ARRIS Group Q2 2009 Earnings Transcript

Jul.31.09 | About: ARRIS International (ARRS)

ARRIS Group, Inc. (NASDAQ:ARRS)

Q2 2009 Earnings Call

July 30, 2009 05:00 AM ET

Executives

James A. Bauer - Vice President of Investor Relations

Robert J. Stanzione - Chairman, President and Chief Executive Officer

David B. Potts - Executive Vice President, Chief Information Officer and Chief Financial Officer

Analysts

Mark Sue - RBC Capital Markets

Nikos Theodosopoulos - UBS Securities

Greg Mesniaeff - Needham & Co.

Todd Koffman - Raymond James

Lawrence Harris - CL King & Associates

Simon Leopold - Morgan Keegan & Co.

Brian Coyne - Wedge Partners

Ari Bensinger - Standard & Poors

Ted Moreau - Cardinal Research

Operator

Good day ladies and gentlemen and welcome to the Second Quarter 2009 ARRIS Group Inc. Earnings Conference Call. My name is Amity and I will be your coordinator for today. At this time all participants on a listen-only mode. We'll conduct question-and-answer session towards end of this conference. (Operator Instructions)

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

James A. Bauer

Thank you Amity and welcome all here on the ARRIS conference call with management today. This afternoon we are going to discuss our second quarter 2009 financial results, which were released shortly after the close of the markets today.

As usual, we will be using a series of slides during a webcast and those slides would be posted on the ARRIS website in the Investor Relations section. With us here at ARRIS headquarters are Bob Stanzione, Chairman and CEO, Dave Potts, Executive Vice President and Chief Financial Officer and several other senior ARRIS management including Bruce McClelland, Larry Margolis, Jim Lakin, Bryant Isaacs and John Caezza.

There will be a replay of this entire call available approximately two hours after the conclusion of this call and an additional replay of the call and the slides will be available on our corporate website for the next 12 months.

Before we begin, let's go forward if we would in the webcast to chart number three, I would like to point out that during this we will be making or we may be called upon to make forward-looking statements, including our statements regarding our outlook and expectations for the industry in general. I think you will see that forward-looking statements on chart number two actually. And we'll also be talking about estimated revenue and earnings for the third quarter of 2009.

Our outlook for 2009 as well certain financial operating metrics, the timing and introduction of certain new products and technologies as well as anticipated 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. For further information in this regard for specific examples of risk that could cause actual results to differ, please go to our recent filings with the SEC and with that said, let's go on forward to one chart number 3 I believe and I want to turn it to over to Bob Stanzione.

Bob is going to provide his comments along as well as will Dave B. Potts on our results and then we will open up for your questions and our answers.

With that over to you Bob.

Robert J. Stanzione

Thanks Jim and good afternoon everyone. I would like to turn your attention to chart four please.

I am extremely pleased with the results that we're reporting this afternoon. Q2 revenues were up approximately 10% sequentially. Gross margins set a new record of 42.1% representing continued strong sales of our new DOCSIS 3 routers and a record breaking performance by our MCS segment.

Cash flow was spectacular with our cash balance up almost a $100 million during the quarter. Most importantly $0.27 of adjusted earnings per share exceeded the top end of our guidance.

This year in spite of very challenging global economic factors, our earnings improvements have just been outstanding. On an adjusted basis compared to the first half of 2008, earnings per share are up by 67% from $0.27 to $0.45 per share. Operating income and net income are both up 61% and our cash balance is up $226 million from a year ago.

And we have not done this by cutting expenses; we have actually increased our investment in R&D by about 5% compared to the first half of 2008.

Now before, Dave presented the details let me share a few observations and highlights. Although overall sales in the quarter we're within less than a point percent of the prior year. I was somewhat disappointed that our international and ATS sales didn't bounce back as much as I thought they would. It's true they were up during the first quarter or up from Q1 international sales are still below last year's level.

We think this is attributable mostly to the severe currency fluctuations and credit restrictions that occurred late in 2008. ATS product sales continued to be affected by the general economic climate. However, we expect that these aspects of our business will recover and provide additional growth opportunities in the longer term.

On the more positive side, internet traffic growth subscriber demand for more control of program content and the ever present competitive pressures that our customers face have provided us with opportunities to strengthen our company as you can see in these impressive overall results.

Now let's go to chart 5 please. Starting with the BCS segment. BCS had a great quarter, the sales were 11% year-over-year and up 9% sequentially. We continue to see strong demand for our CMTS with revenues reaching another all time high.

The DOCSIS 3 rolled out is going extremely well as operators around the world are beginning to transition to this new technology platform.

Total downstream shipments were over 32,000 again this quarter and with internet traffic growing at about 30% a year we expect this business to remain strong for quite some time. CPE shipments were down approximately 4% during the quarter to 1.27 million devices as the weak economy continues to affect demand.

However, this remains a key profitable business and our market share continues to be very high. Growth should resume as the economy recovers and our product mix shifts to higher speed DOCSIS 3 and more highly functional devices. We now anticipate this beginning in earnest in 2010.

Chart six please. Our MCS segment was up sharply in the quarter as operators react to the need to reduce operating expenses, improve network reliability and provide more on demand services. I should mention that we score a significantly WorkAssure revenue at the end of the very end of the quarter that we previously expect it would come in Q3.

All in, MCS sales were up sequentially by 42% in the quarter to their best level ever. Looking now, at ATS the weak housing market cautioned about new plant construction and fewer new subscribers continue to impact the Access, Transport and Supplies businesses.

