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ARRIS Group, Inc. (NASDAQ:ARRS)

Q3 2008 Earnings Call

October 28, 2008 5:00 pm ET

Executives

Bob Stanzione - Chairman and CEO

Dave Potts - EVP and CFO

Bruce McClelland - President of the Broadband Communication Group

Larry Margolis - EVP

Jim Bauer - VP of IR

Analysts

George Notter - Jefferies and Company

Mark Sue - RBC Capital Markets

Blair King - Avondale Partners

Greg Mesniaeff - Needham

Amit Passi - UBS

Rai Archibold - Kaufman Brothers

Todd Koffman - Raymond James

Simon Leopold - Morgan Keegan

Larry Harris - C.L. King

Ehud Gelblum - JPMorgan

Operator

Good day ladies and gentlemen and welcome to the third quarter 2008 ARRIS Group Inc. Earnings Call. My name is Amanda and I will be your operator for today. At this time all participants are in listen-only mode. We will be facilitating a question and answer session after this conference. (Operator Instructions). As a reminder, this course is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Jim Bauer, Vice President of Investor Relations. Please proceed, sir.

Jim Bauer

Well, thank you, Lynn, and welcome all to the ARRIS conference call with management. This afternoon, we are going to discuss our third quarter 2008 financial results which we released after the close of markets today. As usual, we’ll be using a series of slides during the webcast which are posted already on the ARRIS website in the Investor Relations section.

With us here at the ARRIS headquarters are Bob Stanzione, ARRIS Chairman and Chief Executive Officer; Dave Potts, ARRIS Executive Vice President and Chief Financial Officer; Bruce McClelland, President of the Broadband Communication Group, and ARRIS Executive Vice President, Larry Margolis.

There will be a replay of this entire call approximately two hours after the conclusion of the call and the replay of the call and the slides will also be available at our web site for the next 12 months.

Before we begin, I'd like you to just take a look at chart number two and point out that during this call we will be making or we may be called upon to make forward-looking statements including statements regarding our outlook and expectations for the industry in general, estimated revenue and earnings for the fourth quarter of 2008, our outlook for 2009, certain financial operating metrics, the timing and introduction of certain new products and technologies, spending patterns by some of our customers and expected sales levels for certain product categories.

It's important to note that actual results may differ materially from those suggested by any forward-looking statements which may be made during today's call. And, of course, for further information please see our recent filings with the Securities and Exchange Commission.

Bob and Dave now are going to provide their comments on our results for the quarter and any other topics that you may wish to discuss after which we'll open up for questions and answers on those topics.

With that now over to you, Bob.

Bob Stanzione

Thanks, Jim, and good afternoon everyone. This September quarter was a very positive and eventful quarter for ARRIS and as you'll see in a moment our financial results are the best in our history. But before going into that I'd like to highlight a few points on chart four.

First, as we expected, our business with Comcast rebounded very strongly primarily due to the successful launch of our DOCSIS 3.0 wideband equipment.

Next, our overall CMTS sales in Q3 far exceeded the record level of the previous quarter. With the introduction of our new generation of DOCSIS 3.0 wideband equipment shipments of downstream ports grew from just over 8,000 in the second quarter to over 29,000 in the third quarter. Now Bruce is here and I'm sure you'll have some questions for him about that.

Third, we initiated the manufacture of CPE devices in Brazil to address the high cost of finished goods importation into Brazil. And also this increases our local presence and provides better value to our customers in the growing Latin America market.

The fourth point on the chart is that we also began deployment of our WorkAssure operations support systems software at a large customer in Latin America and we believe that this bodes well for further deployments in the region in the future.

And last but not least, we made a small but meaningful investment with the purchase of the assets of a Massachusetts software company called Auspice. This transaction expands our list of ServAssure customers and when integrated with the rest of our software products makes ARRIS the preeminent supplier of assurance software to the cable industry. We are pleased to be adding 24 very talented Auspice employees to this important part of our business.

Now, let's turn to chart five. In spite of the gloomy economic environment, the financial and business trends that we've been talking about all this year are still firmly in place. Clearly, Internet traffic continues to grow and both residential and especially business customers are demanding faster and more reliable service.

In addition, as we saw for example in yesterday’s report from Verizon on their strong FiOS additions, our customers, the cable service providers, continue to face strong competition and must continue to invest less they fall behind in the race to retain and grow market share. Of course, we've had as we've previously explained a part of our business has been negatively affected by the sharp downturns in household formation and the general economy. Nevertheless as you can see from our results, the good news clearly outlays the bad.

Now, Dave is going to provide a lot of financial detail in a minute but I'm going to steal some of his thunder with chart six.

In the third quarter, our sales reached a record level of just under 298 million, and we generated almost $45 million of cash from operations. Both GAAP and non-GAAP operating income reached record levels for the company and gross margins reached a record of 35.7%.

As I mentioned last quarter, this great gross margin performance which is up almost 900 basis points from a year ago, comes from a combination of our C-Cor acquisition and the successful introduction of new products such as our DOCSIS 3.0 equipment, our business service terminals, operations support systems software, as well as continuing cost reductions and changes to our selling strategy.

Now, let's turn to chart seven. You can see here that we've already reached or in some cases exceeded the operating metric goals that we set forth at our Investor Conference for you in March and hopefully these results will soon begin to be reflected in our multiples.

I know that we all want to look forward, not backwards but please indulge me just a bit further by taking a look at chart eight. A couple of important points; first, the so called lumpiness in our business is often noted. So, please compare the quarterly to the annual graphs. Yes, we do have some quarterly revenue variations but there's nothing lumpy about our five years of steady top line growth. That equates to about 17.5% compound annual growth rate over the period.

Second, take a look at the seasonality. In 2003, the fourth quarter was up; in 2004, it was flat; in 2005, it was down; in 2006, it was up and 2007, it was down. As we've said many, many times, the fourth quarter seasonality is hard to predict.

