10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

For the quarter ended September 30, 2014

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 October 31, 2014, 144,777,301 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 Nine Months Ended September 30, 2014

INDEX

 

     Page  

Part I.    Financial Information

  

        Item 1.

  Consolidated Financial Statements (unaudited)   
  a) Consolidated Balance Sheets as of September 30, 2014 and December 31, 2013      2   
  b) Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2014 and 2013      3   
  c) Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2014 and 2013      4   
  d) Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2013      5   
  e) Notes to the Condensed Consolidated Financial Statements      6   

        Item 2.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      24   

        Item 3.

  Quantitative and Qualitative Disclosures About Market Risk      40   

        Item 4.

  Controls and Procedures      40   

Part II. Other Information

  

        Item    1.

  Legal Proceedings      40   

        Item 1A.

  Risk Factors      44   

        Item 6.

  Exhibits      53   

Signatures

       54   


Table of Contents

PART I. FINANCIAL INFORMATION,

Item 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

ARRIS GROUP, INC.

CONSOLIDATED BALANCE SHEETS

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

 

     September 30,     December 31,  
     2014     2013 (1)  

ASSETS

    

Current Assets:

    

Cash and cash equivalents

   $ 526,999      $ 442,438   

Short-term investments, at fair value

     66,817        67,360   
  

 

 

   

 

 

 

Total cash, cash equivalents and short-term investments

     593,816        509,798   

Restricted cash

     1,022        1,079   

Accounts receivable (net of allowances for doubtful accounts of $6,390 in 2014 and $1,887 in 2013)

     703,566        637,059   

Other receivables

     18,227        8,366   

Inventories (net of reserves of $57,481 in 2014 and $42,408 in 2013)

     368,628        330,129   

Prepaid income taxes

     4,431        13,034   

Prepaids

     34,311        61,482   

Current deferred income taxes

     64,948        77,167   

Other current assets

     59,439        39,930   
  

 

 

   

 

 

 

Total Current Assets

     1,848,388        1,678,044   

Property, plant and equipment (net of accumulated depreciation of $253,555 in 2014 and $194,830 in 2013)

     371,496        396,152   

Goodwill

     938,265        940,402   

Intangible assets (net of accumulated amortization of $606,903 in 2014 and $427,143 in 2013)

     1,000,441        1,176,192   

Investments

     74,985        71,176   

Noncurrent deferred income taxes

     12,567        7,678   

Other assets

     59,102        52,363   
  

 

 

   

 

 

 
   $ 4,305,244      $ 4,322,007   
  

 

 

   

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current Liabilities:

    

Accounts payable

   $ 622,867      $ 662,919   

Accrued compensation, benefits and related taxes

     130,116        116,262   

Accrued warranty

     51,277        48,755   

Deferred revenue

     102,717        69,071   

Current portion of long-term debt

     67,062        53,254   

Current income taxes liability

     15,344        3,068   

Other accrued liabilities

     132,551        141,698   
  

 

 

   

 

 

 

Total Current Liabilities

     1,121,934        1,095,027   

Long-term debt, net of current portion

     1,487,585        1,691,034   

Accrued pension

     59,667        58,657   

Noncurrent income tax liability

     31,141        21,048   

Noncurrent deferred income taxes

     42,926        74,791   

Other noncurrent liabilities

     71,882        62,463   
  

 

 

   

 

 

 

Total Liabilities

     2,815,135        3,003,020   
  

 

 

   

 

 

 

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; 144.8 million and 142.1 million shares outstanding in 2014 and 2013, respectively

     1,792        1,766   

Capital in excess of par value

     1,725,383        1,688,782   

Treasury stock at cost, 34.2 million shares in 2014 and 2013

     (306,330     (306,330

Retained earnings (deficit)

     73,881        (60,569

Unrealized (loss) gain on marketable securities (net of accumulated tax effect of $(44) in 2014 and $154 in 2013)

     (77     306   

Unfunded pension liability (net of accumulated tax effect of $981 in 2014 and 2013)

     (2,416     (2,416

Unrealized loss on derivative instruments (net of accumulated tax effect of $1,131 in 2014 and $1,467 in 2013)

     (1,959     (2,541

Cumulative translation adjustments

     (165     (11
  

 

 

   

 

 

 

Total Stockholders’ Equity

     1,490,109        1,318,987   
  

 

 

   

 

 

 
   $ 4,305,244      $ 4,322,007   
  

 

 

   

 

 

 

 

(1) Certain amounts for December 31, 2013 have been recast to reflect results for business acquisitions.

See accompanying notes to the consolidated financial statements.

 

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Table of Contents

ARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

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

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2014     2013 (1)     2014     2013 (1)  

Net sales

   $ 1,405,445      $ 1,067,824      $ 4,059,534      $ 2,421,835   

Cost of sales

     969,711        750,929        2,857,613        1,765,458   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross margin

     435,734        316,895        1,201,921        656,377   

Operating expenses:

        

Selling, general and administrative expenses

     103,497        99,666        314,991        227,691   

Research and development expenses

     142,802        128,716        421,077        296,354   

Amortization of intangible assets

     57,100        65,053        179,835        128,571   

Integration, acquisition, restructuring and other costs

     10,226        12,278        34,246        71,126   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     313,625        305,713        950,149        723,742   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income (loss)

     122,109        11,182        251,772        (67,365

Other expense (income):

        

Interest expense

     14,217        25,188        49,041        48,431   

Loss (gain) on investments

     6,368        (251     11,278        (1,544

Interest income

     (653     (832     (1,937     (2,310

Loss (gain) on foreign currency

     3,107        (3,752     3,760        (2,725

Other expense (income), net

     (63     1,676        6,530        13,356   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before income taxes

     99,133        (10,847     183,100        (122,573

Income tax expense (benefit)

     44,507        (28,016     48,649        (76,630
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss)

   $ 54,626      $ 17,169      $ 134,451      $ (45,943
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) per common share:

        

Basic

   $ 0.38      $ 0.12      $ 0.93      $ (0.35
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

   $ 0.37      $ 0.12      $ 0.91      $ (0.35
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average common shares:

        

Basic

     144,967        138,478        144,085        129,502   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

     148,753        140,605        147,996        129,502   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Certain amounts for the three and nine months ended September 30, 2013 have been recast to reflect results for business acquisitions.

See accompanying notes to the consolidated financial statements.

 

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ARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands) (unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2014     2013(1)     2014     2013(1)  

Net income (loss)

   $ 54,626      $ 17,169      $ 134,451      $ (45,943

Unrealized (loss) gain on marketable securities, net of (expense) benefit of $131 and $(30) for the three months ended September 30, 2014 and 2013, and $221 and $73 for the nine months ended September 30, 2014 and 2013, respectively

     (227     104        (383     (121

Unrealized gain (loss) on derivative instruments, net of (expense) benefit of $(1,468) and $2,450 for the three months ended September 30, 2014 and 2013, and $(336) and $2,450 for the nine months ended September 30, 2014 and 2013, respectively

     2,544        (4,277     582        (4,277

Cumulative translation adjustment

     (285     (331     (154     156   
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income (loss), net of tax

   $ 56,658      $ 12,665      $ 134,496      $ (50,185
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Certain amounts for the three and nine months ended September 30, 2013 have been recast to reflect results for business acquisitions.

See accompanying notes to the condensed consolidated financial statements.