Results improved marginally in the quarter but not as much as I expected. We took steps late in Q2 such as work force reductions in our Tijuana factory and in-sourcing of repair operations that should result in improved profitability in the ATS business as the year goes on.

Looking forward on chart 7, I see reason for optimism as general business trends are improving. In general our customer's customers need to communicate and they want to be entertained and they want to communicate and they want to entertained faster and they want more choices.

Hence internet traffic continues to grow at faster rate and network capacity and capability must improve. I see the DOCSIS 3 wave gaining momentum with CPE picking up as the year goes on. Pressure for operators to reduce OpEx and improve service will create more opportunities for our assurance products and competition among service providers is not letting up any time soon. Therefore, I believe the outlook for Q3 and beyond is very good. Let's go to chart eight.

Now thinking ahead to your question and answers I'm sure the first question is going to be can we sustain these high gross margin levels. And the answer is yes, based on what we see coming we believe we can stay in the range of 40% for the third quarter probably for the rest of the year and beyond. We think we can sustain these levels due to the strong acceptance of our new products as well as our expected customers and product mix.

As well as the continued cost reduction work across all of our product lines. While we are very pleased with our improved profitability this year the more difficult question is when the economy might pickup and when we'll see robust top line growth.

I think we have a fairly good view of the Q3 sales but we continue to see caution being exercised by our customers, making long-term commentary very difficult. As you all know the fourth quarter is almost unpredictable. Nevertheless, we remain confident that as the economic recovers, ARRIS is well positioned to grow as well.

We have some very exciting new products in the pipeline and rather than cutting back as I said earlier we are increasing our investment in R&D in order to further improve our competitive position and to accelerate time to market for important enhancements to our current products and for some new ones.

Chart 9 please. So in summary I want to say that ARRIS has never been stronger and we've never been in better position for long-term growth. We have high sustainable market shares in our key product areas; we are more involved with our customers in planning next generation products than ever before.

And we have a great financial profile and a strong balance sheet giving us a solid foundation for continued growth. ARRIS is a healthy company and we are operating in a healthy segment of the economy. So thank you and like for Dave to take it from here.

David B. Potts

Thanks Bob and thanks everyone for joining us this afternoon.

Now before I get into the details, I think as Bob pointed out, this quarter's results were among the best that we've every posted as a company. Our profitability is up significantly both sequentially and year-over-year. The year-to-date on a non-GAAP basis, our EPS is of $0.18 or 67% from last year.

Our gross margin percent in the quarter was 42.1% by far an all time high. We generated $94 million of cash from operating activities in Q2 and $108 million in the first half. And I think it's also very important to know that we continue to invest aggressively in R&D. Again as Bob mentioned we see significant opportunities in front of us and we plan to invest to reap the benefits.

Okay, let's get into some of the Q2 details starting with the financial highlights in chart 11 please. Sales were $278.5 million in the second quarter which is down slightly from 281.1 million in the second quarter last year, but up from 253.5 in the first quarter of 2009.

I'll provide a break down by segment in just a moment. Gross margin was 42.1% in the second quarter, up from 33% in the second quarter of last year and 37.7% in the first quarter of 2009. And we are obviously very pleased with this result. Our adjusted non-GAAP EPS was $0.27 in the second quarter which compares to $0.15 in the second quarter of 2008 and $0.18 in the first quarter of 2009.

Our second quarter 2009 GAAP EPS was $0.18 per share and compares to $0.06 per share in the second quarter of 2008. Some significant items to note first, is the amortization of intangibles related to the C-COR acquisition which was a before tax expense of approximately $9.3 million in the quarter as compared to $12.5 million in the second quarter of last year.

Included in our GAAP earnings is non-cash interest related to our convertible debt this was $2.7 million in both the second quarter 2009 and 2008. And as required by the new accounting pronouncement FSP 41-1, we've revised our historical financial statements to include the impact of the new rule and as always a reconciliation of our GAAP to non-GAAP earnings is attached to the press release and can also found on our website.

Cash and short term investments were up significantly. We ended the first quarter with $524 million up approximately $100 million from the end of last quarter. We generated approximately $94 million from operating activities in the quarter. I will touch on the balance sheet and cash a bit more in a few minutes but obviously a terrific result. With respect to orders our backlog was a $166 million at the end of the quarter and our book to bill ratio was 1.04. Okay let's turn to chart 12 and look at some of the second quarter sales details.

First, let's focus on sales by segment bar chart for the second quarter comparing our reported sales by segment. BCS sales were 211.8 million in Q2 up from the second quarter 2008 of a 190.4 million and up from a 191 probably 194.1 million in the first quarter 2009.

It is also important to note that sales mix is quite the same, particularly year-over-year we have a larger percentage of DOCSIS 3 CMTS sales. You will see this in our margins in a moment. ATS sales were $43.4 million in the second quarter and compared to $77 million in the second quarter of 2008 and $43 million last quarter.

We continue to see cautious infrastructure spend by our customers and our customers delaying upgrade projects which was not the case in 2008.

MCS sales were $23.3 million in the second quarter as compared to $13.7 million in the same period last year and $16.4 million in the first quarter of 2009. This represents the highest quarterly sales levels ever for these products.

Sales in Q2 last year were impacted by approximately $4.7 million of purchase accounting affects. Let's turn to our geographic split. Our international sales were $73.7 million in the quarter up from the first quarter 2009 but down from the same quarter in 2008.

One final comment on sales; we had two 10% customers in the quarter, Time Warner and Comcast, sales Time Warner were $53 million in the second quarter, sales to Comcast were $97 million.

