FORM 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

For the quarter ended June 30, 2013

of

ARRIS GROUP, INC.

A Delaware Corporation

IRS Employer Identification No. 46-1965727

SEC File Number 000-31254

3871 Lakefield Drive

Suwanee, GA 30024

(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 a large accelerated filer and is not a shell company.

ARRIS is required to submit electronically and post on its corporate web site Interactive Data Files required to be submitted and posted pursuant to Rule 405 of regulation S-T.

As of July 31, 2013, 138,158,497 shares of the registrant’s Common Stock, $0.01 par value, were outstanding.

 

 

 


Table of Contents

ARRIS GROUP, INC.

FORM 10-Q

For the Three and Six Months Ended June 30, 2013

INDEX

 

         Page  

Part I.    Condensed Financial Information

  
        Item 1.   Condensed Consolidated Financial Statements (unaudited)   
  a) Consolidated Balance Sheets as of June 30, 2013 and December 31, 2012      2   
  b) Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2013 and 2012      3   
  c) Consolidated Statements of Comprehensive (Loss) Income for the Three and Six Months Ended June 30, 2013 and 2012      4   
  d) Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2013 and 2012      5   
  e) Notes to the Condensed Consolidated Financial Statements      6   
        Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations      30   
        Item 3.   Quantitative and Qualitative Disclosures About Market Risk      50   
        Item 4.   Controls and Procedures      50   
Part II.    Other Information   
        Item 1.   Legal Proceedings      50   
        Item 1A.   Risk Factors      55   
        Item 4.   Mine Safety Disclosure      63   
        Item 6.   Exhibits      64   
Signatures        65   


Table of Contents

PART I. CONDENSED FINANCIAL INFORMATION,

Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

ARRIS GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data) (unaudited)

 

     June 30,     December 31,  
     2013     2012  

ASSETS

    

Current Assets:

    

Cash and cash equivalents

   $ 610,502      $ 131,703   

Short-term investments, at fair value

     130,723        398,414   
  

 

 

   

 

 

 

Total cash, cash equivalents and short-term investments

     741,225        530,117   

Restricted cash

     3,801        4,722   

Accounts receivable (net of allowances for doubtful accounts of $1,179 in 2013 and $1,630 in 2012)

     662,156        188,581   

Other receivables

     11,007        350   

Inventories (net of reserves of $25,078 in 2013 and $9,977 in 2012)

     320,778        133,848   

Prepaid income taxes

     38,186        9,235   

Prepaids

     17,296        11,682   

Current deferred income taxes, net

     127,225        24,944   

Other current assets

     283,491        16,413   
  

 

 

   

 

 

 

Total Current Assets

     2,205,165        919,892   

Property, plant and equipment (net of accumulated depreciation of $163,569 in 2013 and $151,836 in 2012)

     404,157        54,378   

Goodwill

     807,142        194,115   

Intangible assets (net of accumulated amortization of $305,401 in 2013 and $239,668 in 2012)

     1,372,196        94,529   

Investments

     78,733        86,164   

Noncurrent deferred income taxes, net

     12,340        47,431   

Other assets

     55,476        9,385   
  

 

 

   

 

 

 
   $ 4,935,209      $ 1,405,894   
  

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current Liabilities:

    

Accounts payable

   $ 485,291      $ 45,719   

Accrued compensation, benefits and related taxes

     88,382        29,773   

Accrued warranty

     40,206        2,882   

Deferred revenue

     80,254        44,428   

Current portion of long-term debt

     289,990        222,124   

Current income taxes liability

     8,887        853   

Other accrued liabilities

     498,788        24,942   
  

 

 

   

 

 

 

Total Current Liabilities

     1,491,798        370,721   

Long-term debt, net of current portion

     1,837,952        -   

Accrued pension

     60,216        26,883   

Noncurrent income tax liability

     35,320        24,389   

Noncurrent deferred income taxes, net

     190,176        351   

Other noncurrent liabilities

     51,978        23,162   
  

 

 

   

 

 

 

Total Liabilities

     3,667,440        445,506   
  

 

 

   

 

 

 

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; 138.1 million and 114.1 million shares issued and outstanding in 2013 and 2012, respectively

     1,726        1,488   

Capital in excess of par value

     1,657,383        1,285,575   

Treasury stock at cost, 34.2 million shares in 2013 and 2012

     (306,330     (306,330

Accumulated deficit

     (76,736     (11,809

Unrealized gain (loss) on marketable securities (net of accumulated tax (benefit) expense of $(9) in 2013 and $125 in 2012)

     (19     206   

Unfunded pension liability (net of accumulated tax effect of $2,272 in 2013 and 2012)

     (8,558     (8,558

Cumulative translation adjustments

     303        (184
  

 

 

   

 

 

 

Total stockholders’ equity

     1,267,769        960,388   
  

 

 

   

 

 

 
   $ 4,935,209      $ 1,405,894   
  

 

 

   

 

 

 

See accompanying notes to the condensed consolidated financial statements.

 

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Table of Contents

ARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data and percentages) (unaudited)

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2013     2012     2013     2012  

Net sales

   $ 1,000,362      $ 349,327      $ 1,354,012      $ 652,227   

Cost of sales

     769,285        230,801        1,014,409        424,793   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross margin

     231,077        118,526        339,603        227,434   

Operating expenses:

        

Selling, general and administrative expenses

     87,774        40,135        127,900        79,678   

Research and development expenses

     123,400        42,881        167,482        87,028   

Restructuring charges

     32,257        1,039        32,266        6,242   

Acquisition and other costs

     19,392        102        26,582        1,046   

Amortization of intangible assets

     58,130        7,444        65,733        14,823   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     320,953        91,601        419,963        188,817   

Operating (loss) income

     (89,876     26,925        (80,360     38,617   

Other expense (income):

        

Interest expense

     18,612        4,422        23,243        8,772   

Loss (gain) on investments

     (728     356        (1,293     (605

Interest income

     (640     (729     (1,478     (1,484

Loss on foreign currency

     206        540        1,027        1,348   

Other (income) expense, net

     (7,735     (226     11,681        (662
  

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) from operations before income taxes

     (99,591     22,562        (113,540     31,248   

Income tax (benefit) expense

     (49,314     7,561        (48,613     10,448   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income

   $ (50,277   $ 15,001      $ (64,927   $ 20,800   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net (loss) income per common share:

        

Basic

   $ (0.37   $ 0.13      $ (0.52   $ 0.18   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ (0.37   $ 0.13      $ (0.52   $ 0.18   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average common shares:

        

Basic

     134,626        113,842        124,940        114,457   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

     134,626        115,111        124,940        116,352   
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to the condensed consolidated financial statements.

 

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ARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

(in thousands) (unaudited)

 

     Three Months Ended
June  30,
     Six Months Ended
June  30,
 
     2013     2012      2013     2012  

Net (loss) income

   $ (50,277   $ 15,001       $ (64,927   $ 20,800   

Unrealized gain (loss) on marketable securities, net of tax (benefit) expense of $(137) and $44 for the three months ended June 30, 2013 and 2012, and $(103) and $271 for the six months ended June 30, 2013 and 2012, respectively

     (273     62         (225     478   

Cumulative translation adjustment

     487        -         487        -   
  

 

 

   

 

 

    

 

 

   

 

 

 

Comprehensive (loss) income, net of tax

   $ (50,063   $ 15,063       $ (64,665   $ 21,278   
  

 

 

   

 

 

    

 

 

   

 

 

 

See accompanying notes to the condensed consolidated financial statements.

 

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ARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands) (unaudited)

 

     Six Months Ended
June 30,
 
     2013     2012  

Operating activities:

    

Net (loss) income

   $ (64,927   $ 20,800   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation

     22,118        14,177   

Amortization of intangible assets

     65,733        14,823   

Stock compensation expense

     13,924        14,516   

Deferred income tax benefit

     (41,197     (9,720

Amortization of deferred finance fees

     2,237        320   

Provision for doubtful accounts

            54   

Gain on investments

     (1,293     (605

Revenue reduction related to Comcast’s investment in ARRIS

     13,182          

Mark-to-market fair value adjustment related to Comcast’s investment in ARRIS

     13,189          

Loss on disposal of product line

            337   

Loss (gain) on disposal of fixed assets

     (38     6   

Excess income tax benefits from stock-based compensation plans

     (5,770     (2,460

Non-cash interest expense

     6,552        6,057   

Changes in operating assets and liabilities, net of effect of acquisitions and dispositions:

    

Accounts receivable

     (16,514     (27,743

Other receivables

     (7,127     7,393   

Inventories

     92,632        9,996   

Income taxes payable and recoverable

     (16,633     8,452   

Accounts payable and accrued liabilities

     251,296        5,136   

Prepaids and other, net

     16,645        4,327   
  

 

 

   

 

 

 

Net cash provided by operating activities

     344,009        65,866   

Investing activities:

    

Purchases of property, plant and equipment

     (21,402     (9,256

Sale of property, plant and equipment

     90          

Purchases of investments

     (58,021     (140,353

Sales of investments

     358,021        83,161   

Cash paid for acquisition, net of cash acquired

     (2,159,762       

Sale of product line

            3,249   
  

 

 

   

 

 

 

Net cash used in investing activities

     (1,881,074     (63,199

Financing activities:

    

Repurchase of common stock

            (41,551

Excess income tax benefits from stock-based compensation plans

     5,770        2,460   

Repurchase of shares to satisfy employee tax withholdings

     (12,407     (8,052

Proceeds from issuance of common stock

     165,453        7,996   

Proceeds from issuance of debt

     1,925,000          

Payment of debt obligations

     (15,813       

Cash paid for debt discount

     (9,853       

Early redemption of convertible notes

     (79       

Deferred financing costs paid

     (42,207       
  

 

 

   

 

 

 

Net cash provided by (used in) by financing activities

     2,015,864        (39,147
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     478,799        (36,480

Cash and cash equivalents at beginning of period

     131,703        235,875   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 610,502      $ 199,395   
  

 

 

   

 

 

 

See accompanying notes to the condensed consolidated financial statements.

 

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ARRIS GROUP, INC.

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1. Organization and Basis of Presentation

ARRIS Group, Inc. (together with its consolidated subsidiaries, except as the context otherwise indicates, “ARRIS” or the “Company”), is a premier video and broadband technology company that transforms how service providers worldwide deliver entertainment and communications without boundaries. Its powerful end-to-end platforms enable service and content providers to improve the way people connect – with each other and with their favorite content. The Company’s vision and expertise continue to drive the industry’s innovations, as they have for more than 60 years. Headquartered north of Atlanta, in Suwanee, Georgia, ARRIS has R&D, sales and support centers throughout the world.

ARRIS operates in two business segments, Network and Cloud (“N&C”) and Customer Premises Equipment (“CPE”). ARRIS specializes in integrated broadband network solutions that include products, systems software and systems integration services for multiscreen video delivery, user interfaces, content security, processing and management, video on demand and network operations management. ARRIS is a leading developer, manufacturer and supplier of telephony, data, video, construction, rebuild and maintenance equipment for broadband communications service providers including telephone companies and cable system operators. In addition, ARRIS is a leading supplier of infrastructure products used by cable system operators to build-out and maintain hybrid fiber-coaxial (“HFC”) networks. ARRIS also manufactures video encoding, processing, and storage equipment used by service providers, programmers, and internet video distributors. ARRIS broadband modem products are also sold directly to consumers through retail stores and internet outlets. The Company provides its customers with products and services that enable reliable transmission of video and high speed two-way broadband data and telephony.

On April 17, 2013, the Company completed its acquisition of Motorola Home from General Instrument Holdings, Inc., a subsidiary of Google, Inc. (See Note 3 Business Acquisitions for additional details)

The condensed consolidated financial statements 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. Interim results of operations are not necessarily indicative of results to be expected from a twelve-month period. These 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 year ended December 31, 2012, as filed with the United States Securities and Exchange Commission (“SEC”).

Note 2. Recent Accounting Pronouncements

Adoption of New Accounting Standards - In February 2013, the FASB issued an accounting standards update that adds new disclosure requirements for items reclassified out of accumulated other comprehensive income. This update requires that companies present either in a single note or parenthetically on the face of the financial statements, the effect of significant amounts reclassified from each component of accumulated other comprehensive income based on its source (e.g., the release due to cash flow hedges from interest rate contracts) and the income statement line items affected by the reclassification (e.g., interest income or interest expense). If a component is not required to be reclassified to net income in its entirety (e.g., the net periodic pension cost), companies would instead cross reference to the related footnote for additional information (e.g., the pension footnote). This update was adopted by ARRIS beginning in the first quarter of 2013. This standard and other accounting pronouncements adopted during the periods had an immaterial impact on our consolidated financial position and results of operations.

Accounting Standards Issued But Not Yet Effective - Accounting pronouncements issued, but not effective until after June 30, 2013, are not expected to have a significant impact on our consolidated financial position or results of operations.

 

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Note 3. Business Acquisitions

Acquisition of Motorola Home

On April 17, 2013, ARRIS completed its acquisition of Motorola Home from General Instrument Holdings, Inc. (“Seller”), a subsidiary of Google, Inc., for approximately $2.160 million in cash, subject to working capital adjustments, and 10.6 million shares of ARRIS’ common stock (the “Acquisition”).

The Acquisition enhanced the Company’s scale and product breadth in the telecom industry and diversified the Company’s customer base and expanded dramatically the Company’s international presence. Notably, the acquisition brought to ARRIS, Motorola Home’s product scale and scope in end-to-end video processing and delivery, including a full range of QAM and IP set top box products, as well as IP Gateway CPE equipment for data and voice services for broadband service providers. The Acquisition also enhanced the depth and scale of the Company’s R&D capabilities, particularly in the video arena, and approximately doubled the Company’s patent portfolio to nearly 2,000 patents and patent applications. In addition, via a license, the Company was provided access to approximately 20,000 Motorola Mobility patents as they relate to Motorola Home.

The following table summarizes the fair value of consideration transferred for Motorola Home, net of cash acquired (in thousands):

 

  Cash transferred (1)

   $ 2,159,762   

  Shares issued to Seller (2)

     176,410   
  

 

 

 

  Total value of consideration transferred (3)

   $ 2,336,172   
  

 

 

 

 

  (1) The cash transferred represents the actual cash transferred as part of the transaction, net of cash acquired of $78.0 million, and is subject to working capital adjustments. The cash portion of the consideration was funded with cash on hand, borrowings under ARRIS’ senior secured credit facilities (see Note 14 Long-Term Indebtedness for additional details) and through the sale by ARRIS of approximately 10.6 million shares of ARRIS’ common stock to a subsidiary of Comcast Corporation for $150 million in cash.
  (2) The fair value of the 10.6 million shares issued to Seller was determined based on the opening price of the Company’s common stock at the Acquisition date.
  (3) The consideration is subject to working capital adjustments. The Seller has 120 days after the acquisition date to provide the final acquisition date working capital values to ARRIS. ARRIS has 60 days after receipt of the final acquisition date working capital values to confirm agreement or disagreement with the values. ARRIS has not received a final acquisition date working capital adjustment as of the date of the filing.

