What Watson’s Win Means For IBM’s Stock

Watson’s Jeopardy! win marks an amazing comeback for IBM, the 100 year old computer company that nearly perished in 1993. Back then, IBM was about to run out of cash before former McKinsey consultant Lou Gerstner took over and refocused the company on its core – helping businesses get value out of computing.  During its heyday, IBM was not necessarily the most innovative company, but it always shined when it came to looking at technology – not from a geek’s perspective – but on how it could help companies boost revenues or cut costs. 

Gerstner left IBM in the hands of Sam Palmisano and since then, IBM stock has risen – now standing at a near-record $163.40 with a market capitalization of $203 billion. Watson’s win highlights a technology that IBM expects to apply to helping financial services firms manage risk. And IBM is already using its analytics technology to help insurance companies boost the share of customers that renew their policies by finding better ways to serve them. Despite its success, IBM stock has further to rise based on its valuation and its recent track record of rising upside earnings surprises.

IBM developed a computer system that took 25 scientists four years to build at a cost of about $40 million, dubbed Watson, after its founder, Thomas Watson, that trounced the two best human Jeopardy! players in a two-day match televised Tuesday and Wednesday. With a two-game total of $77,147, Watson won more than three times as much as 74-game winner Ken Jennings -- who earned $24,000 -- and all-time Jeopardy money winner ($3.2 million) Brad Rutter.

Watson's technology has the potential to be much more than a publicity stunt. For Jeopardy!, it downloaded about 200 million pages of material -- including encyclopedias and movie scripts. When Watson got a question, say, in the category "Church and State", about Saturday Night Live's famous "Isn't that special!" comment by Dana Carvey, it searched those pages --known as its corpus -- and came up with hundreds of possible answers that fit some of the clues. Then, according to IBM researcher David Gondek, Watson applied an algorithm to assign a confidence number to each answer, based in part on the number of connections to the clue, and weighed those numbers -- picking the best one. In that case, Watson's guess -- "The Church Lady" -- was correct.

Business Value-Creating Innovation Drives IBM

To understand how Watson might help win customers, it helps to understand how IBM competes. The key to IBM's success was its ability to talk to a company's senior executives and explain how computing could help that company operate more efficiently or increase its revenues. The theme that propelled IBM forward was coming up with technologies that would enable it to sell such customer-focused innovation to businesses.

IBM has enjoyed an amazing comeback since its 1993 low point. According to Forbes, Gerstner started at IBM on April 1, 2003 and through a combination of cost cutting and changing the way it rewarded people -- from competing internally with other IBM groups to winning customers by providing competitively superior value -- he left about a decade later with the company in good shape.

Since then, Palmisano has carried forward Gerstner's decision to keep the pieces of IBM together. IBM's biggest business is services but its most profitable is software. According to IBM's third quarter 2010 financial report, IBM gets 57% of its revenues and 42% of its pretax profit from global services -- where it works with customers to analyze their business needs and develop technology solutions to them. It gets another 16% and 23% of its revenues from selling hardware and software respectively, and 0.3% and 44% of its pretax profits from those two. The balance of revenues and profits comes from IBM's finance unit. 

How Watson Could Boost Bank Profits

This strategy of customer-focused innovation has paid off for IBM, but how will that translate into putting Watson to work for business customers? According to IBM economist, Constantin Gurdgiev, one answer is to help banks and insurance companies manage risk. As Gurdgiev told me, global banks are lowering their targets for return on equity (ROE) -- net income divided by capital. Their net income is dropping because regulators demanded they exit profitable businesses like proprietary trading and their capital is rising because regulators are forcing them to put more capital aside to protect against risk.

Watson, Gurdgiev explains, can help such banks achieve their goals efficiently. For example, a bank could decide that it wants to boost its profit margins and Watson could pick the best way for it to raise the capital it needs to achieve that goal. Gurdgiev pointed out that Watson could develop many scenarios based on analysis of global capital markets -- including macroeconomic, financial, and strategic perspectives -- and possible global regulatory changes. Watson could then calculate odds for all these scenarios, pick the most likely one, and recommend a strategy for enabling the bank to achieve its profit margin goal.

