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ARRIS GROUP INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) We are a global communications technology company, headquartered in Suwanee, Georgia. We operate in three business segments, Broadband Communications Systems ("BCS"), Access, Transport & Supplies ("ATS"), and Media & Communications Systems ("MCS"). A detailed description of each segment is contained in "Our Principal Products" in our Form 10-K for the year ended December 31, 2012. We specialize in integrated broadband network solutions that include products, systems integration, and professional services. We are a leading developer, manufacturer and supplier of telephony, data, video, construction, rebuild and maintenance equipment for the broadband communications industry. In addition, we are a leading supplier of infrastructure products used by cable system operators to build-out and maintain hybrid fiber-coaxial ("HFC") networks. We provide our customers with products and services that enable reliable, high speed, two-way broadband transmission of video, telephony, and data. On April 17, 2013 we acquired the Motorola Home from Motorola Mobility LLC, a subsidiary of Google, Inc. for $2.4 billion in cash and equity, subject to certain adjustments as provided for in the acquisition agreement. We believe acquiring Motorola Home will enhance our ability to provide next-generation consumer video products and services, supporting a more comprehensive product offering while also accelerating our ability to deliver a comprehensive set of industry-leading new products for broadband to a wide spectrum of customers. The acquisition added expertise in video and a larger presence in the home, to our core strengths in voice and data, ensuring we are even better positioned to capitalize on and manage the evolution toward multi-screen home entertainment. The transaction also increased our patent portfolio and provided a license to a wide array of Motorola Mobility patents. Given the significant increase in the size of our business as a result of the acquisition and the increase in our long-term debt, our historical results are not indicative of our combined operations going forward. In addition, as a result of the acquisition, we expect to reduce our reportable operating segments from three to two, as a result of changes in the way that we expect to manage and review our business going forward. Therefore the presentation of our financial results also will change significantly beginning with our financial results reported for the period ended June 30, 2013. Our Strategy and Key Highlights Our long-term business strategy, "Convergence Enabled," includes the following key elements: • Maintain a strong capital structure, mindful of our debt, share repurchase opportunities and other capital needs including mergers and acquisitions. • Grow our current business into a more complete portfolio including a strong video product suite. • Continue to invest in the evolution toward enabling true network convergence onto an all IP platform. • Continue to expand our product/service portfolio through internal developments, partnerships and acquisitions. • Expand our international business and begin to consider opportunities in markets other than cable. • Continue to invest in and evolve the ARRIS talent pool to implement these strategies. To fulfill our strategy, we develop technology, facilitate its implementation, and enable operators to put their subscribers in control of their entertainment, information, and communication needs. Through a set of business solutions that respond to specific market needs, we are integrating our products, software, and services solutions to work with our customers as they address Internet Protocol telephony deployment, high speed data deployment, high definition television content expansion, on demand video delivery, multi-screen video, operations management, network integration, and business services opportunities. In addition, as noted above, we acquired the Motorola Home business from Google, Inc. Below are some key highlights relative to the three months ended March 31, 2013: Financial Highlights • Sales in the first quarter of 2013 were $353.7 million as compared to $302.9 million in the same period in 2012. The increase is the result of higher sales of our DOCSIS CPE and Video Gateway products as well as products in our ATS segment. Excluding the revenue impacts of Comcast's investment in ARRIS, sales in the first quarter of 2013 were $366.8 million. • Gross margin percentage was 30.7% in the first quarter of 2013, which compares to 36.0% in the first quarter of 2012. The reduced margin percentage was primarily due to the higher volume of CPE 19 -------------------------------------------------------------------------------- Table of Contents product, which generally carries lower gross margin percentage than the corporate average. Excluding the impact of Comcast's investment in ARRIS, gross margin percentage was 33.2% for the first quarter of 2013. • Total operating expenses (excluding restructuring charges, acquisition costs, loss on sale of product line and amortization of intangible assets) in the first quarter of 2013 were $84.2 million, as compared to $83.7 million in the same period last year. • Acquisition costs and restructuring charges during the first quarter of 2013 and 2012 were $7.2 million and $5.8 million, respectively. • We ended the first quarter 2013 with an order backlog of approximately $282.1 million and a book-to-bill ratio of 1.17. This compares to $277.7 million and 1.43 in the first quarter 2012, respectively. • We ended the first quarter of 2013 with $631.3 million of cash, cash equivalents, short-term and long-term marketable security investments. We generated approximately $50.1 million of cash from operating activities in the first quarter of 2013. Product Line Highlights • Broadband Communications Systems o CMTS ¡ Continued strong demand for increased network capacity, shipping a record number of C4 CMTS downstream ports, up 11% from the previous high in first quarter 2012 to over 122 thousand ports in the first quarter of 2013 ¡ Continued deployment of new