The Daily Magic Formula Stock for 02/06/2008 is Arris Group Inc. According to the Magic Formula Investing Web Site, the ebit yield is 21% and the EBIT ROIC is 25-50 %.
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ARRIS Group, Inc. (together with its consolidated subsidiaries, except as the context otherwise indicates, â€śARRISâ€ť or the â€śCompanyâ€ť), is a global communications technology company, headquartered in Suwanee, Georgia. ARRIS operates in one business segment, Communications, providing to a range of customers, primarily cable major system operators (â€śMSOsâ€ť), network and system products and services, primarily hybrid fiber-coax networks and systems. ARRIS is a leading developer, manufacturer and supplier of telephony, data, video, construction, rebuild and maintenance equipment for the broadband communications industry. The Company provides its customers with products and services that enable reliable, high-speed, two-way broadband transmission of video, telephony, and data.
The consolidated financial statements reflect all adjustments (consisting of normal recurring accruals) that are, in the opinion of management, necessary for a fair presentation of the consolidated financial statements for the periods shown. Additionally, certain prior period amounts have been reclassified to conform to the 2007 financial statement presentation. Interim results of operations are not necessarily indicative of results to be expected from a twelve-month period. These financial statements should be read in conjunction with the Companyâ€™s most recently audited consolidated financial statements and notes thereto included in the Companyâ€™s Annual Report on Form 10-K for the year ended December 31, 2006, as filed with the United States Securities and Exchange Commission (â€śSECâ€ť).
No minimum funding contributions are required in 2007 under the Companyâ€™s defined benefit plan. However, the Company made voluntary contributions to the plan of approximately $19 thousand and $37 thousand for the three and six months ended June 30, 2007, respectively.
Note 3. Guarantees
ARRIS provides warranties of various lengths to customers based on the specific product and the terms of individual agreements. The Company provides for the estimated cost of product warranties based on historical trends, the embedded base of product in the field, failure rates, and repair costs at the time revenue is recognized. Expenses related to product defects and unusual product warranty problems are recorded in the period that the problem is identified. While the Company engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its suppliers, the estimated warranty obligation could be affected by changes in ongoing product failure rates, material usage and service delivery costs incurred in correcting a product failure, as well as specific product failures outside of ARRISâ€™ baseline experience. If actual product failure rates, material usage or service delivery costs differ from estimates, revisions (which could be material) would be recorded against the warranty liability. ARRIS evaluates its warranty obligations on an individual product basis.
The Company offers extended warranties and support service agreements on certain products. Revenue from these agreements is deferred at the time of the sale and recognized on a straight-line basis over the contract period. Costs of services performed under these types of contracts are charged to expense as incurred, which approximates the timing of the revenue stream.
Note 4. Restructuring and Impairment Charges
During the first quarter of 2004, ARRIS consolidated two facilities in Georgia, giving the Company the ability to house many of its core technology, marketing, and corporate headquarters functions in a single building. This consolidation resulted in a restructuring charge of $6.2 million in the first quarter of 2004 related to lease commitments and the write-off of leasehold improvements and other fixed assets. As of June 30, 2007, approximately $3.1 million related to the lease commitments remained in the restructuring accrual to be paid. ARRIS expects the remaining payments to be made by the second quarter of 2009 (end of lease).
On November 6, 2006, the Company issued $276.0 million of 2% convertible senior notes due 2026. The notes are convertible, at the option of the holder, based on an initial conversion rate, subject to adjustment, of 62.1504 shares per $1,000 base amount (which represents an initial conversion price of approximately $16.09 per share of our common stock), into cash up to the principal amount and, if applicable, shares of the Companyâ€™s common stock, cash or a combination thereof. The notes may be converted during any calendar quarter in which the closing price of ARRISâ€™ common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 120% of the conversion price in effect at that time (which, based on the initial conversion price would be $19.31) and upon the occurrence of certain other events. Upon conversion, the holder will receive the principal amount in cash and an additional payment, in either cash or stock at the option of the Company. The additional payment will be based on a formula which calculates the difference between the initial conversion rate ($16.09) and the market price at the date of the conversion. As of August 3, 2007, the notes could not be converted by the holders thereof. Interest is payable on May 15 and November 15 of each year. The Company may redeem the notes at any time on or after November 15, 2013, subject to certain conditions. As of June 30, 2007 and December 31, 2006, there were $276.0 million of the notes outstanding.
As of both June 30, 2007 and December 31, 2006, the Company had approximately $3.1 million outstanding under letters of credit, which are cash collateralized and classified as restricted cash on the Consolidated Balance Sheets.
