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Arris Group, Inc. (NASDAQ:ARRS)

Q1 2008 Earnings Call

April 29, 2008 5:00 pm ET

Executives

Jim Bauer - Vice President of Investor Relations

Bob Stanzione - Chairman and Chief Executive Officer

Dave Potts - Executive Vice President and Chief Financial Officer

Jim Lakin - President of Advanced Technology & Services

Larry Margolis - Executive VP of Strategic Planning & Admin

Bruce McClelland - President, Broadband Communications Systems

John Caezza - President, Access, Transport and Supplies

Bryant Isaacs - President, Media & Communications Systems

Analysts

Greg Mesniaeff - Needham & Company

Todd Koffman - Raymond James

Paul Bonenfant - Morgan Keegan

Larry Harris - C.L King

Andy Shopick - Nutmeg Securities

Brian Coyne - FBR Capital Management

Larry Harris - C.L. King

Jason Kim - Thomas Weisel Partners

Nikos Theodosopoulos - UBS

Ehud Geblum - JP Morgan

Anton Wahlman - Thinkpanmure

Ehud Geblum - JP Morgan

Anton Wahlman - Thinkpanmure

Operator

Good day ladies and gentlemen and welcome to your First Quarter 2008 Arris Group Earnings Conference Call. My name is Carol and I’ll be your coordinator for today. At this time, all participants are in a listen-only mode. We will be conducting a Q&A session at the end of today’s conference. (Operator instructions).

I would now like to turn the presentation over to your host for today’s Mr. Jim Bauer. Sir, you may proceed.

Jim Bauer - Vice President of Investor Relations

Thank you, Carol and welcome to all of the participants here on the call with management this afternoon. We are going to discuss our first quarter 2008 financial results, which were released just after the close of the markets.

Let me also note that we will be using a series of slides during our webcast today, which are also posted on the Arris website in the Investor Relations Section. With us here at the Arris headquarters are Bob Stanzione, the Arris Chairman and CEO, Dave Potts, our Arris Executive Vice President and Chief Financial Officer, and also with us today are Jim Lakin and Larry Margolis as well as the heads of our new business segments, Bruce McClelland, John Caezza and Bryant Isaacs.

As noted in our press release, there will be a replay of the entire call approximately two hours after the conclusion of this call, and the replay of the call and the slides will be available on our corporate website for the next 12 months.

As usual before we begin, I would like to point out that during this call we will be making or maybe called upon to make forward-looking statements including statements regarding our outlook and expectations for the industry in general, estimated revenue and earnings for the second quarter of 2008, our outlook for 2008, certain financial operating metrics, the timing and introduction of certain new products and technologies, and anticipated spending patterns by some of our customers, as well as expected sales levels for certain product categories. It is important to note that the actual results made differ materially from those suggested by any of these forward-looking statements.

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

Bob and Dave will now provide their comments on our results and any other topics that you may wish to discuss, after which we will open up for your questions and answers. With that now, over to you Bob.

Bob Stanzione - Chairman and Chief Executive Officer

Thanks, Jim and welcome everyone. Before Dave goes through the financials and starting with chart 4, I would like to make some comments on the Q1 results and that our progress on the integration of C-COR after our first full quarter together. And lastly, on the outlook for the business and the environment in the second half of the year.

We will go to chart 5, as you know in February, we announced an authorization to purchase up to a $100 million of our outstanding shares. Since then, we bought back approximately $13 million shares or close to 10% of the outstanding shares of the company for $76 million. We believe that with the cash that we had on hand and our prospects for generating additional cash that this was a prudent way of returning value to our shareholders, while maintaining a strong balance sheet and our ability to continue to invest in the business.

Now taking a brief look at the Q1 results. As you can see and as we expected the combined Arris and C-COR revenues to Comcast, or revenues from Comcast were down by approximately $62 million from Q4 and that was across all the product categories, but particularly in the EMTAs. However, as we pointed out before, we expect much of this Comcast business to bounce back nicely as the year goes on, especially as our new DOCSIS 3 products are released and installed in their network.

On a much more positive note, I can report that on a like-for-like basis Q1, 2008 compared to Q4, 2007, the combined Arris and C-COR sales to all other customers were up by about 11% or $24 million. So, you see that we are making good progress in diversifying our customer and product mix and that our quarter-over-quarter decline in Q1 was concentrated with one customer, who we expect to bounce back over the balance of the year.

Significant proof that our acquisitions strategy and implementation has been spot on is that our gross margin improved to 31.2% and our cash from operations was $30.5 million. And I am especially pleased by these results.

We had another strong performance in the very important international markets, where we recorded almost 85 million of revenue, which was over 30% of our total sales. In particular, we performed well again in Latin America, where we just scored a new win, which we hope to announce details of shortly for our work assure OSS software. CMTS sales of Latin America continue and we also expect soon to begin more significant EMTA shipments into the region.

Sales in Europe especially in Germany were strong as were sales into Canada. And as we reported recently we had a nice DOCSIS 3 win with iTSCOM in Japan. We also see growing opportunities to build on the strong C-COR value added reseller network in the international markets.

As Dave will describe in a moment, our sales from Time Warner and Charter were outstanding in the quarter with both accounts reaching record levels across nearly all product lines. CMTS on-demand and OSS software were notable winners in that mix.

Now let’s turn to chart 6 for a few product highlights. Starting with broadband communication systems or BCS. In spite of the so called wait for DOCSIS 3 effect that I mentioned last quarter CMTS shipments both measured in ports and chassis were again at near record levels. Both new and existing customers are continuing to buy DOCSIS 2 equipment and some are buying partially loaded chassis in anticipation of upgrading to DOCSIS 3 later on.