IBM has already used a related technology, semantic analysis technology (SAT) -- that applies statistical analysis to identify ways to improve a business process -- to help insurance companies boost revenues. According to Christian Biecke, global insurance leader for the IBM's Institute for Business Value, SAT helped insurance clients boost insurance renewal revenue by 119% by enhancing customer satisfaction.

More specifically, SAT helped insurance companies identify dissatisfying elements of customer service and replace them with more personalized service that makes customers want to maintain their relationships with the insurance companies instead of canceling their policies. As a result, the customers renew their policies more often instead of bolting to a competitor.

Instead of simply looking at an insurer’s price relative to competitors’, IBM’s SAT examined customer psychographic factors. For example, IBM helped clients to recognize that a specific customer service agent, say, Joe Smith, seemed to be much more successful renewing policies from women living in southern California than those from Montana. And it found that another agent, say, Ann Morrow, was more successful renewing policies from the insurers’ female customers in Montana. As a result, IBM’s SAT recommended that its female California clients work with Smith and its female Montana clients with Morrow.

Does IBM's ability to use Watson and SAT to boost customers' profits mean you should buy its stock? With a Price/Earnings to Growth (PEG) ratio of 1.1, based on a P/E of 14.2 and earnings expected to grow 12.4% in 2011, IBM stock is fairly priced (since I think a PEG of 1.0 is about right). But the good news is that IBM has been providing investors with ever bigger positive surprises over the last few quarters -- most recently reporting earnings that grew 2.5% faster than expected.

As companies begin spending their $2.4 trillion cash hoards, investors could continue to be pleasantly surprised as some of that cash flows into IBM's business-value-creating coffers.

Can Nokia/Microsoft Stop Google, Apple in Smartphones?

After his colorful burning platform memo, Nokia's new CEO Stephen Elop announced a partnership with Microsoft to compete with Google and Apple in the smartphone market. After a 7.25% decline in Nokia's stock Thursday -- with 8% more to go based on pre-market action -- in the wake of this announcement, investors have correctly guessed that this partnership tells us more about how much ground Nokia needs to make up -- I estimate Nokia would need to boost smartphone sales by 33 million from this deal to make up for this week's lost market capitalization -- than about how it will close the competitive gap.

The reason is simple -- after growing at a fraction of the rate of Google's Android, Nokia plans to replace its Symbian operating system with Microsoft's Windows Phone 7. Gartner reports that Nokia's has lost almost half its market share since June 2007 when Apple introduced the iPhone -- falling from 50.8% to 27.1% in the fourth quarter of 2010. During that time, Nokia's market value has plummeted by over 60%.

To assess whether Nokia is making the right move here, I apply three criteria that I use for evaluating corporate investments in new businesses:

• Is the industry attractive?
• Can the partnership compete?
• Will the partnership's future profit flows pay back the investment?

Smartphone Industry Attractiveness: PASS

The smartphone industry is huge, fast growing, and profitable. According to Gartner, in 2010 296.6 million smartphones were sold, up 72% from 2009. And the rapidly growing smartphone industry is very profitable. For example, if we consider Research In Motion as a proxy for the industry -- Fortune estimates that its gross margin is about in the middle of its competitors --  then Research in Motion's five year average return on equity of 92.8% is nearly seven times the 13.4% sported by the average company in the S&P 500. 

Partnership Competitiveness: FAIL

Despite all the hand wringing on Nokia's part, it led the industry in 2010. Its Symbian controlled 37.6% of the market, selling 111.6 million smartphones, according to Gartner. While that figure is up 38% from 2009, Android grew 23 times faster -- its 22.7% share of 2010's market was up 889% from 2009's 6.8 million units.

Competition in the smartphone industry is all about creating an ecosystem of handset and application builders and wireless service providers to deliver the most compelling end user experience. Android's stunning growth is due to its availability on high end handsets. According to Gartner, these include HTC (Desire range, Incredible and EVO), Samsung (Galaxy S) and Motorola (Droid X, Droid 2).

