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Executives

Jim Bauer - VP of IR

Bob Stanzione - Chairman and CEO

Dave Potts - EVP and CFO

Jim Lakin - President of Advanced Technology & Services

Bruce McClelland - President, Broadband Communications Systems

John Caezza - President, Access, Transport and Supplies

Bryant Isaacs - President, Media & Communications Systems

Analysts

Brian Coyne - FBR Capital Markets

Ehud Gelblum - JPMorgan

Mark Sue - RBC Capital

Greg Mesniaeff - Needham & Company

Amitabh Passi - UBS

Simon Leopold - Morgan Keegan

Rai Archibold - Kaufman Brothers

Andrew Schopick - Nutmeg Securities

Todd Koffman - Raymond James

Chris Blackman - Empirical Capital

Arris Group Inc. (ARRS) Q2 2008 Earnings Call July 30, 2008 5:00 PM ET

Operator

Good day ladies and gentlemen and welcome to the Second Quarter 2008 ARRIS Group Incorporated Earnings Call. My name is Eric, and I'll be your coordinator at this time. At this time all participants are in a listen-only mode. We will facilitate a question-and-answer session at the end of the conference. (Operator instructions).

I would now like to turn your presentation over to Mr. Jim Bauer, Vice President Investor Relations. Please proceed, sir.

Jim Bauer

Thank you, Eric, and welcome to the ARRIS conference call with management. This afternoon, we're going to discuss our second quarter 2008 financial results us, which we released just after the close of market this afternoon. We're going to be using a series of slides during our webcast which are posted on the ARRIS website in the investor relation section.

With us today here at the ARRIS headquarters are Bob Stanzione, ARRIS's Chairman and CEO, Dave Potts, ARRIS's Executive Vice President and Chief Financial Officer, and also with us are Jim Lakin and the heads of our business segments, Bruce McClelland, John Caezza and Bryant Isaacs. There's going to be a replay of this entire call available approximately two hours after the conclusion of the call, and the replay of the call and the slides will be on our website for the next 12 months.

As usual before we begin, I would like to point out that during the call we will be making or we 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 third quarter of 2008, our outlook for the remainder of 2008, certain financial operating metrics, the timing and introduction of new products, and certain technologies, and anticipated spending patterns by some of our customers, as well as expected sales levels for certain product categories.

It's important to note that actual results may differ materially from those suggested by any of these forward-looking statements, and for further information in this regard, and for specific examples of risks that could cause actual results to differ from these statements, please see our recent filings with the Securities and Exchange Commission.

With that said, Bob and Dave, are going to now provide comments on our results for the second quarter and other topics that you may wish to discuss, after which Stan will open up for your questions and our answers. Now with that over to you Bob.

Bob Stanzione

Thanks, Jim. Let's, get started with chart four. Now that the results are in it's worth noting a few of the Q2 highlights before I go on to comment on the outlook for the rest of the year.

First, although revenues were short of our original guidance, we still grew top line by almost 3%, and non-GAAP EPS grew by 25% from $0.12 to $0.15 per share sequentially. Sales to both domestic and international customers rose quarter-over-quarter with Germany, Latin America and Canada leading the international growth.

On the domestic side, our sales to Comcast recovered somewhat from the first quarter low point, and although sales to this customer remain far below the level of 2007, we do expect another nice increase in Q3 as DOCSIS 3.0 takes off. Sales to Time Warner reached a new record level. This is a very pleasing result to us, since they used virtually every product that we make in their networks.

Our CMTS sales reached another new record level in Q2. This was achieved in spite of the DOCSIS 3.084 effect, and shows the strong position that we hold in the market, and just how much demand for bandwidth is a driver in our business. And although not always a good indicator, our book-to-bill ratio has been above one for the past three quarters, and backlog has also grown in each of those quarters.

Now please go to chart 5. I think the most important statistic out of the Q2 results relates to the gross margins which came in strong at 33%. Gross margin improvement is something that our whole organization has been working on for a long time, and now we're seeing good results. This improvement is attributable to several factors.

First, mix continues to shift toward our higher margin products. For example, although plain vanilla EMTA shipments are down from their peak, sales of wireless earless gateway and four and eight-line business terminals are up 40% quarter-over-quarter.

Also, despite the DOCSIS 3.084 effect, record CMTS sales had a very positive impact. Next, as we expected, the integration of the C-COR operations has improved our financial profile with higher margin optical access and transport, and software intensive OSS, and VOD products enriching the mix.

Next, our cost reduction efforts continue to produce results, with margins improving in virtually every product category. And finally, we're seeing the effect of the shift in emphasis in our selling strategy toward seeking higher margin opportunities, rather than only increasing market shares we announced at our investor conference back in March.

All of these factors have and will continue to improve our financial profile as we work towards achieving our goals of 33% to 35% gross margins and 10% to 12% operating margins. As Dave will point out in a minute, expenses continue to be under good control, and we are achieving the expense synergy objectives that we set at the beginning of the year.

Now let's go to chart 6. Looking forward to Q3 and Q4, as I mentioned on our previous call, we have seen a moderation in cable telephony growth and the current economic climate has certainly wade especially on our ATS business. Nevertheless, our outlook for the third quarter and the rest of 2008 is still quite positive.

High definition television, network traffic, and competition continue to increase, and the demand for bandwidth continues to grow. Therefore, we expect both top and bottom line growth in the third quarter, driven primarily by the introduction of our new DOCSIS 3.0 wideband gear.

As you all know, this is the quarter that the long wait is over, and significant DOCSIS 3.0 growth is beginning to have positive impact on the business. We're now ramping the production of this equipment, and in fact, we made first shipments in June. Revenue on these early shipments was deferred into Q3 when final acceptance of the system is expected.

