The Israeli high-tech industry is experiencing a high rate of growth which began in the early 1990's. In 1998 sales originating in the high-tech sector totaled $8.05 billion, a growth of 12% over 1997 sales. The Israeli high-tech industry is a major contributor to Israel's overall industrial export (excluding diamonds and agricultural products and technologies). High-tech exports, totaling $6.6 billion in 1998, grew 15.3% over exports in 1997.

Israel's advanced technologies are in great demand and many Israeli-developed applications can now be found in the products of multi-national companies in the communications, computers, information systems, medicine, optics, consumer goods and software sectors.

The Israeli high-tech industry is characterized by a high added value for the products it manufactures and a high rate of per employee output, more than twice the average posted by other industrial sectors. It is clear that Israel's high-tech industry today is one of the most powerful engines driving its economy. The course of Israel's economic growth for the coming years will continue to be determined by the future of this industry. The following are major contributors to this growth rate:

* Israel has the world's highest percentage of scientists, with 135 engineers per 10,000 citizens. In comparison, the United States has 85 per 10,000.

* Immigration of hundreds of thousands of skilled engineers and technicians from the former Soviet Union.

* Advanced technologies that were developed and utilized for military purposes are now being used for developing commercial products for civilian applications.

* Thousands of skilled personnel were forced to leave the defense industry since 1988. Most of them were well received in the civilian marketplace. In addition, many formed start-up companies which later became successful high-tech firms.

The ongoing success of the Israeli high-tech industry is reflected in the local and foreign stock markets. Israeli firms provide the third largest number of IPOs on NASDAQ (following the U.S. and Canada), and the second largest number of IPOs on the relatively new AIM in London (following the U.K.). Many of the leading American investment houses and Venture Capital funds have established presence in Israel in order to support Israeli high-tech firms and benefit from the current boom.

Origins

The Israel high-tech industry is fifty years old, as is the State of Israel. Its early origins extend to the years prior to Israel's independence, when the newly created Israel Defense Forces established what was euphemistically called "The Science Force."

One may be a bit doubtful about an army fighting for its country's very existence while spending valuable time, people and money on "science." However, the facts are that in 1948 the Science Force played a very important role in the establishment of Israel's independence. This group's soldiers and officers were busy developing and providing the IDF with new arms, explosives, booby traps and a variety of electric and electronic appliances which were necessary for a variety of special operations. In the long run, the Science Force had an enormous influence on the development of Israel's defense industries.

After Israel established its independence, the Israel Military Industry (IMI) developed at a rapid pace, meeting the country's needs for armaments and technologies that it could not obtain for a variety of reasons from its allies. During the same period, Israel was busy developing what was to become the best education and science research system in the Middle East. These world-renowned institutions include the Technion in Haifa, Weizman Institute in Rehovot, and the Hebrew University in Jerusalem, and universities in Haifa, Beersheba and Tel Aviv. In the early Sixties, Israel entered the nuclear era with the establishment of two nuclear plants, entering the global arena in the areas of physics and related science research.

It was at the Weizman Institute that the first Israeli computer was developed and assembled, in the early Fifties. "Golem" (dummy) was an all tube computer, similar to the first computers developed in the U.S.A. in the forties. In the late fifties and early sixties, there were already several mainframe computers in Israel, that were purchased from International Business Machines (IBM) and Philco. Primarily government authorities, universities and a number of banks used those computers. In the late sixties and early seventies, mainframe and mini computers penetrated the financial and business sectors. In the eighties, Israelis hurried to adopt personal computers.

Computing Infrastructure

Since then, Israel has firmly established itself as the most computerized country in the Middle East, surpassing even some Western European nations. 1997 figures show that more than 250 thousand personal computers were sold in Israel, compared to 102 thousand PCs in neighboring countries such as Egypt (with a population approximately 10 times larger than Israel). Turkey, with a population of 65 million, bought only 295,660 PCs in 1997.

IDC/World Times Information Society Index (ISI), a project intended to assess the market potential of the regions and countries of the world in light of the dawning of the information revolution, found Israel and Turkey as the only two nations in the Middle East/Africa region that exceeded the world average growth in ISI. The region as a whole grew 7.6%, just slightly below the world and ahead of Western Europe. According to this study, in the Middle East/Africa region, Israel has the largest capacity by far to absorb technology. At 11.3% overall growth, Israel grew faster than the world and led its regional counterparts in all three infrastructures analyzed. Israel ranked number 19 in the worldwide ISI ranking, between Ireland and Belgium, moving up one place from last year. Israel is ranked in the 20th place worldwide in social infrastructure, 19th place in information infrastructure, and 16th place in computer infrastructure.