However, the most important takeaway from this chart is that ARRIS has been a consistent, solid growth story. In fact, during the four years from 2004 to 2007, we more than doubled the size of the company through organic growth. And then this year with our investment in C-Cor, and our continuing investments in new generation of products, we've been able to extend healthy growth into 2008. This is a track record that we are proud of and we are working very, very hard to extend into the future.

Now, let's look forward with chart nine. While we have a fairly good view of the fourth quarter, predicting into 2009 is not easy. No one knows how long or how deep the current economic storm will last and it's clearly not good for anyone's business.

Our informal checks with industry sources are indicating that operators are understandably deliberating longer than usual in setting next year’s budgets. So, we are clearly facing a more uncertain business environment.

On the other hand, positive data points are not hard to find. For example, Time Warner recently announced the launch of HBO Online, another new Internet-based on demand program download service.

Also just last week, Samsung and Netflix announced a service along with a new device for facilitating the download of high-definition movies. And on October 10, CBS and YouTube announced that they began streaming 30-minute episodes of TV shows to consumers and I could go on and on on this topic.

Head lines such as these continue to appear almost daily and support our belief in the continued growth and the widespread deployment of our technology around the world. Clearly, the macroeconomic fundamentals are shaky at best. However, unless this crisis turns into a catastrophe, we remain cautiously optimistic about our 2009 potential.

So with that, Dave, would you now review the financial details?

Dave Potts

Sure. Thanks, Bob and thanks everyone for joining us this afternoon. Let's start by reviewing some financial highlights on chart 11, please.

Net sales were $297.6 million in the third quarter, up 17% from $254.7 million in the third quarter last year. The increase reflects the addition of C-Cor. Including the revenues which C-Cor reported last year, sales from the third quarter of 2007 were $326.6 million.

Gross margin was 35.7% in the third quarter, up from both the second quarter 2008 and the third quarter of 2007. Including C-Cor, the second quarter 2007 gross margin was 32.4%. We are obviously very pleased with this result. This is slightly above the target we set for ourselves by year-end. In our history, we've only touched 36% once. That was in the third quarter of 2002.

SG&A and R&D totaled $60.5 million in the third quarter and was up approximately $19 million year-over-year, primarily as a result of the acquisition. Most importantly, SG&A and R&D in the third quarter of 2008 were down approximately $5.9 million as compared to the estimated combined expenditures of ARRIS and C-Cor for the same period of 2007. The year-over-year decline in operating expenses reflects our good progress on the synergy front.

Our adjusted non-GAAP EPS was $00.24 in the third quarter, which was up from high end of our guidance and is up from both $0.21 in the third quarter of 2007 and $0.15 in the second quarter of 2008.

Our GAAP EPS was $0.19 and compares to $0.25 in the third quarter of 2007. The three significant items to note: First is the amortization of intangibles related to the C-Cor acquisition which was an after-tax expense of approximately $0.05 per share in the quarter. Second, we had approximately $0.03 per share less interest income year-over-year as a result of lower cash balances and lower returns on deposits and investments.

Finally, included in our third quarter 2008 results is a $0.01 per share discrete tax benefit which we have excluded from our non-GAAP earnings. A reconciliation of our GAAP to non-GAAP earnings is attached to the press release and can also be found on our website.

Cash and short-term investments ended the third quarter at $330 million, up just over $30 million from the end of last quarter. We generated approximately $45 million of cash from operating activities, significantly up from the second quarter as a result of our robust earnings and a managed decline in inventory.

Now, let's turn to chart 12 where I've provided some year-to-date highlights please. For clarity, in addition to providing year-over-year GAAP comparisons, we again have provided comparisons to estimated 2007 combined results of ARRIS and C-Cor. Let me touch briefly on a few of the line items. First, reported sales were up nearly $110 million for the first nine months as compared to last year as a result of the C-Cor acquisition.

When compared to the estimated combined sales of ARRIS and C-Cor year-to-date, sales were down approximately $110 million year-over-year. There are two items to note in regards to this. First, Comcast is down $117 million year-over-year, particularly as a result of lower EMTA. purchases. Second, our ATS product sales are down approximately $57 million reflecting tightening spending by our customers on infrastructure.

Operating expenses decreased $10.8 million as compared to the first nine months of 2007 including C-Cor. Within that, SG&A is down $15 million while R&D is up $4 million. With respect to GAAP EPS, it is important to note that we had significant gains from the TANDBERG deal in 2007 which of course has not repeated itself in 2008.

Now, let's move to chart 13 and review some of the details with respect to sales. As you know the C-Cor acquisition has a significant impact. Our reported results compare our new combined company in 2008 to the former ARRIS standalone in 2007. To help you better understand the trends, on our website is a summary of sales and gross margin by segment as reported and including the former C-Cor results.

Let's first focus on the sales by segment bar chart on the top left comparing to our reported sales by segment. BCS sales were $217.7 million in Q3, up from the second quarter of $190.4 million primarily as a result of DOCSIS 3.0 C4 sales to Comcast, partially offset by lower sales of Time Warner versus last year BCS sales were down primarily as a result of the lower EMTA sales to Comcast.

ATS sales were $62.1 million in Q3 and compared to $77 million in the second quarter 2008. Again, and as Bob mentioned, we saw a decline in infrastructure spend by our customers. MCS sales were $17.7 million in Q3, up from $13.7 million in the second quarter.

Let's move to the bar chart on the bottom left. Here, we provide a comparison of the combined sales of the former ARRIS and C-Cor and we also adjust for estimated purchase accounting impacts. ATS sales were $62 million in the third quarter of 2008 and compared to $82.5 million in the third quarter 2007 on a combined basis. Both supplies and [A&T] are down. MCS sales were $21.3 million in the third quarter of 2008 including the estimated deferred revenue purchase accounting impacts and compares to $19.2 million in the third quarter of 2007 on a combined basis.

The pie charts at the top right provide some domestic versus international splits. Please note that this analysis includes the former C-Cor sales from prior periods. As you can see, our international mix is up year-over-year but down from the second quarter 2008. International sales were $77.4 million in the third quarter and compared to $87 million in the second quarter.

