ARRIS Group's (ARRS) CEO Robert Stanzione on Q2 2014 Results - Earnings Call Transcript

Jul.31.14 | About: Arris Group (ARRS)

ARRIS Group (NASDAQ:ARRS)

Q2 2014 Earnings Call

July 31, 2014 5:00 pm ET

Executives

Robert Puccini - Vice President of Investor Relations

Robert J. Stanzione - Chairman and Chief Executive Officer

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

Bruce W. McClelland - President of Network & Cloud and Global Services

Larry Robinson - Corporate Vice President and General Manager of Home Devices

Analysts

Amitabh Passi - UBS Investment Bank, Research Division

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

James M. Kisner - Jefferies LLC, Research Division

Richard Valera - Needham & Company, LLC, Research Division

Timothy J. Quillin - Stephens Inc., Research Division

Brian Coyne - National Alliance Capital Markets, Research Division

Tavy Rosner - Barclays Capital, Research Division

Mark Sue - RBC Capital Markets, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2014 ARRIS Earnings Conference Call. My name is Estevan, and I will be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to your host for today, Bob Puccini, Investor Relations.

Robert Puccini

Thank you, Estevan, and welcome, everyone, to the ARRIS conference call with management. This afternoon, we will be discussing our second quarter 2014 results, which were released after close of market today. We will be using a series of slides during our webcast, which are also posted on the ARRIS website in the Investor Relations section.

On the call today, we have Bob Stanzione, ARRIS' Chairman and CEO; David Potts, Executive Vice President and Chief Financial Officer; Bruce McClelland, President, Network & Cloud; and Larry Robinson, President, Customer Premises Equipment.

There will be a replay of this entire call available several 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 begin, please go to Chart 2.

During this call, we will be making forward-looking statements, including our outlook and expectations for our industry in general; estimated revenue and earnings; certain financial operating metrics; the timing and introduction of new products and technologies; anticipated spending patterns by some of our customers; and expected sales levels for various products and categories. It is important to note that actual results may differ materially from those suggested by any forward-looking statements, which may be made during today's call.

For further information in this regard and for specific examples of risks that could actual results to differ materially from these forward-looking statements, please see our recent filings with the SEC.

Now if we can go on to Chart 3, Bob and Dave will provide their comments on the quarter results, after which we'll open up for your questions. Bob?

Robert J. Stanzione

Thanks, Bob, and welcome, everyone, to our second quarter results conference call. I'm very pleased this evening to report on the progress that we've made to date, as well as our outlook for Q3 and beyond. In short, our Q2 results reflect the work we've been doing across our product lines, building on the momentum that we achieved over the past several quarters. And as you'll see from our guidance, Q3 is shaping up to be another outstanding quarter. So let's turn to Chart 4.

We saw a strong demand across all product lines with particularly high demand for broadband speed and capacity, leveraging our in-home CPE solutions and our E6000 CCAP platform. Record revenues of $1,429,000,000 were up 17% sequentially. Non-GAAP earnings were $0.70 a share at the top of our guidance and up 49% sequentially.

Book to bill was 0.85, and we entered Q2 with a backlog of $788 million. This follows the normal seasonality in bookings that we've seen in years gone by. As Dave will point out, cash flow for the quarter was outstanding. And as we announced earlier, we paid $150 million advanced optional debt payment at the end of May. DSO and inventory turns also both improved. So overall, we feel very good about what we've achieved, as well as our prospects for going forward.

Let's turn to Chart 5 and look at the CPE segment highlights. Segment sales were up 14% over Q1 of 2014. Direct contribution was up 17% from the previous period, reflecting another great quarter. We continue to see industry-wide increases in investments for new in-home solutions and we benefited from a strong share position, particularly in areas where we've enjoyed some level of product exclusivity. And while we anticipate some amount of quarter-to-quarter fluctuation, we remain well positioned for the long term in this important segment. Excluding DTAs, set-top and video gateway unit shipments were up 8% compared to the first quarter.

We announced the availability of a new high-definition set-top, targeting the growing Latin America market. And we further expanded our European portfolio, enabling the shift toward an all-digital video. We played a large part in the launch of Verizon's Quantum TV service launch with our VMS Gateway and IP client devices, which led to a nice increase in our Q2 unit shipments, and the momentum is continuing across multiple customers for our multi-tuner video gateway solutions and high-speed data products.

On to Chart 6. Demand for our broadband high-speed data devices was outstanding as service providers continue to deliver greater and greater speeds to their subscribers. Unit volumes were up 11% over the strong Q1 level, and we shipped record levels of both DOCSIS and DSL units. We announced new EuroDOCSIS data and EMTA gateways that offer superior wireless performance as we focus on growing our international presence. And 65% of our high-speed data shipments were Wi-Fi-enabled devices. And we're in the process of executing on a portfolio refresh to incorporate the latest Wi-Fi technologies in our platforms.

