ARRIS International Plc (ARRS) Robert J. Stanzione on Q2 2016 Results - Earnings Call Transcript

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ARRIS International Plc (NASDAQ:ARRS)

Q2 2016 Earnings Call

July 27, 2016 5:00 pm ET

Executives

Robert Puccini - Head-Investor Relations, ARRIS Group, Inc.

Robert J. Stanzione - Chairman, & Chief Executive Officer

David B. Potts - Chief Financial Officer & Executive Vice President

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

Analysts

Mitch Steves - RBC Capital Markets LLC

Joseph Wolf - Barclays Capital, Inc.

Douglas Clark - Goldman Sachs & Co.

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

Rich F. Valera - Needham & Co. LLC

Greg Mesniaeff - Drexel Hamilton LLC

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2016 ARRIS International Earnings Conference Call. My name is Whitley, and I'll be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. As a reminder, this conference is being recorded for replay purposes.

I will now turn the conference over to your host for today, Mr. Bob Puccini, ARRIS Investor Relations. Please proceed.

Robert Puccini - Head-Investor Relations, ARRIS Group, Inc.

Thank you, Whitley, and welcome, everyone, to the ARRIS conference call with management. This afternoon, we will be discussing our second quarter 2016 earnings results which were released after close of markets today. We will be using a series of slides during our webcast which are posted on the ARRIS website in the Investor Relations section. There will be a replay of this entire call available, including our slides, on our corporate website for the next 12 months.

Let's please go to chart two. During this call, we may 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 product categories and the completion of pending transactions.

It is important to note that the 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 cause 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 three, please. Here in Atlanta today are Bob Stanzione, ARRIS Chairman and CEO; David Potts, Executive Vice President and CFO; Larry Robinson, President, Customer Premises Equipment; and Bruce McClelland, President, Network & Cloud.

Now, if we could go on to page four. I'd like to turn over to Bob Stanzione. Bob?

Robert J. Stanzione - Chairman, & Chief Executive Officer

Thanks, Bob, and good evening, everyone. Let's move right to chart five now. I'll start by saying that our strategy is working and that these are the kind of results that we enjoy reporting. Through the hard, hard work of the ARRIS employees, we're reporting our best quarter ever. The Pace integration is proceeding on or ahead of schedule and our supply chain has responded to increasing demand. Our second quarter results reflect the momentum we saw as we entered the quarter. And we completed the first half of the year even stronger than we had anticipated.

As a result, we're now estimating that our full year 2016 revenue will be at the high end of our previous guidance, while net income per diluted share is trending above the guidance. Our second quarter came in ahead of both our revenue and earnings guidance. Revenues were $1.73 billion in the quarter. The Network & Cloud segment revenues were up 7.5% sequentially, and we made significant headway in addressing supply constraints we experienced earlier in the year.

Customer Premises segment revenues were up 7%, and a better product mix drove an improved contribution margin over the first quarter. The increased revenue, product mix, and continued execution of our synergy activities drove our non-GAAP earnings to a record $0.84 per share this quarter. Our international revenues grew 23% sequentially to $484 million with increases in all regions led by growth in Asia Pacific and in Europe.

Book-to-bill was 0.94 this quarter and backlog entering Q3 was $1.24 billion. With a significant amount of the Pace acquisition and cash components behind us, we delivered an impressive $261 million cash from operations in the quarter. And in late June, we completed a warrant agreement with Comcast that's based on achieving defined revenue targets within specific product segments.

Dave is going to review the particulars and the impact of our financial reporting. We look forward to working with Comcast on their video, high speed data and voice services. And as Bruce will touch on shortly, we also announced our intentions to divest some of our smaller video assets. As I said, the Pace consolidation is going quite well on target and ahead of schedule and achieving the synergy goals that we announced earlier in the year.

And now, you'll hear from Dave, Bruce and Larry, and then I'll come back and offer some comments on the balance of the year. Dave?

David B. Potts - Chief Financial Officer & Executive Vice President

Thanks, Bob, and thanks, everyone, for joining us this afternoon. And I'm very pleased to report on a very good quarter for us. Now, let's turn to the financial highlights in chart seven please.

So please note the comparisons to prior years will be significantly affected by our acquisition of Pace in the first quarter. So sales in the second quarter were $1.730 billion and this compares to $1.615 billion in the first quarter of 2016 and $1.260 billion in the second quarter of last year. Sales in Q2 were reduced by $4.3 million as a result of recording a non-cash fair value adjustment related to our warrant program. Excluding this impact, our non-GAAP sales would be $1.734 billion. And we'll continue to record adjustments each quarter and I'll discuss a little bit more about this in a moment.

Our second quarter 2016 GAAP EPS was a profit of $0.44 which compares to a GAAP EPS loss of $1.06 in the first quarter and an $0.11 profit in the second quarter of 2015. Non-GAAP EPS was $0.84 in the quarter and compares to $0.47 in the first quarter of 2016 and $0.53 in the second quarter of 2015. And as always, a reconciliation of our GAAP to non-GAAP results is attached to the press release and you can also find it on our website.

Let's go to chart eight please. The Q2 results include the effect of several items which I would like to note. First, we incurred restructuring cost of about $33 million. We do anticipate additional restructuring cost as we progress through 2016, but at a much lower rate and primarily related to facilities.

Next is the purchase accounting treatment of the Pace inventory. As required by accounting guidance, we wrote the Pace inventory up from historical cost to fair value at the close of the acquisition. The difference between the fair value and historical cost impacts margins as the inventory is sold. The effect of this was about $20 million in the second quarter and $30 million in the first quarter, and we have about $2 million left to go. And we adjust this in our non-GAAP EPS and we've done this with prior acquisitions.