One final comment on sales. We have two 10% customers in the quarter; Time Warner and Comcast. Sales to Time Warner were $44 million in the third quarter of 2008 and compared to $75 million in the second quarter. Sales to Comcast were $101 million in the third quarter, up from $47 million in the second quarter 2008 and compare to $109 million on a combined basis in the third quarter of 2007.

With respect to our order backlog and book-to-bill ratio, we ended the third quarter with a backlog of $144 million which compares to $206 million at the end of the second quarter, and $147 million at the end of the first quarter. Our decline in backlog from Q2 primarily is in our BCS segment as we completed many of the initial orders for DOCSIS 3.0 C4s. As a result, our book-to-bill ratio in Q3 was 0.79.

Let’s turn to slide 14 and look at gross margin. Gross margin has been a keen focus of the management team. I'm very pleased with our progress in improving gross margin percentage. It improved to 35.7% in Q3, up from 33% in the second quarter of 2008 and 27% in the third quarter of 2007, terrific results.

As I mentioned earlier, we have hit the year end target we set for ourselves. Let me touch on the individual segments. BCS margin improved to 36.4% in Q3 '08, up from 32.3% in the second quarter of 2008 and 28.3% in the same period last year. The improvement is a result of both product and customer mix and continual cost reduction. ATS margin at 26.8% is down from the second quarter level of 31%. This reflects lower access in transport sales and a less rich product mix.

MCS margin was 57.7% in the third quarter. Given the higher margins associated with these products and the increase in sales particularly as we get through the purchase accounting impacts, this segment is contributing positively to our overall mix. Again, we are very pleased with the result. Of course future results will be very dependent upon mix and continued success of our cost reduction programs.

Let's turn to operating expenses on chart 15. We are also very pleased with our OpEx control. Once again the acquisition comes into play. We have provided both third quarter and year-to-date data for you. On an as reported basis, R&D and SG&A are up as a result of the acquisition. Similarly, amortization of intangibles is up as a result of the transaction.

In the far right-hand column of both blocks, we show what estimated spending was on a combined basis in 2007. As you can see on a combined basis, SG&A is down by about $6.9 million in the third quarter and down $14.7 million through the first nine months. R&D is up. As we have stated, we expect to invest slightly more in R&D.

Let's take a look at some balance sheet and cash highlights on chart 16. We ended the quarter with about $330 million of cash and short-term investments, up $32 million from the second quarter. There are several things to note. First, we generated $45 million of cash from operating activities. Our robust earnings were the foundation of this but as we suggested on the last call, we have also modestly reduced our inventory levels.

Year-to-date, we have generated approximately $86 million of cash from operating activities. Our CapEx was approximately $5 million in the quarter which is in line with our plans. Cash is king in this environment. We are very pleased with our third quarter and year-to-date cash generation and continue to be very focused on prudent working capital management.

Let's turn to guidance on chart 17. At this point, we estimate that fourth quarter sales will be in the range of $280 million to $300 million and that non-GAAP EPS will be in the range of $0.22 to $0.27 per diluted share, and GAAP EPS will be in the range of $0.16 to $0.21 per diluted share.

A reconciliation of GAAP to non-GAAP EPS guidance can be found in chart 18 and is also attached to the press release. Reconciling items include amortization of intangibles and equity compensation expense.

Like many companies, our annual review of the carrying value of goodwill occurs in the fourth quarter. Both our customers and we are in the midst of establishing forecast for the next year and beyond for what I think you would agree are very volatile times. This work will be a key input into the review of our goodwill. Currently, we anticipate and our guidance reflects no impairment. Should our analysis yield any different conclusions, it would impact our GAAP but not our non-GAAP earnings.

With respect to taxes, we are assuming a tax rate in Q4 of approximately 30%. At this point, we project our full year tax rate will be approximately 33%, resulting from the successes of our tax planning strategies.

It is important to note that the R&D tax credit bill was passed in October. As a result, we expect a positive cumulative impact of approximately $0.03 per share on both our GAAP and non-GAAP EPS in the fourth quarter. This too is reflected in our guidance.

Finally on chart 19, we have included a reconciliation of our GAAP to non-GAAP earnings per share for the third quarter and the first nine months of both 2008 and 2007.

Before I turn it back to Jim let me say this. The third quarter was simply a stellar quarter, particularly in the face of very difficult macro conditions. We had record sales of just under $300 million. We had record gross profits. We had record operating income. We generated $86 million of cash from operating activities through the first nine months and we have $330 million of cash. Simply put, the fine men and women of ARRIS have simply executed. Yes, the macro environment is cloudy.

That being said, like Bob, I too am cautiously optimistic and fundamentally believe we have the technology, the products, the relationships, the balance sheet and the people to continue to execute.

With that let me turn it back over to you Jim.

Jim Bauer

Thank you, Dave. That's just great. I want to now open up for questions. Lynn, if you could come back on the line and tell the participants how they can ask their questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of George Notter with Jefferies and Company. Please proceed.

George Notter - Jefferies and Company

Thank you very much. I want to ask about the access business. It was down a good chunk sequentially. My understanding is that is typically a seasonal business, a little bit stronger in the summer times than in the winter time. I know from Harmonic that during their call it sounded like their access business was fairly flat this past quarter. I am wondering if you are losing share; maybe you could talk a bit about what the dynamic is there? Thanks.

Bob Stanzione

George, I do not think we are losing share, but we are definitely hurt by the lower level of household formation, fewer moves that are going on and I think a little bit of belt tightening that is going on in that business.

We benefited by a number of upgrades that were taking place in the past that are done and I think operators given the current economic environment and the fact that there are not many new subdivisions and new streets being built has hurt the entire ATS segment of our business.

George Notter - Jefferies and Company

Got it. Then separately I wanted to ask about EMTAs. I am wondering how fast you expect the shift from DOCSIS 2.0 to DOCSIS 3.0 to really occur. Did you have a meaningful mix of DOCSIS 3.0 in this quarter and again how fast does that transition occur? Thanks.