Let's turn to chart 13 and look at some of the details with respect to gross margin. Our second quarter overall gross margin was 42.1% which compares to 33% in the second quarter of 2008 and 37.7% in the first quarter of 2009.

The year-over-year increase is primarily related to the highly successful introduction of our DOCSIS 3 CMTS in the second half of last year, the improvement in the level of MCS sales and the mix effects of having lower EMTA and ATS sales.

Our gross margin percent for BCS was 43.8% in the second quarter 2009 as compared to 32.3 in the second quarter last year and 40.7% in the first quarter of 2009. The gross margin percent of our ATS segment was 22.6% up a 100 basis points from the first quarter however down from 31% in the second quarter of 2008.

The decline year-over-year reflects a number of factors including lower access and transport sales in the quarter as a percentage of the overall mix.

Lower margin related to certain Optic products and the decline in the overall volume. The margin percent for MCS was about 63% in the quarter, up sharply from 44.6% in Q1. The increase relates to product mix and higher volume.

As we mentioned before performance in this segment can be a bit lumpy as revenue recognition is significantly tied to the customer acceptances and relatively large non-leaner PLs for licenses. As Bob mentioned earlier this lumpiness have some positive impact in the quarter received in order for licenses related to our project very late in the quarter which frankly we were not anticipating until Q3.

This had an impact of about $2 million which of course will come out of Q3. Anticipating your question and again it all depends upon the mix I believe Q3 margin should be in the similar range to what we've achieved in the past couple of quarters and I guess if I would look at it right now its 40% perhaps just a bit more but we'll ultimately see what happens as we get deeper into the quarter.

So, let's turn to operating expenses on chart 14. As expected, operating expenses increased sequentially.

Total R&D and SG&A was $69.2 million in the second quarter up $5.5 million from the first quarter 2009 and up $4.5 million from the same period last year. On a year-to-date basis total R&D and SG&A was $133 million for the first six months of '09 up $3.2 million from the same period in 2008.

With respect to SG&A second quarter 2009 expenses are $2.1 million as compared to the second quarter of 2008. The increase reflects high variable compensation costs and particular sales commissions and incentive approvals and higher legal cost associated with pattern and other litigation matters.

Legal costs were up by $1.7 million year-over-year. For the first six months of 2009 total SG&A expenses are essentially flat as compared to the same period in 2008. Within SG&A, legal costs are up about $2.9 million year-over-year offset by savings achieve from the integration of C-COR.

With respect of our R&D second quarter 2009 expenses are up $2.4 million as compared to the second quarter 2008 and for the first six moths of 2009, total R&D expenses are up $2.7 million as compared to the same period in 2008. And as we stated we're incrementally investing in R&D.

Included in overall operating expenses is amortization intangibles which declined $3.1 million in the second quarter 2009 as compared to the second quarter 2008. For the first half of 2009, amortization decreased $7.2 million as compared to the same period in 2008.

The vast majority of the amortization relates to the C- COR acquisition and the decline reflects a completion of amortization of certain intangibles in 2008, specifically the order backlog.

All right, let's move to chart 15 and review some of the balance sheets items. We ended the quarter with $524 million of cash in short-term investments as compared to $424 million at the end of the first quarter. Some things to note, first we generated approximately $94 million of cash from operating activities in Q2.

Let me touch on some of the pieces. The elements of earnings which are cash based were approximately $43 million. We generated approximately $51 million of cash from working capital on the quarter. Our accounts payable that include liabilities were up $13 million from the end of the first quarter. Within that our AP for inventory increased which was essentially a function of timing in our equity compensation increased reflecting the reports.

Our accounts receivable were lower by about $27 million reflecting timing or payer patterns of our customers. Our inventory declined by about 5 million; this was partially timing and partially an effort to reduce levels. And finally we had net $6 million change in other items including such things as tax expense.

We have classified our loans -- our singular loans $5 million auction rate security from long-term to short-term in Q2 resulting in an increase in cash and short-term investments. You may remember we've put auction for this instrument which we can exercise on the second quarter of next year. And we raised approximately $6 million in cash from the issuance of share as a result of employee stock option exercises in the quarter. And finally CapEx was approximately $6 million in the quarter which is inline with our plan.

So our balance sheet position is very strong. Cash continues to be king in this environment. We remain very focused on cash generation and prudent balance sheet management. I believe we'll continue to generate cash with the balance of the year or be not at the rate we enjoyed in Q2.

In fact its possible we may have to invest a bit more on working capital as year goes on depending upon cash collection patterns.

Okay. Let's turn to guidance on chart 16. At this point the third quarter of 2009 we estimate that sales will be in the range of 260 to 280 million in that non-GAAP EPS will be in the range of $0.22 to $0.26 per diluted share and GAAP EPS will be in a range of $0.14 to $0.18 per diluted share. Our guidance reflects slightly lower sales of these year's products relative to Q2 and the impact of the timing of the MCS project I mentioned a moment ago.

Reconciliation of GAAP and non-GAAP EPS guidance can be found in chart 17, it is also attached the press release. Reconciling items include amortization of intangibles, equity compensation expense and non-cash interest debt.

And finally on chart 18 we've included a reconciliation of our GAAP, non-GAAP earnings per share for the second quarters of 2009 and 2008.

That concludes my remarks and thanks and let me turn back over to Jim Bauer.

James A. Bauer

Thank you Dave and we will now open up for questions and Amity, if you could come back on line and just tell us how to proceed, we'll get under way.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from the line of Mark Sue, RBC Capital Markets. Please proceed.

