One of last week's major news headlines in Israel was that the US had approved the sale of the Arrow 3 missile defense system to Germany for $3.3 billion - Israel's biggest ever weapons system deal. To put matters into proportion, the entire revenue in the first half of 2023 of Israel Aerospace Industries (IAI), the lead company in the project, was $2.5 billion.
Israel's defense exports climbed to a record $12.5 billion of new contracts signed in 2022, up from $11.3 billion in 2021, which was also a record, and in the coming years the country's biggest defense companies expect this figure to grow.
Israel's leadership is banking on future defense deals. This could be seen earlier this year when international rating's agency Moody's cut Israel's credit outlook. Prime Minister Benjamin Netanyahu and Minister of Finance Bezalel Smotrich attempted to reduce the impact of the downgrading by saying, "When the dust settles it will become clear that Israel's economy is very strong". They justified this by saying that "The defense industries are bursting with orders."
The current high demand for weapons is a worldwide phenomenon, but Israeli companies outperforming overseas rivals. In 2022, Israel's three largest defense companies jumped in the 2023 rankings of "Defense News" Top 100 Defense Companies in the world. Elbit Systems Ltd. (Nasdaq: ESLT; TASE:ESLT) rose from 31 to 21, IAI rose from 37 to 29 and Rafael Advanced Defense Systems rose from 41 to 34.
Higher defense budgets in Europe
Defense budgets currently approved in Western countries in general, and Europe in particular, are expected to bring a bigger volume of orders in 2024. Of these budgets, significant orders will be awarded to Israel, which is at the forefront of international defense technology.
Israel's leading position in innovative defense technology was reflected in the sales deal of Rafael's David's Sling missile defense system to Finland for €316 million, which was approved by the US government earlier this month. Finns chose David's Sling from eight companies that bid for the tender including US and French defense firms.
This was not the only major deal won by Rafael this year. The company also sold Spike missiles to Greece for about NIS 1.4 billion in April. Other big deals this year include IAI's supply of two satellites to Azerbaijan for $120 million, while Israel's biggest defense company Elbit Systems won a $55 million contract earlier this week to supply the Netherlands with a multi layered ReDrone Counter Unmanned Aerial Systems (C-UAS)
Elbit Systems SVP Joseph Gaspar says, "When you look at the world's defense budgets over the years, the average annual growth is 3.5%-4% in real terms. Another characteristic is that the growth is not uniform. Sometimes it grows in the US and Europe, and sometimes it does not grow or recedes as seen in recent years in Latin America."
Regarding the future, Gaspar cites three conflict centers that occupy the world. The first is the situation in Europe and Ukraine in particular, the second is the Asia-Pacific arena with China as the focus and thirdly there are local conflicts that are not regional, characterized by military friction. "It is about fighting against terrorism, cybersecurity warfare and fighting between small entities to control areas in Africa and elsewhere." The bottom line is that Gaspar stresses, "In the next two or three years, no reduction in demand is expected."
In the first quarter of 2023, IAI reported the most profitable quarter in its history with a net profit of $165 million (28% up from 2021). "IAI builds large systems and markets them worldwide," IAI CEO Boaz Levy says. "The Arrow 3 deal is indeed the largest deal ever to be signed in Israel, but IAI has been doing deals for years and is used to doing deals abroad."
The security scenario is changing and the world is looking to Israel
High demand for weapons in recent times can be explained by processes taking place around the world. Rafael EVP marketing Brig. Gen. (res.) Ariel Karo, former IDF chief intelligence officer explains, "Already following the occupation of the Crimean Peninsula in 2014, a profound change began in the world, from scenarios leading to the building of low intensive conflict power, such as the situations of Iraq and Afghanistan, to scenarios focused on preparing for the threat of combat with a state enemy. This was clearly seen in the war in Ukraine, but not only there. The compass of building the military power of most countries of the world is for a classic war with new means."
In the face of this scenario, the technological-operational gap that Europe is trying to close through the procurement of advanced technology stands out, which is reflected in the fact that 40% of Rafael's orders abroad in 2022 were from Europe. Karo points to another reason why they turn to companies Israeli companies in general and Rafael in particular. "Aid to Ukraine empties the warehouses of most Western countries. Their production capabilities don't keep up with the pace of supply with rising demand and we know how to provide superior technology in shorter delivery times than our competitors."