And in that ecosystem battle, Symbian is losing momentum to Android at a frightening rate. According to Ramon Llamas, senior research analyst with IDC's Mobile Phone Technology and Trends team, "Android continues to gain by leaps and bounds, helping to drive the smartphone market. It has become the cornerstone of multiple vendors' smartphone strategies, and has quickly become a challenger to market leader Symbian. Although Symbian has the backing of market leader Nokia, Android has a growing list of companies deploying Android on their devices."

And working with Microsoft is not likely to make up much of that growth difference. That's because Microsoft is a distant fourth in the smartphone market -- and it has been losing ground rapidly. According to Gartner, Microsoft's 12.4 million units sold in 2010 represented a mere 4.2% of the market -- less than half its 8.7% 2009 market share.

Nokia must see itself as being in deep trouble indeed if the best it could do to halt its loss of momentum is to abandon its market leading operating system for a partnership with a company that saw its 2010 market share drop even more dramatically.

Investment Payback: UNCLEAR

While it would be nice to know how much Nokia will invest in its partnership with Microsoft, that information is not available. However, a possible proxy for that investment is the stock market's verdict -- that has so far wiped out $3.3 billion in Nokia's market capitalization ($0.87 per share times 3.74 billion shares).

By that measure, it would take a boost of 16.3 million new Nokia smartphones to make up that loss. How so? The average Nokia smartphone sells for $212 (156 Euros) and has a net margin of 6%  -- yielding a profit per phone of $12.70. If we multiply that by Nokia's P/E of 16, we get a market capitalization per unit of $203. Dividing the $3.3 billion in lost market value by $203 gives us the additional 16.3 million units. And if Nokia loses another 91 cents a share today, it would need to sell a grand total of 33 million new units to make up the $6.7 billion ($3.4 billion more today) in lost market value.

Nokia was founded in 1865 as a Finnish wood pulp company. It has evolved considerably since then -- expanding into "papermaking, rubber, cables, and telephone equipment" before dominating the cell phone market in the 1990s, according to Bloomberg -- and it will need to similarly reinvent itself in order to survive. The partnership with Microsoft is an insufficiently radical departure to assure Nokia's ability to sustain its market leadership.

Elop will need to come up with a better idea -- but he deserves more time to try.

AOL's Huffington Post Deal Ditches its Red State Customer Base

A few moments after Sunday's Super Bowl ended, AOL (AOL) announced the $315 million purchase of Huffington Post (HP). In July 2006, AOL announced it would abandon the business of charging for Internet access and try to make up the difference by selling advertising. Through its HP buy, AOL is admitting that this strategy failed. But that's because AOL has been running away from its Red State customers over the last five years, and HP, with its left-leaning approach that garnered 25 million unique visitors, $31 million in 2010 revenues, and $50 million in projected 2011 revenues, is likely to persuade even more of those Red State customers to end their business relationships with AOL. The question is whether HP's totally different customer base will make up the lost revenues.

This Red State customer legacy comes as no surprise to me since I have been writing for AOL's BloggingStocks and DailyFinance for roughly the last five years. I have not found any rigorous analysis of AOL's customers' political views, but this AOL poll of its users that ran a few months before the 2008 election -- finding 68% support for McCain and 37% for Obama -- suggests that AOL users are more Republican than the average American (Obama won 53% of the 2008 popular vote).

User comments on posts also suggest this may be true. My recent posts addressing matters related to politics, attracted vitriolic anti-Obama comments (here's an example from a post I wrote discussing last December's tax compromise). And the comments on David Schepp's Feb. 7 DailyFinance round-up of media reaction to the AOL/HP deal reflect the AOL customer's sense of abandonment in the wake of the announcement.

The media business has a fairly simple economic model based on selling to two sets of customers: readers and advertisers. If AOL wrote content that would appeal to its Red State readers, then it might increase its audience within that segment and then be able to sell advertising to companies seeking to reach those readers. But if AOL was trying to appeal to more of those readers, it would have long abandoned columnists with my perspective on things.