C4 CMTS systems with 32D and 24U line cards, as well as strong license upgrade sales to existing deployed product ¡ Extensive engagement and trials of next generation Converged Edge Router CMTS product that will enable smooth transition of legacy video networks to IP o CPE ¡ Record level of shipments in first quarter 2013 with approximately 2.9 million CPE units shipped ¡ Mix of DOCSIS 3.0 CPE increased to 92% of the total unit shipments ¡ Maintained number one EMTA market share for 33 consecutive quarters. (source: Infonetics) ¡ Strong demand for DOCSIS 3.0 WiFi Voice and Data Gateway variants o Whole Home IP Video Solution ¡ Increased momentum as current customers increase deployment rate and new operators launch service ¡ Announced new Comcast RDK-based Video Gateway product at 2013 Consumer Electronics Show in Las Vegas ¡ Good progress with integration of third party middleware software providers in close collaboration with lead customers. • Access, Transport & Supplies o Strengthening momentum as operators increase investment in Optics, RF, and WiFi infrastructure • Media & Communications Systems o First quarter of 2013 revenue down sequentially and year over year o Investment focused on software tools to reduce customer operational costs and advanced advertising capabilities 20 -------------------------------------------------------------------------------- Table of Contents Non-GAAP Measures As part of our ongoing review of financial information related to our business, we regularly use non-GAAP measures, in particular non-GAAP earnings per share, as we believe they provide a meaningful insight into our business and trends. We also believe that these non-GAAP measures provide readers of our financial statements with useful information and insight with respect to the results of our business. However, the presentation of non-GAAP information is not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. Below are tables for the three months ended March 31, 2013 and 2012 which detail and reconcile GAAP and non-GAAP earnings per share: (in thousands, except per share data) For the Three Months Ended March 31, 2013 Other Income Operating Operating (Income) Tax Expense Net Income Sales Gross Margin Expense Income Expense (Benefit) (Loss) Amounts in accordance with GAAP $ 353,650 $ 108,526 $ 99,010 9,516 $ 23,466 $ 700 $ (14,650 ) Reduction in revenue related to Comcast's investment in ARRIS 13,182 13,182 - 13,182 - - 13,182 Stock compensation expense - 831 (5,913 ) 6,744 - - 6,744 Amortization of intangible assets - - (7,603 ) 7,603 - - 7,603 Acquisition costs, restructuring, and integration costs - - (7,199 ) 7,199 - - 7,199 Credit facility - ticking fees - - - - (388 ) - 388 Mark-to-market FV adjustment related to Comcast's investment in ARRIS - - - - (19,348 ) - 19,348 Non-cash interest expense - - - (3,244 ) - 3,244 Adjustments of income tax valuation allowances and other discrete tax items - - - - - 7,516 (7,516 ) Tax related to items above - - - - - 5,735 (5,735 ) Non-GAAP amounts $ 366,832 $ 122,539 $ 78,295 $ 44,244 $ 486 $ 13,951 $ 29,807 GAAP net income per share - diluted $ (0.13 ) (1) Non-GAAP net income per share - diluted $ 0.25 Weighted average common shares - basic 115,150 Weighted average common shares - diluted 119,022 (1) Basic shares used as losses were reported for those periods and the inclusion of dilutive shares would be anti-dilutive (in thousands, except per share data) For the Three Months Ended March 31, 2012 Other Income Operating Operating (Income) Tax Expense Net Income Sales Gross Margin Expense Income Expense (Benefit) (Loss) Amounts in accordance with GAAP $ 302,901 $ 108,908 $ 97,217 $ 11,691 $ 3,006 $ 2,886 $ 5,799 Acquisition accounting impacts related to deferred revenue 1,258 1,258 - 1,258 - - 1,258 Stock compensation expense - 750 (5,899 ) 6,649 - - 6,649 Amortization of intangible assets - - (7,379 ) 7,379 - - 7,379 Acquisition costs, restructuring, and integration costs - - (5,810 ) 5,810 - - 5,810 Loss of sale of product line - - (337 ) 337 - - 337 Non-cash interest expense - - - - (2,999 ) - 2,999 Tax related to items above - - - - - 8,121 (8,121 ) Non-GAAP amounts $ 304,159 $ 110,916 $ 77,792 $ 33,124 $ 7 $ 11,007 $ 22,110 GAAP net income per share - diluted $ 0.05 Non-GAAP net income per share - diluted $ 0.19 Weighted average common shares - diluted 117,597 In managing and reviewing our business performance, we exclude a number of items required by GAAP. Management believes that excluding these items is useful in understanding the trends and managing our operations. We provide these supplemental non-GAAP measures in order to assist the investment community to see ARRIS through the "eyes of management," and therefore enhance understanding of ARRIS' operating performance. Non-GAAP financial measures should be viewed in addition to, and not as an alternative to, the Company's reported results prepared in accordance with GAAP. Our non-GAAP financial measures reflect adjustments based on the following items, as well as the related income tax effects: Reduction in Revenue Related to Comcast's Investment in ARRIS: In connection with our acquisition of Motorola Home in April 2013, in January 2013 Comcast agreed to invest in ARRIS. Since the per share purchase price for the investment was less than the market price on the date of agreement was executed, it reflected a price that previously had been negotiated. The accounting guidance requires that we record the implied fair value of benefit received by Comcast as a reduction in revenue. We have excluded the effect of the implied fair value in calculating our non-GAAP financial measures. We believe it is useful to understand the effects of these items on our total revenues and gross margin. Acquisition Accounting Impacts Related to Deferred Revenue: In connection with the accounting related to our acquisitions, business combination rules require us to account for the fair values of deferred revenue arrangements for which acceptance has not been obtained, and post contract support in our purchase accounting. The non-GAAP adjustment to our sales and cost of sales is intended to include the full amounts of such revenues as if these purchase accounting adjustments had not been applied. We believe the adjustment to these revenues is useful as a measure of the ongoing performance of our business. We historically have experienced high renewal rates related to our support agreements, and our objective is to increase the renewal rates on acquired post contract support agreements. However, we cannot be certain that our customers will renew their contracts. 