Arris Group Inc. (ARRS)

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Form 10-Q for ARRIS GROUP INC


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9-May-2008

Quarterly Report



Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
We are a global communications technology company specializing in integrated broadband network solutions that include products, systems and software for content and operations management, and professional services. We develop, manufacture and supply cable telephony, video and high-speed data equipment. In addition, we are a leading supplier of infrastructure products used by cable system operators to build-out and maintain HFC networks. We provide products and equipment principally to cable system operators and, more specifically, to MSOs. Our products allow MSOs and other broadband service providers to deliver a full range of integrated voice, video and high-speed data services to their subscribers. Our core strategy is to lead network operators through the transition to Internet Protocol-based networks by leveraging our extensive global installed base of products and experienced workforce to deliver network solutions that meet the business needs of our customers. Our Strategy and Key Highlights
Our long-term business strategy includes the following key elements:
• Transition to IP with an "Everything IP, Everywhere" philosophy and build on current market successes;
• Leverage our current voice, video, and data businesses;

• Expand our existing product/services portfolio through internal developments, partnerships and acquisitions; and

• Maintain and improve an already strong capital and expense structure.

Our mission is to simplify technology, facilitate its implementation, and enable operators to put their subscribers in control of their entertainment, information, and communication needs. Through a set of business solutions that respond to specific market needs, we are integrating our products, software, and services solutions to work with our customers as they address Internet Protocol telephony deployment, high speed data deployment, network capacity issues, on demand video rollout, operations management, network integration, and business services opportunities.
Below is a summary of some of our key trends, actions and highlights relative to these strategies:
"Everything IP, Everywhere" is taking hold as MSOs globally have embraced VoIP and are now rapidly deploying this key new service.
• We have successfully leveraged our existing market position and industry experience to continue to generate robust demand for both EMTA and CMTS products. Further, we have leveraged the market position we acquired as a result of the purchase of C-COR in December 2007 to increase sales of new products, notably Video on Demand, Operations Support Software, Access, and Transport.

• As expected, sales to Comcast for all products were down significantly in the first quarter. We expect sales to Comcast to increase in future quarters.

• We experienced increased sales to other customers, notably Time Warner, Charter and certain international customers.

• We expect strong demand for CMTS products to continue in future periods as new services and competition between our customers and their competitors intensifies the need to provide ever faster download speeds requiring added CMTS capacity and features. In the second half of 2008, a new generation of CMTS products based upon the DOCSIS 3.0 standard is expected to be introduced. It is possible that customers may reduce their short term purchases of DOCSIS 2.0 CMTS products in anticipation of the new product.

• We introduced our Universal EdgeQAM D5 late in 2007. Our expectation, based on customer input, was that demand for this product would be robust in the first quarter of 2008 driven by Switched Digital Video (SDV) requirements. However, customers, in particular Comcast, have since delayed purchasing decisions. We have expanded our marketing and development efforts to include other applications including Modular CMTS, Broadcast and Video on Demand. We expect that sales of this new product will ramp up through 2008 but at a slower rate than initially expected. Initial margins on this product will be low until cost reductions can be implemented later in 2008



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• We expect demand for EMTAs to remain robust; however, we do not anticipate the growth in aggregate sales we have enjoyed for the past few years. Many of our customers have now passed through the initial launch stage, and are at "steady state" deployment rates and may not continue to incrementally increase the rate of their purchases. While most of our customers have a multi-vendor strategy, we enjoyed 100% market share with many customers well into 2007. In late 2007, several of our customers awarded a portion of their business to our competitors, which we expect will continue. Our ultimate level of sales of EMTAs will be affected by, but not limited to, such factors as the success our customers have marketing IP telephony to their subscribers, and the success our customers have retaining their IP telephony subscribers as well as our ability to limit the impact of the implementation of a multi-vendor strategy by our customers. We also anticipate ongoing competition for EMTAs in the future. The deployment of higher speed data service tiers will require new DOCSIS 3.0 capable EMTAs and modems, providing opportunity for sales of a new generation of CPE devices starting in the second half of 2008.

