Israel's Hi, Tech - Bye, Tech

During the 1990's, the number of Israeli firms on NASDAQ was the second or third largest (depending on the year) after American and Canadian ones. Israeli IPO's were hot. Israeli hi-tech was cool. The Internet was conquered by Israeli ingenuity and chutzpah.

Since then the market has matured. Dotcoms bombed. NASDAQ is down 60% even after the post September 11 bounce. Israel's main export markets are in the throes of a global recession. Israel appears to be suffering from the Singapore syndrome - over-dependence on a single sector. Hi tech products constituted a mere 22% of Israel's $7.7 billion in exports in 1991 - but more than 36% of the $18.7 billion it exported nine years later.

The signs are decidedly mixed. In a single week, VocalTec, a Voice over IP (VOIP) technology developer and manufacturer, reported a year on year drop of 53% in revenues in the fourth quarter. Versity - a verification software company - boasted its first profit on revenues up by 50%.

Manpower Israel announced that the number of hi-tech want ads (a fair proxy for employment in the hi-tech sector and for investment in R&D of future products) fell by 52% to 1996 levels (vs. an overall fall of 28%, though the trend has accelerated in the fourth quarter). Demand for hi-tech managers and programmers was down by c. 64%. Manpower attributed these developments to September 11, global recession, the collapse in the equity markets, and the 15 months' long Intifada. Very few foreign investors bothered to attend Ernst and Young's Journey 2001 October conference. Even its sponsor, Silicon Bank of California, didn't show up.

These are bad news for the recession-hit Israeli economy. Hi-tech has been a net contributor of jobs, a generator of small to medium enterprises (SME's), a leader of export growth, and, in short: Israel's economic engine. The government has already reacted by abolishing the capital gains tax on foreign venture capital investments in Israeli firms and by tightening collaboration with other casualties of the global downturn in the technology markets, notably with India. Israel intends to get involved in the telecommunications, medical technology, and software production sectors in India. A ministerial committee recommended that the government invest $450 million over five years in biotechnology projects. It is a sign of the times that this interventionist suggestion is seriously considered.

Coupled with low inflation (i.e., low local costs), the shekel's sharp 10% depreciation in the last few weeks (to 4.60 to the dollar), will boost Israeli exports by $1 billion, said the relieved Israeli Export Institute. Most of this windfall will accrue to export-orientated hi-tech firms. It will boost their competitiveness by increasing their shekel proceeds when they convert their foreign exchange revenues and by allowing them to discount their products.

But the malaise of Israel's hi-tech sector has deeper roots. Israeli firms are R&D champions - innovative and daring. But they are weak when it comes to marketing and sales. Many of them are badly managed, still run by the entrepreneurs who established them. Israeli addiction to venture capital and equity financing fostered a strong image of Israel as a high risk emerging economy based on dotcoms and their "creative" financing and accounting methods. In many cases, maverick Israeli startups failed to position themselves as market leaders which develop and produce for mature markets.

The good news are that venture capitalists invested over $6 billion (or $3.8 billion, excluding portfolio investments) in more than 500 promising products and technologies in Israel (50% of it in 2000 compared to only $1 billion last year). Of 2500 hi- tech firms, at least half are bankrupt or poised to close their doors. Still, between $1.2 and $2 billion are available for VC investment. Israeli VC funds do not publish return on investment figures but rumors are that they managed to outperform the American benchmark of 43% p.a. If true, they will probably re-enter the fray.

This cushion of selectively available financing may prevent a total meltdown of the sector. Investments in companies backed by VC in their first round of financing actually increased by 16% in the fourth quarter (though 36% of local VC funds made no investment at all). Investment by foreign sources of financing dominated the fourth quarter scene.

According to the Money Tree Survey, conducted by a leading Israeli accountancy firm, Kesselman & Kesselman PriceWaterHouseCoopers (PwC) and quoted in Israel's business daily, "Globes", there is a shift from software, Internet, and the biomedical sciences back to the hitherto discredited telecommunications, semiconductors, and networking fields. Almost no seed money is available - but despite the Internet's fall from grace, financing of Internet-related ventures (mainly software and data maintenance) remained unchanged compared to the third quarter (though more than 70% down on 2000). The average size of a typical VC investment is down 50% on 2000 - to $3.6 million (up from $2.8 million in Q3).

In other words: financiers are more careful and more choosey - not necessarily bad news, except for "exit speculators".

Actually, more money is available for mature, market dominant, high potential, fully developed products. The dearth of seed capital may adversely affect the future growth rates of the technology sector in Israel - but, in the short to medium term, it is likely to stabilize this mercurial Bedlam.

Israel's ace may be the biotechnology sector. Startups are well capitalized and gradually becoming profitable (c. 20% of Israel's 160 biotechnology firms did this year, another 25% are expected to do so next year). With close to $1 billion in sales and less than 4,000 workers - their value added and total factor productivity are enormous. According to Ilanot Batucha, a brokerage firm, there are 300 drugs in phase 3 FDA mandated clinical trials. If 200 of these new drugs are approved - they will join more than 100 drugs already approved and selling, no small coup for Israel's pharmaceutical minions. In 2001, the number of deals declined - but the average size of the deals increased. Biotechnology may well Israel's old-new horizon.

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