As I mentioned on the last call, the current conditions cause us to feel there are top line growth, our top line will grow at a healthy sequential rate in the third quarter, but perhaps not as rapidly as we thought earlier in the year. However, based on the factors I've just outlined, we do expect gross margins and EPS to grow nicely in the second half, and I expect that the operating goals that David Potts outlined at our March Investor conference could be achieved by the end of this year.

Now chart 7, please. In summary, we remain optimistic about our growth prospects for the business. Every day I see more encouraging signs pointing to that growth. Announcements like the one by the NFL that they'll be offering live streaming video feeds from some of their games this fall.

Events such as the upcoming Olympics are expected to put more strain on the network. Even the current negative economic climate has some positive effect, as companies and employees implement more work at home arrangements. It seems that everyone is always online, and wants more and more; more content, and more speed, a couple of examples.

According to comScore report, there were 12.1 billion online videos viewed in the month of May. That was up 11% over the month of April, and it's up 45% year-over-year. A recent University of Minnesota Internet study indicated a US and world annual internet traffic growth rate of 50% to 60% per year. That same study points out that in South Korea with one-sixth of the US population, generates the same amount of internet traffic as all of North America.

I believe that these trends are here to stay for the foreseeable future, and I feel that we have the company on the right track for continued growth. And now, Dave would you describe the financials?

Dave Potts

Well thanks, Bob. And thanks everyone for joining us this afternoon. Now let's start by reviewing some financial highlights on chart 9, please.

Sales were $281.1 million in the second quarter compared to in the second quarter of last year. The increase reflects the addition of C-COR, including the revenues which C-COR reported last year, sales in the second quarter of 2007 were $327.1 million.

Gross margins were 33% in the second quarter, up from both the first quarter 2008 and the second quarter of 2007. Including C-COR, the second quarter 2007 gross margin was 32.4%. As I've explained on prior calls, when comparing both sales and gross margins to historical results our current result will be negatively impacted by purchase accounting, in particular, the treatment of our deferred revenue.

We estimate that our second quarter 2008 margin was impacted by approximately $3.7 million or about one percentage point of gross margin this of course, will continue to decrease through the year.

SG&A and R&D totaled $65 million in the second quarter and was up approximately $20 million year-over-year, primarily as a result of the acquisition. However, SG&A and R&D in the second quarter of 2008 were down approximately $4.1 million as compared to the estimated combined expenditures of ARRIS and C-COR for the same period in 2007. The year-over-year decline in operating expenses reflects our good progress on the synergy front.

Our adjusted non-GAAP EPS was $0.15 in the second quarter, this compares to $0.22 in Q2 '07. Decline reflects several factors. First, sales of broadband in supply products, if you like the former ARRIS business, were down year-over-year. Next, interest income was lower, due to lower interest rates and less cash on hand. That being said, it's important to note that, we are making progress with respect to the financial goals, so we outlined at our investor conference in March, most notably our gross margin profile.

Our GAAP EPS was $0.08 and compares to$0.21 in the second quarter of 2007. The significant item to note is the amortization of intangibles related to the C-COR acquisition, which was an expense of approximately $0.06 per share in the quarter. 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 second quarter $298 million. We generated approximately $10 million from operating activities. Our cash generation was less in the first quarter as a result of higher inventory positions. Our outstanding share count declined to 122.7 million shares, or our fully diluted shares outstanding declined to 124.7 million shares at the end of the second quarter, as a result of our previously announced share buyback transactions.

Now let's turn to chart 10, where we've provided some first half 2008 highlights. For clarity, in addition to providing our GAAP comparisons, we again have provided comparisons to estimated 2007 combined results of ARRIS and C-COR. Let me touch briefly on a few of the line items.

First, reported sales were up nearly $67 million for the first six months as compared to last year, as a result of the C-COR acquisition. When compared to the estimated combined sales of ARRIS and C-COR, first half sales are down approximately $81 million year-over-year. As we discussed in our Q1 call Comcast sales of both EMTAs and CMTS were expected to be lower. In fact sales to Comcast declined $116 million on a combined basis for the six months.

Our other customers were up approximately $35 million. Operating expenses on a combined basis decreased approximately $4.9 million, as compared to the first six months of 2007, again, reflecting our synergies that we've been achieving. With respect to GAAP EPS, it's important to note that we had significant gains from the TANDBERG deal in the first half of 2007, which did not repeat in 2008.

So let's move to chart 11 and review some of the details with respect to sales. Again, as you know, the C-COR acquisition has a significant impact. Our reported results compare our combined new company in 2008 to the former ARRIS standalone in 2007. To help you better understand the trends, on our website there's a summary of sales and gross margin by segment as reported and including the former C-COR results.

Let's focus on the sales by segment bar chart on the top left, comparing our reported sales by segment. BCS sales were $190.4 million in Q2, up slightly from the first quarter of $189.6 million, but down from the second quarter 2007 of $218.4 million. As expected, sales to Comcast were down year-over-year, but up from the first quarter. The year-over-year decline was partially offset with gains with other customers, notably Time Warner, and indeed other domestic and international customers.

ATF sales were $77 million in the second quarter and up from both periods, versus last year the increase as a result of the acquisition. In comparison to the first quarter, the $4 million increase is associated with our excess products. MCS sales were $13.7 million in Q2, which compares to $11 million in the first quarter.

Let's move to the bar chart on 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 both the first and second quarter. These impacts are the results of revaluing C-COR's historical cost base deferred revenue to fair market value at close.

Some comments, ATS is up sequentially, but down in comparison to 2007. As Bob mentioned, both supplies and A&T are down. With respect to MCS, adjusting for purchase accounting impacts MCS is actually slightly up year-over-year. The pie charts on the top right provide domestic versus international splits. Please note that this analysis includes the former C-COR sales in prior years. As you can see, our international mix is up year-over-year.