Taxes. The quarterly profile of taxes is significantly affected by the variability in earnings caused by the Pace acquisition this year. Again, following the accounting guidance, we recorded an expense or benefit aiming towards a rate by the end of the year. As a result, we had an expense of $86 million in the first quarter, which included the $55 million for withholding tax that I talked about on our last call. In the second quarter, we had a benefit of $69 million. So when you look at the cash flow of the two quarters and looking at both the earnings element and the change in working capital, they'll be affected by this.

Finally, foreign exchange; in the quarter, we had a gain of about $10 million which equates to about $0.04 per share. And last quarter, we had a loss of about $12 million.

Let's turn to chart nine, please. We ended the Q2 with $903 million of cash resources, and cash from operating activities was $261 million. We did not re-purchase any shares in the quarter. Frankly, we were not in a position to do so as we were negotiating a warrant deal with Comcast. We ended Q2 with a backlog of $1.239 billion and a book-to-bill ratio of 0.94.

Let's turn to slide 10, please. All right. Let's take a look at some of the sales details. Sales in the quarter were $1.730 billion including the warrant adjustment and $1.734 billion without it, and sales came in a little bit hotter (8:42) than expected. Sales of our CPE segment were $1.170 billion, up $79 million or 7% from the first quarter of 2016, and up $332 million or 40% from the second quarter of last year. Sales of our Network & Cloud segment were $564 million, up $40 million or 7.5% from the first quarter of 2016 and up $142 million or 33% from the second quarter last year.

And we had three 10% customers in the second quarter, which accounted for about 51% of our overall sales. And our international sales were $484 million in Q2, or about 28% of our total revenue and is up from $392 million in Q1 and $367 million in the second quarter of last year.

Let's go to slide 11, please. To help you understand the effect of certain items related to sales and gross margins, we've included this chart. I hope it helps. So, GAAP sales were $1.730 billion in the second quarter while non-GAAP sales were $1.734 billion, and the difference being the fair value of the warrants. GAAP gross margin was approximately 25.7% in the second quarter, up from 23.8% in Q1 of this year, but down from 28.9% in the second quarter of last year. And as you can see, the fair value inventory adjustments impact the year over trends, and product mix also impacts all of the trends.

Non-GAAP gross margin was approximately 27.2% in the second quarter of 2016, and up from 25.8% in the first quarter and down from 29.1% in the second quarter of last year. And, again, the changes reflect differences in product mix.

On to chart 12, please. And on this chart, we break out the sales and direct contribution, so sales of our Network & Cloud were $564 million in Q2, with a direct contribution of $183 million. The direct contribution is up $66 million from the second quarter of last year, primarily the result of the Pace deal. Sales of CPU were $1.170 billion in Q2, with a direct contribution of $178 million, and direct contribution was up $27 million from the second quarter of last year, and, again, primarily as a result of the Pace acquisition.

The non-GAAP adjustments you see in the corporate other section are primarily due to the warrant adjustment, equity compensation, and having to write up the acquired inventory to Pace from fair value – to fair value as part of purchase accounting. On to chart 13, please. I am very pleased with the progress that we've made on integration. As you can see from the results, we are better than we guided, and progress is being made in all areas.

Operating expenses were $258 million in the quarter and were down from the first quarter of 2016, reflecting our integration efforts. OpEx is up from the second quarter of last year as a result of the acquisition. It is noteworthy that OpEx as a percentage of revenue has declined to 14.9%, reflecting the benefits of the scale that we've created. R&D was $153 million in the second quarter and is down from $161 million in the first quarter of 2016 and up from $136 million in the second quarter of 2015. The year-over-year increase is a result of the expanded product portfolio we guide as part of the Pace acquisition. SG&A was $106 million in Q2 and is down from $120 million in the first quarter of this year and is down slightly from the second quarter of last year of $107 million again, as a result of our integration efforts.

Included in R&D and SG&A are about $10 million of equity compensation expense in the second quarter of 2016 which compares to $12 million in the first quarter of 2016. In the second quarter of 2016, we incurred integration and acquisition costs of about $8 million, restructuring of $33 million and impairment of acquired in process R&D of about $2 million. And our intangible amortization increased as we've updated the valuation of our intangible assets as we move through the year.

Looking forward to Q3, I expect we will have a slight increase in OpEx. In Q3, we issued equity grants which we expect to increase OpEx by about $6 million quarter-over-quarter. That of course would be adjusted for our non-GAAP. We also implemented annual merit, as a result, we expect our payroll to go up by about $4 million a quarter. This increase will be partially offset by a continued integration actions that we have taken.

On to chart 14, please. As I mentioned earlier, we implemented a warrant program in the second quarter related to Comcast. Let me touch on some of the highlights. So the program is for a maximum of 8 million shares over 2016 and 2017, and to achieve the maximum certain sales and product mix targets much be achieved. As I discussed earlier, there are some accounting impacts. First, we must record a fair value revenue reduction when achievement is probable. This is spread across each period. In the second quarter, we recorded $4.3 million related to the first six months of sales. Until each tranche vests, we must mark-to-market the fair value. So as a result, there could be some significant variability.

The treasury method for share dilution will be used for both GAAP and non-GAAP EPS. And given the non-cash nature variability and the fact that management backs the adjustment our in reviewing its operating results, we will back out the impact of the fair value adjustments in our non-GAAP results.

In our Q3 guidance, we built in an estimated $2 million impact assuming the same full year sales levels and warrant valuation that was used when we're recording in the second quarter. Once again, this can vary significantly.

