IBM: Innovations are Elementary My Dear Watson
By: Hashu Rahim & Dennis Zhan
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Passing the Torch
Watson was built on humble origins: IBM research manager Charles Lickel wanted to create a computer system to stymie the dominant run of Ken Jennings in the Jeopardy! circuit. Today, that system, Watson, represents the best solution to combating revenue contraction trends and the lack of innovation at IBM.
Unlike traditional computer systems which require structured input, Watson is a proprietary cognitive recognition system that processes raw, unstructured data. After users upload relevant data to Watson’s internal processing system, also known as its corpus, experts begin to ask Watson a series of prompt questions. This marks the beginning of the continuous learning process. These prompts teach Watson to recognize linguistic patterns. Consequently, Watson perpetually learns through interactions with end-users.
Since the departure of CEO Samuel Palmisano in 2012, IBM has suffered through negative public and investor sentiment. From 2012-2016 Q1, IBM’s revenue declined for 16 consecutive quarters. Mid-2016 results saw an overall decline of 23 per cent in year-over-year systems sales, historically a critical business unit to IBM’s aggregate performance.
IBM recognizes that it cannot afford to stay stagnant, and must leverage Watson to move forward as a technology giant. In order to drive top-line growth and restore its standing as an innovative firm, IBM is exploring opportunities to grow its cognitive solutions segment. To this end, IBM has acquired nine artificial intelligence (AI) companies over the past six months. These acquisitions were fuelled by the strategic initiative of enhancing the functionality of Watson.
Despite Watson’s immense potential to revolutionize a cascade of industries, IBM is at an impasse over how to incentivize client adoption. Ultimately, Watson was not designed to produce a solution to a particular business problem and was perceived as a discretionary investment. While IBM attempts to monetize Watson, integration misalignments have become rampant. As of Aug. 31, 2016, the clients-to-date list of Watson spans 500 names, well below overall corporate targets by 94 per cent. Meanwhile, competitors such as Alphabet have been developing in-house solutions and acquiring start-ups for their intellectual property and human capital. With the AI market estimated to grow from $420 million in 2014 to $16 billion by 2022 at a CAGR of 57.6% from 2014 to 2022, it is paramount for IBM to redefine its application scope for Watson to a particular niche where it can establish a defensible market position.
The Path Forward
Looking forward, IBM needs to transform its acquisitive strategy. It must emphasize acquiring ideas with strategic value and not just financially stable businesses. Innovative companies acquire startups and other private entities to take advantage of promising technologies which could significantly improve the acquirer’s attractiveness. A successful case study of this strategy is Alphabet, which has made several acquisitions of unprofitable startups with promising intellectual property and management teams. Contrastingly, IBM has historically favoured buying businesses with strong cash flows with the intent of delivering large dividend payouts. Given declining revenues over the last several years, it is in the management’s and investors’ best interests for a shift in strategy. IBM must alter its investment mandate by putting an emphasis on intellectual property over cash flow.
The transformation that IBM must undergo is a perilous one. To succeed in redefining its application scope for Watson, IBM must modify its approach from replacing mundane administrative functions to disrupting existing business processes. IBM’s corporate marketing must pivot from generating excitement around AI and must resist Wall Street’s pressure for short-term results by demonstrating how innovations, such as Watson, take time to have their potential realized. It must develop a portfolio of capabilities with different risk and return profiles. This strategy would be analogous to notable venture capitalists investing in start-ups with promising product pipelines. While some investments would lead to poor returns, others become overwhelming successes.
Innovating Healthcare Investments
IBM has grown its health-care branch, the Watson Health portfolio, through two main initiatives: it has formed partnerships with hospitals to develop the diagnostic function of Watson and has invested in research facilities as a means of synthesizing data, thereby improving the predictive power of the platform. While this is a strong start, IBM’s leadership must focus on deriving the most impact from its acquisition targets and quickly modify or eliminate subdivisions which are failing to meet objectives.
With the intent to develop an economic moat, IBM should adapt the use of Watson by vertically integrating within the healthcare sector. It should create a research arm focused on developing proprietary treatments to receive licensing revenue. There exists a striking gap in large pharmaceutical companies’ due diligence processes, and industry trends are increasing the urgency of correcting this issue. Recent sentiment in the health-care industry is bearish; pricing scrutiny by politicians and enhanced availability of generic substitute products have hampered the performance of large-cap pharmaceutical companies. Significant capital expenditure in developing drug pipelines or acquiring smaller firms is required to defend existing market share. Thomson Reuters estimates M&A deals attributable to the healthcare sector reached a record $664 billion in 2015. Further, growth in VC invested private healthcare firms saw a strong increase of 133 per cent in 2015.There is a tendency in the healthcare M&A market to pay massive premiums for promising drug pipelines, placing tremendous pressure on acquiring firms to realize synergies. A specialized technology which can pinpoint firms with enhanced commercialization potential could be paramount to executing a roll-up growth strategy. In August 2016, Medivation, an American biopharmaceutical company, was acquired by Pfizer for 14x trailing revenues. Comparatively, large-cap pharmaceutical companies are valued in the public market at less than 24x trailing earnings. An acquisitive strategy is difficult to sustain; in pursuing acquisitions, firms would be either constantly diluting shareholder value when using equity or taking on tremendous incremental leverage.
