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Arris Group, Inc. (NASDAQ:ARRS) provides communications equipment and technology, which facilitates the transfer of information in a broadband network. The company's customers are primarily multi-system operators [MSOs] and other broadband service providers in the cable television market, who use its products to deliver a range of integrated voice, video, and data services.

In addition to its broadband offerings, the company provides infrastructure products for building and maintenance of hybrid fibercoaxial [HFC] networks. The company s largest customers are Comcast and Cox Communications. Approximately 74% of revenue was generated domestically in the last quarter. Arris reports its revenue in two different segments: Broadband Product sales (40.9% of fiscal 2006 revenue) and Supplies & CPE sales (59.1%). The company has the potential to be a leading provider of IP voice solutions for cable telephony providers, worldwide. Success to date has been predominantly driven by strong sales of the company s CMTS [Cable Modem Termination Systems] for MSO/cable companies.

Investment Thesis
Continued Growth: Arris has established a strong presence in the rapidly growing cable modem, cable modem termination systems [CMTS], and embedded multimedia terminal adapter [E-MTA] markets. The company s customers are primarily multi-system operators [MSO] and other broadband service providers that use its products to deliver a triple play voice, video, and data services. Telecom service providers are facing increasing network traffic due to ebullient dmand for video download and file sharing. This massive requirement for data transport is benefiting Arris broadband business, in particular sales to cable operators seeking to improve their transport offerings. It has also been reported that Arris enjoyed more than 42% market share (as of the last quarter) for the cable voice modem segment, which is above levles provided by large competitors, such as Motorola and Cisco Systems.

During the fourth quarter, the company shipped 1.37 million of E-MTA units and 68,000 cable voice modems, up 136% year-over-year and up 4.5% sequentially.

Diversified Customer Base:
Arris has significantly diversified its customer base, reducing its dependence on Comcast Corp (largest MSO in U.S.) and Cox Communications. While the company is now generating larger revenue from both Time Warner Cable and Liberty Global, it has strengthened business Cable Want and Eastlink which are CMTS customers in U.S. Arris also consummated a major contract award for C4 cable modem deployment at TV Cabo in Portugal and FlexPath wideband data products deployment at Hyundai communications in South Korea. Furthermore, the company added 15 new customers for its E-MTA products including Softnet, CareView, Carson Communications and a number of municipal cable systems. 30% of the total E-MTA product shipments during the fourth quarter were in the regions outside U.S.

New Strategic Move: The company's recent decision to submit a tender offer in order to acquire Tandberg Television, is a major strategic move to position the company as a larger, more diverse entity. Successful acquisition of Tandberg will vertically expand the company s business into the video equipment and IPTV infrastructure markets. Tandberg has industry-leading solutions for advanced compression, on-demand and interactive television. Tandberg services over 2,000 customers in more than 100 countries commanding 25% share of the global video processing market. While the acquisition still faces hurdles, including a counter-offer by Ericsson, the initiative demonstrates management's intentions to reposition and expand beyond organic (internal) means.

Strong Pipeline: Arris has a strong pipeline of CMTS and E-MTA products which includes a series of next-generation high-capacity head-end and terminal equipment solutions. The company will shortly introduce several new offerings, including four, eight, and twelve-line E-MTA, wireless E-MTA and DS1 modems targeting 3.8 million small enterprises in the U.S. to provide advanced telephone and data services (Centrex and advanced IP networking). Arris is expanding its portfolio of residential products to integrated home networking options for mobile, voice and data applications. The company is also developing its next-generation DOCSIS 3.0 and modular CMTS products for market expansion in 2007.

INDUSTRY OUTLOOK - Favorable

The 2007 outlook for the telecommunications and wireless industries has become more favorable. The fundamental downturn may have reached a bottom, as telecommunications companies reduced spending and improved operating performance over the past several quarters. In addition, telecommunications companies continue to be the largest group in terms of Mergers and Acquisitions. Consolidation among the largest telecommunications services-focused companies has created an environment where equipment-focused companies now interact, on a relative basis, with less customers and reduced selling opportunities.