• Through our acquisition of C-COR in late 2007 we expanded our portfolio to include several key new products that leverage the IP spending of our customers. The Access and Transport products are expected to benefit from the plant upgrades MSOs will undertake to expand the capacity they will require to offer new services to their subscribers. The operations support system ("OSS") and On-Demand products also are well positioned to provide value added services and operational improvements to the MSOs.

We continue to invest significantly in research and development.
• We have made significant investments through our research and development efforts in new products and expansion of our existing products. Our primary focus has been on products and services that will enable MSOs to build and operate high-availability, fault-tolerant networks, which allow them to generate greater revenue by offering high-speed data, IP telephony and digital video. This "success-based" capital expenditure is becoming an increasing portion of the cable operators' total capital spending. In addition, some MSOs have expressed interest in offering bundled wireless telephony as part of their product offering. This product, known as Fixed Mobile Convergence (FMC), will allow cable subscribers to use mobile phones in their homes, connecting to the MSOs' VoIP network in the home, and to roam from the home VoIP network to the cellular network outside of the home and back seamlessly. We are developing products to support this new offering. With our late 2007 acquisition of C-COR, our research and development was significantly expanded to include Access and Transport, Video on Demand, Ad Insertion and OSS products. In the first quarter of 2008, we spent approximately $28.1 million on research and development, or 10.2% of revenue, which compares to $18.1 million or 7.7% of revenue in the same period last year. We expect to continue to spend similar or slightly higher amounts on research and development in the future. We anticipate we may modestly increase our development efforts on Video on Demand and OSS products.

• Key research and development accomplishments in the first quarter 2008 included:

o Initial lab trials of DOCSIS 3.0 C4 CMTS and TM702 EMTA with lead customers.

o EMTA and Data Modem submitted to Cablelabs for DOCSIS 3.0 certification.

o Added support to the D5 Universal EdgeQAM for multiple additional switched digital video ("SDV") and Video on Demand ("VOD") network. architectures, as well as development of M-CMTS features.

o Transition to lower cost 600-series EMTA.

o Release of CORWave multi-wavelength optics platform which provides increased network capacity over existing infrastructure for residential and business applications.

o Release of first of its kind, segmentable optical node design specifically for the European market.

o Release of upgrade kit to allow conversion of existing amplifier deployments to optical nodes in support of 'fiber deep' push and targeted service areas.

o Product enhancements for our Assurance/OSS product line.

o Product enhancements for our nABLE video backoffice platform.



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At the end of the first quarter, we had cash, cash equivalents and short term investments of approximately $293 million. In the quarter we repurchased 13 million shares, and redeemed $35 million of convertible debt.
• In the first quarter 2008 we announced a share buyback program of up to $100 million. In the quarter we repurchased 13 million shares at an average price of $5.84 per share for an aggregate consideration of approximately $76 million.

• As anticipated, in the first quarter 2008 we redeemed, at par, $35 million of convertible notes we assumed as part of the C-COR acquisition.

• We generated $30.5 million of cash from operating activities in the first quarter 2008.

• Through a combination of our cash resources, anticipated cash generation from operating activities and our ability to access capital markets, we continue to be well positioned to execute on strategic opportunities.

Our income statement reflects several significant items year-over- year
• As a result of the acquisition of C-COR in late 2007, sales, gross margin and operating expenses significantly increased. Below is a table which compares first quarter 2008 results to ARRIS and C-COR results for the first quarter 2007:


Results for ARRIS and C-COR
(in millions, except gross margin percentages)
(unaudited)

Three Months Ended March 31,
ARRIS ARRIS C-COR
2008 2007 2007 (1) (2)

Sales 273.5 235.3 73.0
Gross margin - $ 85.2 68.7 32.7
Gross margin - % 31.2 % 29.2 % 44.8 %
SG&A 37.0 24.2 14.9
R&D 28.1 18.1 8.7
Restructuring & impairment 0.4 0.4 0.2
Amortization of intangibles 13.2 - 0.8

Operating income 6.5 26.0 8.1




(1) See C-COR Form 8-K filed with the Securities and Exchange Commission on 8/27/2007.

