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Julian Close
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September 23, 2013 - IBM: Completely Operational and Functioning Perfectly

The Dow Jones Industrial Average (or DJII) is an index that tracks 30 large, publicly traded American companies. Though the index was originally intended to focus on heavy industry, it has broadened over time to track the 30 companies that, due to their size and scope, provide a cross-section and bellwether for the relative health of American business. Naturally, being part of the DJII is a great thing for a company, increasing both its visibility and credibility, but the reverse is also true; being removed from the DJII is a serious blow. Three companies that have recently been given this extremely public brush-off are Alcoa (AA), Hewlett-Packard (HPQ), and Bank of America (BAC), each of which has stumbled significantly in the past 5 years.

Interestingly, stumbling in itself, will not necessarily trigger a company's removal from the DJII. The index contains other laggards as well, including the storied computer giant IBM, which the Index's managers apparently regard as still indicative of America's business health, despite the fact that it has not participated in the stock market's 2013 rally. IBM stock is down 7% over the last 12 months, and there are sound reasons for the decline. Nevertheless, it would be a mistake to dismiss IBM as one more bloated technology dinosaur, collapsing under its own ponderous weight and destined to sink slowly into the tar pits of irrelevance and obscurity.

In fact, IBM is a tremendously creative, opportunistic, and perspicacious company. IBM saw the likely decline of the computer hardware business more than a decade ago and has been transitioning, over that time, toward a completely different business model. Today's IBM receives more than 50% of its revenue from integrated services, frequently designing entire IT structures for its clients from the ground up. The company's dominance as a total solutions provider also allows it to maximize its hardware and software sales, which comprise the remainder of its business. Many computer giants were caught like deer in the headlights of the mobile /cloud computing revolution, but IBM smartly exited the personal computer business in 2005, selling the business to the Lenovo Group (which trades on the Hong Kong stock exchange). Worry not over declining PC sales?IBM, at least, is safe.

Of course, that isn't the whole story. IBM has had a bad year, with revenue in both the first and second quarters of 2013 down from the year-ago quarters. Earnings per share (or EPS) were up in the first quarter, but clearly not because of revenue and not even, in this case, because of improved profit margins. Earnings per share rose because there were fewer shares in existence; IBM has been engaged in a huge share buyback all year. Investors must regard large share repurchases with some concern, as a company with fantastic growth prospects should have better things to spend its money on, but share buybacks do tend to raise the price of the stock, which is all to the good.

So what, you might ask, is going wrong? In a word, the economy. 2013 has been a good year for many industries, but the market for integrated IT services tends to trail the broader economy. If the trend holds, it means that IBM's business climate will improve over the next six to twelve months. Analysts are predicting that IBM will be out of the ditch and back on the road to rising profits by the end of the year. IBM's 2012 EPS was $15.30, and analysts are anticipating $16.92 in 2013 and $18.31 in 2014.

Given IBM's deep pockets, its legendary brand strength, its excellent market positioning and the security afforded by its share buyback program, the chance of any significant, near-term drop in the price of IBM stock appears remote.

Chart courtesy of stockcharts.com

I seek to capitalize on this strength with a bull-put credit spread. Look at the January bull-put spread for at least a $0.40 credit. The bid-ask spreads are wide, so for this trade, use limit orders. This trade has a target return of 8.7% over 117 days, which is an annualized return of 26.2%, (for comparison purposes only) and the stock has to fall 12.3% to cause a problem. Be aware that this is an aggressive trade, best undertaken by investors with diverse portfolios and high tolerance for risk.

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