One final comment on sales, we have two 10% customers in the quarter, Time Warner and Comcast. Sales to Time Warner were $75 million in the second quarter, up from $45.8 million on a combined basis from Q2 '07. Sales to Comcast were $46.7 million, down from $106 million on a combined basis in the second quarter of 2007, as expected, sales to Comcast increased in Q2 as compared to Q1.

With respect to our order backlog and book-to-bill, we ended the first quarter with a backlog of $206 million, which was up from the first quarter backlog of $147 million. Our book-to-bill ratio in Q2 was 1.21. And again as Bob mentioned, we have significant orders on hand for DOCSIS 3.0 equipment.

Now let's turn to slide 12. On this slide we provided the same sales data for the first six months, some takeaways. As reported, sales were up year-over-year again as a result of the acquisition. On a combined basis and adjusted for deferred revenue impacts, our sales are down approximately $69 million. Within that there are some things to note.

First, our sales to Comcast are down about $116 million. The decline is across the board. However, as we've highlighted previously, the key drivers have been a reduction in their EMTA purchases, and their decisions to slow CMTS purchases until DOCSIS 3.0 becomes available.

We expect a significant increase in sales to Comcast in the third quarter as we begin to launch our DOCSIS 3.0 CMTS. Our sales to other customers are up, again notably Time Warner, and indeed other domestic and international customers, which partially offset the decline in Comcast sales.

Let's move to slide 13 and review gross margin. We are very pleased with our progress in improving gross margin percent, and improved to 33% in the second quarter. Let's start with the bar charts on the top left. Here we contrast reported margins by segment. The stack bar shows the value of gross margin dollars in millions generated by each segment. Percentages are the gross margin percent by segment and in total on the top.

Some comments. BCS margins improved to 32.3% in Q2, the improvement is a result of both mix and cost reduction. ATS and MCS are also 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. Notably, the overall margin would have been about 34%.

When we first announced the C-COR acquisition, we commented then that we expected the transaction to improve our financial profile, in particular gross margins. I think you probably have to agree that indeed this is coming to fruition at this point, and we're very, very pleased with the progress that we've made.

Let's turn to operating expenses on chart 14. Once again, the acquisition comes into play. On the chart we've provided both, second quarter and first half data for you. As reported basis, R&D and SG&A are up as a result of the acquisition, similarly, so is the amortization of intangibles.

In the far right column of both blocks, we show what estimated spending was on a combined basis in 2007. As you can see, on a combined basis SG&A is down by about $5.7 million in the second quarter, and down about $7.8 million through the first six months. We're pleased with the synergy results we are getting and indeed, we believe we are on track to hit the targets which we outlined earlier.

Let's turn to chart 15 and look at some balancing and cash highlights. We ended the quarter with $298 million of cash and short-term investments, up about $5 million from the first quarter. There are several things to note. First, we generated just over $10 million of cash from operating activities.

As part of operating activities, we consume cash as a result of increases in inventory of about $23 million. We are taking actions to reduce inventory over the next few quarters. CapEx was approximately $5 million in the quarter, which is in line with our plans.

Let's turn to guidance on chart 16. So at this point, we estimate that sales will be in a range of $288 million to $308 million, and that non-GAAP EPS will be sharply up to a range of $0.19 to $0.24 per diluted share, and GAAP EPS will be in the range of $0.13 to $0.18 per diluted share.

A reconciliation of GAAP to non-GAAP EPS guidance can be found in chart 17, and it is also attached to our press release. Reconciling items including amortization of intangibles and equity compensation expense, we are assuming 125 million fully diluted shares. We're assuming a tax rate in Q3 of 27%.

As you may know, and I've mentioned this previously, Congress is yet to approve the continuation of the QRE credit. Once they do, and assuming it will be applied retroactively which it usually is, our rate should reduce to about 35% for the year.

Finally on chart 18, we've included a reconciliation of our GAAP to non-GAAP earnings per share for the second quarter of 2008 and 2007.

So that concludes my remarks. I'm sorry, a tax rate of 37%, not 27%. Now, that concludes my remarks. And let me turn it over to Jim Bauer.

Jim Bauer

Thank you, Dave. Eric, if you could come back online, and tell our participants, how they can begin to start asking questions, and we'll do the answering.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Brian Coyne with FBR Capital Markets. Please proceed.

Brian Coyne - FBR Capital Markets

Hi, guys. Thanks for taking my call, nice to see the good outlook. A couple of questions. First, I was wondering if you could review a little bit of your product acceptance in revenue recognition situation for CMTS as you transition into DOCSIS 3. I mean are the criteria for DOCSIS 3 similar to those for DOCSIS 2 on what you've experienced? Do you need to kind of have Comcast turn those blades on and launch the market or do you see the revenue sort of roll in perhaps a little bit in advance of that?

And then how should we think about if Comcast is, I guess, prospectively thinking about 20% of their footprint this year, maybe just ballpark it, let's say 60% next June and then the final 20% in 2010. Is that kind of how we ought to see the arc of your sales or does it work a little bit differently?

Bob Stanzione

Okay, Brian. Let me try to answer the question then I'll see if Bruce wants to add to my answer. In terms of acceptance, we have shipped hardware the hardware is installed in a couple of places within the customer. We're still putting the final touches on the software. And that software has to be up and running, and meet their requirements and meet their approval, before we can recognize the revenue.

The feature set of DOCSIS 3 is a lot broader than the feature DOCSIS 2. It includes not only channel bonding but it includes things like IPv6 and new encryption technology and the like, that are fairly complicated. And, first of all difficult to develop, and there's a lengthy prove in process for them. So we'll be going through that process with Comcast, and other customers, throughout the third quarter. And we anticipate that we'll get through that.