Mark Sue - RBC Capital Markets

Thank you. Without the international ATS weakness which have come in behind of your guidance how back in loaded was the international ATS sales. And I guess the higher level question is as most accounts weak economic environment is better now than a quarter ago and they carry a commitment to DOCSIS 3.0 stronger than before and you're seeing sequential growth in your backlog. Why would the guidance imply down quarter sequentially in revenues?

Robert Stanzione

See the first part, we would have been higher yes sure we would have been higher if international is been higher. We at the end of last year we saw fairly substantial derivations in currencies and we had some credit restrictions that kicked in and it was it's been slow getting starter on international this year.

I thought we would getting more momentum in the quarter than we did. Same thing goes on ATS I felt like we would have more growth in ATS after the low first quarter that we did it was up slightly in the second quarter. The second question, second part of the question about DOCSIS 3 is doing so well, why are we guiding such as we are.

I think we are now it's not the time to be giving really aggressive guidance in the market place there is a lot of momentum in this DOCSIS 3 business more and more of our revenue is coming from DOCSIS 3 but DOCSIS 2 is declining. So I will ask Bruce to comment further on that.

{C: Bruce McClelland: President Broadband Communications Systems:} Glad I know I think the what we have seen on the standard voice over IP DOCSIS 2.0 E-MTA businesses is a real flattening of or softness in the so as we've increase shipments in sales of our DOCSIS 3.0 equipment the DOCSIS 2.0 is in trending in the other direction, so we're just trying to watch out that blend plays out the second half for the year and the DOCSIS 3.0 network equipment upgrade of continue to proceeded at the pretty aggressive pace.

But the DOCSIS 3.0 CPE shipments have grown at the same pace and so you're just kind of seen that blend and see how that plays out. We like the DOCSIS 3.0 business did increase this quarter fairly well compared to last quarter. But its still a little unpredictable just how aggressive operators worldwide they're going to be with that and finds that's probable the best explanation we have for you.

Mark Sue - RBC Capital Markets

With the DOCSIS 2.0 trailing of I guess a little bit faster then what most people have thought. Should we kind of think about the business returning to normal seasonality which implies a down December quarter or do we kind of muscle through that where DOCSIS 3.0?

Robert Stanzione

Yeah I think if you look back over the years the fourth quarter is down more often then it's up. I think we're just too early in the year to be predicting how the fourth quarter is going to come out. Some years it's a boomer because operators are willing to bring in equipment at the end of the year to utilize budget that they haven't utilized up to that point in time. And sometimes they run out early, so it's just really hard at this point. And I wouldn't want to be giving fourth quarter guidance at this point.

Mark Sue - RBC Capital Markets

Okay. Thank you gentlemen and good luck.

David Potts

Thanks.

Operator

Your next question comes from the line of Nikos Theodosopoulos with UBS. Please proceed.

Nikos Theodosopoulos - UBS Securities

Yes. Can I ask a couple of questions on the BCS business?

So if I...I mean it's fair to say that the percentage of quotes continues to shift towards CMTS. As that happens and just looking at the way the revenues are increasing, and is it fair to say that the average ASP report is increasing sequentially and it just seems from the growth margin trend in the last three quarters that the gross margin on the DOCSIS 3.0 CMTS systems is higher than the traditional margin. Is that something that you consider to be sustainable over the longer term or is there something in the short term that's causing that?

Robert Stanzione

So its some, it's a little difficult to model because it's three or four moving parts here. You know depending on the type of configuration you know if an operators upgrading excising systems or Greenfield systems that the mix of software and hardware and even that the different margins on the product will change and you add in the service element which become the larger portion of business overtime and so the margins can be moved around little bit.

So, fortunately in second quarter we had fairly positive mix as far as the mix of 2.0 and 3.0 CMTS and the mix of upgrade versus Greenfield kits and that resulted in slightly different margin profile perhaps that we had in first quarter. And we obviously take a look at with third quarter looks like and reflect it our and what we talked about already.

Hey that's why I mean that's really the factor and what's mover the margin percentages around more than save ASP's of suddenly jumped up I wouldn't characterize that way.

David Potts

That's about the fact the ASP's per downstream were down from DOCSIS 2 to DOCSIS 3 that's the big advantage of DOCSIS 3 is that the cost per downstream is much lower for the operator but they have to bound for this channels together.

So we've seen CMTS sales go up fairly steadily over the past 12 months. And we expect them to remain robust and overall we've got a very different margin profile in the company then we had a year ago. And we think we can sustain it.

Nikos Theodosopoulos - UBS Securities

Okay. Just a quick follow up. Do you have the upstream code number?

Robert Stanzione

I do not have that handy. No. I don't have that Nikos.

Nikos Theodosopoulos - UBS Securities

Don't have that. Okay. All right thanks.

Operator

Your next question comes from the line of George Notter with Jefferies & Co. Please proceed.

Unidentified Analyst

Hi guys. This is actually James in place for George Notter. So first question you eluded to the percentage of business that is, DOCSIS 2.0 have been down, in the past you said four percentage of the business, where do you think that is now?

Robert Stanzione

On the CMTS side, in the second quarter it was greater than 60% DOCSIS 3.0 and again I think we will see that continue throughout the rest of the year just incrementally more and more as people are using, the new technology so just, to add capacity to the network whether they launched a DOCSIS 3.0 service center and so the second part of the question is really is on the CBE side, that mix shift is normal nearly that dramatically yet at this point.

Unidentified Analyst

Okay do have been, how many chassis were shipped this quarter?