More specifically we shipped 7,401 downstream ports and 285 new chassis. BCS made great progress during the quarter in our DOCSIS 3 product development for both the CPE devices as well as the CMTS. We have now passed most of the major development hurdles and we are in the process of ramping up the initial production of the new hardware required by our customers to deploy wideband service.

Interest in this product family is very high and we expect to be extremely busy making DOCSIS 3, CMTS and CPE equipment shipments beginning in the latter part of this quarter. However, I should note that customer acceptance of the DOCSIS 3 software is not scheduled until the third quarter and therefore our second quarter shipments will have revenue deferred into Q3.

Now let me focus for a moment on the underlying strength of the EMTA business. Sales to customers other than Comcast actually reached a record level in the first quarter, 20% above the previous high. Shipments of multi-line EMTAs and wireless gateways jumped during the quarter as our customers install more business services and offer residential customers a wireless option.

Overall we shipped 1.64 million CPE units at solid margins during the quarter with over 30% of those units going into international customers. And as I said earlier we have good prospects for further international growth as the year goes on.

In addition our new model 600 Voice-over-IP EMTA reached full production in the quarter. The transition to this product is now almost complete. Because of slower switched digital video deployments we didn’t ship many D5 Universal Edge QAM in the quarter. We are pleased by customer interest in the product for application such as modular CMTS, Broadcast and VOD applications, as well as SDV, but frankly the growth of this product line has been slower than we expected.

Now moving on to Access Transport and Supplies. The ATS business came on strong in March after a slow start at the beginning of the year. In addition margins are improving as we see a continuing mixed trend toward optical transmission equipment as operators continue to split nodes to add capacity for more on-demand and high definition video. Growing supply chain efficiencies allowed to improve inventory levels and will continue to yield margin improvements as the year goes on.

Our new CORWave, wave division multiplexing product is gaining traction in the market with major customer qualifications occurring in the quarter and more to come. CORWave is an extension of our broadly deployed CHP optics platform that allows operators to efficiently add residential and business contact without the need for expensive and time consuming infrastructure changes.

Our extended market presence combination of C-COR and Arris is also yielding fruit with growing A&T sales, Access & Transport sales into Latin America where we've had little activity in recent years. In general, we see good growth opportunities in both the North America and the international markets for our ATS business.

Now turning to media and communication systems. This unit includes our video-on-demand and advertising platforms as well as operation support systems. On-demand highlights for Q1 include major expansions of the VOD platforms in key customers worldwide. This includes both streaming and storage capacity enhancements, as well as increased ingest capacity in anticipation of time-shifted TV service.

We continue to participate in advanced advertising trials with strategic partners and with key customers primarily in North America. In Europe, Arris finalized the first and the second digital program insertion advertising systems and we are laying the groundwork for advanced advertising applied to non-linear program.

And as I mentioned earlier MCS also recorded an impressive win with a major Latin American operator for our work assure OSS software platform. These software platforms provide operators with the capability to improve their network performance and reduce operating expense by more effectively managing their networks. These businesses hold great promise for strong growth at high margins and so we are adding resources in the area to accelerate feature development and increase customer support.

For example, we are working to accelerate our new service show release that integrates the DOCSIS 3 monitoring. Our ability to get this done is an example of the cross products energy that we anticipated with the C-COR acquisition. And some of these development work is taking place in the Arris Development Center in Shenzhen and China.

Now moving to chart 7 and the C-COR integration. I must say it’s just going great. Clearly the objectives we set out to achieve when we announced this deal last year, are being achieved. As I have said we have diversified our customer base, we diversified our product portfolio and we’ve improved our financial profile. The cultures of the two companies have come together very well and the heavy work of integrating the talent and the processes of the two companies is essentially done.

The largest remaining task is the behind-the-scenes work of integrating the back office systems of the two companies. Although, this is truly a difficult task, we’re making progress at or ahead of plan, and we expect to have this mostly complete in the third quarter and fully done by the end of the year. I think it will be fair to expect that in the first quarter of a major merger that more than a few things might [arrive]. However, as you can see from the operating results, receivables, payables, and inventories are clearly under great control. Cash generation is very robust. There is clearly still work to be done, but the integration is proceeding impressively so far.

I also had opportunity during the quarter to meet face-to-face with several of our major customers to describe the new Arris and I have received very positive feedback and some valuable suggestions for further improvement.

Now, let’s move to chart 8. On this chart, I’ve described the outlook for the rest of the year. On the February call, I said that we expected the year to begin slowly and we explained why. I also said that barring an economic crisis, we expected momentum to pick up such that by the second half of the year we should be experiencing year-over-year gains in both revenues and earnings. Now that we are three months further into the year, I’m pleased to report that we continue to feel that this is the case.

Our growing optimism is based on better visibility into specific projects that are going to drive top line growth and margin expansion. Several factors will contribute to these improvements. Some key examples include the good progress we’re making in DOCSIS 3 introduction, the achievement of significant SG&A synergies, key product cost reduction programs, the reduction of purchase accounting effects, and increases in high margin software sales. And you can see from the second quarter guidance that we’re beginning to see improve velocity in the business.

And now, turning to chart 9, and a couple of points before I close. The overall environment in which we operate continues to be to our advantage. Clearly, the overall economy has slowed down somewhat. Accordingly, we will continue to be cautious and monitor and control expenses carefully. However, we believe our performance will continue to strengthen through the years, our customers continue to be driven by the same factors that we have mentioned so many times before. Competition among the MSOs, telco’s and satellite service providers has become even more intense. Network traffic is growing at a very healthy pace, driven by heavy peer-to-peer traffic and growing video content. And more recently regulatory pressures are forcing operators to think about network solutions to cope with the forces of network neutrality and now even the bloggers are out there putting pressure on the operators to improve their service.