So let's turn to Chart 7 and look at the Network & Cloud segment results. Segment sales were up 23% over the first quarter. Direct contribution was up 60% from the previous quarter. Network & Cloud had an outstanding quarter with demand up across all their major product lines. Sales of video system products increased sharply, while demand and shipments of our E6000 platform were extremely pleasing. The base of subscribers served by the E6000 continues to grow around the world, as overall port shipments increased 80% compared to Q1. We expect this momentum will continue into the third quarter as operators add needed capacity, as well as established platform for future growth. Our customers are planning ahead for the introduction of gigabit services, utilizing DOCSIS 3.1 technology and see the E6000 as the best way to accomplish these goals. So the growing footprint of E6000 deployments bodes well for future sales and upgrades to existing chassis.

On to Chart 8. Similarly, our HFC business saw growth in the quarter as operators deployed headend optics and nodes to increase broadband capacity. We introduced our new CORWave 3 platform, which doubles the headend optics density and expands the downstream frequency spectrum to 1.2 gigahertz in support of the DOCSIS 3.1 spec. In our video systems product line, there's growing interest in going beyond traditional video-on-demand by introducing network or cloud-based DVR services. This product line serves both cable and telco operators worldwide.

Our full solution of video ingest and control, storage and streaming are gaining strong interest and acceptance, complemented by our recent SeaWell acquisition. SeaWell's technology fills an important role in the packaging of streaming IP video content, as well as in the delivery of targeted ads to individual devices.

Within our Programmers business, we're working closely with customers as they continue to upgrade their distribution systems to take advantage of MPEG-4 compression. Within the cloud portfolio, we deployed a new subscription-based software as a service or SaaS version of our workforce management product that improves scalability and accelerates new feature development. We're also introducing a new outage management tool for proactively identifying and resolving complex issues within the HFC network, and have been selected by a major international service provider for deployment. We also had several important announcements this quarter with our Moxi Whole Home solution offering. We launched a new companion device that enables the streaming of live and DVR content from the home gateway to smartphones and tablets. And we also launched a new online interactive application marketplace including a broad Over-The-Top video catalog with a partner called Wurl.

And finally, within our Services business, there's just a lot of activity as service providers deploy a variety of enhanced video services, including multi-screen and network DVR services. This translates into the need for more bandwidth, just another important part of our services offering.

And finally, Chart 9. As you've seen in the press release, Q3 2014 reflects continued strong demand across our product lines with a shift toward the higher margin networking cloud products, particularly the E6000 Cable Edge Router. We see opportunities in both domestic and international markets, growing demand for network expansions and video experience enhancements, coupled with broad acceptance of ARRIS CPE and Network & Cloud solutions.

2014 is shaping up to be a very good year, and the outlook for 2015 is also good. However, I want to highlight that fourth quarters have always been the most difficult quarter to project. And this year, that difficulty is amplified by a number of factors, not the least of which is the M&A activity among our top customers. I think we could see some disturbance in the business shortly before and after these deals actually close. Nonetheless, indications are that capital spending will be robust following the reorganizations that are predicted to occur late this or early next year.

That said, service and content providers are announcing new, faster, higher value services and are facing tougher and tougher competition and more demanding customers. At the same time, Over-The-Top traffic is growing at a terrific pace. ARRIS' customers worldwide are announcing faster and faster high-speed data services, such as GigaPower from AT&T, Gigasphere and DOCSIS 3.0 from Cable, Liberty Cable, Comcast, Charter, Time Warner and others have all announced that they're substantially increasing broadband speeds. And we're deeply engaged with our customers in all of these endeavors. We'll continue to invest aggressively in a long list of tomorrow's technologies, such as DOCSIS 3.1, multiscreen, ATVC compression, ultra-high definition, advanced Wi-Fi and targeted and dynamic advertising.

And with that, let's go to Dave.

David B. Potts

Great. Thanks, Bob, and thanks for joining us this afternoon, everyone. And I'm pleased to announce very strong results for the second quarter. So let's go to the financial highlights on Chart 11.

As a reminder, given that we closed the acquisition of Motorola Home in April of last year, comparisons to the first half of 2013 may not be meaningful. So sales in the second quarter were $1.429 billion, this compares to $1.225 billion in the first quarter of '14 and $1 billion in the second quarter of 2013, which includes Motorola Home after April 17.

Gross margin was approximately 29.3% in the second quarter, up from 28.3% in the first quarter of 2014, reflecting a change in product mix and volume; and gross margin was 23.1% in the second quarter of 2013.

Non-GAAP -- GAAP EPS was $0.70 in the quarter, compares to $0.47 in the first quarter of '14 and $0.45 in the second quarter of 2013. In our second quarter 2014, GAAP EPS was a profit of $0.26, which compares to $0.28 in the second (sic) [first] quarter of '14 and a loss of $0.36 in the second quarter of 2013. Recall, in the first quarter of 2014, we recorded certain GAAP tax benefits. And also, recall on the second quarter of 2013, we recorded restructuring and various deal costs as well the impacts of purchase accounting related to the Motorola Home acquisition. And as always, you can find the reconciliation of our GAAP to non-GAAP results, which is attached to the press release, and you can also find it on our website.