On to chart 15 please. So let me touch in some of the cash and some of the key cash items in the quarter. We ended Q2 with $903 million of cash resources, up from $676 million at the end of the first quarter, and we generated approximately $261 million of cash from operating activities in the quarter. The elements of earnings which are cash based resulted in an income of $199 million, and we generated about $62 million for working capital in the quarter. And we had about $15 million of CapEx in the second quarter and we made mandatory debt repayments in Q2 of about $22 million. I'm very pleased with our cash position and our strong balance sheet.

Let's turn to chart 16 please. So with respect to guidance, at this point we estimate that we'll have sales of about $1.7 billion to $1.75 billion. We anticipate non-GAAP earnings will be in the $0.72 to $0.77 range and GAAP earnings in the range of $0.28 to $0.33. And a reconciliation of our GAAP to non-GAAP guidance is attached to this presentation and can also be found on our website.

Given that it is a new item and again for clarity, we have assumed a $2 million impact on sales and gross margin in Q3 for warrants. This could change materially depending upon the ultimate sales mix and warrant fair value. And once again, to reiterate what Bob said with respect to the full year, at this point, we expect to be in the upper end of the guidance for revenue, and we're trending above for earnings.

So with that, thank you very much, and over to you, Larry.

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Thanks, Dave. Now, let's turn to chart 18 and look at the Customer Premises Equipment highlights. Segment sales increased sequentially as demand for cable, telco, and satellite video devices improved. Sales were also favorable as compared to Q2 2015, driven by the integration of the Pace portfolio. During the quarter, we continued to experience solid broadband momentum, with increased DSL revenues offset by lower DOCSIS sales.

Given the strength of the Q2 video shipments, the mix of products shifted slightly towards set-tops, but in general remains approximately 60/40 video movements versus broadband platforms. Our sequential DOI results also improved through a combination of favorable product mix, cost improvements, and synergies resulting from the integration of the Pace and ARRIS businesses.

The CPE integration efforts continue to progress well, with a new cadence of product development underway. The team is realizing portfolio leverage and the benefits of scale across our cable, satellite, telco, retail, and international CPE product areas.

Now, let's turn to chart 19. Looking at the respective product areas, the broadband CPE portfolio was down as we saw sales decrease 8% sequentially and 4% as compared to Q2 2015. The velocity around DSL shipments continued while we saw a decrease in our DOCSIS shipments related to the timing of first half 2016 volumes.

During the quarter, our SURFboard 8200 achieved CableLabs, DOCSIS 3.1 certification, and we began initial shipments of this platform. This device is capable of delivering unprecedented data rates and represents the first in a series of our modem and gateway devices to go through industry certification as we migrate the portfolio to support gigabit speeds.

As we've discussed previously, we anticipate this will start yet another technology refresh cycle with volumes increasing in 2017 and beyond. We were also notified of NetCologne's selection of our Touchstone TG2492, an advanced 24 downstream solution with dual band concurrent radios including 802.11ac Wi-Fi. In addition, we were awarded Get's Wireless Extender business, addressing the need for reliable Wi-Fi coverage around the subscribers' home.

Now, let's turn to chart 20 and transition to Video CPE highlights. Revenues were higher, driven by improvements in all market verticals, cable, telco, and satellite. Sales increased to 18% sequentially and 85% as compared Q2 2015. We experienced strong demand from the U.S. cable market as the technology refresh continued to progress, further enabling the latest in advanced entertainment.

As an aside, it looks as if a more reasonable approach is being considered by the FCC with respect to the original unlock the box proposal. And while the headlines remain challenging at times, it seems that an apps (19:19) based framework is gaining traction and as we previously discussed, is aligned with our thinking around the evolution of CPE within the home and the required investment in the network.

In the meantime, we continue to ship significant volumes of set-tops worldwide. During the quarter, the enthusiasm surrounding 4K continued as we participated in a successful launch of a HEVC-capable set top, the ZD4500 with NOS in Portugal in support of their new immersive 4K service. In addition, we commenced shipments of next-generation 4K set tops with two other international operators, representing both telco and cable segments.

And finally, the ARRIS team was selected by Omantel to provide the VIP2262, an IPTV DVR-capable supporting Omantel's new TV+ service.

I will turn it over to Bruce.

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

Great. Thanks, Larry. Let's turn to chart 22, please. We had a very strong quarter in the network and cloud business, as service providers raced to provide gigabit-per-second broadband speeds to the mass consumer market. Quarter-over-quarter, segment sales increased by 7.5% and contribution income was up 17%, led by record sales in the access technologies business as well as another solid quarter in CMTS.

The year-over-year comparison to ARRIS standalone were obviously very good with segment sales up 33% and contribution income up 56%. As we discussed last quarter, we're in the early stages of a multi-year cycle of increased investment to expand capacity in the physical network infrastructure in order to drive fiber deeper in the network and increase broadband speeds. We continue to add additional manufacturing capacity, expand our supply base and invest in products to address this opportunity.

So the first half of the year is coming a bit stronger than we had anticipated, and we expect the strength in the access technologies division to continue in the third quarter. We expect this to offset somewhat by lower sales in our CMTS division as we complete development of our second generation line cards and get them fully tested and qualified by our customers and into full production.

Please turn to chart 23, please. Cable operators continue to press hard to expand broadband capacity and extend their fiber network closer to the customer, which resulted in the record quarter for our combined ARRIS and Aurora access technologies division. This has also resulted in a stronger mix of fiber optics products, which helps improve the overall margin of the business.

