For IBM, Watson’s Path to Profits Is Anything But Elementary

The world's largest technology services provider hopes the Jeopardy-winning supercomputer can boost sales growth

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Brendan McDermid / REUTERS

Attendees gather at an IBM Watson event in lower Manhattan, New York January 9, 2014. IBM said it will invest more than $1 billion to establish a new business unit for Watson, as the tech giant hopes to get more revenue from the supercomputer system that beat humans on the television quiz show "Jeopardy."

IBM is one of the world’s most legendary technology companies—and the world’s largest provider of technology services—but Big Blue has a problem. For seven straight quarters, sales have fallen, dragging down the company’s stock price as investors question whether the company can find a formula to accelerate growth. Over the last year, IBM shares declined by 3% compared to the Dow Jones Industrial Average, which increased by 20% over that period of time. The company laid off more than 3,000 employees in the United States and Canada last year.

On Tuesday, IBM reported fourth quarter earnings results, and the numbers were disappointing. IBM’s revenue fell 5% to $27.7 billion, missing analysts’ expectations of $28.25 billion and sending the company’s shares down 4.2% in after-hours trading. Sales in emerging markets were particularly dismal, especially in China, where revenue decreased by 23%. The results were so underwhelming that IBM’s top executives will forego their annual bonuses for 2013, company CEO Ginni Rometty said in a statement. “IBM’s string of revenue and now earnings disappointments has become more concerning,” UBS tech analyst Steve Milunovich wrote in a recent note to clients.

Over the last decade, there has been a fundamental shift in the technology industry away from low-margin hardware like PCs and printers and toward software and services, particularly for business customers. IBM navigated this shift by buying PwC’s consulting business in 2002 and selling its personal computer business to Chinese hardware giant Lenovo in 2005. But now IBM faces a new challenge from booming “cloud computing” competitors, which are reducing demand for Big Blue’s on site business servers, which have been a core part of the company’s business. Last quarter, hardware sales collapsed by 26%, leading to a $750 million profit decline in that segment and $1.7 billion for the year.

Judging by IBM’s recent announcements, the company is hoping that Watson, the Jeopardy-winning supercomputer, will be a major catalyst in Big Blue’s resurgence. But Watson’s path from game show champ to money-maker is by no means assured, and will likely take time. IBM executives have projected that the Watson software, which will operate in the cloud and can analyze vast amounts of data to deliver results in natural language, will produce $1 billion in revenue by 2018, according to the Wall Street Journal.

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But three years after its Jeopardy debut, Watson has produced only $100 million, and the company “hasn’t figured out how to generate a reliable revenue stream from Watson,” according to the paper. “Investors’ question will be whether these actions are sufficient to overcome IBM’s large legacy businesses under attack by the cloud,” Milunovich wrote. “Probably not in the near term, possibly in the long-term.”

Named after IBM founder Thomas J. Watson, the computer was programmed by 25 IBM scientists over four years leading up the Jeopardy competition. In front of 15 million viewers, Watson defeated two of the game show’s greatest champions, Ken Jennings and Brad Rutter. Watson is the latest in a distinguished line of IBM supercomputers, including Deep Blue, which defeated chess grandmaster Garry Kasparov in 1997. IBM executives believe its technology could be applied to several industries, including law, business, and especially medicine.

Recently, Rometty has set an even more ambitious target for Watson: $10 billion in annual revenue within 10 years. To achieve that goal, IBM is making a major investment of money and manpower into Watson. Earlier this month, IBM announced that it will invest more than $1 billion into the Watson Group, including $100 million for venture investments to support start-ups and businesses that are building a new class of applications powered by Watson. IBM will also invest $1.2 billion to build 15 data centers in order to bolster its cloud-based services.

Despite IBM’s recent struggles, the company remains at the forefront of U.S. technology innovation — at least judging by the company’s intellectual property output. Last year, IBM received what is described as a “record-setting” 6,809 patents, making 2013 the 21st consecutive year the company topped the annual list of U.S. patent leaders. But it’s unclear when the new patents will translate into tangible revenue. “Despite generating more patents per year than any other company in each of the last 21 years, some investors believe that IBM is ‘old tech’ and that the company has little (to no) exciting growth opportunities,” Bernstein tech analyst Toni Sacconaghi wrote in a note to clients.