We ended the quarter with $552 million of cash resources and we generated $220 million of cash from operating activities in the quarter. And we've made an optional prepayment of our Term Loan B debt of $150 million in the second quarter. And we have a weighted average share count of $148 million in the second quarter. And our backlog at the end of the second quarter remained strong at $788 million. And our book-to-bill ratio was 0.85.

Okay, let's turn to Slide 12, please. So let's look a bit at some of the sales details. So sales from the quarter were $1.429 billion. Sales of our CPE segment were $1.023 billion. Sales of Network & Cloud were $410 million. Both segments were up quarter-over-quarter and, in fact, in the aggregate, sales were up $204 million or 16.7% from the first quarter of '14.

We have 4 10% customers in the second quarter, which in total accounted for 58% of our overall sales. And our international sales were $311 million in Q2, or about 22% of our total revenue.

Let's turn to Slide 13, please. On this chart, we break out sales and direct contribution. And as a reminder, we have 2 segments: CPE and Network & Cloud. And certain costs that aren't allocated to the segments are captured in Corporate/Other, that includes the sales organization and central G&A. We also show the purchase accounting impacts from the Corporate/Other category.

So sales in Network & Cloud were again $410 million in the second quarter, with a direct contribution of $105 million; and sales of CPE were $1.023 billion in the second quarter, with a direct contribution of $225 million.

Okay, on to Chart 14, please. Operating expenses in the quarter were $256.5 million. R&D was $144.1 million, up from $134.2 million in the first quarter. And SG&A was $112.4 million, up from $99.1 million in the first quarter. Included in the R&D and SG&A was $13 million of equity compensation expense from the second quarter, which compares to $10 million in the first quarter. So as anticipated, operating expenses were higher in the second quarter.

Annual raises began on April 1 and equity compensation increased as former Motorola Home employees now have 2 years of grants in play versus 1. And with the higher sales and direct operating income, we experienced higher variable compensation. We also incurred higher trade show costs and some -- other one-off expenses in the quarter. But quite frankly, our OpEx is a bit higher than what we've planned and we're reviewing ways to bring it down.

In the second quarter of 2014, we incurred integration costs of about $12.5 million. We continue integration of our IT and accounting infrastructures. But we do anticipate that this will decline significantly in the third quarter of this year.

Let's turn to Chart 15, please. So let me touch on the balance sheet and some key cash items. We ended the quarter with cash and investments of approximately $552 million, up $30 million from the end of the first quarter. And cash from operating activities was $220 million in the quarter. And on this chart, I've highlighted some of the key items related to it. Very importantly, the elements of earnings, which are cash-based, were approximately $138 million. And we generated about $82 million on working capital in the quarter.

Accounts payable is up approximately $100 million from the first quarter and really reflects timing of payments and we expect this to partially reverse in the third quarter. In the quarter, we have CapEx of approximately $13 million. And as I mentioned earlier, we made an optional prepayment in Q2 of $150 million, along with our mandatory debt payment of $13.8 million. We also paid $4.5 million for short-term debt associated with our acquisition of SeaWell. And we used $16 million of cash to repurchase shares to satisfy employee tax withholdings. So all in all, I'm very pleased with the cash generation and our balance sheet position.

Let's turn to Slide 16, please. So our guidance for the third quarter. At this point, we estimate that we'll have sales between $1.370 billion and $1.410 billion. We anticipate that non-GAAP earnings will be in the range of $0.69 to $0.74, and GAAP earnings in the range of $0.35 to $0.40. With respect to OpEx, we do expect it to decrease over the last 2 quarters of the year. And we estimate our diluted share count will be about $149 million, but we estimate our non-GAAP tax rate to be about 35% and, of course, you'll find a reconciliation of our GAAP to non-GAAP guidance attached to the presentation in our website.

So with that, let me turn it back to you, Bob.

Robert J. Stanzione

Thank you, Dave. With that, we'd like to open the lines up for questions. Estevan, would you mind coming back on please, and helping our participants get into the queue?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Amitabh Passi with UBS.

Amitabh Passi - UBS Investment Bank, Research Division

Well, I had a few questions for you. Maybe if I could just start off, international versus domestic. Your international revenues came in weak again, down slightly sequentially and I think down 9% year-over-year. Can you just maybe help us understand some of the dynamics in the overseas markets?

Robert J. Stanzione

Yes. You're indeed right, the international sales were down this quarter. We do expect them to jump substantially in the third quarter. And I think it's a timing thing with some of the customers that we're dealing with, both in Europe as well as in Latin America and Japan. So again, I think they'll be up in the third quarter.

Amitabh Passi - UBS Investment Bank, Research Division

Okay, understood. And then, Bob, just curious from your perspective. I think about 3 months ago, you sounded less concerned about the impact of consolidation. What's changed? Is there something that, in your conversations with customers, has become apparent that there may be an impact or you guys are just sort of taking a more prudent perspective, just given some of the uncertainties around the consolidation?

