High-tech meltdown

How the US blowout has affected Israeli companies

In the bible Israel is referred to as the land of milk and honey. Over the past decade, however, the country has experienced an industrial transformation and is today a significant participant in the global high-tech industry. Israel excels in areas such as communications (including the internet), software and electronics thanks to the substantial resources invested by the Israeli private and public sectors in advanced research and development.

But with the global high-tech sector in a slowdown, a product mix more in tune with the biblical prophecy might be more attractive than some of the high-tech ideas flowing from Israel today.

As international technology firms respond to the crunch in their respective sectors, repercussions are felt strongly in Israel. The impact comes in the form of layoffs, company closures and salary cuts at Israeli subsidiaries of multinationals as well as homegrown start-ups.

Consider these examples: in summer 2001, Lucent closed Israeli start-up Chromatis after buying the company for roughly $4.5 bn just over a year earlier. A similar case comes from Tradeum, an Israeli provider of marketplace infrastructure for online market-makers and exchanges, which was bought by VerticalNet in March 2000 for $478 mn. The parent company announced Tradeum's closure last October.

Eastman Kodak is closing its Israeli subsidiary, PictureVision, in March 2002, firing all 36 Israeli employees. Founded in 1995, the company developed a product called PhotoNet that lets pictures be stored and shared across the internet.

As for the Israeli branches of multinational companies that are staying, both staffs and salaries are being cut. In late September, Oracle said it would lay off 10 percent of its Israeli staff and cut the remaining salaries by 10 percent. Similar, although unconfirmed, actions are being taken at the Israeli operations of AOL Time Warner and Motorola.

Better times

Before the crisis, though, it was a buoyant relationship between the promised land and the tech industry. Around 125 Israeli and Israeli-related (foreign registered but Israeli-based) companies are listed on Nasdaq, ranking Israel number two behind Canada in the number of non-US companies traded in the US. Some 46 of these firms have a market capitalization of more than $100 mn. These include the likes of internet security firm CheckPoint, billing expert Amdocs, communications equipment maker ECI, pharmaceutical company Teva, cellular firm Comverse, circuit board tester Orbotech, and digital printing company Scitex. On top of that, around 25 Israeli companies are traded on European stock exchanges, mainly in London, Frankfurt, Paris and Zurich.

Israel has also an intense history of M&A. In the period 1998-2000, M&A exceeded $15 bn, involving 50 domestic companies. One of the latest examples is Indigo, which was acquired by Hewlett Packard for $800 mn in Q3 2001.

Top labor force

The success of Israeli-related, high-tech companies comes from several factors, says Dr Gil Bufman, chief economist at Bank Leumi Le-Israel BM, one of the two largest Israeli banks. First, civilian R&D reached 3.6 and 4.2 percent of GDP in 1999 and 2000, respectively. That excludes military R&D, which is intensive. 'Israel is the leader in OECD countries in civilian R&D investment as a percentage of GDP,' says Bufman.

Another important component of Israel's high-tech prowess is the country's heavy investment in education. In 2000, Israel's spending on education reached 7 percent of GDP, significantly higher than the OECD average of 4.7 percent. In addition, a large immigration wave from the former Soviet Union in the 1990s meant an influx of highly educated people. The combined effect is that Israel's labor force is one of the world's best educated. The percentage of the workforce with post-secondary and higher education reached 47.5 percent in 1998. Only Canada has a higher quality of human capital.

Finally, Israel has a strong entrepreneurial spirit. This, with the help of generous venture capital financing through the late 1990s and into the start of 2000, meant a start-up boom. New businesses were established to either create technology, or capitalize on the opportunities presented by technological change.

Start-ups had a relatively small impact on the country's overall economy up until the late 1990s. But their presence was definitely felt in 2000, when Israel's GDP grew by an astonishing 6.2 percent. Excluding start-up activity, the country's GDP grew by a much lower but still impressive 4.3 percent, according to the Israeli Central Bureau of Statistics.

According to the statistics bureau, Israel's overall GDP is expected to have grown by no more than 0.5 percent during 2001. Bufman is even more pessimistic, forecasting zero growth. Unlike the year 2000, start-up activity probably actually had a dampening effect on the country's growth figure for 2001. Excluding start-up activity, GDP would have grown 1.5 percent.

Bufman adds that Israel's exports tend to be high-tech. In 2000, three quarters of the country's manufacturing exports were in the high-tech or medium high-tech sectors. Overall, roughly 95 percent of total exports were industrialized goods. This high level of industrial exports means 'we're the first to feel it if there is a downturn in the world's industrialized countries,' says Bufman.

Israel's strength in high tech led to a boom in foreign investment while the world was exploring the potential of the internet and expanding their telecommunications networks. In 2000 the country benefited from an influx of $9.5 bn in financial and direct investment. In 2001 the tide turned and that figure is expected to have dropped to only $2.5 bn for the year.

It's not so bad

Despite the dire world growth figures and the impact on Israel, Bufman points out that Israel's macroeconomy remains relatively stable, attributing this to sound economic and tight monetary policies by the government and the Bank of Israel.

On an upbeat note, Bufman says, 'Once the industrialized world turns around, Israel will grow at a much more rapid pace.'