The following is a summary of the preliminary estimated fair values of the net assets acquired (in thousands):

 

  Total estimated consideration transferred, net of cash acquired

   $ 2,336,172   

Accounts receivable

     462,162   

Inventories

     279,562   

Deferred income tax assets

     370,543   

Other assets

     153,094   

Property, plant & equipment

     350,547   

Intangible assets

     1,343,400   

Accounts payable

     349,235   

Deferred revenue

     27,797   

Other liabilities

     324,852   

Deferred tax liability

     534,479   
  

 

 

 

  Net assets acquired

     1,722,945   
  

 

 

 

  Goodwill

   $ 613,227   
  

 

 

 

 

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The Acquisition has been accounted for using the acquisition method of accounting in accordance with ASC 805, Business Combinations, which requires, among other things, that the assets acquired and liabilities assumed be recognized at their acquisition date fair values, with any excess of the consideration transferred over the estimated fair values of the identifiable net assets acquired recorded as goodwill. The accounting for the business combination is based on currently available information and is considered preliminary.

Goodwill of $613.2 million arising from the acquisition is attributable to the workforce of the acquired business, strategic opportunities and synergies that are expected to arise from the acquisition of Motorola Home. The goodwill will be assigned to three of the Company’s reporting units; the assignment of goodwill to the Company’s reporting units has not been completed as of the date these financial statements have been issued. The goodwill is not expected to be deductible for income tax purposes.

The $1.3 billion of acquired intangible assets was preliminary assigned to the following (in thousands):

 

     Fair value      Estimated Weighted
Average Life
(years)

Customer relationships

   $ 683,400       8.0

Developed technology

     502,400       6.0

In process R&D

     95,700       indefinite

Backlog

     43,100       1.0

Trademark / trade name

     18,800       1.0
  

 

 

    

Total

   $ 1,343,400      
  

 

 

    

In connection with the Acquisition, the Seller agreed to indemnify ARRIS for a portion of a potential liability from certain intellectual property infringement litigation claims. As such, the Company recorded at the date of acquisition a $70 million liability related to one of these litigation claims and an indemnification asset of $70 million related to this liability; which was subsequently settled for $85 million, for which ARRIS was fully indemnified. The Company also recorded a $13.9 million liability at the date of acquisition related to an infringement lawsuit included as part of the $50.0 million retained by ARRIS pursuant to the acquisition agreement. This lawsuit was settled subsequent to the date of acquisition. See Note 22 Contingencies for additional details.

Certain tax attributes will not likely be known until tax returns of acquired entities are filed. It is possible some tax returns may not be filed until after the measurement period. Therefore, there is likelihood that certain deferred tax assets related to tax attributes may be recorded outside the measurement period. The Company has recorded $71.3 million of tax deductible goodwill arising from the Acquisition, as of June 30, 2013. This amount is preliminary and remains subject to adjustments.

The fair value of account receivable is $462.2 million with the gross contractual amount being $470.9 million. The Company expects $8.7 million to be uncollectible.

The Company incurred acquisition related costs of $11.4 million and $18.6 million, during the three and six months ended June 30, 2013, respectively. These amounts were expensed by the Company as incurred and are included in the Consolidated Statement of Operations in the line item titled “Acquisition and other costs”.

The Motorola Home business contributed revenues of approximately $586 million to our consolidated results from the date of acquisition through June 30, 2013.

The following unaudited pro forma summary presents consolidated information of the Company as if the acquisition of Motorola Home occurred on January 1, 2012, the beginning of the comparable prior annual period. The pro forma adjustments primarily relate to the depreciation expense on stepped up fixed assets, amortization of acquired intangibles, interest expense related to new financing arrangements and the estimated impact on the Company’s income tax provision. The unaudited pro forma combined results of operations are provided for illustrative purposes only and are not indicative of the Company’s actual consolidated results.

 

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In addition, unaudited pro forma net income for the three and six months ended June 30, 2013 was adjusted to exclude $11.4 million and $18.6 million of acquisition related costs, respectively; and unaudited pro forma net income for the three and six months ended June 30, 2013 was adjusted to exclude $57.6 million of expense related to the fair value adjustment to acquisition-date inventory. Unaudited pro forma net income for the six months ended June 30, 2012 was adjusted to include these charges of $76.2 million. In addition, unaudited pro forma net income for the three and six months ended June 30, 2012 includes $4.8 million and $7.1 million reduction in revenue, respectively, related to the fair value adjustment to deferred revenue. These adjustments exclude the income tax impact.

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
(in thousands)    2013     2012     2013     2012  

Net sales

   $ 1,068,887      $ 1,183,498      $ 2,159,902      $ 2,361,103   

Net loss

     (49,275     (12,835     (117,528     (94,706

Net loss per common share

        

Basic

   $ (0.36   $ (0.09   $ (0.85   $ (0.70 )) 

Diluted

   $ (0.36   $ (0.09   $ (0.85   $ (0.70

The proforma results are based on estimates and assumptions, which the Company believes are reasonable.

To the extent that the initial accounting for the business combination is incomplete at the end of the reporting period, provisional amounts are reported for those items which are incomplete. At the time the financial statements were issued, the Company has not received a final valuation report from the valuation expert. In addition, the Company is still waiting on additional information to finalize the accounting for certain pre-acquisition contingencies, cost and equity method investments and tax matters. During the measurement period, the Company will adjust the provisional amounts recognized at the acquisition date to reflect new information obtained about facts and circumstances that existed as of the acquisition date that, if known, would have affected the measurement of the amounts recognized as of that date and ARRIS will record those adjustments to the financial statements.

Note 4. Goodwill and Intangible Assets

Goodwill

As of June 30, 2013, the Company has recorded goodwill of $807.1 million. Effective in the second quarter of 2013, the Company changed its reportable segments due to a change in its underlying organizational model designed to support the business following the Motorola Home acquisition (see Note 16 - Segment Information). The Company did not operate under the realigned reportable segment structure prior to the second quarter of 2013. This change in segments resulted in a reallocation of goodwill amongst some of the Company’s reportable segments. Prior period data has been retrospectively adjusted to reflect this reallocation. For purposes of goodwill and impairment testing, the Company has determined that it has three reporting units based on the organizational structure, the financial information that is provided to and reviewed by segment management and aggregation criteria applicable to component business that are economically similar. For the CPE operating segment, the reporting unit is the same as the operating segment. The Company has determined that the Network & Cloud operating segment is comprised of two reporting units which are Network Infrastructure and Cloud Services.

The following is a summary of the Company’s goodwill (in thousands), reflecting the retrospective reallocation as of December 31, 2012:

 

CPE

   $ 31,850   

Network Infrastructure

     162,265   

Cloud Services

       

Balance as of December 31, 2012

   $ 194,115   

 

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In the quarter ended June 30, 2013, the Company has preliminary recorded additional goodwill of $613.2 million related to the Motorola Home acquisition. The Company is in the process of assigning the assets and liabilities acquired to each of its identified reporting units and as such, the determination of this incremental goodwill by reporting unit is incomplete as of June 30, 2013. The Company intends to finalize the assignment of the goodwill from the Motorola Home acquisition during fiscal year 2013.

Following is a summary of the Company’s goodwill activity (in thousands):

 

     CPE      Network     Cloud      Unallocated      Total  

Net balance at December 31, 2012

   $ 31,850       $ 162,265      $       $       $ 194,115   

Adjustment to deferred tax assets – C-COR Acquisition

        (200           (200

Preliminary estimate of goodwill from acquisition

           $ 613,227       $ 613,227   

Net balance at June 30, 2013

   $ 31,850       $ 162,065      $       $ 613,227       $ 807,142   

Intangible Assets

The gross carrying amount and accumulated amortization of the Company’s intangible assets as of June 30, 2013 and December 31, 2012 are as follows (in thousands):

 

     June 30, 2013      December 31, 2012  
     Gross
Amount
     Accumulated
Amortization
     Net
Book
Value
     Weighted
Average
Remaining
Life
(Years)
     Gross
Amount
     Accumulated
Amortization
     Net Book
Value
     Weighted
Average
Remaining
Life
(Years)
 

Customer relationships

   $ 933,408      $ 216,900      $ 716,508        7.5      $ 250,009      $ 190,285      $ 59,724        4.0  

Developed technology

     580,169        69,242        510,927        5.7        77,769        42,964        34,805        4.4  

Trademarks & patents

     19,058        4,118        14,940        1.0        257        257                

Order backlog

     46,100        11,979        34,121        0.8        3,000        3,000                

Non-compete agreements

     3,162        3,162                      3,162        3,162                

In-process R&D

     95,700               95,700                                     
  

 

 

    

 

 

    

 

 

       

 

 

    

 

 

    

 

 

    

Total

   $ 1,677,597      $ 305,401      $ 1,372,196         $ 334,197      $ 239,668      $ 94,529     
  

 

 

    

 

 

    

 

 

       

 

 

    

 

 

    

 

 

    

The Company recorded approximately $1,343 million of identifiable intangible assets in conjunction with the Acquisition.

 

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Amortization expense is reported in the consolidated statements of operations within operating expenses under the caption “Amortization of intangible assets.” The estimated total amortization expense for each of the next five fiscal years is as follows (in thousands):

 

2014

   $ 222,738   

2015

     204,130   

2016

     176,815   

2017

     159,009   

2018

     120,533   

Thereafter

     254,490   

Note 5. Comcast Investment in ARRIS

In connection with ARRIS’ acquisition of Motorola Home, Comcast was given an opportunity to invest in ARRIS. On January 11, 2013, ARRIS entered into a separate agreement accounted for as a contingent equity forward with a subsidiary of Comcast providing for Comcast to purchase from the Company approximately 10.6 million shares of common stock for $150 million or $14.11 per share. The transaction with Comcast was contingent upon on the closing of the Motorola Home transaction.

As provided for in the definitive agreement for the Acquisition, the shares issued to Comcast reduced, on a share-for-share basis, the number of shares of ARRIS stock issued to Google and simultaneously increased the cash consideration paid to Google by $150.0 million. As a result of the sale of common stock to Comcast, both Comcast and Google each own approximately 7.7% of ARRIS outstanding shares post-closing of the Motorola Home acquisition. The Comcast transaction was consummated on the same day as the Acquisition. Because the amount of shares issued to Comcast was not fixed when the agreement was executed, but prior thereto, the agreement with Comcast is classified as a liability in accordance with the accounting guidance for Derivatives and Hedging.

At the time the agreement was executed with Comcast on January 11, 2013 the Company’s stock price was $15.35 per share. However, consistent with earlier negotiations, Comcast agreed to invest in ARRIS at the same price as Google, which was $14.11 per share. The Revenue Recognition accounting guidance requires that the Company recognize the intrinsic value of the benefit received by Comcast - the entitlement to invest at a price below the market price ($14.11 per share as opposed to the then market price of $15.35 per share) on the date the agreement with Comcast was executed - as a reduction of revenue. As such, revenue and gross margin were reduced by approximately $13.2 million during the quarter ended March 31, 2013.

Because the obligation under the agreement was not indexed to the Company’s stock and does not meet the definition of a derivative, the Company elected to subsequently account for the obligation at fair value by electing the fair value option. That is, the Company has marked-to-market the obligation at each reporting period. This resulted in a mark-to-market income adjustment of $6.2 million for the three months ended June 30, 2013, and $13.2 million expense for the six months ended June 30, 2013. This mark-to-market adjustment is recorded as Other (Income) Expense for the three and six months ended June 30, 2013.

Upon settlement of the contract, the Company recorded the issuance of its common stock to Comcast and is included in stockholders’ equity on the Consolidated Balance Sheets.

 

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Note 6. Investments

ARRIS’ investments as of June 30, 2013 and December 31, 2012 consisted of the following (in thousands):

 

     As of June 30, 2013      As of December 31, 2012  

Current Assets:

     

Available-for-sale securities

   $ 130,723       $ 398,414   
  

 

 

    

 

 

 

Noncurrent Assets:

     

Available-for-sale securities

     27,420         59,549   

Equity method investments

     22,493           

Cost method investments

     6,000         6,000   

Other investments

     22,820         20,615   
  

 

 

    

 

 

 
     78,733         86,164   
  

 

 

    

 

 

 

Total

   $ 209,456       $ 484,578   
  

 

 

    

 

 

 

Available-for-sale securities - ARRIS’ investments in debt and marketable equity securities are categorized as available-for-sale and are carried at fair value. The Company currently does not hold any held-to-maturity securities. Realized gains and losses on available-for-sale securities are included in net income. Unrealized gains and losses on available-for-sale securities are included in the Consolidated Balance Sheets as a component of accumulated other comprehensive income (loss). The total (gains) losses included in the accumulated other comprehensive income related to available-for-sale securities were $19 thousand and $0.2 million, net of tax, as of June 30, 2013 and December 31, 2012, respectively. Realized and unrealized gains and losses in total and by individual investment as of June 30, 2013 and December 31, 2012 were not material. The amortized cost basis of the Company’s investments approximates fair value.

Equity method investments – In connection with the Acquisition, ARRIS acquired certain investments in joint ventures, limited liability companies, and partnerships which are accounted for using the equity method as the Company has significant influence over operating and financial policies of the investee companies.

Cost method investments - ARRIS holds cost method investments in private companies. These investments are recorded at $6.0 million as of June 30, 2013 and December 31, 2012. Due to the fact the investments are in private companies, ARRIS is exempt from estimating the fair value on an interim and annual basis. It is not practical to estimate the fair value since the quoted market price is not available. Furthermore, the cost of obtaining an independent valuation appears excessive considering the materiality of the investments to the Company. However, ARRIS is required to estimate the fair value if there has been an identifiable event or change in circumstance that may have a significant adverse effect on the fair value of the investment.

Other investments – At June 30, 2013 and December 31, 2012, ARRIS held $22.8 million and $20.6 million, respectively, in certain life insurance contracts. This investment is classified as non-current investments in the Consolidated Balance Sheet. The Company determined the fair value to be the amount that could be realized under the insurance contract as of each reporting period. The changes in the fair value of these contracts are included in net income.

Investment Other-Than-Temporary Impairments - ARRIS concluded that no other-than-temporary impairment losses existed as of June 30, 2013. In making this determination, ARRIS evaluates its investments for any other-than-temporary impairment on a quarterly basis considering all available evidence, including changes in general market conditions, specific industry and individual entity data, the financial condition and the near-term prospects of the entity issuing the security, and the Company’s ability and intent to hold the investment until recovery. For the year ended December 31, 2012, ARRIS recognized other-than-temporary impairment charges of $1.5 million in the statements of consolidated income.

 

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Classification of securities as current or non-current is dependent upon management’s intended holding period, the security’s maturity date and liquidity consideration based on market conditions. If management intends to hold the securities for longer than one year as of the balance sheet date, they are classified as non-current.