Robert J. Stanzione

Yes. If you remember, 3 months ago, when we did the call, I said something about the fourth quarter could be dicey. And what I was referring to was that it always is somewhat unpredictable. And I think this year, it could be even more unpredictable, given all the changes that are occurring among our big customers, our Top 5 customers, you know who they are. Four of them are involved in major transactions, AT&T buying DirecTV and Comcast Charter and Time Warner involved in. All of that -- and if you just think about all the people whose bosses are going to change, whose jobs are going to change, during that period of time, I think there might be a temporary -- I call it disturbance in the business. But I don't think it's something that's going to last very long. And all the indications I get are that beyond the reorganizations that are going to take place is that CapEx is actually going to go up. So I think it's a relatively positive statement and just a cautionary point in terms of maybe some quarter-to-quarter fluctuation that may occur.

Amitabh Passi - UBS Investment Bank, Research Division

Got it. And then, one final one for you, Dave. Gross margins came up really nicely this quarter. Can you provide maybe a little more insight what drove that? And is your expectations for gross margin to continue to trend up next quarter, flatline or maybe slightly down?

David B. Potts

So it's 2 things. One is, indeed, the mix between the segments with Network & Cloud up. It helps us in the gross -- in the overall margins and certainly in the gross margin line, given what margins those products carry. So I'd point to that as one of the big pieces. And also, when you're 200 million more of volume, you have to be able to cover some of those sort of semi-variable costs that you have in the COGS structure as well, so that helped actually in both segments. Next quarter, probably similar. I do believe we'll have strength again in Network & Cloud, so I would think it's going to be similar and maybe a little bit better.

Operator

Our next question comes from Simon Leopold with Raymond James.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

A couple of things. One, just a quick clarification here. It looks like you've pulled back on some of the disclosures on 10% customers. You just talked about the number of customers. If we can get that detail that you've historically provided?

David B. Potts

So as we've sort of evolved with our customers, it -- we've concluded that what we should be doing with annual disclosures on those customers, which we'll do as part of our K. But really we're not required to make the quarterly ones and I think our customers are more comfortable if we don't do so. So what we'll continue to do is try to give you the aggregate of the 50% customers, and then whoever makes it into that 10% category at the end of the year, we'll disclose it then.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Can you at least give us some sense of the trending? Historically, you've had one customer significantly higher than the others. And given, I think, what's going on in the CPE, looking like that's starting to slow. I guess that's what I'm trying to get into.

David B. Potts

Yes, I think we're going to stay away from that. As you have noticed in our Q, we didn't quite go that far. But -- and just trying to do the right thing by our customers. I think what we've put in is what we'll be doing on a go-forward basis.

Robert J. Stanzione

Simon, I'll just add to what Dave said that this is something that customers have asked for, more than something we want to do. But we have to respect their request.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Okay. Well, I'm sure investors would ask for more disclosures and customers ask for less and life is a balance. So just kind of -- one of the comments you made in the prepared remarks were -- I think you used the term cloud momentum to continue. So when we think about what you're indicating on Q3, I want to be -- make sure it's clear to me that you're suggesting that the cloud business will be up sequentially within the guidance you've provided for overall revenue. Am I understanding that correctly?

Robert J. Stanzione

Yes, I think so. I think with the success we've had in the marketplace with cloud DVR deployments, both domestic and international, as well as our SaaS deployment of WorkAssure or workforce management and a few other things that are in that category got good growth potential there. And I've got Bruce McClelland in here from Japan. If you want to add something, Bruce, if you can hear us.

Bruce W. McClelland

Yes, I think that's right, Bob. And really, the Network & Cloud, the whole segment, we think is strengthening sequentially and helping with that gross margin mix.

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

And just to clarify what's going on beyond the third quarter, we've expected I guess a secondary product cycle that might occur in 2015 around the Cloud segment. And it sounds like maybe you're suggesting that cycles beginning earlier, as well as maybe the slowing of CPE beginning earlier. Or am I reading too much into lumpiness from quarter-to-quarter?

Robert J. Stanzione

Well, by the way, just to be clear. Are you talking about the Cloud business within the Network & Cloud segment or are you talking about the Network & Cloud segment as a whole?

Simon M. Leopold - Raymond James & Associates, Inc., Research Division

Well, I'm talking about Network & Cloud segment as a whole, but it's really a subtle way of talking about CMTS specifically.

Robert J. Stanzione

Okay. Okay. All right, Bruce, take that.

Bruce W. McClelland

Yes. So certainly, as we look into the third quarter, we see the continued strength that we've really just reported in the second quarter and had some very solid demand, and we believe that continues into 2015. And we've talked previously about the importance of establishing that footprint out there now and our ability to go back in and sell capacity licenses, and then ultimately additional line card upgrades as DOCSIS 3.1 starts to kick in later next year. So there's a long-term cycle certainly there extremely important that we are establishing that footprint today. And that's why we're so excited about the strength and momentum we've seen so far this year.

Operator

Our next question comes from James Kisner with Jefferies LLC.

James M. Kisner - Jefferies LLC, Research Division

So I guess the first point here is just around book to bill. I know that, in the past, your book to bill has pretty reliably declined throughout the calendar year, and you had a drop like this one in 2007 and then things were fine after that. But can you just reexplain for investors, and maybe newer to the story, why the book to bill dropped so much seasonally in Q2? And why are we not that we -- why are we not that should be concerned about that drop in this metric?