21 -------------------------------------------------------------------------------- Table of Contents Stock-Based Compensation Expense: We have excluded the effect of stock-based compensation expenses in calculating our non-GAAP operating expenses and net income (loss) measures. Although stock-based compensation is a key incentive offered to our employees, we continue to evaluate our business performance excluding stock-based compensation expenses. We record non-cash compensation expense related to grants of options and restricted stock. Depending upon the size, timing and the terms of the grants, the non-cash compensation expense may vary significantly but will recur in future periods. Amortization of Intangible Assets: We have excluded the effect of amortization of intangible assets in calculating our non-GAAP operating expenses and net income (loss) measures. Amortization of intangible assets is non-cash, and is inconsistent in amount and frequency and is significantly affected by the timing and size of our acquisitions. Investors should note that the use of intangible assets contributed to our revenues earned during the periods presented and will contribute to our future period revenues as well. Amortization of intangible assets will recur in future periods. Acquisition Costs: We have excluded the effect of acquisition-related expenses in calculating our non-GAAP operating expenses and net income (loss) measures. We incurred significant expenses in connection with our acquisitions, which we generally would not have otherwise incurred in the periods presented as part of our continuing operations. Acquisition related expenses consist of transaction costs, costs for transitional employees, other acquired employee related costs, and integration related outside services. We believe it is useful to understand the effects of these items on our total operating expenses. Restructuring Costs: We have excluded the effect of restructuring charges in calculating our non-GAAP operating expenses and net income (loss) measures. Restructuring expenses consist of employee severance, abandoned facilities, and other exit costs. We believe it is useful to understand the effects of these items on our total operating expenses. Credit Facility - Ticking Fees: In connection with our acquisition of Motorola Home, the cash portion of the consideration was in part funded through debt financing commitments. A ticking fee is a fee paid to our banks to compensate for the time lag between the commitment to make the loan and the actual funding. We have excluded the effect of the ticking fee in calculating our non-GAAP financial measures. We believe it is useful to understand the effect of these items in our other (income) expense. Mark-To-Market Fair Value Adjustment Related To Comcast Investment in ARRIS: In connection with our acquisition of Motorola Home in April 2013, in January 2013 Comcast agreed to invest in ARRIS. Since the per share purchase price for the investment was less than the market price on the date of agreement was executed, it reflected a price that previously had been negotiated. The accounting guidance requires we mark to market the changes in the value of the investment and flow through other (income) expense. Until the closing of the deal, changes in the value of the investment will be marked to market and flow through other (income) expense. We have excluded the effect of the implied fair value in calculating our non-GAAP financial measures. We believe it is useful to understand the effects of these items on our total other (income) expense. Loss on Sale of Product Line: We have excluded the effect of a loss on the sale of a product line in calculating our non-GAAP operating expenses and net income measures. We believe it is useful to understand the effects of these items on our total operating expenses. Non-Cash Interest on Convertible Debt: We have excluded the effect of non-cash interest in calculating our non-GAAP operating expenses and net income (loss) measures. We record the accretion of the debt discount related to the equity component non-cash interest expense. We believe it is useful to understand the component of interest expense that will not be paid out in cash. Income Tax Expense (Benefit): We have excluded the tax effect of the non-GAAP items mentioned above. Additionally, we have excluded the effects of certain tax adjustments related to state valuation allowances, research and development tax credits and provision to return differences. 22-------------------------------------------------------------------------------- Table of Contents Significant Customers The Company's two largest customers (including their affiliates, as applicable) are Comcast and Time Warner Cable. Over the past year, certain customers' beneficial ownership may have changed as a result of mergers and acquisitions. Therefore the revenue for ARRIS' customers for prior periods has been adjusted to include the affiliates under common control. A summary of sales to these customers for the three months ended March 31, 2013 and 2012 are set forth below (in thousands): Three Months Ended March 31, 2013 2012 Comcast and affiliates $ 59,102 (1) $ 81,802 % of sales 16.7% 27.0% Time Warner Cable and affiliates $ 92,856 $ 47,104 % of sales 26.3% 15.6% (1) Revenue was reduced by $13.2 million related to Comcast's investment in ARRIS (see Note 7 Comcast Investment for additional details). Excluding the adjustment, sales to Comcast were $72.3 million and 19.7% of total sales. Comparison of Operations for the Three Months Ended March 31, 2013 and 2012 Net Sales The table below sets forth our net sales for the three months ended March 31, 2013 and 2012, for each of our segments (in thousands): Net Sales Three Months Ended Increase (Decrease) March 31, 2013 vs. 2012 2013 2012 $ % Business Segment: Broadband Communications Systems $ 288,329 $ 244,515 $ 43,814 17.9 % Access, Transport & Supplies 52,343 44,057 8,286 18.8 % Media & Communications Systems 12,978 14,329 (1,351 ) (9.4 )% Total $ 353,650 $ 302,901 $ 50,749 16.8 % In connection with our acquisition of Motorola Home in April 2013, in January 2013 Comcast agreed to invest in ARRIS. At the time of agreement with Comcast, the ARRIS stock price was $15.35 per share; however, as a result of prior negotiations, Comcast had the ability to invest in ARRIS at the same price as Google, Inc. which was $14.11 per share. The accounting guidance requires that we record the intrinsic value of benefit received by Comcast as a reduction in revenue and gross margin of approximately $13.2 million. The table below sets forth our net sales (as adjusted to exclude the impact of the Comcast transaction) for the three months ended March 31, 2013 and 2012, for each of our segments (in thousands): Net Sales - Adjusted Three Months Ended Increase (Decrease) March 31, 2013 vs. 2012 2013 2012 $ % Business Segment: Broadband Communications Systems $ 299,850 $ 244,515 $ 55,335 22.6 % Access, Transport & Supplies 53,656 44,057 9,599 21.8 % Media & Communications Systems 13,326 14,329 (1,003 ) (7.0 )% Total 366,832 $ 302,901 63,931 21.1 % 23 -------------------------------------------------------------------------------- Table of Contents The table below sets forth our domestic and international sales for the three months ended March 31, 2013 and 2012 (in thousands): Net Sales Three Months Ended Increase (Decrease) March 31, 2013 vs. 2012 2013 2012 $ % Domestic $ 241,383 $ 227,525 $ 13,858 6.1 % International Americas, excluding U.S. 81,725 47,904 33,821 70.6 % Asia Pacific 10,172 10,458 (286 ) (2.7 )% EMEA 20,370 17,014 3,356 19.7 % Total International 112,267 75,376 36,891 48.9 % Total $ 353,650 $ 302,901 $ 50,749 16.8 % Broadband Communication Systems Net Sales 2013 vs. 2012 During the three months ended March 31, 2013, sales in our BCS segment increased by approximately 17.9% as compared to the same period in 2012. We had higher sales of CPE products, in particular wireless EMTAs and cable modems in the quarter. Access, Transport & Supplies Net Sales 2013 vs. 2012 During the three months ended March 31, 2013, sales in our Access, Transport and Supplies segment increased by approximately 18.8% as compared to the same period in 2012. The increase in sales was primarily related to products such as headend optics, fiber nodes, RF gear, and WiFi equipment as cable operators have increased investments in their networks. Media & Communication Systems Net Sales 2013 vs. 2012 During the three months ended March 31, 2013, sales in our Media & Communications Systems segment decreased by approximately 9.4% as compared to the same period in 2012. While the On Demand and Assurance revenue levels vary based on timing of license and service cycles, overall demand has not been robust. Gross Margin The table below sets forth our gross margin for the three months ended March 31, 2013 and 2012, for each of our reporting segments (in thousands): Gross Margin $ Three Months Ended Increase (Decrease) March 31, 2013 vs. 2012 2013 2012 $ % Business Segment: Broadband Communications Systems $ 91,151 $ 89,565 $ 1,586 1.8 % Access, Transport & Supplies 10,827 10,635 192 1.8 % Media & Communications Systems 6,548 8,708 (2,160 ) (24.8 )% Total $ 108,526 $ 108,908 $ (382 ) (0.4 )% The table below sets forth our gross margin percentages for the three months ended March 31, 2013 and 2012, for each of our business segments: Gross Margin % Three Months Ended Percentage Point March 31, Increase (Decrease) 2013 2012 2013 vs. 2012 Business Segment: Broadband Communications Systems 31.6 % 36.6 % (5.0 ) Access, Transport & Supplies 20.7 % 24.1 % (3.4 ) Media & Communications Systems 50.5 % 60.8 % (10.3 ) Total 30.7 % 36.0 % (5.3 ) 24 -------------------------------------------------------------------------------- Table of Contents The table below sets forth our gross margin (as adjusted to exclude the impact of the Comcast transaction) for the three months ended March 31, 2013 and 2012, for each of our reporting segments (in thousands): Gross Margin % - As Adjusted (1) Three Months Ended Percentage Point March 31, Increase (Decrease) 2013 2012 2013 vs. 2012 Business Segment: Broadband Communications Systems 34.2 % 36.9 % (2.7 ) Access, Transport & Supplies 22.6 % 24.1 % (1.5 ) Media & Communications Systems 51.8 % 60.8 % (9.0 ) Total 33.2 % 36.2 % (3.0 ) (1) Adjusted for reduction in revenue and gross margin of $13.2 million related to Comcast's investment in ARRIS in the first quarter of 2013. Broadband Communications Systems Gross Margin 2013 vs. 2012 Broadband Communications Systems segment gross margin percentage decreased during the three months ended March 31, 2013 as compared to the same period in 2012. The decrease in gross margin percentage reflects a product mix change as we had higher CPE sales and lower CMTS revenue (CMTS products have a higher gross margin than CPE products). The gross margin dollars increased slightly in 2013 as compared to 2012 as a result of higher sales. Access, Transport & Supplies Gross Margin 2013 vs. 2012 The Access, Transport & Supplies segment gross margin percentage decreased and gross margin dollars remained relatively flat during the three months ended March 31, 2013 as compared to the same period in 2012. The decrease in gross margin percentage was driven by product mix. Media & Communications Systems Gross Margin 2013 vs. 2012 Media & Communications Systems segment gross margin dollars and percentage decreased during the three months ended March 31, 2013. The decrease in gross margin was primarily a result of lower sales. The decrease in gross margin dollar was a result of product mix, coupled with lower sales. Operating Expenses The table below provides detail regarding our operating expenses (in thousands): Operating Expenses Three Months Ended Increase (Decrease) March 31, 2013 vs. 2012 2013 2012 $ % Selling, general, and administrative $ 40,126 $ 39,544 $ 582 1.5% Research and development 44,082 44,147 (65) (0.1)% Restructuring 9 5,203 (5,194) (99.8)% Acquisition costs 7,190 607 6,583 1084.5% Loss on sale of product line - 337 (337) (100.0)% Amortization of intangible assets 7,603 7,379 224 3.0% Total $ 99,010 $ 97,217 $ 1,793 1.8% Selling, General, and Administrative, or SG&A Expenses SG&A expenses were not significantly different year over year. 25-------------------------------------------------------------------------------- Table of Contents Research & Development, or R&D, Expenses Included in our R&D expenses are costs directly associated with our development efforts (people, facilities, materials, etc.) and reasonable allocations of our information technology and corporate facility costs. R&D expenses for the first three months of 2013 remained flat as compared to the same period in 2012. Restructuring Charges During the three months ended March 31, 2013, we recorded an adjustment of approximately $9 thousand related to facilities. During the first quarter of 2012, ARRIS continued its implementation of the restructuring initiative following the acquisition of BigBand to align our workforce and operating costs with current business opportunities. This resulted in restructuring charges of $5.2 million related to severance, termination benefits and facilities. Acquisition Costs During the first quarter of 2013, we recorded acquisition-related expenses of $7.2 million. These expenses related to the pending acquisition of Motorola Home and consisted of transaction costs and legal fees. Loss on Sale of Product Line In March of 2012, the Company completed the sale of certain assets of its ECCO electronic connector product line to Eclipse Embedded Technologies, Inc. for approximately $3.9 million. The Company recorded a net loss of $(0.3) million on the sale, which included approximately $0.3 million of transaction related costs. The results of the ECCO product line were deemed immaterial to the overall financial results of the Company, and as such the Company has not reported the results in discontinued operations. Amortization of Intangibles Intangibles amortization expense for the three months ended March 31, 2013 and 2012 was $7.6 million and $7.4 million, respectively. Our intangible expense is related to the acquisitions of BigBand Networks in November 2011, Digeo, Inc. in October 2009, EG Technologies in September 2009, Auspice Corporation in August 2008 and C-COR Incorporated in December 2007. Other Expense (Income) Interest Expense Interest expense for the three months ended March 31, 2013 and 2012 was $4.6 million and $4.4 million respectively. Interest expense reflects the amortization of deferred finance fees, the non-cash interest component of our convertible subordinated notes, interest paid on the notes, capital leases and other debt obligations. Interest Income Interest income during the three months ended March 31, 2013 and 2012 was $0.8 million and $0.8 million, respectively. The income reflects interest earned on cash, cash equivalents, short-term and long-term investments. Loss on Foreign Currency During the three months ended March 31, 2013 and 2012, we recorded a foreign currency loss of approximately $0.8 million and $0.8 million, respectively. We have certain international customers who are billed in their local currency, primarily the euro. To mitigate the volatility related to fluctuations in the foreign exchange rates, we may enter into various foreign currency contracts. The loss on foreign currency is driven by the fluctuations in the foreign currency exchanges rates, primarily the euro. 26-------------------------------------------------------------------------------- Table of Contents Gain on Investments From time to time, we hold certain investments in the common stock of private and publicly-traded companies, a number of non-marketable equity securities, and investments in rabbi trusts associated with our deferred compensation plans. During the three months ended March 31, 2013 and 2012, we recorded net gains related to these investments of $0.6 million, and $1.0 million, respectively. Other Expense (Income) Other expense (income) for the three months ended March 31, 2013 and 2012 was $19.4 million and $(0.4) million, respectively. In connection with Comcast's agreement in the January 2013 to invest in ARRIS upon the acquisition of Motorola Home, accounting guidance requires that, since the agreed-upon purchase price was less than the market price of the date of agreement, the resulting forward arrangement be marked to market for the difference in fair value at the end of the quarter. This resulted in a mark-to-market adjustment of $19.3 million and is recorded as Other Expense for the three months ended March 31 2013. Upon closing of the Motorola Home acquisition in the second quarter of 2013, we recorded a mark-to-market gain of approximately $4.8 million, as our stock price decreased from the end of the first quarter to the closing date. Income Tax Expense In the three months ended March 31, 2013 and 2012, we recorded income tax expense of $0.7 million and $2.9 million, respectively. During the first quarter of 2013, the Company recorded a tax benefit of approximately $4.9 million relating to research and development tax credits for 2012. The credit was extended during the first quarter of 2013 to include the 2012 and 2013 tax years. The Company recorded mark-to-market adjustments on the contingent equity forward related to the acquisition of Motorola Home in the amount of approximately $32.5 million of pre-tax book loss. The company also recorded a tax benefit of approximately $2.6 million on Motorola Home acquisition-related expenses recorded during the first quarter of 2013 of approximately $7.2 million. There were no discrete tax events during the first quarter of 2012. Financial Liquidity and Capital Resources Overview One of our key strategies is to maintain and improve our capital structure. The key metrics we focus on are summarized in the table below: Liquidity & Capital Resources Data Three Months Ended March 31, 2013 2012 (in thousands, except DSO and turns) Key Working Capital Items Cash provided by operating activities $ 50,057 $ 35,273 Cash, cash equivalents, and short-term