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ARRIS Group, Inc. (NASDAQ:ARRS)

Q3 2009 Earnings Call

October 26, 2009; 5:00 pm ET

Executives

Bob Stanzione - Chairman & Chief Executive Officer

Dave Potts - Executive Vice President, Chief Financial Officer

Bruce McClellend - President of Broadband Communications

Jim Lakin - President of Advance Technologies

Jim Bauer - Vice President of Investor Relations

Analysts

James Kissner - Jefferies & Co.

Johanna - RBC Capital Markets

Greg Mesniaeff - Needham & Co.

Blair King - Avondale Partners

Simon Leopold - Morgan, Keegan & Co.

Larry Harris - CL King & Associates Incorporated

Shubho Ghosh - Thomas Partners

John Marchetti - Cowen & Co.

Ari Bensinger - Standard & Poor’s

Brian Coyne - Wedge Partners

Operator

Good day, ladies and gentlemen and welcome to the quarter three 2009 ARRIS Group Inc. earnings conference call. My name is Veronica and I will be your operator for today. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. (Operator instructions)

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

Jim Bauer

Thank you Veronica and welcome to all to the ARRIS conference call with management. This afternoon we’ll discuss our third quarter 2009 financial results, which we released after the close of markets today. We’ll be using a series of slides during our webcast which were also on the ARRIS website in the Investor Relations section.

With us here at the ARRIS headquarters are Bob Stanzione, ARRIS Chairman and CEO; Dave Potts, Executive Vice President and Chief Financial Officer; Bruce McClellend, President of Broadband Communications; and Jim Lakin, President of Advance Technologies. There will be a replay of this entire call available seven hours after the conclusion of the call and a replay of the call and the slides will be available on our corporate website for the next 12 months.

Before we began please go to chart number two. During this call, we will be making or maybe called upon to make forward-looking statements. Including, our outlook and expectations for our industry in general, estimated revenue and earnings for the fourth quarter 2009, certain financial operating metrics, the timing and introduction of certain new products and technologies.

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 maybe made. For further information in this regard and for specific examples of risks that could cause actual results to differ materially from these forward statements.

Please see our recent filings with the SEC. Now if you go onto chart number three, Bob, Bruce and Jim will provide their comments on the quarter, after which time we’ll open up for your questions and our answers.

With that, now over to you, Bob.

Bob Stanzione

Thanks, Jim and good afternoon everyone. I’m pleased with the good results that we are reporting this quarters as well as with for the fourth quarter guidance that were reporting this afternoon if you take your pay attention then to chart four. The Q3 revenues in earnings were at the high end of our guidance. Gross margin remains strong and cash flow was outstanding and so, we’re operating statistic such as DSOs inventory turns in backlog.

All this reflects continued strong sales of our new DOCSIS 3.0 Routers and tight operating controls. Compared with the first nine months of 2008, year-over-year sales were down about 5% due primarily the weakness that we saw in our CPE and ATS businesses, but offset by robust CMTS estimates and as a results on a non-GAAP adjusted basis year-to-date earnings per share were up by 33% from $0.52 per share in 2008 to $0.69 per share, in 2009 at non-GAAP operating income was up 36% year-over-year.

Now let’s turn to chart five please. Contributing to our third quarter success were several significant international activities. Cablevision Mexico actually became our third largest customer and three Japanese and three Canadian customers were also in top 20. We had a number of other key wins which I’ll discuss further when I comment on the individual business segments.

We further strengthened and already strong balance sheet, cash and investments of $577 million were up shortly from the $330 million in Q3 of 2008. As I indicated several times recently we’re executing on our growth plan by increasing our investment in the future. In September we announced two important steps forward with the acquisitions of EG Technologies in Digeo.

EGT give us some great and Encoder and Transcoder products and Digeo gives our next generation IP gateway program of big boost. In both cases we brought outstanding intellectual property and great talent into the company and very reasonable cost. As we explained on our September 23 conference calls these deals are significant steps forward in our video portfolio expansion plans.

Now let’s go to chart six I’m talk about some of the individual business segments. The BCS segment had solid top line results, which were consistent with the second quarter levels and we were very pleased to note, that we became the number one worldwide market share leader in CMTS in Q2, as reported by in this Infonetics Research. We also continued our lead in EMTA market share. We saw strong demand for all of our CMTS products.

The DOCSIS 3.0 rollout is going extremely well, its operators around the world transition to this new platform. Total downstream shipments were added new record level of 34,000 for the quarter. With internet traffic growing at 40% to 50% a year, we expect this business to remain strong for quite sometime.

