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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------------
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
of
ARRIS GROUP, INC.
A Delaware Corporation
IRS Employer Identification No. 58-2588724
SEC File Number 001-16631
11450 TECHNOLOGY CIRCLE
DULUTH, GA 30097
(678) 473-2000
ARRIS Group, Inc. (1) has filed all reports required to be filed by Section 13
or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months,
and (2) has been subject to such filing requirements for the past 90 days.
ARRIS Group, Inc. is an accelerated filer (as defined in Rule 21b-2 of the
Exchange Act).
As of October 31, 2003, 75,194,277 shares of the registrant's Common Stock,
$0.01 par value, were outstanding.
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ARRIS GROUP, INC.
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2003
INDEX
Page
Part I. Financial Information
Item 1. Financial Statements
a) Consolidated Balance Sheets as of
September 30, 2003 and December 31, 2002 1
b) Consolidated Statements of Operations for the
Three and Nine Months Ended September 30, 2003 and 2002 2
c) Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 2003 and 2002 3
d) Notes to the Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 18
Item 3. Quantitative and Qualitative Disclosures on Market Risk 34
Item 4. Controls and Procedures 35
Part II. Other Information
Item 6. Exhibits and Reports on Form 8-K 36
Signatures 37
i
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ARRIS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30, DECEMBER 31,
2003 2002
---- ----
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents............................................ $ 59,981 $ 98,409
Accounts receivable (net of allowances for doubtful accounts of
$18,083 in 2003 and $10,698 in 2002)............................... 61,345 78,743
Accounts receivable from Nortel Networks............................. 282 2,212
Other receivables.................................................... 1,410 3,154
Inventories.......................................................... 95,009 104,203
Investments held for resale.......................................... - 137
Other current assets................................................. 13,520 14,834
----------- -----------
Total current assets.......................................... 231,547 301,692
Property, plant and equipment (net of accumulated depreciation of
$48,135 in 2003 and $44,810 in 2002)............................... 27,177 34,540
Goodwill .............................................................. 150,569 151,265
Intangibles (net of accumulated amortization of $67,790 in 2003 and
$41,506 in 2002)................................................... 41,144 64,843
Investments............................................................ 2,361 4,594
Other assets........................................................... 8,894 6,478
----------- -----------
$ 461,692 $ 563,412
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable..................................................... $ 25,752 $ 24,253
Accrued compensation, benefits and related taxes..................... 16,947 23,423
Accounts payable and accrued expenses - Nortel Networks.............. 140 11,303
Current portion of long-term debt.................................... 1,060 23,887
Current portion of capital lease obligations......................... 22 1,120
Other accrued liabilities............................................ 36,335 44,360
----------- -----------
Total current liabilities..................................... 80,256 128,346
Capital lease obligations, net of current portion...................... - 158
Long-term debt......................................................... 125,365 -
----------- -----------
Total liabilities............................................. 205,621 128,504
Membership interest - Nortel Networks.................................. - 114,518
----------- -----------
Total liabilities & membership interest....................... 205,621 243,022
Stockholders' equity:
Preferred stock, par value $1.00 per share, 5.0 million shares
authorized; none issued and outstanding............................ - -
Common stock, par value $0.01 per share, 320.0 million shares
authorized; 75.2 million and 82.5 million shares issued and
outstanding in 2003 and 2002, respectively......................... 774 831
Capital in excess of par value....................................... 586,107 603,563
Accumulated deficit.................................................. (320,245) (281,329)
Unrealized holding gain on marketable securities..................... 132 227
Unearned compensation................................................ (9,362) (1,649)
Unfunded pension losses.............................................. (1,219) (1,219)
Cumulative translation adjustments................................... (116) (34)
----------- -----------
Total stockholders' equity.................................... 256,071 320,390
----------- -----------
$ 461,692 $ 563,412
=========== ===========
See accompanying notes to the consolidated financial statements.
ARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
2003 2002 2003 2002
---- ---- ---- ----
Net sales (includes sales to Nortel of $0 and
$1,045 for the three months and $216 and
$2,882 for the nine months ended September
30, 2003 and 2002, respectively) $ 113,111 $ 180,577 $ 306,164 $ 529,476
Cost of sales 81,269 115,360 222,393 345,549
--------- --------- --------- ---------
Gross profit 31,842 65,217 83,771 183,927
Operating expenses:
Selling, general and administrative and
development 35,058 46,106 115,979 161,551
Restructuring and impairment charges - - 336 -
Amortization of intangibles 8,812 8,708 26,284 25,786
--------- --------- --------- ---------
43,870 54,814 142,599 187,337
--------- --------- --------- ---------
Operating income (loss) (12,028) 10,403 (58,828) (3,410)
Interest expense 2,881 2,123 7,535 6,523
Membership interest - 2,659 2,418 7,659
Loss (gain) on debt retirement - - (28,506) 9,276
Loss (gain) on investments (19) 901 995 2,471
Loss (gain) in foreign currency (234) (307) (2,202) (4,169)
Other expense (income), net (63) 134 (152) 326
--------- --------- --------- ---------
Income (loss) from continuing operations
before income taxes (14,593) 4,893 (38,916) (25,496)
Income tax expense (benefit) - - - (6,800)
--------- --------- --------- ---------
Net income (loss) from continuing operations (14,593) 4,893 (38,916) (18,696)
Income (loss) from discontinued operations - (1,406) - (20,465)
--------- --------- --------- ---------
Net income (loss) before cumulative effect of
an accounting change (14,593) 3,487 (38,916) (39,161)
Cumulative effect of accounting change - - - 57,960
--------- --------- --------- ---------
Net income (loss) $ (14,593) $ 3,487 $ (38,916) $ (97,121)
========= ========= ========= =========
Net income (loss) per common share -
Basic and diluted:
Income (loss) from continuing operations $ (0.19) $ 0.06 $ (0.50) $ (0.23)
Income (loss) from discontinued operations - (0.02) - (0.25)
Cumulative effect of an accounting change - - - (0.71)
--------- --------- --------- ---------
Net income (loss) $ (0.19) $ 0.04 $ (0.50) $ (1.19)
========= ========= ========= =========
Weighted average common shares:
Basic 75,039 82,506 77,339 81,675
========= ========= ========= =========
Diluted 75,039 83,110 77,339 81,675
========= ========= ========= =========
See accompanying notes to the consolidated financial statements.
2
ARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------------
2003 2002
---------- ----------
Operating activities:
Net income (loss) $ (38,916) $ (97,121)
Adjustments to reconcile net income (loss) to net cash provided
by (used in) operating activities:
Depreciation ................................................... 13,217 15,659
Amortization of intangibles .................................... 26,284 25,786
Amortization of deferred financing fees ........................ 3,371 1,966
Amortization of unearned compensation .......................... 2,254 1,304
Provision for doubtful accounts ................................ 7,860 27,066
Loss on disposal of fixed assets ............................... 11 317
Loss on investments ............................................ 995 2,471
Cash proceeds from sale of trading securities .................. 226 60
Loss (gain) on debt retirement ................................. (28,506) 9,276
Loss on sale of ESP product line ............................... 1,373 -
Loss (gain) on sale of discontinued product line ............... (2,000) 8,536
Cumulative effect of an accounting change - goodwill ........... - 57,960
Changes in operating assets and liabilities, net of effect of
acquisitions and dispositions:
Accounts receivable .......................................... 10,278 (25,293)
Other receivables ............................................ 1,744 6,283
Inventory .................................................... 9,763 41,100
Accounts payable and accrued liabilities ..................... (21,850) (15,299)
Income taxes recoverable ..................................... - 5,066
Accrued membership interest .................................. 2,418 7,659
Other, net ................................................... (589) (6,697)
---------- ----------
Net cash provided by (used in) operating activities .................. (12,067) 66,099
Investing activities:
Purchases of property, plant and equipment ..................... (4,213) (6,532)
Cash proceeds from sale of Keptel product line ................. - 30,000
Cash proceeds from sale of Actives product line ................ 1,800 -
Cash paid for acquisitions ..................................... (2,842) (874)
Cash paid for disposal of ESP product line ..................... (231) -
Other .......................................................... 26 -
---------- ----------
Net cash provided by (used in) investing activities .................. (5,460) 22,594
Financing activities:
Proceeds from issuance of debt ................................. 126,597 -
Redemption of membership interest .............................. (88,430) -
Repurchase and retirement of common stock ...................... (28,000) -
Payments on capital lease obligations .......................... (2,122) (650)
Payments on debt obligations ................................... (24,325) -
Deferred financing costs paid .................................. (5,797) (350)
Proceeds from issuance of stock ................................ 1,176 1,007
---------- ----------
Net cash provided by (used in) financing activities .................. (20,901) 7
---------- ----------
Net increase (decrease) in cash and cash equivalents ................. (38,428) 88,700
Cash and cash equivalents at beginning of period ..................... 98,409 5,337
---------- ----------
Cash and cash equivalents at end of period ........................... $ 59,981 $ 94,037
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3
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------------
2003 2002
---------- ----------
Noncash investing and financing activities:
Net tangible assets acquired, excluding cash ........................ $ 2,370 $ 5,063
Net liabilities assumed ............................................. (2,135) (15,988)
Intangible assets acquired, including goodwill ...................... 2,607 80,372
Noncash purchase price, including 5,185,650 shares of common stock
and fair market value of stock options issued .................... - (68,573)
---------- ----------
Cash paid for acquisition, net of cash acquired ..................... $ 2,842 $ 874
========== ==========
Equity issued in exchange for 4 1/2% convertible subordinated notes
due 2003 ......................................................... $ - $ 14,497
========== ==========
Supplemental cash flow information:
Interest paid during the period ..................................... $ 3,568 $ 3,310
========== ==========
Income taxes paid during the period ................................. $ 45 $ 2,814
========== ==========
See accompanying notes to the consolidated financial statements.
4
ARRIS GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1. ORGANIZATION AND BASIS OF PRESENTATION
ARRIS Group, Inc., the successor to ANTEC Corporation (together with its
consolidated subsidiaries, except as the context otherwise indicates, "ARRIS" or
the "Company"), is a global broadband communications technology company,
headquartered in Duluth, Georgia. ARRIS specializes in the design, engineering,
development, and distribution of products for hybrid fiber-coax broadband
networks. The Company provides its customers with products and services that
enable reliable, high-speed, two-way broadband transmission of telephony, data,
and video services.
ARRIS operates in one business segment, Communications, providing a range of
customers with network and system products and services for hybrid fiber-coax
networks for the communications industry. This segment accounts for 100% of
consolidated sales, operating profit and identifiable assets of the Company.
ARRIS provides a broad range of products and services to cable system operators
and telecommunication providers. ARRIS is a leading developer,
manufacturer/supplier of telephony, data, construction, rebuild and maintenance
equipment for the broadband communications industry. ARRIS supplies most of the
products required in a broadband communication system, including headend and
customer premises equipment for the provision of telephony and high-speed data
over broadband cable networks, and a wide variety of construction, maintenance
equipment, and supplies.
In 2002, ARRIS sold the Keptel and Actives product lines, which have been
accounted for as discontinued operations in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. As a result, these two product lines and
historical results have been reclassified for all periods presented. See further
discussion in Note 5 of Notes to the Consolidated Financial Statements.
The consolidated financial statements furnished herein reflect all adjustments
(consisting of normal recurring accruals) that are, in the opinion of
management, necessary for a fair presentation of the consolidated financial
statements for the periods shown. Additionally, certain prior period amounts
have been reclassified to conform to the 2003 financial statement presentation.
Interim results of operations are not necessarily indicative of results to be
expected from a twelve-month period. These interim financial statements should
be read in conjunction with the Company's most recently audited consolidated
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the Company's year ended December 31, 2002, as filed with the
United States Securities and Exchange Commission.
NOTE 2. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In May 2003, the Financial Accounting Standards Board ("FASB") issued SFAS No.
150, Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity, which establishes standards for how an issuer of
financial instruments classifies and measures certain financial instruments with
characteristics of both liabilities and equity. It requires that an issuer
classify a financial instrument that is within its scope as a liability if, at
inception, the monetary value of the obligation is based solely or predominantly
on a fixed monetary amount known at inception, variations in something other
than the fair value of the issuer's equity shares or variations inversely
related to changes in the fair value of the issuer's equity shares. This
Statement is effective for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning of the first interim
period beginning after June 15, 2003. The Company has adopted this standard and
it did not have a material impact on the Company's financial position or results
of operations.
In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities, which amends and clarifies
accounting for derivative instruments including certain derivative instruments
embedded in other contracts and hedging activities under SFAS No. 133. It is
effective for contracts entered into or modified after June 30, 2003 and for
hedging relationships designated after June 30, 2003. The Company has adopted
SFAS No. 149 and it did not have a material impact on the Company's financial
position or results of operations.
5
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, an Interpretation of Accounting Research Bulletin
No. 51. This Interpretation provides clarification on the consolidation of
certain entities in which equity investors do not have sufficient equity at risk
for the entity to finance its activities without additional subordinated
financial support from other parties. Such entities are defined as variable
interest entities ("VIEs"). This Interpretation requires that VIEs be
consolidated by the entity considered to be the primary beneficiary of the VIE.
The Interpretation is effective immediately for newly created VIEs after January
31, 2003 and was originally effective July 1, 2003 for any VIEs created prior to
February 1, 2003. In October 2003, the FASB agreed to a deferral of the
effective date of the Interpretation for public companies until periods ending
after December 15, 2003. The Company is still evaluating the impact of
Interpretation No. 46.
In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure. The Company adopted SFAS No. 148 on
January 1, 2003. See Note 3 of Notes to the Consolidated Financial Statements.
