May 28, 2013 - How to Compute Steady Profits When Sales are Slow
When IBM reported earnings on April 19, the market was not impressed and the stock fell 8.2% from $206.18 to close at $189.11. IBM reported earnings of $3.00 a share, beating the prior year's $2.78 but missing the consensus estimate of $3.05 per share. Investors may have been reacting to more than just missing a few cents on earnings expectations.
In the market, it can be hard to keep investors happy all the time. Many companies give guidance and projections, and try to manage earnings expectations very carefully. If the earnings number is met, next investors are wondering about sales, growth, future projections, and costs. If those numbers are kept in line, focus can shift to the turnover of key people or future planning; there is always something to worry about. Most companies probably hope for an uneventful earnings announcement where the market will not punish them, but it is impossible to keep people happy all the time. Smart managers may well be more focused on operations and while still communicating with shareholders, they know that if long term they have a good plan, the shareholders will be rewarded.
IBM is a huge computer services company bringing in $104 billion of (2012) revenues in computers (17%), services (57%), and software (24%). The company has a global footprint with 44% of sales in the Americas, 25% in Asia, and 44% in Europe or elsewhere. After growing 4.2% in 2010 and 7.1% in 2011, in 2012 sales dropped 2.2%. Analysts are expecting sales for 2013 to be flat, and 2014 to see a modest 2.5% rise.
When it is hard to make more sales, smart managers look for another way to deliver the improved results. IBM is a diverse global company with some room for margin improvements. Without a clear way to increase sales, IBM has instead focused its efforts on cutting costs. To help build shareholder value, the company has also been buying back shares. Last year the company bought back $12 billion in stock or about 5% of the company. While some of this stock buyback may be offset by compensation packages, the rest should benefit shareholders as the stock price rises. The stock currently has a 1.6% dividend yield as well.
While IBM stock dipped as a result of its earnings miss, it has since recovered all its lost value. Sales may remain flat in the near-term, but a great deal of revenue is still coming in, which should allow earnings to rise as efficiency improves. In light of both the share buy-back program, and the cost cutting initiatives, we think IBM is very solid at its current price, and seek to capitalize with a covered call.
The October 210 call is going for $7.60. If an investor buys the stock and sells the call they have 2.7% of downside protection, and a 5.3% assigned return over the next 150 days. The 5.3% return over 5 months is 13% annualized return rate (for comparison purposes only). This call is sold just out of the money, so hopefully we will see a little appreciation between now and then.
Summer months are historical hard on the stock market, but given the great rally we have seen so far this year, it seems like an investor should play that a bit more aggressively. The old stock market saying "sell in May and go away" has some truth to it. It would not be surprising if the rally continued and it would also not be surprising if the rally took a break. This uncertainly can make it a little difficult in deciding what exactly which option to play but the 210 looks like a decent balance. The stock has also been paying out dividends quarterly so we should be able to catch a payout that may be $0.95 on August 8.
Companies are ultimately worth their future cash flows and when sales are stable, share buybacks -which have been popular recently- are one way for companies to return value to the shareholders. Another way to try to pull some extra cash off a stock is to sell a call option against it. While losing the appreciation value of the stock, it can pull it extra returns on those stocks that are not outperforming.
Chart courtesy of stockcharts.com