investments $ 608,389 $ 514,347 Long-term U.S. corporate & government agency bonds $ 22,893 $ 52,865 Accounts receivable, net $ 206,236 $ 183,427 Days Sales Outstanding ("DSOs") 51 51 Inventory $ 126,530 $ 105,114 Inventory turns 7.5 7.0 Key Financing Items Convertible notes at face value $ 232,050 $ 232,050 Convertible notes at book value $ 225,368 $ 212,765 Key Shareholder Equity Items Cash used for share repurchases $ - $ 26,315 Capital Expenditures $ 6,289 $ 3,762 27 -------------------------------------------------------------------------------- Table of Contents In managing our liquidity and capital structure, we have been and are focused on key goals, and we have and will continue in the future to implement actions to achieve them. They include: • Liquidity - ensure that we have sufficient cash resources or other short-term liquidity to manage day to day operations • Growth - implement a plan to ensure that we have adequate capital resources, or access thereto, fund internal growth and execute acquisitions while retiring our convertible notes in a timely fashion. • Share repurchases - opportunistically repurchase our common stock. The acquisition of Motorola Home in April 2013 substantially increased our indebtedness, although the values discussed above remain our primary long-term objectives. Below is a description of key actions taken and an explanation as to their potential impact: Accounts Receivable & Inventory We use the number of times per year that inventory turns over (based upon sales for the most recent period, or turns) to evaluate inventory management, and days sales outstanding, or DSOs, to evaluate accounts receivable management. DSOs during the three months of 2013 were 51 days, which was similar to the same period in 2012. Looking forward, it is possible that DSOs may increase dependent upon our customer mix and payment patterns, particularly if international sales increase. Inventory at the end of the first quarter of 2013 was $21.4 million higher than the end of the first quarter of 2012 in support of higher sales. Inventory turns during the first three months of 2013 were 7.5 as compared to 7.0 in the same period of 2012. Common Share Repurchases During the first three months of 2013, ARRIS did not repurchase any shares under the plan. During the first quarter of 2012, we repurchased 2.3 million shares of our common stock for $26.3 million at an average stock price of $11.32. Summary of Current Liquidity Position and Potential for Future Capital Raising We believe our current liquidity position, where we have approximately $608.4 million of cash, cash equivalents, and short-term investments and $22.9 million of long-term marketable securities on hand as of March 31, 2013, together with the prospects for continued generation of cash from operations are adequate for our short- and medium-term business needs. We expect to be able to generate sufficient cash on a consolidated basis to make all of the principal and interest payments under the anticipated credit agreements, indentures and other instruments governing our indebtedness. We may in the future elect to repurchase additional shares of our common stock or additional principal amounts of our outstanding convertible notes. However, a key part of our overall long-term strategy may be implemented through additional acquisitions, and a portion of these funds may be used for that purpose. Should our available funds be insufficient for those purposes, it is possible that we will raise capital through private or public, share or debt offerings. Commitments Our contractual obligations are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2012. There has been no material change to our contractual obligations during the first three months of 2013. However, in April of 2013, we entered into senior secured credit facilities with Bank of America, N.A. and various other institutions, which are comprised of (i) a "Term Loan A Facility" of $1.1 billion, (ii) a "Term Loan B Facility" of $825 million and (iii) a "Revolving Credit Facility" of $250 million. Funding was completed under the senior secured credit facilities effective April 17, 2013, in connection with the closing of the acquisition of Motorola Home. 28-------------------------------------------------------------------------------- Table of Contents Borrowings under the senior secured credit facilities are secured by first priority liens on substantially all of the assets of ARRIS and certain of its present and future subsidiaries who are or become parties to, or guarantors under, the credit agreement governing the senior secured credit facilities (the "Credit Agreement"). The Credit Agreement contains usual and customary limitations on indebtedness, liens, restricted payments, acquisitions and asset sales in the form of affirmative, negative and financial covenants, which are customary for financings of this type. The Credit Agreement provides terms for mandatory prepayments and optional prepayments and commitment reductions. The Credit Agreement also includes events of default, which are customary for facilities of this type (with customary grace periods, as applicable), including provisions under which, upon the occurrence of an event of default, all amounts outstanding under the credit facilities may be accelerated. The Revolving Credit Facility and Term Loan A Facility have terms of five years. The Term Loan B Facility has a term of seven years. Under the Credit Agreement, ARRIS will be required to maintain a minimum consolidated interest coverage ratio of not less than 3.50:1.00. ARRIS will also be restricted by a maximum consolidated net leverage ratio that decreases throughout the first two years of the term of the Credit Agreement from 4.25:1.00 to 3.50:1.00. We believe that we have the ability to be in compliance with these debt covenants. Off-Balance Sheet Arrangements We do not have any material off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. Cash Flow Below is a table setting forth the key line items of our Consolidated Statements of Cash Flows (in thousands): For the Three Months Ended March 31, 2013 2012 Cash provided by operating activities $ 50,057 $ 35,273 Cash provided by (used in) investing activities 238,475 (26,371 ) Cash provided by (used in) financing activities 3,316 (28,969 ) Net increase (decrease) in cash $ 291,848 $ (20,067 ) Operating Activities: Below are the key line items affecting cash provided by operating activities (in thousands): For the Three Months Ended March 31, 2013 2012 Net income (loss) $ (14,650 ) $ 5,799 Adjustments to reconcile net income to cash provided by operating activities 45,568 17,526 Net income including adjustments 30,918 23,325 Increase in accounts receivable (17,655 ) (31,799 ) Decrease in inventory 7,318 7,243 Increase in accounts payable and accrued liabilities 28,014 22,398 All other - net 1,462 14,106 Cash provided by operating activities $ 50,057 $ 35,273 Net income including adjustments, as per the table above, increased $7.6 million during the first three months of 2013 as compared to 2012 reflecting higher sales as discussed above. 