With regard to the second part of your question, the arc of the business, I think that what we're seeing here is that in Asia, and in the US, and in particular in Comcast, they're leading the way. And of course, Comcast being so big is a really very prominent leader in the deployment of DOCSIS 3.0. They commented today on their call that they would reach 20% coverage with DOCSIS 3.0 in 2008, and that the program would continue through 2010, or into 2010. I forget exactly the way they stated it.

But, at the same time, we've got the rest of the world coming on a little bit later. So I wouldn't say there's an arc in the business where it peaks in 2009 because if I look back at DOCSIS 1.1 and DOCSIS 2.0, those businesses -- in fact DOCSIS 2.0 peaked in the second quarter of 2008. I think it's notable that we delivered more DOCSIS 2.0 CMTS equipment in the second quarter of this year than we ever have, and that was without any sales to Comcast. That's pretty remarkable growth for a product line that's being replaced by a new-generation.

Brian Coyne - FBR Capital Markets

That's great. And your degree of confidence in terms of the approval and acceptance criteria, I mean it's pretty high, I'm guessing, I mean you're at this for a bunch of months, right?

Bob Stanzione

What do you think, Bruce?

Bruce McClelland

Yeah, Brian, I mean as you know, exactly right. We've been at this for months and months, it's not a thing that happens over a couple of weeks. It's a very deliberate process and, as you know, we're not only installing Greenfield chassis, but also upgrading existing systems. And as you can imagine, going into an existing system where you're going to transition tens of thousands of existing customers on to a new software base, it's a very deliberate thoughtful process to go through that. But we've been at it for quite a while, as you know, so.

Brian Coyne - FBR Capital Markets

Alright, and then real quickly one more and I'll jump back in the queue. I was wondering if you could talk a little bit about gross margins, obviously real nice this quarter. And I was wondering if you could just talk about sustainability? And then maybe talk a little bit about how your sales efforts are transitioning perhaps more of strategic instead of tactical opportunities, and how that plays out on the margin front?

Dave Potts

Well, we think the margins will continue to improve throughout rest of the year. For the reasons that I've outlined, the mix toward -- our sales going more towards the higher margin products in our portfolio, including those that we acquired with the C-COR portfolio of products. The cost reduction continues unabated. We've just introduced a whole new line of EMTAs, the 600 series. I think many of you may have seen those at the recent trade shows. And that was a cost reduction initiated spin.

And finally, the point that you bring -- brought up, that we first mentioned when we had our investor conference here in March, where we've changed tactics somewhat in our selling, going after higher margin opportunities, as opposed to being more heavily influenced by trying to spread our footprint. So I think that all of those have had an effect, and we're pretty of optimistic that we can keep those margins moving up another point or two as the year goes on.

Brian Coyne - FBR Capital Markets

Alright, sounds good. Thanks for putting my on the podium, by the way, appreciate.

Dave Potts

You're welcome.

Jim Bauer

Next question.

Operator

Your next question comes from the line of Ehud Gelblum with JPMorgan. Please proceed.

Ehud Gelblum - JPMorgan

Hey, guys, good evening, a couple of questions. Now we've got a visibility in the Q3 and I sense off is kind of the trend of this year. Clearly backlog is very strong. How much of that backlog do you expect to kind of come into Q3 and move into Q4? How should we be looking at Q4 with respect to, there has never been much of a seasonality to the business. But as we try to model Q4, the Q3 guidance being a little bit below kind of what it was. How do we look at Q4? And how do we look at the ongoing revenue growth rate going forward? And then I have a follow-up.

Bob Stanzione

I think a couple of key things. I mentioned this on July 10th pre-announcement call, and I mentioned it again here today, and I welcome the opportunity to emphasize the point. I think we have reached a point where the EMTA business, the plain vanilla portion of our Voice-over-IP product line is maturing. So I believe that that business will continue to grow, but we're not growing at the rates that we saw in the past couple of years. We're also being affected by this economy. There is no question that there is less plant extension and upgrade activity going on because there are fewer and fewer new homes being built and occupied. And so that's been weighing in on the business.

With regard to fourth quarter, I don't want to stick my neck out and give fourth quarter guidance at this point, but I think that, I don't expect it to be a boomer by any means. I think that we will see the normal seasonality where we have all the holidays kicking in there is the uptake of subscribers as usually a little bit slower. So I would expect it would be sort of a normal seasonality in the fourth quarter. Dave, you want to comment anything or anymore on that?

Dave Potts

No, thank you. I think that's about right.

Ehud Gelblum - JPMorgan

We haven't really had [normalties] now in the past, we've had several fourth quarters where Comcast has turned things off, and so you have weaker fourth quarters. And then you've got some that were actually up. Can you give us a sense, actually I don't think I heard the number of the EMTAs? This quarter you hinted at them on the pre-announcement call, but I don't remember hearing you say it now.

Bob Stanzione

Yeah, I think, Bruce what was the number?

Bruce McClelland

1.39 I think was the number.

Bob Stanzione

It's just under 1.4 million, EMTA is little over a 100,000 cable modems, or around a 100,000 cable modems.

Ehud Gelblum - JPMorgan

Okay. So as we look at the moving parts here, the EMTAs, the 3.0, the remaining 2.0 CMTS, and the C-COR business, we're surprised it's going to decide. Should we assume therefore, that the EMTAs stay roughly where they are into Q3 and then fall-off in Q4? Should we assume that C-COR sort of falls-off as well? But 3.0, CMTS sort of obviously, increases a lot, and so it doesn't, it sounds like that the seasonality ends are being somewhat flattish in Q4 and there is the least moving parts even if the --?