(2) C-COR gross margin and SG&A have been adjusted to conform to ARRIS accounting policies with respect to freight billed to customers.

• In the first quarter of 2007 we recorded a net gain of $22.8 million related to the termination of the proposed TANDBERG acquisition. We did not experience a similar event in 2008. In the first quarter of 2007 we recorded a tax expense of $15.6 million, which equates to an effective tax rate of 29.3%. Included in the tax expense are discrete items, per the guidance of Accounting Principles Board ("APB") Opinion 28, Interim Financial Reporting, related to the terminated TANDBERG transaction. The foreign exchange gain, break-up fee and deal expenses were considered discrete items and were recorded at a marginal tax rate of 38.0%. The break-up fee and expenses are considered to be capital in nature versus ordinary income. As a result, we reversed a net $3.2 million of deferred tax valuation allowances as we viewed it as more likely than not that we would be able to utilize the capital gain NOLs to offset the capital gain recorded as a result of the TANDBERG break-up fee net of expenses. In the first quarter of 2008, we recorded a tax expense of $3.3 million which equates to an effective tax rate of 37.8%. We did not have any discrete items in the first quarter of 2008. We anticipate that our average tax rate for 2008 will be approximately 35%. Achieving this rate is dependent on Congress passing legislation associated with the continuation of Qualified Research Expenditures. If such legislation is not passed or is not retroactively applied, we believe the effective tax rate will be approximately 38%.

Our outstanding share count has increased year over year reflecting several factors:
• We issued approximately 25 million shares as partial consideration for the purchase of C-COR in 2007.

• We repurchased approximately 13 million shares as part of our share buyback program in the first quarter of 2008.



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Significant Customers
The vast majority of our sales are to cable system operators worldwide. As the U.S. cable industry continued a trend toward consolidation, the six largest MSOs controlled approximately 89.2% of the revenue generating units ("RGUs") within the U.S. cable market (according to Dataxis in the third quarter 2007), thereby making our sales to those MSOs critical to our success. Our sales are substantially dependent upon a system operator's selection of ARRIS' network equipment, demand for increased broadband services by subscribers, and general capital expenditure levels by system operators. Our three largest customers (including their affiliates, as applicable) are Charter, Comcast, and Time Warner Cable. From time-to-time, the affiliates included in our revenues from these customers have changed as a result of mergers and acquisitions. Therefore, the revenue for our customers for prior periods has been adjusted to include, on a comparable basis for all periods presented, the affiliates currently understood to be under common control. A summary of sales to these customers for the three month periods ended March 31, 2008 and 2007 are set forth below (in thousands):


Three Months Ended
March 31,
(unaudited)
2008 2007
Charter $ 29,018 $ 16,676
% of sales 10.6 % 7.1 %

Comcast $ 34,224 $ 82,514
% of sales 12.5 % 35.1 %

Time Warner Cable $ 70,961 $ 22,380
% of sales 25.9 % 9.5 %




Comparison of Operations for the Three Months Ended March 31, 2008 and 2007 In general, most comparisons of the first quarter results of 2008 to 2007 will show an increase in amounts due to the incremental impact of the C-COR acquisition in December 2007.
Net Sales
The table below sets forth our net sales for the three months ended March 31, 2008 and 2007, for each of our segments (in millions):


Net Sales
Three Months Ended Increase (decrease) -
March 31, (unaudited) 2008 vs. 2007
2008 2007 $ %
Business Segment:
Broadband Communications Systems $ 189.6 $ 199.0 $ (9.4 ) (4.7 )%
Access, Transport & Supplies 72.9 36.0 36.9 102.5 %
Media & Communications Systems 11.0 0.3 10.7 3566.7 %

