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Cable/Video

Ups & Downs at Arris

Buoyed by solid third-quarter earnings report, shares of Arris Group Inc. (Nasdaq: ARRS) climbed to a recent high of $13.72 on Halloween. November is not treating the cable vendor nearly as nicely, though. The company's shares have fallen 16.2 percent this month, clearly more trick than treat.

Most of that decline occurred yesterday, with Arris shares dropping $1.21 on news that the company plans to offer $225 million worth of convertible senior notes due 2026. While Wall Street was clearly not thrilled about the possibility of new debt or dilution, the reason for the offering is interesting. According to the Arris press release, the company "expects to use the net proceeds from the offering of the notes for general corporate purposes, including the funding of future acquisitions."

It's no secret that Arris is eyeing options for expansion into the video space. Soon, the company may have the cash on hand to make a serious move. Strategically, that could be a good news story for investors. (See Arris: Time to Add Video?) On the downside, hopes that Arris is setting itself up as acquisition bait for the likes of Alcatel (NYSE: ALA; Paris: CGEP:PA) may be dimming. This fall, Arris has sat on the sidelines watching its larger rivals, Motorola Inc. (NYSE: MOT) and Cisco Systems Inc. (Nasdaq: CSCO), beef up their product portfolios through a series of acquisitions. Motorola snapped up VOD server vendor BroadBus and edge-resource manager (ERM) software startup Vertasent, while Cisco snagged VOD player Arroyo. Compared to these giants, Arris increasingly looks like a one-trick pony with its IP-centric product portfolio. (See Who Makes What: Cable TV Equipment.)

Of course, that pony continues to gallop along nicely. Arris posted $657 million in sales for the first nine months of 2006, up 31 percent over the same period last year. And in the third quarter, Arris generated a healthy gross margin of 27.6 percent, although that number is down from 29 percent in the previous quarter.

Arris noted it increased sales of its Docsis cable modem termination system (CMTS) products to Comcast Corp. (Nasdaq: CMCSA, CMCSK), its largest customer. Additionally, the company finally cracked Time Warner Cable Inc. (NYSE: TWC) as a CMTS customer. For the last several quarters, Arris has been top dog in the EMTA (embedded multimedia terminal adapter) category, outpacing Motorola and Cisco/S-A in sales of integrated Docsis cable modem and PacketCable phone adapter devices. However, in its third-quarter 10-Q Arris warned investors that "the rate of future growth for EMTA sales is expected to be lower than what we have experienced to date as many of our customers have now passed through the initial launch stage." Additionally, its longstanding constant bit rate (CBR) switched telephony income stream is dwindling as MSOs move to VOIP. "We expect sales of CBR products will continue to decline in the fourth quarter of 2006 and during 2007 as customers complete their last time purchases of CBR products and the business migrates to a sustaining service business." With CBR growth dead and EMTA upside diminishing, tuning into video acquisition currency is a logical move for Arris. Acquisitions are likely to be in the future.

- Michael Harris, Chief Analyst, Cable Digital News

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