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Arris Group, Inc. (NASDAQ:ARRS) (9.49) is a communications equipment company that develops and manufactures devices for cable television operators primarily in the United States.  Arris operates three business segments:  Broadband Communications Systems, Access Transport and Supplies, and Media and Communications Systems. 

In the Broadband Communications Systems segment representing roughly 86.5% of net sales last year, Arris sells network infrastructure equipment that is implemented at each tier in hybrid fiber-coaxial networks, from the centralized head-end—where content first arrives at the cable operator’s facilities—to distribution hubs and network nodes—where signals are forwarded before arriving at a consumer's home.  Arris also supplies embedded multimedia terminal adapters (eMTA), which provide data, voice, and multimedia content in the same desktop device for the consumer end-user. 

In the Access Transport and Supplies segment, representing roughly 13% of net sales last year, Arris sells cables, signal converters, and other components that are used in connecting various tiers of hybrid fiber-coaxial networks.  Finally, in the Media and Communications Systems segment representing less than 1% of net sales last year, Arris is developing devices for video-on-demand and advertisement delivery.  Arris also provides services involved in planning for device implementation as well as 24x7 support for its products.

Arris products are instrumental in developing the capability for cable television operators to participate in the "triple play" market, combining television, phone, and internet service.  Arris products also play a critical strategic role in allowing cable operators to compete with telecommunications companies in the broadband market, allowing traditional coaxial cable infrastructure to support faster wideband connection speeds that can compete with fiber-to-the-premises [FTTP] networks that the telecommunications companies are deploying.

Arris is the leading worldwide supplier of eMTAs, and the number-two worldwide supplier of the routing devices for distribution hubs, called cable modem termination systems [CMTS], after Cisco Systems (NASDAQ:CSCO).  Arris competes mainly with Motorola (MOT) and Cisco (Scientific Atlanta) in the United States.  These competitors have a much more diverse product line and serve telecommunications companies as well as enterprise customers.  Arris acquired C-COR Inc in late 2007 for $680 million in order to broaden its product offerings and to try to provide a partial defense against this potential competitive disadvantage.  However, Arris caters its product line specifically to the cable operator niche, which could be perceived as strength.

Strategic Analysis

Arris’ strategy includes trying to move the cable industry’s entire group of services to an “IP” or Internet Protocol standard.  This protocol was not initially designed for such use and the industry is taking steps to revise it.  This transition makes it possible for cable operators to offer data and telephone services in addition to television, and allows them to enhance television to provide digital quality and high-definition content.  However, while this may be a direction the cable companies wish to explore, it does involve changing the core business of cable companies—television distribution—and it is still uncertain whether consumers are truly interested in purchasing all of their communication services—television, data, and now voice telephony—from the same company.

It is also important to note that Arris’ business strategy appears to be highly focused.  It revolves around the single principle of moving cable services to an IP-base and leveraging synergies it hopes to develop by allowing all three signals—voice, data, and television—to pass through its equipment.  Strong sales of hybrid voice/data eMTAs helped to drive growth over the last two years.  However, recently, such sales have temporarily subsided as cable operators have adopted strategies that involve multiple suppliers. 

Further, triple play adoption has required strong marketing efforts on the part of cable operators.  It is uncertain whether consumers are truly interested in “Triple Play” services that Arris’ business depends on, or whether they have simply been lured by attractive deals provided by cable companies.  Further, telecom companies are rolling out high speed fiber lines directly into the home (FTTH, “fiber to the home” or FTTP, “fiber to the premises”) that eventually will provide better Internet, voice, and television transfer speeds than those which could be achieved over legacy coaxial cables deployed by the cable companies.  Motorola and Cisco provide equipment to the telecom companies as well as to cable operators, whereas Arris caters strictly to cable companies.  Therefore, Arris’ long-term performance will be somewhat dependent on the success of large cable operators such as Comcast (NASDAQ:CMCSA) and Time Warner Cable (NYSE:TWC) winning the broadband battle.

In order to understand the differences in technology between coaxial cable potential and fiber potential, the current speed offerings for each type of company should be noted.  Current speeds offered by cable companies are typically between 1.5 – 6 Mbits per second.  Current broadband speeds offered by telecom companies for fiber service are between 5 – 20 Mbits per second.  The pricing is relatively similar.