Bob Stanzione

Again, don't take me into a corner on giving fourth quarter guidance.

Ehud Gelblum - JPMorgan

Okay.

Bob Stanzione

But I think that Comcast has a lot of work to do to get their 3.0 deployed by the end of the year to 20% of their footprint. But even though Comcast is bouncing back significantly in the third quarter, and probably will be strong throughout the rest of the year. And next, we have a lot of other customers who are still buying DOCSIS 2.0 gear where we'll probably experience normal seasonality. So it's hard to say exactly how that fourth quarter is going to end up. As you know, about one out of three years we get a good surprise, but more often than not, there is a tapering off of business in the fourth quarter.

Ehud Gelblum - JPMorgan

So last two pieces are, at what point do we expect that 2.0 business to tail-off for good as people transition to 3.0 and 2.0 becomes really yesterday's business? And at what point do you expect Time Warner to begin that move to 3.0, and watch their 2.0 orders fall-off for good?

Bob Stanzione

So that's a difficult one to predict as well, and highly dependent on economics as far as the increase in competition here in the US, in particular, and then the economics of the 3.0 technology compared to 2.0, I guess you know the CPE devices tend to be more expensive on 3.0 than 2.0. So a lot of factors that go into that, I think the belief is the overall CMTS market year-over-year through the next two or three years to $1.4 billion or so I think is the projection you see.

Ehud Gelblum - JPMorgan

Okay. How about Time Warner?

Bob Stanzione

So I don't -- we don't typically talk individual customers at that level of detail. I think in the US, clearly Comcast has been more vocal about their plans, but most of the other large operators have a significant footprint that competes with the likes of Verizon, and so you kind of believe that they are going to be in a similar situation to compete. Same as we're seeing in Japan and Korea, where the competition with fiber-to-the-home has been much more significant, and there has been a real pent-up demand to get on with 3.0 deployments in Asia.

Ehud Gelblum - JPMorgan

Absolutely. Thanks so much. I appreciate it.

Jim Bauer

Okay. Next question?

Operator

Your next question comes from the line of Mark Sue with RBC Capital. Please proceed.

Mark Sue - RBC Capital

Just extrapolating your comments on EMTAs, how do you think voice ranks in the overall scheme of things when it comes to cable CapEx? In another words, if they had to choose, will MSLs focus on video or voice? And any thoughts on what unit growth assumptions we should be using from now going forward?

Bob Stanzione

From a return on capital, Voice is just incredibly good for the operators, as is high-speed data, because the margins in that business are the highest that they have, and the cost -- the capital investment is the lowest. So from a return on capital, it's very nourishing business for them. Again, I think that we've still got a lot of growth potential in the market for Voice over IP, with customers such as Time Warner, Charter, Comcast, who were later to begin their rollouts than say Cox or Cablevision.

They're just breaking into double figures, in terms of percent penetration, and they are anticipating reaching 25%, 30% penetration. So I think that there's a lot of growth left to go. One of the positive things about our, the date of our announcement today, is that we got to listen to the Comcast announcement this morning. And Steve Burke commented that they were taking one percent share -- one percent of market share per quarter. And so I guess I would defer to Steve Burke on how fast they think they can increase their subscriber-ship.

Jim Lakin

Indeed, if you listen to the call, the success based capital, as we've been describing now is [just and] we described that this is where the CapEx was going, in telephony and high-speed data is indeed the things that will get it, so.

Bob Stanzione

The other thing that is worthy of comment here in the EMTA category, is that we're selling more and more of the high-end products, particularly the business service terminals, that have either four or eight lines. We've introduced a whole new line of those products, and they're selling quite well. In fact, as I minced, they increased about 40% in volume quarter-over-quarter. That was another I think encouraging sign from what's been announced in the market by the cable operators recently.

Mark Sue - RBC Capital

Okay. And then separately, just piecing your comments on Comcast, with 3.0 I guess it's on warded forward from here in terms of absolute revenues from now till forever?

Bob Stanzione

Well again, if you look back at the history of DOCSIS 2, or DOCSIS 1, it just keeps going up. Now, I'm not promising that every quarter is going to be better than the last. But if internet traffic continues to grow, as most people think it will, I think the outlook is good. What do you think, Bruce?

Bruce McClelland

Yeah, I think the analogy we use comparing say a DSL environment to cable, as the speeds go up in DSL, they don't require more CapEx, more equipment, because it's a point-to-point connection. But in cable if they increase the speeds to a subscriber, they have to buy more bandwidth, more ports, more up streams, more down streams. So it's a renewable, continues to grow from an equipment vendor perspective as the capacity requirements go up.

Mark Sue - RBC Capital

Okay.

Dave Potts

The other things that we can't overlook is the fact that the indeed the customer concentration. Our sales of this gear into places like South America, it's great, and these are some what [mason] spaces for us. So, as Bob said, we didn't sell CMTSs really to Comcast in the second quarter, but yet, we had a great, great quarter. I believe all this bodes well.

Bob Stanzione

Just to jump on that Dave. It's amazing, the countries in South America, I just run through a list, Brazil, Argentina, Chile, Mexico, Columbia, Peru, Ecuador, Jamaica, that are all growing their cable franchises as the competition between Telemax based properties and telephony properties, just continues to grow down there. So we've been really pleased at how the South American and Central American businesses are growing for us.

Bruce McClelland

And in you have some spare time on your hand I encourage you to read Telemax's Internationals 20, that's quite to ride.

Dave Potts

Yeah.

Mark Sue - RBC Capital

Lastly, Dave just on the financial model, it seems like its reaching steady stake, any thoughts on just kind of tightening the EPS guidance range for us going forward?

Dave Potts

I'd say no. I think the range decides the company you are at. The range of sales I think is appropriate, as is the EPS.