29 -------------------------------------------------------------------------------- Table of Contents Accounts receivable increased by $17.7 million during the first three months of 2013. This increase was primarily as a result of higher sales in the first quarter of 2013 as compared to first quarter of 2012 and payment patterns of our customers. Inventory decreased by $7.3 million during the first three months of 2013. Accounts payable and accrued liabilities increased by $28.0 million. During the first quarter of 2013, we recorded a liability of $32.5 million related to the implied benefit that Comcast received in its investment in ARRIS and the associated mark-to-market adjustments. This liability will be eliminated when we record the acquisition accounting upon the closing of the Motorola Home transaction in the second quarter of 2013. All other accounts, net, includes the changes in other receivables, income taxes payable (recoverable), and prepaids. The other receivables represent amounts due from our contract manufacturers for material used in the assembly of our finished goods. The change in our income taxes recoverable account is a result of the timing of the actual estimated tax payments during the year as compared to the actual tax liability for the year. The net change during the first three months of 2013 was approximately $1.5 million. Investing Activities: Below are the key line items affecting investing activities (in thousands): For the Three Months Ended March 31, 2013 2012 Purchases of property, plant and equipment $ (6,289 ) $ (3,762 ) Sale of property, plant and equipment 53 - Purchases of investments - (77,766 ) Sales of investments 244,711 51,908 Sale of product line - 3,249 Cash provided by (used in) investing activities $ 238,475 $ (26,371 ) Purchases of Property, Plant and Equipment - This represents capital expenditures which are mainly for test equipment, laboratory equipment, and computing equipment. It also represents expenditures related to the pending acquisition. Cash Proceeds from Sale of Property, Plant and Equipment - This represents the cash proceeds we received from the sale of property, plant and equipment. Purchases and Sales of Investments - These represent purchases and sales of securities. Cash Proceeds from Sale of Product Line - This represents the cash proceeds we received from the sale of our ECCO product line. Financing Activities: Below are the key line items affecting our financing activities (in thousands): For the Three Months Ended March 31, 2013 2012 Repurchase of common stock $ - $ (26,315 ) Excess income tax benefits from stock-based compensation plans 4,659 1,654 Repurchase of shares to satisfy employee tax withholdings (11,992 ) (8,033 ) Proceeds from issuance of common stock 10,649 3,725 Cash provided by (used in) financing activities $ 3,316 $ (28,969 ) Repurchase of Common Stock - This represents the cash used to buy back the Company's common stock. 30 -------------------------------------------------------------------------------- Table of Contents Excess Income Tax Benefits from Stock-Based Compensation Plans - This represents the cash that otherwise would have been paid for income taxes if increases in the value of equity instruments also had not been deductible in determining taxable income. Repurchase of Shares to Satisfy Tax Withholdings - This represents the minimum shares withheld to satisfy the tax withholding when restricted stock vests. Proceeds from Issuance of Common Stock - This represents cash proceeds related to the exercise of employee stock options, offset by expenses paid related to issuance of common stock. Interest Rates As of March 31, 2013, we did not have any floating rate indebtedness or outstanding interest rate swap agreements. Foreign Currency A significant portion of our products are manufactured or assembled in China and Mexico, and we have research and development centers in China, Ireland and Israel. Our sales into international markets have been and are expected in the future to be an important part of our business. These foreign operations are subject to the usual risks inherent in conducting business abroad, including risks with respect to currency exchange rates, economic and political destabilization, restrictive actions and taxation by foreign governments, nationalization, the laws and policies of the United States affecting trade, foreign investment and loans, and foreign tax laws. We have certain international customers who are billed in their local currency. In addition, we have certain predictable expenditures for international operations in local currency. We use a hedging strategy and enter into forward or currency option contracts based on a percentage of expected foreign currency revenues and expenses. The percentage can vary, based on the predictability of the revenues denominated in the foreign currency. Financial Instruments In the ordinary course of business, we, from time to time, will enter into financing arrangements with customers. These financial arrangements include letters of credit, commitments to extend credit and guarantees of debt. These agreements could include the granting of extended payment terms that result in longer collection periods for accounts receivable and slower cash inflows