 

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Table of Contents

ARRIS GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands) (unaudited)

 

     Nine Months Ended
September 30,
 
     2014     2013 (1)  

Operating activities:

    

Net income (loss)

   $ 134,451      $ (45,943

Depreciation

     60,213        42,567   

Amortization of intangible assets

     179,835        128,571   

Stock compensation expense

     39,812        24,653   

Deferred income tax benefit

     (19,503     (54,551

Amortization of deferred finance fees and debt discount

     9,376        4,999   

Provision for doubtful accounts

     5,285        5   

Loss (gain) on investments

     11,278        (1,544

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 (gain) on disposal and write down of fixed assets

     3,128        375   

Non-cash restructuring and related charges

            6,761   

Excess income tax benefits from stock-based compensation plans

     (14,651     (6,417

Non-cash interest expense

            9,926   

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

    

Accounts receivable

     (70,627     17,793   

Other receivables

     (10,465     1,095   

Inventories

     (38,499     60,345   

Accounts payable and accrued liabilities

     2,592        155,264   

Prepaids and other, net

     44,866        9,928   
  

 

 

   

 

 

 

Net cash provided by operating activities

     337,091        380,198   

Investing activities:

    

Purchases of property, plant and equipment

     (41,759     (53,383

Purchases of investments

     (40,901     (104,546

Sales of investments

     29,319        393,234   

Acquisitions, net of cash acquired

     84        (2,208,114

Sales of property, plant and equipment

     19        90   
  

 

 

   

 

 

 

Net cash used in investing activities

     (53,238     (1,972,719

Financing activities:

    

Excess income tax benefits from stock-based compensation plans

     14,651        6,416   

Repurchase of shares to satisfy employee minimum tax withholdings

     (29,605     (12,522

Proceeds from issuance of common stock

     11,565        166,951   

Proceeds from issuance of debt

            1,925,000   

Payment of debt obligations

     (195,903     (31,625

Cash paid for debt discount

            (9,853

Early redemption of convertible notes

            (79

Deferred financing costs paid

            (42,356
  

 

 

   

 

 

 

Net cash (used in) provided by financing activities

     (199,292     2,001,932   
  

 

 

   

 

 

 

Net increase in cash and cash equivalents

     84,561        409,411   

Cash and cash equivalents at beginning of period

     442,438        131,703   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 526,999      $ 541,114   
  

 

 

   

 

 

 

 

(1) Certain amounts for the nine months ended September 30, 2013 have been recast to reflect results for business acquisitions.

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 global media entertainment and data communications solutions provider, headquartered in Suwanee, Georgia. The Company operates in two business segments, Customer Premises Equipment and Network & Cloud (See Note 14 Segment Information for additional details), specializing in enabling multichannel video programming distributors, including cable, telephone, and digital broadcast satellite operators, and media programmers to deliver rich media, voice, and IP data services to end consumer subscribers. ARRIS is a leading developer, manufacturer and supplier of interactive set-top boxes, end-to-end digital video and Internet Protocol Television distribution systems, broadband access infrastructure platforms, and associated data and voice Customer Premises Equipment. The Company’s solutions are complemented by a broad array of services and systems integration that bring localized expertise to every touchpoint in the delivery process. This lends a customized approach to serving each of ARRIS’ primary markets.

The 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, 2013, as filed with the United States Securities and Exchange Commission (“SEC”).

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.)

In connection with the acquisition of Motorola Home, the consolidated financial statements as of September 30, 2013 and for the three and nine months then ended have been recast to include retrospective acquisition accounting and other adjustments. The following tables present the effect on the Company’s affected financial statement line items for the period ended September 30, 2013 and three and nine months ended September 30, 2013 (in thousands):

 

     As Originally
Reported
    As Adjusted     Increase (Decrease)  

Balance Sheet:

      

Inventories, net

   $ 350,919      $ 343,896      $ (7,023

Current deferred income tax assets

     85,373        75,875        (9,498

Other current assets

     60,171        60,111        (60

Property, plant and equipment

     410,047        398,353        (11,694

Goodwill

     926,826        943,258        16,432   

Intangible assets

     1,239,178        1,241,258        2,080   

Investments

     79,894        96,711        16,817   

Noncurrent deferred income tax assets

     12,680        6,535        (6,145

Accrued warranty

     48,619        46,536        (2,083

Current income taxes liability

     5,827        7,012        1,185   

Other accrued liabilities

     147,195        148,282        1,087   

Accrued pension

     61,349        65,395        4,046   

Noncurrent deferred income tax liabilities

     76,005        74,242        (1,763

Accumulated deficit

     (56,189     (57,752     (1,563

 

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Table of Contents
For the three months ended September 30, 2013    As Originally
Reported
     As
Adjusted
     Increase (Decrease)  

Statements of Operations:

        

Depreciation expense

   $ 19,705       $ 20,048       $ 343   

Amortization expense

     64,606         65,053         447   

 

For the nine months ended September 30, 2013    As Originally
Reported
     As
Adjusted
     Increase (Decrease)  

Statements of Operations:

        

Depreciation expense

   $ 41,824       $ 42,567       $ 743   

Amortization expense

     127,751         128,571         820   

Note 2. Recent Accounting Pronouncements

Adoption of New Accounting Standards — In July 2013, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update which provides that an unrecognized tax benefit, or a portion thereof, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, except to the extent that a net operating loss carryforward, a similar tax loss, or a tax credit carryforward is not available at the reporting date to settle any additional income taxes that would result from disallowance of a tax position, or the tax law does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, then the unrecognized tax benefit should be presented as a liability. This update is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. This update was adopted by ARRIS beginning in the first quarter of 2014. The adoption of this guidance did not have a material impact on its consolidated financial position and results of operations.

Accounting Standards Issued But Not Yet Effective – In April 2014, the FASB issued accounting standards update that change the requirements for reporting discontinued operations. A discontinued operation may include a component of an entity or a group of components of an entity. A disposal of a component of an entity or a group of components of an entity is required to be reported in discontinued operations if the disposal represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results and when the component or group of components meets the criteria to be classified as held for sale, is disposed of by sale or is disposed of by other than by sale. This update is effective prospectively for fiscal years, and interim reporting periods within those years, beginning after December 15, 2014, with earlier adoption permitted. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial position and results of operations.

In May 2014, FASB issued an Accounting Standards Update, Revenue from Contracts with Customers. The core principle of this amendment is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The new guidance is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, with earlier adoption not permitted. It can be adopted either retrospectively to each prior reporting period presented or as a cumulative-effect adjustment as of the date of adoption. The Company is currently assessing the potential impact of this update on its consolidated financial statements.

In June 2014, the FASB issued an update to its accounting guidance related to share-based compensation. The guidance requires that a performance target that affects vesting, and that could be achieved after the requisite service period, be treated as a performance condition, and therefore shall not be reflected in determining the fair value of the award at the grant date. This update further clarifies that compensation cost should be recognized in the period in which it becomes probable that the performance target will be achieved and should represent the compensation cost attributable to the period(s) for which the requisite service has already been rendered. The guidance will be effective for annual and interim periods beginning after December 15, 2015 and is not expected to have any material effect on the Company’s consolidated financial position and 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., a subsidiary of Google, Inc. Consideration for the acquisition consisted of approximately $2,208.1 million in cash, inclusive of 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, significantly 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 research and development capabilities, particularly in the video arena.

During the first quarter of 2014, the Company completed the accounting for the aforementioned business combination.

Acquisition of SeaWell Networks, Inc.

On April 17, 2014, a wholly owned subsidiary of the Company acquired all of the issued and outstanding shares of SeaWell Networks, Inc. (“SeaWell”), a corporation organized under the laws of Canada, which is located in Mississauga, Ontario. Initial consideration for the acquisition was $5.9 million (net of assumed cash) and additional contingent consideration of up to $3.0 million could be paid based upon achievement of certain financial targets, over 30 months from the date of acquisition.

Goodwill in the amount of $4.4 million was preliminarily recognized for this acquisition and is calculated as the excess of consideration transferred over the net assets recognized and represents future economic benefits arising from assets acquired that could not be individually identified and separately recognized such as assembled workforce. The goodwill is not deductible for tax purposes. The Company also identified certain customer, marketing and technology related intangible assets which have been preliminarily valued at $2.0 million, with estimated useful lives ranging from 5 to 10 years.

This acquisition is expected to further enhance the Company’s IP video delivery capabilities, by integrating SeaWell’s adaptive bit rate streaming technologies and talent into its Network & Cloud business.

The Consolidated Financial Statements include the operating results of the business combination from the date of acquisition. The effects of the acquisitions, individually and in the aggregate, were not material to the Company’s financial results.

Note 4. Goodwill and Intangible Assets

Goodwill

Goodwill relates to the excess of consideration transferred over the fair value of net assets resulting from an acquisition. Our goodwill is tested for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that the asset is more likely than not impaired. Our annual goodwill impairment test is performed in the fourth quarter, with a testing date of October 1.

