Prophets and Profits

No, this article will definitely not be a Bible sermon. However, it will look at the success levels of two fairly well to-do Israeli companies, and try to get a bit of understanding as to why the land of the Jewish Prophets is not as successful as it might be with Israeli Profits.

Before we begin, it is important to note that this article will not delve into macroeconomic policy. Policy leads to politics, which is absolutely necessary, but writing about it, in this context, is not good for business. We will focus solely on two public Israeli companies, as well as certain macroeconomic data about the State of Israel.

First, the overall view.

• Israel has a population, as of the end of 2008, of 7.4MM people (Israel Central Bureau of Statistics).
• Israel has a GDP of $202BN in 2008 (IMF).
• Israel has a GDP per capita of $28,365 (IMF). Yes, these numbers don't quite add up, due to a slight variance in how the IMF calculates population, and its averages over the year, as opposed to point-in-time census.

By comparison, the United States has a GDP per capita of $46,859, and the UK has a GDP per capita of $43,785. On the other hand, Israel far exceeds its neighbours' GDP per capita, with Egypt at $2,161, Syria at $2,757, Jordan at $3,421, and only Saudi Arabia coming somewhat closer, largely due to oil revenues, at $19,345.

The interesting question is why Israel, with its highly educated workforce, intense innovation and entrepreneurial drive, and multilingual and multicultural workforce, as well as a network of expats around the world, has a GDP of only slightly more than half that of the US and the UK. Interestingly, even in highly educated industries and roles, for example C-level executives, engineers and top academics, the income scales are also normally one third to one half of those for comparable roles in the United States, ignoring the very highly paid executives of American multinationals, the equivalent of which largely does not exist in Israel, due to its small population size, approximately 1/28th that of the United States or the Euro zone.

Rather than delving into macroeconomic management (or mismanagement), although much of that does exist here, we will take the microeconomic view. Many of the larger Israeli conglomerates, like Koor and Klal, are vestiges of the statist/socialist days of the Israeli economy, prior to the economic liberalizations of the 1980s and 1990s. Much of the growth engine of Israel in the last two decades has been due to innovative firms in what is called "high-tech" in Israel, the software, security, hardware, Web, biotechnology and energy sectors. As such, let us investigate two firms that are distinctly "high-tech", have been successful enough to live on their own revenues and even go public, analyze their results, and determine what insights are available.

The two companies we will explore are AudioCodes, manufacturer of Voice over IP, or VoIP, hardware and software, and NICE, manufacturer of enterprise and security information technology products.

For the years 2005 through 2007, the last year for which publicly released financial information is available, AudioCodes had revenues that grew from $116M through $147MM to $158MM, an annual growth rate of 26% in 2006 and 7.5% in 2007. These are undoubtedly respectable growth numbers, especially in a sector that has major players in the market, such as Cisco, Nortel and other technology behemoths. Now, let us turn to operating profit. In 2005, operating income was $12.5MM, or 11%. In 2006, operating income was $4.3MM, or 2.9%. In 2007, operating income was ($4.2MM), or -2.7%. Immediately, we can see that even before the recession, as AudioCodes grew its revenue impressively, its operating margins shrunk and then turned to a loss. Further, even before the shrinkage, in 2005, operating margins were at 11%. By contrast, in 2005, competitor Cisco had operating margins of $5.7BN on $21BN in revenues, or 27%. While one can argue that VoIP products are a small subset of Cisco's business, it is highly unlikely that Cisco would go into any business where it could not foresee maintaining its margins.

If we look at NICE, we see a similar pattern. NICE is much larger than AudioCodes, with 2005 through 2007 sales of $311MM, $410MM and $517MM, respectively. Once again, however, its net income is $32.1MM (10.3%), $17.1MM (4.2%) or, excluding a one-time in-process R&D write-off, $30MM (7.3%), and $33MM (6.4%). Like AudioCodes, despite healthy and growing revenues, and a scale that is sufficient to be solidly profitable, NICE is stuck in low operating margin territory.

Two questions arise from this analysis:

1. Why are these two companies operating with such terribly low margins?
2. What impact does this state of affairs have on the health and robustness of the Israeli economy and GDP per capita?

The answer to the first question, of course, is that it takes some real time on the inside of the company - top-down financial and operations analysis and bottom-up walking the floor, talking to staff and customers, and seeing what is going on inside - to understand why. Nonetheless, there is no reason for these companies to be operating at such a low-level of profitability.

The answer to the second question is, "a lot."

• GDP is defined as the total income of the economy. If these businesses, engines of economic growth in the most dynamic sector, are having such low income, then GDP is directly reduced. With a constant population base, GDP per capita is reduced.
• With such anemic returns from even successful companies, investors will be hesitant to invest in them, or other similar companies. This reduction in investment directly leads to lost growth opportunities and reduced GDP. With the same population base, GDP per capita, again, is reduced.
• With very low returns for the same staff size, company profitability per employee (i.e. productivity) is much lower. The employees themselves may or may not be less productive than their US counterparts. However, for the company as a whole, profit per employee is low, and hence both the willingness to invest in more employees and the desire to pay them more, is reduced, directly reducing the human component of GDP and GDP per capita.

As we can see, despite the miracle of Israeli growth over the last two decades, and the brilliance of its entrepreneurs, many of its more mature companies are focused too intensely on revenues, at the direct expense of profitability. This is not a shortcoming unique to Israeli managers; most entrepreneurs, owners and CEOs are top-line driven rather than bottom-line focused. It is for this purpose that COOs exist. However, the pattern is likely having a negative impact on Israeli GDP, GDP per capita, investment and salary levels. Improving these numbers using real operations expertise is crucial.