By Oded Hermoni

In a report published last week after nine months of research, Morgan Stanley Dean Witter has little but praise for Israel's optical startups. Analysts Barry Leibovits, David Jackson and Alkesh Shah predict that Israeli optical startups will be prime acquisition targets for international optical companies wanting to broaden their product portfolios.

Starting from a strong base of military research, semiconductor expertise and strong venture capital backing, Israel's optical startups have the potential to develop technologies that could disrupt the global competitive landscape, they write.

The areas Israeli startups could substantially affect include metro networks, fast communications and all-optical switching fabrics.

The analysts expect that over the next couple of years, international giants such as JDS Uniphase, Corning and Intel will be buying four to six Israeli companies.

The bottom line is that Morgan Stanley recommends that its customers, including major optical players, invest in Israeli optical companies.

Moreover, Israeli companies will be happy to merge, the analysts predict. Israeli telecoms equipment providers were only partially successful in their attempts to turn multinational.

The failure of telecom equipment companies such as

ECI Telecom

(Nasdaq:ECIL) and

Orckit Communications

(Nasdaq:ORCT) to maintain their strong initial momentum taught a lesson to startups, especially the ones focusing on the systems market. Software companies, such as

Check Point Software Technologies

(Nasdaq:CHKP),

Amdocs

(NYSE:DOX) and

Comverse Technology

(Nasdaq:CMVT) have done well, on the other hand.

It's still early days to say whether an Israeli optical company can become a global player. But the geographical distance between Israel and the U.S. makes it hard for local companies that supply whole systems.

During the first half of 2001, the analysts expect a wave of consolidation among Israel's optical companies, spurred by financing difficulties.

The report names ten optical later-stage companies, out of the 40 established in Israel in recent years:

Cyoptics

,

Lynx Photonics Networks

,

Lambda Crossing

,

MemLink

,

PacketLight Networks

,

Lasercomm

,

Native Networks

Trellis Photonics

,

XLight Photonics

and

KereniX

.

Prominent in its absence from Morgan Stanley's list of notables is the American-Israeli startup

Chiaro Networks

, which secured a whopping $100 million in financing during 2000, a record at the time.

The Israeli tax problem

The report devotes paragraphs to Israeli tax law and to the political situation. Although the Israeli government encourages technological development, the analysts write, Israel's tax laws do not, compared with American tax law. Not only is Israel's corporate tax rate 36% compared with the U.S. rate of 20%, but the U.S. offers a better tax structure on stock-swap M&As.

Change the tax structure, Morgan Stanley admonishes the Israeli administration, or watch companies flee the state.

Although the report was compiled during a period of escalating hostilities, Morgan Stanley's analysts don't see a problem. For optical companies, at least, which they believe will be "relatively immune" from the rising tide of violence. They point out that most of the startups are located far away from the flash-points.

The investment bank's representative in Israel, Yair Seroussi, says optics is the most mature sector in Israeli hi-tech, thanks to the critical mass built up in recent years.