Israel also leads the Middle East with the highest penetration rate of PCs in private homes. There is virtually a personal computer in every two households in Israel, a ratio similar to that of the United States, Canada and a few European and Far Eastern countries. In recent years, the educational system in Israel has purchased tens of thousands of computers for use by students from kindergarten through university age.

Compared to other so-called high-tech 'tigers", such as Korea, Malaysia and Taiwan, Israel is unique in that it is a "true" high-tech country, with a highly developed domestic market for computing and telecommunications. Fifty years of heavy investments in defense technologies and a future-oriented educational system, have made Israel a "quick adopter" of advanced technologies. Today, Israel is the most technologically advanced country in the Middle East, and a leader in the adoption of new technologies. Local expenditure on Information Technology (IT) is estimated by IDC at $2.4 billion in 1997, with a steady growth of 12-15% annually, compared to a worldwide expenditure of about $700 billion and a 5-year compound annual growth rate (CAGR) of about 10%.

Telecommunications Infrastructure

After long years of stagnation, the Israeli government decided in 1984 to convert the telephony and telecommunications services from a government-provided service (under the auspices of the Postal Ministry) to a government-operated company ("Bezeq") which became the Israeli PTT. Since then, the telecommunications infrastructure in Israel has developed at a rapid pace. Today, it is considered to be one of the most highly advanced communication systems in the area, providing full digital service throughout the country, advanced data communications, ISDN, ATM, and fiber-optic and satellite services to business and private citizens. It is evident that the development of its telecommunications services contributed significantly to the development of Israel's high-tech industry.

According to the Ministry of Communications, the current telecommunications infrastructure is composed of:

* 2.5 million telephone lines (penetration rate of 43%).

* 1.9 million cellular users (Early 1998 figures, penetration rate of 29%).

* 180,000+ internet users.

* 1 million CATV users. Geographical coverage is about 88%. 67% of households in the coverage area subscribe to one of the five cable TV operators.

* Bezeq landline infrastructure - 100% digital.

* ISDN services provided (partial).

International Firms in Israel

It has taken several years for the management of international high-tech firms to decide to utilize the benefits which Israel can provide them with as a base of operations. Of course, political policies and events have played a decisive role in international business strategies of the past. The implementation and subsequent progress made in the Arab-Israeli Peace Process, which began in 1993 has encouraged many international firms to establish operations and/or conduct business in the Israeli market.

Despite the above, there has been a U.S. presence in the Israeli market for quite some time including the two high-tech giants IBM and Motorola (both present since the 1960's). These two conglomerates originally intended to establish local subsidiaries for sales and support, however, over time they have evolved into full research and development facilities. Motorola took the process one step further and established one of its largest manufacturing facilities in Arad, close to Israel's Dead Sea.

Governmental Financial Aid to Foreign Investors

During the late 1970's Intel Corporation began operations in Israel. Today, Intel's facilities in Israel range from R&D (in Haifa) to wafer manufacturing (Fab 8 in Jerusalem) and the future Fab 18 in Qiryat Gat. Fab 18 is being built with a $1.6 Billion investment, one-third of which is provided by the Israeli government in accordance with the Law for Encouragement of Capital Investments. During this same period, government financial aid to foreign industrial investors (in the non tax-waiver course) declined to 24%. This $600 million co-investment in Intel's Fab 18 was a deciding factor in the government's controversial decision to modify (both in 1996 and 1997) the terms which need to be met to qualify for this funding.

Israel is highly regarded as a location which includes highly-skilled engineers, governmental aid, good geographic location and some tax and custom benefits (in accordance with NAFTA agreements) which enable U.S. firms to sell products manufactured in Israel to its European markets. This tax advantage is expected to become insignificant, as most westernized countries agreed to tag IT products with zero custom in the coming years. These very encouraging conditions exist despite a continuing unstable political situation in this region of the world.

Within Israel itself, the presence of international firms is somewhat of a controversy. Opponents in local industry claim that foreign firms gain resources as a result of local "brain power", however, do not funnel anything back into the local economy (with the exceptions of Intel and Motorola), as they do not build manufacturing facilities (the more massive employers) in the local market. Today, with the growing local demand for highly-skilled manpower, this argument has gained further ground. Despite the inroads of this dissenting point of view, most Israelis continue to consider the presence and contribution of international high-tech firms to be very important.