IBM Re-Imagined
Start-Up Culture in a Giant
To properly tap into the healthcare analytics sector and address uncertainty in the healthcare M&A field, IBM should acquire a contract-research organization (CRO). CROs are firms which specialize in trial-based Phase I to IV clinical development services for small- to mid-sized pharmaceutical companies. With this acquisition, IBM will own the entire value chain for proprietary drug development and can automate its due diligence process, realizing substantial value creation across the healthcare industry. Additionally, IBM will be emphasizing the acquisition of ideas and fostering a start-up culture.
From the development perspective, Watson will be able to process thousands of similar precedent test case symptoms with a differential case to determine the probability of drug efficacy. Alternatively, Watson has a data pool of regulatory statures and will be able to synthesize the data to determine the probability that a differential case will be accepted by the Food and Drug Administration (FDA). Coupling Watson with the capabilities of a CRO will allow IBM to more effectively develop a portfolio of drugs which may be outside the normal risk tolerance of a pharmaceutical company.
After leveraging AI to build a portfolio of successful pharmaceutical products, IBM can license its drug patents to large-cap pharmaceutical companies for commercialization and production. Biologic drugs are offered 12 years of market exclusivity by the FDA, creating a supply-driven monopoly. This will lead to substantially recurring revenue flowing to the bottom-line of IBM.
The Answer to IBM's Woes
Headquartered in Cincinnati, Ohio, Medpace is a player in the CRO sector that could offer a high return for IBM. It has a clinical research arm as well as a medical device development segment. Medpace has reported solid revenue growth in recent years and in 2009, was recognized by CenterWatch, a CRO industry publication, as a top CRO. The company reported 19 per cent revenue growth on the fiscal quarter ending on March 31, 2016. Moreover, Medpace has reported attractive adjusted EBITDA growth and robust Free Cash Flow (FCF). Its FCF and EBITDA growth in 2015 was just shy of 11 per cent and 25 per cent, respectively.
Medpace brings differentiating factors, such as its control of the value-chain, promising operational and financial metrics and a diverse clientele. Medpace is full-service; it does not outsource partial contracts or functions to outside agencies. This is an advantage in the sector as there have been numerous cases of third-party contract researchers erring on timely data delivery. As a full-service CRO, Medpace consistently provides timely, efficient and high quality results to customers. With its top ten clients composing only 40 per cent of revenues, Medpace does not depend significantly on any single client to generate revenues. This contributes to low customer concentration risk, evidenced by its largest customer accounting for 7 per cent of revenues. In comparison, competitors typically revolve entirely around one or two major customers. Medpace’s client mix is also diverse as it has clients from all segments of the pharmaceutical space, ranging from small- to large-scale companies.
Medpace Investment Thesis
Medpace has one of the highest organic revenue growth rates in the CRO sector. It reported net service revenue and adjusted EBITDA CAGRs of 22 per cent and 26 per cent from 2012 to 2015, respectively. While growing at such dramatic rates, Medpace has maintained an average adjusted EBITDA margin around 32 per cent. This points to Medpace’s operational efficiencies as it has achieved steady margins despite accelerated growth. Moreover, Medpace’s net new customer growth hit 18 per cent in recent years. In 2016 it projected new business opportunities of approximately $415 million, up by $55 million from last year. Consequently, Medpace’s growth has not been fuelled by unsustainable initiatives such as aggressive pricing.
In addition to its strong financial standing, Medpace’s large geographical reach and the diversity of the clinical tests it runs further differentiates it from other CROs. This is reflected in Medpace’s four global College of American Pathologists accreditations in the U.S., Netherlands, China and Singapore, and its operation of a GLP-compliant bioanalytical laboratory and an ECG laboratory. Medpace’s international geographical footprint and company-operated laboratories allow it to achieve global outreach.
IBM’s corporate strategy has historically been focused on optimizing short-term operating metrics such as EPS. Consequently, recent investor sentiment has experienced downturns; significant revenue contractions in legacy businesses have raised concerns regarding the sustainability of IBM’s business model. Looking forward, IBM needs to transform brand perceptions by acquiring new ideas and fostering a start-up culture. In particular, it should leverage its Watson Health platform to support the activities of venture capitalists in the healthcare sector. IBM will assess the attractiveness of small-cap pharmaceutical companies and their drug pipelines and determine an appropriate valuation using Watson. IBM can then support the commercialization of the product in the development and marketing aspects of the value chain.