Bob Stanzione

Now that is one for Bruce.

Bruce McClelland

Hi, George. So, in the Q3 shipments, the 3.0 mix was not meaningful. We do expect that to grow over time as I am sure you know but I think it is going to be fairly modest for some time as the network upgrades proceed and then the marketing strategies and take rates which nobody knows for sure exactly how that will shake out. For Q3, it was not a big meaningful number.

George Notter - Jefferies and Company

If I were to look out for example a year from now, would you expect that to be a substantial percentage of your EMTA mix or what is your thought there?

Bruce McClelland

We do although again we are not sure exactly what that looks like. Given the emphasis on the network upgrades, you have got to believe there is going to be a fairly significant transition to 3.0 in 2009.

George Notter - Jefferies and Company

Great, thanks.

Operator

Your next question comes from the line of Mark Sue with RBC Capital. Please proceed.

Mark Sue - RBC Capital Markets

Thank you. Bob, maybe if you could comment on bookings linearity thus far and qualitative comments on whatever now the cable service providers are slowing or maintaining their spending urgency for the near-term?

Bob Stanzione

Well, for the very near-term meaning the fourth quarter, I think our guidance reflects our thinking about the fourth quarter. We think we are going to end with a pretty darn good fourth quarter.

Looking into 2009, it becomes a little murkier quite honestly because we have not seen any announcements yet from the cable operators and as I noted in my comments even in private conversations with members of the industry, what I am hearing is that they are taking longer to deliberate over what their CapEx plans are for next year.

I really think that next year is not going to be a great year, but it can be a good year because there continues to be this demand for more and more traffic, more and more people using the Internet with richer and richer content as I mentioned. So I think that as Dave and I both pointed out, I think that we are at least cautiously optimistic that we can have a good year in 2009.

I think that the DOCSIS 3.0 rollouts are going to drive our business. One thing that is notable in Bruce's CPE business is the growth of business terminals for small and medium sized businesses and we saw that take a pretty healthy growth in the third quarter.

Mark Sue - RBC Capital Markets

Hey Bob, since operators are still working on their budgets, should we factor in magnified seasonality during the March quarter or should we be modeling a down sequential March quarter?

Then separately for you, Dave; perhaps you would talk to us about the trajectory of gross margin improvements thus far, you could see some snapback in several segments particularly on the ATS side, so we are just wondering about the sustainability of margin improvements in the BCS side?

Bob Stanzione

Let's see, the first part of that. Why do not you answer the margin thing…?

Dave Potts

So, they are trying to predict out beyond what we are already talking about what is difficult. There are so many different things that go into the margin mix between customer and product mix. The amount of upgrades the customers are doing to the installed base versus new net adds of CMTSs, all go into trying to predict what that mix looks like. As you can tell, this is an area we have been real focused on cost reductions across all the programs. So, we are awfully focused on trying to make sure we sustain this.

Bob Stanzione

To answer the first part of your question, Mark, the March quarter, first of all we do not give guidance beyond one quarter and secondly as I said I think it is harder to predict any seasonality in that quarter at this point than it would be in a normal year. Just look at the market yesterday and today and the huge difference in swings in psychology and then motion in the market right now, it just makes it real tough and therefore I would like to wait before commenting on the March quarter.

Mark Sue - RBC Capital Markets

Got it. We have the gray hairs to prove it. Thank you gentlemen.

Operator

Your next question comes from the line Blair King with Avondale Partners. Please proceed.

Blair King - Avondale Partners

Good afternoon. A couple of quick questions, the first one would be, Bob, maybe you could give us some indication as to the thought process on the OSS segment and what is driving investment there and obviously I think that is a bright spot in ARRIS's business and I was hoping you might be able to talk about how that is playing out and what your thought process is in terms of how that business is going to grow both on the OSS side and the VOD side.

Bob Stanzione

Right, I would be glad to. I think the OSS segment or the OSS product line that we have is just one of our most exciting products because it really can sell in good times and bad because it saves money for the operators. We have two types of operations support systems that we sell. One is called ServAssure which is surveilling the network constantly and indicating back to the operators where the trouble spots are so that they can fix them. That is leading to more efficiency in maintaining the network and it also improves customer satisfaction which they dearly need to do.

Then the second segment is called WorkAssure and WorkAssure is a workforce management system so that the work, the thousands and thousands of trucks and technicians that leave the yard every morning to go out and do work are more productive than they would be otherwise and we have proven statistics that indicate that these software systems when deployed properly can save the operators considerable amounts of money. Again customer satisfaction goes up because people are showing up at the right place at the right time more often than they might otherwise.

So, I think in both cases WorkAssure and ServAssure we have got a real great product. It is not a big part of our business but as you can see from the margins in MCS, it is a pretty nice software business that we are growing there and the acquisition of Auspice really enhanced the ServAssure side of the business because Auspice was a big network OSS supplier to Comcast. So, that is helped our business also and we picked up some great talent there too. So, with the VOD side of the business again, everything on demand, all the time and I think that business has equal potential to grow.

Blair King - Avondale Partners

That is great. Thanks for the feedback. Then one last question on the business service side, maybe two more questions but is the business service segment, the MTA group really driving or tracking along as planned on trying to get at the growth trajectory on the MTA side and see that as a good way of doing it. So, has that really come to play and do you see a lot of traction with the business service and particularly on the multi-line MTA and also in residential as you mentioned in your comments?

Bruce McClelland

Yes. Hi, Blair, this is Bruce. So, we had a real solid MTA quarter in Q3. Bob mentioned the growth in the small business, the multi-line products again was fairly substantial in Q3. We do not break those numbers out, but that just continues to grow quarter-over-quarter for us as the operators are focused on that part of their business and try to penetrate the small, medium size business. So, that is doing very well.