As of June 30, 2007, the Company had approximately $22.4 million of other long-term liabilities, which included $12.8 million related to its accrued pension, $4.3 million related to its noncurrent income tax payable, $3.3 million related to its deferred compensation obligations, and deferred rental expense of $2.0 million related to landlord funded leasehold improvements. As of December 31, 2006, the Company had approximately $20.7 million of other long-term liabilities, which included $12.1 million related to its accrued pension, $3.0 million related to its noncurrent income tax payable, $3.5 million related to its deferred compensation obligations and $2.1 million related to landlord funded leasehold improvements.
The Company has not paid cash dividends on its common stock since its inception. In 2002, to implement its shareholder rights plan, the Companyâ€™s Board of Directors declared a dividend consisting of one right for each share of its common stock outstanding. Each right represents the right to purchase one one-thousandth of a share of its Series A Participating Preferred Stock and becomes exercisable only if a person or group acquires beneficial ownership of 15% or more of its common stock or announces a tender or exchange offer for 15% or more of its common stock or under other similar circumstances.
Note 8. Comprehensive Income
Total comprehensive income represents the net change in stockholdersâ€™ equity during a period from sources other than transactions with stockholders. For ARRIS, the components of total comprehensive income include the unrealized gain (loss) on marketable securities and unrealized gain (loss) on derivative instruments qualifying for hedge accounting
In the second quarter of 2007, ARRIS reclassified the accumulated gain of approximately $1.3 million related to its deferred compensation plan, resulting in a gain on investments.
In March 2007, ARRIS concluded that the foreign exchange contract hedges were no longer effective and discontinued hedge accounting resulting in a reclassification of $551 thousand remaining in other comprehensive income to the applicable income statement lines.
Note 9. Sales Information
The Companyâ€™s four largest customers (including their affiliates, as applicable) are Comcast, Cox Communications, Liberty Media International and Time Warner Cable. Over the past year, certain customersâ€™ beneficial ownership may have changed as a result of mergers and acquisitions. Therefore, the revenue for ARRISâ€™ customers for prior periods has been adjusted to include the affiliates under common control.
ARRIS sells its products primarily in the United States. The Companyâ€™s international revenue is generated from Asia Pacific, Europe, Latin America and Canada. The Asia Pacific market primarily includes China, Japan, Korea, and Taiwan. The European market primarily includes Austria, Belgium, the Czech Republic, Germany, Hungary, the Netherlands, Poland, Portugal, Romania, Russia, and Switzerland. The Latin American market primarily includes Argentina, Chile, Colombia, and Mexico. Sales to international customers were approximately $67.8 million, or 26.8% of total sales, and $128.3 million, or 26.3% of total sales, for the three and six months ended June 30, 2007. International sales during the same periods in 2006 were $58.2 million, or 26.4% of total sales, and $109.1 million, or 25.4% of total sales, respectively.
As of June 30, 2007, ARRIS held approximately $1.8 million of assets in Ireland (related to its Com21 facility), comprised of $0.9 million of cash, $0.1 million of prepaid assets and $0.8 million of fixed assets. As of December 31, 2006, ARRIS held approximately $2.3 million of assets in Ireland, comprised of $1.5 million of cash and $0.8 million of fixed assets.
Excluded from the dilutive securities described above are employee stock options to acquire approximately 2.9 million shares and 2.5 million shares, for the three and six months ended June 30, 2007, respectively. During the same periods in 2006, approximately 1.5 million shares and 1.2 million shares, respectively, were excluded from the dilutive securities above. These exclusions were made because they were antidilutive.
In November 2006, the Company issued $276.0 million of 2% convertible senior notes. Upon conversion, ARRIS will satisfy at least the principal amount in cash, rather than common stock. This reduced the potential earnings dilution to only include the conversion premium, which is the difference between the conversion price per share of common stock and the average share price. ARRISâ€™ policy is to use the average market price of its stock during the reporting period to calculate the number of shares, if any, to be included in the denominator of the dilutive EPS calculation. The average market price during the three and six months ended June 30, 2007 was less than the conversion price of $16.09 and, consequently, the dilutive EPS was not impacted.
Note 11. Income Taxes
Adoption of FASB Interpretation No. (â€śFINâ€ť) 48, Accounting for Uncertainty in Income Taxesâ€”an interpretation of FASB Statement No. 109, Accounting for Income Taxes.
