RealMoney Silver - Keep a Close Eye on IBM

Keep a Close Eye on IBM
By Bill Trent
RealMoney.com Contributor
1/31/2008 10:17 AM EST

When IBM (IBM) reported earnings a couple of weeks ago, the consensus among Wall Street's finest was that the company would earn $7.98 a share in 2008. The company smashed that number, providing guidance of $8.20 to $8.30 per share. Even Papa Bear called it impressive.

The market reacted by enthusiastically doing ... well, pretty much nothing. The shares were up a smidge the next day, then dropped back and recovered in line with all the market weirdness. The conference call featured one question after another about the macroeconomic environment.

It's true that there were some signs that the results were built on a wobbly foundation. Fourth-quarter revenues were up 10%, but 6% of that growth was due to currency fluctuations that may or may not reverse next year. If I want to bet on a rising euro, I think I'll play the currency rather than IBM.

Worse, though short-term global services contracts were up 8%, total contract signings declined 13% compared to the prior-year quarter. That means a big drop (25%) in long-term signings, which likely explains why analyst estimates for 2009 only rose by about a nickel after the 2008 guidance hike.

On the bright side, though, the short-term contracts likely mean that the $8.25 guidance midpoint for this year is pretty well in the bag. Since this year is likely the point of maximum economic uncertainty, that is a good thing.

The company also generates plenty of free cash flow, and mostly uses it the way I would want them to. In 2007, IBM generated $16.1 billion in cash from operations, $5.5 billion of which stayed on the balance sheet as increased cash holdings. The company used:

$18.8 billion to buy back shares,
$5.0 billion for capital expenditures,
$2.1 billion for dividends, and
$1.0 billion for acquisitions.

Debt increased by $12.5 billion, to just over $35 billion. Most of the debt is related to its financing operations. With $16 billion in cash on hand and free cash flow generation of more than $11 billion, I don't see the debt as a concern at all.

IBM is now trading at a P/E of 12.7 times 2008 earnings, compared to a five-year average P/E of nearly 18 times. It offers a free cash flow yield of nearly 7% at a time when five-year Treasuries are yielding 2.8%.

Expected long-term earnings growth of 11% annually marks a modest slowdown from the 13% generated over the last five years. It is also well below the sustainable growth rate of 29%, which is further evidence of excess cash flow that can be used for more share repurchases.

Valuation aside, things seem a little dicey here. The new guidance seemed sufficient to spark a better rally than we got. If IBM can't move when estimates are jacked up by a quarter a share, what will make it move?

I can't claim to be an expert in technical analysis, but a look at the charts, especially the moving averages, suggests that $109 may be a make-or-break price point for many investors. In today's market environment, I think I'd rather keep my powder dry than chase a possibly elusive extra 4 percentage points of upside.

But I'll be watching. I also might be tempted to find some approach using options. For example, the March $110 call options would provide upside in the event of a strong rally, and could largely be paid for by writing $100 puts. Since I think the valuation is reasonable, being forced to buy at $5 lower wouldn't hurt my feelings too badly, and I'd still get the exposure to the additional upside if the stock does rally.