As a result, the markets estimate that sales records will continue to be broken in the coming years. Leumi Economist Gili Ben Avraham wrote in an internal report that he is cautiously optimistics of Israeli defense sales of $16 billion per year in 2023 and 2024. He wrote, "This significant sum is equivalent to about 27% of the total industrial exports (without diamonds) from Israel in 2022," Leumi estimates, "Companies in the domestic defense industry are expected to benefit from the increase in demand for defense industry products among European countries in the coming years."
All this, of course, is expressed in the strengthening of growth of Israeli GDP. The big security deals are extended over periods of time with manufacturing the product, the supply and delivery and the income obtained in stages over the years. The signing of a multi-billion deal itself is not reflected immediately in GDP, but is felt throughout the life of the deal, through receipts from buyers, tax payments and production components.
Taxes, dividends, and government deals
Beyond strengthening GDP, there are three main avenues through which the money from defense industry sales flows into the state coffers. The first is in taxes paid by Israeli manufacturers. However, due to foreign countries' requirements, sales deal are often completed through a subsidiary of the manufacturer, which is registered abroad, and therefore the corporate taxes flowing into Israel state coffers are relatively low.
Additional state revenues come through the dividends paid by the government companies - both IAI and Rafael are state owned. Over the years the bulk of dividends to the state from government companies comes from the defense companies. But here too there is a problem - about NIS 2 billion in dividends are simply trapped and not transferred. Of these, NIS 1.2 billion come from the defense companies.
Although the company directors announce the distribution of dividends to the state and record provisions in the financial statements, but the minister in charge of the Government Companies Authority, Dudi Amsalem, who serves as the representative of the shareholders (the state), has not signed off on the distribution of the funds due to his dispute with Government Companies Authority director Michal Rosenbaum, who acted to collect the dividends.
Meanwhile, the Ministry of Finance and Government Companies Authority fear that by the time the state decides to recover the funds, there will already be much less than the NIS 2 billion announced. At the same time, another development is underway in which the Ministry of Defense owes money to the government companies, which are considering using the dividend funds, if they do not meet their budget requirements.
The third way in which the state is supposed to benefit from the proceeds from the sales of the defense industry is in G to G (government to government) deals, as in the case of Arrow 3. These are framework agreements that the Ministry of Defense makes with other countries through which the defense firms sell military equipment abroad. In most of these deals, the Ministry of Defense issues a commission coupon, which goes directly into the Ministry's budget. Since these are projects that are implemented over many years, the Ministry of Defense knows how to structure the budget according to projected IAI and Rafael overseas revenue.
Not even close to high-tech sales
There is no doubt that Israel's arms industry is a national strategic asset and the sale of advanced weapons systems should bring a generous return for the entire Israeli economy. Yet taxes paid by defense companies are the same as in any other industry, and sometimes even less, because of subsidiaries abroad. The dividends are important, but even if Amsalem releases the trapped dividends, it is not a dramatic amount in relation to the NIS 484 billion 2023 state budget.
Even including fees charged by the Ministry of Defense from foreign countries, it still does not come close to the level of state revenue from the high-tech industry. On the other hand, the defense industries and civilian tech companies often compete for the same high quality engineers and tech professionals. Due to the cuts in high-tech, there is a trend of employees migrating to the defense sector, which is flourishing and continually hiring.
In addition, the economic benefits from the defense industry are also felt in areas beyond direct state revenues. There is a positive impact for the country in employment, the balance of payments and even in a certain strengthening of the shekel after completion of huge deals like Arrow 3.
Now Israel's defense firms will have to cope with "positive problems" like meeting the deadlines of the many orders they have signed.
Israel Missile Defense Organization (IMDO) director Moshe Patel says, "IAI, Rafael and Elbit will have to significantly increase their workforce and set up infrastructures because one of the requirements of the Ministry of Defense and US government is that there will be no harm to Israel's and shared (multi-layered missile defense) plans. We also need to prove to the Americans that we are not even one day behind in delivering David's Sling systems to the IDF, and no joint Israel-US development is being delayed."
Published by Globes, Israel business news - en.globes.co.il - on August 25, 2023.
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