Meanwhile, how are Israeli analysts reacting to the sharp downturn in the global high-tech sector? When the global meltdown started in 2000, equity analysts covering Israel's high-tech companies were caught off-guard. 'Prior to the fall of 2000, we were increasing estimates for the companies under coverage, but then everything dropped sharply,' says Daniel Meron, senior high-tech analyst at US Bancorp Piper Jaffray/Nessuah Zannex. 'We've lowered our estimates consistently for the last four quarters,' he adds.

A clear example of this reaction can be seen in recent quarterly reports on Orbotech by Lehman Brothers analysts Tobias Fischbein and Edward White. Based in Yavne, and with a market capitalization of $819 mn, Orbotech's 2001 EPS estimates stood at $2.25 prior to May 3, 2001. The estimate was lowered to $1.85 due to continued low visibility resulting from the ongoing slowdown in capital spending. By July 11, analysts had lowered the year's estimates again to $0.96, and then again on November 6 to $0.88. In all this time, the target price was lowered from $50 to $27.

But Orbotech is certainly not on its own. Matthew Pearson of Investec Bank says Israeli companies that supply hardware to telecoms companies have been suffering from a sharp decline in capital expenditure. Pearson attributes this situation to 'an over-build-out prior to the [drop in 2000] and changes in the competitive landscape.'

The basic story is that competitive local exchange carriers (CLecs) had raised vast sums of money from overly gracious capital markets and venture capital funds, and invested heavily to build up infrastructure to compete with the incumbent local exchange carriers (ILecs). This turned into a vicious circle: ILecs were forced to increase capital expenditure to stay competitive, while in the last 12-18 months, the CLec model has turned out to be unsuccessful, forcing them to close down and cancel orders. ILecs in turn are thus able to reduce capital expenditure. This boom and bust cycle means that Israeli telecoms hardware providers are now left with a much smaller market for their wares.

However, Pearson points out that while larger telecoms equipment makers such as Lucent have aggressively laid off employees worldwide to counter the drop in sales, Israeli companies have not been hit quite as hard. There are cuts, to be sure, but not to the degree seen by the large North American and European companies. The reason, Pearson says, is that most of the cuts have been in sales and support, and 'Israel has been fortunate because it is not a sales base but a research base.' Nonetheless, Pearson does see more room for layoffs and consolidation among some of Israel's telecoms equipment makers.

Seeking immunity

Some Israel high-tech companies are practically immune to the slowdown, though equity analysts say most have been dragged down due to negative sentiment. One such company is Paradigm Geophysical, a seismic data analysis company that works for the oil and gas industry. CFO Brian Berman notes that Paradigm services old economy players and is therefore not experiencing any decline in activity directly attributable to the high-tech slowdown. In fact, Berman notes, 'A few of our investors have mentioned that our share has been a stable element in their high-tech investment portfolios.'

A similar positive example is Retalix, formerly known as Point of Sale, which also caters to old economy customers. With a market capitalization of $175 mn, Retalix provides software mainly for food retailers. Its products have been installed in over 15,000 stores across 41 countries worldwide. As CEO Barry Shaked says, 'The retail food world is a low-tech industry which uses technology to drive it.' He adds that in the next 18-24 months most food chains will be making a next generation choice regarding their information technology. As such, 'We are in a growth mode.'

Implications for IROs

Looking at how IROs are handling the current slowdown, Sigal Gefen, managing partner at Cubitt Consulting in Tel Aviv, identifies three situations typically faced by Israeli companies. First, there are companies asking if there is still a market for the technology they developed in the past. 'Many companies woke up and saw there was no market for their products,' Gefen says, adding that the IR role in this case is to show with research that a real market does exist for the company's products; alternatively, to show that there are applications in other areas.

In other cases, companies must manage expectations better. 'The gap between investors' expectations and results has narrowed,' says Gefen. 'Investors don't expect much anymore.' Overall, IROs are giving more realistic expectations and reporting less dramatic numbers because the 'dreams are gone.'

Finally, Gefen points out that many Israeli companies are benefiting from new opportunities. ECTel, for example, helps telecoms companies monitor the quality of service over their networks, detecting and preventing fraud and billing for traffic that is transported across their networks by other service providers. These monitoring products are of interest to security-minded government agencies in western countries after the events of September 11. Gefen expects more interest in monitoring in the short to medium term as western governments beef up homeland security.

Looking forward

Everyone interviewed for this article agrees it would be a mistake to predict the demise of the Israeli high-tech sector. Indeed, from both macro and microeconomic points of view there are discouraging developments. But the story is not finished yet.

'The boom may be over, but it doesn't mean we're bust,' pronounces Robert Rosenberg, executive director of still private Datasphere, based in Tel Aviv. The company manages a database of start-ups and investors on its Koldoon.com web site. Rosenberg emphasizes that the underlying ingredients that made Israel a high-tech powerhouse still exist. He is referring to the entrepreneurial spirit, the concentration of highly qualified, freethinking personnel, and the knowledge-sharing environment. Plus, for good and for bad, 'As long as Israel has to deal with its security situation, it is constantly in a state of invention and re-invention.'

So, the consensus? Israel will continue to be a significant contributor to technology as the world's industrialized countries weather the downturn and ultimately return to stronger growth.

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