In November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting
and Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness to Others, an interpretation of FASB Statements No. 5, 57, and 107
and a rescission of FASB Interpretation No. 34 ("FIN 45"). The Company adopted
FIN 45 as of January 1, 2003. FIN 45 elaborates on the disclosures to be made by
a guarantor in its interim and annual financial statements about its obligations
under guarantees issued. FIN 45 also clarifies that a guarantor is required to
recognize, at inception of a guarantee, a liability for the fair value of the
obligation undertaken. The initial recognition and measurement provisions of FIN
45 are applicable to guarantees issued or modified after December 31, 2002. The
disclosure requirements are effective for financial statements of interim and
annual periods ending after December 31, 2002, and are discussed in Note 4 of
Notes to the Consolidated Financial Statements. The Company may, from time to
time under certain circumstances, grant trade-in rights with respect to certain
products. The trade-in rights are recorded in accordance with FIN 45, which may
have a material impact on the Company's results of operations. When trade-in
rights are granted at the time of sale, a portion of the sale is treated as a
guarantee and is deferred until the trade-in right is exercised or the right
expires. In determining the deferral amount, management estimates the expected
trade-in rate and future value of the product upon trade-in. These factors are
periodically reviewed and updated by management, and the updates may result in
either an increase or decrease in the deferral. The adoption of FIN 45 did not
have a material impact on the Company's results of operations or financial
condition as of September 30, 2003.
In November 2002, the Emerging Issues Task Force ("EITF") of the FASB reached a
consensus on Issue No. 00-21, Revenue Arrangements with Multiple Deliverables.
EITF 00-21 provides guidance on how to account for arrangements that involve the
delivery or performance of multiple products, services or rights to use assets.
The Company has adopted EITF 00-21, and the provisions of EITF 00-21 apply to
revenue arrangements entered into after June 15, 2003. This accounting
pronouncement did not have a significant impact on the Company's financial
position or results of operations as of September 30, 2003.
NOTE 3. STOCK-BASED COMPENSATION
The Company uses the intrinsic value method for valuing its awards of stock
options and restricted stock and records the related compensation expense, if
any, in accordance with APB Opinion No. 25, Accounting for Stock Issued to
Employees and related interpretations. No stock-based employee or director
compensation cost for stock options is reflected in net income, as all options
granted have exercise prices equal to the market value of the underlying common
stock on the date of grant. The Company records compensation expense related to
its restricted stock awards and director stock units. The following table
illustrates the effect on net income and earnings per share as if the Company
had applied the fair value recognition provisions of SFAS No. 123, Accounting
for Stock-Based Compensation, to all stock-based employee compensation.
6
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
2003 2002 2003 2002
---- ---- ---- ----
Net income (loss), as reported ..................... $ (14,593) $ 3,487 $ (38,916) $ (97,121)
Add: Stock-based employee compensation included
in reported net income, net of taxes ............. 1,001 418 2,254 1,304
Deduct: Total stock-based employee compensation
expense determined under fair value based
methods for all awards, net of taxes ............. (4,393) (7,444) (17,366) (22,207)
----------- ----------- ----------- -----------
Net income (loss), pro forma ....................... $ (17,985) $ (3,539) $ (54,028) $ (118,024)
=========== =========== =========== ===========
Net income (loss) per common share:
Basic - as reported .............................. $ (0.19) $ 0.04 $ (0.50) $ (1.19)
=========== =========== =========== ===========
Basic - pro forma ................................ $ (0.24) $ (0.04) $ (0.70) $ (1.45)
=========== =========== =========== ===========
Diluted - as reported ............................ $ (0.19) $ 0.04 $ (0.50) $ (1.19)
=========== =========== =========== ===========
Diluted - pro forma .............................. $ (0.24) $ (0.04) $ (0.70) $ (1.45)
=========== =========== =========== ===========
NOTE 4. GUARANTEES
Warranty
ARRIS provides for the estimated cost of product warranties at the time revenue
is recognized. While the Company engages in extensive product quality programs
and processes, including actively monitoring and evaluating the quality of its
suppliers, the estimated warranty obligation could be affected by changes in
ongoing product failure rates, material usage and service delivery costs
incurred in correcting a product failure as well as specific product class
failures outside of ARRIS' baseline experience. If actual product failure rates,
material usage or service delivery costs differ from estimates, revisions, which
could be material, to the estimated warranty liability would be recorded. ARRIS
evaluates its warranty obligations on a product line basis.
Information regarding the changes in ARRIS' aggregate product warranty
liabilities was as follows for the nine-month period ended September 30, 2003
(in thousands):
Balance at December 31, 2002...................................... $ 6,031
Accruals related to warranties (including changes in estimates)... 1,024
Settlements made (in cash or in kind)............................. (1,925)
----------
Balance at September 30, 2003..................................... $ 5,130
==========
NOTE 5. DISCONTINUED OPERATIONS
Upon evaluation and review of the ARRIS product portfolio, the Company concluded
that the Keptel product line was not core to its long-term strategy and thus
sold the product line on April 24, 2002. Keptel designed and marketed network
interface systems and fiber optic cable management products primarily for
traditional residential and commercial telecommunications applications. The
transaction generated cash proceeds of $30.0 million. Additionally, ARRIS
retained a potential earn-out over a twenty-four month period based on the
achievement of sales targets. The transaction also included a distribution
agreement whereby the Company will continue to distribute Keptel products until
April 2005. Total assets of approximately $31.1 million were disposed of, which
included inventory, fixed assets, intangibles (formerly classified as goodwill),
and other assets. ARRIS incurred approximately $5.0 million of related closure
costs, including severance, vendor liabilities, outside consulting fees, and
other shutdown expenses. During 2002, a net loss of $6.1 million was recorded in
connection with the sale of the Keptel product line. As of September 30, 2003,
approximately $0.9 million related to outside consulting fees remained in an
accrual to be paid. ARRIS expects to complete the remaining payments by the end
of 2003.
Upon continued review of ARRIS' product portfolio, the Company sold its Actives
product line on November 21, 2002, for net proceeds of $31.8 million. Total
assets of approximately $20.3 million were disposed of, which included
inventory, fixed assets, and other assets attributable to the product line.
Additionally, ARRIS incurred approximately $7.3 million of related closure
costs, including severance, vendor liabilities, professional fees, and other
shutdown expenses. In connection with the sale, the Company recognized a gain of
approximately $2.2 million
7
in 2002. During the second quarter of 2003, the Company reduced its accrual for
vendor liabilities by $2.0 million as a result of settling certain vendor
liabilities for amounts less than originally anticipated. With this adjustment,
the Company has now recognized a cumulative gain of approximately $4.2 million
related to the transaction. As of September 30, 2003, approximately $0.1 million
related to severance, $2.8 million related to vendor liabilities, and $0.9
million related to other shutdown expenses remained in an accrual to be paid.
ARRIS expects to complete the remaining payments by the end of 2003.
The Company's Keptel and Actives product lines, as a whole, constituted the
majority of its transmission, optical and outside plant product category and
qualified as discontinued operations in accordance with SFAS No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. Accordingly, the results of
these product lines have been reclassified to discontinued operations for all
periods presented. The remaining product lines within the transmission, optical
and outside plant product category have been reclassified to the supplies and
services product category.
Revenues from discontinued operations were $17.0 million and $53.8 million for
the three and nine months ended September 30, 2002, respectively. The net loss
from discontinued operations, net of taxes, for the three and nine months ending
September 30, 2002 was $(1.4) million and $(20.5) million, respectively. During
2002, the Company recorded a net loss on these disposals of $(4.0) million.
During 2003, the Company recorded a gain of $2.0 million related to the Actives
adjustment described above, resulting in a cumulative net loss of $(2.0) million
related to the disposal of discontinued operations. This $2.0 million gain on
disposal of discontinued operations was offset by an approximately $2.0 million
increase in the accrual for restructuring liabilities associated with the
discontinued operations of the Company's manufacturing facilities. See Note 6 of
Notes to the Consolidated Financial Statements.
NOTE 6. BUSINESS ACQUISITIONS
ACQUISITION OF CERTAIN ASSETS OF COM21
On August 13, 2003, the Company completed the acquisition of certain cable modem
termination system (CMTS) related assets of Com21, including the stock of its
Irish subsidiary. Under the terms of the agreement, ARRIS obtained accounts
receivable, inventory, fixed assets, other current prepaid assets, and existing
technology in exchange for approximately $2.4 million of cash, of which $2.2
million has been paid, and the assumption of approximately $0.6 million in
liabilities. The Company has retained $0.2 million of the cash consideration for
any liabilities which ARRIS may be required to pay resulting from Com21 activity
prior to the acquisition date. The Company also incurred approximately $0.2
million of legal and professional fees associated with the transaction. ARRIS
retained approximately 50 Com21 employees. The Company completed this
acquisition because it believes that the newly acquired product line, along with
the existing product offerings of ARRIS, will allow the Company to reach smaller
scale cable systems domestically and internationally.
The following is a summary of the preliminary purchase price allocation to
record ARRIS' purchase of certain assets of Com21, including the stock of the
Irish subsidiary of Com21. The purchase price was equal to the net tangible and
intangible assets acquired. The final allocation of the purchase price will be
determined after completion of thorough analyses to identify and determine the
fair values of Com21's tangible and identifiable intangible assets and
liabilities as of the date the transaction was completed.
(IN THOUSANDS)
Cash paid to Com21 .................................... $ 2,213
Cash retainer.......................................... 200
Acquisition costs ..................................... 210
Assumption of certain liabilities of Com21 ............ 634
--------
Adjusted preliminary purchase price ................. $ 3,257
========
Allocation of preliminary purchase price:
Net tangible assets acquired ........................ $ 1,357
Existing technology (to be amortized over 3 years)... 1,900
--------
Total allocated preliminary purchase price .......... $ 3,257
========
8
ACQUISITION OF ATOGA SYSTEMS
On March 21, 2003, ARRIS purchased the business and certain assets of Atoga
Systems, a Fremont, California-based developer of optical transport systems for
metropolitan area networks. The Company decided to undertake this transaction
because it would expand the Company's existing broadband product portfolio and
is anticipated to have a positive impact on future results of the Company. Under
the terms of the agreement, ARRIS obtained certain inventory, fixed assets, and
existing technology in exchange for approximately $0.4 million of cash and the
assumption of certain lease obligations. Further, the Company retained 28
employees and issued a total of 500,000 shares of restricted stock to those
employees. The value of the restricted stock will be recognized as compensation
expense over the related vesting period.
The following is a summary of the preliminary purchase price allocation to
record ARRIS' purchase price of the assets and certain liabilities of Atoga
Systems. The final allocation of the purchase price will be determined after
completion of thorough analyses to identify and determine the fair values of
Atoga Systems' tangible and identifiable intangible assets and liabilities as of
the date the transaction was completed.
(IN THOUSANDS)
Cash paid to Atoga Systems ............................ $ 434
Acquisition costs (legal fees) ........................ 100
Assumption of certain liabilities of Atoga Systems .... 1,162
--------
Adjusted preliminary purchase price ................. $ 1,696
========
Allocation of preliminary purchase price:
Net tangible assets acquired ........................ $ 1,013
Existing technology (to be amortized over 3 years)... 683
--------
Total allocated preliminary purchase price .......... $ 1,696
========
ACQUISITION OF CADANT, INC.
On January 8, 2002, ARRIS completed the acquisition of all of the assets and
business of Cadant, Inc., a privately held designer and manufacturer of next
generation Cable Modem Termination Systems ("CMTS"). The Company acquired Cadant
because it provided significant broadband product and technology extensions of
its existing product portfolio. As a part of this transaction:
- ARRIS issued 5,250,000 shares of ARRIS common stock for the
purchase of substantially all of Cadant's assets and certain
liabilities.
- During the second quarter of 2003, 64,350 shares of ARRIS
common stock were returned to ARRIS and retired. This
transaction was pursuant to the terms of a settlement
agreement between ARRIS and the trustee in the liquidation of
CDX Corporation (formerly know as Cadant).
- ARRIS agreed to pay up to 2.0 million shares based upon future
sales of the CMTS product through January 8, 2003. These
targets were not met as of January 8, 2003, and therefore, no
further shares were issued.
9
The following is a summary of the purchase price allocation to record ARRIS'
purchase price of the assets and certain liabilities of Cadant, Inc. for
5,250,000 shares of ARRIS Group, Inc. common stock based on the average closing
price of ARRIS' common stock for 5 days prior and 5 days after the date of the
transaction as quoted on the Nasdaq National Market System. The excess of the
purchase price over the fair value of the net tangible and intangible assets
acquired has been allocated to goodwill.
(IN THOUSANDS)
5,250,000 shares of ARRIS Group, Inc.'s $0.01 par value
common stock at $10.631 per common share ..................... $ 55,813
64,350 returned shares of ARRIS Group, Inc.'s $0.01 par value
common stock at $10.631 per common share ..................... (684)
Acquisition costs (banking fees, legal and accounting fees,
printing costs) .............................................. 897
Fair value of stock options to Cadant, Inc. employees .......... 12,760
Assumption of certain liabilities of Cadant, Inc. .............. 14,858
----------
Adjusted purchase price ...................................... $ 83,644
==========
Allocation of Purchase Price:
Net tangible assets acquired ................................. $ 5,001
Existing technology (to be amortized over 3 years) ........... 53,000
Goodwill (not deductible for income tax purposes) ............ 25,643
----------
Total allocated purchase price ............................... $ 83,644
==========
SUPPLEMENTAL PRO FORMA INFORMATION
Presented below is summary unaudited pro forma combined financial information
for the Company, Com21, Atoga Systems, and Cadant, Inc. to give effect to the
transactions. This summary unaudited pro forma combined financial information is
derived from the historical financial statements of the Company, Com21, Atoga
Systems, and Cadant, Inc. This information assumes the transaction was
consummated at the beginning of the applicable period. This information is
presented for illustrative purposes only and does not purport to represent what
the financial position or results of operations of the Company, Com21, Atoga
Systems, and Cadant, Inc., or the combined entity would actually have been had
the transactions occurred at the applicable dates, or to project the Company's,
Com21's, Atoga Systems', and Cadant, Inc.'s, or the combined entity's results of
operations for any future period or date. The actual results of Com21 are
included in the Company's operations from August 13, 2003 to September 30, 2003.