On January 1, 2007, the Company adopted the provisions of FIN 48, Accounting for Uncertainty in Income Taxesâ€”an Interpretation of FASB Statement No. 109, Accounting for Income Taxes. FIN 48 seeks to clarify the accounting or uncertainty in income taxes recognized in an enterpriseâ€™s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes , by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Under FIN 48, the financial statement effects of a tax position should initially be recognized when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. A tax position that meets the more-likely-than-not recognition threshold should initially and subsequently be measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority.
The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2001. Neither the Company nor any of its subsidiaries are currently under income tax audit, nor have they received notices of any planned or proposed income tax audits. Additionally, the Company has no outstanding unpaid income tax assessments for prior income tax audits.
Due to the immaterial amount of the calculated adjustment to the liability for unrecognized tax benefits arising from the adoption of FIN 48, the Company recorded no adjustment to the January 1, 2007 balance in retained earnings.
At the beginning of 2007, the Companyâ€™s unrecognized tax benefits totaled approximately $3.1 million, all of which would cause the effective income tax rate to change upon the recognition of those benefits. ARRIS does not currently anticipate that the total amount of unrecognized tax benefits will significantly increase or decrease within the next twelve months. The Company has recorded no interest or penalty accrual related to payment of these potential tax liabilities, since it does not anticipate that interest and penalties will be assessed on these liabilities in the future. The Company intends to classify interest and penalties recognized on the liability for uncertain tax benefits, when it is appropriate to accrue them, as income tax expense.
Income Tax Expense
In the six months ended June 30, 2007 and 2006, the Company recorded income tax expense of $26.7 million and $1.2 million, respectively.
â€˘ In the first quarter of 2007, the Company considered the net gain related to the termination of the proposed TANDBERG Television acquisition to be discrete in nature in accordance with the guidance of APB Opinion 28, Interim Financial Reporting and FIN 18, Accounting for Income Taxes in Interim Periods . As a result, income tax expense was recorded at a discrete rate of 38.0%. There were no discrete events during the second quarter of 2007.
â€˘ The termination fee, less expenses, associated with the terminated TANDBERG Television acquisition was considered capital in nature. As a result, during the first quarter of 2007, the Company reversed a net of $4.0 million of valuation allowances associated with deferred tax assets related to net capital loss carryforwards. Prior to the capital gain created by the terminated acquisition, the Company considered it more-likely-than-not that capital loss carryforwards would not be realizable. Additionally, the Company recorded an additional $0.8 million of discrete income tax expense related to the terminated TANDBERG transaction.
â€˘ For the first six months of 2006, income tax expense was recorded at the federal Alternative Minimum Tax (â€śAMTâ€ť) rate and state rates, as applicable. Prior to the end of 2006, the Company was in a cumulative loss position for the prior three fiscal years. As a result, it had recorded a valuation allowance equivalent to its net deferred tax assets. At the end of 2006, the Company reversed the majority of the valuation allowance. See the Companyâ€™s Annual Report on Form 10-K for the year ended December 31, 2006, as filed with the SEC for further discussion.
The Company anticipates that the effective tax rate, excluding any future discrete events, will be approximately 33% for the remainder of 2007.
Note 12. Termination of Proposed Acquisition
In January 2007, ARRIS announced its intention to purchase the shares of TANDBERG Television for approximately $1.2 billion. In February 2007, another party announced its intent to make a competing all cash offer for all of TANDBERG Televisionâ€™s outstanding shares at a higher price than ARRISâ€™ offer. Ultimately, the board of directors of TANDBERG Television recommended to their shareholders that they accept the other partyâ€™s bid and ARRISâ€™ bid lapsed without being accepted.
As part of the agreement with TANDBERG Television, ARRIS received a break-up fee of $18.0 million. In conjunction with the proposed transaction, the Company incurred expenses of approximately $7.5 million. ARRIS also realized a gain of approximately $12.3 million on the sale of foreign exchange contracts the Company purchased to hedge the transaction purchase price.
Note 13. Contingencies
The Company is a defendant or believes that it is reasonably likely that it may be a defendant in three patent disputes. Each dispute involves the assertion against the Companyâ€™s customers of patent infringement based upon their networks, including products supplied by ARRIS and its competitors, use of or compliance with the DOCSIS standard.