And so to summarize on chart 10, I’m very pleased with the progress that we have made in the quarter. I anticipate continued improvements as the year goes on and we are operating in an environment that favors Arris Solutions.

Dave, would you go through the financials now?

Dave Potts - Executive Vice President and Chief Financial Officer

Sure. Thanks, Bob, and thanks everyone for joining us this afternoon. Let’s start by reviewing some of the financial highlights on chart 12.

Sales were $273.5 million in the first quarter and compare to 235.3 million in the first quarter last year. The increase reflects the addition of C-COR. Including the revenues which C-COR reported last year, sales in the first quarter of 2007 were 308.3 million. Gross margin was 31.2% in the first quarter, up 180 basis points from the first quarter of 2007. Including C-COR, the first quarter 2007 gross margin was about 32.9%.

As I have explained on prior calls, when comparing both sales and gross margin to historical results, our current results will be negatively affected by purchase accounting impacts in particular the treatment of our deferred revenue. We estimate that our first quarter margins were impacted by approximately $7.4 million or nearly 200 basis points of gross margin. This of course will decrease through the year.

SG&A and R&D totaled $65 million and was up $23 million year-over-year primarily as a result of the acquisition. Including C-COR’s results in the first quarter of last year, our spending was down by approximately $1 million.

Our non-GAAP EPS was $0.12, which was at the upper end of the guidance we provided in February. This compares to $0.20 in the first quarter of 2007. The decline reflects several factors: first the broadband and supplies products or if you will the former Arris business, were down year-over-year as a result of anticipated lower sales to Comcast. Next, interest income was lower due to lower rates and less cash on hand. Finally, the C-COR acquisition was mildly dilutive primarily as a result of the purchase accounting impacts.

Our GAAP EPS was $0.04 and compares to $0.34 in the first quarter of 2007. Significant items to note are the amortization of intangibles related to the C-COR acquisition and gains recorded last year as a result of the breakup of the Tandberg acquisition. A reconciliation of our GAAP to non-GAAP earnings is attached to the press release and can also be found on our website.

Cash and short-term investments ended the first quarter at $293 million. We generated $30 million from operations. You will probably note that our cash position is down from year-end. In the first quarter, we used $76 million of cash to buyback 13 million shares at an average price of $5.84 per share.

We also retired $35 million of debt, which we assumed as part of the C-COR transaction. As a result of our share buyback program, our outstanding share count declined to 122.4 million shares at the end of the first quarter.

Now let’s turn to sales on chart 13. As you know the C-COR acquisition has a significant impact, our reported results compare our new combined company in 2008 to the former Arris standalone in 2007. To help you better understand the trends, attached to our press release is a summary of sales and gross margin by segment as reported and also including the former C-COR results.

Let’s first talk to some of the sales by segment bar chart on the top left comparing our reported sales by segment. BCS sales were $189.6 million in Q1 and were down from both the fourth quarter and the first quarter of 2007. As expected, our sales to Comcast were down across the board. The decline was partially offset by gains with other customers notably Time Warner, Charter and international customers.

ATS sales were $72.9 million in Q1 and were up from both periods. This is a result of the acquisition. Relative to the first quarter of 2007, both the supplies products and access and transport products were lower.

MCS sales were $11 million in Q1 and were up from Q4 and Q1 ’07. This too is a result of the acquisition.

Let’s move to the bar chart in the bottom left. Here we provide a comparison of the combined sales of the former Arris and C-COR and we also adjust for the estimated purchase accounting impacts in Q4 ’07 and Q1 ’08. These impacts are the results of re-valuing C-COR’s historical cost base deferred revenue to fair market value at close. The vast majority of this foregone revenue an estimated $7.1 million in the first quarter of 2008 will be associated with our MCS segment.

Some comments. ATS was down when compared to both periods, again both supplies and A&T are down. Within the Access & Transport products, we are seeing slower demand for RF. However, good demand for our higher margin optics gear, adjusting for purchase accounting impacts, MCS is up.

The pie chart in the top right provides a domestic versus international split. Please note that this analysis includes a former C-COR sales in prior periods. As you can see, our international mix was up in Q1 ’08. The combined international sales were $85 million in the first quarter of ’08, $93 million in the fourth quarter of ’07, and $77 million in the first quarter of ’07.

One final comment on sales. We have three 10% customers: Time Warner, Comcast, and Charter. Sales to Time Warner were $71 million in the first quarter, up from $46.4 million on a combined basis from the first quarter of 2007. Sales to Comcast were $34.2 million, down from 90.5 million on a combined basis in the first quarter 2007. Sales to Charter were $29 million in the first quarter of ’08, up from $18.5 million on a combined basis in the first quarter of ’07. You may note that we have adjusted historic Comcast sales. We are required to report affiliates under common control. Historically, Insight was considered an affiliate, but is no longer.

With respect to our order backlog and book-to-bill ratio, we ended the first quarter with a backlog of $147 million, which was up from the year-end backlog of 137 million. Our book-to-bill ratio in the first quarter was 1.04.

Let’s turn to gross margins on slide 14. Once again, the trends are impacted by the acquisition. Let’s start with the bar charts on the top left. Here we contrast the reported margins by segment. The stack bar show the dollar value of gross margins in millions generated by each segment, the percentages of the gross margin percent by segment and in total on the top. Some comments. BCS margin improved to 30.6% in Q1 from Q4. The improvement is a result of both product and customer mix. ATS and MCS are both improved as a result of the acquisition.