As of September 30, 2014, the Company has recorded goodwill of $938.3 million. The Company has recast goodwill as of December 31, 2013 to appropriately reflect the goodwill arising from the Acquisition.

 

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The changes in the carrying amount of goodwill for the year to date period ended September 30, 2014 are as follows (in thousands):

 

     CPE     Network
Infrastructure
    Cloud
Services
    Total  

Goodwill

     688,658        497,741        132,659        1,319,058   

Accumulated impairment losses

            (257,053     (121,603     (378,656
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance as of December 31, 2013

   $ 688,658      $ 240,688      $ 11,056      $ 940,402   
  

 

 

   

 

 

   

 

 

   

 

 

 

Goodwill acquired in SeaWell acquisition

            4,448               4,448   

Adjustments

     (4,061     (2,103     (421     (6,585
  

 

 

   

 

 

   

 

 

   

 

 

 

Goodwill

     684,597        500,086        132,238        1,316,921   

Accumulated impairment losses

            (257,053     (121,603     (378,656
  

 

 

   

 

 

   

 

 

   

 

 

 

Balance as of September 30, 2014

   $ 684,597      $ 243,033      $ 10,635      $ 938,265   
  

 

 

   

 

 

   

 

 

   

 

 

 

Intangibles

The Company’s intangible assets have an amortization period of six months to ten years. The gross carrying amount and accumulated amortization of the Company’s intangible assets as of September 30, 2014 and December 31, 2013 are as follows (in thousands):

 

     September 30, 2014      December 31, 2013  
     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

   $ 904,035       $ 341,416       $ 562,619         6.3       $ 903,409       $ 266,323       $ 637,086         7.0   

Developed technology, patents & licenses

     634,230         205,290         428,940         4.4         563,326         120,679         442,647         5.0   

Trademark, trade and domain names

     21,079         15,597         5,482         1.1         20,900         8,549         12,351         1.5   

Order backlog

     44,600         44,600                         44,600         31,592         13,008         0.3   

In-process R&D

     3,400                 3,400                 71,100                 71,100           
  

 

 

    

 

 

    

 

 

       

 

 

    

 

 

    

 

 

    

Total

   $ 1,607,344       $ 606,903       $ 1,000,441          $ 1,603,335       $ 427,143       $ 1,176,192      
  

 

 

    

 

 

    

 

 

       

 

 

    

 

 

    

 

 

    

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 finite-lived intangibles for each of the next five fiscal years is as follows (in thousands):

 

2014 (for the remaining three months)

   $ 57,027   

2015

     220,731   

2016

     190,003   

2017

     173,068   

2018

     122,376   

2019

     100,061   

Thereafter

     133,775   

Amounts reflected in the above table exclude $3.4 million of amortization that would be incurred upon successful completion of in-process research and development projects.

 

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Note 5. Investments

ARRIS’ investments as of September 30, 2014 and December 31, 2013 consisted of the following (in thousands):

 

     As of September 30, 2014      As of December 31, 2013  

Current Assets:

     

Available-for-sale securities

   $ 66,817       $ 67,360   

Noncurrent Assets:

     

Available-for-sale securities

     9,109         7,004   

Equity method investments

     29,237         23,803   

Cost method investments

     10,342         15,250   

Other investments

     26,297         25,119   
  

 

 

    

 

 

 
     74,985         71,176   
  

 

 

    

 

 

 

Total

   $ 141,802       $ 138,536   
  

 

 

    

 

 

 

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 (losses) gains included in the accumulated other comprehensive income related to available-for-sale securities were $(77) thousand and $306 thousand, net of tax, as of September 30, 2014 and December 31, 2013, respectively. Realized and unrealized gains and losses in total and by individual investment as of September 30, 2014 and December 31, 2013 were not material. The amortized cost basis of the Company’s investments approximates fair value.

The contractual maturities of the Company’s available-for-sale securities as of September 30, 2014 are shown below. 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):

 

     September 30,
2014
 

Within one year

   $ 66,817   

After one year through five years

     5,330   

After five years through ten years

       

After ten years

     3,779   
  

 

 

 

Total

     75,926   
  

 

 

 

Equity method investments – In connection with the Acquisition, ARRIS acquired certain investments in limited liability companies and partnerships that are accounted for using the equity method as the Company has significant influence over operating and financial policies of the investee companies. These investments are recorded at $29.2 million and $23.8 million as of September 30, 2014 and December 31, 2013, respectively. The carrying amount of equity method investments is adjusted for the Company’s proportionate share of net earnings or losses adjusted for any basis differences of the investees, or dividends received. The Company evaluates its equity method investments for impairment whenever events or changes in circumstances indicate that the carrying amount of such investments may not be recoverable. An equity method investment is written down to fair value if there is evidence of a loss in value which is other than temporary.

Cost method investments – ARRIS holds cost method investments in private companies. These investments are recorded at $10.3 million and $15.3 million as of September 30, 2014 and December 31, 2013, respectively. 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.

 

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Other investments – At September 30, 2014 and December 31, 2013, ARRIS held $26.3 million and $25.1 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 – During the third quarter of 2014, the Company performed an evaluation of its investments for any other-than-temporary impairment, by reviewing the current revenues, bookings and long-term plans of the private companies. ARRIS concluded that two private companies had indicators of impairment that resulted in other-than-temporary impairment charges of $4.0 million during the quarter ended September 30, 2014. For the nine months ended September 30, 2014, ARRIS recognized other-than-temporary impairment charges of $7.0 million. ARRIS concluded that no other-than-temporary impairment losses existed at December 31, 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.

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.

Note 6. 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.

 

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The following table presents the Company’s investment assets (excluding equity and cost method investments) and derivatives measured at fair value on a recurring basis as of September 30, 2014 and December 31, 2013 (in thousands):

 

     September 30, 2014  
     Level 1      Level 2     Level 3      Total  

Certificates of deposit

   $       $ 3,920      $       $ 3,920   

Commercial paper

             999                999   

Corporate bonds

             37,548                37,548   

Short-term bond fund

     29,679         —                  29,679   

Cash surrender value of company owned life insurance

             26,270                26,270   

Corporate obligations

             21                21   

Money markets

     213                        213   

Mutual funds

     208                        208   

Other investments

             3,336                3,336   

Interest rate derivatives – asset derivatives

             3,766                3,766   

Interest rate derivatives – liability derivatives

             (6,856             (6,856

Foreign currency contracts – asset position

             1,789                1,789   

Foreign currency contracts – liability position

             (184             (184

 

     December 31, 2013  
     Level 1      Level 2     Level 3      Total  

Certificates of deposit

   $       $ 3,814      $       $ 3,814   

Commercial paper

             2,994                2,994   

Corporate bonds

             34,591                34,591   

Short-term bond fund

     29,565         —                  29,565   

Cash surrender value of company owned life insurance

             25,119                25,119   

Corporate obligations

             18                18   

Money markets

     212                        212   

Mutual funds

     184                        184   

Other investments

             2,986                2,986   

Interest rate derivatives – asset derivatives

             3,011                3,011   

Interest rate derivatives – liability derivatives

             (7,018             (7,018

All of the Company’s short-term and long-term investments at September 30, 2014 and December 31, 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, commercial paper and certificates of deposit. Such instruments are classified within Level 2 of the fair value hierarchy.

The Company believes the face value of the debt as of September 30, 2014 approximated the fair value based on recent market conditions, prevailing interest rates, and other Company specific factors. The Company has classified the debt as a Level 2 item within the fair value hierarchy.

Note 7. Derivative Instruments and Hedging Activities

ARRIS is exposed to risks associated with changes in interest rates and foreign currency exchange rates and utilizes a variety of measures to monitor and manage these risks, including the use of derivative financial instruments. The Company recognizes all derivative financial instruments as assets or liabilities in the Consolidated Balance Sheets at fair value.

 

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In April 2013, ARRIS entered into senior secured credit facilities having variable interest rates 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. In July 2013, ARRIS entered into six $100 million interest rate swap arrangements, which effectively converted $600 million of the Company’s variable-rate debt based on one-month LIBOR to an aggregate fixed rate of approximately 3.15% as of September 30, 2014. This fixed rate could vary up by 75 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.