Mark Sue - RBC Capital

Okay, thanks. And good luck, gentlemen.

Dave Potts

Thank you.

Operator

Next question comes from the line of Greg Mesinaeff with Needham & Company. Please proceed.

Greg Mesniaeff - Needham & Company

Yes, thank you. My first question is on 3.0. It appears that clearly, we are in a CMTS centric phase of the ramp. And I'm wondering when that gives way to a more balanced ramp where you have both CMTS deployments, as well as shipments of next-generation 3.0 EMTAs. Number one, how will that affect the gross margin mix, and number two, I assume that by that name the silicon pricing will settle down and will be somewhat more favorable. Can you comment on that?

Bob Stanzione

Sure. Certainly the front end investment is in starting to get the technology into the head ends into the network, and then the subscriber devices will follow. And trying to estimate an exact velocity, as far as transition to 2.0 to 3.0 is tough, because as we mentioned earlier it's highly dependent on the level of competition and how fast the service, the higher speeds are marketed. But in general, I think it's certainly much more of a 2009 phenomenon, than a second half '08. I think the marketing programs around these are still being formed at this point. Your comment on the technology absolutely true, like all these technologies, they go through several iterations, as the operators and the service providers really finalize the set of requirements on some of these devices.

As an example, there is lots of discussion on home gateways, and additional capabilities that would go into these devices to do additional home networking and distribution of both, data and Video-over-IP within the home. And as they settle on some of those requirements, you integrate some of these functionalities into a single device, a single [SSP] and drive the cost out of the product. We've seen it with 1.0, 1.1, 2.0 and you'll see the same thing with 3.0. But it does take a generation of silicon, typically which is 18 to 24-month cycle, at least to get it in the market.

Greg Mesniaeff - Needham & Company

Right, great. And also just as a follow-up, I mean, given that the very strong gross margin number you've just printed, is it fair in the early stage cycle that we're in right now, is it fair to say that at some point as EMTA shipments of 3.0 begin to ramp, that could have some flattening of the gross margin expansion that we're seeing right now?

Bob Stanzione

It could, Greg, but remember those modems are going to replace 2.0 modem. So as 3.0 modems grow, 2.0 modems sales will diminish. So in terms of the waiting within the mix of our product lines, it's somewhat hard to predict, but I wouldn't imagine it shifting things dramatically. But I think that, we're going to see margins improve for the next couple of quarters. We'll see what happens after that.

Greg Mesniaeff - Needham & Company

Got you, okay. And just a final question. You've mentioned that you're in the midst of somewhat of a recalibration of your sales and marketing strategy, more towards going after higher margin sales as opposed to going after just market share. What kind of impact, if any, will that have on your SG&A, on your sales and marketing expense levels?

Bob Stanzione

None whatsoever. It's a matter of sales tactics, but not sales coverage. And so it shouldn't really have an effect on the marketing and sales part of the budget.

Greg Mesniaeff - Needham & Company

Great. Thank you.

Bob Stanzione

All right, thanks.

Operator

Next question comes from the line of Amitabh Passi with UBS.

Amitabh Passi - UBS

Hi, thank you. I had a couple of housekeeping questions. Did you disclose the number of CMTS chassis and down streams that were shipped in the quarter?

Bob Stanzione

We didn't but we'd be glad to. Bruce?

Bruce McClelland

Amitabh, the number of down streams was 8,090. And the number of chassis, I think, was 319.

Amitabh Passi - UBS

Got it. And then Bob, I was wondering if you could help put some brackets around your phraseology that Comcast revenues will be significant in the back half? I mean if we look at the incremental revenues quarter-over-quarter, from 2Q to 3Q, is it fair to assume the bulk of that will come from Comcast with Time Warner staying at relatively constant levels?

Bob Stanzione

I don't know that I can comment, really on -- I don't think I can bracket the phraseology as you put it, any better than we have. We've given you guidance on the third quarter, and we've talked quite a bit about what might happen in the fourth quarter. Still too far out to know, but to give you customer-specific stuff, it's hard to do. One of the things that we have worked so hard on here is to try to diversify our customer base, and we've really accomplished that in the past six months, in the past few quarters of the business.

And from quarter-to-quarter we see individual customers go up, and individual customers go down, but the diversification that we've achieved has helped mute that effect somewhat. So I think it's just the world that we live in, that customers don't buy regularly quarter-after-quarter, we do see ups and downs.

Amitabh Passi - UBS

Got it, and then just one other question. I wanted to come back to the gross margin sort of outlook. I think you said that once you start shipping 3.0 modems, or EMTA's to a large extent, they will replace 2.0 modems. But I assume there is also the potential to upgrade your installed base where it seems like you could potentially ship quite a few more 3.0 modems. So just coming back to that question about the sustainability of the margins because there is a large installed base of high-speed data subscribers that could potentially upgrade to 3.0. I'm just wondering, what gives you the confidence that we could stay in that 33 or approach the lower view, I think presented at the analyst day, 33% to 35%?

Bob Stanzione

One indicator is we hit the 33, and I think with some purchase, with some accounting...

Dave Potts

The purchase accounting impacts takes us to 34. And don't forget we bought C-COR and C-COR had higher margins, plus we get the results from those two businesses that's got to help us downstream, as well.

Amitabh Passi - UBS

Yeah, I guess the fundamental question is, I mean if your modem shipments ramp back up by a couple of hundred thousand units, it seems you could probably see a 100, 150 basis point impact again, just because it is so sensitive to margin. So I guess the fundamental question is do you think you'll stay at sort of the current level of modem shipments, or is there risk that shipments could significantly increase once the 3.0 ramp fully kicks in?

