Arris Dips on Downgrade

Arris Group Inc. (Nasdaq: ARRS) shares dropped more than 9 percent Tuesday morning amid concerns that the vendor's product margins will come under big pressure as MSOs, particularly Comcast Corp. (Nasdaq: CMCSA, CMCSK), wrap up their initial deployments of Docsis 3.0.

"We believe investors currently under-appreciate the degree to which Docsis 3.0 software upgrades have boosted Arris's recent gross margin performance," noted Jefferies & Company Inc. analyst George Notter, who downgraded Arris shares from Hold to Underperform. Arris posted a gross margin of 42 percent in the second quarter, up 4 percent versus the previous period.

Arris, a key supplier of Docsis modems and cable modem termination system (CMTS) gear, has benefited greatly from MSO wideband upgrades in recent quarters. In fact, a strong showing in the second quarter allowed Arris to snare the CMTS revenue lead from perennial leader Cisco Systems Inc. (Nasdaq: CSCO) for the first time ever. (See Arris Snares CMTS Crown From Cisco and Arris Pumps Up the Docsis 3.0 Volume .)

Notter says Arris has been aided by the "simplicity" of the Docsis 3.0 upgrade path for its flagship CMTS, the C4, which requires a new linecard with 16 downstreams and a software upgrade costing on the order of $50,000. "Relative to other vendors' CMTS solutions, the upgrade path is attractive, as roughly 80 percent of an operator's original Docsis 3.0 investment is reused," he asserted in a research note issued today.

But Notter doesn't think Arris will be able to play out this advantage forever because Docsis 3.0 upgrades will eventually taper off. Comcast, Arris's largest customer, expects to have 80 percent of its plant plumbed for Docsis 3.0 by year's end, and to complete the job by the end of 2010. Notter estimates that as much as 30 percent of Arris's quarterly operating profits are coming via software upgrades at Comcast. (See Comcast Speeds Up '09 Wideband Goal .)

He's therefore concerned that there's not enough new Docsis 3.0 business out there to help Arris fill the gap and sustain its wideband software upgrade intensity. Although Time Warner Cable Inc. (NYSE: TWC) is starting to deploy Docsis 3.0, it's not as large as Comcast and isn't expected to replace its Cisco CMTS base. The analyst also doesn't expect Arris to score significant growth in international markets where Cisco and Motorola Inc. (NYSE: MOT), another CMTS rival, "are relatively stronger." (See TWC Fights FiOS in NYC.)

Despite Notter's concerns, Arris indicated confidence on its second-quarter earnings call that the vendor can indeed keep margins "in the range of 40 percent" in the third quarter of 2009 and beyond, thanks to a mix of new customer wins and an expanding product portfolio.

Among recent activity, Arris is looking to diversify its customer and product mix through the acquisitions of video encoding specialist EGT Inc. and set-top box and software developer Digeo Inc. And Arris has indicated that it's still seeking out more acquisitions that would help it further expand its sales and product base. (See Digeo Gives Arris Multimedia Gateway Potential , Arris Digs Digeo , and Arris Gets EGT for a Song .)

Although Arris may be able to keep margins at or near their present levels out into the distant future as these strategies bear fruit, Notter's still not convinced it can do so in the nearer term. "In total, we expect that the roll-off of Arris's Docsis 3.0 software upgrade activity will start to impact the company's financial performance going forward," he said.

Arris shares were down $1.17 (9.23%) to $11.50 each in morning trading Tuesday.

— Jeff Baumgartner, Site Editor, Cable Digital News

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