The Company also has U.S. dollar functional currency entities that bill certain international customers in their local currency and foreign functional currency entities that procure in U.S. dollars. Additionally, certain intercompany transactions created in conjunction with the Motorola Home acquisition are denominated in foreign currencies and subject to revaluation. To mitigate the volatility related to fluctuations in the foreign exchange rates, ARRIS has entered into various foreign currency contracts. As of September 30, 2014, the Company had option collars with notional amounts totaling 30 million euros which mature through 2015, a forward with a notional amount of 5 million euros which matures in 2015, and a forward with a notional amount of 10 million pounds sterling which matures in the fourth quarter of 2014.

Cash Flow Hedges of Interest Rate Risk

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2013, such derivatives were used to hedge the variable cash flows associated with debt. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three and nine months ended September 30, 2014, the Company did not have expenses related to hedge ineffectiveness in earnings.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. Over the next 12 months, the Company estimates that an additional $6.9 million may be reclassified as an increase to interest expense.

The table below presents the pre-tax impact of the Company’s derivative financial instruments had on the Accumulated Other Comprehensive Income and Statement of Operations for the three and nine months ended September 30, 2014 (in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2014     2013     2014     2013  

Gain or (Loss) Recognized in OCI on Derivative (Effective Portion)

   $ 2,107      $ (7,979   $ (4,730   $ (7,979

Location of Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)

     Interest expense        Interest expense        Interest expense        Interest expense   

Gain or (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)

     (1,905     (1,253     (5,647     (1,253

 

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Credit-risk-related Contingent Features

ARRIS has agreements with each of its interest rate derivative counterparties that contain a provision where the Company could be declared in default on its interest rate derivative obligations if repayment of the underlying indebtedness is accelerated by the lender due to the Company’s default on the indebtedness. As of September 30, 2014, the fair value of interest rate derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was $3.1 million. As of September 30, 2014, the Company has not posted any collateral related to these agreements nor has it required any of its counterparties to post collateral related to these or any other agreements.

Non-designated Hedges

The Company’s objectives in using foreign currency derivatives are to add stability to foreign currency gains and losses recorded as other expense (income) and to manage its exposure to foreign currency movements. To accomplish this objective, the Company uses foreign currency option and foreign currency forward contracts as part of its foreign currency risk management strategy. The Company’s foreign currency derivative 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 12 months.

The Company does not currently use derivatives for trading or speculative purposes.

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.

The fair values of ARRIS’ derivative instruments recorded in the Consolidated Balance Sheets as of September 30, 2014 and December 31, 2013 were as follows (in thousands):

 

     As of September 30, 2014      As of December 31, 2013  
     Balance Sheet Location    Fair Value      Balance Sheet Location    Fair Value  

Derivatives designated as
hedging instruments:

           

Interest rate derivatives
– asset derivatives

   Other assets    $ 3,766       Other assets    $ 3,011   

Interest rate derivatives
– liability derivatives

   Other accrued liabilities    $ 6,856       Other accrued liabilities    $ 7,018   

Derivatives not designated as
hedging instruments:

           

Foreign exchange contracts
– asset derivatives

   Other current assets    $ 1,789       Other current assets    $   

Foreign exchange contracts
– liability derivatives

   Other accrued liabilities    $ 184       Other accrued liabilities    $   

The assets and liabilities for the interest rate derivatives and foreign exchange contracts were considered as Level 2 under the fair value hierarchy.

The change in the fair values of ARRIS’ derivative instruments recorded in the Consolidated Statements of Operations during the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands):

 

         Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     Statement of Operations Location   2014     2013      2014     2013  

Derivatives Not Designated
as Hedging Instruments:

           

Foreign exchange contracts

   Loss (gain) on foreign currency   $ (1,699   $       $ (1,699   $ 428   

Derivatives Designated
as Hedging Instruments:

           

Interest rates derivatives

   Interest expense   $ 1,905      $ 1,253       $ 5,647      $ 1,253   

 

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Note 8. Pension Benefits

Components of Net Periodic Pension Cost (in thousands):

 

     Three Months Ended September 30,     Nine Months Ended September 30,  
     2014     2013     2014     2013  

Service cost

   $      $ 310      $      $ 637   

Interest cost

     446        562        1,337        1,479   

Expected gain on plan assets

     (219     (259     (656     (730

Amortization of net loss

     76        355        229        829   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic pension cost

   $ 303      $ 968      $ 910      $ 2,215   
  

 

 

   

 

 

   

 

 

   

 

 

 

Employer Contributions

No minimum funding contributions are required in 2014 under the Company’s defined benefit plan. 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 September 30, 2014 was approximately $20.1 million and is included in Investments on the Consolidated Balance Sheets.

Note 9. 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.

Information regarding the changes in ARRIS’ aggregate product warranty liabilities for the nine months ended September 30, 2014 was as follows (in thousands):

 

Balance at December 31, 2013

   $ 81,500   

Accruals related to warranties (including changes in estimates)

     25,741   

Settlements made (in cash or in kind)

     (27,827
  

 

 

 

Balance at September 30, 2014

   $ 79,414   
  

 

 

 

 

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Note 10. Restructuring Charges

The following table represents a summary of and changes to the restructuring accrual, which is primarily composed of accrued severance and other employee costs and contractual obligations that related to excess leased facilities (in thousands):

 

     Employee
severance &
termination
benefits
    Contractual
obligations and
other
    Total  

Balance at December 31, 2013

   $ 2,674      $ 673      $ 3,347   

Restructuring charges

     2,610        32        2,642   

Cash payments

     (2,900     (396     (3,296
  

 

 

   

 

 

   

 

 

 

Balance at September 30, 2014

   $ 2,384      $ 309      $ 2,693   
  

 

 

   

 

 

   

 

 

 

Employee severance and termination benefits – In the second quarter of 2013, ARRIS completed its acquisition of Motorola Home. ARRIS initiated restructuring plans as a result of the Acquisition that focuses on the rationalization of personnel, facilities and systems across multiple segments in the ARRIS organization.

The total estimated cost of the restructuring plan was approximately $30.8 million and was recorded as severance expense during 2013. As of September 30, 2014, the total liability remaining for this restructuring plan was approximately $0.4 million. The remaining liability is expected to be paid by the end of first quarter of 2015.

In addition, in the third quarter of 2014, the Company implemented a restructuring initiative to rationalize facilities in which it expects to incur approximately $4.9 million through first quarter of 2015. The Company recorded cumulative restructuring charges of $3.0 million related to severance and employee termination benefits for 150 employees during the third quarter of 2014. This initiative affected all segments. As of September 30, 2014, the total liability remaining for this plan was approximately $2.0 million.

Contractual obligations and other - Represent contractual obligations that relate primarily to excess leased facilities.

Note 11. 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):

 

     September 30,      December 31,  
     2014      2013  

Raw material

   $ 53,628       $ 60,520   

Work in process

     10,196         6,010   

Finished goods

     304,804         263,599   
  

 

 

    

 

 

 

Total inventories, net

   $ 368,628       $ 330,129   
  

 

 

    

 

 

 

Note 12. Property, Plant and Equipment

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

 

     September 30,     December 31,  
     2014     2013  

Land

   $ 87,951      $ 88,742   

Building and leasehold improvements

     137,581        133,668   

Machinery and equipment

     399,519        368,572   
  

 

 

   

 

 

 
     625,051        590,982   

Less: Accumulated depreciation

     (253,555     (194,830
  

 

 

   

 

 

 

Total property, plant and equipment, net

   $ 371,496      $ 396,152   
  

 

 

   

 

 

 

During the quarter ended June 30, 2014, the Company entered into a binding letter of intent with a potential buyer for the sale of land and building for $2.9 million which is lower than its carrying amount of $4.8 million. The asset

 

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has been reclassified as held for sale and was measured at the lower of its carrying amount or fair value less cost to sell. Total asset held for sale at September 30, 2014 was $2.7 million, which is reported in the Consolidated Balance Sheets as a component of “Other current assets.” The Company has recorded an impairment charge of $2.1 million to reduce the asset’s carrying amount to its estimated fair value less cost to sell during the nine months ended September 30, 2014, which is reported in the Consolidated Statements of Operations under the caption “Other expense (income), net.” The sale is expected to close during the fourth quarter of 2014.