In Hybrid Patents, Inc. v. Charter Communications, Inc., Case No. 2:05-CV-436 (E.D. Tex), the Companyâ€™s customer Charter Communications, Inc. has been sued for patent infringement and has requested indemnification from other manufacturers and the Company. On summary judgment, the court held that the Company did not have any rights in the patent (which the Company believes that it has as a result of the acquisition of a licensee of the patent), and at trial, the jury held that the plaintiffâ€™s patent was valid but that the products did not infringe. The parties currently are considering whether to appeal. The Companyâ€™s rights in the underlying patent also are the subject of ARRIS International, Inc. (now ARRIS Group, Inc.) v. Hybrid Patents, Inc., Hybrid Networks, Inc., HYBR Wireless Industries, Inc., London Pacific Life & Annuity Company, and Carol Wu, Trustee of the Estate of Com21, Inc., Case No. 03-54533MM, Chapter 7, Adversary Proceeding in Bankruptcy, Adv. No. 06-5098MM (Bankr. N.D. Cal.). This case has been stayed pending the outcome of the Texas case above.
In a series of fifteen lawsuits in Federal Court, a number of the Companyâ€™s customers have been sued by Rembrandt Technologies LP for patent infringement related to the cable systems operatorsâ€™ use of data transmission, video, cable modem, voice-over-internet, and other technologies and applications. Although the Company is not a defendant in any of these lawsuits, its customers either have requested indemnification from, or are expected to request indemnification from, the Company and other manufacturers. On June 18, 2007, the Judicial Panel of Multidistrict Litigation issued an order centralizing the litigation in the District of Delaware.
GPNE Corp. has sued three of the Companyâ€™s customers in the United States District Court for the Eastern District of Texas. The Company is not a defendant, but it believes that it is likely the defendants will make indemnification requests of the Company, as well as a request to contribute to the legal costs and expenses of the litigation.
It is premature to assess the likelihood of a favorable outcome in any of these matters. In the event of adverse outcomes, the Company and other similarly situated suppliers of DOCSIS-compliant products could be required to indemnify its customers, pay royalties, and/or cease using certain technology. Also, an adverse outcome could require a change in the DOCSIS standards to avoid using the patented technology. Management does not believe an accrual is required at this time.
Name: Alex B. Best Age: 66 Director since: 2003 ARRIS Board Committee: Compensation Committee, Nominating and Corporate Governance Committee and Technology Committee (Chair) Principal occupation and recent business experience: Prior to his retirement in 2000, Mr. Best was the Executive Vice President of Cox Communications, Inc. From 1986 through 1999, he served as the Vice President of Engineering of Cox. Since 2000, Mr. Best has continued to consult for Cox on a part-time basis. From 1966 through 1986, Mr. Best worked for Scientific-Atlanta and was involved in nearly every aspect of its cable television product development and business applications. Mr. Best served as Chairman of the National Cable Television Associationâ€™s Engineering Advisory Committee from 1995 until 2000. Other directorships: Concurrent Computer Corporation
Name: Harry L. Bosco Age: 61 Director since: 2002 ARRIS Board Committee: Audit Committee and Nominating and Corporate Governance Committee (Chair) Principal occupation and recent business experience: Since 2000, Mr. Bosco has served as the Chief Executive Officer and President of OpNext, Inc. From 1965 to 2000, Mr. Bosco held numerous senior management positions within Lucent Technologies, formerly Bell Labs. Other directorships: OpNext, Inc.
Name: John Anderson Craig Age: 64 Director since: 1998 ARRIS Board Committee: Audit Committee and Compensation Committee Principal occupation and recent business experience: Mr. Craig is a business consultant. From 1999 through 2000, Mr. Craig was Chief Marketing Officer of Nortel Networks, Inc. From 1981 to 1999, he held various senior management positions within Northern Telecom Inc., now known as Nortel Networks Inc. Other directorships: Bell Canada International and CAE, Inc.
Name: Matthew B. Kearney Age: 67 Director since: 2003 ARRIS Board Committee: Audit Committee Principal occupation and recent business experience: Prior to his retirement in 1997, Mr. Kearney was the Chief Financial Officer of Griffin Gaming & Entertainment, Inc. (formerly Resorts International, Inc.). Mr. Kearney also served as President of Griffin Gaming & Entertainment, Inc. from 1993 through 1995. Prior to joining Resorts International, Inc., Mr. Kearney worked in public accounting for Price Waterhouse & Co. Mr. Kearney is a CPA (inactive) in New York and Florida.
Name: William H. Lambert Age: 70 Director since: 1997 ARRIS Board Committee: Compensation Committee (Chair) and Nominating and Corporate Governance Committee Principal occupation and recent business experience: Mr. Lambert is retired. From 1988 to 1997, Mr. Lambert served as the Chairman, President and Chief Executive Officer of TSX Corporation, which was acquired by ARRIS in 1997. Mr. Lambert has been a private investor since 1998.