The actual results of Atoga Systems are included in the Company's operations
from March 21, 2003 to September 30, 2003. The actual results of Cadant, Inc.
are included in the Company's operations from January 8, 2002 to September 30,
2003.
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
2003 2002 2003 2002
---- ---- ---- ----
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
Net sales ................................... $ 113,111 $ 180,782 $ 306,164 $ 529,681
Gross profit ................................ 31,842 65,143 83,771 183,849
Operating income (loss) ..................... (12,606) 5,310 (64,424) (20,973)
Income (loss) before income taxes ........... (15,220) (297) (44,728) (43,320)
Income (loss) from continuing operations .... (15,220) (297) (44,728) (36,520)
Income (loss) from discontinued operations .. - (1,406) - (20,465)
Net income (loss) before cumulative effect of
an accounting change ...................... (15,220) (1,703) (44,728) (56,985)
Net income (loss) ........................... $ (15,220) $ (1,703) $ (44,728) $(114,945)
========= ========= ========= =========
Net income (loss) per common share:
Diluted ................................... $ (0.20) $ (0.02) $ (0.58) $ (1.40)
========= ========= ========= =========
Weighted average common shares:
Diluted ................................... 75,039 83,110 77,339 81,829
========= ========= ========= =========
10
The following table represents the amount assigned to each major asset and
liability caption of Com21 as of August 13, 2003, Atoga Systems as of March 21,
2003 and Cadant, Inc. as of January 8, 2002, as adjusted:
AS OF ACQUISITION DATE
(IN THOUSANDS)
----------------------------------------
ATOGA
COM21 SYSTEMS CADANT, INC.
---------- ---------- ------------
Total current assets....................... $ 273 $ 330 $ 782
Property, plant and equipment, net......... $ 1,084 $ 683 $ 4,219
Goodwill................................... $ - $ - $ 25,643
Intangible assets ......................... $ 1,900 $ 683 $ 53,000
Total assets............................... $ 3,257 $ 1,696 $ 83,644
Total current and long-term liabilities ... $ 634 $ 1,162 $ 14,858
NOTE 7. BUSINESS DIVESTITURE - ELECTRONIC SYSTEM PRODUCTS ("ESP")
On August 18, 2003, ARRIS sold its engineering consulting services product line,
known as ESP, to an unrelated third party. The agreement involved the transfer
of net assets of approximately $1.3 million, which included accounts receivable,
fixed assets, an investment, and other assets attributable to the product line.
Further, the transaction provided for the transfer of approximately 30
employees. Additionally, the Company incurred approximately $0.1 million of
related closure costs, primarily legal and professional fees associated with the
closing. ARRIS recognized a loss on the sale of approximately $1.4 million
during the third quarter 2003. The ESP product line contributed revenue of
approximately $0.2 million and $1.3 million during the three and nine-month
periods ended September 30, 2003, respectively, and revenue of $0.7 million and
$2.5 million during the three and nine-month periods ended September 30, 2002,
respectively. The ESP revenue is classified in the supplies product category. In
accordance with the provisions of SFAS No. 144, Accounting for the Impairment of
Disposal of Long-Lived Assets, ESP is not reflected as a discontinued operation
because it was determined to be an insignificant component of the Company's
consolidated operations and assets. As of September 30, 2003, approximately $0.1
million related to legal and professional fees remained in an accrual to be
paid. ARRIS expects to complete the remaining payments by the end of 2003.
NOTE 8. RESTRUCTURING AND OTHER CHARGES
On October 30, 2002, the Company announced that it would close its office in
Andover, Massachusetts, which was primarily a product development and repair
facility. The Company decided to close the office in order to reduce operating
costs through the consolidation of its facilities. The closure affected
approximately 75 employees and will be substantially completed by the end of
2003. In connection with these actions, the Company recorded a charge of
approximately $7.1 million in the fourth quarter of 2002. Included in this
restructuring charge was approximately $2.1 million related to remaining lease
payments, $2.7 million of fixed asset write-offs, $2.1 million of severance, and
$0.2 million of other costs associated with these actions. As of September 30,
2003, approximately $1.3 million related to lease commitments, $0.2 million
related to severance, and $0.2 million related to other costs remained in the
restructuring accrual to be paid. ARRIS expects to complete the remaining
payments by the second quarter of 2006 (end of lease).
In the fourth quarter of 2001, ARRIS closed a research and development facility
in Raleigh, North Carolina and recorded a $4.0 million charge related to
severance and other costs associated with closing that facility. This charge
included termination expenses of $2.2 million related to the involuntary
dismissal of 48 employees, primarily engaged in engineering functions at that
facility. Also included in the $4.0 million charge was $0.7 million related to
lease commitments, $0.2 million related to the impairment of fixed assets, and
$0.9 million related to other shutdown expenses. In September 2003, ARRIS took
advantage of an early buyout clause in connection with the remaining lease
payments, which reduced the Company's original estimate of restructuring expense
by approximately $0.4 million. As of September 30, 2003, the Company has no
remaining liabilities related to this closure.
In the third quarter of 2001, the Company announced a restructuring plan to
outsource the functions of most of its manufacturing facilities. This decision
to reorganize was due in part to the ongoing weakness in industry spending
patterns. The plan entailed the implementation of an expanded manufacturing
outsourcing strategy and the related
11
closure of the four factories located in El Paso, Texas and Juarez, Mexico. As a
result, the Company recorded restructuring and impairment charges of $66.2
million, of which approximately $50.1 million relates to and is classified in
discontinued operations. Included in these charges was approximately $33.7
million related to the write-down of inventories, and remaining warranty and
purchase order commitments of which approximately $8.6 million was reflected in
cost of goods sold and $25.1 million was reflected in discontinued operations.
Additional charges incurred were approximately $5.7 million related to severance
and associated personnel costs, $5.9 million related to the impairment of
goodwill due to the sale of the power product lines, $14.8 million related to
the impairment of fixed assets, and approximately $6.1 million related to lease
terminations of factories and office space and other shutdown expenses. Of these
charges, approximately $7.5 million is reflected in restructuring expense and
$25.0 million is reflected in discontinued operations. The personnel-related
costs included termination expenses for the involuntary dismissal of 807
employees, primarily engaged in production and assembly functions performed at
the facilities. ARRIS offered terminated employees separation amounts in
accordance with the Company's severance policy and provided the employees with
specific separation dates. Due to unforeseen delays in exiting the facility
after the shutdown, the Company increased its reserve by approximately $2.4
million and $2.0 million during the fourth quarter 2002 and the second quarter
2003, respectively, charged to discontinued operations. As of September 30,
2003, approximately $0.1 million related to severance and associated personnel
costs, and $2.1 million related to lease terminations of factories and office
space and other shutdown costs remained in an accrual to be paid. ARRIS expects
to complete the remaining payments by the end of the first quarter 2004.
NOTE 9. INVENTORIES
Inventories are stated at the lower of average, approximating first-in,
first-out, cost or market. The components of inventory, net of reserves, are as
follows (in thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
(UNAUDITED)
Raw material................................. $ 4,996 $ 3,941
Finished goods............................... 90,013 100,262
--------- ---------
Total inventories...................... $ 95,009 $ 104,203
========= =========
NOTE 10. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment, at cost, consists of the following (in
thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
(UNAUDITED)
Land ........................................ $ 1,822 $ 1,822
Building and leasehold improvements ......... 7,702 7,295
Machinery and equipment ..................... 65,788 70,233
--------- ---------
75,312 79,350
Less: Accumulated depreciation .............. (48,135) (44,810)
--------- ---------
Total property, plant and equipment, net... $ 27,177 $ 34,540
========= =========
NOTE 11. GOODWILL AND INTANGIBLE ASSETS
ARRIS adopted SFAS No. 142, Goodwill and Other Intangible Assets, on January 1,
2002. Upon adoption of SFAS No. 142, the Company recorded a goodwill impairment
loss of approximately $58.0 million, primarily related to the Keptel product
line, based upon management's analysis including an independent valuation. The
resulting impairment loss has been recorded as a cumulative effect of a change
in accounting principle on the accompanying Consolidated Statements of
Operations for the nine months ended September 30, 2002. The valuation was
determined using a combination of the income and market approaches on an
invested capital basis, which is the market value of equity plus
interest-bearing debt. The Company's remaining goodwill was reviewed in the
fourth quarter of 2002, and based upon management's analysis including an
independent valuation, an impairment charge
12
of $70.2 million was recorded with respect to its supplies product category. The
Company will analyze its goodwill on an annual basis during the fourth quarter
of each year or on an interim basis if circumstances change that would indicate
the possibility of an impairment.
The changes in the carrying amount of goodwill for the year ended December 31,
2002 and for the nine months ended September 30, 2003 are as follows (in
thousands):
Balance as of December 31, 2001............................................ $ 259,062
Transitional impairment charge............................................. (57,960)
Purchase price allocation adjustment - Arris Interactive L.L.C............. 33
Goodwill in connection with Cadant, Inc. acquisition....................... 26,339
Transferred to intangible asset upon adoption of SFAS No. 142.............. (6,000)
Goodwill impairment charge, October 1, 2002................................ (70,209)
---------
Balance as of December 31, 2002............................................ $ 151,265
Purchase price allocation adjustments - Cadant, Inc. (see Note 6).......... (696)
---------
Balance as of September 30, 2003........................................... $ 150,569
=========
The gross carrying amount and accumulated amortization of the Company's
intangible assets, other than goodwill, as of September 30, 2003 and December
31, 2002 are as follows (in thousands):
SEPTEMBER 30, 2003 (UNAUDITED) DECEMBER 31, 2002
--------------------------------------- ---------------------------------------
GROSS ACCUMULATED NET BOOK GROSS ACCUMULATED NET BOOK
AMOUNT AMORTIZATION VALUE AMOUNT AMORTIZATION VALUE
-------- ------------ -------- --------- ------------ --------
Existing technology acquired:
Arris Interactive L.L.C .... $ 51,500 $ (37,053) $ 14,447 $ 51,500 $ (24,178) $ 27,322
Cadant, Inc. ............... 53,000 (30,578) 22,422 53,000 (17,328) 35,672
Atoga Systems .............. 685 (113) 572 - - -
Com21 ...................... 1,900 (46) 1,854 - - -
Pension asset ................... 1,849 - 1,849 1,849 - 1,849
--------- --------- -------- --------- --------- --------
Total ...................... $ 108,934 $ (67,790) $ 41,144 $ 106,349 $ (41,506) $ 64,843
========= ========= ======== ========= ========= ========
Amortization expense recorded on the intangible assets listed in the above table
for the three months ended September 30, 2003 and 2002 was $8.8 million and $8.7
million, respectively. Amortization expense for the nine months ended September
30, 2003 and 2002 was $26.3 million and $25.8 million, respectively. The
estimated remaining amortization expense is as follows (in thousands):
2003................ $ 8,957
2004................ $ 28,683
2005................ $ 1,200
2006................ $ 455
2007................ $ -
NOTE 12. LONG TERM DEBT, CAPITAL LEASE OBLIGATIONS AND MEMBERSHIP INTEREST
Long term debt, capital lease obligations and membership interest consist of the
following (in thousands):
SEPTEMBER 30, DECEMBER 31,
2003 2002
------------- ------------
(UNAUDITED)
Capital lease obligations $ 22 $ 1,278
Machinery and equipment notes payable 1,425 -
Membership interest -Nortel Networks - 114,518
4.5% Convertible Subordinated Notes due 2003 - 23,887
4.5% Convertible Subordinated Notes due 2008 125,000 -
---------- ----------
Total debt, capital lease obligations and membership 126,447 139,683
interest
Less current portion (1,082) (25,007)
---------- ----------
Total long term debt, capital lease obligations and
membership interest $ 125,365 $ 114,676
========== ==========
13
On March 18, 2003, the Company issued $125.0 million of 4 1/2% Convertible
Subordinated Notes due 2008 ("Notes due 2008"). The Notes due 2008 are
convertible, at the option of the holder, at any time prior to maturity, into
the Company's common stock at a conversion price of $5.00 per share, subject to
adjustment. The Notes due 2008 will pay interest semi-annually, based on an
annual rate of 4 1/2%, on March 15 and September 15 of each year, commencing
September 15, 2003. The Company used approximately $88.4 million of the proceeds
from the issuance, including the reduction in the forgiveness of the Class B
membership interest, to redeem the Class B membership interest in Arris
Interactive held by Nortel Networks resulting in a gain of approximately $28.5
million, recorded in operations in accordance with SFAS No. 145, Rescission of
FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections. The Company used approximately $28.0 million of the
proceeds of the issuance to repurchase and retire 8 million shares of its common
stock held by Nortel Networks at a discount. As of September 30, 2003, there
were $125.0 million of the Notes due 2008 outstanding.
In 1998, the Company issued $115.0 million of 4 1/2% Convertible Subordinated
Notes due May 15, 2003 ("Notes due 2003"). The Notes due 2003 were convertible,
at the option of the holder, at any time prior to maturity, into the Company's
common stock at a conversion price of $24.00 per share. In 2002, ARRIS exchanged
1,593,789 shares of its common stock for approximately $15.4 million of the
Notes due 2003. Additionally, the Company redeemed $23.9 million and $75.7
million of the Notes due 2003 during 2003 and 2002, respectively, using cash. As
of May 15, 2003, all of the Notes due 2003 were redeemed.