Note 13. Long-Term Indebtedness

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 September 30, 2014, ARRIS had $1,561.3 million face value outstanding under the Term Loan A and Term Loan B Facilities, no borrowings under the Revolving Credit Facility and letters of credit totaling $2.6 million issued under the Revolving Credit Facility.

 

     Rate   As of September 30, 2014

Term Loan A

   LIBOR + 1.75 %   1.90%

Term Loan B

   LIBOR(1) + 2.50 %   3.25%

Revolving Credit Facility(2)

   LIBOR + 1.75 %   Not Applicable

 

  (1) Includes LIBOR floor of 0.75%
  (2) Includes unused commitment fee of 0.35% and letter of credit fee of 1.75% 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 3.75:1 (with an additional scheduled decrease to 3.5:1). As of September 30, 2014, ARRIS was in compliance with all covenants under the Credit Agreement.

The Credit Agreement provides for certain step downs in the interest rates paid on the Term Loan A, Term Loan B and Revolving Credit Facility upon achievement of tiered lowered leverage ratios. As a result of ARRIS’ lowered leverage ratio at the end of the second quarter, the interest rate paid on the Term Loan A, Term Loan B and Revolving Credit Facility decreased by 25 basis points. Since inception, the Company has realized a total 50 basis points decrease in the interest rate paid on the Term Loan A and Revolving Credit Facility and 25 basis points decrease in the interest paid rate on the Term Loan B. There are no further interest rate decreases available to ARRIS in the current 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.

During the three and nine months ended September 30, 2014, the Company made mandatory repayments of approximately $13.8 million and $41.2 million, respectively, and optional prepayments of $150.0 million related to the senior secured credit facilities.

Following is a summary of our contractual debt obligations at face value as of September 30, 2014 (in thousands):

 

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

Credit facilities

   $ 68,750       $ 206,250       $ 742,500       $ 543,813       $ 1,561,313   

Note 14. 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.

 

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Our 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 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.

Effective with the acquisition of Motorola Home in 2013, the Company made certain changes to its operating segments. In addition, effective January 1, 2014, the Company changed management responsibility for certain product lines. 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 Company assesses its segment’s operating performance based on direct contribution, which is defined as gross margin less direct operating expense. Corporate and other expenses, such as selling and home office G&A, not included in the measure of segment direct contribution are reported in “Other” and are reconciled to income (loss) before income taxes.

The table below represents information about the Company’s reporting segments for the three and nine months ended September 30, 2014 and 2013 (in thousands):

 

    Reportable Segments              
    N&C     CPE     Other     Consolidated  
For the three months ended September 30,   2014     2013     2014     2013     2014     2013     2014     2013  

Sales

  $   460,837      $ 325,471      $   945,386      $   743,890      $ (778   $ (1,537   $ 1,405,445      $ 1,067,824   

Direct Contribution

    134,217        61,763        208,163        158,035        (152,945     (131,285     189,435          88,513   

Amortization of intangible assets

            57,100          65,053          57,100        65,053   

Integration, acquisition,
restructuring & other

          10,226        12,278        10,226        12,278   
             

 

 

   

 

 

 

Operating income

              122,109        11,182   

Other expense

              22,976        22,029   
             

 

 

   

 

 

 

Income (loss) before income taxes

            $   99,133      $ (10,847
             

 

 

   

 

 

 

 

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    Reportable Segments              
    N&C     CPE     Other     Consolidated  
For the nine months ended September 30,   2014     2013     2014     2013     2014     2013     2014     2013  

Sales

  $ 1,202,105      $ 849,382      $ 2,861,912      $ 1,589,785      $ (4,483   $ (17,332   $ 4,059,534      $ 2,421,835   

Direct Contribution

    304,133        187,354        624,732        315,305        (463,012     (370,327     465,853        132,332   

Amortization of intangible assets

          179,835        128,571        179,835        128,571   

Integration, acquisition,
restructuring & other

          34,246        71,126        34,246        71,126   
             

 

 

   

 

 

 

Operating income (loss)

              251,772        (67,365

Other expense

              68,672        55,208   
             

 

 

   

 

 

 

Income (loss) before income taxes

            $ 183,100      $ (122,573
             

 

 

   

 

 

 

Note 15. Sales Information

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 September 30, 2014 and 2013, sales to international customers were approximately 26.8% and 31.5%, respectively, of total sales. For the nine months ended September 30, 2014 and 2013, sales to international customers were 24.7% and 32.7%, respectively, of total sales.

International sales by region for the three and nine months ended September 30, 2014 and 2013 were as follows (in thousands):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2014      2013      2014      2013  

Americas, excluding U.S. (1)

   $ 246,922       $ 217,843       $ 661,005       $ 501,052   

Asia Pacific

     38,584         48,869         113,674         108,102   

EMEA

     90,759         69,673         226,885         181,598   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total international sales

   $ 376,265       $ 336,385       $ 1,001,564       $ 790,752   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Excludes U.S. sales of $1,029.2 million and $3,058.0 million for the three and nine months ended September 30, 2014, respectively. Excludes U.S. sales of $731.4 million and $1,631.1 million for the three and nine months ended September 30, 2013, respectively.

Note 16. Earnings Per Share

The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share (“EPS”) computations for the periods indicated (in thousands except per share data):

 

     Three Months Ended
September 30,
     Nine Months Ended
September 30,
 
     2014      2013      2014      2013  

Basic:

           

Net income (loss)

   $ 54,626       $ 17,169       $ 134,451       $ (45,943
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average shares outstanding

     144,967         138,478         144,085         129,502   
  

 

 

    

 

 

    

 

 

    

 

 

 

Basic earnings (loss) per share

   $ 0.38       $ 0.12       $ 0.93       $ (0.35
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted:

           

Net income (loss)

   $ 54,626       $ 17,169       $ 134,451       $ (45,943
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average shares outstanding

     144,967         138,478         144,085         129,502   

Net effect of dilutive equity awards

     3,786         2,127         3,911           
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     148,753         140,605         147,996         129,502   
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted earnings (loss) per share

   $ 0.37       $ 0.12       $ 0.91       $ (0.35
  

 

 

    

 

 

    

 

 

    

 

 

 

For the three months ended and nine months ended September 30, 2014, approximately zero and 4.5 thousand of the equity-based awards, respectively, were excluded from the computation of diluted earnings per share shares because

 

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their effect would have been anti-dilutive. During the same periods in 2013, approximately 2.8 million and 1.4 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 nine months ended September 30, 2014, 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 3.6 million shares for the twelve months ended December 31, 2013.

In 2013, in connection with the Motorola Home acquisition, Google was issued approximately 10.6 million shares of ARRIS’ common stock as part of the purchase consideration. Furthermore, Comcast was given an opportunity to invest in ARRIS, and 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.

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

Note 17. Income Taxes

For the three months ended September 30, 2014 and 2013, the Company recorded income tax expense (benefit) of $44.5 million and $(28.0) million, respectively. For the nine months ended September 30, 2014 and 2013, the Company recorded income tax expense (benefit) of $48.7 million and $(76.6) million, respectively.