While we're very pleased with the growth in the business, we still have work to do to increase our overall production capacity and keep up with demand. We expect continued improvement in the third quarter, but to still be allocating some products into the fourth quarter. It's been great to see the team come together this year and the creative energy within the organization. It's an exciting time, and we've got the best team in the industry.

Sales of our CCAP and PON products in the second quarter were up year-over-year but down modestly from our record Q1 level and with a higher overall mix of hardware sales. This bodes well for future software and hardware upgrades to the platform. Shipments of downstream software licenses were down significantly in the quarter as capacity previously purchased was being deployed and utilized across our customer networks.

Deployment of DOCSIS 3.1 network capacity continues as operators ready the network for deployment of this new technology. But actual subscriber additions remain fairly low as the new CP devices begin to come to market like the new SURFboard 8200, Larry just spoke about.

We've begun lab testing and certification of our new Gen2 upstream line card with customers and are on track for full field trials later this quarter. This is the first step in a refresh of the platform, with the remaining Gen2 cards on track for delivery early next year. We expect sales in the second half of the year to moderate somewhat during this transition period, and we anticipate a growing amount of revenue deferral as a result of the introduction of this new technology.

In parallel, we're making great progress with our work on Remote Phy that distributes the physical access layer of the DOCSIS CMTS into the fiber node. This new Remote Phy module can be deployed into an existing ARRIS fiber node and connect the network through the E6000 or ultimately through a virtual DOCSIS core that is also in development. This will provide the ultimate in flexibility and massive broadband capacity for the cable operator while leveraging the installed base of the E6000 chassis.

Please turn to chart 24. We had a solid quarter in our video systems division, and I wanted to highlight one of the new products in our Advertising business. This is a technology that came to us from our SeaWell acquisition two years ago that provides for network-based ad insertion into an IP video stream, enabling service providers to have complete parity of their advertising spots across both main screen and mobile, and extend video advertising to be richer and more targeted.

As reported last quarter, our project with HBO has proceeded extremely well, and the new satellite-receiver platform is now in place and able to support 4K Ultra HD and HDR video content. And our ME-7000 platform continues to get good reviews and is squarely targeted at highly dense main screen quality applications where performance and density really matter.

You've probably seen our recent announcement to sell our Moxi Whole Home Solution business to Espial. We believe this is a real win-win for both customers and employees, and combines the great technology developed by the ARRIS team with a smaller, focused innovator in the video middleware and applications space. We will continue to work closely with Espial to support their efforts with our mutual customers and have agreed to a multi-year partnership to continue to provide the hardware platforms that they will use to deliver an advanced feature-rich consumer experience.

Another highlight within our Cloud business in the second quarter were several recent wins with our TR-069 management platform called ECO, which is used by cable, telco, and satellite operators to surveil and manage tens of millions of broadband and video devices.

I want to give a shout-out to our great customer in Australia, NBN, on achieving commercial launch of their HFC service recently. Although this is just the beginning of their ambitious plans to improve broadband service across the country, our professional services team has worked very closely with NBN over the last 18 months, and we're proud to say we're part of this important accomplishment. We expect to be part of their plans for years to come.

And finally, we're encouraged by several recent wins we've achieved with our hosted service provider Wi-Fi offering, whereby we're providing both the equipment and the resources to activate and deploy Wi-Fi broadband service to small and medium enterprises. This is a new way of partnering with our service provider customers, providing a turnkey approach that will accelerate the deployment of their service to enterprise customers.

So, in summary, the first half of 2016 has gone well and demand for our Network & Cloud products remains strong. The pace of technology change has never been faster, and we have a great pipeline of new products and services. With that, Bob, back to you.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Thank you, Bruce. Let's go to the next slide, 26. In spite of the turmoil across the globe and the interesting U.S. election cycle, I'd say that the macro environment for our business is looking good and holding steady. The U.S. cable consolidation seems to be done, at least for the time being, and the outlook is looking strong for the next few years. I expect the U.S. telco and satellite market should improve as AT&T and DIRECTV look to regain momentum, as Verizon gets past the disruption caused by their strike, and as Frontier digests the FiOS acquisition and accelerates their marketing programs. On the international front, the strong dollar is not helping, particularly in the UK, but overall things are no worse and we're adjusting. And as we reported, we saw international sales rebound nicely in Q2 and we expect the momentum to continue into Q3, with improving sales in Canada and in Europe.

I've said many times that the fundamental driver of our business is the growth of Internet traffic. And in past calls, I've mentioned trends such as 4K TV and virtual reality. And I can't think of a better example of the growth of broadband consumption that the sensational adoption of the game Pokémon GO!. This augmented reality experience is just the beginning of what I think is going to be a phenomenal surge in demand across all types of networks over the next several years, and ARRIS will be in the middle of serving those needs.

And with that, back to Bob Puccini for the Q&A.

Robert Puccini - Head-Investor Relations, ARRIS Group, Inc.

Thanks Bob. With that, we'd like to open the lines up for questions. Whitley, would you mind coming back on the line please and letting our participants know how they can queue their questions.

Question-and-Answer Session

Operator

Our first question comes from the line of Mitch Steves with RBC Capital Markets. Please, proceed.

Mitch Steves - RBC Capital Markets LLC

Hey, guys. Thanks for taking my questions. So I guess starting with the revenue line, I think the Comcast piece is probably the one that's moving around quite a bit. So can you guys provide some numbers, at least some sort of I guess trajectory for the piece? So for example if you do the high-end, let's say three million shares and five million shares as well next year, does that mean that Comcast will grow on a year-over-year basis?

Robert J. Stanzione - Chairman, & Chief Executive Officer

We really are not liberty to answer that question, Mitch, because Comcast – because of the confidentiality we have with that customer. So, sorry, I just can't answer that question.