CPE shipments were approximately the same as the second quarter at 1.26 million devices. DOCSIS 3.0 devices represented 10% of the total for the first time. CPE remains a key profitable business and our market share continues to be very high. We expect that our unit growth should resume as the economy recovers and our product mix shifts to higher speed DOCSIS 3.0 and more highly functional devices. One last note regarding BCS is that, I’m especially pleased with our international traction with some notable developments in the quarter, including Cablevision Mexico, which is a Televisa property, SK Broadband in Korea, ZON in Portugal, and KTG in Germany.

Onto chart seven, MCS sales were roughly inline with our expectations. During the quarter, we deployed our new ConvergeMedia management back office software and VOD service and a number of MSOs is North America, including Charter. Also during the quarter, Time-Warner began deployment of our workforce or WorkAssuretm workforce management software in several of their regions.

Now to chart eight, the ATS segment continues to show modest improvement in revenue and margin. However, economic factors are still causing caution about plant construction. Steps that we took late in Q2 such as workforce reductions in our Tijuana factory and in sourcing of repaired operations are beginning to result in improved profitability in ATS business. Sales of note in this segment included new core wave DWDM sales to Comcast and to ConvergeMedia in Europe.

Let’s go to chart nine, please. Looking forward, general business trends and business drivers remain strong. As I’ve said before, our customers’ customers, they need to communicate, and they want to be entertained and they want to communicate, and be entertained faster, and they want more choices.

Hence, internet traffic and especially IP video continues to grow at a fast rate. Pressure for operators to reduce OpEx and improved service will create more opportunities for our assurance products and competition among service providers is not letting up anytime soon. For all these reasons, I believe the outlook for Q4 and beyond is very positive, especially in light of the investments we’re making for the future.

Chart 10, this is perhaps the most important chart that I’m presenting this afternoon, because of the many questions that have come up regarding the sustainability of our CMTS rollout. The key reason for our optimism is the remarkable growth in internet traffic.

In recent conversations with our customers, we’ve confirmed that internet traffic continues to grow at 40% to 50% per year and in some cases even faster. According to the most recent Comscore report internet video downloads increased 19% in August, as compared to July and seems to be accelerating as the year goes on.

At this growth rate our service provider customers have to double network capacity every 18 to 24 months. This growth in traffic fuels the demand for our CMTS Routers and helps to explain the enormous growth in bandwidths with per subscriber. No, I’m not saying, the road ahead is perfectly smooth. However, I do believe that we’re still in the early stages of the DOCSIS 3.0 network expansion.

Now lets move ahead to chart 11. We now see good fourth quarter shaping up. We entered the quarter with a healthy backlog and fairly good visibility. Although it’s early to begin to a point about the outlook for 2010, as many of our customers still early in the process to planning for next year, we do know that investments and capacity optimization and then with our top priorities. We also know that there’s a keen focus on driving OpEx savings, which may board will for Assurance products and we also know that longer terms video is going to be a significant growth driver.

In addition, more high definition on demand and competition will be key factors in capital expenditures, therefore we remained confident, especially as recovery occurs that ARRIS will be very well positioned to grow. So I’ll summarize on chart 12, as I’ve said several times recently, ARRIS has never been stronger and it ever been better positioned for long term growth.

We have high sustainable market shares in our key product areas. We’re more involved with our customers and in planning next generation products than ever before. We have exciting new products in the pipeline, and we’re increasing our investment in R&D to further improve our competitive position. We have a great financial profile, strong balance sheet giving us a solid foundation for continued growth.

Thank you and it’s over to you Dave.

Dave Potts

Thanks Bob and thanks everyone for joining us this afternoon. As Bob said, that we’re very pleased with our third quarter results. So let’s get into some of the detail starting with the financial highlights with chart 14, please.

Sales were $275.8 million in the third quarter, which is down from $297.6 million in the third quarter last year, down slightly from $278.5 million in the second quarter of 2009. I’ll provide a breakdown by segment in a moment. Gross margin was 41.9% in the third quarter, up from 35.7% in the third quarter last year, down slightly from 42.1% in the second quarter of 2009.

Our adjusted non-GAAP EPS was $0.25 in the third quarter, which compares to $0.24 in the third quarter of 2008 and $0.27 in the second quarter of 2009. Our third quarter 2009 GAAP EPS was $0.17 per shares it compares to $0.18 per share in the third quarter of 2008, some significant items snap: First is amortization of intangibles, which was a before tax expense of approximately $9 million in both periods and also included in our GAAP earnings is non-cash interest related to our convertible debt.

This was approximately $2.7 million both the third quarter of 2009 and 2008 and of course there’s always a reconciliation of our GAAP to non-GAAP earnings is attached to press release, it could also be found in our website. Cash and short term and long term marketable securities were up to $577 million at the end of the third quarter.