Maturity Information - The contractual maturities of the Company’s investments as of June 30, 2013 are shown below (in thousands). Actual maturities may differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties. The amortized cost basis of the Company’s investments approximates fair value (in thousands):

 

     June 30,
2013
 

Due in one year or less

   $ 130,723   

Due after one year through five years

     22,904   

Due after five years

     27,310   
  

 

 

 
   $ 180,937   
  

 

 

 

Note 7. Fair Value Measurement

Fair value is defined as the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (the exit price). The authoritative guidance establishes a fair value hierarchy that is based on the extent and level of judgment used to estimate the fair value of assets and liabilities. In order to increase consistency and comparability in fair value measurements, the FASB has established a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three broad levels. An asset or liability’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the measurement of its fair value. The three levels of input defined by the authoritative guidance are as follows:

Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities. The fair value hierarchy gives the highest priority to Level 1 inputs.

Level 2: Observable prices that are based on inputs not quoted on active markets, but corroborated by market data.

Level 3: Unobservable inputs are used when little or no market data is available. The fair value hierarchy gives the lowest priority to Level 3 inputs.

The following table presents the Company’s investment assets measured at fair value on a recurring basis as of June 30, 2013 (in thousands):

 

     Level 1      Level 2      Level 3      Total  

Current Assets:

           

Certificates of deposit

   $       $ 4,659       $       $ 4,659   

Commercial paper

             7,490                 7,490   

Corporate bonds

             89,183                 89,183   

Short-term bond fund

     29,391                         29,391   
  

 

 

    

 

 

    

 

 

    

 

 

 
     29,391         101,332                 130,723   

Noncurrent Assets:

           

Cash surrender value of company owned life insurance

             22,794                 22,794   

Corporate bonds

             22,903                 22,903   

Corporate obligations

             17                 17   

Money markets

     227                         227   

Mutual funds

     201                         201   

Other investments

             4,098                 4,098   
  

 

 

    

 

 

    

 

 

    

 

 

 
     428         49,812                 50,240   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets

   $ 29,819       $ 151,144       $       $ 180,963   
  

 

 

    

 

 

    

 

 

    

 

 

 
              5   

 

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The following table presents the Company’s investment assets measured at fair value on a recurring basis as of December 31, 2012 (in thousands):

 

     Level 1      Level 2      Level 3      Total  

Current Assets:

           

Certificates of deposit

   $         $ 5,416       $       $ 5,416   

Commercial paper

             18,964                 18,964   

Corporate bonds

             209,093                 209,093   

Municipal bonds

     164,941                         164,941   
  

 

 

    

 

 

    

 

 

    

 

 

 
     164,941         233,473                 398,414   

Noncurrent Assets:

           

Cash surrender value of company owned life insurance

             20,615                 20,615   

Corporate bonds

             53,914                 53,914   

Corporate obligations

             15                 15   

Money markets

     226                         226   

Mutual funds

     179                         179   

Other investments

             5,215                 5,215   
  

 

 

    

 

 

    

 

 

    

 

 

 
     405         79,759                 80,164   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets

   $ 165,346       $ 313,232       $       $ 478,578   
  

 

 

    

 

 

    

 

 

    

 

 

 

In addition to the amounts disclosed in the above table, the fair value of the Company’s Israeli severance pay assets, which were almost fully comprised of Level 2 assets, was $4.1 million and $3.8 million as of June 30, 2013 and December 31, 2012, respectively.

All of the Company’s short-term and long-term investments at June 30, 2013 are classified within Level 1 or Level 2 of the fair value hierarchy as they are valued using quoted market prices, market prices for similar securities, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued based on quoted market prices in active markets include the Company’s investment in money market funds, mutual funds, government agency bonds and municipal bonds. Such instruments are generally classified within Level 1 of the fair value hierarchy. The types of instruments valued based on other observable inputs include the Company’s cash surrender value of company owned life insurance, corporate obligations and bonds, bond funds, commercial paper and certificates of deposit. Such instruments are classified within Level 2 of the fair value hierarchy.

In determining the value of certain Level 2 instruments, ARRIS has performed steps to verify the accuracy of the valuations provided by ARRIS’ brokerage firms. ARRIS has reviewed the most recent Statement on Standards for Attestation Engagements No. 16 (SSAE report) for each brokerage firm holding investments for ARRIS. The SSAE report for each did not identify any control weakness in the brokerages’ policies and procedures, in particular as they relate to the pricing and valuation of financial instruments. ARRIS has determined the third party pricing source used by each firm to be a reliable recognized source of financial valuations. In addition ARRIS has performed further testing on a large sample of its corporate obligations and commercial paper investments. These tests did not show any material discrepancies in the valuations provided by the brokerage firms. It is the Company’s intent to continue to verify valuations on a quarterly basis, using one or more reliable recognized third party pricing providers. See Note 6 Investments and Note 8 Derivative Instruments and Hedging Activities for further information on the Company’s investments and derivative instruments and hedging activities.

 

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In addition to the financial instruments included in the above table, certain nonfinancial assets and liabilities are to be measured at fair value on a nonrecurring basis in accordance with applicable authoritative guidance. This includes items such as nonfinancial assets and liabilities initially measured at fair value in a business combination (but not measured at fair value in subsequent periods) and nonfinancial long-lived asset groups measured at fair value for an impairment assessment. In general, nonfinancial assets including goodwill, other intangible assets and property and equipment are measured at fair value when there is an indication of impairment and are recorded at fair value only when any impairment is recognized. As of June 30, 2013, the Company had not recorded any impairment related to such assets and had no other material nonfinancial assets or liabilities requiring adjustments or write-downs to their current fair value.

The carrying value of debt as of June 30, 2013 approximated the fair value.

Note 8. Derivative Instruments and Hedging Activities

Risk Management Policies – ARRIS is exposed to financial market risk, primarily related to foreign currency and interest rates. These exposures are actively monitored by management. To manage the volatility relating to certain of these exposures, the Company enters into a variety of derivative financial instruments. Management’s objective is to reduce, where it is deemed appropriate to do so, fluctuations in earnings and cash flows associated with changes in foreign currency and interest rates. ARRIS’ policies and practices are to use derivative financial instruments only to the extent necessary to manage exposures. ARRIS does not hold or issue derivative financial instruments for trading or speculative purposes.

Accounting Policy for Derivative Instruments - ARRIS recognizes all derivative financial instruments as assets or liabilities in the Consolidated Balance Sheets at fair value. The Company’s foreign currency derivative financials instruments are not designated as hedges, and accordingly, all changes in the fair value of the instruments are recognized as a loss (gain) on foreign currency in the Consolidated Statements of Operations. The maximum time frame for ARRIS’ derivatives is currently less than twelve months.

Balance Sheet Recognition and Fair Value Measurements - The following table indicates the location on the Consolidated Balance Sheets in which the Company’s derivative assets and liabilities have been recognized, the fair value hierarchy level applicable to each derivative type and the related fair values of those derivatives (in thousands).

ARRIS has master netting arrangements with substantially all of ARRIS’ counterparties giving ARRIS the right of offset for ARRIS’ derivative positions. However, ARRIS has not elected to offset the fair value positions of the derivative contracts recorded on ARRIS’ Consolidated Balance Sheets.

 

     As of June 30, 2013      As of December 31, 2012  
     Balance Sheet Location    Fair Value      Balance Sheet Location    Fair Value  

Derivatives Not Designated
as Hedging Instruments:

           

Foreign exchange contracts
– asset derivatives

   Other current assets    $       Other current assets    $ 590   

Foreign exchange contracts
– liability derivatives

   Other accrued liabilities    $       Other accrued liabilities    $ 513   

The change in the fair values of ARRIS’ derivative financial instruments recorded in the Consolidated Statements of Operations during the three and six months ended June 30, 2013 and 2012 were as follows (in thousands):

 

         Three Months Ended
June  30,
    Six Months Ended
June  30,
 
     Statement of Operations Location   2013      2012     2013      2012  

Derivatives Not Designated
as Hedging Instruments:

            

Foreign exchange contracts

   Loss (gain) on foreign currency   $ 384       $ (708   $ 428       $ 77   

 

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Note 9. Pension Benefits

Components of Net Periodic Pension Cost (in thousands):

 

     Three Months Ended June 30,     Six Months Ended June 30,  
     2013     2012     2013     2012  

Service cost

   $ 266      $ 84      $ 327      $ 167   

Interest cost

     531        521        918        1,042   

Expected gain on plan assets

     (252     (315     (471     (629

Amortization of net loss

     319        210        473        420   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic pension cost

   $ 864      $ 500      $ 1,247      $ 1,000   
  

 

 

   

 

 

   

 

 

   

 

 

 

The Company assumed $32.2 million of pension liability related to a defined benefit plan in Taiwan, in connection with the Acquisition. Net period pension cost for the three and six month periods ended June 30, 2013, includes pension costs of $0.5 million related to this Taiwan pension plan.

Employer Contributions

No minimum funding contributions are required in 2012 under the Company’s defined benefit plan. However, the Company made voluntary contributions to the plan of approximately $39 thousand and $105 thousand for the three and six months ended June 30, 2013. Additionally, the Company made a voluntary contribution to the plan of $0.2 million in April 2013. The Company has established two rabbi trusts to fund the Company’s pension obligations under the non-qualified plan of the Chief Executive Officer and certain executive officers. The balance of these rabbi trust assets as of June 30, 2013 was approximately $18.4 million and is included in Investments on the Consolidated Balance Sheets.

Note 10. Guarantees

Warranty

ARRIS provides warranties of various lengths to customers based on the specific product and the terms of individual agreements. The Company provides for the estimated cost of product warranties based on historical trends, the embedded base of product in the field, failure rates, and repair costs at the time revenue is recognized. Expenses related to product defects and unusual product warranty problems are recorded in the period that the problem is identified. 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 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) would be recorded to the warranty liability.

The Company offers extended warranties and support service agreements on certain products. Revenue from these agreements is deferred at the time of the sale and recognized on a straight-line basis over the contract period. Costs of services performed under these types of contracts are charged to expense as incurred, which approximates the timing of the revenue stream.

 

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Information regarding the changes in ARRIS’ aggregate product warranty liabilities for the six months ended June 30, 2013 was as follows (in thousands):

 

Balance at December 31, 2012

   $ 6,069   

Motorola Home warranty reserve at acquisition

     65,478   

Accruals related to warranties (including changes in estimates)

     3,920   

Settlements made (in cash or in kind)

     (5,787
  

 

 

 

Balance at June 30, 2013

   $ 69,680   
  

 

 

 

Note 11. Restructuring Charges

ARRIS has restructuring accruals representing contractual obligations that relate to excess leased facilities and equipment in ARRIS’ Network and Cloud segment. Payments will be made over their remaining lease terms through 2014, unless terminated earlier (in thousands):

 

  Balance as of December 31, 2012

   $ 763   

  Payments

     (191
  

 

 

 

Balance as of June 30, 2013

   $ 572   
  

 

 

 

In the fourth quarter of 2011, ARRIS initiated a restructuring plan as a result of its acquisition of BigBand Networks. The plan focuses on the rationalization of personnel, facilities and systems across multiple segments in the ARRIS organization. This acquisition resulted in a restructuring charge of $3.4 million, of which $3.3 million was related to severance and termination benefits and $0.1 million was related to facilities. In 2012, ARRIS recorded an additional restructuring charge of $6.8 million, of which $5.6 million was related to severance and termination benefits and $1.2 million was related to facilities. As of June 30, 2013, the total liability remaining for this restructuring plan was approximately $0.3 million and is related to facilities. This remaining liability will be paid over the remaining lease terms through 2016, unless terminated earlier (in thousands):

 

  Balance as of December 31, 2012

   $ 400   

  Restructuring charges

     16   

  Payments

     (98
  

 

 

 

  Balance as June 30, 2013

   $ 318   
  

 

 

 

In the second quarter of 2013, the Company initiated a restructuring plan as a result of the Acquisition. The plan focuses on the rationalization of personnel, facilities and systems across the multiple segments in the organization. The total estimated cost of this restructuring plan was approximately $32.2 million and was recorded as severance expense during the second quarter of 2013. As of June 30, 2013, the total liability remaining for this restructuring plan was approximately $27.0 million. The remaining liability is expected to be paid by the end of Q1 2014 (in thousands):

 

  Balance as of December 31, 2012

   $   

  Restructuring charges

     32,244   

  Payments

     (5,256
  

 

 

 

  Balance as June 30, 2013

   $ 26,988   
  

 

 

 

Additionally, ARRIS acquired remaining restructuring accruals of approximately $1.9 million representing Motorola Home contractual obligations that related to an excess leased facility. As of June 30, 2013, the total liability remaining for this restructuring plan was approximately $0.1 million. These payments will be paid over their remaining lease terms through 2018, unless terminated earlier (in thousands):

 

  Balance acquired

   $ 173   

  Restructuring charges

     6   

  Payments

     (39
  

 

 

 

  Balance as June 30, 2013

   $ 140   
  

 

 

 

 

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Note 12.   Inventories

Inventories are stated at the lower of average cost, approximating first-in, first-out, or market. The components of inventory were as follows, net of reserves (in thousands):

 

     June 30,      December 31,  
     2013      2012  

Raw material

   $ 41,417       $ 24,798   

Work in process

     10,453         2,800   

Finished goods

     268,908         106,250   
  

 

 

    

 

 

 

Total inventories, net

   $ 320,778       $ 133,848   
  

 

 

    

 

 

 

Note 13.   Property, Plant and Equipment

Property, plant and equipment, at cost, consisted of the following (in thousands):

 

     June 30,     December 31,  
     2013     2012  

Land

   $ 88,742      $ 2,562   

Building and leasehold improvements

     122,641        25,995   

Machinery and equipment

     356,343        177,657   
  

 

 

   

 

 

 
     567,726        206,214   

Less: Accumulated depreciation

     (163,569     (151,836
  

 

 

   

 

 

 

Total property, plant and equipment, net

   $ 404,157      $ 54,378   
  

 

 

   

 

 

 

Note 14.   Long-Term Indebtedness

Convertible Senior Notes

In 2006, ARRIS issued $276.0 million of 2% convertible senior notes due 2026. The notes may be converted only upon the occurrence of specified events and during specified periods, including (i) from October 15, 2013 to November 15, 2013 and (ii) during any calendar quarter in which the closing price of the Company’s common stock for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter exceeds 120% of the conversion price in effect on the last trading day of the last calendar quarter (which, based on the current conversion price, would be $19.31). The conversion rate for the senior notes, subject to adjustment, is 62.1504 shares per $1,000 principal amount (which represents an initial conversion price of approximately $16.09 per share of the Company’s common stock). Upon conversion, the holder will receive up to the principal amount in cash and may receive, depending on the price of the Company’s common stock, an additional payment, in cash, the Company’s common stock or a combination thereof, at the option of the Company. Each component of the conversion consideration is based on a formula that includes the conversion rate and the market price of the Company’s common stock during a period following the date of the conversion.