Robert Stanzione

I don't think we've mentioned it, yes I have it here. I think 214 chassis we did in this quarter.

Unidentified Analyst

Just to relate this, mix of assets on the 2.0 and a profitability on 3.0, I just understand as a pretty major software upgrade that you need to when you upgrade an existing C4 to just I am curious, how is the mix of software revenue in DOCSIS 2.0 business related to DOCSIS 2.0. Can you give us a feel for that in anyway?

Robert Stanzione

Yeah, I guess it's a little tough to break that for you, both obviously have a software and a hardware element and a part of upgrading the 2.0 system to 3.0 is a software upgrade to the existing hardware and think we have talked about the, now big advantage we've had of building at install base and being able go back now in upgraded.

So both hardware and software. So there is a larger software element there.

Unidentified Analyst

Okay. And thank you very much for the final question. I understand that some operators, I mean I know the acreage are really low right now, for DOCSIS 2.0, I would imagine in this economy a $100 service is not really advertising for a lot of consumers and I understand and there is not a lot of turnover in terms of rules changes.

But I understand some cable operators are choosing to deploy cable modems, cable modem along side E-MTA's is about bringing in to DOCSIS 3.0. I am just curious are you seeing that given that the trend that would continue for a while on a future perspective on that, that's it.

Robert Stanzione

So there are some operators that manage or call them non conversed network, they manage the voice network separate from the data network and so if they are wanting to increases the speeds on the data service, even today is an example of putting E-MTA and data modem together into a host.

So, there are some operators that will do that to upgrade the 2.0. Generally speaking, I don't think that's a real trend, of I think the general trend is for a high end triple play customer.

The strategies have a single device in the host that enables voice and data. And it's a converged 3.0 E-MTA both domestically here in the U.S. as well as in the Europe is an example. The last thing they want is cash multiple devises.

Unidentified Analyst

Okay. Thank you very much guys, I appreciate it.

David Potts

Sure.

Operator

Your next question comes from the line of Greg Mesniaeff with Needham & Co., please proceed.

Greg Mesniaeff - Needham & Co.

Yes, thank you. Regarding that same issue of the texture of the CMTS business in the second quarter. Is it fair to say that some of the early stage software load upgrade activity is giving away to a more online card intensive upgrade activity for the CMTS, in other words.

The first stage of populating the installed base, with the early stage software upgrades is now giving way to a more lan card in terms type of business.

Robert Stanzione

I don't think, we are really at that point yet. There are numerous examples where an operator has upgraded a system and has gone back now and stared to add additional capacity or in general let's say, we've got small, considerably smaller amounts and they're picking up the typical just normal upgrades that are going on.

Greg Mesniaeff - Needham & Co.

So, its fair to say that we are still on those front, early innings of the high software upgrade stage.

Robert Stanzione

Yeah, again I will characterize it is high software but certainly we are in the early stages of the network upgrade and the system upgrades, yeah.

Greg Mesniaeff - Needham & Co.

Got you and just one quick follow up. As you continue into the second half of '09 and as you start to ship more through each of the line cards are you envisioning any silicon redesign into those line cards that would improve your cost profile of those line cards? Thanks.

Robert Stanzione

Yeah, great question. There are several developments under way focused on increasing capacity, reducing cost, decreasing power consumption, all of those sorts of things both kind of short-term incremental improvements as well as longer term substantial increases. So yes, both are going on.

Greg Mesniaeff - Needham & Co.

Thank you.

Robert Stanzione

Okay.

Operator

Your next question comes from the line of Todd Koffman, Raymond James. Please proceed.

Todd Koffman - Raymond James

Thank you very much. You've been incredibly successful with Comcast pulling out DOCSIS 3.0 with having some literally some months or quarters which actually started in the December quarter, I guess of last year and it's holding up but listening to Comcast and where they are in that deployment term and given some of the unusual fluctuation you had with them. When you look at their deployment and then look out will it be a more gradual finishing or it's the same run of the mill as you've always experienced in this business going forward?

Robert Stanzione

Well, it's certainly a facing here of upgrade cycle going on to implement the new functionality. But as well as just the normal capacity expansion but as we go around and talk to operators above or none we are hearing that there are annual planning for capacity addition is in the 1.3 to 1.5 annual growth rate range and so as they install capacity and they plan for the next year they need to add another 30 to 50% capacity on top of the capacity that they've now added.

And so that annual growth rate from our number of downstreams perspective capacity perspective just continues to go up. It's an exponential factor. So you can run a complex model on this but obviously it's a growing curve so tough to give you a more accurate answer Todd on that. I understand what you are asking but it just continues to grow.

Todd Koffman - Raymond James

Then just a quick follow-up on that. Is it fair to say that when you first got going with DOCSIS 3.0 with Comcast, they had some really big footprint expansion opportunities that you had capitalized on and that type of thing is maybe somewhat of a one-time event or no?

Robert Stanzione

Well, so with operators in general they have a real focused initiative on a metro area to implement a new functionality and then you know once that square around the metro area then its going to be normal capacity addition so yes it's a different, it certainly goes through a different operational phase to get the initial capabilities added into the network.

Todd Koffman - Raymond James

Thank you very much. Good luck.

Robert Stanzione

Thanks, Todd.

Operator

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

Lawrence Harris - CL King & Associates

Yes, thank you. Couple of questions. First, I think congratulations to Dave Potts and everyone for the cash flow generation, Dave nice accounts to money. Dave just counted he didn't earn it anyway well but--

David Potts

Thank you, Larry.