We generated approximately $63 million from operating activities in the quarter. I will touch more on the balance sheet and cash in a few minutes, but obviously a terrific result. With respect to orders, our order backlog was $169 million at the end of the quarter, and our book-to-bill ratio was 1.01, both improved to comparable numbers last year.

Let’s turn to chart 15 and look at the third quarter sales. First, let’s focus on the sales by segment bar chart for the second quarter, comparing our reported sales by segment. BCS sales were $211.3 million in the third quarter, and compared to $217.8 million in third quarter 2008 and $211.8 million of last quarter. It is also important to note that the sales mix is quite germane, particularly year-over-year, where we have a larger percentage of DOCSIS 3.0 CMTS sales and you’ll see this particularly in our margins in a momentum.

ATS sales were $45.5 million in the third quarter, compared to $62.1 million in the third quarter of 2008, and $43.4 million last quarter. MCS sales were $19 million in the third quarter, as compared to $17.7 million in the same period last year and $23.3 million in the second quarter of 2009. If you recall, I mentioned on our last call that we had a customer order of approximately $2 million late in Q2 that we have expected in Q3.

Let’s turn to our geographic split. Our international sale was $79 million were bright spot in the quarter, up from the both the second quarter 2009, in the same quarter in 2008. One final comment on sales, we have to 10% customers sales to Time Warner were $46 million and sale to Comcast were a $102 million.

Okay we’ll let’s turn into chart 16 and look at gross margins. Our third quarter, overall gross margin was 41.9%, which compares to 35.7% in the third quarter of 2008 and 42.1% in the second quarter of 2009. The year-over-year increases primarily related to the highly successful introduction of our DOCSIS 3.0 CMTS in the second half of last year, the improvement in the level of MCS sales and the mix effects of lower EMTA and ATS sales.

Our gross margin percent for BCS was 44.6% in the third quarter 2009, as compared to 36.4% in the third quarter last year and 43.8% in the second quarter of 2009. The gross margin percent of our ATS segment was 23.4% up 80 basis points from the second quarter of 2009, however down from 26.8% in the third 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 total mix; lower margin related certain head end optic products, and the decline in the overall volume. The gross margin percent for MCS was 55.3% in the quarter down a bit from 57.7% in the third quarter 2008 and 63.4% in Q2 of 2009. The decrease relates to product mix.

As we mentioned before, performance in this segment can be a bit lumpy as revenue recognition in tied to customer acceptances and relatively large non linear POs for licenses. Looking forward, I believe Q4 margin should be in a similar range to Q3, perhaps a bit higher.

Let’s turn to operating expense in chart 17. Total R&D and SG&A was $67.2 million in the third quarter down approximately $2 million in the second quarter 2009 and up $6.7 million from the same period last year. On a year-to-date basis, total R&D and SG&A was $200.2 million for the first nine months of 2009 up $9.9 million from the same period in 2008.

With respect to SG&A third quarter 2009 expenses were up $3.3 million as compared to the third quarter of 2008. The increase reflects higher variable compensation costs, in particular sales commissions and incentives growth and higher legal cost associated with patent and other litigation matters.

Legal costs were up about a $1 million year-over-year. For the first nine months of 2009 total SG&A expenses were up $3.8 million as compared to the same period in 2008. Within the SG&A legal costs were up about $4 million year-over-year. Although somewhat our predictable, we believe that legal costs may decline. With respect to R&D third quarter 2009 expenses were up $3.4 million as compared to the third quarter of 2008.

For the first nine months of 2009 total R&D expenses were up $6.1 million as compared to the same period in 2008 and as we said before, we are incrementally investing in R&D.

In the fourth quarter, we anticipated R&D will increase as a result of Digeo and EGT acquisitions and included in overall operating expenses as amortization of intangibles, which remains flat as compared to the third quarter of 2008.

For the first nine months of 2009, amortization decreased $7 million as compared to the same period of last year. The vast majority of the amortization related to the C-COR acquisition. The decline reflects the completion of the amortization of certain intangibles in 2008, specifically the order backlog.

Now let’s move to slide 18 and review some balance sheet highlights. We ended the quarter with $576.7 million of cash short term and long term marketable securities as compared to $524 million at the end of the second quarter. In this quarter, we invested approximately $15 million in T-Bills which mature in the fourth quarter 2010 and so classified is long term. Something’s to note, we generated approximately $63 million of cash from operating activities in the third quarter.

Let me, touch on some of the pieces. The elements of earnings which are cash based were approximately $51.6 million and we generated approximately $11.05 million of cash and working capital in the quarter. Our accounts payable accrued liabilities were down $10 million from the end of Q2. Our AP for inventory decreased which was essentially a function of timing and accrued compensation increase reflecting the incentive accruals.