Mitch Steves - RBC Capital Markets LLC

Okay. I got it. And then, I guess the second question I have is on the OpEx side. So you mentioned that you're tracking ahead of plan and I remember you guys mentioned, call it about $135 million in OpEx savings and then $75 million in COGS. Can you maybe provide a percentage of how far are you through that, if you think you're entirely through or just sort of I guess a granular view there.

David B. Potts - Chief Financial Officer & Executive Vice President

Yeah. So I guess I look forward to the end of the year. I think from Q2 to Q3 we can go up some, but we are ahead of where I thought we would be at this point in time. I think as we get into Q4, we'll be into the, call it the $250 millions, as we described at the Analyst Day. So we began, if you like, at $305 million as a combined basis exiting the fourth quarter of this year into those $250 millions. So you can say that we're there, basically. We've done a very good job and we've got to the numbers ahead of schedule.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Same thing on the COGS.

David B. Potts - Chief Financial Officer & Executive Vice President

Yeah. The COGS – and it's harder to find obviously, but I think we're doing pretty well on the COGS side.

Mitch Steves - RBC Capital Markets LLC

Got it. And then one small one, since we're talking about OpEx there. So since the revenue line is essentially going to be flat Q over Q, can you explain why the EPS is going to be down sequentially?

Robert J. Stanzione - Chairman, & Chief Executive Officer

Yeah. Go ahead, Dave.

David B. Potts - Chief Financial Officer & Executive Vice President

So part of it is certainly the mix of – there's $0.04, first of all, remember that we had as an FX gain and when we start the quarter we never think of excess as being either a gain or a loss, but we had a $0.04. So I just remind everybody of that. But there is indeed a difference in product mix which we'll have in the third quarter and that we're anticipating as Bruce spoke about where we think that the CMPS sales are not as rich as what we had in the second quarter.

Mitch Steves - RBC Capital Markets LLC

All right. Great quarter, guys.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Thank you.

David B. Potts - Chief Financial Officer & Executive Vice President

Thank you.

Operator

Your next question comes from the line of Joseph Wolf with Barclays. Please proceed.

Joseph Wolf - Barclays Capital, Inc.

Thanks. Just I was curious if you could give us any more insight into what's changed on the guidance that you provided. How do you feel about the upside in the environment just relative to when you provided it last quarter? And if you could weave in, you kind of mentioned Brexit, but there's been other companies talking about a little bit of a slowdown because of indecisiveness of the customers, but that doesn't seem to have impacted your business at all even internationally with currency pressure. So could you just walk us through some of the outlook and the guidance and your feeling about the sector?

Robert J. Stanzione - Chairman, & Chief Executive Officer

Well, certainly we know a lot more now. We just got out hands on the Pace acquisition on January 3rd or 4th and we've got now six months under our belt and we're beginning to feel more comfortable with what we're looking at. We just finished a pretty strong quarter and we think that the revenue range that we gave back in March at our Investor Day of 6.6 to 6.8; (32:35) we should be at the high end of that by the end of the year assuming things go well.

Same thing on the earnings side, Joseph. We think we'll be above the $260 million that we had as the high end of the range when we started the year with that guidance. On the international side, we actually saw sales go up in Europe. And so, right now, in terms of demand in Europe, it's I would say okay. It's holding steady.

David B. Potts - Chief Financial Officer & Executive Vice President

Yeah. But I would still say currency is on everybody's mind.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Currency is definitely on...

David B. Potts - Chief Financial Officer & Executive Vice President

Yeah. And it's just not – you mentioned Brexit, but I think it's again in CALA and in Europe, I do believe that there's still some damping effects of the currency. The U.S. dollar strength is just not a help obviously from that perspective. Helps us on indigenous expenses, but it's not a help.

Joseph Wolf - Barclays Capital, Inc.

Okay. And then moving on to technology. You mentioned the video divestment of MOXI which I know is small. But could you just sort of balance that with the commitment to being part of video delivery? What ARRIS thinks is important in that side of the business and what you divested in terms of priorities?

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

Yeah. I guess the way I'd answer that is there's a whole variety of elements that go into a video solution or system. And we continue to invest heavily in – I'd mentioned video processing ME-7000 platform which is encoding and transcoding platform with a lot of projects under way relative to network DVR, those types of capabilities. We felt that combining our middleware UI MOXI business with SPL would be the best path for the customers to get a little more scale on that solution and have a company that's focused innovating in that space.

If you look at the solutions that we provide today, Larry's business, we tend to have a whole variety of third party software suppliers that we work with to provide an end-to-end solution for middleware and user experience. It could be a Mediaroom Ericsson solution. It could be a TiVo solution. There's a whole variety of different innovators in that space, as well as our customers themselves with the Comcast X1 solution.

So we just felt like this would be the best path forward to really have the MOXI solution kind of keep up with that pace of innovation.

Joseph Wolf - Barclays Capital, Inc.

I mean, reading between the lines, does that mean you are more comfortable with the behind the scenes and not the user interface, or you see more value on what you're delivering that way?

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

Yeah. I guess I'd say we feel like the other areas that we're targeting in today are areas that we can differentiate and succeed at more effectively and have them work with a variety of middleware and user experience suppliers. And it's the right path for us, and it's a great solution, as I mentioned, for both the customers of that solution today as well as the employees that are working on that program.

Joseph Wolf - Barclays Capital, Inc.

Okay. Thank you.

Operator

Your next question comes from the line of Doug Clark with Goldman Sachs. Please proceed.

Douglas Clark - Goldman Sachs & Co.

