Investment bank Merrill Lynch has joined the list of analysts taking aim at

Gilat Satellite Networks

(Nasdaq:GILTF), slamming the share with a 50% cut in price objective.

In mid-November Goldman Sachs issued a pretty savage report on Gilat, cutting its forecasts and querying the company's liquidity though it reiterated its Buy recommendation. It could have been dismissed as sour grapes at losing its position as the company's investment bank of choice. Piper Jaffray joined the fray, cutting its forecasts, which could have been dismissed as lack of familiarity with the company.

Come December 18, Wit Soundview downgraded Gilat Sat from Buy to Hold.

Now the blow comes from Merrill Lynch, the bank closest to the company. The bank cut its target for Gilat for the third time in a year, and this time adds that it doesn't believe the company's cash flow will meet guidance.

Merrill Lynch's satellite communications analysts, headed by Marc Nabi, haven't changed their mind much on Gilat. They reiterate their Buy recommendation in their report released today, and repeat their sales and profits forecast for the fourth quarter and say the same optimistic things.

But there were two differences from their last report of mid-November. They slashed Gilat's 12-month price objective from $116 to $57. They also sharply lowered cash flow per share from $5.5 to $4.86 for the coming two years.

Another debt issue in five years

Investors have been worrying about Gilat's cash flow, mainly after Goldman Sachs raised the issue in a report whose title advised that liquidity was becoming a problem. Merrill Lynch isn't sanguine about Gilat's cash flow from regular activity. It does mention expectations of $4 to $5 per share, but it isn't clear where the number came from.

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When it does dive into the nitty gritty, Merrill Lynch writes that it estimates Gilat to end 2000 with less than $4 million cash flow from regular activity, compared with profits of $50 million. Adding cash flow from the company's investments, which should cost $140 million in 2000 and another annual $100 million in the years to come, clearly, the company's cash situation isn't encouraging.

Merrill Lynch does predict that Gilat will end 2000 with $176 million in cash, mainly by right of the bonds issue it held last year. But by 2003 its situation will have deteriorated. Even if it meets cash objectives, by then its cash will stand at $16 million and its debt at $371 million, largely because of the bonds weighing down on its balance sheet, expiring in 2005. Merrill Lynch sees no way for Gilat to redeem the bonds using cash generated in the intervening years. Clearly it will need to issue new debt, albeit in five years' time, to pay the bill.

Merrill Lynch doesn't dwell on its apprehension relating to Gilat's cash flow, but together with the condition of the market, they may explain why the bank lowered its price objective so sharply. Only 10 months ago, in March 2000, Merrill Lynch set a price target of $196, extrapolating to a company value of $5 billion. Today the objective is down to $57, reflecting a market cap of $1.4 billion. That's some drop.

Merrill Lynch attributes its slash-and-burn to changing market conditions. We believe that Gilat is best valued using a P/E-to-growth multiple methodology, the analysts write. Based on multiyear earnings per share growth of 30%, its multiple should be 16.5, the analysts say. The forecast that Gilat will end 2002 with earnings of $3.5 per share and a multiple of 16.5 on that profit leads Merrill Lynch to a price target of $57.

That is still 100% above Gilat's market price, now at $26.75, which prices the company at only $670 million.

Cash flow aside, Merrill Lynch is enthusiastic about Gilat's business. Core VSAT Business Still Looks Healthy is the title of one item in the report. The bank mentions several positive developments in the last quarter, the most important being the contract with Goodyear. The tire maker is buying satellite service to 1,000 outlets using Gilat's SkyStar Advantage two-way technology. The contract boosts Gilat's back orders to a hefty $300 million.

StarBand IPO who?

One big question mark hanging over Gilat's head is its broadband Internet by satellite venture, StarBand. The venture is biting deep into profits, because Gilat's contribution is to sell it products at razor-thin profit. Also, profit margins in the consumer market are narrower than in the organizations market. Gilat's margins are therefore eroding fast. Its fourth-quarter gross profit is expected to decline to an all-time low of 30%.

The reverberations die down in the operating profits item, but Gilat is being forced to slash its R&D spending. Merrill Lynch estimates that fourth-quarter R&D margins will be down to 4.7% from 5.9% in the third quarter and 7.3% in the fourth quarter of 1999. Gilat is also sharply cutting its general and management costs.

The company's big test this year will be how well StarBand does. Gilat's share price may well recover if it can recruit major numbers of subscribers for the satellite Internet service. It needs a boost: Gilat stock has lost 85% of its value from its peak. StarBand has already filed a prospectus to issue shares. Merrill Lynch is supposed to lead its IPO. But under the prevailing market conditions, issuing a dewy-eyed money-losing Internet supplier doesn't look promising. Merrill Lynch doesn't even mention it in its report.