Name: John R. Petty Age: 76 Director since: 1993 ARRIS Board Committee: Audit Committee (Chair) and Nominating and Corporate Governance Committee. Mr. Petty is also the lead independent director. Principal occupation and recent business experience: Mr. Petty is the Chairman and CEO of TECSEC Incorporated, a data security company. Mr. Petty also has served as the Chairman of Federal National Payables, Inc., Federal National Commercial, Inc., and Federal National Services, Inc., since 1992. Mr. Petty has been a private investor since 1988.
Name: Robert J. Stanzione Age: 59 Director since: 1998 ARRIS Board Committee: Technology Committee Principal occupation and recent business experience: Mr. Stanzione has been Chief Executive Officer of the Company since 2000. From 1998 through 1999, Mr. Stanzione was President and Chief Operating Officer of the Company. Mr. Stanzione has been Chairman of the Board of Directors since 2003. From 1995 to 1997, he was President and Chief Executive Officer of Arris Interactive L.L.C. From 1969 to 1995, he held various positions with AT&T Corporation. Other directorships: National Cable & Telecommunications Association (NCTA) and Symmetricom, Inc.
Based on information included in a Schedule 13G, Barclays Global Investors, NA has sole voting power with respect to 5,585,101 shares and sole dispositive power with respect to 5,951,288. The address for Barclayâ€™s Global Fund Advisors is 45 Fremont Street, San Francisco, California 94105.
Based on information included in a Schedule 13G, Neuberger Berman Inc. has sole voting power with respect to 1,727,936 shares, shared voting power with respect to 4,747,782 shares, and shared dispositive power with respect to 6,935,893. The address for Neuberger Berman Inc. is 605 Third Avenue, New York, New York 10158.
Based on information included in a Schedule 13G, Vanguard Group, Inc has sole voting power with respect to 126,283 shares and sole dispositive power with respect to 5,391,322. The address for Vanguard Group, Inc. is 100 Vanguard Blvd., Malvern, Pennsylvania 19355.
Based on information included in a Schedule 13G, Wellington Management Company, LLP has shared voting power with respect to 5,540,195 shares and shared dispositive power with respect to 7,613,873 shares. The address for Wellington Management Company, LLP is 75 State Street, Boston, Massachusetts 02109.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Our long-term goal is to continue to strengthen our position as a leading provider of broadband access products and services worldwide. Our primary market and focus is cable service providers, or major system operators (â€śMSOsâ€ť). Our customers, the MSOs, seek new cost effective revenue generating services that they can market and sell to their subscribers. The key new services at this time are digital video, high speed data and IP telephony. Through internal development and various acquisitions that we have made and may make in the future, we market and sell broadband access products that enable the delivery of these services by the MSOs, and to potentially other operators such as satellite service providers and telephone companies.
Our Strategy and Key Trends and Highlights
Taking into consideration industry conditions, to achieve our goal of increasing our position as a leading worldwide provider of broadband access products and services, we have implemented a long-term business strategy that includes the following key elements:
â€˘ Transition to VoIP with an â€śEverything IP, Everywhereâ€ť philosophy and build on current market successes;
â€˘ Leverage our current voice and data business;
â€˘ Strengthen and grow our supplies infrastructure distribution channel;
â€˘ Expand our existing product/services portfolio through internal developments, partnerships and acquisitions; and
â€˘ Maintain and improve an already strong capital and expense structure.
Below is a summary of some of our key trends, actions and highlights:
â€śEverything IP, Everywhereâ€ť is taking hold as MSOs globally have embraced VoIP and are now rapidly deploying this key new service.
â€˘ Our sales and operating income, improved year over year primarily as a result of the growth in the VoIP market and customer acceptance of our products.
â€˘ We have successfully leveraged our existing market position and industry experience to increase sales of both EMTA and CMTS products.
â€˘ We expect demand for CMTS products will continue to increase in future periods as new services and competition between our customers and their competitors intensifies the need to provide ever faster download speeds which require additional CMTS capacity and features.
â€˘ We expect demand for residential EMTAs to moderate as many of our customers have now passed through the initial launch stage and have reached a sustainable level of deployments.