Lawrence Harris - CL King & Associates

Yeah, now that you are back over 500 million in cash what are your thoughts in terms of cash utilization either retiring a little more of the debt or making acquisitions or share repurchases or just simply retaining it for a while?

David Potts

No, really it's no different than what we've said all along Larry. We look at all of those things and we process it. And obviously, the bond at the stage is trading above par. Our stock price is pretty robust and we're always of course as we state is one of our objectives should be able to grow through acquisition as well. So afraid I haven't given you much info but it is same as it always is.

Lawrence Harris - CL King & Associates

Okay. I understand. With respect to customer mix and there was a question I think I tried a couple of minutes regarding Comcast, Time Warner said on their call earlier this week I believe that they are going to be ramping their investment in DOCSIS 3.0 and I assume some of the other cable operators are somewhat behind Comcast, you think we might see over the next few quarters a shift in terms of your DOCSIS 3.0 customer base towards Time Warner and some of the other cable operators?

Robert Stanzione

I think that's possible yes. And I think also it's notable that our sales to Comcast in the fourth quarter of last year were much higher than they are in the second quarter of this year. And other customers have been growing in that period. So, I think the answer is yes. You want to explain on that.

David Potts

No, I think you're right I think there are kind of different phases and different approaches to the technology and perhaps Comcast was one of the certainly the earlier more aggressive form in the North American market and there is lot of other operators that still have that in their plans going forward.

Robert Stanzione

It's never a smooth ride, it's never a smooth ride. One customer is up and the other is down and one market is up and another is down, and one product is up and others down it's just -- it may appear smooth at the top but there is a lot of churn in the middle.

Lawrence Harris - CL King & Associates

Okay. Is there a way to quantify with respect to DOCSIS 3.0 how much is added just because of the capacity requirements because of the additional throughput of data and video versus introducing DOCSIS 3.0 service with paying customers?

David Potts

Well, so most of the capacity has been put in place today is for today's hi-speed data service. There is somewhat the other question there is not a lot of new DOCSIS 3.0 subscribers consuming that bandwidth, it's going in for today's data service and as they do get more aggressive in marketing and selling the higher speed data services and as that subscriber base increases.

I guess you know personally that the bandwidth you consume in your house is kind of limited by the access place. And so that place figure you want to consume more bandwidth. And I do think there is a perhaps an exponential equation that you could model that with that capacity is going to have to continue to be added to meet those needs.

Robert Stanzione

I think folks underestimate the sustainability of this business. I really do I just -- if you think about the fact that the cable operator is being offering cable mode of service now for about a dozen years. And in one year, they have to add 30 to 50% more capacity than they installed in that entire dozen years that have gone by. And I just don't believe that folks completely understand the magnitude of the growth when we say 30 to 50% growth per year in Internet traffic.

That's a rather astounding number and if we weren't reducing the cost per downstream and shipping increasing qualities of these products, the operators wouldn't be able to handle the traffic, and the products that we're selling the DOCSIS 3 CMTS routers that we're selling are going right into service and their capacity is being used. That's why we are getting more orders from the same locations quarter-after-quarter-after-quarter. It's really a very robust business.

David Potts

And again I think people have insatiable appetites for information and entertainment and this has just began.

Lawrence Harris - CL King & Associates

Okay, thank you.

Operator

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

Simon Leopold - Morgan Keegan & Co.

Thank you very much. Couple of handful actually left. Looking at the DCS gross margin improvements, I wonder if you could talk a little bit about how much of that is reflective of mix with sort of consideration of software, CMTs, E-MTAs versus how much is actual improvement on an absolute basis for the element of that segment and one of things I'm specifically trying to get my hands around is the E-MTA gross margin improvement maybe some of that coming from multi line I am just guessing little more color please?

Robert Stanzione

Yeah, good question. Obviously, we don't break that OT in detail anymore like we perhaps used to I think we've been able to sustain the profitability of the CPE business in general. And so that this half time miles is down but the profitability of that business is still very healthy And it's just a constant effort to keep pulling the cost over that product.

Obviously, now the mix you know the quantity of revenue generated of the CPE business versus the revenue generated off QAMs and off CMTSs has an impact on the overall gross margin mix for broadband. And obviously, we are shipping a lot more CMTS products than we have say two years ago and so that, that overall mix, that product mix is certainly highly leveraged from the CMTS shipments.

Simon Leopold - Morgan Keegan & Co.

Okay. And just one other things as we keep talking about Comcast, well mention of Time Warner when we talk about DOCSIS 3.0 maybe would help to get a sense of how many DOCSIS 3.0 customers you have and how that compares to the overall customer base. How many of your customers have actually made that shift in -- while they may not be bigger than numbers but are so that re-stepping their toes?

Robert Stanzione

Yes, difficult to talk about every specific customer in general practically all of the operators are doing something with 3.0 equipment and again that's different than saying margin of 3.0 service but of the economics of deploying the newer technology are compelling. And so if there is a way to engineer their network to use 3.0 equipments instead of 2.0 equipments, most operators worldwide are going in that direction. There are some scenarios the configurations where it's more economic to continue using 2.0 equipment as there are markets in the CALA regions and a few other places where some expense to do that but in general by far the transit towards using the new technology.

Simon Leopold - Morgan Keegan & Co.

And over the last several quarters I think you've shown some good progression in market share gains in CMTS what's your feeling about this quarter?

Robert Stanzione

It's awfully hard to tell where we are in competition with a new customer, we're doing pretty well in gaining some share we think, but this business tends to be fairly lumpy book for us and for our competitors. So any individual quarters will hard to predict I think if you do upward quarter or trailing view on it I think our general feel is we continue to ease out some shares gains. And clearly, we're real focused on that. So I'll tell we'll see that the market share reports from Internet expert for another week and half or some think like that.