The Company has in place an asset-based revolving credit facility (the "Credit
Facility") permitting the Company to borrow up to $92.5 million (which can be
increased under certain conditions by up to $25.0 million), based upon
availability under a borrowing base calculation. In general, the borrowing base
is limited to 85% of net eligible receivables (with a cap of $5.0 million in
relation to foreign receivables), subject to a reserve of $10.0 million. In
addition, upon obtaining appropriate asset appraisals the Company may include in
the borrowing base calculation 80% of the orderly liquidation value of net
eligible inventory (not to exceed $60.0 million). The Credit Facility contains
traditional financial covenants, including fixed charge coverage, senior debt
leverage, minimum net worth, and minimum inventory turns ratios. The facility is
secured by substantially all of the Company's assets. The Credit Facility has a
maturity date of August 3, 2004. The commitment fee on unused borrowings is
0.75%.
The Credit Facility was amended in January 2003 to provide that the minimum net
worth covenant applied only to the period prior to December 31, 2002. In March
2003, ARRIS amended its credit facility to permit the Company to issue up to
$125.0 million of the Notes due 2008, to use the proceeds of such notes as
described above. The amendment also reduced the revolving loan commitments by
$10.0 million to $115.0 million. The Credit Facility was further amended in
August 2003 to reduce the aggregate revolving loan commitments to $92.5 million
and to waive the fixed charge coverage ratio for the third and fourth quarters
of 2003. In conjunction with obtaining the waiver, the financial covenants were
expanded to include EBITDA covenants for the third and fourth quarters of 2003.
The EBITDA covenant for the third quarter 2003 was met and the Company
anticipates meeting the covenant in the fourth quarter.
As of September 30, 2003, ARRIS had no borrowings outstanding under its credit
facility and approximately $7.0 million outstanding under letters of credit. The
Company had approximately $47.1 million of available borrowing capacity.
In connection with the acquisition of Arris Interactive in August 2001, Nortel
Networks exchanged its remaining ownership interest in Arris Interactive for 37
million shares of ARRIS common stock and a subordinated redeemable Class B
membership interest in Arris Interactive with a face amount of $100.0 million.
The Class B membership interest earned an accreting non-cash return of 10% per
annum, compounded annually, and was redeemable in approximately four quarterly
installments commencing February 3, 2002, provided that certain availability and
other tests are met under the Company's Credit Facility. Those tests were not
met. In June 2002, ARRIS entered into an option agreement with Nortel Networks
that permitted ARRIS to redeem the Class B membership interest in Arris
Interactive at a discount of 21% prior to June 30, 2003. To further induce the
Company to redeem the Class B membership interest, Nortel Networks offered to
forgive approximately $5.9 million of the amount owed Nortel Networks if ARRIS
redeemed it prior to March 31, 2003. The Company used
14
approximately $88.4 million of the proceeds, including the reduction in the
forgiveness of the Class B membership interest, of Notes due 2008 to redeem the
Class B membership interest at a discount resulting in a gain of approximately
$28.5 million, recorded in operations in accordance with SFAS No. 145,
Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No.
13, and Technical Corrections.
In conjunction with the acquisition of Cadant, Inc. and Atoga Systems, the
Company assumed capital lease obligations and a note payable related to
machinery and equipment. The leases required future rental payments until 2005;
however, during the third quarter 2003, the Company paid the remaining Cadant
lease payments at an early buyout discount using the proceeds of a new note
payable. The new note payable is due January 2005 with an interest rate of 5%
per annum. The balance of the remaining capital lease obligations and notes
payable at September 30, 2003 was approximately $1.4 million.
ARRIS has not paid cash dividends on its common stock since its inception. The
Company's credit agreement contains covenants that prohibit it from paying such
dividends. In 2002, to implement its shareholder rights plan, the Company's
board of directors declared a dividend consisting of one right for each share of
its common stock outstanding. Each right represents the right to purchase one
one-thousandth of a share of its Series A Participating Preferred Stock and
becomes exercisable only if a person or group acquires beneficial ownership of
15% or more of its common stock or announces a tender or exchange offer for 15%
or more of its common stock or under other similar circumstances.
NOTE 13. COMPREHENSIVE INCOME (LOSS)
Total comprehensive income (loss) for the three-month periods ended September
30, 2003 and 2002 was $(14.6) million and $3.8 million, respectively. Total
comprehensive income (loss) for the nine-month periods ended September 30, 2003
and 2002 was $(39.1) million and $(97.5) million, respectively. Such
comprehensive loss, which is recorded as a separate component of stockholders'
equity, differs from net loss due to cumulative translation adjustments and
unrealized holding gains (losses) on marketable securities.
NOTE 14. SALES INFORMATION
A significant portion of ARRIS' revenue is derived from sales to Comcast and Cox
Communications. Sales to these two customers for the three and nine-month
periods ended September 30, 2003 and 2002 are set forth below (in thousands):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2003 2002 2003 2002
---- ---- ---- ----
Comcast ................. $ 35,809 $ 89,548 $ 95,540 $ 215,240
% of sales .............. 31.7% 49.6% 31.2% 40.7%
Cox Communications ...... $ 29,801 $ 23,647 $ 74,748 $ 76,627
% of sales .............. 26.3% 13.1% 24.4% 14.5%
15
ARRIS operates globally and offers products and services that are sold to cable
system operators and telecommunications providers. ARRIS' products and services
are focused in two product categories, Broadband and Supplies, instead of the
previous three categories. As a result of the sale of the Company's Keptel and
Actives product lines in 2002, revenues from the remaining product lines within
the former Transmission, Optical, and Outside Plant product category are now
reported with the Supplies product category. All prior period revenues have been
aggregated to conform to the new product categories. Consolidated revenues by
principal products category for the three and nine-month periods ended September
30, 2003 and 2002 were as follows (in thousands):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2003 2002 2003 2002
---- ---- ---- ----
PRODUCT CATEGORY
Broadband.............. $ 75,050 $ 132,341 $ 203,232 $ 370,643
Supplies............... 38,061 48,236 102,932 158,833
---------- ---------- ---------- ----------
Total sales....... $ 113,111 $ 180,577 $ 306,164 $ 529,476
========== ========== ========== ==========
The Company sells its products primarily in the United States with its
international revenue being generated from Asia Pacific, Europe, Latin America
and Canada. The Asia Pacific market primarily includes China, Hong Kong, Japan,
Korea, and Singapore. The European market primarily includes Austria, Germany,
France, Netherlands, Poland, Portugal, Romania, Spain, and Switzerland. The
Latin American market primarily includes Argentina, the Bahamas, Chile,
Colombia, Mexico, and Puerto Rico. Sales to international customers were
approximately 17.5%, and 24.2% of total sales for the quarters ended September
30, 2003 and 2002, respectively. Sales for the three and nine-month periods
ended September 30, 2003 and 2002 are as follows (in thousands):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------- --------------------------------
2003 2002 2003 2002
---- ---- ---- ----
INTERNATIONAL REGION
Asia Pacific.................... $ 7,077 $ 11,585 $ 22,346 $ 39,337
Europe.......................... 6,119 13,454 18,972 58,280
Latin America................... 2,066 6,735 5,596 16,208
Canada.......................... 2,272 2,248 7,108 7,243
---------- ---------- ---------- ----------
Total international sales..... 17,534 34,022 54,022 121,068
Total domestic sales.......... 95,577 146,555 252,142 408,408
---------- ---------- ---------- ----------
Total sales................. $ 113,111 $ 180,577 $ 306,164 $ 529,476
========== ========== ========== ==========
Total identifiable international assets were immaterial.
16
NOTE 15. EARNINGS PER SHARE
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share ("EPS") computations for the periods
indicated (in thousands except per share data):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
--------------------------------- --------------------------------
2003 2002 2003 2002
---- ---- ---- ----
Basic:
Income (loss) from continuing operations...... $ (14,593) $ 4,893 $ (38,916) $ (18,696)
Income (loss) from discontinued operations.... - (1,406) - (20,465)
Cumulative effect of an accounting change..... - - - (57,960)
---------- ---------- ---------- ----------
Net income (loss)........................... $ (14,593) $ 3,487 $ (38,916) $ (97,121)
========== ========== ========== ==========
Weighted average shares outstanding......... 75,039 82,506 77,339 81,675
========== ========== ========== ==========
Basic earnings (loss) per share............. $ (0.19) $ 0.04 $ (0.50) $ (1.19)
========== ========== ========== ==========
Diluted:
Income (loss) from continuing operations...... $ (14,593) $ 4,893 $ (38,916) $ (18,696)
Income (loss) from discontinued operations ..... - (1,406) - (20,465)
Cumulative effect of an accounting change ...... - - - (57,960)
---------- ---------- ---------- ----------
Net income (loss) .......................... $ (14,593) $ 3,487 $ (38,916) $ (97,121)
========== ========== ========== ==========
Weighted average shares outstanding ........ 75,039 82,506 77,339 81,675
Net effect of dilutive stock options ....... - 604 - -
---------- ---------- ---------- ----------
Total ................................. 75,039 83,110 77,339 81,675
========== ========== ========== ==========
Diluted earnings (loss) per share ..... $ (0.19) $ 0.04 $ (0.50) $ (1.19)
========== ========== ========== ==========
The 4 1/2% convertible subordinated notes due 2003 and 2008 were antidilutive
for all periods presented. The effects of options were not presented for the
three months ended September 30, 2003 and the nine months ended September 30,
2003 and 2002 as the Company incurred net losses during these periods and
inclusion of these securities would be antidilutive.
NOTE 16. OPTION EXCHANGE PROGRAM
On June 27, 2003, the Company offered to all eligible employees the opportunity
to exchange certain outstanding stock options for restricted shares of ARRIS
common stock. The Company's Board of Directors and its eight most highly
compensated executive officers during 2002 were not eligible to participate in
the offer. The offer expired on July 25, 2003. On July 28, 2003, ARRIS cancelled
options to purchase approximately 4.7 million shares of common stock and granted
approximately 1.5 million restricted shares in exchange. Employees tendered
approximately 76% of the options eligible to be exchanged under the program. In
accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees,
the Company will record a fixed compensation expense equal to the fair market
value of the shares of restricted stock granted through the offer. This cost
will be amortized over the four-year vesting period for the restricted shares,
and equates to a charge of approximately $0.5 million per quarter. All eligible
options that were not surrendered for exchange are subject to variable
accounting. This variable accounting charge will fluctuate in accordance with
the market price of the ARRIS common stock until such stock options are
exercised, forfeited, or expire unexercised.
17
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's Discussion and Analysis of Financial Condition and Results of
Operations discusses ARRIS' Consolidated Financial Statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities and 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. On an on-going basis, management evaluates its
estimates and judgments, including those related to customer incentives, product
returns, bad debts, inventories, investments, intangible assets, income taxes,
financing operations, warranty obligations, restructuring costs, retirement
benefits, and contingencies and litigation. Management bases its estimates and
judgments on historical experience and on various other factors that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions.
Our critical accounting policies and estimates are disclosed extensively in our
Form 10-K for the year ended December 31, 2002, as filed with the United States
Securities and Exchange Commission. That discussion is incorporated herein by
reference. In addition to the policies and estimates discussed in our most
recent Form 10-K, following is a summary of our accounting policy with regards
to revenue recognition.
Revenue Recognition
ARRIS' revenue recognition policies are in compliance with Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial Statements, as issued by the
Securities and Exchange Commission.
Product revenue is recognized when persuasive evidence of an arrangement exists,
delivery has occurred, the fee is fixed or determinable, and collectibility is
reasonably assured. Contracts and customer purchase orders generally are used to
determine the existence of an arrangement. Shipping documents, proof of delivery
and customer acceptance (when applicable) are used to verify delivery. Revenue
is deferred if certain circumstances exist, including:
- when undelivered products or services that are essential to
the functionality of the delivered product exist, revenue is
deferred until such undelivered products or services are
delivered,
- when final acceptance of the product is specified by the
customer, revenue is deferred until the acceptance criteria
have been met, or
- when trade-in rights are granted at the time of sale, a
portion of the sale is treated as a guarantee and is deferred
until the trade-in right is exercised or the right expires. In
determining the deferral amount, management estimates the
expected trade-in rate and future value of the product upon
trade-in. These factors are periodically reviewed and updated
by management, and the updates may result in either an
increase or decrease in the deferral. Such deferrals have been
immaterial to date. Actual results could materially differ
from the estimates made by management. See the discussion
related to FIN 45 in Note 2 of the Notes to the Consolidated
Financial Statements.
ARRIS' Cadant C4 CMTS is, by design, an upgradeable product. We currently are
developing a DOCSIS 2.0 module for this product, which customers can interchange
for a DOCSIS 1.1 module. We anticipate that as part of some arrangements, where
price, quantity and other terms support it, customers may be granted trade-in
rights if the customers choose to move from DOCSIS 1.1 to DOCSIS 2.0 modules. If
granted, a portion of the future sales of DOCSIS 1.1 modules will likely be
deferred, in accordance with FIN 45, applying the deferral methodology described
above in the description relating to trade-in rights. It is possible that other
trade-in rights may also be granted in the future.
Sales of services are recognized at the time of performance. ARRIS resells
software developed by outside third parties as well as internally developed
software. Software sold by ARRIS does not require significant production,
18
modification or customization. Software revenue is generally recognized when
shipment is made, no significant vendor obligations remain and collection is
considered reasonable assured.
OVERVIEW
Set forth below is a description of how our business performed during the three
and nine-month periods ending September 30, 2003 as compared to the same periods
in 2002. During the past two years, we have significantly changed our business
through product portfolio actions and cost reduction actions, allowing us to
focus on our long-term business strategy. As a result of our acquisitions and
dispositions, our business has changed significantly and our historical results
of operations are not as indicative of future results of operations as they
otherwise might suggest.
CAPITAL STRUCTURE ACTIONS
Notes due 2008. On March 18, 2003, we issued $125.0 million of 4 1/2%
convertible subordinated notes due March 15, 2008. These notes are convertible
at the option of the holder into our common stock at $5.00 per share, subject to
adjustment. We are entitled to call the notes for redemption at any time,
subject to our making a "make whole" payment if we call them for redemption
prior to March 15, 2006. In addition, we are required to repurchase the notes in
the event of a "change in control."
