Written by Jared Levy, Editor, Options Strategy Weekly
IBM (IBM:NYSE) is one of the few tech companies that have been able to reinvent themselves. With the fast-paced evolution of technology, many of its early peers are long gone.
IBM has a history of strong earnings growth, and the stock has been on a tear over the past year — gaining almost 28%. The question now is whether its earnings will support its lofty stock price.
My earnings thesis uses several points of analysis so that I can fine-tune my estimates. There is no absolute when it comes to how the markets will respond to an earnings report, but with a checklist, logic and a little experience, you can substantially stack the odds in your favor.
Graphing Growth
Comparing data visually is extremely helpful when you need to put things in perspective. The first data I analyze is price-to-earnings and revenue growth. The chart below tells us several things:
- IBM is at a relative price-to-earnings (P/E) multiple high point over the past two years (solid yellow line) — this brings risk of a pullback.
- IBM tends to generate its most revenue in the last quarter of the year, so the big expectations are going to come at the next report; this quarter may not be as heavily weighted.
Chart Courtesy of Bloomberg
View larger chart
The average analyst is looking for IBM to earn $3.22 this quarter, which should knock down the P/E multiple to 13.37 with IBM at $186.80. Out of those analysts, 16 of them rate IBM as a buy and 14 have it as a hold, with zero sell ratings.
The problem I see here is that the target price is about $191 per share, which is only a couple dollars higher from where it stands now.
We are very early into earnings season. Only eight of the 496 companies in the S&P 500 have reported so far. Earnings growth has averaged 9.48% for the quarter in those companies. That’s a slightly positive sign… I discussed this in Monday’s article; check it out here.
Fundamentals
The bulk of IBM’s revenue comes from software, specifically middleware, which is sort of like plumbing for all sorts of applications. Another analogy would be that they provide telephone lines with thousands of translators linking people, businesses and processes together. It’s a niche market with Red Hat and Oracle as IBM’s major competition.
Then of course there is the “Cloud” connection. IBM is quietly increasing its Cloud focus. Last year it promised to spend some serious time, energy and money on Cloud technology and it has since signed the likes of Kaiser, ING, Citi and Lockheed Martin.
The goal for the Cloud rollout is to support about 200 million Cloud users by the end of 2012. This means strong recurring revenue and an impetus for more earnings growth over the next year.
IBM is also piloting a ton of new projects that could propel growth. One project I found interesting was an application that optimizes renewable energy consumption specifically related to electric vehicles and the smart grid, both of which are going to be key factors as we reduce reliance on fossil fuels.
This is just one of a plethora of ideas that IBM is incubating.
Technicals
IBM made a fresh 52-week high of $187.50 on Thursday and is back up above its 50- and 200-day moving averages. But I wouldn’t get too comfortable at these levels. The stock has been up seven of the past eight days and it’s at the top of its Bollinger band on low volume, indicating a short-term overbought condition, which could continue to after the earnings report.
The stock should move lower, down to the $173 level, which is support and a key Fibonacci level. Stocks that run up sharply into earnings have a higher probability of selling off after the report, which I think will be the case here as this is typically NOT a huge revenue quarter for IBM.
Option traders are expecting IBM to move less than 3% by the end of next week. This further confirms my thesis that the earnings report is most likely going to be met with modest buying then a move lower.
Broad Market and Summary
We find ourselves in an odd spot at the moment. Earnings season is shaping up to be a decent one as I expected, but the world is still on edge.
IBM has had a tremendous run, and even though its growth prospects still look good, the momentum will most likely dissipate after the report is out. I believe we will see a rally in the stock on the report, perhaps to the $192 area at which point I would sell and then look to buy it back in the $173 area.
If you don’t already own the stock, don’t worry; you should be able to buy it cheaper before the end of October.
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