Bob Stanzione

I think anywhere around the country you look in the newspapers and you see the advertising that is getting done, promotions like $99 per month for small and medium businesses, phone and high-speed data service, I think as well as video I think it is being pushed real hard and I think it is beginning to pick up steam.

Blair King - Avondale Partners

Dave, one last question. If you do not mind, is there any input on the tax rate for '09, should we just keep that the same 30% through or how would you?

Dave Potts

Not 30%, Blair. For the year what we got to is about 33%. So, I would suggest 33%, 34% for next year is good which is better than what we have been predicting. We have invested a lot of time and effort, the good thing is we are a taxpayer and the bad thing is we are a taxpayer, right? We have invested quite a bit of energy in some good tax planning strategies that have paid. So I would say 33%, 34% is looking about the number for now.

Blair King - Avondale Partners

Okay, great. Thank you.

Operator

Your next question comes from the line of Greg Mesniaeff from Needham. Please proceed.

Greg Mesniaeff - Needham

Yes, thank you. Good evening. As far as your gross margin number for the third quarter, you have clearly hit some very nice milestones here. I am wondering given the mix of CMTS versus EMTAs and other end user products whether as the DOCSIS 3.0 ramp continues through 2009 and the mix shift towards the end user products how that margin profile could shift over the next several quarters whether you are enjoying an unusually nice period right now followed by maybe something a little more moderate or is this something that we can see as a more secular trend going forward?

Dave Potts

Sure, it is Dave. So as we looked at the targeting we put if you remember the top end of it was into the 35% range or so. My thinking behind that or our thinking behind that at the time was it was actually more than just the CMTS, EMTAs you have to get into the AT business which has got optics and RF which have different profiles, also has the supplies which has a different profile and as we saw the opportunity to grow the revenues within the MCS space which adds about 60 points of margins, all of these things come into play.

So my longwinded answer to you is that I still believe that within the range the targeting we put out there is pretty good. We could have some up, some down and if we sell dealing in the EMTAs in the quarter of course it is going to go down, it will take the gross margin dollars every day. We make money and that is the point.

Greg Mesniaeff - Needham

Got you and just two quick follow-ups, I will phrase them in one question. Give us some color on pricing vis-à-vis your closest competitors and also if you could give us some color as to what percentage of your customers perhaps not Comcast but some of the smaller once are currently relying on third-party financing for their CapEx? Thanks.

Dave Potts

I am not aware of any vendor financing as far as third-party financing. I really can not comment on it. I am not aware of any. Most of our customers have pretty solid balance sheets and some would have course operating lines that they would draw in for things but I am not aware myself of any vendor financing per se if that is where you are going.

Greg Mesniaeff - Needham

Gotcha. I was referring to perhaps some of your smaller customers that do not make the greater than 10% list.

Bob Stanzione

Yes. Dave, why do not you elaborate a little bit?

Dave Potts

So the capacity of the marketplace at this stage, we really have not seen an impact in the ability for folks to pay and our track record barring I do not want to even say the word the Adelphia pieces of a few years ago has been very good. We really just do not have exposure like other industries due to bad debts but it is I think perhaps there could be contraction if the capital markets stay the way they are but there really has not been something that we have seen at this stage as being a negative to us. DSOs are hanging in there and our write off history is pretty darn good.

Greg Mesniaeff - Needham

Gotcha. Now just a quick follow-up on the pricing; any indication that any of your customers could potentially be using the deteriorating economic backdrop as an excuse to extract better pricing?

Bob Stanzione

Our customers use every excuse in the world to extract the best prices that they can and we love our customers but they want us to sell our products at low price so that they can get them. I will say that I think our pricing is very competitive. I do not think that there are big outliers out there where one vendor is far below another. I think our market share speaks for itself. We are number one in a number of areas. Number two in others. So, we tend to be the first or second. So I think concerning our pricing, the term that I have used in the past still holds; it is rational.

Bruce McClelland

So, Greg the one thing I would add is that the pricing with our customers that leads downstream if you like, we are no different with our vendors and as we have to buy products, the EMTAs, CMTSs, RFPs. We too are as aggressive as our customers in making sure we get the cost equations.

Greg Mesniaeff - Needham

Thank you.

Bob Stanzione

Greg, thanks. Next question.

Operator

Your next question comes from the line of Amit Passi with UBS. Please proceed.

Amit Passi - UBS

Hi. I had a couple of housekeeping questions. Did you disclose the number of EMTAs shipped in the quarter?

Bob Stanzione

We did not but we will.

Amit Passi - UBS

Okay. Thank you.

Bruce McClelland

Let me tell, I think we are at 1.507 EMTAs, 1.507 million EMTAs in the quarter.

Amit Passi - UBS

That was just the residential two line EMTAs?

Bruce McClelland

It is residential and the multiline products.

Amit Passi - UBS

Got it. Then the number of CMTS chassis in the quarter?

Bruce McClelland

I think we are right at 241 chassis.

Amit Passi - UBS

Got it. Then I was hoping if you could provide some color. It looks like the 29,000 downstream ports that you shipped for CMTS certainly very impressive but I suspect that is obviously a combination of both higher [SP] DOCSIS 2.0 ports and lower SP DOCSIS 3.0 ports. Can you just give some sense of sequentially or maybe on a year-over-year basis, how your CMTS business trended?

Bruce McClelland

Well, let me answer the first part. So, yes, it is a mix of blend of both I call it traditional DOCSIS 2.0 downstreams and DOCSIS 3.0. In case you remember the DOCSIS 3.0 product, it actually splits the upstream and downstreams into different cards and so as we ship DOCSIS 3.0, we are shipping downstream ports but not upstream ports any more and so you will see a shift in how the ASP works because there is different functionality shipping in these blades. So, it was a combination of both.

Amit Passi - UBS

Then just sequentially any color you can give how the CMTS business as a whole performed like on a percentage basis, was it up 15% to 20% more or less?

Bruce McClelland

It was a record quarter both from a port shipment and revenue perspective for us.