Robert J. Stanzione

Well, there are a number of reasons. One is that -- one is actually seasonality. It's just that when budgets are finally established and orders come in, in the first of the year, there's kind of a burst of ordering activity in the first quarter. And included within that are service contracts that are billed throughout the year. So we get that bump also in the first quarter. And not unusual whatsoever for our book to bill to be below 1 in the second, third and even the fourth quarter of the year and then pop up again in the first quarter. It happens -- I think it's happened every year.

James M. Kisner - Jefferies LLC, Research Division

Yes, that makes sense. So I guess the big question in the table here is -- Simon was alluding to the set-top box business sort of slowing in Q3. But I just want to get your perspective on a longer-term trajectory and also perhaps explain the Q3 slowdown. Is it perhaps one of your customers is wrapping up their all digital transition? Is there sort of like a fall off after initial inventory build? Or is there something else that surrounds sort of Q3 video shipments? What's driving that? And I guess I'd also be curious if you give us perspective -- I mean how confident are you that in 2015, your set-top -- or just the industry of set-top box volumes will be up?

Robert J. Stanzione

Larry?

Larry Robinson

Sure, James. As Bob described in his remarks in the summary around the CPE segment, we certainly experienced what I would describe to be very strong share positions within certain customers. And as we would expect, as we would anticipate, when customers go through product transitions, introducing new products, making different sourcing or dual-sourcing decisions, we may see quarter-to-quarter fluctuations as it relates to our market share. That being said, when I step back and look at the business over the last 4 quarters, I think we've continued to grow share in the aggregate very nicely. And when I look out going into 2015, I'm very confident in our ability to continue to grow that share when I look at the number of engagements that were involved with customers. So my perspective is the CPE business has continued to grow very, very nicely quarter-on-quarter, and we're seeing some of those shifts. But long term, I think, we're very well positioned to continue to deliver products to the market and benefit from the continued investment cycles that our customers are going through.

James M. Kisner - Jefferies LLC, Research Division

Okay. And just last and I'll pass here. Just operating expense. Dave, I mean obviously, you said they were more than you expected. Can you just give us a little more color on perhaps why -- what might you expect sequentially? Will they be up? And perhaps even just give us a little picture on just how we should kind of be modeling that in the future assuming that your top line is going up.

David B. Potts

Yes. So in the last call, I did say that I thought they would go up and then, there's 2 pieces of it which I'll call run rate, which are the equity comp, which we talked about in annual raises, which will have to be built in. Then, on top of that, there's a portion I'll call performance base, which relates to both commissions and other variable compensation, given the financial performance we have this year. Then, we did have some things which I'll call one-offs. So there is probably more of those than I would've thought, but that were into play. And then, a little bit more run rate than we thought. So I think it comes down and I think it comes down in Q3, and I think it comes down again in Q4, partly because again of the variable piece of it. So I think the Q3 numbers, $240 million to $250 million, we'll see where we actually head into it and it's probably similar into the fourth, but probably in the lower end of that, maybe at the very low end of that.

Operator

Our next question comes from Rich Valera with Needham & Company.

Richard Valera - Needham & Company, LLC, Research Division

Bob, I just wanted to go circle back on the fourth quarter visibility, just to clarify. Have you actually seen or heard anything specific from your customers that would suggest they would be pausing? Or is this just an abundance of caution around the fact that you expect several transactions to actually potentially be closing in that time period?

Robert J. Stanzione

No, we've not heard anything specific back from a customer. And frankly, I think if you would ask them, they'd say nothing is going to change. But I just think you have to be somewhat cautious in looking out at the enormous changes that are going to occur. As I said, 4 of the 5 customers that we have are going through major changes. There's going to be a whole new company out there with a whole new management called SpinCo. They have to perform transition service agreements with Charter. That's going to take a little bit of time. So I just think, being realistic, we ought to put that out there for you to think about and that's why I said it.

Richard Valera - Needham & Company, LLC, Research Division

And I know you don't want to give fourth quarter guidance at this point, but should we -- if we are probability weighting things, should we think about things probably being sequentially down in 4Q or do you not want to go there at this point?

Robert J. Stanzione

I really don't want to go there at this point. We don't have good visibility into the fourth quarter ever. And I'll tell you, every year, we go into the fourth quarter and customers say they're not going to spend more money at the end of the year and 2 out of 3 times, they do. So I don't think it would be prudent to give guidance at this point. I do want to emphasize what I said about 2015. I think 2015 is going to be a very solid year.

Richard Valera - Needham & Company, LLC, Research Division

Great. That's helpful color. Bob, I wanted to talk about gigabit services in DOCSIS 3.1. You mentioned you think there is some CCAP, I mean E6000 demand you're seeing now and that's going to be sort of gigabit ready. Is there any other products you're seeing demand for now that you think are potentially going to advance to gigabit services? And how do you see the timing of gigabit services in DOCSIS 3.1 specifically and potential products cycles around that, on both the network side and ultimately, the CPE side?