We used approximately $88.4 million of the proceeds, including the reduction in
the forgiveness of the Class B membership interest, of the notes issuance to
redeem the entire Class B membership interest in Arris Interactive held by
Nortel Networks. We used approximately $28.0 million of the proceeds of the
issuance to repurchase and retire 8 million shares of our common stock held by
Nortel Networks at a discount.
Credit Facility. On several occasions during 2002 we modified our credit
facility in order to allow us to use existing cash reserves and proceeds of
asset sales to purchase or redeem our outstanding 4 1/2% convertible
subordinated notes due 2003. These modifications imposed certain conditions on
the use of such cash to purchase or redeem additional notes. In March 2003, we
amended the credit facility to permit us to issue up to $125.0 million of new
convertible subordinated notes due 2008 and to use the proceeds of the new notes
to redeem the Class B membership interest in Arris Interactive held by Nortel
Networks and to purchase shares of our common stock held by Nortel Networks,
subject to certain limitations. The amendment also reduced the revolving loan
commitments to $115.0 million. The Credit Facility was amended in January 2003
to provide that the minimum net worth covenant applied only to the period prior
to December 31, 2002. The Credit Facility was further amended in August 2003 to
reduce the aggregate revolving loan commitments to $92.5 million and to waive
the fixed charge coverage ratio for the third and fourth quarters of 2003. In
conjunction with obtaining the waiver, the financial covenants were expanded to
include EBITDA covenants for the third and fourth quarters of 2003. The EBITDA
covenant for the third quarter 2003 was met and the Company anticipates meeting
the covenant in the fourth quarter.
Membership Interest. In connection with the acquisition of Arris Interactive in
August 2001, Nortel Networks exchanged its remaining ownership interest in Arris
Interactive for 37 million shares of our common stock and a subordinated
redeemable Class B membership interest in Arris Interactive with a face amount
of $100.0 million. The Class B membership interest earned an accreting non-cash
return of 10% per annum, compounded annually, and was redeemable in
approximately four quarterly installments commencing February 3, 2002, provided
that certain availability and other tests are met under our revolving credit
facility. Those tests were not met. The balance of the Class B membership
interest as of December 31, 2002 was approximately $114.5 million. In June 2002,
we entered into an option agreement with Nortel Networks that permitted us to
redeem the Class B membership interest in Arris Interactive at a discount of 21%
prior to June 30, 2003. To further induce us to redeem the Class B membership
interest, Nortel Networks offered to forgive an additional $5.9 million of the
amount owed Nortel Networks if we redeemed it prior to March 31, 2003. We used
approximately $88.4 million of the proceeds of the March 2003 convertible note
offering to redeem the entire Class B membership interest.
Notes due 2003. In May 1998, we issued $115.0 million of 4 1/2% convertible
subordinated notes due May 15, 2003. In 2002, we retired $91.1 million of these
notes through cash repurchases and exchanges for our common stock. During the
first quarter 2003, we repurchased an additional $12.4 million of the notes, and
repurchased the remaining $11.5 million of the notes during the second quarter
2003 on the maturity date on May 15, 2003.
19
Common Stock. Of the 37 million shares of our common stock that Nortel Networks
received in 2001, it sold 15 million in a registered public offering in June
2002. In order to reduce its holdings further, in March 2003 Nortel Networks
granted us an option to purchase up to 16 million shares at a 10% discount to
market, subject to a minimum purchase price of $3.50 per share for 8 million
shares and $4.00 per share for the remainder. In addition, to the extent that we
purchased shares at a price of less than $4.00 per share, we were obligated to
return to Nortel Networks a portion of the return that was forgiven with respect
to the Class B membership interest, up to a maximum of $2.0 million. Pursuant to
this option, on March 24, 2003, we purchased 8 million shares for an aggregate
purchase price of $28.0 million. Contemporaneously with this transaction, we
paid Nortel Networks $2.0 million, which represented the reduction in the
forgiveness of the Class B membership interest. We did not exercise the option
to repurchase the remaining 8 million shares offered by Nortel Networks, which
expired on June 30, 2003. On July 25, 2003, we filed a registration statement
with the Securities and Exchange Commission on Form S-3 related to the
registration for resale of the remaining 14 million shares of ARRIS common stock
held by Nortel Networks. Pursuant to this registration statement, Nortel
Networks, over the next two years, may sell up to 14 million shares of the
Company's common stock in one or more offerings.
PRODUCT PORTFOLIO ACTIONS
Acquisition of Certain Assets of Com21. On August 13, 2003, we completed the
acquisition of certain cable modem termination system (CMTS) related assets of
Com21, including the stock of its Irish subsidiary. Under the terms of the
agreement, we obtained accounts receivable, inventory, fixed assets, other
current prepaid assets, and existing technology in exchange for approximately
$2.4 million of cash, of which $2.2 million has been paid, and the assumption of
approximately $0.6 million in liabilities. We retained $0.2 million of the cash
consideration for any liabilities we may be required to pay resulting from Com21
activity prior to the acquisition date. We also incurred approximately $0.2
million of legal and professional fees associated with the transaction. We
retained approximately 50 Com21 employees. We completed this acquisition because
we believe that the newly acquired product line, along with the existing product
offerings of ARRIS, will allow us to reach smaller scale cable systems
domestically and internationally. We anticipate the transaction to be slightly
dilutive to our earnings in 2003.
Acquisition of Atoga Systems. On March 21, 2003, we purchased the business and
certain assets of Atoga Systems, a Fremont, California-based developer of
optical transport systems for metropolitan area networks. Under the terms of the
agreement, we obtained certain inventory, fixed assets, and intellectual
property in consideration for approximately $0.4 million of cash and the
assumption of certain obligations. Further, we retained 28 employees and issued
a total of 500,000 shares of restricted stock to those employees. The value of
the restricted stock will be recognized as compensation expense over the related
vesting period. We anticipate the transaction to be slightly dilutive to our
earnings in 2003.
Acquisition of Cadant, Inc. On January 8, 2002, we acquired substantially all of
the assets of Cadant, Inc., a designer and manufacturer of next generation CMTS.
Under the terms of the transaction, we issued 5.25 million shares of our common
stock and assumed approximately $14.9 million in liabilities in exchange for the
assets. During the second quarter of 2003, 64,350 shares of ARRIS common stock
were returned to ARRIS and retired in a settlement of claims by ARRIS against
the trustee in the liquidation of CDX Corporation (formerly known as Cadant).
Also in connection with the acquisition, we issued options to purchase 2.0
million shares of our common stock and 250,000 shares of restricted stock to
Cadant employees. We also agreed to issue up to 2.0 million additional shares of
our common stock based upon the achievement of future sales targets through
January 2003 for the CMTS product, which were not met.
Sale of ESP Consulting Services Product Line. On August 18, 2003, we sold our
engineering consulting services product line, known as ESP, to an unrelated
third party. The agreement involved the transfer of net assets of approximately
$1.3 million, which included accounts receivable, fixed assets, an investment,
and other assets attributable to the product line. Further, the transaction
provided for the transfer of approximately 30 employees. Additionally, we
incurred approximately $0.1 million of related closure costs, primarily legal
and professional fees associated with the closing. We recognized a loss on the
transaction of approximately $1.4 million during the third quarter 2003. The ESP
product line contributed revenue of approximately $0.2 million and $1.3 million
during the three and nine-month periods ended September 30, 2003, respectively,
and revenue of $0.7 million and $2.5 million during the three and nine-month
periods ended September 30, 2002, respectively. The ESP revenue is classified in
the supplies product category. In accordance with the provisions of SFAS No.
144, Accounting for the Impairment
20
of Disposal of Long-Lived Assets, ESP is not reflected as a discontinued
operation because it was determined to be an insignificant component of the
Company's consolidated operations and assets.
Sale of Actives Product Line. On November 21, 2002, we sold our Actives product
line, excluding receivables and payables, for $31.8 million in net proceeds. The
agreement provided for the transfer of inventory and equipment attributable to
the product lines, plus the transfer of approximately 34 employees. Total assets
of approximately $20.3 million were disposed of, which included inventory, fixed
assets, and other assets attributable to the product line. Additionally, we
incurred approximately $7.3 million of related closure costs, including
severance, vendor liabilities, professional fees, and other shutdown expenses.
In connection with the sale, the Company recognized a gain of approximately $2.2
million in 2002. During the second quarter of 2003, the Company has reduced its
accrual for vendor liabilities by $2.0 million as a result of settling for
amounts less than originally anticipated. With this adjustment in the second
quarter, the Company has now recognized a cumulative gain of approximately $4.2
million related to the sale of this discontinued operation.
Sale of Keptel Product Line. On April 24, 2002, we sold our Keptel product line.
Keptel designed and marketed network interface systems and fiber optic cable
management products primarily for traditional telecommunications residential and
commercial applications. The transaction generated cash proceeds of $30.0
million. Additionally, we retained a potential earnout over a twenty-four month
period based on sales achievements. The transaction also included a distribution
agreement whereby we will continue to distribute Keptel products. Total assets
of approximately $31.1 million were disposed of, which included inventory, fixed
assets, intangibles (formerly classified as goodwill), and other assets. We
incurred approximately $5.0 million of related closure costs, including
severance, vendor liabilities, outside consulting fees, and other shutdown
expenses. The net result of the transaction was a loss on the sale of the
product line of approximately $6.1 million.
COST REDUCTION ACTIONS
During 2001 and 2002, we implemented significant cost reduction actions. In the
third quarter of 2001, we concluded that it would be more cost effective to
outsource manufacturing of our Actives and Keptel product lines. This resulted
in the closure of four factories in Juarez, Mexico and El Paso, Texas. In
conjunction with the purchase of Cadant, we closed our facility in Raleigh,
North Carolina. The Raleigh location was a development facility where
duplicative work to that being done by the Cadant organization was being
performed. In 2001 and 2002, we continuously reviewed our cost structure with
the goal of improving both our effectiveness and efficiency of operations. As a
result, in October 2002, we announced the closure of our development and repair
facility in Andover, Massachusetts and implemented other expense reduction
actions including general reductions in force. These actions were, in part,
facilitated by the simplification of our business model as a result of the
closure of factories and product line rationalizations.
During the first three quarters of 2003, we undertook actions to further reduce
our breakeven point. This included a reduction in workforce of a total of
approximately 125 employees, as well as other cost saving measures.
INDUSTRY CONDITIONS
Our performance is largely dependent on capital spending for constructing,
rebuilding, maintaining and upgrading broadband communications systems. After a
period of intense consolidation and rapid capital expenditures within the
industry through the fourth quarter of 2000, there was a tightening of credit
availability throughout the telecommunications industry and a broad-based and
severe drop in market capitalization for the sector. This caused broadband
system operators to become more cautious in their capital spending, adversely
affecting us and other equipment providers.
Developments in the industry and in the capital markets over the past several
years have reduced access to funding for new and existing customers, causing
delays in the timing and scale of deployments of our equipment, as well as the
postponement or cancellation of certain projects by our customers. In addition,
during the same period, we and other vendors received notification that several
customers were canceling new projects or scaling back existing projects or
delaying new orders to allow them to reduce inventory levels which were in
excess of their current deployment requirements.
21
This industry downturn and other factors have adversely affected several of our
largest customers. In September 2002, Adelphia Communications filed bankruptcy
at a time when it owed us approximately $20.2 million in accounts receivable. As
a result, we incurred a $20.2 million charge during the second quarter 2002, of
which approximately $18.9 million was reflected in continuing operations and
$1.3 million was reflected in discontinued operations.
As of November 12, 2003, Cabovisao, a Portugal-based customer owed us
approximately 18.1 million euros in accounts receivable, after receiving a
payment of approximately 0.6 million euros on August 7, 2003. A substantial
portion of the accounts receivable balance is past due. This customer accounted
for approximately 6% of our sales in 2002. Cabovisao and its parent company,
Csii, are in the process of restructuring their financing. On June 30, 2003,
Csii filed for court-supervised restructuring and recapitalization in Canada. We
are continuing to monitor the progress of the financing efforts by Cabovisao and
we are actively negotiating the settlement of the past due amount. ARRIS added
approximately $6.4 million in incremental reserves for the Cabovisao receivable
in the second quarter of 2003.
In the fourth quarter of 2002 Comcast completed its purchase of AT&T Broadband.
Historically, AT&T Broadband had been our largest customer. AT&T Broadband, with
the deployment of telephony as part of its core strategy, had been using our CBR
telephony products in many of its major markets. Comcast had announced that its
initial priority after its acquisition of AT&T Broadband was to emphasize video
and high-speed data operations and focus on improving the profitability of its
telephony operations rather than subscriber growth. As a result, we experienced
a significant decline in sales of our constant bit rate, or CBR, telephony
product to Comcast beginning in the fourth quarter of 2002 and continuing
through 2003. However, this decline has been partially offset by an increase in
CMTS C4 sales to Comcast.
SIGNIFICANT CUSTOMERS
A significant portion of ARRIS' revenue is derived from sales to Comcast and Cox
Communications. Sales to these two customers for the three and nine-month
periods ended September 30, 2003 and 2002 were as follows (in thousands):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2003 2002 2003 2002
---- ---- ---- ----
Comcast.................. $35,809 $89,548 $95,540 $215,240
% of sales............... 31.7% 49.6% 31.2% 40.7%
Cox Communications....... $29,801 $23,647 $74,748 $ 76,627
% of sales............... 26.3% 13.1% 24.4% 14.5%
As described above, we have uncertainties surrounding our future transactions
with Adelphia Communications and Cabovisao. Sales to these two customers for the
three and nine-month periods ended September 30, 2003 and 2002 were as follows
(in thousands):
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- -------------------------------
2003 2002 2003 2002
---- ---- ---- ----
Adelphia Communications..... $4,109 $ 796 $10,875 $22,253
% of sales.................. 3.6% 0.4% 3.6% 4.2%
Cabovisao................... $ 107 $8,287 $ 617 $36,024
% of sales.................. 0.1% 4.6% 0.2% 6.8%
COMPARISON OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003
AND 2002
As the sale of our Actives and Keptel product lines in 2002 represented a
majority of the transmission, optical and outside plant product category, we
reclassified the results of these product lines to discontinued operations for
all periods presented in accordance with Statement of Financial Accounting
Standards No. 144, Accounting for the
22
Impairment or Disposal of Long-Lived Assets. Our products and services are
summarized in the following two product categories, broadband and supplies,
instead of the previous three categories. The balance of the product lines
previously reported in the former transmission, optical and outside plant
product category have been combined with our supplies product category. All
prior period amounts have been reclassified to conform to the new product
categories.