On the bottom left, we show margins including the former C-COR and we also adjust for purchase accounting impacts specifically deferred revenue and cost and inventory revaluation. Some comments on this. Notably, the overall margin would have been above 33% for the combined company. ATS margin percent improved from Q4 ’07 as a result of product mix in particular more optics. MCS margins, if we were to adjust for purchase accounting impacts, would be north of 50%. Our overall margins of course are very sensitive to product and customer mix. That being said and while it’s early days, I am very pleased with the product and customer diversification that the C-COR acquisition has provided us and indeed the corresponding margin impacts.

Let’s turn to operating expenses on chart 15. Once again the acquisition comes into play. R&D and SG&A are up to combined $23 million year-over-year as a result of the deal. Amortization of intangibles is up $13 million again as a result of the transaction. In the far right column, we show what Q1 ’07 was on a combined basis. As you can see, SG&A is down by about $2.1 million reflecting first synergies we have achieved.

Let’s take a look at some balance sheet and cash highlights on chart 16. We ended the quarter with $293 million of cash and short-term investments, down about $99 million from year-end. There are some several things to know which are quite important.

First, we generated $30 million of cash from operations. Next, we bought 13 million shares back at an average price of $5.84 per share. In doing so, we used $76 million of cash. As planned, we redeemed at par the $35 million convertible note we assumed as part of the C-COR transaction. And finally, we used about $12 million to pay off various deal related liabilities.

I thought I should also touch on auction rates securities today given the buzz in the market about these. Included in our year-end number of 392 million was $27 million of auction rates. Included in the $293 million at the end of the first quarter was $22 million. We also have $5 million included in long-term investments at the end of March. In April, we either sold or had redeemed all at par the $22 million of short-term instruments hence we classify them as short-term investments at the March quarter-end. The remaining $5 million from year-end is a single student loan issue which is AAA rated and backed by the Federal government. It failed at auction twice. As a result, we moved it from short-term to long-term for the time being. Given the AAA rating and backing, we do not believe it is a credit risk and hence continue to value at par. So the bottom line is we have very very little exposure to the Arris.

Let’s turn to guidance, which is on chart 17. At this point, we estimate the sales to be in a range of 288 million to 303 million and that non-GAAP EPS will be in the range of $0.13 to $.0.17 per diluted share and GAAP EPS will be in the range of $0.04 to $0.08 per diluted share. A reconciliation of our GAAP to non-GAAP EPS guidance can be found in chart 18 and is also attached to the press release. Reconciling items include amortization of intangibles and equity compensation expense. We are assuming 124 million fully diluted shares and we are assuming a tax rate of 37% in Q2.

With respect to the tax rate, as many of you probably know, Congress is yet to approve the continuation of the QER credit. Once they do so and we assume that we will apply that interactively as it usually is, our rate should reduce to about 35% for the year.

Finally, on chart 19, we’ve included a reconciliation of our GAAP to non-GAAP earnings per share for the first quarter of 2008 and 2007.

So that concludes my remarks and let me turn it over to Jim Bauer to moderate the questions and answers.

Jim Bauer - Vice President of Investor Relations

Very good. Carol, if you would come back on the phone and just give the participants' instructions how to ask questions, we’ll get underway.

Question-and-Answer Session

Operator

(Operator Instructions). And our first one comes from Greg Mesniaeff of Needham & Company. Please proceed.

Greg Mesniaeff

Yes, thank you and nice to hear the results for the first quarter the way they have been tracking. Question on the gross margin, which obviously came in quite a bit better than the previous quarter. Taking C-COR out of the equation just momentarily, how much of the gross margin improvement was due to the shift in customer mix and customer concentration that you saw in the first quarter namely the lessening of reliance on Comcast?

Dave Potts

Well, I think it's customer and product mix, Greg, it’s Dave speaking. So, of course, we had less Comcast and we had less EMTAs, which had to help the mix and we also had marginally less D5 sales in the first quarter as well. So, those pieces triggered the change in the BCS gross margin improvement which you see.

Greg Mesniaeff

And as far as my other question is on DOCSIS 3.0, regarding Comcast and other MSOs, what kind of visibility do you currently have on the ramp of 3.0? I know Comcast already announced a trial in the Minneapolis area and I am sure there is more down the road. So, I was just kind of wondering if what kind of visibility have they given you so far for the second half of the year?

Bruce McLelland

Hi Greg, this is Bruce McLelland here. So, I guess, in general our visibility on the 3.0 rollout and ramp in the second half of the year has increased significantly. I think we've got a pretty accurate view of who, what, when, where and why basically and the details on how that’s going to happen. So I think we’ve got a pretty good handle on the second half of the year and how that's going to or at least start in third quarter here.

Greg Mesniaeff

And just to finish up here. As your international customer concentration continues to increase, what kind of receivables outlook do you see in terms of DSOs and do you see any departures from the current collection profile?

Bruce McLelland

So, in the big picture so you see that our DSOs were 55 days in the first quarter, which reflects international makes and just sort of what's going on in the industry, so 55, 60 is probably the right range.

Greg Mesniaeff

So 55 to 60 is what we should sort of be assuming for going forward basis.

Bruce McLelland

Yes.

Greg Mesniaeff

Thank you.

Bruce McLelland

Sure.

Operator

Thank you. Your next question comes to you from the line of Todd Koffman of Raymond James. Please proceed.

Todd Koffman

Thank you. Can I get a clarification on the pretty dramatic increase in your Time Warner business, was that --what products is driving that and was that impacted by the mix at C-COR or older traditional Arris product? Thank you.