â€˘ In July 2007 we were advised by Comcast that the ARRIS D5 Next Generation Edge QAM had been selected as one of only two Universal Edge QAM products for deployment in its switched digital video initiative. This is the successful culmination of many years of research and development effort and represents a substantial long term growth opportunity. We are currently anticipating receiving orders under this award in the second half of 2007.
â€˘ We believe we are gaining momentum in commercial services over cable with several large U.S. cable operators. Our TM504, TM508, and TM512, four line, eight line, and twelve line multi-line EMTAs are well suited to providing commercial telephone service over cable.
â€˘ Sales of our CBR products, consistent with the expectation that we previously disclosed, decreased significantly year over year as this product line nears the end of its life. We anticipate minimal sales of this product in 2007.
We continue to invest significantly in research and development.
â€˘ We have made significant investments through our research and development efforts in new products and expansion of our existing products. Our primary focus has been on products and services that will enable MSOs to build and operate high-availability, fault-tolerant networks, which allow them to generate greater revenue by offering high-speed data, IP telephony and digital video. This â€śsuccess-basedâ€ť capital expenditure is becoming an increasing portion of the cable operatorsâ€™ total capital spending. In addition, some MSOs have expressed interest in offering bundled wireless telephony as part of their product offering. This product known as Fixed Mobile Convergence (FMC) will allow cable subscribers to use mobile phones in their homes, which connects the MSOsâ€™ VoIP network in the home to the cellular network outside of the home and roams back and forth seamlessly. We are developing products to support this new offering. In the second quarter of 2007, we spent approximately $17.8 million on research and development, or 7.0% of revenue, which compares to $19.3 million or 8.8% of revenue in the same period last year. We expect to continue to spend similar levels on research and development in the future.
â€˘ Key research and development accomplishments through the first six months of 2007 included:
o Introduction of the TTM502C, a Japanese version of our industry leading two line battery powered EMTA.
o Introduction of the TM552-series EMTA with an integrated 802.11G wireless base station with wireless mesh networks and VLAN features to support commercial services.
o C4 CMTS with support for Flexpathâ„˘ wideband data services, Layer-3 VLAN, lawful intercept, and dynamic load balancing in both the upstream and downstream. During the first quarter, JComm, a major Japanese MSO, announced the commercial launch of a 160 megabit data service in several cities using the C4 CMTS with Flexpath. Layer-3 VLAN support is a major feature supporting business services over cable. Dynamic load balancing enables the operators to efficiently manage wide variations in data and VoIP traffic patterns across the day and the week.
o C4 CMTS which will support DOCSIS 3.0 and modular CMTS. A prototype version of this product was demonstrated at the Society of Cable Telecommunications Engineers conference in 2007. The demonstration included working versions of the new C4 16-downstream port module and the new MAC processor module which are currently under development. When commercially available, this product will enable currently installed C4 CMTS to be efficiently upgraded to DOCSIS 3.0 and modular CMTS.
o D5 Universal Edge QAM Modulator provides the required protocols to support switched digital video network. In July 2007, we were advised that we had been selected by Comcast to provide the D5 for part of Comcastâ€™s switched digital video network.
At the end of the second quarter we had cash, cash equivalents and short- term investments of approximately $604 million.
â€˘ Through a combination of our cash resources, anticipated cash generation from operating activities and our ability to access capital markets, we continue to be well positioned to execute on strategic opportunities.
â€˘ At the end of the second quarter 2007, we had $90.5 million of inventory on hand. In order to better meet our customer demand, we are planning on increasing our inventory of key products by approximately $10 million in the third quarter 2007.
â€˘ Accounts receivable, net ended the second quarter 2007 at $120.7 million with annualized DSOs of 44 days. We are presently in discussions with customers about various business terms including payment terms. It is possible that these discussions may lead to an increase in our DSOs in the future.
â€˘ As a result of our recent success with respect to our D5 QAM product line, we anticipate that we will have higher capital expenditures for lab equipment and test equipment in the second half of 2007. Our forecast for capital expenditures for 2007 is now $13 million to $15 million.
Our income statement reflects significantly higher income tax expense year over year and we have essentially utilized the vast majority of our Net Operating Losses (â€śNOLsâ€ť).
â€˘ In the fourth quarter of 2006, given our recent history of cumulative profitability, we concluded that it was more likely than not that we would generate sufficient income in the future to utilize deferred tax assets, including NOLs. As a result, we reversed a portion of the valuation allowances that had been recorded related to those deferred tax assets. Further, through the fourth quarter of 2006 we had sufficient NOLs to limit our actual cash tax liabilities. Given these facts, we had minimal tax expense of $1.2 million in the first half of 2006, which equated to an effective tax rate of 2.6%.
