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Earnings reports

Terayon Reveals New Warts

Cleaning up its balance sheet in preparation for its expected sale, Terayon Communication Systems Inc. has quietly issued its restated earnings results for the past four years and plans to give investors a long-awaited "business and strategic update" this evening.

But the new financial disclosures will likely make Terayon a less appealing company to buy, and some believe this could prompt would-be suitors to drop out of the bidding. Until now, the company has been considered the subject of a feverish bidding war among Cisco Systems Inc. (Nasdaq: CSCO), Harmonic Inc. (Nasdaq: HLIT), Motorola Inc. (NYSE: MOT), and possibly Arris Group Inc. (Nasdaq: ARRS). (See Motorola, Cisco Bidding for Terayon .)

Terayon released revised financial statements for 2003, 2004, and 2005 during the recent holiday break. The cable equipment vendor then followed up earlier this week with restated numbers for the first three quarters of 2006.

Notably, the two sets of filings indicate that Terayon produced less revenue than industry analysts had been figuring for 2005 and 2006. In particular, the company fell short of expectations in its core digital video business, which is the main attraction for its several would-be suitors.

Terayon reported revenues of $90.7 million for all of 2005, well below analyst estimates of $110 million or more. Its digital video products generated $41.8 million in 2005, down from estimates of at least $64 million.

Likewise, Terayon's performance during the first three quarters of 2006 proved disappointing. The company reported revenues of $58.7 million for the nine months ended Sept. 30, down from $60.2 million in the year-ago period and well below analyst estimates. Its digital video products generated $42.3 million in sales, again missing estimates.

In a research report sent out earlier today, Jefferies & Co. Inc. analyst George Notter noted that Terayon's digital video invoices also came in lower than anticipated for the first three quarters. Partly for these reasons, he cut his rating on the company's stock from a Buy to a Hold and lowered his long-term price target to $2.20 per share from $3.35.

"Coming into these quarterly reports, we didn't expect the company's digital video results to be stellar," Notter writes. "That said, the business – for the first three quarters of 2006 – was softer than we had expected."

The filings also reveal that Terayon, which has been wrapping up settlement of a long-lingering class action lawsuit by shareholders, is fighting a number of new lawsuits from shareholders, former executives, and other tech vendors. Plus, the company disclosed that it's still under investigation by the Securities and Exchange Commission (SEC) because of accounting questions about a series of contracts with Thomson S.A. (NYSE: TMS; Euronext Paris: 18453).

As a result of these factors, industry observers say Terayon may not be as appealing a takeover target as it previously seemed. They're especially concerned about the impact of the new lawsuits and the year-old SEC probe.

"At a minimum, we're guessing that Terayon's significant litigation expenditures will continue in the future," Notter writes. "Moreover, they'll create additional management distractions. More negatively, these lawsuits could make it more difficult for any potential acquirer to step in."

On the bright side for Terayon, its latest financial statements also reveal that the company has more cash on hand than analysts thought. As Notter points out, the company closed September with at least $28 million in net cash, several million higher than expected.

But Terayon also continues to burn through its cash. In the first nine months of 2006, the vendor's operations suffered a net cash outflow of $7.6 million.

Terayon may remain attractive to potential buyers because of its sizable net operating losses, which could be carried forward by an acquirer to offset future profits and thus cut corporate tax bills. The company says it has racked up $368 million in net operating losses since inception.

Terayon might also retain its appeal because of the overall prospects for digital video and the continued popularity of its CherryPicker line of products. Even with its lower recent sales numbers and his reduced expectations, Notter reckons the company will still produce $56 million in digital video revenue this year and $71 million next year.

— Alan Breznick, Site Editor, Cable Digital News

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