Dave Potts

Well, we can come up with a, what if scenario that would cover most any outcome. Yes, if modem -- if our modem business were to go through the roof, it would dilute the gross margins, it would improve our EPS. It's kind of the old story of do you want to turn away business that's going to be accretive to the bottom line of the company because the middle line of the Company is affected by it. We have historically, and will continue I believe, to be focused primarily on earnings per share. And by getting better margins and better mix, we're improving the earnings per share. But it's the bottom line, the operating income line, that I think is very important in this.

Amitabh Passi - UBS

Great, and then just my last question. Did I hear you correctly did you say you could potentially approach your target business model by year end?

Dave Potts

Yes, I did.

Amitabh Passi - UBS

Okay. Thank you.

Operator

Your next question comes from the line of Simon Leopold with Morgan Keegan. Please proceed.

Simon Leopold - Morgan Keegan

I had a couple of quick housekeeping questions. First one is on the OpEx trends. You've had the synergies kicking in, and I'm sort of seeing perhaps some head win if your sales start rising that maybe the SG&A should go up. And if you could elaborate a little bit on how you're thinking about OpEx trends moving from this quarter, synergies versus business demands?

Bob Stanzione

I don't think there's going to be any significant movement up in the SG&A trends. We're continuing to work away at it. We still I think, have some opportunity to go. I'll put it that way.

Simon Leopold - Morgan Keegan

Okay. And in terms of share buybacks if we could get an update of where you are now?

Bob Stanzione

Sure. We, as we announced we did the 77 -- $76 million, and we've not done any others. And obviously, we constantly review what to do.

Simon Leopold - Morgan Keegan

And what are sort of the puts and takes of how you're thinking about that?

Bob Stanzione

Well, obviously it depends upon the share price, the accretion, dilution and the other opportunities we have. But it is something we regularly discuss with our board.

Simon Leopold - Morgan Keegan

Okay. And just want to make sure I'm doing my back of the envelope in the right ballpark. Trying to guesstimate the CMTS revenue in the quarter and I'm coming up with something in the neighborhood of 90 million?

Dave Potts

Sorry, we won't comment on the individual product revenues, I'm sorry.

Simon Leopold - Morgan Keegan

And the last one is getting to the D5 Edge QAM product. I believe on your last conference call, the commentary discussed rethinking the strategy as oppose to focusing on one customer, one application. If we could get an update on the strategic thinking around that product category?

Bryant Isaacs

So not a lot change from the last call, it is -- we're certainly focused on CMTS as one of the lead applications in a lot of work with customers, in labs in testing that product for that application. It is also being deployed for switch digital and for VoD, as well, so not a lot different than what we talked about on the last call.

Simon Leopold - Morgan Keegan

How many customers do you have for that now?

Bryant Isaacs

I don't have that in front of me.

Simon Leopold - Morgan Keegan

But it's multiple. It's safe to say?

Bryant Isaacs

Sure, yeah. Absolutely, yeah.

Simon Leopold - Morgan Keegan

And on the DOCSIS 3.0, obviously we've got the Comcast announcement. How many other customers have selected you for the DOCSIS 3.0 rollout?

Bryant Isaacs

So I think the once we've announced publicly, obviously, it's the Comcast, as well as iTSCOM in Japan, and I can't remember any other public once we've announced. But again -- you can imagine the installed base that we have with customer. All of those customers are planning a migration at some point in time to 3.0 so.

Simon Leopold - Morgan Keegan

Well, I guess what I'm looking for is account of wins, even if you can't identify the customer, if we could get some sense of the progress as measured by?

Bob Stanzione

Simon, we're in multiple trials of DOCSIS 3.0. We have dozens of CMTS customers. And by, I would imagine this time next year, most of them all be converted to 3.0. So that gives you some element of -- to base your projection on.

Jim Lakin

There are advantages to the hardware and software upgrade. We're talking about beyond 3.0, the separation of up streams and down streams, we've talked about that allow an operator to dial in the capacity they need in both directions. So we anticipate really a blanket adoption of this new technology across the entire base. So as we sit here a year from now, we'll be shipping, I anticipate, almost 100% of the new technology, even if it's only being deployed for voice and data in a 2.0 mode. That will be the way...

Bob Stanzione

Backward compatible.

Jim Lakin

It's all backwards compatible, absolutely.

Simon Leopold - Morgan Keegan

Thank you very much.

Jim Lakin

You're welcome.

Operator

Next question comes from the line of Rai Archibold with Kaufman Brothers. Please proceed.

Rai Archibold - Kaufman Brothers

My questions have been answered.

Bob Stanzione

Okay, Rai.

Operator

Next question comes from the line of Andrew Schopick with Nutmeg Securities. Please proceed.

Andrew Schopick - Nutmeg Securities

Thank you. I wanted to ask the question about what type of sensitivity analysis or correlation the company has ever done or attempted to do with respect to new housing starts, foreclosure rates. We are in clearly a very volatile environment certainly as it pertains to the whole real estate market.

And one of the things that's bothering me right now, is just the whole sequence of events that's occurred with ARRIS this year, especially going back to the early part of the month. And really getting some sense of your level of confidence about the visibility or forecasting into any of these periods going forward?

Bob Stanzione

Is that a question?

Andrew Schopick - Nutmeg Securities

Yeah.

Bob Stanzione

What's our level of confidence? I mean how, I'm not sure how to express that. We have a range, this is why we've got a range on our forecast of, plus or minus 10, I guess, on the revenues, and about a $0.05 range, so plus or minus $2.5 on our earnings, because we -- it is hard for us to know exactly how things are going to come in. I've commented on this before.

One large order, flipping from one month to another, makes a big difference in this business. And therefore, I would try to look at longer term trends. I think we have, unless the economy falls apart, I think that our forecasts are good ones. And the drivers of the business as I said remain intact. People are, even if they're staying home more, they're actually online more, using cable modem service more. So I think that can actually have a stabilizing affect on the business.