Instead, AOL -- based in New York City -- seems to reflect the aspirations of most content providers in that relatively left-leaning metropolis. In short, it aspires to appeal to the kinds of people who read The New Yorker, where a Ken Auletta profile of AOL's CEO Tim Armstrong, a former Google (GOOG) marketing executive, appeared in January. Acquiring HP goes further than any move so far to get AOL a share of the affluent, influential women readers that Armstrong hopes to attract in order to sell advertising to the companies aspiring to reach them.

In July 2006, I wrote a BloggingStocks post about AOL's then-new strategy of giving away $2 billion in subscription revenue with the goal of doubling advertising to make up the difference. I concluded that there was no compelling evidence that the strategy would work. And since 2006, AOL has lost 69% of its revenues from $7.8 billion in 2006 to $2.4 billion in 2010 while net income fell from $718 million to a $790 million loss during the period. 

Unfortunately, this financial decline has been caused by a loss in market position. According to the New York Times, AOL’s display advertising market share fell from 6.8% in 2009 to 5.3% in 2010, while revenue for display advertising plunged 14.3% and search revenue tumbled an even more severe 33.7% -- not what one might expect from a former Google executive.

With AOL's stock down over 3% in the wake of today's announcement, investors do not appear confident that the AOL/HP deal will reverse this trend.

Can Startups Put Globe's Young Unemployed to Work?

The globe is awash in unemployed young people. This demographic time bomb is spurring revolution in the streets of Middle Eastern capitals and creating what looks like a lost generation in Japan. With big companies reluctant to hire, their best hope for work could be start-ups. And ironically enough, Israel may offer valuable lessons to its Arab neighbors on that key job creating process.

It is startling to examine the evidence of youth unemployment around the world. According to BusinessWeek, there are 78 million unemployed youth globally. About 24% of youth in the Middle East and North Africa are unemployed and with the exception of South and East Asia -- they have single digit youth unemployment -- the rest of the world's youth unemployment rate is in the high teens. Young people are almost three times more likely than adults to be out of work.

Youth's failure to ignite covers many countries and goes by different names, reports BusinessWeek:

• Britain's NEETs: "not in education, employment, or training;"
• Japan's freeters: a combination of the English freelance and the German Arbeiter (worker);
• Spain's mileuristas: so-called because they earn at most 1,000 euros a month;
• Tunisia's hittistes, "French-Arabic slang for those who lean against the wall;"
• Egypt's shabab atileen or unemployed youths; and 
• U.S. boomerang kids live with their parents. Here, 18% of 16- to 24-year-olds were unemployed in December 2010, nearly double the overall unemployment rate. Graduating in a recession results in an initial wage loss of 6% to 7% and 15 years later, these grads make 2.5% less than average according to Yale economist Lisa Kahn.

If large companies needed enough people, they might be the logical place to look for employing these youth. But after attending college, many of them either lack the skills that companies need or there are simply more of them than the companies need. After all, in the U.S., companies finished a record year in 2010 with $1.66 trillion in profits and nearly $2 trillion in cash. Meanwhile, in the final quarter of 2010, wages fell 1.5% as productivity rose rapidly at 2.6% and unemployment remained a stubbornly high 9.4%.

This leaves start-ups as a possible solution. One example of a program that teaches young people to create them is in Miami. As BusinessWeek reports, in 2008 the University of Miami started an entrepreneurship program called Launch Pad -- following which its graduates started 45 companies including Coral Morphologic, that collects and raises corals for sale to aquarium owners and Audimated, a music website that allows fans to profit by promoting their favorite musicians.

Can Israel's Arab Neighbors Benefit From Its Start-Up Success

While this sounds good, it's unclear whether such programs would create nearly enough start-ups and jobs to keep those 78 million unemployed youth busy. One model that my co-author, Srini Rangan and I discussed in our book, Capital Rising: How Global Capital Flows Are Changing Business Systems All Over the World, is Israel, whose ability to spur entrepreneurial innovation vastly exceeds its size.