Since 1995, many foreign firms have established a presence in Israel. Of these, some entered the market by setting up operations directly, whereas others established a presence by friendly takeovers of small Israeli firms. International firms who maintain a base of operations in Israel include the following:

* Motorola - Semiconductor development, wireless communications development and manufacturing

* Intel - Semiconductor development and manufacturing. * DEC - Semiconductor manufacturing

* IBM - Software development

* National Semiconductors - Semiconductor development

* Applied Materials (Orbot/Opal) - Semiconductor production tools

* LSI Logic - Semiconductor development

* Bay Networks - Data communications and LAN equipment

* 3Com - Data communications and LAN equipment

* Madge - Data communications and LAN equipment

* News Datacom - CATV encryption

* Sun Microsystems - Software development

* Cisco Systems - Data communications and LAN equipment

* Qualcomm - Wireless and satellite telecommunications technologies

* Rockwell - Data communications chips

* Microsoft Israel - Software development

* EMC2 - 2 - Storage technologies

* Siemens Data Communications (via Ornet) - ATM

The above list can be expanded to include additional firms that are listed as U.S. firms, however all development and manufacturing facilities are located in Israel and management is Israeli, or largely Israeli:

* Comverse (via Efrat) - Voice manipulation technologies * Sapiens - Software tools

* Geotek - Wireless communications

* NetManage - TCP/IP and related internet products * Mercury - Software development quality control tools

Many international firms also maintain a presence in Israel by virtue of their minority holdings in Israeli start-up companies. This phenomenon began a few years ago and is expected to continue in the future. These minority shareholders also invariably hold options for share increases. Some examples of this phenomenon are:

* Microsoft - bought shares at Ross Technology, VDOnet

* Informix - bought shares at Comsoft, its local distributor

* Nortel - bought shares at Telrad Communications, manufacturer of switching equipment

* Oracle - bought its Israeli distributor, John Bryce. Plans to establish an R&D center in Israel.

Israeli High-Tech R&D and Exporting Endeavors

Moving from an economy previously based on agricultural, textile, and mineral exports, Israeli high-tech export had its beginnings in government and privately-held defense industries; i.e., IAI (Israel Aviation Industries), Rafael (The Armament Authority), Elbit, Tadiran, El-Op, and Elta. It was in these firms that advanced technologies turned into electronics-defense products which were intended to be used by the Israel Defense Forces (IDF) alone. Demand for the "proven in battle" products from Israel led to a developing export industry of defense-related products which still comprises a large percentage of Israeli high-tech export. In addition, technologies which were utilized by the defense industries were later used by the growing civilian electronics industries.

Another major contribution to the industry was the presence of international firms which established local research and development centers in Israel. The international firms which came to Israel in the 70's and the 80's (Motorola, Intel, IBM, DEC, National Semiconductors) brought the know-how and the operating procedures of large conglomerates which were so needed in the development of the local, inexperienced firms. These firms exposed the industry to new areas, primarily in the telecommunications and the semiconductors industries.

During the 80's and early 90's Israeli developments contributed significantly to the following IT and telecommunications industries:

* Wireless Communications (voice and data)

* Advanced Data Communications Technologies (ATM, xDSL, SDH)

* Advanced LAN Technologies (ATM, Fast Ethernet, FDDI, ISDN)

* Satellite VSAT (Very Small Aperture Terminal)

* Voice Mail and Related Voice Manipulation Technologies

* DSP - Digital Signal Processing Technologies and Products

* Encryption and Data Security

* Anti-Virus Technologies

* Software Utilities for Mainframe and Mid-Range Computers (including year 2000 problem solving utilities)

* Databases for Mainframe and Mid-Range Computers

* A Large Variety of Internet Technologies and Products

* Educational Software and Multimedia

* Graphic Arts and Color Printing Technologies

* Billing Software for Telephony and Cellular Operators

* Semiconductor Development and Post-Production Inspection Tools

* CAD, CAM, and CAE.

Strengths

Technologically, the Israeli high-tech industry is well positioned among the top five world leaders. This assessment is supported by the following conditions, which exist in the local market:

* "high-tech atmosphere"

In a country where PCs are bought in one out of two households, the atmosphere is conducive for the younger generation to develop the appropriate skills to become the engineers of the future. * Ingenuity and Devotion

One could say that Israelis are people with many challenges. The challenges of the past had to do with the combat fields. The challenges of the present and future are technological. The attitude, nevertheless, is the same: "to invest all efforts and resources at our disposal to reach our stated goal".