Amit Passi - UBS

Okay. Then perhaps one for Dave; Dave, as we look out into '09, what is the best way to think about your OpEx? I mean relatively consistent on a percentage of sales basis, where you end 2008 or should we be thinking about it in absolute dollar basis? Any color you can give us in terms of looking at OpEx in '09?

Dave Potts

Well, I would say I thinking of it in terms of absolute dollar basis and we always have. We want the leverage off of the operating expense base.

Amit Passi - UBS

Okay. Then on the gross margin line, I was curious what the volume leverage is in your business model and where I am going with that is let's just say hypothetically speaking, sales are flat to down next year, should we expect any meaningful downward movement in your gross margins or are your gross margins largely a function of mix and volume does not play as much a role?

Bob Stanzione

Mix, where volume matters is it matters in the AT business plus we do it factories, right? So, there is a fixed element in there and part of the reduction quarter-on-quarter in the AT business, albeit it was really more product mix in that.

So again the way I think about this is I take the multiple inputs of EMTAs, I take the C4s I take RF, I take optics and I take OSS and supplies and really it is the combination of those things and they will vary, they just will. So, there will be some jitter in it but the volume per se been able to cover fixed costs that the more relevant for the AT business where we do have a Maquila in Tijuana.

Amit Passi - UBS

Got it. Then just my final question, any impact the stronger dollar is having in your business either just in terms of you having a harder time competing with some of your foreign competitors or just from a translation perspective?

Bob Stanzione

We sell in euros in Europe. That would be the place one would do that and why would not it be, and we do have forward contracts. So, we are in the business to sell and buy and make margin, so we generally try to hedge our exposures to the best of our abilities.

Amit Passi - UBS

Okay. So, you do not expect any meaningful impact?

Bob Stanzione

No, I do not. It obviously the just the volatility is something that is just not normal. I mean really.

Bruce McClelland

The only thing to think of is the cost of the technology that goes into our products is comparable for our competitors as well. We are all buying in the same technology and the same cost base of it. I do not think there is a substantial competitive advantage for any of us in that space.

Amit Passi - UBS

Got it, okay. Thanks.

Operator

Your next question comes from the line of Rai Archibold with Kaufman Brothers. Please proceed.

Rai Archibold - Kaufman Brothers

Thank you. I have a couple of questions. One is, in the release you all talk about optimism related to Latin America, Europe and Asia. So, I am wondering if you would give us some color in terms of what the source of that optimism is for 2008. Then second, obviously the Comcast deployments have been well documented. I was just curious if you can give us some color in terms of timing for when we should expect to see some of the other North American operators beginning to deploy DOCSIS 3.0?

Bob Stanzione

On Latin America, Rai, I am glad you brought that up because this is one of the places where I can clearly see a revenue synergy that is occurred as a result of our having C-Cor because as you know there are C-Cor products that are being sold in Latin America as well as the former ARRIS products. So a lot of our optimism comes from the increasing presence that we have been able to establish in that market.

I mentioned two things in my comments. One in Bruce's area, he is established local manufacturing in Brazil for EMTAs which has improved our profile down there. I also mentioned that we have begun a fairly substantial deployment of WorkAssure with a Latin American customer who happens to also be a CMTS customer and that is where I can see this synergy actually happening. So, I think that we have got good evidence of both the good market in Latin America as well as our increasing profile in the region. On the 3.0 for other customers, I will let Bruce comment on that. I think we have sold to a number of different customers already in a number of different places in the world.

Bruce McClelland

Yes, we have talked about Asia in the past and particularly Japan and Korea where the battle for higher speeds has been going on longer really than in the US market and so there is certainly a pent-up demand and urgency around 3.0 or wideband higher speed deployments in Japan and Korea.

Europe is a similar environment not the same level of intensity but certainly the competition is pretty high there and having first mover advantage in some of these higher speeds is pretty important. So, I think there is certainly demand in getting deployments accelerated in Europe as well.

Rai Archibold - Kaufman Brothers

Okay. Can I just follow-up on the manufacturer of CP in Brazil for the EMTA? How much of your volume is being manufactured down there and what is the impact on your cost structure as a result of that?

Bruce McClelland

So, there is got to be a reasonable volume to go to the investment of setting up the lines. We are not disclosing geographical numbers but it is a fairly substantial manufacturing rates and really the focus in Brazil is trying to find and optimize solution for the cost of import duties which are pretty substantial for finished goods, so it is just simply a matter of fitting into the business model there and importing raw material instead of finished goods and lowering the overall effect of cost to the operator.

Rai Archibold - Kaufman Brothers

Very good. Thank you.

Operator

Your next call comes from the line of Todd Koffman with Raymond James. Please proceed.

Todd Koffman - Raymond James

Thank you very much. You had made a comment I think in your prepared remarks that you had finished up some CMTS deployments and partly reflected the backlog maybe not being quite as big number. As you look out into 2009, where are you as it relates to the beginning, middle or end of that deployment?

Bruce McClelland

Todd, you are asking about where are we at from a upgrade of the installed base basically?

Todd Koffman - Raymond James

That is exactly right.

Bruce McClelland

So it is obviously difficult for to us comment about where our customers are at with that information. Certainly, we had backlog that was priming the pump in third quarter on the initial launch of the service with some customers and we are back into a normal ongoing mode with orders and shipments in quarter, etcetera, at this point.

I think we are at a fairly early stage of the upgrades obviously. We have only been shipping for three or four months now, so we are having a thought of it in that context, we are in the early stages here.

Bob Stanzione

Todd, the only customer who has been very public about their plans has been Comcast who said that they would have 20% of their footprint enabled by the end of this year and they would have 100% done in 2010.

Now, you have to dig in a little bit under that. It does not mean that if all the subscribers in that footprint it does not mean that all the subscribers in that footprint would be upgraded to do 3.0 by that point. It means that the service is going to be available. So, this is something that is going to go on for quiet sometime.