This has incubated consolidation among equipment companies as these technology vendors adapt to the changing carrier base. With enhanced marketing value by merging product offerings for converged wireless and wireline networks. Nevertheless, the economic scale of consolidated telecom service companies is creating pricing pressure and potential margin erosion as equipment companies contend for contracts based on pricing and features. Long-term growth prospects for the sector are not nearly as favorable as in the early part of 2000, but are more attractive than in 2006, with further consolidation expected.

While telecom carriers plan to increase capital expenditures in 2007, they will be more selective on technology choices and identifying cost savings synergies, such as streamlining purchasing arrangements and limiting the number of preferred vendors. In addition, shareholders continue to foster an environment where executives are held accountable to metrics assigned for balance sheet improvements, financial discipline and generating free cash flow. This promotes greater diligence in investment decisions for long-term growth initiatives. Unfortunately for the equipment vendors, the conservative nature of tightened capital outlay remains the method of choice for improving free cash flow.

In recognition of spending constraints by carriers, telecom and wireless equipment vendors have already prepared by slashing expenses also in response to the previous protracted industry downturn. Now that expenses are under control and productivity is at higher levels, profit margins, in general, are expected to respond rapidly even with a modest pickup in demand. Companies that perhaps have favorable opportunities are focused on third-generation [3G] wireless technology, broadband [DSL] equipment and fiber-to-the-home/node gear. There are also a few market leaders that have proven the ability to survive the sometimes turbulent opportunity swings in the industry.

Presently, the telecommunications equipment industry has a Zacks Industry Rank of 2.82, which places it 62nd out of more than 200 industries as of February 2007.

INDUSTRY POSITION

Arris is a leading provider of communications equipment and technology for cable telephony and highspeed broadband local access networks. We believe that the market for such offerings is very competitive and is prolifically supplied by companies, including Motorola (MOT), Cisco Systems (NASDAQ:CSCO), and Ericsson (ERCY). Arris' differentiation is based on established relationships with a wide array of multi-system operators and other broadband service providers that use its products to deliver integrated voice, video, and data services. In addition to broadband offerings, Arris also provides infrastructure products for building and maintaining hybrid fiber-coaxial [HFC] networks.

RECENT NEWS
Fourth Quarter and Full Year 2006 Financial Highlights
On February 15, Arris Group announced fourth quarter revenues of $234.6 million, up 29.4% as compared to $181.3 million in the fourth-quarter of 2005 and up 2.6% sequentially from $228.6 million. Net income in fourth quarter was $70.3 million or $0.64/share compared to $22 million or $0.20/share in the fourth quarter of 2005, and a net income of $26.6 million or $0.24/share in the previous quarter. Net income in the reported quarter was favorably impacted by a tax benefit of $37.4 million. Gross margins remained at 29.3% compared to 31.9% in the prior year quarter and 27.6% in the previous quarter. This was compiled from gross margins of Broadband products at 46.2% in the fourth quarter 2006 and gross margins of the Supplies & CPE products of 18.3% in the fourth quarter 2006.

Total revenue for the full year 2006 was $891.6 million, up 31% as compared to $680.4 million in fiscal 2005. Net income in 2006 was $142.3 million or $1.30/share compared to $51.5 million or $0.52/share in fiscal 2005. Gross margins remained at 28.3% in 2006 compared to 28% in the previous year.

Highlighting the business segments, broadband product revenues were $92.4 million in the fourth quarter, remaining essentially the same compared to $92.9 million in the fourth quarter 2005, but up approximately 5.5% from the third quarter 2006 level of $87.6 million. Supplies & CPE product revenues were $142.2 million in the fourth quarter, up 60.9% as compared to $88.4 million in fourth quarter 2005 and up approximately 1% as compared to $141 million in the third quarter of 2006.

International sales were $59.9 million in the fourth quarter and compared to $52.3 million in fourth quarter 2005 and $54.4 million in third quarter 2006. The book-to-bill ratio in the fourth quarter was approximately 0.87 as compared to 0.88 in third quarter 2006 and 0.97 in fourth quarter 2005.

The Company ended the fourth quarter with $549 million of cash on hand and short-term investments, up from the third quarter level of $210 million and up from the fourth quarter 2005 level of $129.5 million.

Arris had $276 million of outstanding debt at the end of fourth quarter. Approximately $65 million of cash was generated from operating activities in the fourth quarter. Free cash flow was $59.5 million in the fourth quarter.