Total sales $ 273.5 $ 235.3 $ 38.2 16.2 %




The table below sets forth our domestic and international sales for the three months ended March 31, 2008 and 2007 (in millions):


Net Sales
Three Months Ended Increase -
March 31, (unaudited) 2008 vs. 2007
2008 2007 $ %
Domestic sales $ 188.7 $ 174.8 $ 13.9 8.0 %
International sales 84.8 60.5 24.3 40.2 %

Total sales $ 273.5 $ 235.3 $ 38.2 16.2 %






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Broadband Communication Systems Net Sales 2008 vs. 2007 During the first quarter of 2008, sales of our BCS segment products decreased by approximately 4.7% as compared to the first quarter of 2007. This decrease in sales resulted from:
• As expected, we had lower sales to Comcast of both CMTS and EMTAs. Sales to Comcast of EMTAs are expected to increase in the second quarter of 2008. Sales of CMTS to Comcast are expected to increase in conjunction with the launch of our DOCSIS 3.0 product in the third quarter 2008.

• The declines associated with Comcast were partially offset with gains at several customers, notably Time Warner, Charter and certain international customers.

Access, Transport and Supplies Net Sales 2008 vs. 2007 Access, Transport and Supplies segment revenue increased by approximately 102.5% in the first quarter of 2008, as compared to the first quarter of 2007:
• The increase was the result of the acquisition of C-COR. In 2007 we estimate that C-COR recorded sales of approximately $57 million associated with this segment.

• 2007 sales in this segment represent sales of our Supplies products. Year over year sales of these products modestly declined primarily as a result of lower purchases by Comcast.

Media & Communication Systems Net Sales 2008 vs. 2007 Media & Communication Systems revenue increased in the first quarter of 2008, as compared to the first quarter of 2007. This increase is attributable to the C-COR acquisition.
Gross Margin
The table below sets forth our gross margin for the three months ended March 31, 2008 and 2007, for each of our reporting segments (in millions):


Gross Margin $
Three Months Ended Increase (decrease)
March 31, (unaudited) 2008 vs. 2007
2008 2007 $ %
Business Segment:
Broadband Communications Systems $ 58.0 $ 62.4 $ (4.4 ) (7.1 )%
Access, Transport and Supplies 21.9 6.4 15.5 242.2 %
Media & Communications Systems 5.4 (0.1 ) 5.5 5500.0 %

Total $ 85.3 $ 68.7 $ 16.6 24.2 %




The table below sets forth our gross margin percentages for the three months ended March 31, 2008 and 2007, for each of our business segments:


Gross Margin %
Three Months Ended Percentage Point
March 31, (unaudited) Increase (Decrease)
2008 2007 2008 vs. 2007
Business Segment:
Broadband Communications Systems 30.6 % 31.4 % (0.8 )
Access, Transport and Supplies 30.0 % 17.8 % 12.2
Media & Communications Systems 49.0 % (52.6 )% 101.6
Total 31.2 % 29.2 % 2.0






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Broadband Communications Systems Gross Margin 2008 vs. 2007 Broadband Communications Systems segment gross margin dollars and percentage decreased year over year:
• The reduction in gross margin dollars was the result of lower sales.

• The reduction in gross margin percentage reflects product mix.

Access, Transport and Supplies Gross Margin 2008 vs. 2007 The Access, Transport and Supplies segment gross margin dollars and percentage increased year over year:
• The increase in revenues year-over-year significantly impacted gross margin dollars.

• The increase in gross margin percentage was the result of the addition of higher margin Access and Transport products which we added to our portfolio as part of the C-COR acquisition.

Media & Communications Systems Gross Margin 2008 vs. 2007 Media & Communications Systems segment gross margin dollars and percentage increased year over year:
• The increases are attributable to the Video on Demand and OSS products we added to our portfolio as a result of the C-COR acquisition.