Robert Stanzione

It was both Todd. The CMTS sales, the EMTA sales, the on demand sales, OSS product, it was really across the board. If it had been Arris alone, it would have still been a record quarter for Time Warner. Of course, Time Warner was the strongest account that C-COR had and I attribute some of our success to the fact that we have combined these two operations, but it was definitely both sides contributing.

Todd Koffman

Was there any weak categorization since you cited as Time Warner an affiliate?

Robert Stanzione

No.

Bruce McLelland

Only in the Comcast account,

Todd Koffman

And then just unrelated, on the D5, can you give any more color? You said it's kind of coming along slower than you would have hoped. Any more color? Thank you.

Robert Stanzione

You want do that Bruce.

Bruce McLelland

Yes. Todd, I guess the SDV deployments are slower than we had anticipated, but I think most of the focus is on all the other applications that go with the Universal Edge QAM, so there is an awful lot of interest in the MCMTS deployment and then obviously just given the broad expansion, but certainly a lot of effort going into the MCMTS set of features and really that’s in the labs and going through integration testing at this point.

Todd Koffman

Thank you. Good luck.

Robert Stanzione

Thanks.

Operator

Thank you. Your next question comes from the line of Paul Bonenfant of Morgan Keegan. Please proceed.

Paul Bonenfant

Hi, thank you. Dialing in for Simon Leopold today. First question, I may have missed it, but you talked about shipping 1.64 million in CPE this quarter and I wonder if you didn’t already, if you could breakout your EMTA and also if you could the percentage of that that was multiline?

Bruce McLelland

EMTA was by far the largest piece of that. The data-only modems were in the 100,000 unit range and the rest is a combination of a two-line and the multiline products and again most of it is the residential, but we were pleased with some growth in both multiline and as Bob mentioned the wireless MTA was a real healthy growth order.

Paul Bonenfant

So multiline then was about, I think, you talked about 21,000 last quarter?

Bruce McLelland

Right. It was about that not dramatically, but it was above the fourth quarter deployment number.

Paul Bonenfant

Okay. And revisiting the question that was just asked about the D5, earlier you had given guidance or forecast of exiting 2008 at a run rate of 10 to 15 million per quarter. It sounds like we are going to fall short of that. Can you give us some update as to where you think you will be exiting 2008 or when you think you will hit that 10 to 15 million number?

Robert Stanzione

Yes, this is Bob and since it was Bob who said that I will take the question. I think that we are going to have difficulty in reaching that level by the fourth quarter of this year simply because of the redirection of the Switched Digital Video programs at our largest customer and we talked about that on the call before. Therefore, what we are doing is broadening our perspective or broadening our marketing efforts as well as our development efforts to develop the features we need on the Edge QAM for the other applications such as VOD, Modular CMTS and the like. I wouldn’t give up. I am not giving up. We are not giving up on the 10 to 15 by the end of the year, but I think the probability of reaching that is lower than it had been say three months ago.

Paul Bonenfant

Okay, thank you. And coming back again to an earlier question, it sounds like your international trends are certainly promising. I am wondering if international MSOs are doing anything differently than the MSOs in the US and where are they in terms of relative maturity?

Robert Stanzione

Well, really they are not different. I think that one of the things that you noticed from country to country is that the technology is very similar and because the US is the largest penetration of cable subscribers that a lot of the technology does emanate from the US. But in terms of country to country, some are more advanced than others. I would say that in Asia, for instance in Japan and Korea, they are moving ahead with wideband service and they are probably six, maybe even 12-months ahead of what we see in the US market. On the other hand, if we look toward Latin America, there really is no interest in DOCSIS 3 at this point. They are still deploying broadband services at low penetration rates and so there is a lot of growth left in those markets. I’d say all over the world, we’re seeing voice deployed probably most advanced in places like Chile, in the US, Japan, and less deployed in places like Argentina and Brazil and Mexico where we've got really good growth opportunities.

Paul Bonenfant

One last question if I might. Bob, I think in the past and it might have been at the Analyst Meeting you had suggested that CMTS revenue would be up in 2008? And again I apologize if it was part of the prepared remarks, but is that still your expectation today?

Robert Stanzione

I believe so. I think that we’re going to see a big increase in CMTS revenues in the second half of this year. And as I made remark earlier, Bruce’s team is very busy ramping up production of the 16D cards, the cards with 16 downstreams and the new control modules that go into the chassis for wideband services. So again, barring a negative economic climate or a more negative than it is now, economic climate, I think we’re going to have just a fine year in CMTS. I think our market share could go up somewhat and I think that the deployments are going to go up because the pressure on the network just gets more and more intense. I mentioned in my prepared remarks the bloggers that are out there and they’re criticizing the operators for not having enough bandwidth. And then, with all of the video content that is being put on the net, it’s just putting a lot of pressure on. So I think we’re going to have a fine year and I would say it would be up.

Paul Bonenfant

Okay. Thank you for taking my questions.

Robert Stanzione

You’re welcome.

Operator

Gentlemen your next question comes to you from the line of Larry Harris of C.L King. Please proceed. Well, we are going to move out of that line and take the question from Andy Shopick of Nutmeg Securities.

Andy Shopick

Thank you. Two basic questions, first one financial. How do you expect purchase accounting to impact results for the balance of the year? Can you quantify it at all?

Dave Potts

Sure. Actually if go back to our website or read into the charts which we used, I guess it was at year-end. We tried to layout specifically by quarter.

Andy Shopick

Any change? No change to that?

Dave Potts

No.

Andy Shopick

Okay. And also, I am really curious to ask you Bob to what extent you have factored in a steadily eroding or weakening real estate market in the expectations for the business. Whether this is affecting any of these plans of your major customers or if this is something that could become more of a factor in the outlook as the year progresses?