Hi. Thanks for taking my question. I want to start kind of geographically, particularly the international strength being up 24% sequentially. Could you give a little bit more detail kind of by region and what was going on there, if it was a few large customers or broadly distributed?

Robert J. Stanzione - Chairman, & Chief Executive Officer

Well, it was fairly broadly distributed. As I said, I think we were up quite a bit in Europe and in Asia. In Asia, of course, the stand-out was with NBN which launched its service in the second quarter. And therefore, we recognized revenue, and we shipped a lot of product in there and had some professional services revenues in Australia. In Europe, it was a little more across the board. Of course, in Europe, Liberty is the largest operator. So as you would expect, they would have been our largest customer in Europe.

In Latin America, things are actually doing okay around in places like Mexico, but really terrible in Brazil. So, that's the kind of the scene as I see it.

Douglas Clark - Goldman Sachs & Co.

Okay. And then, related to that, the third 10% customer is that an international customer or you're still counting kind of the two standalone U.S. cable companies that combined.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Sorry, we can't comment on those customers in here.

Douglas Clark - Goldman Sachs & Co.

You can't say if any of them were international?

Robert J. Stanzione - Chairman, & Chief Executive Officer

Sorry, we won't, we can't comment on that.

Douglas Clark - Goldman Sachs & Co.

Okay. And then I guess a replacement question for that would be on the broadband CPE side, being down sequentially. Is that for customer mix or perhaps a bit of a pause in anticipation of DOCSIS 3.1 broadband equipment?

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

Yes. I think it's a little bit of timing as I said in terms of just customers and working through some inventory. I think in general there would be – we anticipate or discuss there could be a little bit of pause before 3.1 ramps in earnest, although I think that's more of a next year phenomenon. So I think we're just seeing kind of the quarter-to-quarter movement of inventory and shipments. I think in general the momentum around broadband particularly DOCSIS remains quite strong.

Douglas Clark - Goldman Sachs & Co.

Okay. Great. Thanks a lot.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Thanks, Doug.

Operator

Your next question comes from the line of Simon Leopold with Raymond James. Please, proceed.

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

Great. Thank you for taking my question. I just want to get a clarification first, Dave gave us some color on the operating expense expectations for the September quarter I think you indicated on a pro forma basis we'd be up by about $4 million. I just want to make sure I got my notes correct on that.

David B. Potts - Chief Financial Officer & Executive Vice President

We'll see where it comes in but we'll certainly have equity compensation and some merits which will kick in which probably the aggregate of those two things, so about $10 million, Simon. Of course we back out equity comp for non-GAAP. Offsetting that is that we have in for three and four actions that we have taken to lower operating expenses in the third and fourth quarter is will kick in and we've taken essentially the charges for it along the way. So that helps offset some of that in the third quarter and into the fourth quarter as well where we'll see some of the impacts of those. So again I would say we're in the $250 million to the fourth quarter including equity comp.

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

Okay.

David B. Potts - Chief Financial Officer & Executive Vice President

Does that help you?

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

Hopefully I'm getting it correct. I'm sure I can manage to screw it up. But I'm modeling roughly $253 million on a pro forma basis, so excluding equity comp. Does that sound reasonable?

David B. Potts - Chief Financial Officer & Executive Vice President

Yeah. Give Bob a call later on and then go through some of the math with him. But again equity comp, when I'm talking to the $250 millions, so I believe I'm accounting equity comp in there.

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

Okay. So in terms of kind of kind of trending question, I know you're hesitant to give details on customers, but what I really would like to try to understand is that coming into this period, this quarter or next quarter, many of us have talked about this concept of consolidation pause. And so I'm trying to understand whether or not the good sales in June and good outlook for September are telling us that there either isn't much of a consolidation pause or there is a pause but the other customers are much better. Can you help us discern between those two scenarios?

Robert J. Stanzione - Chairman, & Chief Executive Officer

Well there all kinds of things going. Obviously Charter absorbing Time Warner is a big deal and that's liable to present some turbulence in the business. At the same time, Comcast as you saw this morning is hitting on all cylinders and doing quite well and then we've got the other operators in the U.S. So I would say as a whole, U.S. cable is holding steady. What we're seeing happening in U.S. telco/satellite is that we expect that as the year goes on, some of the things that I talked about earlier, the DIRECTV AT&T gaining some traction as the year goes on with Verizon gaining some momentum after their strike and coming back a little bit more; and then Frontier doing a little bit more. So, that's kind of the scene in the U.S.

Internationally, I think that we see things ups and downs. It's kind of everywhere, but it looks like the outlook for the second half is fairly bright.

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

Okay. And one last one if I might. I wanted to focus on slide 18. You've given us some nice disclosure splitting the broadband devices from the video devices, and I'm surprised that the strength in video devices, because everybody keeps telling us that video devices are going to zero. So in light of this surprising trend, could you help us understand I guess why you're continuing to see strength in the broadband whether there's sort of one-offs there or – sorry, why the broadband slowed down this quarter. And then in terms of the video strength, do you see that as sustainable or were there one-offs in the quarter? Thanks.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Let me start on that, Larry, and then, you finish. Set-top boxes are not going away. We've said that, and we've had trouble getting folks to believe that, but I think the evidence right here is that set-top boxes are not going away. We are designing new next-generation set-tops for major cable operators around the world as we speak, and we believe that video set-tops will remain a significant component of our business for quite some time into the future.

This debate that's going on I think has clouded that quite a bit. There's clearly an evolution going on within video devices, and a lot of new things have been shown recently such as the app-based approach using other devices than traditional set-tops. Nevertheless, those have not penetrated the market very much yet. Over the next three, four, five years, we expect that evolution to continue. So, Larry, take it from there.