Andrew Schopick - Nutmeg Securities

But have you ever really to attempt to do any type of analysis with respect to just the whole real estate market and the various statistics?

Bob Stanzione

What we've done is we've talked to our customers, and they've told us, how much plant, for example, that they're building this year compared to a year ago, and two years ago, and we factor that into our forecast. The plant -- the new plant build, is directly proportional to the number of new homes that are built. What we're seeing is that if people are -- in the housing market, people are abandoning single family units, and MDU occupancy is going up.

So there's an offsetting effect there. But it doesn't offset all of it. So I think, again, we've taken the hit in our A&T business and our supplies business, and I think in our EMTA business for the economy. But I've said before, the economy is fairly turbulent, and a major change could affect things.

Andrew Schopick - Nutmeg Securities

Sure.

Bob Stanzione

What we've done is we've listened to our customers. I think we have time for one more question. Eric, is there one more question?

Operator

Yes, sir. Your next question comes from the line Todd Koffman with Raymond James. Please proceed.

Todd Koffman - Raymond James

Thank you. Thanks for squeezing me in, a quick one. Simon Leopold asked what the CMTS revenue was. You said you don't want to talk about think specific revenue. But I thought I heard you say in the opening remarks that your CMTS revenue hit a record. Maybe what was the old record or are you just going to say?

Bob Stanzione

A great question.

Todd Koffman - Raymond James

Did I misunderstand you that, it was not a record?

Bob Stanzione

No, it was a record, Todd. It was the highest revenue we've ever had for CMTS and Bruce told you what the number of down streams was and it was the highest number of down streams we've ever shipped. And again I think it's remarkable that we were able to achieve that with no sales to Comcast of CMTS -- no CMTS sales to Comcast.

Todd Koffman - Raymond James

Can I just have a quick follow on to that? As I look back when you actually used to report and breakout your CMTS business, it was always running plus or minus 10 million, at about 90 million a quarter for a number of years. I've got data back to '05, through a number of product transitions. But you're talking sounds like much more optimistically about the DOCSIS 3.0 transition. But through historically all the different technology transitions, the business has kind of been plus or minus 90 million a quarter. Why is it department this time that you sound so much more optimist about this business being a growth business now going forward?

Dave Potts

To my knowledge we've never disclosed the pure CMTS business.

Bruce McClelland

We do every quarter give you the number of down streams we've shipped, and they've been steadily increasing. We have steadily gained market share during that period of time, too. And we're optimistic because we've got visibility into this quarter with large DOCSIS 3 orders coming in on top of DOCSIS 2 orders from other customers. So I think we'll set a new record this quarter.

Todd Koffman - Raymond James

Very good. Thank you.

Bob Stanzione

You're welcome. That was a quick one. One more question, and then we'll adjourn.

Operator

Your next question comes from the line of Chris Blackman with Empirical Capital. Please proceed.

Chris Blackman - Empirical Capital

Thanks. I appreciate you squeezing me in. Of your large installed base of DOCSIS 2.0 equipment, which is expected to be upgradeable to DOCSIS 3.0, can you guess or give us some percentage of your legacy base that has already been upgraded?

Bob Stanzione

Zero.

Dave Potts

Very small.

Chris Blackman - Empirical Capital

Clever, okay. And so you didn't sell any CMTS to Comcast in Q2. From what I'm hearing, Comcast is splitting their purchases between modular CMTS and an integrated approach. And I know you've stated in the past that at some point you may issue modular CMTS product, have you issued a modular CMTS product?

Bob Stanzione

So our approach is what they call an integrated CMTS, but really it's the same capability from an operator perspective. It's all about increasing the speeds and giving the flexibility up streams and down streams of the redundancy capability that we've built into the product seems to obviously be a popular feature. And that's something that's much easier to implement on the integrated CMTS. So that's what we are deploying today.

Chris Blackman - Empirical Capital

I mean, it sure makes sense, obviously with your install base. But where you don't have an install base, at the end of the day, the customer is going to determine, obviously over the long haul, which approach they're going to take. And I am just kind of curious, how you've positioned yourself, or how you are positioning yourself for potential customers that don't have your installed DOCSIS 2.0 equipment?

Bob Stanzione

So it's not really a barrier either way. But obviously we have the D5 Universal Edge QAM that increases the MCMTS architecture for customers who want to go that direction as well.

Chris Blackman - Empirical Capital

Is that similar to Harmonic's Edge QAM, I mean is that a product like they use to sell into the modular CMTS market?

Bob Stanzione

It's similar. Of course, it's a better product, as you know so.

Chris Blackman - Empirical Capital

Of course.

Bob Stanzione

But, yes, that's the same idea, yes.

Jim Bauer

Chris, thanks.

Chris Blackman - Empirical Capital

I am sorry.

Jim Bauer

I think we're going to have to wrap the call up. If, Eric, you want to just summarize the call. We'll be taking calls later today and tomorrow from our covering analysts. And appreciate you all joining us on the conference call. Bob, any closing remarks that you'd like to make.

Bob Stanzione

Just in closing, what I would like to say is that 2008 so far, we've diversified our product portfolio, we've diversified our customer mix, we've improved our financial profile. We've achieved synergies as we said we would. We didn't do a great job forecasting this quarter, I will admit.

But I think we are positioned for a great second half, and more profitable growth in the economy, as time goes on. So with that, I would like to thank everybody for joining the call and we'll adjourn.

Operator

Thank you for your participation in today's conference. This concludes our presentation. You may now disconnect. Have a good day.

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Source: Arris Group Inc. Q2 2008 Earnings Call Transcript
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