Net Sales. Our sales for the third quarter 2003 decreased by 37.4% to $113.1
million as compared to the third quarter 2002 sales, but increased 11.2%
sequentially from the sales recorded in the second quarter 2003. For the
nine-month periods ended September 30, 2003 and 2002, net sales were $306.2
million and $529.5 million, respectively, a decrease of 42.2% year-over-year.
- - Broadband product revenues decreased by $57.3 million or 43.3%, to
$75.1 million in the third quarter 2003 as compared to the same quarter
last year, but marked an increase of $8.6 million or 12.9%, from the
previous quarter's sales of $66.5 million. The revenue growth in the
third quarter 2003, as compared to the previous quarter, was primarily
the result of increased sales to Cox Communications of our CBR
telephony product line. Revenues for the first nine months of 2003
decreased approximately $167.4 million or 45.2%, to $203.2 million as
compared to the same period in 2002. The significant decrease in
broadband product revenue in 2003 as compared to 2002 is the result of
several factors:
- Sales to Comcast for constant bit rate ("CBR")
telephony products declined by approximately $156.0
million. AT&T Broadband had been our largest customer
of CBR telephony products. In the fourth quarter
2002, Comcast completed its purchase of AT&T
Broadband. Comcast had announced that its initial
priority after its acquisition of AT&T Broadband
would be to emphasize video and high-speed data
operations and focus on improving the profitability
of its telephony operations rather than subscriber
growth. As a result, our sales of CBR products to
Comcast have decreased significantly in 2003. This
decline has been partially offset by an increase in
CMTS C4 sales to Comcast.
- Broadband product revenue internationally declined by
$65.6 million during the first nine months of 2003,
as compared to the same period in 2002. A significant
portion of this decline is attributable to the
reduced purchases by Cabovisao, which accounted for
approximately $36.0 million in broadband
international revenue for the first nine months of
2002.
- - Supplies product revenues decreased by approximately $10.1 million or
21.1%, to $38.1 million in the third quarter 2003 as compared to
revenues of $48.2 million in the same quarter last year; however, third
quarter 2003 marked an increase of $2.9 million or 8.2%, from the
previous quarter's sales. The sequential quarter-over-quarter growth
was predominantly due to the increase of cable modem sales during the
third quarter 2003. Revenues for the first nine months of 2003
decreased $55.9 million or 35.2%, to $102.9 million as compared to the
first nine months of 2002. The year-over-year decrease for the first
nine months of the year in supplies product revenue is the result of
several factors:
- Sales of power supplies related to CBR products
declined as a direct result of the significant
decrease in Comcast's purchases of telephony
products, as described above. Consolidated power
supply revenue for the first nine months of 2003 was
$0.2 million, as compared to revenue of $15.2 million
for the same period in 2002.
- Revenues have been significantly impacted by the
decline in shipments to Adelphia, which filed for
bankruptcy during the second quarter of 2002. The
bankruptcy filing by Adelphia and the resulting
reduced sales to Adelphia accounted for approximately
$7.9 million of the overall decrease in supplies
product revenue year-over-year.
- A general slowdown in MSO's infrastructure spending
contributed to the remaining decrease in supplies
revenue year-over-year.
International sales decreased by approximately $16.5 million or 48.5%, to $17.5
million for the three months ended September 30, 2003 as compared to the same
quarter in 2002, and marked a decrease of $0.3 million or 1.7%, when compared to
the previous quarter's international sales. International sales for the nine
months ended September 30, 2003 decreased $67.0 million or 55.4%, to $54.0
million as compared to sales recorded during the same period in 2002. The
reduced level of international business is reflective of the tight capital
spending market, coupled with the
23
situation with Cabovisao, as previously discussed. Cabovisao accounted for
approximately $36.0 million or 54%, of the decrease in total international
revenues. We have halted shipments to Cabovisao until its restructuring status
is clarified.
Gross Profit. Gross profit decreased by $33.4 million or 51.2%, to $31.8 million
in the third quarter 2003, as compared to the third quarter 2002, but marked an
increase of $4.6 million or 17.1% sequentially over the previous quarter. Gross
profit margins for the quarter ended September 30, 2003 decreased approximately
7.9 percentage points to 28.2% as compared to the same quarter of 2002. Gross
profit for the nine months ended September 30, 2003 was 27.4%, as compared to
34.7% for the first nine months 2002. This reduction in gross margin reflects
two primary factors:
- The reduction in sales volume of approximately $223.3
million during the first nine months of 2003, as
compared to the same period in 2002, provided a lower
base to cover our fixed costs leading to a reduction
in our gross margin percentage.
- Our gross margin within the broadband product
category declined as a result of a shift in product
mix. Specifically, we sold less constant bit rate
telephony equipment in 2003 as compared to 2002.
During the first nine months of 2003, we recorded severance charges of $0.4
million, as compared to severance of $1.0 million recorded during the same
period in 2002. Also impacting gross margins during 2002 was a charge of $2.1
million to write off the balance of the power product line inventory. This
product line was sold in late 2001.
Selling, General and Administrative and Development ("SGA&D") Expenses. SGA&D
expenses decreased by approximately $11.0 million or 24.0% to $35.1 million
during the third quarter 2003 as compared to the third quarter 2002. SGA&D
expenses for the nine months ended September 30, 2003 decreased by $45.6 million
or 28.2%, to $116.0 million, as compared to the same period in 2002. This
significant decrease in SGA&D expenses for the first nine months of the year is
the result of several factors:
- Expenses related to our provision for doubtful
accounts decreased by approximately $14.9 million for
the nine months ended September 30, 2003, as compared
to 2002. This decrease was primarily due to the
reserve of $14.9 million recorded for our Adelphia
accounts receivable in 2002.
- The elimination of the Nortel Networks' agency fee in
2003 accounted for approximately $10.6 million of the
year-over-year decrease. The agreement with Nortel
Networks for international agency fees terminated in
December 2002.
- The remaining decrease of approximately $20.1 million
was a result of the overall reduced employee levels,
the closure of our Andover facility, and aggressive
operating expense management. Further, the first nine
months of 2003 reflects a reduction in bonus accruals
as compared to the same period in 2002.
Restructuring and Impairment Charges. In the first quarter of 2003, we evaluated
the restructuring accruals related to previously closed facilities within our
broadband product category. Upon review, we recorded an additional restructuring
charge of $0.3 million during the first quarter as a result of a change to the
initial estimates used. During the first nine months of 2002, no restructuring
charges were recorded related to continuing operations.
Amortization of Intangibles. Intangibles amortization expense for the
three-month periods ended September 30, 2003 and 2002 was $8.8 million and $8.7
million, respectively. Intangibles amortization expense for the year-to-date
periods ended September 30, 2003 and 2002 was $26.3 million and $25.8 million,
respectively. The majority of our intangibles represent existing technology
acquired as a result of the Arris Interactive L.L.C. acquisition in the third
quarter 2001, the Cadant, Inc. acquisition in the first quarter 2002, the Atoga
Systems' acquisition in the first quarter 2003, and the Com21 acquisition in the
third quarter 2003.
Interest Expense. Interest expense for the quarters ended September 30, 2003 and
2002 was $2.9 million and $2.1 million, respectively. Interest expense for the
first nine months of 2003 was $7.5 million, as compared to $6.5 million recorded
during the same period in 2002. Interest expense for all periods reflects the
cost of borrowings on our revolving line of credit, amortization of deferred
finance fees, and the interest paid on our convertible
24
subordinated notes and capital leases. As of September 30, 2003 and 2002, we did
not have a balance outstanding under our credit facility.
Membership Interest Expense. In conjunction with the acquisition of Arris
Interactive L.L.C., we issued to Nortel Networks a subordinated redeemable Class
B membership interest in Arris Interactive with a face amount of $100.0 million.
This membership interest earned a return of 10% per annum, compounded annually.
During the first quarter 2003, we redeemed the entire Class B membership
interest in Arris Interactive held by Nortel Networks, at a discount, and,
therefore, the membership interest ceased. For the three-month periods ended
September 30, 2003 and 2002, we recorded membership interest expense of $0 and
$2.7 million, respectively. For the nine-month periods ended September 30, 2003
and 2002, we recorded membership interest expense of $2.4 million and $7.7
million, respectively.
Gain on Debt Retirement. During the first quarter 2003, ARRIS redeemed the
entire Class B membership interest in Arris Interactive held by Nortel Networks
for approximately $88.4 million. This discounted redemption resulted in a gain
of approximately $28.5 million during the first quarter of 2003.
During the second quarter 2002, we exchanged 1,593,789 shares of our common
stock for approximately $15.4 million of the convertible subordinated notes due
2003. The exchanges were recorded in accordance with SFAS No. 84, Induced
Conversions of Convertible Debt, which requires the recognition of an expense
equal to the fair value of additional shares of common stock issued in excess of
the number of shares that would have been issued upon conversion under the
original terms of the notes. As a result, in connection with these exchanges, we
recorded a non-cash loss of approximately $8.7 million, based upon a weighted
average common stock value of $9.10 (as compared with a common stock value of
$24.00 per share in the original conversion ratio for the notes). In connection
with the exchanges, we also incurred associated fees of $0.6 million, resulting
in an overall net loss of $9.3 million.
Loss on Investments. We held certain investments in the common stock of publicly
traded companies totaling approximately $0.1 million at September 30, 2002 which
were classified as trading securities; the shares of common stock were sold
during the third quarter 2003 and the balance was $0 at September 30, 2003.
Changes in the market value of these securities and gains or losses on related
sales of these securities were recognized in income and resulted in net pre-tax
loss of approximately $7 thousand and $83 thousand during the third quarter 2003
and 2002, respectively. During the nine months ended September 30, 2003, we
recognized a pre-tax gain of $0.1 million as compared to a pre-tax loss of $0.7
million during the same period of 2002.
We hold certain investments in the common stock of publicly traded companies
totaling approximately $1.4 million at both September 30, 2003 and 2002, which
are classified as available for sale. Changes in the market value of these
securities are recorded in other comprehensive income. These securities are also
subject to a periodic impairment review, which requires significant judgment.
In addition, we hold a number of non-marketable equity securities totaling
approximately $1.0 million and $11.0 million at September 30, 2003 and 2002,
respectively, which are classified as available for sale. Pursuant to the terms
of the definitive agreement of the ESP divestiture, an investment totaling
approximately $0.8 million was transferred to the buyer. The non-marketable
equity securities are subject to a periodic impairment review, which requires
significant judgment as there are no open-market valuations. During the second
quarter 2003, we recorded a charge of approximately $1.1 million in relation to
the impairment of the carrying value of an investment in a start-up company,
which raised a new round of financing at a substantial discount in early July
2003. During the second quarter 2002, we wrote off a $1.0 million investment in
a technology start-up company, as it was unable to raise further financing and
filed for bankruptcy during the second quarter 2002.
Gain in Foreign Currency. During the third quarter 2003, we recorded a foreign
currency gain of approximately $0.2 million, as compared to a foreign currency
gain of $0.3 million for the third quarter 2002. The first nine months of 2003
included a foreign currency gain of approximately $2.2 million, as compared to a
gain of $4.2 million for the first nine months of 2002. The foreign currency
gains are primarily driven by the fluctuation of the value of the euro, as
compared to the U.S. dollar, as we have several European customers whose
receivables and collections are denominated in euros.
25
Other Expense (Income). Other expense (income) for the three-month periods ended
September 30, 2003 and 2002 was $(0.1) million and $0.1 million, respectively.
Other expense (income) for the nine-month periods ended September 30, 2003 and
2002 was $(0.2) million and $0.3 million, respectively. The other expense
(income) for all periods was primarily related to interest income and bank
charges.
Income Tax (Benefit) Expense. During the first quarter 2002, we recorded an
income tax benefit of $6.8 million as a result of a change in tax legislation,
allowing us to carry back losses for five years versus the previous limit of two
years. As we are in a cumulative loss position for tax purposes, we did not
incur income tax expense (benefit) during the subsequent periods.
Discontinued Operations. In 2002, ARRIS sold the Keptel and Actives product
lines, which have been accounted for as discontinued operations in accordance
with Statement of Financial Accounting Standards ("SFAS") No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. As a result, these two
product lines and historical results have been reclassified accordingly for all
periods presented. Revenues from the discontinued operations were $17.0 million
and $53.8 million, respectively, for the three and nine-month periods ended
September 30, 2002. The net loss from discontinued operations, net of taxes, for
the three and nine-month periods ended September 30, 2002 was $(1.4) million and
$(20.5) million, respectively.
Cumulative Effect of an Accounting Change - Goodwill. We adopted SFAS No. 142,
Goodwill and Other Intangible Assets, on January 1, 2002. Under the transitional
provisions of SFAS No. 142, we recorded a goodwill impairment loss of
approximately $(58.0) million. The impairment loss has been recorded as a
cumulative effect of a change in accounting principle on the accompanying
Consolidated Statement of Operations for the nine months ended September 30,
2002.