Our accounts receivable were lower by $10 million, reflecting timing and payout patterns of our customers. In our inventory declined by about $17 million. This was partially timing and partially continued effort to reduce levels. Finally, we had a net change in about $5 million for other items including such things as tax accounts.

Some other pieces of the balance sheet we’ve raised approximately $4 million in cash from issuance of shares as a result of employee stock option exercises in the quarter, CapEx was above $4 million in the quarter, and of course we spend approximately $8 million in the quarter on EGT and Digeo.

Approximately, $15 million will be used in the fourth quarter for the Digeo transaction with another $4 million to go for the Escrow in 2010. Our balance sheet position is very strong, with the net cash position including short term investments and long term marketable securities of approximately $316 million. We remained very focused on cash generation and prudent balance sheet management.

Okay, let’s turn to guidance on chart 19. At this point for the fourth quarter of 2009, we estimate that sales will be in a range of $265 million to $285 million, that non-GAAP EPS will be in a range of $0.22 to $0.26 per diluted share and GAAP EPS will be in a range of $0.13 to $0.17 per diluted share.

A reconciliation of GAAP to non-GAAP EPS guidance can be found on chart 20, and is also attached to the press release, reconciled the items include amortization of intangibles equity compensation expense of certain acquisition in restructuring costs and non-cash interest on the convertible. Finally, on chart 21, we’ve included direct conciliation of our GAAP to non-GAAP earnings per share for the third quarters of 2009 and 2008.

Thanks and back over to you Jim.

Jim Lakin

Thanks, Dave. Veronica, if you could come back online now and just tell the participants how we can move ahead with the Q-and-A sessions, we’ll get into that.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from James Kissner - Jefferies & Co.

James Kissner - Jefferies & Co.

The mix of business in Q4, should we assume that there’s more BCS and less ATS in EMTAs, is that a safe assumption?

Bob Stanzione

Compared to what?

James Kissner - Jefferies & Co.

Due to this quarter?

Bob Stanzione

Yes, it should be roughly the same. Maybe a little more CMTS oriented fourth quarter.

James Kissner - Jefferies & Co.

Can you guys, show how many CMTS chassis were shipped in Q3?

Dave Potts

317, I think James was the final number.

James Kissner - Jefferies & Co.

On the DOCSIS 3.0 EMTAs it’s an impressive statistic 10% DOCSIS 3.0. Can you sort of share or use with the CPE, is there a split of EMTAs versus just regular modems within that you can share?

Bob Stanzione

We generally report the overall numbers. So I think the 1.26 million of total CPE has broken down into mostly EMTAs I think 1.19 million EMTAs on the rest, kind of 66,000 are so were data modems. The majority of the 3.0 shipments were EMTAs, but I don’t have the complete break down.

James Kissner - Jefferies & Co.

As I’m curious, is that adoption of DOCS 3.0 EMTAs is that fair to say that’s skewing more towards enterprise or is that more consumer or is it sort of split evenly? How do we declare that?

Bruce McClellend

Yes I don’t know if I have completely accurate break down, what I think look a large percentages is focused on residential.

Dave Potts

Okay, that’s great. We want to move on to the next question, because you got lot of folks in queue here.

Operator

Your next question comes from Johanna - RBC Capital Markets.

Johanna - RBC Capital Markets

It’s encouraging to see the ATS segment improved. I guess if you could expand on that and let us know where this Strength came from? Was there any particular region? Also is that upwards and onwards from here, should we expect revenues from the ATS segment to increase sequentially as well as margin?

Bruce McClellend

I don’t expect a sharp snapback in demand for ATS because of the economies are so, flat right now, apparently. So, I do expect gradual improvement overtime, but not a sharp growth in the next quarter or two. I do believe that, we should be able to improve our cost basis in the business and with to answer you question about the customers.

We did have more international sales in ATS and I think the orders are coming in, more skewed towards international than they have in the past. Nevertheless the U.S. market remains the biggest one for ATS and we are picking up some new customers along the way. So it’s kind of combination of the all customers plus some new ones.

Johanna - RBC Capital Markets

On the R&D fund you did mentioned that next quarter R&D would be up because of Digeo for modeling purposes, can you quantify that, the magnitude of the increase and when should be expect R&D to sort of decline again all or taper off?

Bob Stanzione

I’ll answer the second part and then ask Dave answer the first part. I think that, after this fourth quarter we’ll start to see R&D level off, because we’ve added a number of people through the Digeo and EG Technologies acquisitions. Dave you can quantify that as you did on the last call.

Dave Potts

So we’ve said we probably had about $3 million about increase in the R&D rate. I do caution that there’s always some variability in R&D particularly for things like prototypes and things like that, which could be $1 million or two a quarter, but I think the number three for the Digeo piece is a good one.