In connection with the holding company reorganization, the Company, ARRIS and the indenture trustee executed a supplement to the indenture governing the senior notes. Among other things, under the supplemental indenture, the Company guaranteed ARRIS Enterprises’ obligations related to the senior notes. The supplemental indenture also provides that the conversion value of the senior notes will now be calculated by reference to the Company’s common stock rather than ARRIS Enterprises’ common stock, and any shares issuable upon conversion of the senior notes will now be settled in the Company’s common stock rather than ARRIS Enterprises’ common stock.

 

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As a result of the holding company reorganization undertaken in connection with the Acquisition, holders of the senior notes had the right, (i) to require ARRIS to repurchase the senior notes for 100% of the principal amount of the senior notes, plus accrued and unpaid interest to, but not including the repurchase date (the “Repurchase Right”) or (ii) to convert the senior notes for the consideration described above (the “Conversion Right”). Senior notes in the aggregate principal amount of $68 thousand were tendered pursuant to the Repurchase Right, and $11 thousand were surrendered pursuant to the Conversion Right. As a result, approximately $232.0 million aggregate principal amount of senior notes were outstanding as of June 30, 2013.

ARRIS may redeem the senior notes at any time on or after November 15, 2013, subject to certain conditions. In addition, the holders may require ARRIS Enterprises to purchase all or a portion of their senior notes (i) on November 15, 2013, November 15, 2016 and November 15, 2021 and (ii) for a period of time following the occurrence of specified fundamental changes. Upon redemption, the holder will receive the principal amount of the notes in cash plus any accrued and unpaid interest. The calculation of the redemption conversion consideration for the November 2013 redemption right is expected to be the same as the calculation for the May 2013 redemption right. Likewise, the calculation of the conversion consideration for the November 2013 conversion right is expected to be the same as the calculation for the May 2013 conversion right.

The notes are unsecured senior obligations of ARRIS and are effectively subordinated to all liabilities, including trade payables and lease obligations of ARRIS’ subsidiaries. Interest is payable on May 15 and November 15 of each year. There are no significant financial covenants related to the notes. As of June 30, 2013, the carrying amount of the convertible senior notes was $228.6 million and was recorded in current liabilities on the Company’s Consolidated Balance Sheets.

ARRIS accounts for the liability and equity components of the notes separately. The Company is accreting the debt discount related to the equity component to non-cash interest expense over the estimated seven year life of the convertible notes, which represents the first redemption date of November 15, 2013 when ARRIS Enterprises may redeem the notes at its election or the note holders may require their redemption. The equity and liability components related to the notes were as follows (in thousands):

 

     June 30,     December 31,  
     2013     2012  

Carrying amount of the equity component

   $ 48,209      $ 48,209   
  

 

 

   

 

 

 

Principal amount of the liability component

   $ 231,971      $ 232,050   

Unamortized discount

     (3,374     (9,926
  

 

 

   

 

 

 

Net carrying amount of the liability component

   $ 228,597      $ 222,124   
  

 

 

   

 

 

 

The following table presents the contractual interest coupon and the amortization of the discount on the equity component related to the notes during the three and six months ended June 30, 2013 and 2012 (in thousands):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2013      2012      2013      2012  

  Contractual interest recognized

   $ 1,160       $ 1,160       $ 2,320       $ 2,321   

  Amortization of discount

     3,308         3,058         6,552         6,057   

The effective annual interest rate on the debt component is 7.93%.

The Company paid approximately $7.8 million of finance fees related to the issuance of the notes. Of the $7.8 million, approximately $5.3 million was attributed to the debt component and $2.5 million was attributed to the equity component of the convertible debt instrument. The portion related to the debt component is being amortized over seven years. The remaining balance of unamortized financing costs from these notes as of June 30, 2013 and December 31, 2012 was $0.2 million and $0.6 million, respectively.

 

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The Company has not paid cash dividends on its common stock since its inception.

Senior Secured Credit Facilities

In April 2013, ARRIS entered into senior secured credit facilities with Bank of America, N.A. and various other institutions, which are comprised of (i) a “Term Loan A Facility” of $1.1 billion, (ii) a “Term Loan B Facility” of $825 million and (iii) a “Revolving Credit Facility” of $250 million. The Term Loan A Facility and the Revolving Credit Facility have terms of five years. The Term Loan B Facility has a term of seven years. Interest rates on borrowings under the senior credit facilities are set forth in the table below. As of June 30, 2013, ARRIS had no amounts drawn under the Revolving Credit Facility.

 

     Rate   As of June 30, 2013

Term Loan A

   LIBOR + 2.25 %   2.45%

Term Loan B

   LIBOR(1) + 2.75 %   3.50%

Revolving Credit Facility(2)

   LIBOR + 2.25 %   Not Applicable

 

  (1) Includes LIBOR floor of 0.75%
  (2) Includes unused commitment fee of 50 basis points not reflected in interest rate above.

Borrowings under the senior secured credit facilities are secured by first priority liens on substantially all of the assets of ARRIS and certain of its present and future subsidiaries who are or become parties to, or guarantors under, the credit agreement governing the senior secured credit facilities (the “Credit Agreement”). The Credit Agreement contains usual and customary limitations on indebtedness, liens, restricted payments, acquisitions and asset sales in the form of affirmative, negative and financial covenants, which are customary for financings of this type, including the maintenance of a minimum consolidated interest coverage ratio of not less than 3.5:1 and a maximum consolidated net leverage ratio of 4.25:1 (which decreases to 3.5:1 throughout the first two years of the Credit Agreement). As of June 30, 2013, ARRIS was in compliance with all covenants under the Credit Agreement.

The Credit Agreement provides terms for mandatory prepayments and optional prepayments and commitment reductions. The Credit Agreement also includes events of default, which are customary for facilities of this type (with customary grace periods, as applicable), including provisions under which, upon the occurrence of an event of default, all amounts outstanding under the credit facilities may be accelerated.

The Credit Agreement also provides that ARRIS should hold Unrestricted Cash in an amount at least equal to the aggregate principal amount outstanding under the Convertible Notes at such time. The Unrestricted Cash balance recorded in the Company’s Consolidated Balance Sheet as of June 30, 2013 was in excess of the principal amount outstanding under the Convertible Notes.

During the three months ended June 30, 2013, the Company made mandatory prepayments related to the senior secured credit facilities of approximately $15.8 million. As of June 30, 2013, the balance for the senior secured credit facilities was $1,909.2 million.

Note 15. Supplemental Financial Information

Consolidated Balance Sheets Information

Other current assets consist of the following (in thousands):

 

     June 30,
2013
     December 31,
2012
 

  Miscellaneous receivables

   $ 12,709      $ 5,095  

  Deferred cost of sales

     11,525        9,537  

  Verizon indemnification asset (1)

     85,000          

  TiVo indemnification asset (2)

     146,100          

  Other

     28,157        1,781   
  

 

 

    

 

 

 

    Total

   $ 283,491      $ 16,413  
  

 

 

    

 

 

 

 

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(1) The Company has recorded a contingent liability for the Verizon settlement of $85 million. A corresponding indemnification asset of $85 million has been recognized related to Seller’s portion of settlement based on the terms of our Motorola Home acquisition agreement.
(2) The Company has recorded a contingent liability for the TiVo settlement of $160 million. The liability reflects the total amount to be paid to TiVo of $196 million, less amounts that have been allocated to certain intangibles and future licenses conveyed as part of the settlement. The Company has allocated $36 million to these future deliverables based upon their relative fair values which will be recognized upon payment. A corresponding indemnification asset of $146 million has been recognized related to Seller’s portion of settlement based on the terms of our Motorola Home acquisition agreement.

Other non-current assets consist of the following (in thousands):

 

     June 30,
2013
     December 31,
2012
 

  Deferred financing fees

   $ 32,825      $ 400  

  Trade receivables

     10,982           

  Other

     11,669         8,985  
  

 

 

    

 

 

 

    Total

   $ 55,476      $ 9,385  
  

 

 

    

 

 

 

Other accrued current liabilities consist of the following (in thousands):

 

     June 30,
2013
     December 31,
2012
 

  Accrued restructuring

   $ 27,579       $ 527  

  Accrued volume rebates

     31,057         3,434  

  Google(1)

     119,101           

  Verizon indemnification liability (2)

     85,000           

  TiVo indemnification liability (3)

     160,000           

  Other liabilities

     76,051         20,981  
  

 

 

    

 

 

 

    Total

   $ 498,788       $ 24,942  
  

 

 

    

 

 

 

 

  (1) Excludes working capital adjustments to be determined during the third quarter of 2013.
  (2) The Company has recorded a contingent liability for the Verizon settlement of $85 million. A corresponding indemnification asset of $85 million has been recognized related to Seller’s portion of settlement based on the terms of our Motorola Home acquisition agreement.
  (3) The Company has recorded a contingent liability for the TiVo settlement of $160 million. The liability reflects the total amount to be paid to TiVo of $196 million, less amounts that have been allocated to certain intangibles and future licenses conveyed as part of the settlement. The Company has allocated $36 million to these future deliverables based upon their relative fair values which will be recognized upon payment. A corresponding indemnification asset of $146 million has been recognized related to Seller’s portion of settlement based on the terms of our Motorola Home acquisition agreement.

 

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Other noncurrent liabilities consist of the following (in thousands):

 

     June 30,
2013
     December 31,
2012
 

Long-term deferred revenue

   $ 5,305       $ 4,288  

Long-term warranty

     29,474         3,187  

Long-term severance liability

     3,782         4,119  

Other

     13,417         11,568  
  

 

 

    

 

 

 

Total

   $ 51,978       $ 23,162  
  

 

 

    

 

 

 

Note 16. Segment Information

The “management approach” has been used to present the following segment information. This approach is based upon the way the management of the Company organizes segments within an enterprise for making operating decisions and assessing performance. Financial information is reported on the basis that it is used internally by the chief operating decision maker (“CODM”) for evaluating segment performance and deciding how to allocate resources to segments. The Company’s chief executive officer has been identified as the CODM.

Prior to the second quarter of 2013, the CODM managed the operating results of the Company as three segments, including Broadband Communications Systems (“BCS”), Access, Transport and Supplies (“ATS”) and Media & Communications Systems (“MCS”). In connection with the Acquisition, the Company changed its reportable segments to align with how the CODM expected to evaluate financial information used to allocate resources and assess performance of the Company. As a result, the segment information presented in these financial statements has been conformed to present segments on this revised basis for all prior periods. Under the new organizational structure, the CODM manages the Company under two segments:

 

   

Customer Premises Equipment (“CPE”) – The CPE segment’s product solutions include set-top boxes, gateways, and Subscriber Premises equipment that enable service providers to offer Voice, Video and high-speed data services to residential and business subscribers.

 

   

Network and Cloud (“N&C”)The N&C segment’s product lines cover all components required by facility-based Service Providers to construct a state-of-the-art residential and metro distribution network. For Cable providers this includes Hybrid Fiber Coax (“HFC”) equipment, edge routers, metro WiFi, video management, storage, and distribution equipment. For Telco providers this includes fiber-based and copper-based broadband transmission equipment. In addition, the portfolio includes an advanced video headend management system for both legacy MPEG/DVB systems as well as full IP Video systems. Finally, the portfolio also includes full support for advanced multi-screen video management, protection, monetization and delivery, and a suite of products for performance management, configuration, and surveillance.

These operating segments were determined based on the nature of the products and services offered. The measures that are used to assess the reportable segment’s operating performance are sales and direct contribution. A measure of assets is not applicable, as segment assets are not regularly reviewed by the CODM for evaluating performance or allocating resources.

In addition, in conjunction with changing operating segments, the Company has changed its measure of assessing segment’s operating performance from gross margin to direct contribution, which is defined as gross margin less direct operating expense. Corporate and other expenses, such as selling and central G&A, not included in the measure of segment direct contribution

 

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are reported in “Other” and are reconciled to income (loss) before income taxes. As a result, the segment information presented in these financial statements has been conformed to present the Company’s segments on this revised basis for all prior periods presented.

The table below represents information about the Company’s reporting segments for the three and six months ended June 30, 2013 and 2012 (in thousands):

 

    Reportable Segments                          
    Network & Cloud     CPE     Other     Consolidated  
For the three months ended June 30,   2013     2012     2013     2012     2013     2012     2013     2012  

Sales

  $ 339,986      $ 200,015      $ 662,981      $ 149,312      $ (2,605          $ 1,000,362      $ 349,327   

Direct Contribution

    66,427        62,622        123,785        14,542        (170,309     (41,756     19,903        35,408   

Restructuring charges

            32,257        1,039        32,257        1,039   

Acquisition & other costs

            19,392               19,392          

Amortization of intangible assets

            58,130        7,444        58,130        7,444   
             

 

 

   

 

 

 

Operating income (loss)

                (89,876     26,925   

Other expense

                9,715        4,363   
             

 

 

   

 

 

 

Income (loss) before income taxes

                (99,591     22,562   
             

 

 

   

 

 

 
    Reportable Segments                          
    Network & Cloud     CPE     Other     Consolidated  
For the six months ended June 30,   2013     2012     2013     2012     2013     2012     2013     2012  

Sales

  $ 517,435      $ 385,197      $ 852,364      $ 267,030      $ (15,787          $ 1,354,012      $ 652,227   

Direct Contribution

    123,843        122,781        144,635        20,352        (224,257     (82,405     44,221        60,728   

Restructuring charges

            32,266        6,242        32,266        6,242   

Acquisition & other costs

            26,582        1,046        26,582        1,046   

Amortization of intangible assets

            65,733        14,823        65,733        14,823   
             

 

 

   

 

 

 

Operating income (loss)

                (80,360     38,617   

Other expense

                33,180        7,369   
             

 

 

   

 

 

 

Income (loss) before income taxes

                (113,540     31,248   
             

 

 

   

 

 

 

Note 17. Sales Information

The Company’s two largest customers (including their affiliates, as applicable) are Comcast and Time Warner Cable. Over the past year, certain customers’ beneficial ownership may have changed as a result of mergers and acquisitions. Therefore the revenue for ARRIS’ customers for prior periods has been adjusted to include their affiliates under common control. A summary of sales to these customers for the three and six months ended June 30, 2013 and 2012 are set forth below (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2013     2012     2013     2012  

  Comcast and affiliates

   $ 190,100      $ 96,189      $ 249,202      $ 177,991   

  % of sales

     19.0     27.5     18.4     27.3

  Time Warner Cable and affiliates

   $ 98,415      $ 75,317      $ 191,271      $ 122,421   

  % of sales

     9.8     21.6     14.1     18.8

 

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ARRIS sells its products primarily in the United States. The Company’s international revenue is generated from Asia Pacific, Canada, Europe, and Latin America. For the three months ended June 30, 2013 and 2012, sales to international customers were approximately 34.2% and 26.2%, respectively, of total sales. For the six months ended June 30, 2013 and 2012, sales to international customers were 33.6% and 25.6%, respectively, of total sales.