LIQUIDITY AND CAPITAL RESOURCES
Financing
We have in place an asset-based revolving credit facility permitting us to
borrow up to $92.5 million (which can be increased under certain conditions by
up to $25.0 million), based upon availability under a borrowing base
calculation. In general, the borrowing base is limited to 85% of net eligible
receivables (with a cap of $5.0 million in relation to foreign receivables),
subject to a reserve of $10.0 million. In addition, upon obtaining appropriate
asset appraisals, we may include in the borrowing base calculation 80% of the
orderly liquidation value of net eligible inventory (not to exceed $60.0
million). The facility contains traditional financial covenants, including fixed
charge coverage, senior debt leverage, minimum net worth, and minimum inventory
turns ratios. The facility is secured by substantially all of our assets. The
credit facility has a maturity date of August 3, 2004. The commitment fee on
unused borrowings is 0.75%.
The credit facility was amended in January 2003 to provide that the minimum net
worth covenant applied only to the period prior to December 31, 2002. In March
2003, we amended our credit facility to permit us to issue up to $125.0 million
of the Notes due 2008, to use the proceeds of such notes as described above. The
amendment also reduced the revolving loan commitments by $10.0 million to $115.0
million. The credit facility was further amended in August 2003 to reduce the
aggregate revolving loan commitments to $92.5 million and to waive the fixed
charge coverage ratio for the third and fourth quarters of 2003. In conjunction
with obtaining the waiver, the financial covenants were expanded to include
EBITDA covenants for the third and fourth quarters of 2003. The EBITDA covenant
for the third quarter 2003 was met and we anticipate meeting the covenant in the
fourth quarter.
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As of September 30, 2003, we had no borrowings outstanding under our credit
facility (and have not had any outstanding balances under the facility for the
past eight quarters), and had approximately $7.0 million outstanding under
letters of credit. We had approximately $47.1 million of available capacity. We
were in compliance with all covenants mandated by the credit facility,
including:
Requirement Level at September 30, 2003
-------------- ---------------------------
Maximum senior leverage ratio 1.25 -0-
Minimum fixed charge coverage ratio (1) N/A N/A
Minimum inventory turns 2.3 3.1
Maximum capital expenditures (annual) $ 30.0 million $4.2 million
Minimum EBITDA (2) $(3.0) million $2.3 million
(1) Obtained waiver for third and fourth quarters of 2003. The requirement
beginning with the first quarter 2004 will be a minimum ratio of 1.5.
(2) Applicable only to the third and fourth quarters of 2003. The
requirement for the fourth quarter 2003 is a minimum of $3.0 million.
Cash Flow
Operating activities used cash of $12.1 million during the first nine months of
2003. A net loss used $(38.9) million in cash flow during 2003. Other non-cash
items such as depreciation, amortization, provisions for doubtful accounts, a
loss on disposal of fixed assets, a loss on disposal of product line, and a loss
on investments accounted for positive adjustments of approximately $55.6 million
during 2003. A gain on the retirement of debt and a gain on the sale of a
discontinued product line accounted for adjustments to net income of $(30.5)
million. A net decrease of $1.8 million in operating assets and liabilities was
primarily comprised of decreases in accounts receivable and inventory, which
were offset with a decrease in accounts payable and accrued liabilities.
Operating activities provided cash of approximately $66.1 million during the
first nine months of 2002. A net loss used $(97.1) million in cash flow during
this period. Other non-cash items such as depreciation, amortization, provisions
for doubtful accounts, losses on investments, a loss on debt retirement, a loss
on the sale of a discontinued product line, and cumulative effect of an
accounting changes accounted for positive adjustments of approximately $150.4
million during the first nine months of 2002. A net decrease of $12.8 million in
operating assets and liabilities was primarily comprised of decreases in other
receivables and inventory, which were offset with an increase in accounts
receivable and a decrease in accounts payable and accrued liabilities. We
continue to have a strong focus on working capital management, particularly in
the areas of accounts receivable and inventory. Our days sales outstanding
improved from 65 days to 47 days from the third quarter 2002 to the third
quarter 2003. Our inventory levels decreased by approximately $9.0 million to
$95.0 million from the third quarter 2002 to third quarter 2003.
Cash flows used by investing activities were approximately $5.4 million for the
nine months ended September 30, 2003 as compared to cash flows provided of $22.6
million during the same period in 2002. The investments made during 2003
included $4.2 million related to capital expenditures, approximately $2.8
million related to the Atoga Systems' and Com21 acquisitions, and $0.2 million
of costs associated with the disposal of our ESP product line. These
expenditures were partially offset with the final proceeds of $1.8 million
related to the sale of the Actives product line. The investments during 2002
included $6.5 million spent on capital assets and approximately $0.9 million for
fees related to the Cadant acquisition, offset with proceeds of $30.0 million
related to the sale of the Keptel product line.
Cash flows used in financing activities were $20.9 million for the first nine
months of 2003. Proceeds from the issuance of debt provided $126.6 million in
cash, and proceeds from the issuance of common stock provided $1.2 million.
These cash inflows were offset with a cash use of approximately $88.4 million to
redeem the Nortel Networks membership interest, $28.0 million used to repurchase
and retire 8 million shares of common stock held by Nortel Networks, and $24.3
million used for payments on debt obligations. Other uses of cash included
payments on capital lease obligations and deferred financing activities of $2.1
million and $5.8 million, respectively. Cash flows in financing activities for
the first nine months of 2002 were relatively flat, with proceeds from issuance
of common stock of approximately $1.0 million offset by capital lease payments
and deferred finance fees paid of $0.7 million and $0.3 million, respectively.
27
Based upon current levels of operations, we expect that sufficient cash flow
will be generated from operations so that, combined with cash on hand and other
financing alternatives available, including bank credit facilities, we will be
able to meet all of our current debt service, capital expenditure and working
capital requirements.
Foreign Currency
A significant portion of our products are manufactured or assembled in Mexico,
the Philippines, and other countries outside the United States. 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.
Beginning in 2002, we implemented a hedging strategy to mitigate the monetary
exchange fluctuations from the time of invoice to the time of payment, and have
entered into forward contracts based on a percentage of expected foreign
currency receipts. The percentage can vary, based on the predictability of cash
receipts. We regularly review our accounts receivable in foreign currency and
purchase additional forward contracts when appropriate. As of September 30,
2003, we did not have any forward contracts outstanding. During the second
quarter 2003, we purchased a 5.0 million euro put contract with an expiration of
October 31, 2003. The contract was purchased as part of our internal hedging
strategy to reduce the risk associated with our euro receivables. The contract
was purchased for approximately $174 thousand and the cumulative fair value
adjustment as of September 30, 2003 was a loss of approximately $139 thousand
which is included in the loss in foreign currency in the Consolidated Statements
of Operations.
Financial Instruments
In the ordinary course of business, we, from time to time, will enter into
financing arrangements with our vendors and customers. These financial
instruments 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. As of September 30, 2003, we had approximately $7.0 million outstanding
under letters of credit with our banks.
Investments
In the ordinary course of business, we may make strategic investments in the
equity securities of various companies, both public and private. We held certain
investments in the common stock of publicly traded companies, which were
classified as trading securities; the shares of common stock were sold during
the third quarter 2003 and the balance was $0 at September 30, 2003. Changes in
the market value of these securities and gains or losses on related sales of
these securities were recognized in income and resulted in net pre-tax losses of
approximately $7 thousand and $83 thousand during the third quarter 2003 and
2002, respectively. During the nine months ended September 30, 2003, we
recognized a pre-tax loss of $0.1 million as compared to a pre-tax loss of $0.7
million during the same period of 2002.
We hold certain additional investments in the common stock of publicly traded
companies totaling approximately $1.4 million at September 30, 2003, which are
classified as available for sale. In addition, we hold a number of
non-marketable equity securities totaling approximately $1.0 million, which are
classified as available for sale. At September 30, 2003, we had unrealized
losses related to these available for sale securities of approximately $0.3
million included in comprehensive income.
We offer a deferred compensation arrangement, which allows certain employees to
defer a portion of their earnings and defer the related income taxes. These
deferred earnings are invested in a "rabbi trust," and are accounted for in
accordance with Emerging Issues Task Force 97-14, Accounting for Deferred
Compensation Arrangements Where Amounts Earned Are Held in a Rabbi Trust and
Invested. A rabbi trust is a funding vehicle used to protect deferred
compensation benefits from events (other than bankruptcy). The investment in the
rabbi trust is classified as a current asset on our balance sheet. At September
30, 2003, we had a cumulative unrealized gain related to the rabbi trust of
approximately $0.5 million included in comprehensive income.
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Capital Expenditures
Capital expenditures are made at a level designed to support the strategic and
operating needs of the business. ARRIS' capital expenditures were $1.6 million
and $4.2 million for the three and nine months, respectively, ended September
30, 2003, as compared to $2.9 million and $6.5 million for the same periods in
2002. We had no significant commitments for capital expenditures at September
30, 2003. Management expects to invest approximately $6.0 million in capital
expenditures for the year 2003.
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. In this report,
these statements include, among others, statements regarding the impact of
acquisitions and divestitures, future amounts of capital expenditures, and
estimates of contractual commitments. 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 below. 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.
RISK FACTORS
OUR BUSINESS IS DEPENDENT ON CUSTOMERS' CAPITAL SPENDING ON BROADBAND
COMMUNICATION SYSTEMS, AND REDUCTIONS BY CUSTOMERS IN CAPITAL SPENDING COULD
ADVERSELY AFFECT OUR BUSINESS.
Our performance has been largely dependent on customers' capital spending for
constructing, rebuilding, maintaining or upgrading broadband communications
systems. Capital spending in the telecommunications industry is cyclical. A
variety of factors will affect the amount of capital spending, and therefore,
our sales and profits, including:
- general economic conditions;
- availability and cost of capital;
- other demands and opportunities for capital;
- regulations;
- demands for network services;
- competition and technology; and
- real or perceived trends or uncertainties in these factors.
Developments in the industry and in the capital markets over the past two years
have reduced access to funding for new and existing customers, causing delays in
the timing and scale of deployments of our equipment, as well as the
postponement or cancellation of certain projects by our customers. In addition,
during the same period, we and other vendors received notification from several
customers that they were canceling new projects or scaling back existing
projects or delaying new orders to allow them to reduce inventory levels which
were in excess of their current deployment requirements.
29
Further, several of our customers have accumulated significant levels of debt
and have recently announced, or are expected to announce, financial
restructurings, including bankruptcy filings. For example, Adelphia has been
operating under bankruptcy since the September 2002. Even if the financial
health of that company and other customers improve, we cannot assure you that
these customers will be in a position to purchase new equipment at levels we
have seen in the past. In addition, Adelphia's bankruptcy filing has further
heightened concerns in the financial markets about the domestic cable industry.
This concern, coupled with the current uncertainty and volatile capital markets,
has affected the market values of domestic cable operators and may further
restrict their access to capital.
DEVELOPMENTS RELATING TO CABOVISAO MAY ADVERSELY AFFECT OUR BUSINESS AND RESULTS
OF OPERATIONS.
Cabovisao, a Portugal-based MSO, accounted for approximately 6% of our total
sales in 2002. As of November 12, 2003, Cabovisao owed us approximately 18.1
million euros in accounts receivable. Cabovisao and its parent company, Csii,
are in the process of restructuring their financing. On June 30, 2003, Csii
filed for court-supervised restructuring and recapitalization in Canada. We are
continuing to monitor the progress of the financing efforts by Cabovisao and we
are actively negotiating the settlement of the past due amount. ARRIS added
approximately $6.4 million in incremental reserves for the Cabovisao receivable
in the second quarter of 2003. We will not deliver further products to Cabovisao
until we have a satisfactory payment plan with Cabovisao and are considering
what actions should be taken regarding the situation. We cannot assure you that
Cabovisao will pay us according to a schedule, if at all, or that we will make
any sales to Cabovisao in the future.
THE MARKETS IN WHICH WE OPERATE ARE INTENSELY COMPETITIVE, AND COMPETITIVE
PRESSURES MAY ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.
The markets for broadband communication systems are extremely competitive and
dynamic, requiring the companies that compete in these markets to react quickly
and capitalize on change. This will require us to retain skilled and experienced
personnel as well as deploy substantial resources toward meeting the
ever-changing demands of the industry. We compete with national and
international manufacturers, distributors and wholesalers including many
companies larger than us with broader product lines, which may enable them to
bundle more products in customer offerings than us. Our major competitors
include:
- ADC Telecommunications, Inc.;
- Broadband Services, Inc.;
- Cisco Systems, Inc.;
- Motorola, Inc.;
- Riverstone Networks, Inc.;
- Scientific-Atlanta, Inc.;
- Tellabs, Inc.;
- Terayon Communications Systems, Inc.; and
- TVC Communications, Inc.
The rapid technological changes occurring in the broadband markets may lead to
the entry of new competitors, including those with substantially greater
resources than ours. Because the markets in which we compete are characterized
by rapid growth and, in some cases, low barriers to entry, smaller niche market
companies and start-up ventures also may become principal competitors in the
future. Actions by existing competitors and the entry of new competitors may
have an adverse effect on our sales and profitability. The broadband
communications industry is further characterized by rapid technological change.
In the future, technological advances could lead to the obsolescence of some of
our current products, which could have a material adverse effect on our
business.
Further, many of our larger competitors are in a better position to withstand
any significant reduction in capital spending by customers in these markets.
They often have broader product lines and market focus and therefore will not be
as susceptible to downturns in a particular market. In addition, several of our
competitors have been in operation longer than we have been, and therefore they
have more long-standing and established relationships with domestic and foreign
broadband service providers. We may not be able to compete successfully in the
future, and competition may harm our business.
30
OUR BUSINESS HAS PRIMARILY COME FROM SEVERAL KEY CUSTOMERS. THE LOSS OF ONE OF
THESE CUSTOMERS OR A SIGNIFICANT REDUCTION IN SERVICES TO ONE OF THESE CUSTOMERS
WOULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS.