Robert. Stanzione

Yeah, that’s a good question. I think that our customers and we have both factored a weak market into our plans, and I think it was part of the reason that we started the year off so slowly. There are, I believe, if I am reading the headlines correctly something like 2 million empty homes in the United States right now. And of course, with new home construction at 20 or 30 year low, the opportunities for serving new customers has declined and so we do indeed take that into account. And that’s why one of the reasons I couch my statements by saying, as long as the economic climate doesn’t get any worse than it is now and I don’t think it will. Also, people are cutting back on their budgets. That has I think on balance a positive effect on our business. It may be that they buy less premium services, but they sure will think twice about going out to the movies when they could order a movie online. So I think with people going out, eating out less, they are spending more time at home, they are online. I know my family is online 24 hours a day, and so I think that that really on balance could have a positive effect on the business. So, I think the answer is we have factored it in. And if things don’t change dramatically, I think the statements we made about the growth of the business going forward are solid.

Andy Shopick

Thank you.

Operator

And thank you. Your next question comes to you from the line of Brian Coyne of FBR Capital Management. Please proceed.

Brian Coyne

Hi guys. Can you hear me alright?

Robert. Stanzione

Yes.

Dave Potts

Yes.

Brian Coyne

Great, thanks. Few questions, first of all is obviously is real strong CMTS quarter. If you can go back and just refresh memory. Were you sort of expecting a reasonably significant drop off in the quarter? I think you remember some mention of some concerns that there might be a bit of a slowdown on the part of your biggest customer just ahead of DOCSIS 3.0?

Robert J. Stanzione

Yeah, that’s in fact what occurred when we talked about the quarter and I said, it was a near record quarter. It wasn’t as high as the highest we've had. And most of that is attributable to the Comcast plan that they are waiting for us to deliver the DOCSIS 3.0 equipment. But we saw again record quarter with Time Warner for example we saw great sales into Latin America. Bruce were there any other notable things, does that kind of cover?

Bruce McLelland

Yeah that was really, I guess frankly across the board other than the plan with Comcast. And I think we did about 7800 downstreams last quarter we had 7400 this quarter. So not quite a record, but awfully close even with the planning for 3.0 happening this quarter.

Brian Coyne

Right, that’s great. So you thought that sort of the overall trend, you expect to going into the quarter Comcast sort of played out more or less, right?

Bruce McLelland

Yeah, and I guess you know Bob mentioned earlier I mean, the demand for more bandwidth and more services isn’t stopping. So, its not like operators can just stop and wait completely. They just have to continue to invest in the upgrades for the services. So you know I think that what played out.

Robert Stanzione

They certainly have competition and the competition is getting a lot of play these days and they are responding to that.

Brian Coyne

That’s great. A couple other questions, Time Warner Cable strong across the board, clearly they have missed aggressive of the MSO on switched digital. How does that play into the OSS rolled out. I mean, I think really this has been a lot of time with C-COR, we recall that there is sort of an expectation I think that that business might actually sort of drop off as the outset in the back office software solutions were deployed across the platform or sort of across all their market. Does that change at all with SDV and sort of the added complexity of the network?

Bryant Isaacs

This is Bryant Isaacs. I wouldn’t take on SDV particularity for this, in general our major customers are all focused on improved customer experience, just improvements in managing the networks to better serve customers. And so we are seeing the lift from that as we see increase tick up of licenses and increased completion of projects that we had started in the past.

Brian Coyne

That’s great. So you sort of see OSS continuing at Time Warner even though that’s sort of first been deployed, right?

Bryant Isaacs

Yes. And customers experience is across the board of services, so we are talking not just video, but voice and data and SDV is obviously a piece of video.

Brian Coyne

Got it, great. And then last one. You had sort of an up quarter and a down quarter now on the D5 into Comcast. And I guess, competitor who you are going to split the business there was had a pretty good quarter actually going in. Do you think it might have been some any kind of probably, I mean the competitive differentials, but maybe just sort of you guys are on, one quarters now or one quarter or something like that. Or would you treat it perhaps more to the fact that -- and if this the case that the D5 was sort of I guess intended to address the SDV opportunity, Comcast that now obviously a bit fuller, a bit smaller versus your competitor, which is probably you know, largely replacing installed based for more MCMTS application?

Bryant Isaacs

Brain, I'm not sure they really talked to Comcast in particular. And I guess, we probably won’t either, but clearly they have a broad set of products, they sell into both satellite and then to cable and Telco and they had a good quarter as well. There is absolutely some lumpiness to the way that equipment sales happened and we had a good quarter in Q4 and a slower quarter in Q1. And obviously, if the deployment of SDV, continue to accelerate it will pick back up again, as Bob talked about earlier.

Brian Coyne

That’s great, very helpful. Thanks a lot guys.

Operator

Gentlemen, we do have Larry Harris of C.L. King back on the line. Sir you may ask your question.

Larry Harris

Yes, my apologies for earlier and my apologies if this was addressed on the call. But if you could give us your thoughts in terms of DOCSIS 3.0, at the North American cable operators, obviously Comcast is moving in that direction, but other cable operators in the US as well or North America?

