Collecting Big Yield From Big Blue

| About: International Business (IBM)


IBM has heard cries of "stagnation" for some time.

When you take a closer look all may not be quite as bad as it appears.

This article looks at various ways to generate a large cash flow stream from the security.

IBM (NYSE:IBM) gets all sorts of flak for its lack of growth. And you can argue that some of it is warranted. On the top line, IBM generated north of $100 billion in revenues back in 2008. This number was repeated in 2011 and 2012, and was close in 2010 and 2013, but since that time has come down materially. This year the expectation is just under $80 billion.

Company-wide profits hit $12 billion back in 2008, reached a peak of $16.6 billion in 2012 and this year the expectation is once more less than $12 billion. Notably, earnings-per-share are still up materially during this time (~35%), but this has been a consequence of the share repurchase program - decreasing the number of common shares outstanding from ~1.34 billion down to ~950 million. (Some cry "financial engineering" here, but it's simply one of many capital allocation decisions.)

The company is a mix of declining legacy businesses and a smaller but growing "strategic imperatives" segment. The question is 1) whether or not these imperatives continue to grow robustly, and 2) when or if this side will eventually outweigh the slowing growth on the other side. For the moment the consensus is not especially upbeat, with anticipating earnings growth in the low single digits.

It'd be easy to write the security off. Indeed, many have done just that as the share price went from over $200 back in 2013 down to $120 or so to start this year, and is now sitting at $165 or so as I write this. Yet in my view, this is often when things start to get interesting.

It's true that the business has not been growing as of late. However, there are a few mitigating factors that ought to be considered.

For one, a couple years does not always tell the story. In a previous article, I highlighted two separate ~5 year periods for CVS (NYSE:CVS). In each time frame, earnings-per-share grew by ~90%. Yet, in one instance, the share price basically stayed the same, while in the other the price increased by 260%. Over the long term, things generally work out, but in the short term, disconnects between business results and share price performance can come about often.

Despite the last few years, IBM has been a fine investment over the long term. Had you invested back in 2006, 2007 or 2008, you'd still be looking at 7% to 10% annual gains, despite the results as of late and the idea of a declining earnings multiple. It's true there has been business stagnation, but over the past decade shareholders have also seen margin improvement, a reduced share count and a materially higher dividend.

More to the point, you could make an argument that the "coiled spring" is in its early stages for IBM now. Granted this is predicated on the ability of the firm to grow into the future, but this remains as a possibility nonetheless. You're now looking at a security trading at ~13 times expected earnings with a well covered 3.4% starting yield.

From that point you don't need a whole lot of growth to make for a reasonable investment. The much lower valuation and higher dividend allow for a much lower "investment bar" as well. It's easy to fixate on short-term business results and not simultaneously consider the valuation.

So one way to generate an above average yield from IBM is to simply buy shares, collect the above average dividend and see what happens. Stagnating company-wide earnings may not be the worst of news (you could still see reasonable gains via share repurchases and the dividend). And should a bit of growth actually formulate in the years to come, you could stand to see solid gains.

Two other ways to think about collecting a big yield from the security are by agreeing to potentially selling your stake or by agreeing to potentially buy shares.

Here's a look at some available call options for IBM for the January 2018 expiration date:

Note that I have no affinity for this expiration date, but it does give you an idea of what's out there. The first column details the strike price or the price at which you would be agreeing to potentially sell your IBM stake in 100 share increments. The "net" premium takes the most recent bid less $0.15 per share for frictional expenses.

The premium yield column highlights the "extra" cash flow that this would represent based on the current share price (which may be taxed differently). And the "max" gain column indicates the maximum gain should the option be exercised including sale and option proceeds, but excluding any dividends received along the way.

So as an example, suppose that you'd like to double the yield of IBM in the coming year. Shares have already gone ex-dividend for this year, so you'd anticipate collecting four payments in 2017. Currently, the mark is set at $1.40 per quarter, but you'd expect this to increase in the future. For simplicity, we'll stick with this mark, equating to an annual cash flow of $5.60 per share.

In the table above, you can see that the $180 strike price also has an option premium quite near this mark. Let's think about what this agreement would mean.

If you sold this agreement, you'd receive ~$565 upfront that is yours to keep regardless. Your total return will depend on what happens to IBM's share price.

If the option is not exercised, nothing changes for the buy and hold investor. You still own shares of IBM and you still collect the dividends along the way. The only difference is that you received an "extra" ~$565 to begin. So regardless of whether the future share price is $179 or $79, you will always be ahead of the buy and hold investor. (And you want to make sure that you'd be content to hold anyway in this situation.)

The risk of selling the covered call, given that you're content to hold, is not a lower share price. Instead, it's a higher one where the opportunity cost comes in.

If the option is exercised, you'll receive $18,000 (less fees) in sale proceeds, plus the ~$565 in option proceeds to start. In addition, you could also receive dividends along the way. So your total value would be ~$18,565 to ~$19,125 or a total return of ~13.5% to 17%.

The risk is that shares later trade at say $200 and you're "stuck" selling at $180. Still, a 13% to 17% gain in just under 14 months is no great tragedy. The important part is being content with either side of the agreement.

The same logic applies on the buying side. Here's a look at some available put options with the same expiration date:

This time instead of the price at which you would be willing to sell, the above strike prices represent the price at which you would be agreeing to potentially buy shares. You have the net premium calculated in the same way as above, along with the yield this would represent on a "cash secured" basis and the discount it represents to today's share price.

In a world where one-year CDs are going for 1%, here you have an agreement to buy shares of IBM at a 50% discount offering the same cash flow. Naturally, this agreement is not guaranteed (shares could go to zero), but this is the sort of thing that strikes me as interesting. Not from an investment standpoint, but more from a "see what's out there" view. It sets up other interesting things.

For instance, if you'd like to collect the 3%+ yield but are a bit unimpressed with the current valuation of IBM, you're not stuck between the alternatives of buying or not buying. Instead, there's an intermediate option that is quite literally available to you.

As an illustration, you could agree to buy at $130 - a 20% discount to today's price. Your capital would be tied up for almost 14 months, but if you're more concerned about the immediate cash flow its an alternative nonetheless.

It's important to only consider these things should you be willing to own the underlying security anyway. The larger risk here is that shares increase by a material rate and you're "stuck" with a return of just 3% or 4% for the period. If that fits your cash flow needs, that's fine news. If not, you're obviously not limited to this single strike or expiration.

The takeaway is that you have some flexibility to achieve your investing ambitions. A lot of investors get fixated on buying or not buying instead of thinking about the intermediate possibilities. You could simply own shares of IBM and generate an above average yield. Or you could agree to buy or sell shares and generate comparable or even superior cash flow returns. The precise agreement (or lack thereof) all comes down to your expectations for the business and whether or not you'd be content with either side of the potential agreements.

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.