Operator

Your next question comes from Greg Mesniaeff - Needham & Co.

Greg Mesniaeff - Needham & Co.

I was wondering if you guys could give us some color on the SMB targeted products you currently have in the pipeline, particularly I guess in the EMTA area for your key MSO customers? What are they telling you as far as the general mix that they’re expecting to see residential versus SMB deployments?

Bob Stanzione

The core products we’re shipping into that space today are the multiline EMTA products and a little bit of commercial DOCSIS 3.0 modems, but most of its multiline EMTAs. There’s some work going on to look at additional product enhancements, things like shift trunking and those sorts of things, but I think those are a ways off.

The other key focus area for a lot of the operators in the U.S. is cell tower backhaul and that is a segment we’re focused on particularly with the ATS business with some of the direct fiber connections that extend the current plant to pickup some of the cell towers for backhaul. So I guess those are probably the ones that come into mind immediately.

Greg Mesniaeff - Needham & Co.

Do you anticipate making any significant product announcements for the commercial CPE market segment over the next two, three quarters?

Bob Stanzione

I think the next two or three quarters, we don’t have any big new products that are planned to be slashed in that sort of timeframe.

Greg Mesniaeff - Needham & Co.

Just one final wrap up question here, when you look at the general silicon redesign roadmap that you generally have for your customer prim equipment, what you can say about the current state of that for your EMTAs? Are you kind of in the midst of another redesign of the silicon configuration and what kind of impact can we expect to see on the margin profile?

Dave Potts

It’s a pretty active area. We’re kind of in the early phases of 3.0 product definition and deployment and so there’s a lot of work going onto try and get more costs out of those products as well as at the same time, add more features. There’s a huge amount of interest in advanced gateway products to take advantage of that broader pipe, so additional wireless capabilities and other real phases into the products. So it’s a pretty active area right now.

Operator

Your next question comes from Blair King - Avondale Partners.

Blair King - Avondale Partners

A couple of quick ones; one, Bob, I appreciate the chart on the bandwidth growth. I was hoping maybe there could be a little bit of a follow-up there in terms of, I guess and I appreciate the broadness of this question, but if there’s a way to quantify or help understand what the capacity in the network is today relative to the bandwidth growth, that might be helpful as we think about 2010?

Bob Stanzione

Let me try, I’ll try and ask Bruce to expand on it. So my point about 18 to 24 months being a cycle, I think it’s key to that. So let’s say, over a two-year period, a company goes around and upgrades their capacity. When they do an upgrade, they’re upgrading segments of the network that are running at what they’ll call capacities, so they don’t want to exceed a certain network utilization otherwise in peak hours they’re degrading the traffic.

So when they do the upgrade, they’ll probably upgrade its down to half its rated capacity. So they’re running at a 100% of weighted capacity they derated to 50% when they add the capacity. Then over an 18 months to 24 months its right back up bumping against their peak utilization factor and they have to go back in and do it again. So, the point is where ever they are 18 months to 24 months out they’ve got to go back and in add more capacity is that about?

Bruce McClelland

No absolutely, I mean these are well planned, well managed networks and they have structured trigger points on when they start to plan to add capacity and trigger point from when the capacity needs to go in the networks and then I want to monitoring and looking at peak usage as well as average usage, tools like our service your product used to collect all that information and it’s a structured process.

We’ve been out validating a lot of what the operator’s have seen this year as far as traffic growth and if anything it’s increasing not diminishing and every time they go through adding capacity that drives toward expansion, both downstream and upstream on the head end equipment.

Blair King - Avondale Partners

On the deferred revenue line, if there is a way you can help us work through, how I know there are a lot of puts and takes in deferred revenue, but I’m assuming there is a fairly good piece of DOCSIS 3.0 deferred revenue in there and was curious to understand kind of how that filters through on a timing basis?

Bruce McClelland

We don’t get into the segment pieces of, Blair on that, but there is a mix share of both BCS and MCS for actually lots of different pieces to be honestly.

Blair King - Avondale Partners

Dave, congratulations on the cash…

Bruce McClelland

Bob said I don’t generate it, Blair. There you go.

Operator

Your next question comes from Simon Leopold - Morgan, Keegan & Co.

Simon Leopold - Morgan, Keegan & Co.

I wanted to a couple of quick housekeeping ones first. One was the tax rate this quarter jumped up just if we could understand what the sustainable trend is how to think about the rate this quarter versus what we should expect in the fourth quarter?

Dave Potts

You’re right, it was 37% if you just the peer amount of the income statement. If you go on a year-to-date basis taking on the discrete items which you can find on the GAAP to non-GAAP reconciliations, which would help you the notice of the year-to-date rate is 34% which I think is the rate you should be thinking about for the fourth quarter.

