Israel Turns to Outsourcing as the Shekel Soars

As Israel's high-tech industry loses its cost advantage, jobs are moving to Romania and India, and local wages are being frozen
Mirrors point to the sky at a solar energy development centre in Rotem industrial park, June 12, 2008 near the southern Israeli town of Dimona Uriel Sinai/Getty Images

The high cost of doing business in Israel these days is forcing many local high-tech companies to expand abroad to remain competitive. Wireless broadband developer Alvarion (ALVR) is a case in point. With local costs skyrocketing in the past year, thanks to a meteoric rise in the shekel, Alvarion has imposed a freeze on hiring and wages at its Tel Aviv headquarters. Yet at the same time it aims to double the number of engineers it employs at its R&D facility in Bucharest, Romania, to over 150 by the end of this year.

For years the cost advantage of Israel's high-tech industry over Silicon Valley and other tech hot spots was a major selling point. This led global giants like Intel (INTC), Motorola (MOT), and Microsoft (MSFT) to set up major R&D operations in Israel, and was the catalyst for local success stories like Check Point Software Technologies (CHKP), Nice Systems (NICE), and Amdocs (DOX). That's no longer the case. "The cost of an Israeli engineer is now on par with the U.S., while his Romanian counterpart is just one-third," says Tzvi Friedman, CEO and president of Alvarion. An Israeli high-tech engineer makes about $90,000 at the latest exchange rate.

Other companies are looking farther afield in an effort to cut costs. "We're in advanced discussions with several companies in India on moving some of our development work over there," says Shmuel Arvatz, chief financial officer at Click Software Technologies. The Tel Aviv-based optimization software company has already frozen wages for part of its Israeli staff. Alvarion and Click Software have not yet been forced to lay off workers in Israel, as demand for their products remains strong. But that has not been the case with a growing list of companies, including Retalix, Metalink, and the Israeli subsidiary of Polycom, which was shut down last month.

Bank of Israel Intervenes

So far there have not been significant layoffs in the high-tech sector, but there are growing fears that this could change as the global slowdown in the U.S. and Europe spreads. The main problem: Wages are in shekels, while revenue is in dollars. The greenback has dropped in value by 30% against the shekel since March 2007, with half of the decline during the first half of this year (BusinessWeek, 2/7/08). The shekel's performance has been attributed largely to the strong growth of the Israeli economy over the past four years.

To make matters worse, wages in the industry have risen an average of 8% in the past two years. On July 10, the shekel was trading at 3.22 to the dollar, its highest level in nearly 13 years. That same day, Bank of Israel Governor Stanley Fischer announced that the central bank would enter the foreign currency market and buy up $100 million daily in an effort to rein in the shekel. The dollar has risen by around 6% since the Bank of Israel's intervention, but many say the correction only partly offsets the meteoric rise of the shekel over the past two years.

The shekel's strength has not had an effect on high-tech exports, which accounted for 41% of the $20 billion in industrial exports in the first half of 2008. They rose at a 22% clip. But many experts believe the statistics are deceiving, since many deals were signed months ago and are not profitable at today's exchange rates. Dozens of companies have already lowered their earnings guidance for 2008.

"High-tech companies are going to have to rethink their model of hiring in Israel and how to compensate employees if they want to remain profitable, in line with global standards," says Daniel Meron, technology analyst at RBC Capital Markets.

Startups Feel the Squeeze

The mighty shekel is having a serious impact on local startup companies, which have in the past been key to the success of the Israeli high-tech industry. "Our expenses in the past few months have been running 10% ahead of our budget, so we're being forced to cut back," says Inon Beracha, CEO of PrimeSense, a developer of three-dimensional technologies for digital devices. In April the two-and-a-half-year-old company raised $20.4 million in financing, but it has already had to cut back on hiring and travel, and has frozen wages. In an attempt to meet its target of breaking even in 2010, PrimeSense is also planning to outsource some of its R&D work to China and Eastern Europe, something that was almost unheard of in the past for startups.

Israel's venture capital industry, the main source of financing for local startups, is also feeling the pinch. "We have to choose between the various startups in our portfolio since the cost of investing is so much higher these days," notes Orna Berry, venture partner at Gemini Israel Funds, a Herzliya venture capital fund and chairperson of the Israel Venture Assn. She adds that venture capital funds will be far more selective as they will be forced to invest in fewer startups.

Global market conditions have also complicated matters. In the first six months of 2008 not a single Israeli company went public on NASDAQ, where nearly 100 local high-tech companies trade, and M&A activity has also slowed down. This will mean that late-stage companies will need additional financing to stay afloat from increasingly hard-pressed venture funds and investment companies.

A Hindrance to the High-Tech Scene

Even with the disappearance of its historical cost advantage, Israel's high-tech industry is still viewed as highly innovative. But nowadays, in order to bring its new ideas to market, the local industry increasingly is subcontracting a growing chunk of development abroad, in places like Romania and India. That trend is likely to continue for the foreseeable future and will no doubt have a dramatic effect on the local high-tech scene.

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