New technologies offered by Arris, Motorola, and Cisco can potentially allow cable companies to increase their speeds to somewhere near 160 Mbits per second.  Their equipment increases existing bandwidth speeds by allowing cable operators to integrate fiber into the cable operator’s existing coaxial networks, splitting nodes to allow faster speeds by dividing the pipe among fewer customers, and channel bonding, which allows information to be sent to the customer by combining multiple connection channels. The potential of the fiber lines being rolled out by the telecom companies currently is approximately 2.4 Gbits per second (roughly 2400 Mbits), more than 10 times cable’s current potential.  However, it is unlikely that consumer bandwidth demand will necessitate this speed in the foreseeable future, somewhat negating any immediate advantage for telecom companies.

As cable companies rush to try to provide competitive speeds, they will gradually bring fiber lines closer and closer to the consumer’s home, transforming their existing network infrastructure to keep pace with consumer demand.  This alleviates the need for a full-network overhaul, as is being performed by telecom companies—like Verizon’s (NYSE:VZ) $18 billion FiOS network or AT&T’s (NYSE:T) $6 billion U-verse network.

Pros

  •  Cable companies are strongly marketing Triple Play services to their customers in an attempt to steal telephone market share from the telecommunications companies.
  • New DOCSIS 3.0 technology holds the much-needed relief for cable companies that are maxing out the transmission capability of older DOCSIS 2.0 technologies.
  • Following the acquisition of C-COR, Arris has attempted to broaden its product line to provide on-demand video equipment and other devices.

Cons

  • VoIP phone service is adequate, but needs some improvement before it can truly rival traditional landline telephone service.  For example, in the event of an emergency or power outage, phone service could be interrupted.
  • Fiber lines hold much greater potential.  Although the demand for the speed fiber can provide does not yet exist, as the internet becomes a bigger part of the ordinary life of the average person and as content distribution by the television studios migrates to the Internet, such speed demands will present themselves.
  • Competitors, Motorola and Cisco, provide broader product lines and benefit from the diversification related to servicing both of the competing industries.

Valuation

By almost all metrics, Arris is an inexpensive stock.  It trades at 13.0 times next 12-months estimated EPS, 1.1 times sales, and 1.1 times book value.  This discount relates to poor earnings comparisons over the last several quarters, a lack of immediate synergies from the C-COR acquisition, and a highly concentrated client base (which makes possible both positive and negative earnings surprises.)  Arris has considerable capital appreciation potential if it can deliver solid and consistent growth.

Conclusions

Expect Arris to show gains in the next few years as Triple Play services are pushed by the cable companies and bandwidth-enhancing DOCSIS 3.0 devices are implemented, but understand the reality that fiber lines being laid by the telecom companies provide much more bandwidth potential.  If cable companies are not able to continue to develop strategies to out-compete the telecoms in delivering broadband internet, phone, and television services, Arris will suffer tremendously.

While it is clear that the technology being offered by the telecom companies is far superior to that offered by the cable companies, the cable companies are ultimately still winning the war at this point.  There appear to be three reasons for this.

First, consumers simply do not understand the technological differences between the offerings from cable companies and telecom companies and they are satisfied with the current service. 

Second, cable companies’ infrastructure is generally already developed.  Coaxial cable lines are already laid, whereas Verizon is sluggish in rolling out its new fiber lines.  For example, the waiting period to have new FiOS service installed in some markets is approximately 6-8 months.  Such slow adoption is likely inhibiting the “break-through word-of-mouth technology hype” that would ordinarily accompany a technology like fiber-to-the-home.

Third, telecom marketing strategies have been relatively weak.  The cable companies, on the other hand, have maintained a consistent and aggressive triple play marketing strategy with attractive television spots (taking advantage of the average consumer’s lack of knowledge with respect to the technology), as well as mailers and special deals.  They are also effective in suppressing the hype surrounding fiber lines by reminding consumers that cable operators have fiber segments built into their networks as well.

The next year or two should provide an opportunity for strong price appreciation for Arris.  Cable is currently winning the triple play battle and Arris is selling the ammunition.  For Arris to be successful it needs to experience increasing adoption of DOCSIS 3.0 technology, broader penetration into international market and greater synergies in its C-COR acquisition.  At its current price level, Arris appears to be attractively valued for risk tolerant investors seeking strong capital appreciation potential.

Source: Arris Group: Well-Positioned for the Ongoing Broadband War