The reason for the bump in the third quarter is that we sort of go through a normal filing of the tax returns for the last year we were challenging some of our assumptions we have for 2009 on the usage of R&D credits actually mostly in specific states and the portion of them and we concluded we probably had to increase the rate just a bit, we had to catch it up in the third quarter by about $1 million as I think you find the map to be. So, hence, the 37 rate for this quarter but 34, I think, is the number to us for the full year.

Simon Leopold - Morgan, Keegan & Co.

Then on OpEx you highlighted the potential for an incremental $3 million to R&D. Is there anything else we should be thinking about in terms of additional SG&A, because of the acquisitions or other factors?

Dave Potts

That could be a little bit, but I wouldn’t say it’s going to be meaningful at this stage.

Simon Leopold - Morgan, Keegan & Co.

Then more about big picture question, typical seasonality for the fourth quarter is usually down a little bit, September usually a good quarter for cable spending. Can you sort of outline what are the factors that lead you at least at the mid point to think about flat spending, maybe some commentary around mix might help?

Bob Stanzione

I guess what we are looking at is the visibility of the order that we have coming in right now, Blair is pretty good and that indicates a fairly solid fourth quarter. As you know, it’s been his all the historically, the hardest one to predict, but this year, I think early in the quarter early in the quarter in fact in the end of September, I think we commented to look like the visibility was starting to clear and looked it like a solid quarter. So, that’s about all I can I don’t see any major trend…

Simon Leopold - Morgan, Keegan & Co.

Any mix changes versus what you anticipate?

Bob Stanzione

It’s a slightly richer mix. Slightly richer mix than we had in the third quarter.

Simon Leopold - Morgan, Keegan & Co.

Then if we try to take a longer term view about 2010, do you have at least kind of a first pass sense of the direction for sales or direction for gross margin?

Bob Stanzione

Dave, you want to comment on that? I think for 2010, it’s really, as I said in my comments, it’s very early to be commenting on trends for margin, but, I just see a lot of good things happening with the growth of this video traffic, which is just if you look at the chart 10 that I commented on, taking the inflection point up in the past few months.

Dave Potts

The reality is that our customers are in the midst of their planning for 2010 as we speak as well.

Simon Leopold - Morgan, Keegan & Co.

So I guess, it’s really I’m looking for kind of your first past impressions and not hard and fast numbers. So almost a binary question is it upwards or down both on sales and gross margin?

Bob Stanzione

It’s so dependent upon a couple of things that the economy, number one. Your guess is as good as mine on the economy. The other thing is our customer’s comments about next year and they haven’t even commented on their third quarter results yet. So, we’re still pretty far away from hearing what they’re saying about next year’s Cap Ex.

The only comments that I have heard have been things like, a comment that Comcast made in a presentation a month or so ago that they expect CapEx to be down as a percent of revenue and I expect their revenue is going to be up. So, I’m expecting sort of flat overall CapEx, but what I do expect is that within that, there will be opportunities for us to grow, because I think that the things that they spend the money on from year-over-year shifts quite a bit and I really believe that it could shift our way, but it’s really too early.

Operator

Your next question comes from Larry Harris - CL King & Associates Incorporated.

Larry Harris - CL King & Associates Incorporated

I just want to confirm with respect to R&D that once we get past this current quarter where there is an incremental $3 million related to Digeo, you’re not looking for significant incremental expenditures in 2010.

Bob Stanzione

That’s about right. As we kind of reported after the first and second quarter, we were earning R&D resources in the company earlier in the year and then we had this big ad at the end of September with the addition of 100 people, most of whom are R&D folks. So I think we’ll hold at that level. As Dave pointed out, there are other expenses within R&D than the personnel expenses and so, those can bounce around, but I think we’ll hold it roughly this level for a while.

Larry Harris - CL King & Associates Incorporated

I know it’s difficult to talk about individual customers, but I did see, I believe, that Time-Warner declined on a sequential basis here in the quarter and it’s been reported that you’re participating in their DOCSIS 3.0 rollout here in New York City. Any sort of commentary you can provide to what you’re seeing in terms of the Time-Warner rollout or maybe more broadly, what you’re seeing with respect to non-Comcast cable operators. So they’ve going to catching up in the next 12 months? Are they going to continue with the current rate? Any thoughts you might have.

Bruce McClellend

I think we’re pretty pleased with the growth of business at Time-Warner and, as you commented, the DOCSIS 3.0 launches New York City, etc. I think it’s been a real success story over the last 18 months in the growth of that particular business. Obviously, it’s a combination of all the products and they can have ebb and flow quarter-to-quarter, but certainly the CMTS portion has been a real success.