International sales by region for the three and six months ended June 30, 2013 and 2012 were as follows (in thousands):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2013      2012      2013      2012  

  Americas, excluding U.S. (1)

   $ 201,483       $ 55,923       $ 283,208       $ 103,827   

  Asia Pacific

     49,062         14,289         59,233         24,748   

  EMEA

     91,556         21,361         111,926         38,375   
  

 

 

    

 

 

    

 

 

    

 

 

 

  Total international sales

   $ 342,101       $ 91,573       $ 454,367       $ 166,950   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

  (1) Excludes U.S. sales of $658.3 million and $899.6 million for the three and six months ended June 30, 2013, respectively. Excludes U.S. sales of $257.7 million and $485.2 million for the three and six months ended June 30, 2012, respectively.

 

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Note 18. 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
June 30,
     Six Months Ended
June 30,
 
     2013     2012      2013     2012  

Basic:

         

Net (loss) income

   $ (50,277   $ 15,001       $ (64,927   $ 20,800   
  

 

 

   

 

 

    

 

 

   

 

 

 

Weighted average shares outstanding

     134,626        113,842         124,940        114,457   
  

 

 

   

 

 

    

 

 

   

 

 

 

Basic (loss) earnings per share

   $ (0.37   $ 0.13       $ (0.52   $ 0.18   
  

 

 

   

 

 

    

 

 

   

 

 

 

Diluted:

         

Net (loss) income

   $ (50,277   $ 15,001       $ (64,927   $ 20,800   
  

 

 

   

 

 

    

 

 

   

 

 

 

Weighted average shares outstanding

     134,626        113,842         124,940        114,457   

Net effect of dilutive equity awards

            1,269                1,895   
  

 

 

   

 

 

    

 

 

   

 

 

 

Total

     134,626        115,111         124,940        116,352   
  

 

 

   

 

 

    

 

 

   

 

 

 

Diluted (loss) earnings per share

   $ (0.37   $ 0.13       $ (0.52   $ 0.18   
  

 

 

   

 

 

    

 

 

   

 

 

 

As discussed in Note 14 Long-Term Indebtedness, in November 2006, the Company issued $276.0 million of convertible senior notes. Upon conversion, ARRIS will satisfy at least the principal amount in cash, rather than common stock. This reduced the potential earnings dilution to only include the conversion premium, which is the difference between the conversion price per share of common stock and the average share price. The average share price during the three and six months ended June 30, 2013 and 2012 was less than the conversion price, and consequently, did not result in dilution. However, basic shares were used for the three and six months ended June 30, 2013 as a net loss was reported for the quarter and the inclusion of dilutive shares would be antidilutive.

For the three and six months ended June 30, 2013, approximately 1.5 million and 0.8 million of the equity-based awards, respectively, were excluded from the computation of diluted earnings per share shares because their effect would have been anti-dilutive. During the same periods in 2012, approximately 4.2 million and 3.3 million of the equity-based awards, respectively, were excluded from the dilutive securities above. These exclusions are made if the exercise price of these equity-based awards is in excess of the average market price of the common stock for the period, or if the Company has net losses, both of which have an anti-dilutive effect.

During the six months ended June 30, 2013, the Company issued 2.7 million shares of its common stock related to stock option exercises and the vesting of restricted shares, as compared to 1.7 million shares for the twelve months ended December 31, 2012.

In connection with the Acquisition, the Seller was issued approximately 10.6 million shares of ARRIS’ common stock as part of the purchase consideration. The fair value of the 10.6 million shares issued, $150 million, was determined based on the 20 trading day trailing average closing price of the Company’s common stock at signing of the definitive agreement. Furthermore, Comcast was given an opportunity to invest in ARRIS, and on January 11, 2013, the Company entered into a separate agreement accounted for as a contingent equity forward with a subsidiary of Comcast providing for the purchase by it from the Company of approximately 10.6 million shares of common stock for $150 million. As a result of the sale of common stock to Comcast, both Comcast and Google each own approximately 7.7% of the outstanding ARRIS shares post-closing based on ARRIS’ current capitalization. The Comcast transaction was consummated on the same day as the acquisition date of Motorola Home. (See Note 3 Business Acquisitions and Note 5 Comcast Investment in ARRIS for additional details)

 

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Note 19. Income Taxes

For the six month periods ended June 30, 2013 and 2012, the Company recorded income tax expense (benefit) of $(48.6) million and $10.4 million, respectively. Below is a summary of the components of the tax expense (benefit) for the three and six month periods ended June 30, 2013 and 2012 (in thousands, except for percentages):

 

     Three Months Ended June 30,  
     2013     2012  
     (Loss)
Income
Before

Tax
    Income
Tax
Expense
(Benefit)
    Effective
Tax Rate
    Income
Before
Tax
     Income
Tax
Expense
(Benefit)
     Effective
Tax Rate
 

Non-discrete items

   $ (49,796   $ (32,405     65.1   $ 22,562       $ 7,561         33.5

Discrete events - Acquisition-related costs

     (51,659     (17,109          

2012 R&D credit

                                  

Comcast’s investment in ARRIS

     6,159                              

Gain / (loss) from certain foreign entities acquired

     (4,295                           

Other

            200                       
  

 

 

   

 

 

     

 

 

    

 

 

    

Total

   $ (99,591   $ (49,314     49.5   $ 22,562       $ 7,561         33.5
  

 

 

   

 

 

     

 

 

    

 

 

    

 

     Six Months Ended June 30,  
     2013     2012  
     (Loss)
Income
Before

Tax
    Income
Tax
Expense
(Benefit)
    Effective
Tax Rate
    Income
Before
Tax
     Income
Tax
Expense
(Benefit)
     Effective
Tax Rate
 

Non-discrete items

   $ (24,026   $ (24,188     100.7   $ 31,248       $ 10,448         33.4

Discrete events - Acquisition-related costs

     (58,848     (19,750          

2012 R&D credit

            (4,875                    

Comcast’s investment in ARRIS

     (26,371                           

Gain / (Loss) from certain foreign entities acquired

     (4,295                           

Other

            200                       
  

 

 

   

 

 

     

 

 

    

 

 

    

Total

   $ (113,540   $ (48,613     42.8   $ 31,248       $ 10,448         33.4
  

 

 

   

 

 

     

 

 

    

 

 

    

 

   

The reduction in the income tax expense (benefit) for the three and six month periods ended June 30, 2013, compared to the three and six months ended June 30, 2012, was due to the change in earnings from continuing operations, as a result of the Motorola Home acquisition that occurred on April 17, 2013 and its related significant, infrequent and unusual book charges.

   

For the six month periods ended June 30, 2013 and 2012, our estimated effective tax rates were 42.8% and 33.4%, respectively. The rate of 42.8% is based on the Company’s pre-tax book loss of approximately $(113.5) million and a tax benefit of approximately $(48.6) million, for the six month period ended June 30, 2013. The change in the estimated effective tax rate for the six month periods ended June 30, 2013, compared to the six months ended June 30, 2012 was due to a benefit from the research and development tax credit legislation reenacted retroactively to January of 2012, a significant increase in projected qualified research expenditures for 2013 further increasing our 2013 tax credits, and a benefit from generating a higher percentage of our profits from foreign jurisdictions, which are taxed at a lower rate than the U.S. federal statutory rate. The two latter events were a result of the impact of the Acquisition.

   

For the six month period ended June 30, 2013, the Company recorded a benefit of approximately $(4.9) million related to 2012 research and development tax credits. The U.S. research and development credit was reenacted in January 2013 retroactive to the beginning of 2012. The full year 2012 impact of the

 

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research and development tax credits was recognized in the three month period ended March 31, 2013. For the six month period ended June 30, 2012, the Company did not record any benefits attributed to research and development tax credits, as the tax credit was not reenacted until January 2013.

   

For the six month period ended June 30, 2013, the Company recorded significant book expenses of and infrequent and unusual nature of approximately $(58.8) million relating to the acquisition of the Home business of Motorola, generating a tax benefit of $(19.8) million. These unusual expenses include the restructuring charges that were identified and arose from the synergy and integration plans of the Company. Additionally, for the six month period ended June 30, 2013, the Company recorded a pre-tax book loss on an investment in ARRIS by Comcast of approximately $(26.4) million and a pre-tax book loss of approximately $(4.3) million on certain foreign entities from the Motorola Home acquisition, on which no tax benefit was recorded.

   

For the six month period ended June 30, 2012, the Company did not identify any significant unusual or infrequent book charges, or discrete tax events.

The increase in the Company’s unrecognized tax benefits for the six month period ended June 30, 2013, compared to the twelve month period ended December 31, 2012, was primarily due to the impact of the Acquisition.

Note 20. Accumulated Other Comprehensive Income

The following table summarizes the changes in accumulated other comprehensive income by component, net of taxes, for the six months ended June 30, 2013 (in thousands):

 

    

Unrealized gain

on marketable
securities

    Unfunded
pension
liability
    Cumulative
translation
adjustments
    Total  

Balance as of December 31, 2012

   $ 206      $ (8,558   $ (184   $ (8,536

Other comprehensive income before reclassifications

     (303     -        487        184   

Amounts reclassified from accumulated other comprehensive income

     78        -        -        78   
  

 

 

 

Net current-period other comprehensive income

     (225     -        487        262   
  

 

 

 

Balance as of June 30, 2013

   $ (19   $ (8,558   $ 303      $ (8,274
  

 

 

 

Note 21. Commitments

ARRIS leases office, distribution, and warehouse facilities as well as equipment under long-term leases expiring at various dates through 2023. Included in these operating leases are certain amounts related to restructuring activities; these lease payments and related sublease income are included in restructuring accruals on the consolidated balance sheets. Future minimum operating lease payments under non-cancelable leases at June 30, 2013 were as follows (in thousands):

 

     Operating Leases  

2014

   $ 23,629   

2015

     17,251   

2016

     14,692   

2017

     10,332   

2018

     6,811   

Thereafter

     6,821   

Less sublease income

     (7,260
  

 

 

 

Total minimum lease payments

   $ 72,276   
  

 

 

 

Total rental expense for all operating leases amounted to approximately $8.6 million and $12.4 million for the six months ended June 30, 2013 and twelve months ended December 31, 2012, respectively.

As of June 30, 2013, the Company had approximately $3.8 million of restricted cash. Of the total restricted cash, $1.8 million related to outstanding letters of credit that were cash collateralized and $2.0 million is security for hedge transactions. Additionally, the Company had contractual obligations of approximately $576.4 million under

 

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agreements with non-cancelable terms to purchase goods or services over the next year. All contractual obligations outstanding at the end of prior years were satisfied within a 12 month period, and the obligations outstanding as of June 30, 2013 are expected to be satisfied in 2014.

Note 22. Contingencies

The Company accrues a liability for legal contingencies when it believes that it is both probable that a liability has been incurred and that it can reasonably estimate the amount of the loss. The Company reviews these accruals and adjusts them to reflect ongoing negotiations, settlements, rulings, advice of legal counsel and other relevant information. To the extent new information is obtained and the Company’s views on the probable outcomes of claims, suits, assessments, investigations or legal proceedings change, changes in the Company’s accrued liabilities would be recorded in the period in which such determinations are made. Unless noted otherwise, the amount of liability is not probable or the amount cannot be reasonably estimated; and, therefore, accruals have not been made.

Due to the nature of the Company’s business, it is subject to patent infringement claims, including current suits against it or one or more of its wholly-owned subsidiaries, or one or more of our customers who may seek indemnification from us, alleging infringement by various Company products and services. The Company believes that it has meritorious defenses to the allegation made in its pending cases and intends to vigorously defend these lawsuits; however, it is currently unable to determine the ultimate outcome of these or similar matters. In addition, the Company is a defendant in various litigation matters generally arising out of the normal course of business.

As part of the Acquisition Agreement, whereby the Company purchased Motorola Home from General Instrument Holdings, Inc. (“Seller”), a subsidiary of Google Inc., the Seller has agreed to indemnify the Company for any and all losses suffered by the Company as it relates to certain Specified Retained Litigation Matters, subject to ARRIS being responsible for 50% of the first $50 million in respect of past infringement and 50% of the first $50 million in respect of certain future royalty payments related to the Specified Retained Litigation Matters, for a total obligation of $50 million.

During the second quarter ended June 30, 2013, the Company reached tentative settlements related to certain of these Specified Retained Litigation Matters as follows:

TiVo:

The Company, Google, Inc. and TiVo reached a tentative settlement agreement to settle all claims associated with certain patent infringement litigation for $196 million, which included non-exclusive, worldwide, non-transferable and perpetual license to the patents subjected to the litigation. On the date the Settlement Agreement and Release was executed the Company was legally responsible for the entire litigation to TiVo, and as such during the quarter ended June 30, 2013, the Company recorded a liability and an offsetting indemnification asset of $146 million (for which Google, Inc. indemnified ARRIS). This liability reflects the settlement amount of $196 million less the $50 million for which the Company is responsible pursuant to the Acquisition Agreement.

Verizon:

The Company, Google, Inc., and Verizon Sourcing LLC (“Verizon”), reached a settlement agreement, whereby the Company will pay $85 million to Verizon. Payment is expected to be made in the quarter ended September 30, 2013. During the quarter ended June 30, 2013, the Company has recorded a contingent liability for the amount of the settlement and an offsetting indemnification asset of $85 million (for which Google, Inc. has indemnified ARRIS). In consideration for this cash payment, the Company will have no further obligation for any indemnification of any claim arising from the Action.

 

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Note 23. Subsequent Event

As stated in Note 14 Long-Term Indebtedness, ARRIS has entered into senior secured credit facilities having variable interest rates. In July 2013, ARRIS entered into six $100.0 million interest rate swap arrangements, which effectively converted $600.0 million of the Company’s variable-rate debt based on one-month LIBOR to an aggregate fixed rate of approximately 3.65%. This fixed rate could vary up by 25 basis points or down by 50 basis points based on future changes to the Company’s net leverage ratio. Each of these swaps matures on December 29, 2017. ARRIS has designated these swaps as cash flow hedges, and the objective of these hedges is to manage the variability of cash flows in the interest payments related to the portion of the variable-rate debt designated as being hedged.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We are a premier video and broadband technology company that transforms how service providers worldwide deliver entertainment and communications without boundaries. Our powerful end-to-end platforms enable service and content providers to improve the way people connect with each other and with their favorite content. Headquartered north of Atlanta, in Suwanee, Georgia, we have R&D, sales and support centers throughout the world.

Acquisition of Motorola Home

On April 17, 2013 we acquired the Motorola Home business from General Instrument Holdings, Inc., a subsidiary of Google, Inc. for $2.4 billion in cash and equity, subject to certain adjustments as provided for in the acquisition agreement (the “Acquisition”). We believe the acquisition enhances our ability to provide next-generation consumer video products and services, supporting a more comprehensive product offering while also accelerating our ability to deliver a comprehensive set of industry-leading new products to a wide spectrum of customers. We more than doubled in size as a result of the acquisition, which had significant effects on virtually every aspect of our business and operations and which make comparisons in this discussion to our historical results difficult. These impacts include:

 

   

Significant Increase in Scale and Geographic Footprint. Our sales increased from $353.7 million for the first quarter 2013 to $1,000.4 million for the second quarter of 2013 (which includes Motorola Home sales subsequent to the acquisition and not for the entire quarter), compared to $302.9 million and $349.3 million, respectively for the same periods in 2012. We more than tripled our number of employees from approximately 2,200 employees to more than 7,000 employees. In addition, we now have a direct presence in over 25 countries and channel presence in over 85 countries compared to 21 and 30, respectively, prior to the Acquisition.