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Yes. So I would just echo some of Bob's comments. I think, Simon, we saw improvements across really all of the market verticals, right, so it was cable, telco, satellite. It wasn't one particular item. It was, I think, a series of things that came together as customers still obviously focus on the video part of their business.

And we expect that that will go through an upgrade cycle to support 4K HDR, et cetera. To Bob's point, over time – and when I say time, several years – there will be a migration to IP video delivery, specifically for the cable vertical, which will drive towards much more advanced broadband gateways and a different home ecosystem and architecture, if you will. But I think the video piece continues to run for quite some time. On the broadband...

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

And how about the decline in broadband? Yes. Thanks.

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Yes. So broadband is a combination of really, in this case, the two axis (45:15) technology, DSL as well as DOCSIS. I indicated that the DOCSIS was down, really in my mind, primarily due to kind of some timing issues around shipments, where Q1 was a little bit healthier for a few particular customers. I think they've worked through some of that.

In general, I would expect DOCSIS to continue to provide good momentum over multiple quarters. We're still seeing a strong emphasis on advanced Wi-Fi capabilities, and then when 3.1 really becomes available and kicks into full stride I would expect, and the dialogues we're having with customers indicates a pretty substantial multi-year upgrade cycle will take place on that platform. So I think both are good. But to Bob's comments, I expect the in-home ecosystem to change over the three- to five-year timeframe.

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

Great. Thank you for taking my questions.

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Sure.

Operator

Your next question comes from the line of Rich Valera with Needham & Company. Please proceed.

Rich F. Valera - Needham & Co. LLC

Thank you. Dave, I think – I want to sort of clarify what I think you were saying in terms of the two segments quarter-over-quarter. It sounds like you expect CMTS to be down. And I'm presuming that would tend to drive Network & Cloud down quarter-over-quarter and presumably CPE up quarter-over-quarter to keep that sort of flat trajectory, and that results in that sort of lower margin, lower overall gross margin. Is that a fair way to think of it?

David B. Potts - Chief Financial Officer & Executive Vice President

Yeah, I think that there'll be a change in mix. I can let Bruce comment a little bit more too.

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

Yeah. I think what I tried to say, maybe I wasn't clear enough, was the access infrastructure part of the Network & Cloud business we expect to grow in third quarter. It will be offset somewhat by CMTS being down in third quarter. That's what we think. And that mix shift along with the CPE business all goes into the pool as we put our guidance together for the third quarter.

Rich F. Valera - Needham & Co. LLC

Great. Bruce, I was hoping you can give a little bit more color on the dynamics of this Gen2 transition? So I think what you said last quarter is, you thought that some customers might sort of pause purchases in front of the Gen2. I mean obviously some I think will continue to buy capacity presumably that they need. So is that what it really is, is a pause as customers wait for the Gen2 cards and then once you get them out you get sort of a bump? And that happens – it sounds like you're saying next year.

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

Yeah. I guess every customer is a little bit different. But as we get into testing the new line cards, of course, you're going to spend a dollar, you'd rather spend it on newer stuff than older stuff. And so we think there's some pause and that's what I'm pointing to here in third quarter. In some cases, we're providing an ability to transition from first gen to second gen where we're shipping product and waiting for that certification, and that's kind of the revenue deferral piece I talked about.

Rich F. Valera - Needham & Co. LLC

Got it. That's helpful. And then I'm not sure that you can comment on this, but Comcast on their call today made reference to a next generation box for the X1 service or the XFINITY service, actually – wireless, I guess, video delivery. Anything you can say about your involvement in that at this point?

Robert J. Stanzione - Chairman, & Chief Executive Officer

I'm afraid not. Afraid not.

Rich F. Valera - Needham & Co. LLC

I kind of figured that was the case. I thought I'd try. Okay. Thanks, gentlemen. Appreciate it.

Operator

Your next question comes from the line of Greg Mesniaeff with Drexel Hamilton. Please proceed.

Greg Mesniaeff - Drexel Hamilton LLC

Yes. Thank you. Focusing on the CPE business, we talked a lot about 3.1 as a key driver for next year, mostly. Can you give us some range as to how much the Wi-Fi upgrade roadmap is going to be a driver here as well, if not even greater?

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

So, Wi-Fi certainly has been a key feature in the broadband gateways that we deploy across all-access technologies and has been a real driver, obviously, for consumers but also service providers looking to deploy the latest in Wi-Fi for coverage in the home. I can tell you, every customer meeting that we have, the discussion around Wi-Fi comes up in terms of what is the roadmap, what are the points of inflexion for driving new capabilities into the platform. So, I would agree and that goes to a statement back, that Wi-Fi is very much a key driver.

Certainly, the access technologies in the reference of DOCSIS 3.1 getting gigabit speeds to the home, but then, you don't want that bottleneck to be Wi-Fi. So we are continuing to focus on that area and our roadmap supports I'll say continued feature development both on the hardware and software sides, both within the home as well as into the network in terms of the capabilities that exist there. So, I would say that it's a very important area for us.

Greg Mesniaeff - Drexel Hamilton LLC

So I guess what you're saying is to avoid any potential bottlenecks on the Wi-Fi piece of it, as 3.1 rolls out, you're going to be timing that with a more appropriate Wi-Fi roadmap as well.

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Yeah. So I would expect we will continue to see Wi-Fi being upgraded certainly with the 3.1 introduction. Broadly speaking, we would look to provide that or tie that to a more capable Wi-Fi subsystem in the gateway. But recalling the two technologies in some cases, while there's intersections, they also are advancing at different rates. So there are situations that I would expect we'll experience in the future as we have in the past where we'll be doing platform upgrades to the Wi-Fi subsystem based on the same access technology and vice versa. But obviously as we're able to put them together, we do.