We see certainly more and more customers deploy 3.0 technology for a variety of purposes. I think the majority of operators at this point buy that technology rather than buying 2.0 technology certainly and I think the CPE shipment percentages gives you some flavor for the increased focus around DOCSIS 3.0 as a deployment.

Larry Harris - CL King & Associates Incorporated

One final question, there’s one competitor. I think its Thompson or RCA, is that a come and go. Have you seen any greater presence or additional push on their part to become a larger player recently in the EMTA market?

Bob Stanzione

I don’t know if I can comment on Thompson much. What we do now is that, the companies that are successful in the space have a presence both in head end and CPE and particularly when you’re launching a new service like 3.0, or voice, or video over IP or all these things having a presence in both ends allows you to build better products and build a better solutions. So I think you’ll see the trend continue.

Operator

Your next question comes from Shubho Ghosh - Thomas Partners.

Shubho Ghosh - Thomas Partners

This is Shubho Ghosh, on behalf of Hasan Imam, Thomas Weisel Partners. I was wondering if you could get some more colors on the gross margin scenario that you have both for this quarter, it’s been the second quarter row that you had an elevated level of gross margins. You expected this two be even slightly higher for Q4. So what’s really driving this? Can you perhaps break it down in terms of customer and product mix versus cost improvements versus anything else?

Bob Stanzione

The combination of all the above, certainly there’s a lot of focus that goes into driving the cost out of these products every quarter across all of them and the product mix certainly influences. I think the customer mix as well clearly, the type of product we ship. So Ghosh, it’s a whole bunch of factors that go into it.

Shubho Ghosh - Thomas Partners

I know you can’t give guidance beyond Q4, but generally looking at things going forward, is this the new normal or do you expect things to kind of comedown to what they were before Q2?

Dave Potts

Bob answered it before and really it will depend upon the product customer mix that evolves.

Bob Stanzione

I think on our last conference call, I said that something in the low 40s is the new normal. There was the concern after we hit 40, but we dropped back down to where we were a year ago. We don’t see that happening. We see continued strength in our higher margin products and therefore, I think something in the 40 range is what we expect for the next several quarters.

Operator

Your next question comes from John Marchetti - Cowen & Co.

John Marchetti - Cowen & Co.

We’ve had a couple quarters in a row where you’ve had some sequential improvement in the international business. I was just wondering Bob, if you think that business now is started to turn a little bit of corner for you. You given the economy starting to show some life and just any color there would be appreciated?

Bob Stanzione

Yes, thanks for noticing, because we did want to emphasize that point this evening. We do see a lot of good opportunities in international. I’ve been talking about opportunities in Latin America for a long time and it’s really gratifying now to see some of the things happening.

Mexico was a big win for us in the third quarter and we expect that business to continue to grow throughout the region. What’s happening in Latin America is consolidation. The consolidation’s been taking place over the last couple of years and these consolidated companies are investing in their network. So Latin America continues to be a bright spot.

As I commented, we had three customers in Japan, that were on our top 20 list and that is in contrast to several years ago, where we had one big customer in Japan and not another, and we’ve done well in diversifying our business in Japan. We mentioned Canada. There were five operators up there and three of them were on our top 20 list.

So Asia, Latin America, Canada continue to do very well and what we’re not doing great in is in Europe right now. We’ve got intensify our efforts in Europe. We do see some opportunities over there. I mentioned Virgin Media, which was a customer for ours many years ago and has reemerged as a customer in the past quarter and we see some opportunities in the U.K. as a result of that. SO I hope that helps.

John Marchetti - Cowen & Co.

If I can just follow-up real quick, in terms of the Mexico win, is this primarily 3.0 type equipment and secondly, you mentioned sort of stepping things up in Europe. Do you anticipate the need for any real incremental spending to try to drive some improvements to that market?

Bob Stanzione

Again, the second part of the question is no. I don’t expect incremental spending to ramp up for the market, because we’ve got the infrastructure in place there. The first part of the question, I’ll ask Bruce to answer.

Bruce McClelland

The Mexico business, as Bob talked about was Cablevision Mexico, which is a group of Televisa property, and it’s a general capacity build out or capacity expansion project and it is using 3.0 CMTS technology. It’s not necessarily a 3.0 service offering yet today, but it’s certainly using the new technology.

Operator

Your next question comes from Ari Bensinger - Standard & Poor’s.

Ari Bensinger - Standard & Poor’s

Can you touch upon the impact of the DOCSIS 3.0 EMTAs to the margin profile, CPE in terms of shipment timing? How do you expect that to play out going forward?