Our two largest customers are Comcast (primarily through the recently acquired
AT&T Broadband business) and Cox Communications. For the nine months ended
September 30, 2003, sales to Comcast accounted for approximately 31.2 % of our
total revenues, while sales to Cox Communications accounted for approximately
24.4%. We currently are the exclusive provider of telephony products for both
Cox Communications and, in eight metro areas, Comcast, as successor to AT&T
Broadband. In addition, we have one other customer who accounted for more than
5% each of our total revenues for the first nine months of 2003. The loss of Cox
Communications, Comcast, or any of our other large customers, or a significant
reduction in the services provided to any of them would have a material adverse
impact on our business. In addition, as a result of the merger of Comcast with
AT&T Broadband in late 2002, we have experienced interruptions in purchasing by
the resulting Comcast entity in 2003. Comcast has announced that its initial
priority after its acquisition of AT&T Broadband will be to emphasize video and
high-speed data operations and focus on improving the profitability of its
telephony operations at the expense of subscriber growth. As a result, we
experienced a significant decline in sales of our CBR telephony product to
Comcast in the fourth quarter of 2002, which has continued into 2003.
OUR CREDIT FACILITY IMPOSES FINANCIAL COVENANTS THAT MAY ADVERSELY AFFECT THE
REALIZATION OF OUR STRATEGIC OBJECTIVES.
We and certain of our subsidiaries have entered into a revolving credit facility
providing for borrowing up to a committed amount of $92.5 million, with
borrowing also limited by a borrowing base determined by reference to eligible
accounts receivable and, subject to certain conditions, eligible inventory. As
of September 30, 2003, the borrowing base was $47.1 million. The credit facility
imposes, among other things, covenants limiting the incurrence of additional
debt and liens and requires us to meet certain financial objectives. The credit
facility has a maturity date of August 3, 2004. As of November 12, 2003, we had
no borrowings outstanding under the credit facility. Any acceleration of the
maturity date of the credit facility could have a material adverse effect on our
business.
WE HAVE SIGNIFICANT STOCKHOLDERS THAT MAY NOT ACT CONSISTENTLY WITH THE
INTERESTS OF OUR OTHER STOCKHOLDERS.
As of November 12, 2003, Nortel Networks owned approximately 18.6% of our common
stock and Liberty Media Group beneficially owned approximately 10.2% of our
common stock. These respective ownership interests result in both Nortel
Networks and Liberty Media having a significant influence over us. Nortel
Networks and Liberty Media may exert their respective influences or sell their
respective shares at a time or in a manner that is inconsistent with the
interests of our other stockholders. Any sales of substantial amounts of our
common stock in the public market, or the perception that such sales might
occur, could have a depressive effect on the market price of our common stock.
WE HAVE ANTI-TAKEOVER DEFENSES THAT COULD DELAY OR PREVENT AN ACQUISITION OF OUR
COMPANY.
On October 3, 2002, our board of directors approved the adoption of a
shareholder rights plan (commonly known as a "poison pill"). This plan is not
intended to prevent a takeover, but is intended to protect and maximize the
value of shareholders' interests. This poison pill could make it more difficult
for a third party to acquire us or may delay that process.
WE MAY DISPOSE OF EXISTING PRODUCT LINES OR ACQUIRE NEW PRODUCT LINES IN
TRANSACTIONS THAT MAY ADVERSELY IMPACT US AND OUR FUTURE RESULTS.
On an ongoing basis, we evaluate our various product offerings in order to
determine whether any should be sold or closed and whether there are businesses
that we should pursue acquiring. Future acquisitions and divestitures entail
various risks, including:
- the risk that acquisitions will not be integrated or otherwise perform as
expected;
- the risk that we will not be able to find a buyer for a product line while
product line sales and employee morale will have been damaged because of
general awareness that the product line is for sale; and
31
- the risk that the purchase price obtained will not be equal to the book
value of the assets for the product line that we sell.
PRODUCTS CURRENTLY UNDER DEVELOPMENT MAY FAIL TO REALIZE ANTICIPATED BENEFITS.
Rapidly changing technologies, evolving industry standards, frequent new product
introductions and relatively short product life cycles characterize the markets
for our products. The technology applications currently under development by us
may not be successfully developed. Even if products under development are
successfully completed, they may not be widely used or we may not be able to
successfully exploit these technology applications. To compete successfully, we
must quickly design, develop, manufacture and sell new or enhanced products that
provide increasingly higher levels of performance and reliability. However, we
may not be able to successfully develop or introduce these products if our
products:
- are not cost-effective;
- are not brought to market in a timely manner;
- fail to achieve market acceptance; or
- fail to meet industry certification standards.
Furthermore, our competitors may develop similar or alternative new technology
applications that, if successful, could have a material adverse effect on us.
Our strategic alliances are based on business relationships that have not been
the subject of written agreements expressly providing for the alliance to
continue for a significant period of time. The loss of a strategic partner could
have a material adverse effect on the progress of new products under development
with that partner.
CONSOLIDATIONS IN THE TELECOMMUNICATIONS INDUSTRY COULD RESULT IN DELAYS OR
REDUCTIONS IN PURCHASES OF PRODUCTS, WHICH WOULD HAVE A MATERIAL ADVERSE EFFECT
ON OUR BUSINESS.
The telecommunications industry has experienced the consolidation of many
industry participants, and this trend is expected to continue. We and one or
more of our competitors may each supply products to businesses that have merged,
such as AT&T Broadband and Comcast, or will merge in the future. Consolidations
could result in delays in purchasing decisions by the merged businesses, and we
could play either a greater or lesser role in supplying the communications
products to the merged entity. These purchasing decisions of the merged
companies could have a material adverse effect on our business. For example, we
experienced delays while the Comcast and AT&T Broadband deal was pending, and
have experienced slowdowns since the transaction was completed. Mergers among
the supplier base also have increased, and this trend may continue. The larger
combined companies with pooled capital resources may be able to provide solution
alternatives with which we would be put at a disadvantage to compete. The larger
breadth of product offerings by these consolidated suppliers could result in
customers electing to trim their supplier base for the advantages of one-stop
shopping solutions for all of their product needs. Consolidation of the supplier
base could have a material adverse effect on our business.
OUR SUCCESS DEPENDS IN LARGE PART ON OUR ABILITY TO ATTRACT AND RETAIN QUALIFIED
PERSONNEL IN ALL FACETS OF OUR OPERATIONS.
Competition for qualified personnel is intense, and we may not be successful in
attracting and retaining key executives, marketing, engineering, and sales
personnel, which could impact our ability to maintain and grow our operations.
Our future success will depend, to a significant extent, on the ability of our
management to operate effectively. In the past, competitors and others have
attempted to recruit our employees and in the future, their attempts may
continue. The loss of services of any key personnel, the inability to attract
and retain qualified personnel in the future or delays in hiring required
personnel, particularly engineers and other technical professionals, could
negatively affect our business.
WE ARE SUBSTANTIALLY DEPENDENT ON CONTRACT MANUFACTURERS, AND AN INABILITY TO
OBTAIN ADEQUATE AND TIMELY DELIVERY OF SUPPLIES COULD ADVERSELY AFFECT OUR
BUSINESS.
Many components, subassemblies and modules necessary for the manufacture or
integration of our products are obtained from a sole supplier or a limited group
of suppliers. Our reliance on sole or limited suppliers, particularly
32
foreign suppliers, and our reliance on subcontractors involves several risks
including a potential inability to obtain an adequate supply of required
components, subassemblies or modules and reduced control over pricing, quality
and timely delivery of components, subassemblies or modules. Historically, we
have not generally maintained long-term agreements with any of our suppliers or
subcontractors. An inability to obtain adequate deliveries or any other
circumstance that would require us to seek alternative sources of supply could
affect our ability to ship products on a timely basis. Any inability to reliably
ship our products on time could damage relationships with current and
prospective customers and harm our business.
OUR INTERNATIONAL OPERATIONS MAY BE ADVERSELY AFFECTED BY ANY DECLINE IN THE
DEMAND FOR BROADBAND SYSTEMS DESIGNS AND EQUIPMENT IN INTERNATIONAL MARKETS.
Sales of broadband communications equipment into international markets are an
important part of our business. The entire line of our products is marketed and
made available to existing and potential international customers. In addition,
United States broadband system designs and equipment are increasingly being
employed in international markets, where market penetration is relatively lower
than in the United States. While international operations are expected to
comprise an integral part of our future business, international markets may no
longer continue to develop at the current rate, or at all. We may fail to
receive additional contracts to supply equipment in these markets.
OUR INTERNATIONAL OPERATIONS MAY BE ADVERSELY AFFECTED BY CHANGES IN THE FOREIGN
LAWS IN THE COUNTRIES IN WHICH OUR PRODUCTS ARE MANUFACTURED.
A significant portion of our products are manufactured or assembled in Mexico
and the Philippines and other countries outside of the United States. The
governments of the foreign countries in which we have plants may pass laws that
impair our operations, such as laws that impose exorbitant tax obligations or
nationalize these manufacturing facilities.
WE FACE RISKS RELATING TO CURRENCY FLUCTUATIONS AND CURRENCY EXCHANGE.
We may encounter difficulties in converting our earnings from international
operations to U.S. dollars for use in the United States. These obstacles may
include problems moving funds out of the countries in which the funds were
earned and difficulties in collecting accounts receivable in foreign countries
where the usual accounts receivable payment cycle is longer.
We are exposed to various market risk factors such as fluctuating interest rates
and changes in foreign currency rates. These risk factors can impact results of
operations, cash flows and financial position. We manage these risks through
regular operating and financing activities and periodically use derivative
financial instruments such as foreign exchange forward contracts. There can be
no assurance that our risk management strategies will be effective.
OUR PROFITABILITY HAS BEEN, AND MAY CONTINUE TO BE, VOLATILE, WHICH COULD
ADVERSELY AFFECT THE PRICE OF OUR STOCK.
We have experienced several years with significant operating losses. Although we
have been profitable in the past, we may not be profitable or meet the level of
expectations of the investment community in the future, which could have a
material adverse impact on our stock price. In addition, our operating results
may be adversely affected by timing of sales or a shift in our product mix.
WE MAY FACE HIGHER COSTS ASSOCIATED WITH PROTECTING OUR INTELLECTUAL PROPERTY.
Our future success depends in part upon our proprietary technology, product
development, technological expertise and distribution channels. We cannot
predict whether we can protect our technology or whether competitors can develop
similar technology independently. We have received and may continue to receive
from third parties, including some of our competitors, notices claiming that we
have infringed upon third-party patents or other proprietary rights. Any of
these claims, whether with or without merit, could result in costly litigation,
divert the time, attention and resources of our management, delay our product
shipments, or require us to enter into royalty or licensing agreements. If a
claim of product infringement against us is successful and we fail to obtain a
license or develop non-infringing technology, our business and operating results
could be adversely affected.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various market risks, including interest rates and foreign
currency rates. The following discussion of our risk-management activities
includes "forward-looking statements" that involve risks and uncertainties.
Actual results could differ materially from those projected in the
forward-looking statements.
In the past, we have used interest rate swap agreements with large creditworthy
financial institutions, to manage our exposure to interest rate changes. These
swaps would involve the exchange of fixed and variable interest rate payments
without exchanging the notional principal amount. During the quarter ended
September 30, 2003, we did not have any outstanding interest rate swap
agreements.
A significant portion of our products are manufactured or assembled in Mexico,
the Philippines, and other countries outside the United States. 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.
Changes in the monetary exchange rates may adversely affect our results of
operations and financial condition. To manage the volatility relating to these
typical business exposures, we may enter into various derivative transactions,
when appropriate. We do not hold or issue derivative instruments for trading or
other speculative purposes. The euro is the predominant currency of those
customers who are billed in their local currency. Taking into account the
effects of foreign currency fluctuations of the euro versus the dollar, a
hypothetical 10% weakening of the U.S. dollar (as of September 30, 2003) would
provide a gain on foreign currency of approximately $1.7 million. Conversely, a
hypothetical 10% strengthening of the U.S. dollar would provide a loss on
foreign currency of approximately $1.7 million. As of September 30, 2003, we had
no material contracts, other than accounts receivable, denominated in foreign
currencies.
We regularly review our accounts receivable in foreign currency and purchase
forward contracts when appropriate. As of September 30, 2003, we had no foreign
currency forward contracts outstanding. During the second quarter 2003, we
purchased a 5.0 million euro put contract with an expiration of October 31,
2003. The contract was purchased as part of our internal hedging strategy to
reduce the risk associated with our euro receivables. The contract was purchased
for approximately $174 thousand and the cumulative fair value adjustment as of
September 30, 2003 was a loss of approximately $139 thousand.
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ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. Our Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of our
disclosure controls and procedures (as such term is defined in Rules 13a-14(c)
and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the
"Exchange Act") as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"). Based on such evaluation, such
officers have concluded that, as of the Evaluation Date, our disclosure controls
and procedures are effective in alerting them on a timely basis to material
information relating to our company (including our consolidated subsidiaries)
required to be included in our reports filed or submitted under the Exchange
Act.
(b) Changes in Internal Controls. Since the Evaluation Date, there have not
been any significant changes in our internal controls or in other factors that
could significantly affect such controls.
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PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibit No. Description of Exhibit
- ----------- ----------------------
31.1 Section 302 Certification of Chief Executive Officer
31.2 Section 302 Certification of Chief Financial Officer
32.1 Section 906 Certification of Chief Executive Officer
32.2 Section 906 Certification of Chief Financial Officer
Reports on Form 8-K
FILING DATE ITEMS REPORTED
07-24-03 Item 5 and Item 7
08-05-03 Item 5
09-09-03 Item 5 and Item 7
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SIGNATURES
Pursuant to the requirements the Securities Exchange Act of 1934, the Registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
ARRIS GROUP, INC.
/s/ Lawrence A. Margolis
----------------------------
Lawrence A. Margolis
Executive Vice President,
Chief Financial Officer
Dated: November 14, 2003
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