But the short answer to your question is yes, we will continue to look to improve the Wi-Fi capabilities in the 3.1 platforms.

Greg Mesniaeff - Drexel Hamilton LLC

Got it. And just regarding the telco guidance or outlook you gave us for CPE, any additional color on AT&T Direct TV CPE that you can give us?

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Nothing specific. Some of Bob's comments earlier were anticipating or expect I would say the momentum to be regained with respect to AT&T and Direct TV. But nothing really beyond that.

Greg Mesniaeff - Drexel Hamilton LLC

Great. Thank you.

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Thanks Greg.

Operator

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

Unknown Speaker

Hi guys, this is Kyle (53:05) in for George. Thanks for taking my call. I guess the one thing – you mentioned the merger activity that closed this year had caused you to add a bit of conservatism into your guidance at the last quarter. I was wondering whether that is still true in this quarter's guidance, whether you feel the same way or whether that's changed. And I have a follow-up.

Robert J. Stanzione - Chairman, & Chief Executive Officer

I would say it's changed. I think we're three months smarter than we were three months ago, and the deal with Time Warner and Charter is done. So, I think we're a little bit better in terms of having visibility towards what they're going to do the rest of the year.

Unknown Speaker

Sure. Thanks. And then I guess I was also looking for a little bit more color on DOCSIS 3.1 and what the eventual revenue ramp may look like in terms of timing, just in a general sense. I guess, first of all, did you have any DOCSIS 3.1 revenue in this quarter? And then, if not, can you give any color around any projects or customers you're working with on 3.1 and whether you have any kind of insight as to what the timing of the eventual revenue and ramp might look like?

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

There are two pieces to that.

David B. Potts - Chief Financial Officer & Executive Vice President

That's correct.

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

So I think on the network side, we have customers already starting to enable DOCSIS 3.1 spectrum in the plant. That takes time to find the right frequencies, get the technology, get the licenses loaded, all those sorts of things from a CMTS perspective and be able to turn on your first DOCSIS 3.1 modem. So we've certainly had sales already this year of that DOCSIS 3.1 license capability on the E6000 and certainly had some in the quarter.

Robert J. Stanzione - Chairman, & Chief Executive Officer

You certainly had some in your house, too.

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

Oh, yes, picture.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Tell them.

Bruce William McClelland - President, Network & Cloud and Global Services, ARRIS International Plc

The picture on my opening slide was actually a snapshot from my home here in Atlanta where we have a DOCSIS 3.1 modem from Comcast XFINITY service, and you can see it was running about 950 megabits per second which is great for my son's gaming experience. So, good stuff.

Robert J. Stanzione - Chairman, & Chief Executive Officer

And then, Larry, on the CPE side.

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

Yes. On the CPE side, in terms of the quarter now, I mean, we've really just begun to get the first units certified and literally, the first year out. I would expect the migration to be similar to kind of the cutovers that we've seen previously with DOCSIS 2.0 to 3.0 and then successful generations of the increasing downstream capability. So, I don't know there's a ramp overnight. It will be a portfolio mix item that we'll continue to look at and monitor as we go, going to 2017.

Unknown Speaker

Sure. And with that answer, you may have already answered – kind of given some color around this, but should we see the Network & Cloud start ramping before CPE and then eventually CPE would also follow or would it be the other way around?

Larry Robinson - President, Customer Premises Equipment, ARRIS International Plc

I think some of the strength this year is already – on the CPE side, is already related to DOCSIS 3.1. And the great ability to be able to go to a software upgrade turn on this additional new capability in the platform. So, we're definitely starting to see that upgrade cycle on the network side happen already this year, and I think CPE we believe will be a phenomenon for 2017 in a material way.

Unknown Speaker

Okay. Thanks a lot.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Thanks, Kyle (56:50).

Operator

And your next question comes from the line of Mitch Steves with RBC Capital Markets. Please proceed.

Mitch Steves - RBC Capital Markets LLC

Hey, guys. I just have a quick follow-up regarding the cash flows. And since you guys are doing about $261 million this quarter, I'm just wondering what a rough idea for kind of annualized free cash would be fair for the company.

David B. Potts - Chief Financial Officer & Executive Vice President

Yeah. So there's obviously changes in working capital that are embedded in the cash flow. But here is sort of how I think of it, we have the $199 million if you like from the earnings elements. Some of which was a tax benefit in the GAAP results, so I take that out. Remember that which was what $60 million or so I believe. Remember that we did have about $33 million of restructuring charges which we took in the quarter as well. And those should slow down as we think through the remainder of the year.

And CapEx is probably $10 million to $15 million a quarter. So, you should be able to model off of that. What should be a pretty robust free cash flow if all other things being equal were at a similar rate today. But that's sort of how I go at it (57:56).

Mitch Steves - RBC Capital Markets LLC

Perfect. Thank you.

David B. Potts - Chief Financial Officer & Executive Vice President

Sure.

Robert J. Stanzione - Chairman, & Chief Executive Officer

Thanks Mitch.

Operator

There are no further questions in queue.

Robert Puccini - Head-Investor Relations, ARRIS Group, Inc.

Thank you, Whitley. Bob, any final words?

Robert J. Stanzione - Chairman, & Chief Executive Officer

No. Just keep going and go play Pokémon GO! And put more traffic on the network.

Robert Puccini - Head-Investor Relations, ARRIS Group, Inc.

Thanks everyone. That concludes our call.

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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