Below is a summary of the components of the tax expense (benefit) for the three and nine month periods ended September 30, 2014 and 2013 (in thousands, except for percentages):

 

     Three Months Ended September 30,  
     2014     2013  
     Income
(Loss)
Before

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

Non-discrete items

   $ 109,703      $ 39,136        35.7   $ 8,691      $ (14,547     (167.4 )% 

Discrete tax events -

            

2012 R&D Credit

                                

Loss on asset held for sale

                                

Book write down in cost method investment

   $ (4,000   $ (1,440                  

Acquisition costs

   $ (6,570   $ (2,367     $ (12,277   $ (3,818  

Return to provision adjustments

          $ 4,550               $ (2,052  

Valuation allowances, uncertain tax positions

          $ 7,234               $ (7,599  

Comcast’s investment in ARRIS

                                

Change in state deferred rates

          $ 1,403                     

Gain/(loss) from certain foreign entities acquired

                   $ (7,261         

Intangible reattribution

          $ (4,009                  
  

 

 

   

 

 

     

 

 

   

 

 

   

Total

   $ 99,133      $ 44,507        44.9   $ (10,847   $ (28,016     258.3
  

 

 

   

 

 

     

 

 

   

 

 

   

 

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     Nine Months Ended September 30,  
     2014     2013  
     Income
(Loss)
Before Tax
    Income
Tax
Expense
(Benefit)
    Effective
Tax Rate
    Income
(Loss)
Before Tax
    Income
Tax
Expense
(Benefit)
    Effective
Tax Rate
 

Non-discrete items

   $ 222,815      $ 79,577        35.7   $ (13,521   $ (38,736     286.5

Discrete tax events -

            

2012 R&D Credit

                                

Loss on asset held for sale

   $ (2,125   $ (760                  

Book write down in cost method investments

   $ (7,000   $ (2,502                  

Acquisition costs

   $ (30,590   $ (10,936     $ (71,126   $ (23,568  

Comcast’s investment in ARRIS

                   $ (26,371         

Change in state deferred rates

          $ (3,836                  

Net operating losses acquired

          $ (18,163                  

Gain/(loss) from certain foreign

                   $ (11,555         

Return to provision adjustments

          $ 6,186               $ (8,552  

Valuation allowances, uncertain tax positions

          $ 2,582               $ (5,774  

Intangible reattribution

          $ (4,009                  

Other

          $ 510                     
  

 

 

   

 

 

     

 

 

   

 

 

   

Total

   $ 183,100      $ 48,649        26.6   $ (122,573   $ (76,630     62.5
  

 

 

   

 

 

     

 

 

   

 

 

   

 

   

The change in the income tax expense (benefit) for the three and nine month periods ended September 30, 2014 compared to the three and nine months period ended September 30, 2013, 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. The unusual book charges were mostly attributable to restructuring, integration and other acquisition-related costs. For the nine month period ending September 30, 2014, the Company recorded book expenses of an infrequent and unusual nature of approximately $30.6 million relating to the acquisition of the Home business of Motorola, generating a tax benefit of $10.9 million.

   

For the nine month periods ended September 30, 2014 and 2013, our estimated effective tax rates were 26.6% and 62.5%, respectively. The rate of 26.6% is based on the Company’s pre-tax book income of approximately $183.1 million and a tax expense of approximately $48.7 million, for the nine months period ending September 30, 2014. The change in the estimated effective tax rate for the nine month period ended September 30, 2014, compared to the nine month period ended September 30, 2013 was due to an increase in earnings from continuing operations, and the impact of certain tax discrete tax events described in the discussion below.

   

In conjunction with an agreement executed with Google in January 2014, as of March 31, 2014 the Company recorded net operating losses of $545.5 million arising from the Motorola Home acquisition, of which the Company estimated $493.5 million of the amount would not be realizable and was subject to a valuation allowance. As a result, in the first quarter of 2014 the Company released $18.2 million of valuation allowances related to these acquired net operating losses. The ultimate realization of the remaining net operating losses was dependent upon Google completing and filing their income tax returns and the Company completing analysis and finalizing planning relating to the usage of net operating losses.

Google completed and filed their income tax return during the third quarter of 2014, and the Company has determined that $556.8 million of net operating losses are now available to the Company, of which the Company has recorded net operating losses of $51.9 million as of September 30, 2014. Our ability to fully utilize these net operating losses, however, is limited for various reasons, such as under the “Separate Return Loss Year” (“SRLY”) rules which may limit the Company’s ability to utilize carryforward attributes should income attributable to specific subgroup members be insufficient to allow for full utilization. In addition, annual limitations apply under Internal Revenue Code Section 382 with respect to the Company’s ability to utilize its net operating loss carryforwards against future U.S. taxable income.

 

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As of September 30, 2014, the Company was analyzing several potential planning alternatives, regarding the limitations discussed above, to determine the ultimate net operating loss carryforward benefit to be realized from the Motorola Home acquisition. Accordingly, the Company expects to complete this analysis in the fourth quarter of 2014. The analysis will determine how much of the remaining $504.9 million of net operating loss, if any, will be realizable, which could result in a significant favorable adjustment to deferred tax assets in the fourth quarter of 2014, if successful.

 

   

As of June 30, 2014, the Company recorded a benefit of $5.2 million from changes in state deferred income tax rates, relating to the integration of the Motorola Home business. For the three month period ended September 30, 2014, this benefit was reduced by $1.4 million, for a total benefit of $3.8 million for the nine month period ended September 30, 2014.

   

For the nine month period ended September 30, 2014, the Company recorded $9.1 million of book losses on investments and available for sale assets, which generated income tax benefits of $3.3 million.

   

For the nine month period ended September 30, 2014, the Company recorded expense of $6.2 million related to changes in estimates finalized upon the filing of the 2013 income tax returns. During this period, the Company also recorded a benefit of $1.8 million relating to changes in valuation allowances. During the third quarter of 2014, as a result of completing certain analysis associated with the preparation and filing of the 2013 U.S. Federal Income Tax Return, the Company identified and corrected an immaterial error in the accounting for income taxes related to the prior year ended December 31, 2013. The correction related to the Company’s subsequent consideration of certain tax consequences related to a legal entity and tax restructuring completed in the fourth quarter of 2013. The impact of adjusting these amounts had a non-cash effect, increasing income tax expense and noncurrent income tax liabilities by $9.8 million. In accordance with ASC Topic 250, Accounting Changes and Error Corrections, the Company evaluated the impact on its financial statements for the year ended December 31, 2013 and the expected full year results for the year ending December 31, 2014 and concluded that the results of operations for these periods were not materially misstated. In reaching its conclusion the Company considered both quantitative and qualitative factors. The quantitative factors included calculating the impact of the error on the affected financial statements and assessing materiality. The qualitative factors included, but were not limited, to the absences of impact on debt covenants, management compensation and segment reporting. Based on its evaluation, the Company concluded that it is not probable that the judgment of a reasonable person relying on the financial statements would have been changed or influenced by the correction. In addition to the charge of $9.8 million, there were also benefits from audit settlements and expirations of statute, which impacted uncertain tax liabilities. The total discrete tax impact of uncertain tax positions during the nine month period ended September 30, 2014, inclusive of the $9.8 million charge, was an additional tax expense of $4.4 million.

   

For the nine month period ended September 30, 2014, the Company did not record any benefits attributed to research and development tax credits, as the tax credit has yet to be reenacted.

The earnings from the Company’s non-U.S. subsidiaries are considered to be permanently invested outside of the United States. Accordingly, no provision for U.S. federal and state income taxes on those non-U.S. earnings has been made in the accompanying consolidated financial statements. Any future distribution of these non-U.S. earnings may subject the Company to both U.S. federal and state income taxes, after reduction for foreign taxes credited.

Note 18. Accumulated Other Comprehensive Income

The following table summarizes the changes in accumulated other comprehensive income by component, net of taxes, for the nine months ended September 30, 2014 (in thousands):

 

     Unrealized gain
(loss) on  marketable
securities
    Unfunded
pension
liability
    Unrealized
loss on
derivative
instruments
    Cumulative
translation
adjustments
    Total  

Balance as of December 31, 2013

   $ 306      $ (2,416   $ (2,541   $ (11   $ (4,662

Other comprehensive (loss) income before reclassifications

     (383     -        4,162        (154     3,625   

Amounts reclassified from accumulated other comprehensive income (loss)

     -        -        (3,580     -        (3,580
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net current-period other comprehensive income (loss)

     (383     -        582        (154     45   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance as of September 30, 2014

   $ (77   $ (2,416   $ (1,959   $ (165   $ (4,617
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Note 19. 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. Accordingly, with respect to these proceedings, we are currently unable to reasonably estimate the possible loss or range of possible losses. In addition, the Company is a defendant in various litigation matters generally arising out of the normal course of business. (See Part II, Item 1 “Legal Proceedings” for additional details)

 

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

Overview

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”). For more detail, see Note 3 Business Acquisitions to Notes to our Consolidated Financial Statements. 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.

