revenue projections. (Using Wall Street research as a sort of educated coin flip is one of the only valid uses for this research we've found over 20 years in the business.)
Incorporating this assumption into our valuation model, we wind up with best- and worst-case revenue assumptions over the next five years that look like this:
After having written a detailed article in January about IBM's profitability, we will not belabor the point here. Reviewing IBM's annual financial statements, IBM's profits as measured by OCP were even higher than we had expected in January and in another article, we characterized IBM's profitability "astounding." Still, we suspect that the elevated profitability level is at least in part due to the issue of ratable revenues mentioned above, so we have kept our best- and worst-case OCP margin assumptions unchanged from our original model. The graphic illustration of these assumptions look like this:
"Medium-term" means years 6-10 of our valuation model. This is the time frame in which the effects of IBM's present-day business strategy realignment and investments in cloud software will become apparent to investors. Considering the brisk growth of revenues in IBM's "Strategic Imperatives" businesses (which include cloud computing and artificial intelligence - Watson), we have projected best-case growth of the metric IOI uses to value companies - Free Cash Flow to Owners (FCFO) - of 7% per year. In the worst-case, we have projected medium-term growth of FCFO to be 5% per year. There is solid academic research and a sensible reason for projecting these levels of 5% and 7%, but not enough room here to fully discuss.
Incorporating these operating assumptions into our valuation model and selecting the scenarios we think most likely yields the following valuations:
The takeaway from all of this is while we are uncertain exactly how high the value of IBM is, we do have a high level of confidence that the market is paying too much for downside protection of IBM. We are happy to act as an insurance company by selling nervous investors some overpriced put options.
* Notes: A covered call has the same risk/reward profile as a sold cash-secured put.
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. I have no business relationship with any company whose stock is mentioned in this article.