Simon Leopold - Morgan Keegan & Co.

Okay. And one last question and this maybe some bigger picture trending maybe I'm little surprised nobody has asked it yet but Bob if you could comment on the government broadband stimulus what you think if anything it can do to your business and what segments, what levers and whether you think the cable guys have some opportunity to get a piece of that government money or it's really mostly telco oriented?

Robert Stanzione

I think there are a lot of smaller cable operators around the country that are going to dip into that we have announced a program to help those operators and we have our product certified under the program et cetera. So, I think there is some momentum building around that I don't -- we haven't had any sales associated with that program yet. But I think that we will over the next year or so. I don't think its going to be an appreciable percentage of our business so even next year.

Simon Leopold - Morgan Keegan & Co.

Okay. Thank you very much.

Robert Stanzione

You're welcome.

Operator

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

Unidentified Analyst

Hey, guys this is Chris Clancy (ph) in for Blair King. How are you doing?

Robert Stanzione

Very good.

Unidentified Analyst

I've got two quick questions on the international side of things. I know you said you were slightly disappointed at the tough back you attribute some of that to foreign exchange effects.

I am wondering just trying to A: get a little more color to see if maybe there was any sort of share loss or anything like that, due to some pricing pressure, maybe they were some unprofitable opportunities that you walked away from possibly?

And also secondly just wondered I know the strength has been pretty strong in Japan and Korea. I am wondering order of magnitude, is there any chance that 10% customer or somewhat close to come out of that region?

Robert Stanzione

I don't think we've experienced anything unusual in terms of market shift, share shifts in international over the past six or eight months. We win some and we lose some. So, I wouldn't say that there is any share shift going on but I think it's very cautious spending on the part of the operators and it's a matter of, in some regions where there were drastic currency fluctuations at the end of year and we had to kind of, we and they had to regroup.

So, I expect that even in this quarter, we'll start to see that business fall back in fact, second quarter was better than the first quarter. But, we are not quite up to where we were a year ago.

The second part of the question was 10% in the years gone by, Liberty has been a 10% customer but what Liberty is, is an international operator with operations in South America, in Japan as well as in Europe. And so, we view those as one and they have been above 10% in the past. It's possible they could reach that again.

Unidentified Analyst

Okay. Thank you, that's all I've got. I appreciate it.

Robert Stanzione

Thanks.

Operator

The next question comes from the line of Nikos Theodosopoulos with UBS. Please proceed.

Nikos Theodosopoulos - UBS Securities

Thanks. My question was answered, thank you.

Operator

The next question is a follow-up from the line of George Notter, Jefferies & Company.

Unidentified Analyst

Yeah, hi thanks for letting me get in again. Again this is James Alexander. I was listening your update ended the DOCSIS 2.0, E-MTA and modem shipments be increased quarter-over-quarter or where they are at?

Robert Stanzione

Yeah, thank you.

Unidentified Analyst

And just the final question. So, could you give us an update on DOCS the pioneer Edge QAM and that, how is that one trending, are you guys getting attraction there, are you still committed to that products just what's your thinking on that? Thanks a lot.

Robert Stanzione

Well, we are certainly committed to the product. In fact, there is a new denser version of the product is now starting to ship this quarter. It's still not a large portion of the overall revenue mix for us but it's a similar product to a CMTS and our strategic direction for the company as we grow more into the video arena. So, no question we're committed behind that product.

Unidentified Analyst

Okay, thank you very much.

Operator

The next question comes from the line of Brian Coyne with Wedge Partners. Please proceed.

Brian Coyne - Wedge Partners

Hey, guys thanks for taking my call. I am really just trying to get better feel for your guidance and given your confidence in the margins around that follow, obviously this past quarter you had a CMTS downstreams up 30 plus percent and you had the E-MTA as end, CPE kind of 5 to down. I mean are you, what are the moving parts as you look ahead to the third quarter within, particularly gets within the BCS Group that gives you confidence, given the fact that, I mean it would look like CMTS probably comes off a little bit and maybe CPE as well.

Robert Stanzione

Well, normally, first of all welcome back. Secondly, we normally don't go into the moving parts but there are some, we have mentioned already. We think that MCS just had a wonderful quarter in the second quarter.

We did have a pool in there that we didn't expect of a couple million dollars. It would have had a fabulous quarter, had it not have the pool in, but that came out of what would have normally been a third order -- the third quarter revenue.

Within the BCS piece as I said, we see DOCSIS 2, the DOCSIS 2 CMTS sales declining in favor of the DOCSIS 3. The DOCSIS 3.0 is going out, it's flying off the shelf, is about as fast as we can make it. So, that gives us a lot of confidence in terms of the guidance that we are giving.

And I think even on the E-MTA side, the CPE side, we have pretty darn good visibility for the rest of the quarter. So, we are feeling confident about the guidance that we have given and we are not about to give really aggressive guidance given the circumstances in the marketplace this year.

We're also very proud of the fact that we have got a much more profitable profile here. As we knock the cover off the ball in terms of profitability in the second quarter. And I think that we'll do fairly well in the third quarter on profitability.

Brian Coyne - Wedge Partners

That's very helpful. And do you feel like your CPE share is doing okay, I mean obviously there has certainly been some back and forth at Comcast and sort of the recent announcement of a new platform. And we've obviously heard these in the past about an integrated phone or something like and geez how great would that be in and nothing really comes of it, I mean is that sort of you're viewing now or kind of just a sense on the competitive side on the CPE?