Todd Koffman - Raymond James

Like any deployment that you have done over a number of different product cycles, there is a period there where you go through that inflexion point where it builds, it builds, it builds and then as I do not know, a third of the way through then the subsequent two-thirds, the business goes on and on and on but it is at a moderating rate. If you just had to take a wild guess and maybe you do not even want to venture out doing this but where would the peak of that spend likely happen. When would the peak of that spend likely happen if you had to guess?

Bob Stanzione

Anybody wants to take?

Bruce McClelland

Gosh, that is a tough one. It is going to differ customer by customer. They are all going to be at different stages at different times to trying to predict. An aggregate peak is literally impossible, but you got the right idea that there is a an initial upgrade of installed base call it city by city or metro area by metro area and as they go along, that it is the first wave but then they have to go back and add capacity as they figure out what the engineering rules are and what the take rate is and frankly they do not no yet. I mean they really do not know what that speed of velocity of deployment is and the take rate. But….

Bob Stanzione

Comes the insatiable demand for new services and all those pieces.

Bruce McClelland

Yes people figure out what to do with that bandwidth it just continues to evolve. It is not a great answer, but that is really what how it is working.

Todd Koffman - Raymond James

Thank you. Good luck.

Operator

Your next question comes from the line of Simon Leopold with Morgan Keegan. Please proceed.

Simon Leopold - Morgan Keegan

Thanks. I wanted to see if you could talk to what mix assumptions you have in your guidance for the December quarter? Typically, I would imagine it is a slower quarter for EMTAs. Then I think trying to follow on, how you think things are trending in '09 in terms of the overall mix and how the company is evolving from a historically lower margin business into the higher margin CMTS products? How you see that shaping out through '09?

Bob Stanzione

Let's see, mix assumptions for Q4, I think the mix will be similar to Q3. I do not see any startling mix shifts that would occur in this quarter. Quite honestly, I do not really think we are going to see a huge shift in 2009. I think there is still going to be a large demand for the CMTS. We will sell more 3.0 modems in 2009 but those are substitutions for what would otherwise be 2.0 modems.

So, Simon, I do not think it is going to shift too much and I think that you go back to Dave's comment about the range of goals that we have and we think that we will be operating within that range most of next year.

Simon Leopold - Morgan Keegan

Yes, within that broadband segment in the old segment discussions it used to be clearer EMTAs around 20% and CMTS around 40%, both plus or minus and you seem to be doing very well with that blend. If you could maybe talk to what are the levers on that the old segment discussion of the EMTAs? Have you gotten that above the 20% range, have you gotten the CMTS back over above 40, how do we think about what is going on there?

Bob Stanzione

I would say yes, yes, we are above 40 and we are above 20 and really do not want to disclose beyond that. It just becomes too apparent to our competitors as to what we are doing.

Simon Leopold - Morgan Keegan

These are sustainable. So I think.

Bob Stanzione

We think so, yes.

Simon Leopold - Morgan Keegan

It is how sustainable are the results, we do not want to see a flame out because it is big orders and then it is gone. That is really what we are looking for.

Bob Stanzione

Right, I understand. Again, it is one quarter at a time for us in terms of guidance, a specific guidance and we will see what next year holds. I think that given the macro environment, it is a little more confusing than it would be otherwise but I think that people are going to stay home and use their computers a lot next year and I see just constant announcements of new things that are putting more pressure on the network.

Another thing that we do not know yet but although I anticipate that it will help our business is the Teleco reaction to the deployment of DOCSIS 3.0 by the cable companies. I do not think they are going to sit back and do nothing. I think they are going to send something back. So, I think that could bode well for us.

Simon Leopold - Morgan Keegan

Sure. Then just to close out my question, thoughts about the customer mix; you had a nice flip-flop this quarter, Time Warner down and then Comcast up big, how do you think about the customer mix in the fourth quarter?

Bob Stanzione

Again I think it will be somewhat similar to the third quarter. Go back to my point about looking at ARRIS year-to-year as oppose to quarter-to-quarter. These things do flip from quarter-to-quarter and what if two of them flip the same way in one quarter, then everybody is terribly alarmed. I do believe that year over year over year that we could continue to score solid growth.

Simon Leopold - Morgan Keegan

Okay. Thank you very much, Bob.

Bob Stanzione

Right.

Operator

Your next question comes from the line of Larry Harris from C.L. King. Please proceed.

Larry Harris - C.L. King

Yes, thank you. Did you indicate the number of cable modems that were shipped in the quarter?

Bruce McClelland

That was about 80,000.

Larry Harris - C.L. King

Okay, great. In terms of the timeframe say between the shipment, the upgrades to DOCSIS 3.0 and when commercial service can be turned on based upon your announcement of a significant order in the May timeframe and the initial service in the Philadelphia and Boston and other markets soon.

Should we be looking at around a four or five-month lag on the initial markets between say when you ship the product and when the cable operators might turn on service and then that would decline over time, how should we be thinking about it?

Bruce McClelland

I would not think it would be that duration Larry. I mean, obviously the initial startup phase was more extended. I think, we will be into a more normal ship and deployment cycle which is shorter than that.

Larry Harris - C.L. King

Okay, alright. More like three months or two months…?

Bruce McClelland

Depends on the operator and their procedures; I mean some go into service extremely quickly and some take longer depending on the amount of reconfiguration going on in the network.

Larry Harris - C.L. King

Understood. In terms of modular cable modem termination system, is that product still in development, could we see it say in the second half of next year?

Bruce McClelland

It is although there continues to be no wait for if you will on the product we have today. That is absolutely what is going on with the integrated approach and, Larry, you and I have talked multiple times about the value of the integrated CMTS and the reliability, redundancy, all those sorts of things that I think the customers resonate with.

Larry Harris - C.L. King

Great. All right. Well, thank you very much.

Operator

Your next question comes from the line of Joe Parker with Oppenheimer. Please proceed.

Unidentified Analyst

Hi, just had a couple of questions here. You had a record quarter of port shipments on the CMTS side, just wanted to see what type of traction or outlook you expect going forward? Is this something that you think will be sustainable and also if you could get an update on your share repurchase program and what your take is on there? Thanks.