from operations and/or could result in the deferral of revenue. ARRIS executes letters of credit in favor of certain landlords and vendors to guarantee performance on lease and insurance contracts. Additionally, we have cash collateral account agreements with our financial institutions as security against potential losses with respect to our foreign currency hedging activities. The letters of credit and cash collateral accounts are reported as restricted cash. As of both March 31, 2013 and December 31, 2012, we had approximately $4.7 million outstanding, of cash collateral. Cash, Cash Equivalents, and Short-Term Investments Our cash and cash equivalents (which are highly-liquid investments with an original maturity of three months or less) are primarily held in money market funds that pay either taxable or non-taxable interest. We hold short-term investments consisting of debt securities classified as available-for-sale, which are stated at estimated fair value. These debt securities consist primarily of commercial paper, certificates of deposits, and U.S. government agency financial instruments. ARRIS holds cost method investments in private companies. Due to the fact the investments are in private companies, we are exempt from estimating the fair value on an interim basis. It is not practical to estimate the fair value since the quoted market price is not available. Furthermore, the cost of obtaining an independent valuation appears excessive considering the materiality of the investments to the Company. However, ARRIS is required to estimate the fair value if there has been an identifiable event or change in circumstance that may have a significant adverse effect on the fair value of the investment. Each quarter, we evaluate our investment for any other-than-temporary impairment, by reviewing the current revenues, bookings and long-term plan of the private companies. No indicators of impairment existed during the Company's evaluations during the first quarter of 2013 and 2012. These investments are recorded at $6.0 million as of both March 31, 2013 and December 31, 2012. See Note 4 of Notes to the Consolidated Financial Statements for disclosures related to the fair value of our investments. 31-------------------------------------------------------------------------------- Table of Contents We have a deferred compensation plan that was available to certain current and former officers and key executives of C-COR. During 2008, this plan was merged into a new non-qualified deferred compensation plan which is also available to our key executives. Employee compensation deferrals and matching contributions are held in a rabbi trust, which is a funding vehicle used to protect the deferred compensation from various events (but not from bankruptcy or insolvency). Additionally, we previously offered a deferred compensation arrangement to certain senior employees. As of December 31, 2004, the plan was frozen and no further contributions are allowed. The deferred earnings are invested in a rabbi trust. We also have deferred retirement salary plans, which were limited to certain current or former officers of C-COR. We hold investments to cover the liability. ARRIS also funds its nonqualified defined benefit plan for certain executives in a rabbi trust. Capital Expenditures Capital expenditures are made at a level designed to support the strategic and operating needs of the business. ARRIS' capital expenditures were $6.3 million in the first three months of 2013 as compared to $3.8 million in the first three months of 2012. Management expects to invest approximately $70 million in capital expenditures for the fiscal year 2013, which includes the incremental purchases as a result of the recent acquisition of Motorola Home. Critical Accounting Policies and Estimates The accounting and financial reporting policies of ARRIS are in conformity with U.S. generally accepted accounting principles, which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Management has discussed the development and selection of the Company's critical accounting estimates with the audit committee of the Company's Board of Directors and the audit committee has reviewed the Company's related disclosures. Our critical accounting policies and estimates are disclosed in our Form 10-K for the year ended December 31, 2012, as filed with the SEC. Our critical accounting estimates have not changed in any material respect during the three months ended March 31, 2013. Forward-Looking Statements Certain information and statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this report, including statements using terms such as "may," "expect," "anticipate," "intend," "estimate," "believe," "plan," "continue," "could be," or similar variations or the negative thereof, constitute forward-looking statements with respect to the financial condition, results of operations, and business of ARRIS, including statements that are based on current expectations, estimates, forecasts, and projections about the markets in which we operate and management's beliefs and assumptions regarding these markets. These and any other statements in this document that are not statements about historical facts are "forward-looking statements." We caution investors that forward-looking statements made by us are not guarantees of future performance and that a variety of factors could cause our actual results to differ materially from the anticipated results or other expectations expressed in our forward-looking statements. Important factors that could cause results or events to differ from current expectations are described in the risk factors set forth in Item 1A, Part II, "Risk Factors." These factors are not intended to be an all-encompassing list of risks and uncertainties that may affect the operations, performance, development and results of our business. In providing forward-looking statements, ARRIS expressly disclaims any obligation to update publicly or otherwise these statements, whether as a result of new information, future events or otherwise except to the extent required by law. 32-------------------------------------------------------------------------------- Table of Contents |