   

Expansion of the Industry that we Serve. Historically almost all of our revenues were derived from sales to cable television multiple system operators (“MSOs”). While MSOs remain a large and important component of our business, our operations have broadened through the Acquisition to include more sales to telephone companies and programmers, as well as the addition of retail distribution channels. As a result, we have a significantly more diverse customer base. Our top five customers following the Acquisition would have accounted for approximately 50% of our 2012 sales on a pro forma basis, compared with over 50% from only our two largest customers, Comcast and Time Warner, prior to the Acquisition.

   

Additional Product Offerings. Our roster of products expanded as a result of the Acquisition to include products for passive optical networks, optical Ethernet components, multiscreen software solutions and DSL modems and gateways. In addition, our traditional product lines, such as set-top boxes and gateways, routers, DOCSIS cable modems, encoders and transcoders, have expanded, in many cases, increasing our relevance with our customers.

   

Increased IP Portfolio and R&D. We now have over 2,000 granted and in-process patents, which is more than double our portfolio prior to the Acquisition. In addition, as part of the transaction we also received a limited license to approximately 20,000 additional patents. With the additional resources and employees gained from the Acquisition, we expect to significantly increase our investment in fundamental research, expanding our intellectual property rights and developing new product offerings.

   

Long-term Debt. As described below under “Financial Liquidity and Capital Resources,” we entered into senior secured credit facilities to fund a portion of the acquisition costs and to support our on-going working capital needs. As a result, our long-term debt increased from $225.4 million at March 31, 2013 to $2,127.9 million at June 30, 2013. We are subject to a number of financial covenants under the senior secured credit facilities that could impact our operational flexibility.

In addition, as described below, we have reduced our reportable operating segments from three to two. Readers should consider the size and transformative nature of the Motorola Home acquisition described above when reviewing this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

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New Operating Segments

The completion of the Motorola Home acquisition changed the way that we manage and review our business. As a result, beginning with the periods ended June 30, 2013, we now report two operating segments, (1) Network & Cloud and (2) Customer Premises Equipment. Corporate and other expenses not included in the measure of segment contribution will be reported in an “All Other” category. A comparison of our products and the acquired Motorola Home products included in our new reporting segments is set forth in the table below. See Note 16 for additional information regarding this resegmentation.

 

Prior Segments    New Segments

ARRIS

 

Motorola Home

    

Broadband Communications Systems:

•        CMTS, CCAP, Edge QAMs, Encoder/Decoder/Transcoder

Access, Transport & Supplies:

•        HE Optics, Fiber Nodes & RF Amplifiers

Media & Communication Systems:

•        Service Assurance, Analytics, Workforce Management, Video on Demand, Ad Insertion & Management

 

Network Infrastructure:

•        CMTS, Edge QAMs, HE Optics, Fiber Nodes, RF Amplifiers, Encoders/Decoders/Transcoders

Convergence Experiences:

•        Service Assurance, Content Management & Security, Ad Insertion, Video on Demand, User Experience

   Network and Cloud (“N&C”)
    
    

Broadband Communications Systems:

•        Modems, EMTAs, Gateways

 

Home Devices:

•        Modems, EMTAs, Gateways, Set-top Boxes

   Customer Premises Equipment (“CPE”)

Key Highlights

Set forth below are some key highlights that we achieved in the three and six months ended June 30, 2013:

Financial Highlights

 

   

Sales in the second quarter and first half of 2013 were $1,000.4 million and $1,354.0 million, respectively, as compared to $349.3 million and $652.2 million in the same periods in 2012. The increase is primarily attributed to the inclusion of sales of Motorola Home business. We estimate that Motorola Home had approximately $66 million of sales prior to the closing of the acquisition on April 17, 2013.

   

Gross margin percentage was 23.1% in the second quarter of 2013, which compares to 33.9% in the second quarter of 2012. The year over year decline reflects the inclusion of the Motorola Home products, which in the aggregate, have lower overall margins than the historic ARRIS products. The second quarter 2013 gross margin also includes a $57.6 million impact associated with writing up the historic cost of the Motorola Home inventory to fair value at the date of acquisition (subsequently increasing cost of goods sold) as well as $13.6 million of costs associated with the rationalization of certain products after the acquisition date.

   

Total operating expenses (excluding amortization of intangible assets, restructuring charges and acquisition and other costs) in the second quarter of 2013 were $211.2 million, as compared to $83.0 million in the same period last year. The increase is the result of the inclusion of expenses associated with Acquisition. We estimate that Motorola Home had approximately $34 million of operating expenses (excluding amortization of intangible assets, restructuring charges and acquisition costs) prior to the closing of the acquisition on April 17, 2013.

   

We incurred $32.3 million of restructuring charges and $19.4 million of acquisition and integration related costs in the second quarter 2013 related to our acquisition of Motorola Home.

 

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Intangible amortization increased from $7.4 million in the second quarter 2012 to $58.1 million in the second quarter 2013 as a result of our acquisition of Motorola Home.

   

We ended the second quarter of 2013 with $764.1 million of cash, cash equivalents, short-term and long-term marketable security investments. The Company generated $294.0 million of cash from operating activities during the second quarter 2013 and $344.0 million through the first six months of 2013, which compares to $30.6 million and $65.9 million generated during the same periods in 2012. Changes in working capital, primarily accounts payable and inventory, are the major factors impacting the first half of 2013, a portion of which (estimated to be $200 million) is expected to reverse in the second half of 2013. The Company and Google have settled certain litigation matters for which the Company’s maximum liability is $50 million under the terms of the acquisition agreement. The Company anticipates paying the litigation settlement in the third quarter 2013.

   

We ended the second quarter 2013 with long-term debt of $2,127.9 million, the current portion of which is $290.0 million. We anticipate retiring the short term debt with cash resources. We issued $1.9 billion of new debt in the second quarter 2013 in conjunction with our acquisition of Motorola Home.

Product Line Highlights

 

   

Customer Premises Equipment

 

  o Set-top Solutions
  ¡  

Continued strong industry momentum for video gateway-based solutions. Building upon plans to provide the cable industry’s first Reference Design Kit (“RDK”) based Whole Home Network and Entertainment gateway, the ARRIS Media Gateway 2402, ARRIS also announced a program to deliver the Comcast X1 experience on a XG1 gateway

  ¡  

Extended coverage of the ARRIS Whole Home IP Video solution as current customers increased deployment rates

  ¡  

Successfully deployed an advanced wireless IPTV set-top solution in support of Bell Canada’s Fibe TV service offering expansion.

  ¡  

Selected by Vectra, Poland’s second largest cable service provider, to provide hybrid set-top solutions in support of their analog to digital migration

  ¡  

Recognized as one of six companies as part of AT&T’s 2013 Supplier Award Program providing both IPTV set-top and DSL solutions

  o Broadband Devices
  ¡  

Based on continued strong demand for broadband services, achieved record levels of DOCSIS device shipments, including both embedded WiFi gateways and stand-alone high-speed data and voice modems.

  ¡  

Continued momentum to DOCSIS 3.0-based solutions, and growing demand for integrated gateway solutions.

 

   

Network and Cloud

  o CMTS
  ¡  

Successful E6000 introduction and product ramp-up as operators begin deployment of the industry first Converged Cable Access Platform (“CCAP”) platform

  ¡  

Record levels of downstream and upstream channel shipments on the strength of significant new E6000 chassis shipments

  ¡  

Continued deployment of both C4 and BSR CMTS platforms as operators continue to cost effectively extend their current installed base

 

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  o Access and Transport
  ¡  

Strong year-over-year growth in sales as operators incrementally invest in their HFC network to increase narrowcast capacity for services such as High Speed Data and Video On Demand

  ¡  

Continued metro WiFi deployments as operators augment fixed line network with mobility access

  ¡  

Momentum building around deep fiber and all-digital optics network architectures

 

  o Video Infrastructure
  ¡  

Introduction of new highly dense GT-3 transcoding platform addressing growing multi-screen adaptive bit rate video opportunities

  ¡  

Successful early deployments of new APEX3000 CCAP-capable Universal EdgeQAM

  ¡  

Continuing field trial of Network DVR storage and control plane with Tier 1 cable operator

  ¡  

Continued shipments of MPEG4 encoder/Transcoder products to programmer and IPTV operators

 

  o Cloud
  ¡  

Ongoing Multi-screen Video engagements with several Tier 1 Service Providers

  ¡  

Significant WorkAssure Capacity Management capability delivered for deployment with large South American cable operator

Non-GAAP Measures

As part of our ongoing review of financial information related to our business, we regularly use non-GAAP measures, in particular non-GAAP earnings per share, as we believe they provide a meaningful insight into our business and trends. We also believe that these non-GAAP measures provide readers of our financial statements with useful information and insight with respect to the results of our business. However, the presentation of non-GAAP information is not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. Below are tables for the three and six months ended June 30, 2013 and 2012 which detail and reconcile GAAP and non-GAAP earnings per share:

 

(in thousands, except per share data)    For the Three Months Ended June 30, 2013  
     Sales      Gross Margin Expense      Operating
Expense
    Operating
Income
    Other
(Income)
Expense
   

Income
Tax Expense

(Benefit)

    Net Income
(Loss)
 

Amounts in accordance with GAAP

   $ 1,000,362       $ 231,077       $ 320,953      $ (89,876   $ 9,715      $ (49,314 )$      (50,277

Reduction in revenue related to Comcast’s investment in ARRIS

     -             -             -            -            -            -            -       

Acquisition accounting impacts related to fair value of inventory

     -             57,600         -            57,600        -            -            57,600   

Acquisition accounting impacts related to deferred revenue

     2,417         1,472         -            1,472        -            -            1,472   

Product Rationalization

     -             13,582         -            13,582        -            -            13,582   

Stock compensation expense

     -             866         (6,314     7,180        -            -            7,180   

Amortization of intangible assets

     -             -             (58,130     58,130        -            -            58,130   

Acquisition costs, restructuring, and integration costs

     -             -             (51,649     51,649        -            -            51,649   

Credit facility - ticking fees

     -             -             -            -            (477     -            477   

Mark-to-market FV adjustment related to Comcast’s investment in ARRIS

     -             -             -            -            6,159        -            (6,159

Non-cash interest expense

     -             -             -            -            (3,308     -            3,308   

Adjustments of income tax valuation allowances and other discrete tax items

     -             -             -            -            -            -            -       

Tax related to items above

     -             -             -            -            -            74,784        (74,784
  

 

 

 

Non-GAAP amounts

   $ 1,002,779       $ 304,597       $ 204,860      $ 99,737$      $ 12,088      $ 25,470$      $ 62,178   
  

 

 

 

GAAP net income per share - diluted

                 $ (0.37
                

 

 

 

Non-GAAP net income per share - diluted

                 $ 0.46   
                

 

 

 

Weighted average common shares - basic

                   134,626   
                

 

 

 

Weighted average common shares - diluted

                   136,626   
                

 

 

 

 

  (1) Basic shares used as losses were reported for those periods and the inclusion of dilutive shares would be anti-dilutive

 

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(in thousands, except per share data)    For the Six Months Ended June 30, 2013  
     Sales      Gross Margin      Operating
Expense
    Operating
Income
    Other
(Income)
Expense
    Income
Tax Expense
(Benefit)
    Net Income
(Loss)
 

Amounts in accordance with GAAP

   $ 1,354,012       $ 339,603       $ 419,963      $ (80,360   $ 33,180      $ (48,613   $ (64,927

Reduction in revenue related to Comcast’s investment in ARRIS

     13,182         13,182         -            13,182        -            -            13,182   

Acquisition accounting impacts related to fair value of inventory

     -             57,600         -            57,600        -            -            57,600   

Acquisition accounting impacts related to deferred revenue

     2,417         1,472         -            1,472        -            -            1,472   

Product Rationalization

     -             13,582         -            13,582        -            -            13,582   

Stock compensation expense

     -             1,697         (12,227     13,924        -            -            13,924   

Amortization of intangible assets

     -             -             (65,733     65,733        -            -            65,733   

Acquisition costs, restructuring, and integration costs

     -             -             (58,848     58,848        -            -            58,848   

Credit facility - ticking fees

     -             -               -            (865     -            865   

Mark-to-market FV adjustment related to Comcast’s investment in ARRIS

     -             -             -            -            (13,189     -            13,189   

Non-cash interest expense

     -             -               -            (6,552     -            6,552   

Adjustments of income tax valuation allowances and other discrete tax items

     -             -             -            -            -            7,516        (7,516

Tax related to items above

     -             -             -            -            -            80,520        (80,520
  

 

 

 

Non-GAAP amounts

   $ 1,369,611       $ 427,136       $ 283,155      $ 143,981      $ 12,574      $ 39,423      $ 91,984   
  

 

 

 

GAAP net income per share - diluted

                 $ (0.52
                

 

 

 

Non-GAAP net income per share - diluted

                 $ 0.72   
                

 

 

 

Weighted average common shares - basic

                   124,940   
                

 

 

 

Weighted average common shares - diluted

                   127,876   
                

 

 

 

 

  (1) Basic shares used as losses were reported for those periods and the inclusion of dilutive shares would be anti-dilutive

 

(in thousands, except per share data)    For the Three Months Ended June 30, 2012  
     Gross Margin      Operating
Expense
    Operating
Income
     Other
(Income)
Expense
    Income
Tax Expense
(Benefit)
     Net Income
(Loss)
 

Amounts in accordance with GAAP

   $ 118,526       $ 91,601      $ 26,925       $ 4,363      $ 7,561       $ 15,001   

Acquisition accounting impacts related to deferred revenue

     663         -            663         -            -             663   

Stock compensation expense

     809         (7,058     7,867         -            -             7,867   

Amortization of intangible assets

     -             (7,444     7,444         -            -             7,444   

Acquisition costs and restructuring costs

     -             (1,141     1,141         -            -             1,141   

Impairment of investment

     -             (466     466         -            -             466   

Non-cash interest expense

     -             -            -             (3,058     -             3,058   

Tax related to items above

     -             -            -             -            6,749         (6,749
  

 

 

 

Non-GAAP amounts

   $ 119,998       $ 75,492      $ 44,506       $ 1,305      $ 14,310       $ 28,891   
  

 

 

 

GAAP net income per share - diluted

                $ 0.13   
               

 

 

 

Non-GAAP net income per share - diluted

                $ 0.25   
               

 

 

 

Weighted average common shares - diluted

                  115,111   
               

 

 

 

 

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Table of Contents
(in thousands, except per share data)    For the Six Months Ended June 30, 2012  
     Gross Margin      Operating
Expense
    Operating
Income
     Other
(Income)
Expense
    Income
Tax Expense
(Benefit)
     Net Income
(Loss)
 

Amounts in accordance with GAAP

   $ 227,434       $ 188,817      $ 38,617       $ 7,369      $ 10,448       $ 20,800   

Acquisition accounting impacts related to deferred revenue

     1,921         -            1,921         -            -             1,921   

Stock compensation expense

     1,559         (12,957     14,516         -            -             14,516   

Amortization of intangible assets

     -             (14,823     14,823         -            -             14,823   

Acquisition costs and restructuring costs

     -             (6,951     6,951         -            -             6,951   

Loss of sale of product line

     -             (337     337         -            -             337   

Impairment of investment

     -             (466     466         -            -             466   

Non-cash interest expense

     -             -            -             (6,057     -             6,057   

Tax related to items above

     -             -            -             -            14,870         (14,870
  

 

 

 

Non-GAAP amounts

   $ 230,914       $ 153,283      $ 77,631       $ 1,312      $ 25,318       $ 51,001   
  

 

 

 

GAAP net income per share - diluted

                $ 0.18   
               

 

 

 

Non-GAAP net income per share - diluted

                $ 0.44   
               

 

 

 

Weighted average common shares - diluted

                  116,352   
               

 

 

 

In managing and reviewing our business performance, we exclude a number of items required by GAAP. Management believes that excluding these items is useful in understanding the trends and managing our operations. We provide these supplemental non-GAAP measures in order to assist the investment community to see ARRIS through the “eyes of management,” and therefore enhance understanding of ARRIS’ operating performance. Non-GAAP financial measures should be viewed in addition to, and not as an alternative to, the Company’s reported results prepared in accordance with GAAP. Our non-GAAP financial measures reflect adjustments based on the following items, as well as the related income tax effects:

Reduction in Revenue Related to Comcast’s Investment in ARRIS: In connection with our acquisition of Motorola Home, in January 2013 Comcast agreed to invest in ARRIS. The per share purchase price, which was based on the value used to determine the number of shares issued in the Motorola Home acquisition, for the investment was less than the market price on the date the agreement was executed. As a result, the accounting guidance requires that we record the implied fair value of benefit received by Comcast as a reduction in revenue. We have excluded the effect of the implied fair value in calculating our non-GAAP financial measures. We believe it is useful to understand the effects of these items on our total revenues and gross margin.