In addition, we have revised our segment disclosures to reflect changes in operating responsibilities that occurred during the first quarter of 2014. For more detail, see Note 14 Segment Information to Notes to our Consolidated Financial Statements. Readers should consider the size and transformative nature of the Acquisition when reviewing this “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Business and Financial Highlights

Business Highlights

 

   

32% year-over-year revenue growth as a result of increased demand across much of the company’s product portfolio

   

Increased international sales, representing 27% of third quarter sales

   

Strong earnings and cash generation

CPE Segment

   

Sales up 27% year-over-year with direct contribution dollars up 32% for the same time period. Sequential revenue and direct contribution dollars declined by 7%.

  Overall performance driven by strong cable and telco set-tops and DSL demand
  Broadband device and accessory unit volumes improved 13% year-over-year. Unit volumes down slightly (3%) as compared to second quarter of 2014 record levels. Continued to experience strong demand for advanced VDSL & DOCSIS 3.0 WiFi gateways
  Announced upcoming trial with Comcast of a new RDK software solution on ARRIS broadband gateways. The trial is planned for fourth quarter of 2014 with general availability expected in first quarter of 2015.
  Introduced new broadband and telephony devices targeting latest DOCSIS & Wi-Fi technologies
  Video CPE (set-tops and video gateways) unit volumes improved 27% year-over-year and were consistent with second quarter of 2014 shipment levels
  Announced latest evolution of set-top designs at IBC2014 trade show
  Shipped one millionth video gateway device during third quarter of 2014
  Successfully integrated the Playcast Media solution for Portugal Telecom enabling cloud gaming services
  Deployed high definition IPTV set top with TTNET (the largest internet service provider in Turkey ) enabling new & enhanced services

N&C Segment

   

Sales up 42% year-over-year with direct contribution dollars up 117% for the same time period. Sequential revenue up by 13% and direct contribution dollars increased by 28%.

  Outstanding quarter as the industry momentum to expand bandwidth and video processing continues, and new services such as Network DVR take hold
  Record level shipments of E6000 CCAP platform as operators re-fresh technology and expand capacity

 

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  Leading the industry in DOCSIS3.1 technology maturity – SCTE demo show casing early interoperability with CPE silicon development platforms
 

Strong demand for DOCSIS3.1-compatible CORWaveTM 3 Headend Optics platform

  Continued strength in Video Systems portfolio including CherryPicker video processing platform and Network DVR products
  Growing momentum and opportunity pipeline for ARRIS Professional Services

Financial Highlights

   

Sales in the third quarter and nine months ended September 30, 2014 were $1,405.4 million and $4,059.5 million, respectively, as compared to $1,067.8 million and $2,421.8 million in the same periods in 2013, reflecting the acquisition of Motorola Home and strong demand.

   

Gross margin percentage was 31.0% in the third quarter of 2014, which compares to 29.7% in the third quarter of 2013.

   

Total operating expenses (excluding amortization of intangible assets, integration, acquisition, restructuring and other costs) in the third quarter of 2014 were $246.3 million, as compared to $228.4 million in the same period last year. As expected, operating expenses decreased from $256.5 million in the second quarter of 2014.

   

We ended the third quarter of 2014 with $599.1 million of cash, cash equivalents, short-term and long-term marketable security investments. The Company generated $337.1 million of cash from operating activities through the first nine months of 2014, which compares to $380.2 million generated during the same period in 2013.

   

We ended the third quarter 2014 with long-term debt of $1,561.3 million, at face value, the current portion of which is $68.8 million. We repaid $191.3 million of our Term Loans in the first nine months of 2014, including a $150 million optional prepayment.

   

We ended the third quarter 2014 with an order backlog of $594.1 million and had a book-to-bill ratio of 0.86 in the quarter.

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 nine months ended September 30, 2014 and 2013 which detail and reconcile GAAP and non-GAAP earnings per share (in thousands, except per share data):

 

     For the Three Months Ended September 30, 2014  
     Sales      Gross
     Margin     
     Operating
Expense
    Operating
Income
     Other
(Income)
Expense
    Income
Tax Expense
(Benefit)
     Net
   Income   
(Loss)
 

Amounts in accordance with GAAP

   $ 1,405,445       $ 435,734       $ 313,625      $ 122,109       $ 22,976      $ 44,507       $ 54,626   

Acquisition accounting impacts related to deferred revenue

     780         47         -            47         -            -             47   

Stock compensation expense

     -             1,824         (11,671     13,495         -            -             13,495   

Amortization of intangible assets

     -             -             (57,100     57,100         -            -             57,100   

Integration, acquisition, restructuring and other costs

     -             -             (10,226     10,226         -            -             10,226   

Impairment of investments

     -             -             -            -             (4,000     -             4,000   

Net tax items

     -             -             -            -             -            19,375         (19,375
  

 

 

 

Non-GAAP amounts

   $ 1,406,225       $   437,605       $ 234,628      $ 202,977       $ 18,976      $   63,882       $ 120,119   
  

 

 

 

GAAP net income per share - diluted

                   $ 0.37   
                  

 

 

 

Non-GAAP net income per share - diluted

                   $ 0.81   
                  

 

 

 

Weighted average common shares - basic

                     144,967   
                  

 

 

 

Weighted average common shares - diluted

                     148,753   
                  

 

 

 

 

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     For the Nine Months Ended September 30, 2014  
     Sales      Gross Margin      Operating
Expense
    Operating
Income
    Other
(Income)
Expense
    Income
Tax Expense
(Benefit)
    Net Income
(Loss)
 

Amounts in accordance with GAAP

   $ 4,059,534       $ 1,201,921       $ 950,149      $ 251,772      $ 68,672      $ 48,649      $ 134,451   

Acquisition accounting impacts related to deferred revenue

     4,475         3,048         -            3,048        -            -            3,048   

Stock compensation expense

     -             4,934         (34,878     39,812        -            -            39,812   

Amortization of intangible assets

     -             -             (179,835     179,835        -            -            179,835   

Integration, acquisition, restructuring and other costs

     -             -             (34,246     34,246        -            -            34,246   

Impairment of investments

     -             -             -            -            (7,000     -            7,000   

Asset held for sale impairment

     -             -             -            -            (2,125     -            2,125   

Net tax items

     -             -             -            -            -            107,428        (107,428
  

 

 

 

Non-GAAP amounts

   $ 4,064,009       $ 1,209,903       $ 701,190      $ 508,713      $ 59,547      $ 156,077      $ 293,089   
  

 

 

 

GAAP net income per share - diluted

                 $ 0.91   
                

 

 

 

Non-GAAP net income per share - diluted

                 $ 1.98   
                

 

 

 

Weighted average common shares - basic

                   144,085   
                

 

 

 

Weighted average common shares - diluted

                   147,996   
                

 

 

 
     For the Three Months Ended September 30, 2013  
     Sales      Gross Margin      Operating
Expense
    Operating
Income
    Other
(Income)
Expense
    Income
Tax Expense
(Benefit)
    Net Income
(Loss)
 

Amounts in accordance with GAAP

   $ 1,067,824       $ 316,895       $ 305,713      $ 11,182      $ 22,029      $ (28,016   $ 17,169   

Acquisition accounting impacts related to deferred revenue

     1,556         1,006         -            1,006        -            -            1,006   

Stock compensation expense

     -             1,248         (9,481     10,729        -            -            10,729   

Amortization of intangible assets

     -             -             (65,053     65,053        -            -            65,053   

Integration, acquisition, restructuring and other costs

     -             -             (12,278     12,278        -            -            12,278   

Non-cash interest expense

     -             -             -            -            (3,374     -            3,374   

Net tax items

     -             -             -            -            -            54,998        (54,998
  

 

 

 

Non-GAAP amounts

   $ 1,069,380       $ 319,149       $ 218,901      $ 100,248      $ 18,655      $ 26,982      $ 54,611   
  

 

 

 

GAAP net income per share - diluted

                 $ 0.12   
                

 

 

 

Non-GAAP net income per share - diluted

                 $ 0.39   
                

 

 

 

Weighted average common shares - basic

                   138,478   
                

 

 

 

Weighted average common shares - diluted

                   140,605   
                

 

 