Bruce McLelland

Hi Larry, this is Bruce. So, I guess across the board again we are seeing increased visibility into everyone’s plans for the second half of the year. I think Comcast will certainly, I think, be out further in front perhaps as the year progresses. But with the competition in the US it’s really hard to not be focused on that and it is off a lot of buzz, a lot at lab testing and just a lot of planning underway for 3.0 in the second half of the year. And if you think about how the upgrades have to happen in order to offer a higher speed tier service in a particular metro area, you really got to get out and kind of upgrade the head and the equipment across the base. And so, that just takes a bit of time, the planning, the plant work and everything that’s got to go on to make that happen is really the work that leads the marketing of the service and the deployment of the CP and all sorts of things. So, I think the second half of the year is kind of about the infrastructure and the planning on the network and then the actual, you know, the deployment of this service and the volume happens after that is finished.

Larry Harris

Understood. Alright, thank you. It’s very helpful. Thank you.

Operator

Gentlemen, your next question comes from the line of Jason Kim of Thomas Weisel Partners. Please proceed.

Jason Kim

Yeah, great. Thank you. I just wanted to hammer into the EMTA market and I just want to understand a little more as far as, how you guys are doing with obviously your major customer, as well as from the other customers out there? And in particular what I am interested in is any sort of pricing pressure and can you update us on sort of some of these contracts we have with major customers. Should we expect sort of a step down in our pricing anytime soon? And how has the share shipping been going on, it has been pre-dramatic or pre-benign from what you can say so far?

Bruce McLelland

Hi Jason, so I guess the non-Comcast EMTA business we talked about was really a record quarter. We were up over 20% from our peak levels in 2007. So very, very solid growth kind of across the board. And I think that just kind of emphasizes the customer diversification that we’ve achieved and really the ongoing strength of Voice-over-IP in general really across our customer base. We may have talked about pricing and competitive pressures of course that is always there and the 600 series EMTA, that Bob talked bout is a crucial part of making sure we stay on that. That curve of cost and value and so we are well in to that transition and that just to keep part of staying ahead of the pricing pressure. And if you've got the volume leadership, it obviously help some cost and those sort of things as well. So, I think we’ve shown over the last three or four years where we are real focused on that side of the business none of that has changed and we plan to continue to stay real aggressive there.

Jason Kim

Okay. But just again I think in the past you guys have had given some pricing concessions every now and then, but is that something that sort of tie with contracts and is that something that could be -- that we should pay attention to, in the near future or no?

Bruce McLelland

Well again, every operator kind of has a different way of wanting to do business, some of them are on longer term volume and pricing, agreements, and some are quarter-to-quarter and some are PO to PO, so they all tend to be a little different in the keys, making sure you understand what your future cost structure looks like, so that you don’t get yourself in trouble. And that’s what we have been able to do. I can’t really give you a lot of visibility in detail on particular customers, but I think the last 12 quarters in a row we've managed to maintain #1 market share and things look good going forward there as well.

Jason Kim

Okay, great. Thank you.

Operator

Gentlemen, your next question comes from the line of Nikos Theodosopoulos of UBS. Please proceed.

Nikos Theodosopoulos

Yes. Hi, can you hear me?

Robert Stanzione

Yes.

Nikos Theodosopoulos

Hey, Bob. You mentioned in your opening comments that you talked to customers and you mentioned that you've got some good feedback on areas of improvement. What were they? Were there some common one or two things and what are you doing about that?

Robert Stanzione

Yeah, I think one of the common themes, that I picked up in a couple of places, in a couple of major places, was, -- we’re pleased to see Arris and C-COR come together. We bought products from both companies in the past. One of the things that Arris has always been favorable in our minds about, is the customer support and the reliability of our feature deployment. And therefore make sure that you don’t get distracted and let anything fall in a crack. And in response to that, a specific response to that, is the fact that we’re adding resources in the development and the sales support or the customer support, particularly in the OSS and the video-on-demand area, where we felt like there was some jeopardy in terms of being able to support some pretty aggressive rollouts that are occurring throughout the world. So that was a good example. That’s probably the one that comes to my mind first, and that’s the reaction that we took to it. Therefore, you’re going to see our R&D bill go up slightly in the second half of the year.

Nikos Theodosopoulos

Okay. Alright. And I mean, just I think it sounds like you’re-- is it fair to say that you feel pretty confident now or comfortable that your Comcast revenues have bottomed at these levels. You wouldn’t expect to see go down lower from here. Is that correct?

Robert Stanzione

Oh, absolutely yes.

Nikos Theodosopoulos

Okay. Alright. Thank you.

Operator

Gentlemen, we have another question from the line of Ehud Geblum of JP Morgan. Please proceed.

Ehud Geblum

Hi, this is Steve O'Brien for Ehud today. Thanks for taking my question. Going back to the gross margin, I think Dave outlined pretty clearly that the BCS segment margins were down a little bit. It looks like 80 basis points from Q1, ’07. Where would the sort of remainder of the legacy Arris gross margin kind of trend on a year-over-year basis, if we stripped out the C-COR contribution? And then I guess looking out for the remainder of the year, last year the seasonality in gross margins seemed to be stronger in the first half of the year, weaker as the year went on and certainly their mix might have been the biggest factor. How do you anticipate mix or seasonality with revenues trending higher, impacting gross margin as we go forward in 08?

David Potts

So, let me take your first piece, which is of the traditional Arris products, how did the other piece do? Well the piece of the last of supplies and those margins are more or less flat. So, the BCSP is sort of the remaining piece. I can let Bruce comment as well, but sort, if as I look forward I think in the ATS side, we are taking all purchase accounting, because obviously that is going to increase our margins as we go through the year. On the ATS side I think the mix between optics and RF will be a part of what will make a difference and in the cost reductions which I think we can get, other supplies will also make a difference. So, hopefully, we see those to be improving through the year on a like-for-like basis. When we go into Bryant's business on MCS, this is a software business and I’m very jazzed by what we’ve been able to accomplish and I think that we will continue to see that improving the mix which should drive our margins. So and on Bruce’s side I think it’s going to as we bring in more EMTAs that should obviously in the aggregate bring some pressure on the margins to come down. But as DOCSIS 3 comes in it is the opposite effect, it’s going to presumably bring more into the mix in terms of the higher margin products. So hence that should be a good news. So, there is multiple variables in play. I hope that helps you. Is Steve there? Operator.