Operating Expenses
The table below provides detail regarding our operating expenses (in millions):

Operating Expenses
Three Months Ended March 31, Increase (Decrease) -2008 vs. 2007
2008 2007 $ %
Selling general and administrative $ 37.0 $ 24.2 $ 12.8 52.9 %
Research and development 28.1 18.1 10.0 55.2 %
Restructuring & impairment 0.4 0.4 0.0 0.0 %
Amortization of intangibles 13.3 0.1 13.2 13200.0 %

Total $ 78.8 $ 42.8 $ 36.0 84.1 %




Selling, General, and Administrative, or SG&A, Expenses The year over year increase in SG&A expense reflects:
• The inclusion of expenses associated with the former C-COR. In the first quarter of 2007, we estimate that C-COR spent approximately $14.9 million for SG&A expenses.

• We estimate that we have achieved approximately $2 million of SG&A synergies associated with the C-COR acquisition in the first quarter.

Research & Development Expenses
We continue to aggressively invest in research and development. Our primary focus is on products that allow MSOs to capture new revenues and reduce operating costs. The increase in research and development expense reflects:
• The inclusion of expenses associated with the former C-COR. In the first quarter 2007 we estimate that C-COR spent approximately $8.7 million for R&D expenses.

• We anticipate that we may modestly increase our R&D spending as a combined company, particularly on Video on Demand and OSS products.



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Restructuring and Impairment Charges
On a quarterly basis, we review our existing restructuring accruals and make adjustments if necessary. For the first three months of 2008 and 2007, we recorded $0.4 million. The $0.4 million recorded in the first quarter 2008 related to severance for the C-COR acquisition and changes in estimates associated with real estate leases. The $0.4 million recorded in the first quarter of 2007 related to changes in estimates associated with real estate leases. These adjustments were required due to changes to the initial estimates used.
Amortization of Intangibles
Intangibles amortization expense for the three months ended March 31, 2008 and 2007 was $13.3 million and $0.1 million, respectively. Our intangible expense for 2008 represents the amortization of intangible assets acquired as a result of the C-COR acquisition in December of 2007. Our intangible expense for 2007 represents the amortization of existing technology acquired as a result of the cXm Broadband acquisition in the second quarter of 2005, which were fully amortized by the end of 2007.
Other Expense (Income)
Interest Expense
Interest expense for the first quarter 2008 and 2007 was $1.5 million and $1.7 million, respectively. Interest expense reflects interest and the amortization of deferred finance fees primarily associated with our $276.0 million 2% convertible subordinated notes. Loss (Gain) in Foreign Currency
During the first quarter 2008, we recorded a foreign currency gain of approximately $1.0 million. During the first quarter 2007, we recorded a foreign currency loss of approximately $0.3 million. The gains and losses are primarily driven by the fluctuation of the value of the euro, as compared to the U.S. dollar, as we had several European customers whose receivables and collections are denominated in euros. We have implemented a hedging strategy to mitigate the monetary exchange fluctuations from the time of invoice to the time of payment, and have occasionally entered into forward contracts based on a percentage of expected foreign currency receipts.
Interest Income
Interest income during the first quarter of 2008 and 2007 was $2.7 million and $6.5 million, respectively. The income reflects interest earned on cash, cash equivalents and short term investments. Interest income decreased year over year as result of: 1) having less cash on hand due to the use of $289 million of cash to partially fund the C-COR acquisition, $76 million to fund share repurchases, and $35 million to redeem the convertible notes and 2) lower interest rates earned in 2008 as compared to 2007.
Gains Related to Terminated Acquisition, Net of Expenses In the first quarter of 2007 we recorded a net gain of $22.8 million related to the proposed TANDBERG Television acquisition which was terminated in March 2007. The gain consisted of a termination fee of $18.0 million, gains of $12.3 million on foreign exchange contracts we entered into to hedge the purchase, offset by expenses incurred of approximately $7.5 million. Other Expense (Income)
Other expense (income) for the three months ended March 31, 2008 and 2007 was ($0.0) million and $0.1 million, respectively, and relates primarily to bank fees.



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