Robert J. Stanzione

Right. So our HFC products are headend optics and nodes. The upgrade that we just announced called CORWave 3 is sort of a get-ready product for providing the bandwidth that comes along with DOCSIS 3.1, which is how you get to gigabit services. The timing is that -- gosh, the timing is if we have it now, it would be selling right now and we're selling platforms that support it in the case of the CORWave 3 as well as the E6000. But real gigabit service over cable, I think has to wait for DOCSIS 3.1 and we expect that to roll after the end of next year. I'll ask Bruce to elaborate on that.

Bruce W. McClelland

Yes, and just an initial comment. I mean, on the one hand, you ask yourself what do you need gigabit services for. But there is just a growing set of use cases, not the least of which is operators launching their own IP video streaming service to the main screen, not just to the tablet. And that is one of the primary reasons behind adding the capacity into the network, and there's no question that the networks evolved in that direction. DOCSIS 3.1 is a new technology that allows them to get more efficiency out of their current HFC network, anywhere from 10%, 30%, 50% more effective bandwidth from the same frequency spectrum. And so they're very keen on that. Obviously, it's a great way just to get more out of the current assets in the field. We expect to the see trials throughout most of 2015 and then serious to point of starting in 2016, both on our customer premise equipment, as well as our headend. And that's another huge refresh technology cycle for us as we looked further out in time.

Richard Valera - Needham & Company, LLC, Research Division

Great. And then, with respect to the E6000 last quarter, you were essentially demand constrained -- I'm sorry, not in the quarter just reported, but I think in Q1, you're demand constrained on the E6000. Are you now all caught up with in terms of production capacity versus demand on the E6000? And how do you actually see that demand trending, Q2 to Q3?

Bruce W. McClelland

Yes, I think you mean supply constrained, which is...

Richard Valera - Needham & Company, LLC, Research Division

That's right, supply constraint. Sorry. Yes.

Bruce W. McClelland

So I think we've reached a decent balance there. And I think we said earlier that I think we see growth in that product segment in Q3 as well on top of what was just a great quarter in Q2.

Operator

Our next question comes from Tim Quillin with Stephens Inc.

Timothy J. Quillin - Stephens Inc., Research Division

I just want to follow-up on discussion of the projected sequential decline in the CPE business in 3Q. So my understanding is your largest customer has been rolling out your video gateway and maybe you took some share, some fairly significant share there for period of time. I think that customer is still ramping up CapEx, but it sounds like -- and I guess if I read between the lines is maybe some of that share is shifting back to the secondary suppliers. That a fair way to think about it?

Larry Robinson

Yes, so this is Larry. I think as I mentioned kind of in a prior question, quarter-to-quarter shift in share, I mean we kind of anticipate and would expect there is a little bit of that going on in a particular account. I mean, we're calling -- we're participating obviously in a number of accounts in different markets. So it's -- I hate to highlight one particular account and one shift, but there is that dynamic taking place. And as I mentioned earlier, I think over the long term, we're in a good position to continue to grow the CPE business based on our position with customers and the ongoing investments in R&D that we have taking place today.

Robert J. Stanzione

Add to that, that we have a clear line of sight to -- if you want to talk about share, we have a clear line of sight to winning share in Latin America and in Europe, but we have new products in the pipeline similar to the situation we were discussing about this time last year. We had line of sight to new products that were in the pipeline that would hit later this year and early next year, not only in the international market but also in the domestic market. And I, again, I think it's going to be a pretty robust demand cycle ahead of us as DOCSIS. 2.0 modems get thrown out and 3.0s get put in and 802.11g gets thrown away and AC gets put in and 3.0s get thrown away and 3.1s get put in. We can all -- that's all coming down the pipe. And so I think the outlook for the CPE business is as good as it's been in a long call long time.

Timothy J. Quillin - Stephens Inc., Research Division

And then, on the CMTS business, is the C4 platform going to be compatible with DOCSIS 3.1 or will that installed base need to be replaced? And if so, what's the time frame for doing that?

Robert J. Stanzione

Bruce?

Bruce W. McClelland

Yes. So the existing installed base will not be upgradeable to DOCSIS 3.1, and I think that's a kind of a blanket statement across all of the installed base of legacy CMTS products. So operators look to the new platforms like E6000 for that functionality.

Timothy J. Quillin - Stephens Inc., Research Division

And then, in terms of that replacement cycle that's specifically related to getting ready for DOCSIS 3.1, do you see that more then late 2015, 2016 event?

Bruce W. McClelland

Yes. And our platform -- we were going to be able to add that capability in the downstream, which is the most important piece just through additional software and licensing. So it's not like the operators necessarily have to wait for that. They'll be able to add that capability as they need it.

Timothy J. Quillin - Stephens Inc., Research Division

Okay. And then, just one last question, if I may. Bob, you talked about potential wins in Europe. You're relatively underscaled in Europe. Is there are enough opportunities to grow organically there? Or is that an area where you might want to consider acquisitions to get a little bit bigger?