Operator

Yes, sir. As I hadn’t transferred. The next question comes from Anton Wahlman, of Thinkpanmure. Please proceed.

Anton Wahlman

Yeah Bob, you mentioned in terms of ramping the read out or roll out just to be clear on the way of practical level in terms of the initial stages of the stuff that you’ll be delivering to customers. Will it be fair to say that which you are delivering to them is a combination of A). A new line card for your large chassis and B). A new software loaded, is that the initial stage and then couple of quarters or one quarter down the road or so, we’re looking at CPE after that?

Robert Stanzione

I’ll let Bruce answer that one.

Bruce McLelland

Yeah. Hi, Anton. Yeah, that’s pretty well that’s pretty well correct. It’s a software upgrade for the existing C-COR footprint and a new dense line card that supports the channel bonding and those things and a new rolling module that increases the overall capacity of the chassis by a factor or 10. And there is different models to consider obviously, there is an upgrade model where you are taking existing footprints and upgrading. It’s obviously also new chassis to Greenfield installs and you know, both of those are going to happen as the year progresses.

Anton Wahlman

Yeah, but basically then shows the -- if an operator chooses to simply keep the original C4 chassis, they can do so, and add a couple of extra line cards lets say its was half filled to being with they can add kind of add up 4 line card say together. Is there some sort of external coupler at that point that you need to sell in conjunction with that in conjunction with the new software and the new line card as well?

Bruce McLelland

Well, the new dense 16 card spawns those channels together effectively and provide the signal, the downstream signal. And you are right the install basis is being crucial, and the strategy for last two or three years is to basically expand that footprint so that we can go back and do this upgrade. It’s just being a fundamental key part of strategy of the last several years that we can now capitalize on and the ramp or the deployment of the CPE devices and you got it exactly right. You’ve got to basically go through and get the equipment on the head end upgraded in order to be able to offer the higher speed service. But obviously, you can still provide the existing 2.0 service on 3.0 blades, its forwards and backwards compatible and again that’s a real important element of the product.

Anton Wahlman

But for the larger cities where there are already fairly dense deployments of the stuff, would you in vision that this would be more a case of adding an extra fresh brand new chassis sitting next to the previous 2.0 deployments would that be kind of the more common way to it at that point?

Bruce McLelland

I think you are going to see a series of strategies, there may be a strategy where you install kind of some seed stock, some Greenfield and initial New chassis and then kind of repurpose the existing chassis. It kind of depends a little bit on the kind of the operational model the operators want to deploy. I think you’re going to see all different types.

Anton Wahlman

And, finally just everybody keeps on beating this whole Comcast exposure to death. But the on the 3.0 CMTS initial deployment. Would you say that this is an extremely broad-based phenomenon where within the quarter or two virtually everyone of your top, at least the top half dozen or so customers will be going down a very similar path or would you say that there are outliers in the sense that there are top 4, 5, 6 type customers yours that haven’t really -- they don’t seem to be going until sometime in ’09?

Bruce McLelland

Yeah, I think the latter to some extent Anton, I think it’s a longer term phenomena where there is going be a some the high priority, highly competitive metro areas, they kind of go first. But its all not going to happen over a night over a one quarter two quarter period, its absolutely over a longer period of time. And I guess the other -- one of the other motivators I think about the thinks like IP address exhaust and the need for things like IPv6 which are part at DOCSIS 3.0, there is a lot more driving these DOCSIS 3.0 deployments than just channel bonding and those sorts of things. So it’s a long-term phenomena kind of across the entire base.

Anton Wahlman

Thank you.

Operator

Gentlemen, you do have another question, that’s a follow up question from the line of Greg Mesniaeff of Needham & Company. Please proceed.

Greg Mesniaeff

Yes, thank you. Just as a quick follow-up to Anton’s question. So, I guess its fair to say that Greenfield 3.0 installed should initially carry lower margins, because repurposing existing chassis, essentially implies shipments of the so far upgrade not new lower margin chassis, is that correct?

Robert Stanzione

Well this is actually a combination of new hardware required for upgrades, as well as hardware obviously for Greenfield. So it’s a mixture and I wouldn’t necessarily model at the way you just described. I wouldn’t make that assumption.

Greg Mesniaeff

Okay. So there is more moving parts to this?

Robert Stanzione

Exactly, right, yeah

Greg Mesniaeff

Okay, thank you.

Operator

Gentlemen, you have no further questions in queue at this time.

Robert Stanzione

Alright, well then this is Bob. Thank you all for attending today’s call. In summary you know, I hope we’ve made the point that we’ve accomplished a lot in the first quarter especially the stock buyback, which interestingly we got no questions about and we have gotten so many before we did it. The DOCSIS 3.0 programs are really gaining stream, network upgrades are continuing and we think that bodes well for the second half of the year. And things like the OSS and on-demand businesses are greatest growth opportunities with good margin expansion prospects. And we will see you hopefully many of you at the NCTA Convention in New Orleans in May where we will all be there and we will be able to meet with many of you face-to-face and show you our products first hand. So, with that thank you very much. We will adjourn.

Operator

Ladies and gentlemen, thank you very much for your participation today. You may now disconnect your lines. Have a great day.

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Source: Arris Group, Inc. Q1 2008 Earnings Call Transcript

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