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Arris Downgraded on Cable Modem Tariff Worries

Jeff Baumgartner
10/15/2018

Raymond James has downgraded Arris shares from "Strong Buy" to "Outperform" on concerns that the cable modem supplier will have to "absorb at least a portion" of new US tariffs on Chinese goods that are at 10% now, and set to rise to 25% in January.

"Our checks indicate that operators intend to hold Arris to price agreements negotiated prior to the tariff introduction," Simon Leopold, analyst with Raymond James Financial Inc. (NYSE: RJF), said in a research note issued Monday.

Although he still sees upside on Arris Group Inc. (Nasdaq: ARRS) shares and considers Arris "a great value stock," Raymond James nonetheless lowered its target on the stock to $29 (from $36) on anticipated lower income tied to the tariffs. Arris shares were down $1.08 (4.69%) to $22.05 each in Monday morning trading.

Leopold noted that the Trump adminstration's new tariffs apply to broadband modems, which contribute about 25% of sales to Arris, but not to set-tops, which contribute about 35% of sales at the vendor.

While the good news is that about 40% of Arris sales coming way of international customers aren't subject to the new tariffs, the bad news is that Raymond James's Washington Policy analyst believes that US-China trade tensions will be long-lasting.

Technicolor (Euronext Paris: TCH; NYSE: TCH), which has production facilities in China and Southeast Asia, "will face a similar situation," Leopold said.

In a 10-Q filed in August, Arris acknowledged that the proposed tariffs would apply to certain products, but downplayed the impact, as it expects to "pass those tariffs along to customers, which could alter customer spending and prices." And while some products and components that Arris imports are on that list, "we do not expect these tariffs to have a material impact on us," the company added.

"We're operating under the assumption that the tens of millions of devices that deliver high-speed internet into consumers' homes will be impacted by these tariffs," Jim Brennan, Arris's senior vice president of supply chain, quality and operations, told Reuters last month. "It feels anti-consumer because our devices are what enables the core of consumer tech."

Consumer Technology Association CEO Gary Shapiro echoed that sentiment in September, while calling on the Trump administration to reconsider the move. Those "retaliatory tariffs are not an effective trade policy and may violate US law," he said.

Arris has been asked for further comment on how the tariffs will affect its cable modem business.

Update: On Tuesday (October 16), an Arris official said the company is moving ahead with efforts aimed at mitigating the financial impact of the tariffs, including agreements with customers that would absorb most of the current tariffs costs. Arris also plans to shift more device-related production and supply chain outside of China in the first half of 2019. Light Reading will post a separate story with more details about this new development soon.


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Leopold, meanwhile, presented a bull case in which Arris is successful in passing along tariff expenses to customers, and a bear case in which it can't.

Leopold's latest revisions reflect a $30 million gross profit reduction in Q4 2019, and a $200 million reduction in 2019. For 2019, he's modeling sales of $6.76 billion with earnings of $2.42 per share, down from $6.7 billion and $3.04.

Based on sheer market share, Arris and Technicolor stand to be hardest hit by the tariffs. Arris has about 52% of that market, compared to about 23.3% for Technicolor, with Hitron Technologies Inc. and Ubee Interactive each hovering at about 10%, according to Jeff Heynen, technology research director at S&P Global Market Intelligence.

"It's going to disrupt the supply chain, there's no question about it," Heynen said of the tariffs issue faced by cable modem suppliers.

The potentially detrimental effects of the tariffs could administer another dose of distress to Arris's consumer premises equipment (CPE) business, which is still dealing with component shortages affecting its family of cable modems, gateways and set-top boxes. Arris has been trying to remedy that components shortage -- primarily for memory and multilayer ceramic capacitors (MLCCs) -- in part by focusing on the most profitable deals and not just top-line sales. (See Arris Financials Clipped by Component Shortages.)

"Although it will take time, we expect Arris to adjust its supply chain to reduce the effect of tariffs," Leopold added. However, the analyst isn't counting on relief from component supplies, despite improvements in the market for MLCCs and the apparent stabilization of memory pricing.

Even if the effects of the tariffs are long-lasting, there will be no change in demand, Heynen said. He noted that Q3 usually sees purchases ramp up, so the coming financial results from Arris and other suppliers for the period "will be really telling."

"There's going to pent-up demand for operators for those devices and the infrastructure to support it," he said.

— Jeff Baumgartner, Senior Editor, Light Reading

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