Robert J. Stanzione

Well, acquisitions are a whole another topic, as they say in the south. I think that our performance in Europe has under -- I think we've underperformed in Europe, let me say it that way, over the past couple of years. And I think, based on what I see happening and, as I said, line of sight to some new opportunities, both in network and cloud as well as in CPE, I think we upped our game in Europe in 2015. I'm pretty confident with that based on deals -- deal flow that is actually in place right now.

Operator

Our next question comes from Brian Coyne with National Alliance.

Brian Coyne - National Alliance Capital Markets, Research Division

One for Larry on the set-top side. I understand the mix shift that you anticipate that looks to drive the overall gross margin trends here in the coming quarters. But can you give me some more granularity on the CPE front? I mean are you seeing pricing pressures on set-tops as you have some of these market share shift? And just if you could give a sort of a general feel for what that looks like right now.

Larry Robinson

Sure, Brian. I guess from my perspective when I look at the CPE segment, gross margins seem to be actually holding fairly well. Obviously, not at the level of the Network & Cloud profile, but certainly as I look at kind of where we've come from and where I'd project us going, they seem to be holding up fairly well. That being said, it's always a competitive marketplace and we continue to look the leverage, our cost structure and supply chain capability to make sure we're competitive in the marketplace. But from a gross margin performance standpoint, I think we're holding and what you're seeing is the overall mix at the ARRIS level, shift a little bit and had a slightly greater emphasis on the Network & Cloud segment, which is influencing the product margins.

Brian Coyne - National Alliance Capital Markets, Research Division

Yes, I guess I was -- yes, I was just getting along the lines of the different product introductions you've got coming in the pipeline that, that sort of brings. Now I guess sort of mixed question within the product segment.

Larry Robinson

Not to a -- I mean, not to a greater degree, not affecting, at least in my mind, the results that we're seeing or what we're projecting. I mean, on any given product, you may go into slightly lower margin and look to take cost out over time on an individual product basis. And there certainly mix, it absolutely affects the overall performance of the portfolio. But I don't see anything that I would describe as out of the ordinary or trend that would be potentially unfavorable to the performance we have today.

Brian Coyne - National Alliance Capital Markets, Research Division

Okay, got it. That's great. And then, the only other follow-up I had I guess was, you talked a little bit about -- or maybe, Bob, this is you. You talked a bit about confidence that you'll see sequential rebound internationally. I'm just wondering if you can help us on sort of the drivers of that confidence. Is that just bookings that you see right now that were just taking a little bit longer to recognize? Is it perhaps driven a little bit by some of these new products that you've introduced or maybe something else?

Robert J. Stanzione

Well, we're a month into the quarter and we've got orders that look pretty good in terms of achieving a jump up in international sales, again both in Network & Cloud. I guess I would say especially in Bruce's area. Network & Cloud, we have some nice business coming in this quarter in Europe, in particular, as well as in Latin America. I shouldn't overlook that.

Operator

The next question comes from Joseph Wolf with Barclays.

Tavy Rosner - Barclays Capital, Research Division

This is for Tavy Rosner for Joseph. Just a follow-up. There were some announcements of international win for the E6000. I was wondering if there are geographic distinctions in what operators are planning for?

Robert J. Stanzione

Bruce?

Bruce W. McClelland

Yes. Certainly, there are differences depending on the region. So as an example, we're here in Japan today and they architect their network a little differently than in other regions in North America. So as an example, they will dedicate spectrum to voice separate from data. And typically in the North American environment, they're putting both those services into the same spectrum. So we do have to consider those types of things and it does mean that the product certification cycles can change and be different. And maybe you get certified for one application and you still have to go through testing for another. So there's definitely dynamics. Having said that, the great thing about DOCSIS technology is it tends to be a very international or very worldwide technology. So although, we've got some feature differences that we have to account for, for the most part, we can take a pretty standard platform and take it anywhere in the world.

Operator

Our next question comes from Mark Sue with RBC Capital Markets.

Mark Sue - RBC Capital Markets, LLC, Research Division

The carrier M&A that could potentially impact your business, the M&A seems to be more about scale and content purchasing power and less about network optimization or customer consolidation. Is that why -- do you feel it's somewhat transitory and we will have a better 2015? And as these carriers potentially combine, what does it mean for your share position within these respective customers?

Robert J. Stanzione

Okay. Well, I'm basing my confidence in 2015 on what these customers are telling us they're going to do and what they're telling the market they're going to do. As well as the competition that they're facing among themselves, gigabit services, whether it's AT&T or Google or Verizon or the many cable operators in the country that we serve are coming, they're coming as fast as these operators can deploy them and that's going to require substantial investment in their networks. So if you just look at the announcements that have already been made about gigabit services by AT&T, for example, rolling out gigabit services or GigaPower, I think they call it, in city-after city using the types of devices we've been supplying to them for years and years and, in fact, new triple play boxes that we're putting out right now, new double play boxes that we're putting out right now. Verizon, refreshing their entire network fiOS using Larry's BMS Gateways and IP clients. We're right in the front of that parade and it's just left the station a couple of months ago. So there are just -- there's a lot of evidence to support increased CapEx next year, and I think that no one is better positioned than ARRIS is to win a share or a bigger share of that growing pie. Same thing is true, by the way, internationally. We see things happening in Mexico and Brazil, in particular in Latin America, all over in Europe with Liberty Global and on and on and on.