â€˘ In the first six months of 2007, we recorded a tax expense of $26.7 million, which equates to an effective tax rate of 30.5%. Included in the tax expense are discrete items, per the guidance of Accounting Principles Board (â€śAPBâ€ť) Opinion 28, Interim Financial Reporting . We anticipate a tax rate in the second half of 2007 of approximately 33%.
The Companyâ€™s four largest customers (including their affiliates, as applicable) are Comcast, Cox Communications, Liberty Media International and Time Warner Cable. Over the past year, certain customersâ€™ beneficial ownership may have changed as a result of mergers and acquisitions. Therefore the revenue for ARRISâ€™ customers for prior periods has been adjusted to include the affiliates under common control.
During the three and six months ended June 30, 2007, sales of our Broadband products decreased by approximately 21.7% and 14.4% as compared to the same periods from the prior year. These decreases in Broadband revenue resulted from:
â€˘ As previously disclosed, sales of our CBR product decreased significantly year over year as this product line nears the end of its life. In the second quarter 2007, we sold $2.5 million of CBR product as compared to $38.1 million in the same period last year. We anticipate that sales of CBR products will be immaterial in future periods.
â€˘ The decline in CBR sales was partially offset with an increase in our CMTS product year over year as operators continue to expand their capacity to handle new services and greater bandwidth demand by their customers.
Supplies & CPE Net Sales 2007 vs. 2006
Supplies & CPE product revenue increased by approximately 44.6% and 35.4% in the three and six month periods ended June 30, 2007, as compared to the same periods in 2006. These increases reflect:
â€˘ Increased sales of our EMTA product as operators ramped up deployment of VoIP. In the second quarter of 2007, we sold approximately 1.9 million EMTAs in comparison to approximately 1.1 million in the second quarter of 2006.
Broadband Gross Margin 2007 vs. 2006
Broadband gross margin dollars and gross margin percentage were down year over year:
â€˘ Gross margin percentage declined 1.4 percentage points in the second quarter 2007 as compared to the same period last year primarily as a result of lower price points for our CMTS product, as previously disclosed. Gross margin dollars declined by $10.9 million, or 24%, as a result of lower sales of CBR product, lower margin percentages for CMTS product, partially offset by increased sales of CMTS product.
â€˘ For the first half of 2007, gross margin dollars declined by $11.1 million, or 13%, due to lower CBR sales, partially offset by higher sales of CMTS.
Supplies & CPE Gross Margin 2007 vs. 2006
The Supplies & CPE category gross margin dollars and percentage increased year over year for both the second quarter and the first six months:
â€˘ The increase in revenues year-over-year significantly impacted gross margin dollars. This was predominantly related to our increase in sales of EMTAs. The improvement in gross margin percentage also contributed significantly to the increase in gross margin dollars.
â€˘ Gross margin percentage improved by 6.5 percentage points and 6.0 percentage points, year over year for the three and six month periods. The improvement was the result of cost reductions and new product introductions. In early 2006, we implemented price reductions related to our EMTA products in conjunction with agreements entered into with customers that provided us with better market share and visibility. The reductions were implemented as we were in the process of introducing a cost reduced version of the product. Until the product was fully introduced in the first quarter 2007, we recorded lower gross margins.
Selling, General, and Administrative, or SG&A, Expenses
SG&A expenses increased year over year for both the three and six months ended June 30 by $4.7 million and $7.7 million, respectively:
â€˘ Employee costs increased $1.9 million and $3.6 million for both the three and six months ended June 30, 2007, respectively. The increase in costs resulted from higher staffing levels, salary increases, other fringe benefits, equity compensation and travel. Over the past twelve months, we made the decision to supplement our staffing particularly in sales and marketing. Further, annual salary increases were implemented in the second quarter.
â€˘ We incurred higher bad debt expense in the second quarter and first half of 2007 as compared to the same periods in 2006. In the second quarter of 2006, we recorded a $1.1 million gain as compared to the first half of 2006 we recorded a $1.6 million gain. The gains related to previously written off accounts receivable. This did not reoccur in 2007.
â€˘ We incurred higher legal costs in the three and six month periods ended June 30, 2007 as compared to the same periods in 2006. The higher legal expenses relate primarily to ongoing activities related to potential patent claims. See Legal Proceedings in Part II, Item 1 for further discussion.