How so? According to Dan Senor, co-author of Start-up Nation, Israel has 7.1 million people but the number of Israeli companies listed on the NASDAQ far exceeds its relative population. For example, in 2009 India had three companies listed. Japan had six, Canada had 48 Israel had 63. Israel has received as much foreign venture capital as the much larger Britain -- $2 billion in foreign venture capital invested there in 2008 alone. And Israel had the highest density of start-ups in the world 3,850 – the equivalent of one start-up for every 1,844 Israelis. Moreover, during the last few decades, Israel’s high-tech innovations have spread around the world.

How did Israel accomplish this feat? It was certainly not because its geographical neighbors welcomed it with open arms. Instead Israel took its many physical limitations and overcame them with the spirit of its people. After all an Arab nation boycott made regional trade impossible and it had very few natural resources. And yet thanks to the way it managed its human capital – Israel became an innovation hub.

Israel’s entrepreneurial success depends on the people it attracts and how it harnesses their skills. Since Israel is besieged by enemies, all its citizens serve in the military which creates social networks and leadership training. Furthermore, Israel’s culture of critique, fostered by centuries of Jewish tradition, encourages a spirit of relentless improvement. Moreover, an open immigration policy for Jews restocks Israel's population with motivated people. The result is a business climate that embraces risk and spurs the growth of good ideas.

Many examples of Israel’s most successful start-ups spring from the application of its human capital to the gap between demand and supply. For example, drip irrigation was invented when a farmer in the Negev desert noticed one of his trees flourishing despite drought conditions. When he discovered a leaky underwater pipe, he had a moment of creative inspiration, developing a technology that spread around the world.

Israel’s success at building a start-up nation suggests four important implications for policymakers in nations with high youth unemployment:

• Focus on policies that close the most important gaps between demand and supply. Rather than wallow in the misery of being surrounded by enemies with no significant natural resources, Israeli policymakers recognized that with their backs against the wall, they would need to adapt in order to survive. Israel needed food and water to feed its people and healthy industries to provide jobs and tax revenues. And Israel found a way to use the one resource it had – human capital – to close the gap between those needs and its ability to supply them.
• Manage human capital in a way that rewards innovation. Israel could have taken a hard line against bringing in new people since they certainly imposed a cost on its scarce resources – particularly before those immigrants could contribute to the economy. Instead Israel chose to welcome the immigrants while requiring them to serve in its military as a way to defend the country and forge a unique culture. Moreover, Israel placed a high value on risk taking and pushing good ideas from all sources. Its valuable human capital attracted the venture capital Israel needed to build these ideas into viable companies.
• Locate activities where they will yield the greatest corporate advantage. To maximize local employment, Israel could have required that Israeli companies perform all their activities – such as R&D, manufacturing, marketing, and logistics -- in Israel. But Israeli policymakers saw such limitations as short-sighted. Instead, they encouraged entrepreneurs to locate activities where they could generate the most global growth. As a result, many Israeli companies located their R&D in Israel and Silicon Valley while starting marketing and manufacturing outposts in their largest markets – such as the United States or China. Such global value chains enabled Israeli entrepreneurs to develop new products and sell them around the world.
• Push companies to adopt the corporate governance standards needed to list their shares in the deepest global capital markets. Finally, Israel’s high rate of listings on the NASDAQ illustrates the importance that its policymakers placed on high standards of corporate governance. By encouraging the flow of global venture capital into Israel, its policymakers also realized that the companies receiving that capital would need to meet the governance standards of the securities exchanges where the VCs would aspire to an IPO. Israel’s decision to permit such capital flows pushed its start-ups to adopt the highest standards of corporate governance.

It would indeed be ironic if its Arab neighbors adopted Israel's ideas for putting its young people to work. While it might be natural to conclude that the gap between the two is unbridgeable, it's worth noting that in the 1970s, Israel's socialist economy stagnated under the weight of inflation but during the 1980s and 1990s, it transformed itself into a Start-up Nation.

Israel's metamorphosis suggests that its ideas just might make a big enough difference to channel some of the youthful energy of these unemployed workers from angry protests into successful start-ups.