Bob Stanzione

We don’t break them out by individual products. We are at those kind of the front end of increasing volumes on the products, but in general the margin profiles are pretty similar to others products. We’re hoping that we’re at the front end still of our transition, obviously to larger 3.0 volumes as 2.0 diminishes, and 3.0 increases for both new subscriber net ads as well as ultimately for replacement business. I don’t think our outlook on that as changed much. I think that’s what it looks like over the next several years and you’ll see that and mix increasing quarter-over-quarter and year-over-year.

Ari Bensinger - Standard & Poor’s

Then the MCS business, I understand it’s lumpy, but a flat quarter translates to like 30% plus growth for the year. Do you see that business continuing to be strong in ‘10, given its ROI profile?

Bob Stanzione

The MCS business?

Ari Bensinger - Standard & Poor’s

Yes.

Bob Stanzione

I think it will continue to be strong in 2010. The number of opportunities there, particularly in the OSS arena with both our ServAssure and our WorkAssuretm products and then ever increasing demand for on demand viewing, not only on televisions, but on computers and PDAs is driving those businesses. So we do have a positive outlook for those businesses in 2010.

Operator

Your final question comes from Brian Coyne - Wedge Partners.

Brian Coyne - Wedge Partners

I was wondering if you could talk first about, back on the EMTA and the shares. Do you think you gained share in the third quarter on the CPE side? Do you think it largely held?

Bruce McClellend

I don’t think it changed substantially. It’s always a difficult to tell, but I don’t think we’ll see any big dramatic changes that I can think of, so.

Brian Coyne - Wedge Partners

Do you think, as we progress and get a little bit closer to more volume rollouts and you do continue to face some competition there? I mean do you think most of it’s going to be along price or do you think it’s going to be along, potential whether it’s real perceived quality, or features, or software, or do you really think it has a lot to do with incumbency and the fact that you and one or two of the other competitors do have a pretty strong presence at that end?

Bruce McClellend

It begins and ends with price, of course every discussion that we’ve does and then you get a fill it in with all the differentiators and at the end of the day, all things being equal. You want the decision to go your direction. We have to be competitive on cost and price, just part of the world we live in, but I think we do a reasonable job of selling on the differentiation and I think customers like the support and the quality of the product and all of those things, but you’ve got to be competitive and I think we will be.

Brian Coyne - Wedge Partners

Also on the CMTS side, have you started to see any reorders or incremental orders of DOCSIS 3.0 going into markets that, where the operators rolled out DOCSIS 3.0. It’s like quote, unquote, DOCSIS 3.0 operational market. I mean, are you starting to see reorders new incremental demand just because whatever they did to switch the market on for DOCSIS 3.0 either may not have been enough or perhaps it’s sort of more geographical build outs from those markets?

Bruce McClellend

We’re just kind of entering that period where that starts. I think we just started doing our initial deployments in the late second quarter a year ago, the year basically five quarters ago, so, I stay tuned on that topic, I think, Brian.

Brian Coyne - Wedge Partners

Finally, digging a little bit deeper into another part of the business, on the, kind of the equipment side, I’m thinking a little bit more along the lines of taps and filters and all that other good stuff. I mean, are you seeing sort of any more demand for that within the broader business, perhaps, as operators look to clean up some of the noise in their networks ahead of rolling out DOCSIS 3.0? I mean, should we think about those being linked or and some of that tap and filter business being kind of a leading indicator?

Bruce McClellend

No, I wouldn’t call them linked or leading indicators, but we have seen some, as part of the ATS business, we have seen some growth and demand for the surprise part of ATS as well as the AIT part and I think it just has to do with business stabilizing inventories being run down to as low as they can go and orders coming in. No, I don’t think it’s a leading indicator of DOCSIS 3.0 network cleanups.

Brian Coyne - Wedge Partners

I guess to put a final point on that, I guess, are you seeing any difference in the level of demand on that ATS business from, let’s say your top two or three or four customers. The one, you don’t want to identify which if there’s a difference, but is there one or two where that’s hot more than sort of that the slight improvement, is that kind of and across board. Is that across the board?

Bob Stanzione

It’s been across the board. There is no one hotspot, no.

Operator

You have no further questions on the line.

Bob Stanzione

Okay, thanks. If that’s it for this evening, thank you all for tuning into the call. I will just summarize by reminding you that we’re off tomorrow, out to cable-Tec Expo in Denver where we’ll be exhibiting there. I think we’ll have one of the largest exhibits at the expo, and we’ll be showing our current product lines along with our anticipated ones that will be hitting the market over the next year, we’ll be meeting with a lot of customers out there and hopefully some of you will be there. So, we’ll look forward to seeing you there and look forward to our next call.

Jim Bauer

Great thank you, Bob and that should conclude the call for today.

Operator

Ladies and gentlemen that concludes today’s conference. Thank you for your participation. You may now disconnect. Have a great day.

Jim Bauer

Thank you

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