Acquisition Accounting Impacts Related to Deferred Revenue: In connection with our acquisitions, business combination rules require us to account for the fair values of deferred revenue arrangements for which acceptance has not been obtained, and post contract support in our purchase accounting. The non-GAAP adjustment to our sales and cost of sales is intended to include the full amounts of such revenues as if these purchase accounting adjustments had not been applied. We believe the adjustment to these revenues is useful as a measure of the ongoing performance of our business. We historically have experienced high renewal rates related to our support agreements and our objective is to increase the renewal rates on acquired post contract support agreements. However, we cannot be certain that our customers will renew our contracts.

Acquisition Accounting Impacts Related to Inventory Valuation: In connection with our acquisition of Motorola Home, business combinations rules require the inventory be recorded at fair value on the opening balance sheet. This is different from historical cost. Essentially we were required to write the inventory up to end customer price less a reasonable margin as a distributor. This resulted in an increase in the value of inventory and will result in higher cost of goods sold as it is sold.

Product Rationalization: In conjunction with the integration of Motorola Home, we have identified certain product lines which overlap. In the second quarter of 2013, we made the decision to eliminate certain products. As a result, we recorded expenses related to the elimination of inventory and certain vendor liabilities. We believe it is useful to understand the effects of this item on our total cost of goods sold.

Stock-Based Compensation Expense: We have excluded the effect of stock-based compensation expenses in calculating our non-GAAP operating expenses and net income (loss) measures. Although stock-based compensation

 

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is a key incentive offered to our employees, we continue to evaluate our business performance excluding stock-based compensation expenses. We record non-cash compensation expense related to grants of options and restricted stock. Depending upon the size, timing and the terms of the grants, the non-cash compensation expense may vary significantly but will recur in future periods.

Amortization of Intangible Assets: We have excluded the effect of amortization of intangible assets in calculating our non-GAAP operating expenses and net income (loss) measures. Amortization of intangible assets is non-cash, and is inconsistent in amount and frequency and is significantly affected by the timing and size of our acquisitions. Investors should note that the use of intangible assets contributed to our revenues earned during the periods presented and will contribute to our future period revenues as well. Amortization of intangible assets will recur in future periods.

Restructuring, Acquisition and Integration Costs: We have excluded the effect of acquisition related and other expenses and the effect of restructuring expenses in calculating our non-GAAP operating expenses and net income measures. We will incur significant expenses in connection with our recent acquisition of Motorola Home, which we generally would not otherwise incur in the periods presented as part of our continuing operations. Acquisition related expenses consist of transaction costs, costs for transitional employees, other acquired employee related costs, and integration related outside services. Restructuring expenses consist of employee severance, abandoned facilities, and other exit costs. We believe it is useful to understand the effects of these items on our total operating expenses.

Credit Facility - Ticking Fees: In connection with our acquisition of Motorola Home, the cash portion of the consideration was in part funded through debt financing commitments. A ticking fee is a fee paid to our banks to compensate for the time lag between the commitment to make the loan and the actual funding. We have excluded the effect of the ticking fee in calculating our non-GAAP financial measures. We believe it is useful to understand the effect of these items in our other (income) expense.

Mark-To-Market Fair Value Adjustment Related To Comcast Investment in ARRIS: In connection with our acquisition of Motorola Home, in January 2013 Comcast agreed to invest in ARRIS. The per share purchase price for the investment, which was based on the value used to determine the number of shares issued in the Motorola Home acquisition, was less than the market price on the date of agreement was executed. As a result, the accounting guidance requires we mark to market the changes in the value of the investment and flow through other (income) expense. Until the closing of the deal, changes in the value of the investment for the full quarter were marked to market and flow through other (income) expense. We have excluded the effect of the implied fair value in calculating our non-GAAP financial measures. We believe it is useful to understand the effects of these items on our total other (income) expense.

Loss on Sale of Product Line: We have excluded the effect of a loss on the sale of a product line in calculating our non-GAAP operating expenses and net income measures. We believe it is useful to understand the effects of these items on our total operating expenses.

Impairment of Investment: We have excluded the effect of an other-than-temporary impairment of a cost method investment in calculating our non-GAAP financial measures. We believe it is useful to understand the effect of this non-cash item in our other expense (income).

Non-Cash Interest on Convertible Debt: We have excluded the effect of non-cash interest in calculating our non-GAAP operating expenses and net income (loss) measures. We record the accretion of the debt discount related to the equity component non-cash interest expense. We believe it is useful to understand the component of interest expense that will not be paid out in cash.

Income Tax Expense (Benefit): We have excluded the tax effect of the non-GAAP items mentioned above. Additionally, we have excluded the effects of certain tax adjustments related to state valuation allowances, research and development tax credits and provision to return differences.

 

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Significant Customers

The Company’s two largest customers (including their affiliates, as applicable) are Comcast and Time Warner Cable. Over the past year, certain customers’ beneficial ownership may have changed as a result of mergers and acquisitions. Therefore the revenue for ARRIS’ customers for prior periods has been adjusted to include the affiliates under common control. A summary of sales to these customers for the three and six months ended June 30, 2013 and 2012 are set forth below (in thousands). The significant changes in the percentages of the total sales primarily result from the greater customer diversification as a result of the Motorola Home acquisition.

 

    

Three Months Ended

June 30,

   

Six Months Ended

June 30,

 
     2013     2012     2013     2012  

Comcast and affiliates

   $ 190,100      $ 96,189      $ 249,202      $ 177,991   

% of sales

     19.0     27.5     18.4     27.3

Time Warner Cable and affiliates

   $ 98,415      $ 75,317      $ 191,271      $ 122,421   

% of sales

     9.8     21.6     14.1     18.8

Comparison of Operations for the Three and Six Months Ended June 30, 2013 and 2012

Net Sales

The table below sets forth our net sales for the three and six months ended June 30, 2013 and 2012, for each of our segments (in thousands):

 

     Net Sales      Increase (Decrease) Between 2013 and 2012  
     For the Three Months Ended      For the Six Months Ended      For the Three Months Ended     For the Six Months Ended  
     June 30,      June 30,      June 30     June 30  
     2013     2012      2013     2012      $     %     $     %  

Business Segment:

                  

CPE

   $ 662,981      $ 149,312       $ 852,365      $ 267,030       $ 513,669        344.0   $ 585,335        219.2

N&C

     339,986        200,015         517,434        385,197         139,971        70.0     132,237        34.3

Other

     (2,605     –           (15,787     –           (2,605     100.0     (15,787     100.0
  

 

 

    

 

 

    

 

 

     

 

 

   

Total sales

   $ 1,000,362      $ 349,327       $ 1,354,012      $ 652,227       $ 651,035        186.4   $ 701,785        107.6
  

 

 

    

 

 

   

 

 

    

 

 

     

 

 

   

The table below sets forth our domestic and international sales for the three and six months ended June 30, 2013 and 2012 (in thousands):

 

     Net Sales      Increase (Decrease) Between 2013 and 2012  
     For the Three Months Ended      For the Six Months Ended      For the Three Months Ended     For the Six Months Ended  
     June 30,      June 30,      June 30     June 30  
     2013      2012      2013      2012      $      %     $      %  

Domestic

   $ 658,261       $ 257,754       $ 899,645       $ 485,278       $ 400,507         155.4   $ 414,367         85.4

International

                      

Americas, excluding U.S.

     201,483         55,924         283,208         103,826         145,559         260.3     179,382         172.8

Asia Pacific

     49,062         14,289         59,233         24,748         34,773         243.3     34,485         139.3

EMEA

     91,556         21,360         111,926         38,375         70,196         328.6     73,551         191.7

Total International

     342,101         91,573         454,367         166,949         250,528         273.6     287,418         172.2
  

 

 

    

 

 

    

 

 

      

 

 

    

Total sales

   $ 1,000,362       $ 349,327       $ 1,354,012       $ 652,227       $ 651,035         186.4   $ 701,785         107.6
  

 

 

    

 

 

    

 

 

      

 

 

    

 

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Customer Premises Equipment Net Sales 2013 vs. 2012

During the three and six months ended June 30, 2013 sales in our CPE segment increased by approximately 344.0% and 219.2%, respectively, as compared to the same period in 2012. The increase is primarily attributable to the inclusion of sales associated with our acquisition of Motorola Home.

Network and Cloud Net Sales 2013 vs. 2012

During the three and six months ended June 30, 2013, sales in N&C segment increased by approximately 70.0% and 34.3%, respectively, as compared to the same period in 2012. The increase in sales is primarily the result of the inclusion of sale associated with our acquisition of Motorola Home.

Gross Margin

The table below sets forth our gross margin for the three and six months ended June 30, 2013 and 2012 (in thousands):

 

     Gross Margin     Increase (Decrease) Between 2013 and 2012  
     For the Three Months Ended     For the Six Months Ended     For the Three Months Ended     For the Six Months Ended  
     June 30,     June 30,     June 30     June 30  
     2013     2012     2013     2012     $      %     $      %  

Gross margin dollars

   $ 231,077      $ 118,526      $ 339,603      $ 227,434      $ 112,551         95.0   $ 112,169         49.3

Gross margin percentage

     23.1     33.9     25.1     34.9        (10.8        (9.8

During the three and six months ended June 30, 2013, gross margin dollars increased and gross margin percentage decreased as compared to the same period in 2012. Increase in gross margin dollars is primarily the result of the inclusion of sales associated with our acquisition of Motorola Home. The decrease in gross margin percentage is the result of product mix. The historic gross margin of Motorola Home products is lower than the average of the historic ARRIS business. Also leading to the mix impact is the relative proportion of legacy Motorola Home sales and ARRIS sales; legacy Motorola Home sales are significantly higher. The second quarter 2013 gross margin also includes a $57.6 million impact associated with writing up the historic cost of the Motorola Home inventory to fair value at the date of acquisition (subsequently increasing cost of goods sold) as well as $13.6 million of costs associated with the rationalization of certain products after the acquisition date. We do not expect these items to impact future quarters.

Operating Expenses

The table below provides detail regarding our operating expenses (in thousands):

 

     Operating Expenses      Increase (Decrease) Between 2013 and 2012  
     For the Three Months Ended      For the Six Months Ended      For the Three Months Ended     For the Six Months Ended  
     June 30,      June 30,      June 30     June 30  
     2013      2012      2013      2012      $      %     $     %  

SG&A

   $ 87,774       $ 40,135       $ 127,900       $ 79,678       $ 47,639         118.7   $ 48,222        60.5

Research & development

     123,400         42,881         167,482         87,028         80,519         187.8     80,454        92.4

Restructuring charges

     32,257         1,039         32,266         6,242         31,217         3,004.5     26,024        416.9

Acquisition & other costs

     19,392         102         26,582         709         19,291         18,912.7     25,873        3,649.2

Loss on sale of product line

     –           –           –           337         –           –          (337     (100.0 )% 

Amortization of intangibles

     58,130         7,444         65,733         14,823         50,686         680.9     50,910        343.5
  

 

 

    

 

 

    

 

 

      

 

 

   

Total

   $ 320,953       $ 91,601       $ 419,963       $ 188,817       $ 229,352         250.4   $ 231,146        122.4
  

 

 

    

 

 

    

 

 

      

 

 

   

SG&A and R&D expenses for the second quarter 2013 include only those expenses related to Motorola Home after the April 17 closing date. We estimate that SG&A/R&D expenses incurred by Motorola Home in the second quarter prior to the acquisition were approximately $36 million. Also, during the quarter, we implemented certain actions to reduce workforce and other costs as a result of the acquisition. These actions will reduce future expenditures. As a result, the current quarter expenses will not be indicative of future results. We anticipate that SG&A/R&D, in the aggregate, will be in the range of $235 million to $245 million in the second half of 2013.

 

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Selling, General, and Administrative, or SG&A, Expenses

The year over year increase in SG&A expenses primarily reflects the inclusion of expenses associated with the Motorola Home acquisition.

Research & Development, or R&D, Expenses

Included in our R&D expenses are costs directly associated with our development efforts (people, facilities, materials, etc.) and reasonable allocations of our information technology and corporate facility costs. R&D expenses for the three and six months ended June 30, 2013 increased as compared to the same period in 2012 due to the inclusion of expenses associated with the Motorola Home acquisition.

Restructuring Charges

During the first half of 2013, ARRIS continued its implementation of the restructuring initiative following the acquisition of Motorola Home to align our workforce and operating costs with current business opportunities. This resulted in restructuring charges of $32.3 million related to severance, termination benefits and facilities during both the three month and six month ending June 30, 2013. The restructuring charges of $1.0 million and $6.2 million for the three and six month periods ending June 30, 2012, respectively, were related to the BigBand acquisition.

Acquisition and Other Costs

During the second quarter of 2013, we recorded acquisition-related expense and integration expenses of $19.4 million. During the first half of 2013, we recorded acquisition-related expense and integration expenses of $26.6 million. These expenses related to the acquisition of Motorola Home and consisted of transaction costs and legal fees.