Robert Stanzione

Yeah, I meant to mention something earlier on that. We seem to be continuing to maintain the market share on the CPE business and don't see that significantly changing with the visibility we have right now.

There is more interest in the market in general, in additional home networking capabilities and different types of gateways and you can imagine everybody has got a different opinion on what needs to be in the gateway but a lot goes into getting the right features and then getting it at the right cost points that really flies off the shelf.

We have gosh I don't how many different flavors of gateways with different types of home networking interfaces and some of them are doing fairly well, integrated et cetera. We have integrated that cordless phone capability in different products. One of the things that are important to kind of watch going as the operators shift their thinking towards DOCSIS 3.0, if they are going to deploy the advanced device that includes additional home networking and most of the thinking is around, it being a DOCSIS video device.

And so we have got a number of different products in the pipeline here for the share next year that add those capabilities and we'll just see how successful they are in the market because you're right we've all heard this multiple times before.

Brian Coyne - Wedge Partners

Great. And then just a follow-up I think, on the question of sort of the DMSS spending the back half and Comcast perhaps stretching beyond and getting it's two-thirds of the foot print upgraded and so and so forth. I mean do you think and then obviously in the context of your 3Q guidance, do you think your total second half sales can still grow over the first half?

Robert Stanzione

Yeah, I think it all depends on how the fourth quarter comes out, I think that there is a good shot at that, with continued momentum into the fourth quarter like we have seen in second and third. I think there is that good possibility out there.

Brian Coyne - Wedge Partners

Great, it's all I have. Thanks guys.

Robert Stanzione

Thank you.

Operator

The next question comes from the line of Ari Bensinger with Standard & Poors. Please proceed.

Ari Bensinger - Standard & Poors

Thanks. Most of my questions have been answered but can you just talk more about the sales linearity for the quarter and off setting about a month in the quarter, how is the sort of activity in interest expense?

Robert Stanzione

The sales linearity within the quarter had, it's always skewed towards the end of the quarter, usually about the last three or four minutes of the quarter. Not that big but, we do more business in the third month of the quarter than we do in either the first or the second. I would say this quarter, we have good visibility and we are off to a good start, maybe better than normal.

Ari Bensinger - Standard & Poors

Thank you.

Operator

Your next question comes from the line of--.

Robert Stanzione

Go ahead.

Operator

Your next question comes from the line of Hasan Imam with Thomas Weisel Partners. Please proceed.

Unidentified Analyst

Hi, this is Shubho Ghosh (ph) here for Hasan Imam. I had a question about your share count. It's significantly diluted from 125 to 128. Any comments on how we should look at this going forward?

David Potts

So, on the charts you will see that, I believe we said a 129 million as what we're anticipating for the fourth, of course we have options that would come into play different traunches so we have made our best guesstimate as to way that will come out.

Unidentified Analyst

Great thanks. And another question. Last quarter you had loss on the purchase of debt which had a three spent effect that will effect on your earnings which you didn't have this quarter, you also had a tax valuation allowance which had a $0.01 benefit. You didn't have that effect this quarter. Going forward how should we look at this?

David Potts

Well. I think it was a gain I assume the debt repurchase not a loss because we had variable to purchase and convert in back below par and we had tax impacts on that. But if you go into the tax rate it was really no discrete items as called this quarter. The rate is the rate so that's not a bad proxy for the go forward unless we do things like we purchase debt.

Unidentified Analyst

Great. Thank you.

David Potts

Sure.

Operator

Your final question comes from the line of Ted Moreau of Cardinal Research. Please proceed

Ted Moreau - Cardinal Research

Yes, good afternoon thanks for taking my question. Little bit of a big picture question as well and you probably addressed at a number of venues and I've seen you in a number of commenting. At your Analyst Day Bob where we are on the DOCSIS 3.0 cycle are we early in the cycle, are we in the third inning how long will it go on well it just continue indefinitely and is there a metric that you measure on how much penetration into the cable networks that DOCSIS 3.0 will ultimately reach?

Robert Stanzione

The DOCSIS 3 cycle is just beginning and it will go on until the DOCSIS 4 cycle starts. Which is probably two, three, four years out. Just like the DOCSIS 2 cycle lasted three or four years and began when the DOCSIS 1 cycle ended. This is just a new generation of Edge router that comes along every three or four years, and again as long as the traffic grows and the demand for speed increases we'll see continued robust demand for these routers.

Ted Moreau - Cardinal Research

Okay, great. And I know I'm sure various as been indicated various cable companies are at different stages. But does these software upgrades ultimately reach like 75, 80% of the network or out of the network?

Robert Stanzione

It's not just a software upgraded it's a software and hardware upgrade and I would imagine that by three or four years from now the whole network will be upgraded to the DOCSIS 3 equipment probably in the U.S. may be worldwide.

Ted Moreau - Cardinal Research

But typically they ultimately penetrate almost the entire network maybe some areas that are going as maybe won't get in there and then you get into the cycle?

Robert Stanzione

Right.

Ted Moreau - Cardinal Research

All right. Thank you.

Robert Stanzione

Okay. So just in summary, I just want to reiterate the major change in the profile for the company from five to six quarters ago we were taking about 30% margin in this business now we are talking about 40s. We are a very healthy company, we've got high market share in all of key areas and we are more involved in planning our next generation products with our customers and we're a healthy company and with great earnings power. So, I appreciate everyone joining us this afternoon and we'll sign off at this point. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.

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