Proposed Acquisition
On February 15, Arris Group launched a tender offer to acquire the shares of Tandberg Television ASA, a leading supplier of digital video and IPTV hardware, software, and services. Total offer value of this transaction is approximately $1.2 billion at the exchange rate between US dollar [$] and Norwegian Kroner [NOK] as of January 12, 2007. Tandberg Television share holders will receive no more than NOK 16 in Arris shares and at least NOK 80 in cash for each Tandberg Television share held. The proposed acquisition will be completed subject to the Tandberg shareholders approval and regulatory clearance.

VALUATION
Arris is trading at 13.0x our estimated earnings for fiscal 2007. This represents a significant discount to the S&P 500 and the peer group telecom equipment manufacturers. On the basis of other selected valuation metrics, the stock is also trading at a discount to its peers. Given the strong presence of Arris in the rapidly growing next-generation IP telephony and high-speed broadband equipment market, we believe, the current valuation does not adequately reflect the company s future growth prospects. The company maintains a strong balance sheet and ongoing operating activities are likely to improve overall margins. Therefore, we upgrade our recommendation to Buy with a six-month target price of $18 based on a P/E multiple of 18x to our fiscal 2007 earning estimates, closer to the industry median.

RISKS

  • Investing in foreign markets entails additional dimensions of risk, particularly currency, regulatory and accounting control risks.
  • Approximately 26% of Arris' sales are outside the United States where currency fluctuations can materially impact revenue levels.
  • Market opportunities for the company s telecom/cable products and services depend on several factors including competition, customer demand, network coverage and overall growth of economies within different countries. There can be no assurance that the market for such offerings will continue to remain robust in each of its business areas.
  • Risk related to the inability of the company to control its costs and expenses may erode its margin significantly.
  • If the transition from circuit-based networks and corporate phone systems to Internet-based telephony systems stagnates then the near-term growth prospects of the company will be adversely affected.
  • Macro-economic and geo-political events may adversely impact our rating projections.
  • INSIDER TRADING AND OWNERSHIP
    According to SEC filings and information posted on Nasdaq, there were 0 inside buy transactions and 5 inside sell transactions in the last three months. In the last twelve months, there were 16 inside buy transactions and 37 inside sell transactions.

    Key Points

  • Arris established a strong foothold in the IP telephony and other broadband infrastructure segments, despite facing competition from large players, including Motorola and Cisco Systems. During the fourth quarter, the company showed impressive performance led by industry-leading touchstone voice over IP [VoIP] products and C4 cable modem terminating systems.
  • Earnings momentum remains robust as next-generation cable telephony systems gain traction in a rapidly evolving market. Increasing network traffic trends, driven by video download and file sharing, have stimulated demand for Arris broadband infrastructure equipment.
  • Arris has a growing list of customers. Comcast, Cox Communications, Cable Want, and Time Warner Cable are major customers for the company as IP voice over cable proliferates with customer demand. In addition, the company expanded its international business in Germany, Japan, South Korea, and Portugal.
  • Arris raised funds and announced a tender offer to acquire Tandberg Television. If Arris becomes successful in acquiring Tandberg, the merged entity will be able to address global telecom, satellite, and broadcast video market supported by a unique solution of triple play voice, data, on-demand and interactive video systems. A counter-offer by Ericsson, however, makes the Arris acquisition less likely.
  • The company maintains a strong balance sheet, with product backorders of approximately $93 million, in addition to a solid net cash (total cash & short-term investment less total debt) position of $2.53/share. The company continues to remain profitable on a yearly basis as it generates positive free cash flow quarter after quarter.
  • OUTLOOK
    We upgrade our recommendation to Buy for Arris Group (ARRS), a leading provider of communications equipment and technology for broadband networks, following improved fourth quarter results and encouraging earnings momentum. Arris has emerged as a strong contender in the next-generation cable voice modem market. In synergy with the proliferation of IP voice over cable, the company established solid business relationship with a large number of multi-system operators and broadband service providers, in addition to its strategic customer Comcast. Arris recently completed an investment banking transaction, bolstering its net-cash position. It maintains solid financials with continued cash flow generated from operations.

    ARRS 1-yr chart:

    Source: Arris: Broad Customer Base, Solid Financials Make It a Buy