Research & Development Expenses
We continue to aggressively invest in research and development. Our primary focus is on products that allow MSOs to capture new revenues, in particular, high-speed data, VoIP, and Video over IP; however, we also continue to place emphasis on reducing product costs and test equipment costs.
R&D expense decreased $1.6 million in the three months ended June 30, 2007 as compared to the same period in 2006:
â€˘ In the second quarter of 2006, we incurred a $2.4 million expense for licensing fees related to our Fixed Mobile Convergence development that did not reoccur in the second quarter of 2007.
â€˘ Offsetting the above, we incurred higher employee costs of approximately $1.2 million related to higher staffing levels, salary increases, taxes, other fringe benefits, equity compensation and travel.
R&D expense increased $1.4 million in the six months ended June 30, 2007 as compared to the same period in 2006:
â€˘ We incurred higher employee costs of approximately $2.4 million related to higher staffing levels, salary increases, bonus accruals, taxes, other fringe benefits, equity compensation and travel.
â€˘ Partially offsetting the above, in the first half of 2006, we incurred a $2.5 million expense for licensing fees related to our Fixed Mobile Convergence development as compared to a $1.5 million expense in the first half of 2007.
Restructuring and Impairment Charges
On a quarterly basis, we review our existing restructuring accruals and make adjustments if necessary. As a result of these evaluations, we did not record a charge during the three months ended June 30, 2007. However we recorded an increase to a restructuring accrual of $0.4 million during the six months ended June 30, 2007, related to changes in estimates associated with real estate leases. These adjustments were required due to changes to the initial estimates used.
Amortization of Intangibles
Intangibles amortization expense for both the three and six months ended June 30, 2007 was $0.1 million, and compares to expense of $0.2 million and $0.4 million, respectively, for the same periods in 2006. Our intangible expense represents the amortization of existing technology acquired as a result of the cXm Broadband acquisition in the second quarter of 2005.
Other Expense (Income)
Interest expense for the three and six months ended June 30, 2007 was $1.7 million and $3.3 million, respectively. Interest expense reflects interest and the amortization of deferred finance fees associated with our $276.0 million 2% convertible subordinated notes. In 2006 interest expense was immaterial due to the fact that we had no outstanding debt.
Gain on Investments
The gain on investments for both the three and six months ended June 30, 2007 was $1.4 million. During the second quarter, we recognized a gain related to the deferred compensation assets of $1.3 million in our operating statement which had previously been recorded as an unrealized gain and included in other comprehensive income. The gain on investments for both the three and six months ended June 30, 2006 was $3 thousand. Loss (Gain) in Foreign Currency
During the three and six months ended June 30, 2007, we recorded foreign currency losses/(gains) of approximately $(0.1) million and $0.2 million, respectively, and compares to gains of $0.8 million and $1.1 million for the same periods in 2006. The gains and losses were primarily driven by the fluctuation of the value of the euro, as compared to the U.S. dollar, as we have several European customers whose receivables and collections are denominated in euros. We have implemented a hedging strategy to mitigate the monetary exchange fluctuations from the time of invoice to the time of payment, and have occasionally entered into forward contracts based on a percentage of expected foreign currency receipts.
Interest income during the three and six months ended June 30, 2007 was $6.5 million and $12.9 million respectively. During the same periods in 2006, interest income was $2.1 million and $3.6 million, respectively. The income reflects interest earned on cash, cash equivalents and short term investments, which increased year over year by approximately $407.1 million, thus resulting in higher interest income.
Gains Related to Terminated Acquisition, Net of Expenses
In the first quarter of 2007, we recorded a net gain of $22.8 million related to the proposed TANDBERG Television acquisition which was terminated in March 2007. The gain consisted of a termination fee of $18.0 million, gains of $12.3 million on foreign exchange contracts we entered into to hedge the payment of the purchase price, offset by expenses incurred of approximately $7.5 million.
In the six months ended June 30, 2007 and 2006, we recorded income tax expense of $26.7 million and $1.2 million, respectively. See Note 11 of the Notes to the Consolidated Financial Statements for additional information about income taxes.
We anticipate that the effective tax rate, excluding any future discrete events, will be approximately 33% for the remainder of 2007.
Proxy Statement for Annual Meeting of Stockholders
In ARRISâ€™ proxy statement filed in April 2007, a number was misprinted in the outstanding equity awards at fiscal year-end for Mr. Lakin. Under the header Market Value of Shares or Units of Stock That Have Vested, the market value corresponding to the 24,172 shares of restricted stock that were granted on April 18, 2005 should have been $302,392 (the original proxy as filed had the market value as $02,392).