Mark Sue - RBC Capital Markets, LLC, Research Division

Okay. So the fourth quarter, I guess, is a little dicey, but next year can be spicy?

Robert J. Stanzione

Can be spicy? It could be.

Mark Sue - RBC Capital Markets, LLC, Research Division

I was just trying to find a rhyme. But on the -- maybe, Dave, for you, the cash flow, if we think about cash flow and how equity investors should think about deleveraging your balance sheet in the future, considering your early payments and what you give it against.

David B. Potts

Yes. So really our approach is not change. So I think deleveraging is important and fundamental of what we're going to do. And we also are mindful of any M&A that we want to do as well. So I think we'll continue down the path of looking at delevering the balance sheet between now and the end of the year. As I think we're -- I talked about deleveraging to the 2.5, 2 timeframe, which sounds good to us. And if you think about how much Term Loan B we have left on the balance sheet, I've talked about that as before as a -- if we can get that off, it provides us with great flexibility.

Mark Sue - RBC Capital Markets, LLC, Research Division

Okay. Any bracket on how we should think about annual cash flow, Dave? As a -- thinking about your working capital requirements, the business seems to be in pretty steady state and your margins...

David B. Potts

The working capital has ups and downs. As you saw in the first quarter, it was a bit higher as we used some for working capital. The second quarter, we had a good inflow because of accounts payable. I think some of that will actually go back out. But I always point to that line which I call the cash portion of earnings, which I'd put on the cash flow side. I think it was $138 million this quarter. I mean that's the fundamental. That's EBITDA. Cash taxes themselves this year will be lower. As we move into next year, we'll see what the R&D tax credits do, but I will begin to pay more cash taxes but I think we will have considerable cash generation. Moving in the working capital, there'll be some movement up but I wouldn't think it's substantial.

Operator

It looks like we have another question from Amitabh Passi with UBS.

Amitabh Passi - UBS Investment Bank, Research Division

Bob, just a quick question for you. You mentioned gigabit rollouts a couple of times. We've also seen announcements from Cox and Comcast talking about the greater role of PON in the network. I know you acquired some PON assets from Motorola. Are those assets still sort of competitive from your perspective? Did they require great investment? Do you look at inorganic ways of trying to address PON. How big this PON become within the cable footprint? I just would love to get your thoughts there.

Robert J. Stanzione

Yes, this one is for Bruce.

Bruce W. McClelland

Yes, great question. So that is an active product line we have today that is primarily sold into the Verizon account for their FiOS deployments. Having said that, we have a pretty significant effort underway to enhance the CCAP portfolio, as well as our node product line with PON capability. And so it's not a product line we've announced yet, but it's kind of in the process. And we do believe that the cable operators start to deploy more and more deeper fiber, and there's a number of different ways to do that including a concept called RF over Glass or basically taking the node and putting it all the way to the home or to the MDU, as well as ultimately a PON interface, once the video content is ubiquitously available over IP. So it's a longer-term investment cycle, somewhat complementary to where DOCSIS 3.1 goes over time, and an area we're definitely pursuing.

Amitabh Passi - UBS Investment Bank, Research Division

Okay. And then, maybe just a quick follow-up for either a few, either Bob or Dave. I'm curious, there's a lot of talk around architectural shifts to the cloud. Are you seeing an acceleration whether it'd be through initiatives like cloud DVR, or I don't have -- if there's even talk of virtualized CPE? And just how do you think about these transitions and the outlook for your CPE segment?

Robert J. Stanzione

Well, I'll let Larry talk about virtualized CPE. We'll probably run over time on that.

Larry Robinson

I mean it's absolutely a trend that we're seeing everything from taking the user experience to the cloud, as well as storage that fits nicely into Bruce's activity for Network DVR, and then you mentioned virtualizing additional certain functions. When I think about that trend, with the exception of obviously storage, many of them are what I would describe as software features and capabilities that provide a great deal more flexibility to operators to deliver more compelling and flexible services to subscribers. So moving certain software functionality up into the cloud allows you to get better insight in terms of what's happening into the home across multiple devices versus kind of having, if you will, everything behind the router or the broadband gateway and not having that visibility whether it'd be everything from provisioning of devices to location-based services and just a variety of other things. So it's absolutely a trend that we're participating in. I think it provides us a greater opportunity to provide software-based solutions to our customers.

Robert J. Stanzione

Okay. So thank you, all, for attending the conference call. In summary, I'm very pleased with the Q2 results. In fact, they're remarkable if you look at what we've done over the past year compared to where we were just one short year ago or even one short quarter. We're looking forward to an even more profitable Q3. We see the top line coming down a little bit, but the bottom line coming up, which indicates a richer mix of products, which is based on the diversification that we have in both customers and the portfolio and long-term positive outlook, and we're well positioned to grow. And I'd like to also issue a big thank you to the people of ARRIS who've done a wonderful job this quarter. Thank you for attending the call.

David B. Potts

Thanks, everyone.

Operator

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

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