Bob Stanzione

So, during the quarter we did not announce any additional share repurchases but that is a program that is certainly active and alive for us.

Unidentified Analyst

Okay.

Bob Stanzione

Bruce, on the…

Bruce McClelland

We are not looking out much further than fourth quarter. We think we are going to have another solid quarter of shipments of both CMTS and CPE product in Q4 as I think you can see from our forward-looking guidance here.

Unidentified Analyst

Okay. Thanks.

Operator

Your next question comes from the line of Ehud Gelblum with JPMorgan. Please proceed.

Ehud Gelblum - JPMorgan

Hi, thank you. It was a fairly strong cash quarter. The press release said you generated 45 million in cash. As you look to next quarter with the numbers being relatively similar, a little bit low on the revenue and little bit higher on the EPS, both about the same actually. Do you expect the same cash flow generation next quarter?

Dave Potts

I think it might be a bit less if perhaps timing of the tax payments would be one thing we have to consider, but I do believe we will generate meaningful cash in the fourth.

Ehud Gelblum - JPMorgan

Then if we model out in the next year I know you do not know exactly what the revenue is but if we assume that roughly speaking we are at the same quarterly level. So, we should be assuming that the cash flow is in that same vicinity of $40 million plus per quarter as we go through next year or the special things going on your capital that we have to take into account?

Dave Potts

Back into the way I look at this is it is get to good old fashioned EBITDA and then what should happen with working capital management. I think we are pretty darn good again at receivable management, inventory management and in payables that go with it. Some timing of tax payments in between, but you look to the sustainable underlying earnings; that is fundamental.

Bob Stanzione

Once again…

Ehud Gelblum - JPMorgan

86 year-to-date, right?

Bob Stanzione

Yes, there you go. Dave said 86 year-to-date, so you can not just look at one quarter and project. You have to…

Ehud Gelblum - JPMorgan

What I was asking is it stepped up a lot this quarter. So, we should be looking more of that smooth $30 million, $25 million to $30 million a quarter that we have now seen for three quarters, that is the 86 over three quarters as oppose to 45 in one quarter, is that a better indication?

Dave Potts

Yes, if you again just go back to the sustainable earnings piece of it that should be giving you the answers, right.

Ehud Gelblum - JPMorgan

We are now entering a new phase of DOCSIS 3.0 deployments that will last for a little longer which we did not really have in Q1 and Q2 of this year and so that is probably a part of the cash flow, so I would imagine cash flow could be a little bit stronger as you go through '09 than it was in Q1 and Q2 of this year or is that incorrect?

Dave Potts

Then you have obviously the customer mix piece so we have with better sales with Time Warner in the first half. We will see what happens in the first half of 2009. Again back to Bob’s point we are focusing on individual pieces but in the aggregate, we are hoping the sustainability is there. The number that you have out there, you said 45, we did have some inventory decline this quarter which was there and again probably lower than average tax payments in the fourth, we will have some of that. I do not think inventory will move. I do not think receivables will move meaningfully. So the number that you are into I think is a reasonable range.

Ehud Gelblum - JPMorgan

Okay, helpful. Last thing, as you talked to your cable customers not just in the US but overseas as well, cable customers have this, they always have this tendency to spend their money too quickly and then limp into the end of the year.

You have traditionally had a book-to-bill below one as you enter the fourth quarter part of the way the business runs. Are there any indications that you are picking up that some of the spending that some of the cable companies have come close to the end of their budgets and given what is going on around, they may curtail a bit earlier than we all were expecting?

Bob Stanzione

I think that our guidance reflects what our best guess is to what we think is going to happen towards the ends of the year. We think that we are aware of some customers that are asking us to get some stuff to them before the end of the year and others have run out of budget and are not buying much the rest of the year. So, I think the guidance answers that question.

Ehud Gelblum - JPMorgan

Okay. Thanks so much.

Bob Stanzione

If I understood the question…

Ehud Gelblum - JPMorgan

It was. I mean obviously guidance takes all these things into account but the question is were there somebody who three months ago seem like they would have been spending more in the fourth quarter and now because of budgetary constraints is not and that is factored into your 280 to 300 but given what they were showing you three months ago, not from the economy but from the way they spent money in Q3 possibly and other things it brought you there but it otherwise would have been higher.

Bob Stanzione

I can not think of anything like that.

Ehud Gelblum - JPMorgan

Okay. Thanks, Bob.

Operator

Your next question comes from the line of Kevin Miller with RBC Capital Markets. Please proceed

Unidentified Analyst

Thank you. I just have one question regarding your convertible debt. The debt has been trading in the 50s and everything we just heard seems to be driven by non fundamental reasons. So I was curious if you would look to buyback some of the debt and I realize it is 2% not due for five years but it just appears to me it could be a rare and accretive opportunity?

Bob Stanzione

Sure, but it is a onetime gain so that partly goes into our thinking. That is 2% money which on our capital structure is a wonderful source of financing, obviously. So you line that up against the continuation of a share repurchase program and the forward accretion dilution and that versus using the funds as we have grown this business organically and through acquisition and so making sure we have the fire power to do that and making sure we have the working capital buffer through what is the turbulent times. So, yup, we have looked at all of them and continue to look at all of them but boy, it is nice to have 2% money in my capital structure at this stage.

Unidentified Analyst

I agree with that. Just trading in the 50s it just seems like it is really been driven by non fundamental reasons that it just looks like very rare opportunity.

Dave Potts

We agree with that.

Jim Bauer

Well, we have probably come a little bit longer or actually over our scheduled time. So, I think we are going to bring the conference call to a close. Bob if you got any closing comments that you want to make.

Bob Stanzione

Just, thank you all for listening and following through this presentation. We are really pleased with the momentum that we have got going into the end of the year and just stay tune to see what happens in 2009.

Jim Bauer

With that, we have come to the end of the call. Lynn, any closing comments?

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day.

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Source: ARRIS Group, Inc. Q3 2008 Earnings Call Transcript

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