* Cooperative Governmental Authorities

Israeli leaders of all parties are proud of Israel's high-tech "label" and promote it everywhere. The result is that the country is willing to accept and co-operate with foreign investors in the high-tech fields, as opposed to potential investors in other areas.

* Chief Scientist at the Industry and Trade Ministry

A unique Israeli phenomenon is this governmental institution, which maintains close to $1 billion annually in funds that are in turn invested in R&D projects with the expectation of return through long-term royalty payments. The Chief Scientist is a good source for local seed money (via the Incubators Program) as well as with basic research funding (via Magnat Program).

* BIRD Foundation and other VCs

BIRD (U.S. - Israeli Bi-national R&D) Fund is an excellent source for locating an Israeli partner, with the careful and sound "matching" process of BIRD professionals. Cooperation is also available through the over 30 venture capital funds operating in Israel

* The Law for Encouragement of Capital Investment

Although the situation has changed somewhat, the government of Israel is still considered a generous partner for foreign investors who establish operations in the northern or the southern parts of the country. Governmental assistance can be converted to long-term tax-waivers, rather than cash refund if so desired.

Shortcomings

Certain factors which are considered shortcomings as related to investment in Israel are obvious. The following details possible shortcomings as relate to investing in, or doing business with an Israeli high-tech start-up:

* Lack of High Management Skills

One cannot become an excellent manager of a medium to large company, in a milieu which does not have an overabundance of large companies which often serve as "finishing schools" for management of the future. Israelis tend to lack good management skills as is sometimes reflected when small start-ups become up and coming companies establishing branches all over the world.

* Lack of Understanding as Regards Market Trends

A direct result of not "listening to the market" and/or learning from continuous market research. All too often, Israeli companies are busy exploring one direction, while markets demands are shifting to the opposite.

* Lack of Skilled Marketing Personnel

As mentioned previously, Israeli manpower is heavy on excellent technical skills; i.e., lots of engineers and very light on marketing skills; i.e., sales, advertising, support.

* Short-Term Targets

Israelis plan for one or two years in advance. They lack the ability to draw a long term plan for themselves, or for their start-ups. Instead of designing their own future, they wait for the market to do the job.

Israel High-Tech Industry Toward the 21st Century

The Israel high-tech industry is less affected than other industries by the political and economic situation. Of course this sector is not a separate entity in and of itself. It is an integral part of the Israel economy. During 1997, Israel's economy began to experience a slowdown which has also impacted the high tech industry. This slowdown is expected to continue through 1998.

There are a number of reasons for this, however, on a macro-level, there are benefits to be derived by cooling down the local market and lowering inflation rates to West European levels.

The main problems that the Israel high-tech industry faces today are:

* The Developing Shortage in Electronics and Software Professionals

The shortage of professionals in electronics and software is a common problem in the western world. Israel has gone through a process in which immigrants from the former Soviet Union served as a stop-gap measure during 1992 through 1995. Since than, immigration to Israel has slowed down, and the problem has arisen again. This in turn has increased the cost of professional salaries to a level where the advantage in Israel of cost per employee no longer exists.

Former chairman of The Israel Electronics Manufacturers Association and the president of Motorola Israel, Mr. Hanan Achsaf, has stated that rapidly growing as it is, Israel's high-tech industry has the potential to grow at an even faster rate. Israel, which holds only a very small share of the vast international electronics market, can achieve a much greater share. In terms of productivity per employee too, Israeli high-tech still has a long way to go, compared to international standards. Although output per employee in the industry is $160,000 per annum, other countries boast an output of upward of $250,000 per employee per annum. Hanan Achsaf believes that the ability of Israel's high tech industry to persist in its rapid growth in the future is presently in question due to the shortage of technological manpower, and the need to train another 15,000 engineers at a cost of one billion dollars in the next five years.

* Achieving Market Share versus Spending R&D Budgets

As described above, R&D budgets are available via several sources. Seed money can be raised from various governmental sources, including a unique Incubator Program that is run under the Chief Scientist at the Industry and Trade Ministry. Hundreds of start-up companies raised R&D money, but when the marketing stage was reached financial resources were depleted. It is a common assumption in the high-tech world that on each dollar invested in development, another five to ten dollars should be invested in marketing. This is not the situation in Israel and the results are that start ups may have developed very worthy technologies only to discover that their target market is unaware of them. The Country needs to change its focus from R&D to marketing in order to capture the market share local companies deserve in this highly competitive arena. While there are hundreds of start-ups that produce annual sales of very few millions of dollars, only a handful of Israeli companies have achieved annual sales of hundreds of millions of dollars. Not one Israeli company is positioned among the worldwide leaders that sell high-tech products in the billions.