During the second quarter of 2012, we recorded acquisition related expenses of $0.1 million. For the six month period ending June 30, 2012, we recorded acquisition related expenses of $0.7 million. These expenses were related to the acquisition of BigBand and consisted of transaction costs and integration related outside services.

Loss on Sale of Product Line

In March of 2012, the Company completed the sale of certain assets of its ECCO electronic connector product line to Eclipse Embedded Technologies, Inc. for approximately $3.9 million. The Company recorded a net loss of $(0.3) million on the sale, which included approximately $0.3 million of transaction related costs. The results of the ECCO product line were deemed immaterial to the overall financial results of the Company, and as such the Company has not reported the results in discontinued operations.

Amortization of Intangible Assets

Intangibles amortization expense for the three months ended June 30, 2013 and 2012 was $58.1 million and $7.4 million, respectively. For the six months ended June 30, 2013 and 2012, intangible amortization expense was $65.7 million and $14.8 million, respectively. Our intangible expense is related to the acquisitions of Motorola Home in April 2013, BigBand Networks in November 2011, Digeo, Inc. in October 2009, EG Technologies in September 2009, Auspice Corporation in August 2008 and C-COR Incorporated in December 2007.

 

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Direct Contribution

The table below sets forth our direct contribution for the three and six months ended June 30, 2013 and 2012, for each of our segments (in thousands):

 

     Direct Contribution     Increase (Decrease) Between 2013 and 2012  
     For the Three Months Ended     For the Six Months Ended     For the Three Months Ended     For the Six Months Ended  
     June 30,     June 30,     June 30     June 30  
     2013     2012     2013     2012     $     %     $     %  

Business Segment:

                

CPE

   $ 123,785      $ 14,542      $ 144,635      $ 20,352      $ 109,243        751.2   $ 124,283        610.7

N&C

     66,427        62,622        123,843        122,781        3,805        6.1     1,062        0.9

Other

     (170,309     (41,756     (224,257     (82,405     (128,553     (307.9 )%      (141,852     (172.1 )% 
  

 

 

   

 

 

   

 

 

     

 

 

   

Total

   $ 19,903      $ 35,408      $ 44,221      $ 60,728      $ (15,505     43.8   $ (16,507     (27.2 )% 
  

 

 

   

 

 

   

 

 

     

 

 

   

Customer Premises Equipment Direct Contribution 2013 vs. 2012

During the three and six months ended June 30, 2013 direct contribution in our CPE segment increased by approximately 751.2% and 610.7%, respectively, as compared to the same period in 2012. The increase is primarily attributable to the inclusion of direct contribution associated with our acquisition of Motorola Home. Further, the direct contribution is favorably impacted by mix, given, that in the aggregate the contribution margin of former Motorola Home products are greater than that of former ARRIS products.

Network and Cloud Direct Contribution 2013 vs. 2012

During the three and six months ended June 30, 2013, direct contribution in our N&C segment increased by approximately 6.1% and 0.9%, respectively, as compared to the same period in 2012. Despite the higher sales, as a result of the Motorola Home acquisition, second quarter direct contribution did not increase materially. The second quarter contribution was impacted year over year by (1) higher operating expenses associated with investing in the acquired Cloud software portfolio, as well as overlapping investments in next generation CCAP (which is an area of synergy focus); (2) the ramp of E6000 CMTS in 2013 resulted in higher shipments of new chassis and line cards, which have lower margin relative to license upgrades of deployed C4 CMTS products shipped in 2012.

Other Expense (Income)

Interest Expense

Interest expense for the three months ended June 30, 2013 and 2012 was $18.6 million and $4.4 million respectively. For the six months ended June 30, 2013 and 2012, interest expense was $23.2 million and $8.8 million respectively. Interest expense reflects the amortization of deferred finance fees, the non-cash interest component of our convertible subordinated notes and term loans, interest paid on the notes and term loans, and other debt obligations.

Interest Income

Interest income during the three months ended June 30, 2013 and 2012 was $0.6 million and $0.7 million, respectively. During the six months ended June 30, 2013 and 2012, interest income was $1.5 million and $1.5 million, respectively. The income reflects interest earned on cash, cash equivalents, short-term and long-term investments.

Loss (Gain) on Foreign Currency

During the three and six months ended June 30, 2013, we recorded a foreign currency loss of approximately $0.2 million and $1.0 million, respectively. During the three months and six months ended June 30, 2012, we recorded a foreign currency loss of approximately $0.5 million and $1.3 million, respectively. We have certain international

 

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customers who are billed in their local currency. To mitigate the volatility related to fluctuations in the foreign exchange rates, we may enter into various foreign currency contracts. The loss (gain) on foreign currency is driven by the fluctuations in the foreign currency exchanges rates.

Loss (Gain) on Investments

From time to time, we hold certain investments in the common stock of private and publicly-traded companies, a number of non-marketable equity securities, and investments in rabbi trusts associated with our deferred compensation plans.

During the three months ended June 30, 2013 and 2012, we recorded net loss (gain) related to these investments of $(0.7) million, and $0.4 million, respectively. During the six months ended June 30, 2013 and 2012, we recorded net gains related to these investments of $1.3 million, and $0.6 million, respectively.

Other Expense (Income)

Other income for the three months ended June 30, 2013 and 2012 was $7.7 million and $0.2 million, respectively. For the six months ended June 30, 2013 and 2012, other (expense) income was $(11.7) million and $0.7 million, respectively.

In connection with Comcast’s agreement in January 2013 to invest in ARRIS upon the acquisition of Motorola Home, accounting guidance requires that, since the agreed-upon purchase price was less than the market price on the date of agreement, the resulting forward arrangement be marked to market for the difference in fair value. This resulted in a mark-to-market adjustment of $(6.2) million for the three months ended June 30, 2013 and $13.2 million in the six months ended June 30, 2013 and is recorded as Other Expense (Income).

Income Tax Expense

For the three and six month periods ended June 30, 2013, we recorded income tax expense (benefit) of $(49.3) million and $(48.6) million, respectively, as compared to $7.6 million and $10.4 million, respectively in the same periods in 2012. The reduction in the income tax expense for the three and six month periods ended June 30, 2013, compared to the three and six month periods ended June 30, 2012, was primarily due to the change in earnings from continuing operations, as a result of the Motorola Home acquisition that occurred on April 17, 2013 and its related significant, infrequent and unusual book charges.

For the six month period ended June 30, 2013, the Company recorded a pre-tax book loss of approximately $(58.8) million relating to the acquisition costs incurred on Motorola Home acquisition, on which a tax benefit of $(19.8) was recorded; a pre-tax book loss of approximately $(4.3) million on certain foreign entities from the Motorola Home acquisition, on which no tax benefit was recorded; a tax benefit of approximately $(4.9) million related to 2012 research and development tax credits, as the credit was reenacted in January 2013 retroactive to the beginning of 2012; and a pre-tax book loss of approximately $(26.4) million on the Comcast investment in ARRIS, on which no tax benefit was recorded. The full year 2012 impact of the research and development tax credits was recognized in the three month period ended March 31, 2013. There were no discrete tax events during the first six months of 2012.

 

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Financial Liquidity and Capital Resources

Overview

Following completion of the Motorola Home acquisition, one of our key strategies remains maintaining and improving our capital structure. The key metrics we focus on are summarized in the table below:

Liquidity & Capital Resources Data

 

     Six Months Ended June 30,  
     2013     2012  
     (in thousands, except DSO and turns)  

Key Working Capital Items

    

Cash provided by operating activities

   $ 344,009      $ 65,866   

Cash, cash equivalents, and short-term investments

   $ 741,225      $ 539,561   

Long-term U.S. corporate & government agency bonds

   $ 22,903      $ 36,691   

Accounts receivable, net

   $ 662,156      $ 179,371   

Days Sales Outstanding (“DSOs”)

     57 (1)      46   

Inventory

   $ 320,778      $ 102,361   

Inventory turns

     9.6 (1)      7.8   

Key Financing Items

    

Convertible notes at face value

   $ 231,971      $ 232,050   

Convertible notes at book value

   $ 228,597      $ 215,823   

Term loans at face value

   $ 1,909,199      $   

Key Shareholder Equity Items

    

Cash used for share repurchases

   $      $ 41,551   

Capital Expenditures

   $ 21,402      $ 9,256   

 

(1)

Using single point average for these calculations for six months ended June 30, 2013 due to the Motorola Home acquisition

In managing our liquidity and capital structure, we have been and are focused on key goals, and we have and will continue in the future to implement actions to achieve them. They include:

 

   

Liquidity – ensure that we have sufficient cash resources or other short term liquidity to manage day to day operations

   

Growth – implement a plan to ensure that we have adequate capital resources, or access thereto, to fund internal growth and execute acquisitions while retiring our convertible notes in a timely fashion.

   

Timely debt retirement – implement a plan to retire the term loans.

   

Share repurchases – opportunistically repurchase our common stock to the extent permitted under our credit agreements.

The acquisition of Motorola Home in April 2013 substantially increased our total indebtedness.

Accounts Receivable & Inventory

We use the number of times per year that inventory turns over (based upon sales for the most recent period, or turns) to evaluate inventory management, and days sales outstanding, or DSOs, to evaluate accounts receivable management.

 

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Accounts receivable increased during the first six months of 2013 as compared to 2012 primarily as a result of the inclusion of sales associated with the Motorola Home products, which were not included in 2012. DSOs increased during the first six months of 2013 as compared to 2012. As part of the Acquisition, we acquired approximately $462.2 million of accounts receivable. Looking forward, it is possible that DSOs may increase dependent upon our customer mix and payment patterns, particularly if international sales increase as customers internationally typically have longer payment terms.

Inventory increased in the second quarter of 2013 as compared to 2012, primarily as a result of the Motorola Home acquisition. We acquired approximately $279.6 million of inventory upon closing of the Motorola Home transaction in April 2013. Inventory turns during the first six months of 2013 were 9.6 as compared to 7.8 in the same period of 2012.

Common Share Repurchases

During the first six months of 2013, ARRIS did not repurchase any shares under the previously adopted share repurchase plan. During the first half of 2012, we repurchased 3.7 million shares of our common stock for $41.6 million at an average stock price of $11.28. We believe it is unlikely that we will repurchase a significant number of shares in the near-term.

Tender offer for 2.00% Convertible Senior Notes due 2026

As a result of the holding company reorganization undertaken in connection with the Motorola Home acquisition, holders of the senior notes had the right (i) to require us to repurchase the senior notes for 100% of the principal amount of the senior notes, plus accrued and unpaid interest to, but not including the repurchase date (the “Repurchase Right”) and (ii) to convert the senior notes for the consideration provided for in the indenture governing the senior notes (the “Conversion Right”). The calculation of the Repurchase Right and the Conversion Right is the same as the calculation would be upon redemption in November 2013. See Note 14, Long-Term Indebtedness for further discussion.

Senior notes in the aggregate principal amount of $68 thousand were tendered in connection with the Repurchase Right, and $68 thousand of cash-on-hand was used to repurchase these notes. Eleven notes were submitted for conversion, and $11 thousand of cash-on-hand was used to satisfy ARRIS’ obligations on these notes. Following the tender offer, $232.0 million in aggregate principal amount of the senior notes remain outstanding. Based on current market conditions, we expect to redeem the senior notes in full in November 2013.

Summary of Current Liquidity Position and Potential for Future Capital Raising

We believe our current liquidity position, where we have approximately $741.2 million of cash, cash equivalents, and short-term investments and $22.9 million of long-term marketable securities on hand as of June 30, 2013, together with approximately $248.7 million in availability under our new Revolving Credit Facility entered into in connection with the Motorola Home acquisition and the prospects for continued generation of cash from operations, are adequate for our short- and medium-term business needs. Our cash and cash-equivalents as of June 30, 2013 include approximately $200 million held by foreign subsidiaries whose earnings we expect to reinvest indefinitely outside of the United States. We do not expect to need the cash generated by those foreign subsidiaries to fund our domestic operations. However, in the unforeseen event that we repatriate cash from those foreign subsidiaries, in excess of what is owed to the United States parent, we may be required to provide for and pay U.S. taxes on permanently repatriated funds.

We expect to be able to generate sufficient cash on a consolidated basis to make all of the principal and interest payments under our senior secured credit facilities, indentures and other instruments governing our indebtedness. We expect to redeem the remaining outstanding senior notes in November 2013. Should our available funds be insufficient to support these initiatives or our operations, it is possible that we will raise capital through private or public, share or debt offerings.

 

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Senior Secured Credit Facilities

In April 2013 we entered into senior secured credit facilities with Bank of America, N.A. and various other institutions, which are comprised of (i) a “Term Loan A Facility” of $1.1 billion, (ii) a “Term Loan B Facility” of $825 million and (iii) a “Revolving Credit Facility” of $250 million. The Term Loan A Facility and the Revolving Credit Facility have terms of five years. The Term Loan B Facility has a term of seven years. Interest rates on borrowings under the senior credit facilities are set forth in the table below. As of June 30, 2013, we had $1,909 million face value outstanding under the Term Loan A and Term Loan B Facilities and no amounts drawn under the Revolving Credit Facility.

 

    

Rate

   As of June 30, 2013  

Term Loan A

   LIBOR + 2.25 %      2.45

Term Loan B

   LIBOR(1) + 2.75 %      3.50

Revolving Credit Facility(2)

   LIBOR + 2.25 %      Not Applicable   

 

  (1) Includes LIBOR floor of 0.75%
  (2) Includes unused commitment fee of 50 basis points not reflected in interest rate above.

Borrowings under the senior secured credit facilities are secured by first priority liens on substantially all of our assets and certain of our present and future subsidiaries who are or become parties to, or guarantors under, the credit agreement governing the senior secured credit facilities (the “Credit Agreement”). The Credit Agreement contains usual and customary limitations on indebtedness, liens, restricted payments, acquisitions and asset sales in the form of affirmative, negative and financial covenants, which are customary for financings of this type, including the maintenance of a minimum consolidated interest coverage ratio of not less than 3.5:1 and a maximum consolidated net leverage ratio of 4.25:1 (which decreases to 3.5:1 throughout the first two years of the Credit Agreement). As of June 30, 2013, we were in compliance with all covenants under the Credit Agreement.

The Credit Agreement provides terms for mandatory prepayments and optional prepayments and commitment reductions. The Credit Agreement also includes events of default, which are customary for facilities of this type (with customary grace periods, as applicable), including provisions under which, upon the occurrence of an event of default, all amounts outstanding under the credit facilities may be accelerated.

Commitments

As a result of the Motorola Home acquisition, our contractual obligations have significantly increased from the amounts shown in the table included in our Annual Report on Form 10-K for the year ended December 31, 2012. Included below is a summary of the additional contractual obligations that we have undertaken.

Following is a summary of our contractual obligations as of June 30, 2013 (in thousands):

 

     Payments due by period  
Contractual Obligations    Less than 1 Year      1-3 Years      3-5 Years      More than 5 Years      Total  

Senior notes (1)

   $ 231,971       $       $       $       $ 231,971   

Credit facilities