* Political and Economical Uncertainty

During the last decade, the political situation in the Middle East did not unduly influence Israeli high-tech companies. It is quite significant that foreign companies did not halt their activities in Israel, and the investment flow remained stable. Nevertheless, this situation could change quickly if the status quo in the Middle East is disturbed. In addition, during periods of increased terrorist activity or in the event of war, as occurred in early 1988 and during the Gulf War, foreign governments often issue travel advisories to their citizens, and travel to Israel, particularly for business purposes, is severely affected.

Other difficulties include the frozen rate of the Shekel to the Dollar, which has a negative impact on the profitability of the high tech industry. In late 1997/early 1998, with the advent of economic slowdown, an ensuing reduction in capital investment occurred which will effect investment in upgrade of equipment and materials over the near term.

Cooperation with Foreign Companies

The Israel high-tech industry is capable of enjoying tremendous profitability. It already leads the Israeli economy in terms of added value, export rates and productivity per employee. By taking the appropriate strategic decisions, the Israel high-tech industry can turn, by the year 2000 and beyond into a $10-15 billion industry, from the $7.2 billion industry it is today.

The Israel high-tech industry can benefit from cooperation with foreign companies at all levels.

* Marketing Fronts

As described above, Israel companies lack some of the marketing capabilities that can be achieved and provided by companies whose presence in the target markets is substantial. Israel can profit by gaining access to distribution firms, large scale integrators, and software and hardware retail chains.

* Development and Marketing Cooperation

Some of the best success stories of the Israel high-tech industry involve a partnership between an Israeli and a foreign partner, in which the Israeli partner provides the technology or the product, and the foreign partner provides the sales and support functions in target markets. This type of cooperation is a win-win situation for both the Israeli and the foreign side. For U.S. partners it is even more beneficial as the partnership can apply for BIRD foundation funds.

* Direct Investment in an Israeli Company

During the past five years, investment has become available via many channels, including venture capital funds and public and private offerings. A direct investment of a foreign high-tech company in an Israeli company is highly valued. Israeli firms benefit not only from the capital invested, but perhaps to an even greater extent, from the experience and management skills provided by their new partner(s). As described above, direct investments in Israeli companies began to increase in the '90's and many American and European companies are now involved directly in Israeli firms.

* Establishing Production Plants in Israel

Motorola, Intel and other world leaders made Israel a preferred site for production facilities. Those companies benefit from the higher degree of technicians and engineers in Israel, and from the proximity of the country to their target markets in Europe. NAFTA agreements made Israel the place of choice for production of products that are to be exported to Europe. It is quite difficult for Israel to compete with South Asian countries on the basis of labor costs, but the Israeli advantage still exists in better product quality. In addition, governmental aid is offered to foreign investors and can reach up to 24% of capital investment, if a facility is to be built in specifically-defined development areas. These include parts of Jerusalem and areas which are located 40-60 miles from the center of the Country and Ben-Gurion Airport.

* Establishing R&D Centers in Israel

A number of foreign companies chose Israel to establish R&D centers. For the Israel high-tech industry, this kind of involvement is appreciated, but to a lesser extent. In the past, foreign-owned R&D centers often functioned as "hothouses" for personnel who went on to create local start-ups. It is quite clear that without the presence of world leaders, Israeli engineers could not have brought the high-tech industry to it's current level. Nevertheless, with the current shortage of trained professionals, every engineer that is hired by a foreign R&D center is considered one less engineer for a manufacturing concern. While ten engineers in an R&D center contribute about $1 million a year to the economy (assuming an annual cost of $100,000 per each engineer), ten engineers in a manufacturing high-tech plant can bring an added value of $10-15 millions in exported products and in a higher employment rate of technicians and other employees.

Israeli high-tech is on the way to the forefront of world technology not only in terms of knowledge and development, but also in terms of profitability and added value to the economy. Israeli leaders believe that the high-tech industry can lead not only Israel, but its neighbors as well, to a better future. The opportunity is no longer a gamble - the industry has proven its ability. It now needs to expand and firmly establish its position as a recognized world leader.

Sources: The Israeli IT Industry: Leading Technology Suppliers Guide 1998, IDC

Israel Science & Technology: Fifty Years of Excellence in the High-Tech Sector