 
     For the Nine Months Ended September 30, 2013  
     Sales      Gross Margin      Operating
Expense
    Operating
Income
    Other
(Income)
Expense
    Income
Tax Expense
(Benefit)
    Net Income
(Loss)
 

Amounts in accordance with GAAP

   $ 2,421,835       $ 656,377       $ 723,742      $ (67,365   $ 55,208      $ (76,630   $ (45,943

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

     3,973         2,478         -            2,478        -            -            2,478   

Product Rationalization

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

Stock compensation expense

     -             2,945         (21,708     24,653        -            -            24,653   

Amortization of intangible assets

     -             -             (128,571     128,571        -            -            128,571   

Integration, acquisition, restructuring and other costs

     -             -             (71,126     71,126        -            -            71,126   

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

     -             -               -            (9,926     -            9,926   

Net tax items

     -             -             -            -            -            143,034        (143,034
  

 

 

 

Non-GAAP amounts

   $ 2,438,990       $ 746,164       $ 502,337      $ 243,827      $ 31,228      $ 66,404      $ 146,195   
  

 

 

 

GAAP net loss per share - diluted (1)

                 $ (0.35
                

 

 

 

Non-GAAP net income per share - diluted

                 $ 1.11   
                

 

 

 

Weighted average common shares - basic

                   129,502   
                

 

 

 

Weighted average common shares - diluted

                   132,169   
                

 

 

 

 

(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 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 Investment in ARRIS: In connection with our acquisition of Motorola Home, Comcast was given an opportunity to invest in ARRIS. The accounting guidance requires that we record the implied fair value of benefit received by Comcast as a reduction in revenue. Until the closing of the deal, changes in the value of the investment were marked to market and flowed through other expense (income). 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 other expense (income).

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

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 resulted in higher cost of goods sold as it was sold.

Product Rationalization: In conjunction with the integration of Motorola Home, we 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 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.

Integration, Acquisition, Restructuring and Other Costs: We have excluded the effect of integration, acquisition, restructuring and other costs 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.

 

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Credit Facility—Ticking Fees: In connection with our acquisition of Motorola Home, the cash portion of the consideration was 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, Comcast was given an opportunity to invest in ARRIS. The accounting guidance requires we mark to market the changes in the value of the investment and flow through other expense (income). 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 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.

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).

Asset Held for Sale Impairment: In the second quarter of 2014, we entered into a contract to facilitate the sale of a building at less than its carrying value. The asset has been reclassified as held for sale and was measured at the lower of its carrying amount or fair value less cost to sell. We have recorded an impairment charge to reduce the assets carrying amount to its estimated fair value less costs to sell in the period the held for sale criteria were met. We have excluded the effect of the asset held for sale impairment 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).

Net Tax Items: 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 tax and legal restructuring, state valuation allowances, research and development tax credits and provision to return differences.

Comparison of Operations for the Three and Nine Months Ended September 30, 2014 and 2013

Net Sales

The table below sets forth our net sales for the three and nine months ended September 30, 2014 and 2013, for each of our segments (in thousands):

 

     Net Sales     Increase (Decrease) Between 2014 and 2013  
     For the Three Months Ended
September 30,
    For the Nine Months Ended
September 30,
    For the Three Months Ended
September 30
    For the Nine Months Ended
September 30
 
     2014     2013     2014     2013     $      %     $      %  

Business Segment:

                  

CPE

   $ 945,386      $ 743,890      $ 2,861,912      $ 1,589,785      $ 201,496         27.1   $ 1,272,127         80.0

N&C

     460,837        325,471        1,202,105        849,382        135,366         41.6     352,723         41.5

Other

     (778     (1,537     (4,483     (17,332     759         49.3     12,849         74.1
  

 

 

   

 

 

   

 

 

      

 

 

    

Total sales

   $ 1,405,445      $ 1,067,824      $ 4,059,534      $ 2,421,835      $ 337,621         31.6   $ 1,637,699         67.6
  

 

 

   

 

 

   

 

 

      

 

 

    

 

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The table below sets forth our domestic and international sales for the three and nine months ended September 30, 2014 and 2013 (in thousands):

 

     Net Sales      Increase (Decrease) Between 2014 and 2013  
     For the Three Months Ended
September 30,
     For the Nine Months Ended
September 30,
     For the Three Months Ended
September 30
    For the Nine Months Ended
September 30
 
     2014      2013      2014      2013      $     %     $      %  

Domestic

   $ 1,029,180       $ 731,439       $ 3,057,970       $ 1,631,083       $ 297,741        40.7   $ 1,426,887         87.5

International

                     

Americas, excluding U.S.

     246,922         217,843         661,005         501,052         29,079        13.3     159,953         31.9

Asia Pacific

     38,584         48,869         113,674         108,102         (10,285     (21.0 )%      5,572         5.2

EMEA

     90,759         69,673         226,885         181,598         21,086        30.3     45,287         24.9
  

 

 

    

 

 

    

 

 

     

 

 

    

Total International

     376,265         336,385         1,001,564         790,752         39,880        11.9     210,812         26.7
  

 

 

    

 

 

    

 

 

     

 

 

    

Total sales

   $ 1,405,445       $ 1,067,824       $ 4,059,534       $ 2,421,835       $ 337,621        31.6   $ 1,637,699         67.6
  

 

 

    

 

 

    

 

 

     

 

 

    

Customer Premises Equipment Net Sales 2014 vs. 2013

During the three months ended September 30, 2014 sales in our CPE segment increased by approximately 27.1% as compared to the same period in 2013. The increase was driven by strong cable and telco set-tops and DSL demand.

During the nine months ended September 30, 2014 sales in our CPE segment increased by approximately 80.0%, as compared to the same period in 2013. The sales increase reflects the inclusion of sales associated with our acquisition of Motorola Home as well as the introduction of new products, in particular the XG1 and Verizon Media Server (VMS) video gateways and a variety of new advanced broadband gateway devices in the second part of 2013.

Network and Cloud Net Sales 2014 vs. 2013

During the three months ended September 30, 2014, sales in N&C segment increased by approximately 41.6% as compared to the same period in 2013. The increase reflects strong sales across most product lines, led by our new CMTS platform, the E6000 CCAP, and video solutions.

During the nine months ended September 30, 2014, sales in N&C segment increased by approximately 41.5%, as compared to the same period in 2013. The increase reflects the inclusion of sales associated with our acquisition of Motorola Home, as well as sales of the E6000, which was introduced during 2013.

Gross Margin

The table below sets forth our gross margin for the three and nine months ended September 30, 2014 and 2013 (in thousands, except percentages):

 

     Gross Margin     Increase (Decrease) Between 2014 and 2013  
     For the Three Months Ended
September 30,
    For the Nine Months Ended
September 30,
    For the Three Months Ended
September 30
    For the Nine Months Ended
September 30
 
     2014     2013     2014     2013     $      %     $      %  

Gross margin dollars

   $ 435,734      $ 316,895      $ 1,201,921      $ 656,377      $  118,839         37.5   $  545,544         83.1

Gross margin percentage

     31.0     29.7     29.6     27.1        1.3           2.5   

During the three months ended September 30, 2014, gross margin dollars and gross margin percentage increased as compared to the same period in 2013. The increase in gross margin dollar is the result of higher sales. The increase in gross margin percentage is the result of product mix, reflecting a higher percentage of N&C products which carry a higher gross margin percent.

 

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During the nine months ended September 30, 2014, gross margin dollars and gross margin percentage increased as compared to the same period in 2013. The increase in gross margin dollars is primarily the result of the inclusion of sales associated with our acquisition of Motorola Home. The increase in gross margin is the result of product mix. In addition, the gross margin for the nine months ended September 30, 2013 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.

Operating Expenses

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

 

     Operating Expenses      Increase (Decrease) Between 2014 and 2013  
     For the Three Months Ended
September 30,
     For the Nine Months Ended
September 30,
     For the Three Months Ended
September 30
    For the Nine Months Ended
September 30
 
     2014      2013      2014      2013      $     %     $     %  

Selling, general and administrative

   $ 103,497       $ 99,666       $ 314,991       $ 227,691       $ 3,831        3.8   $ 87,300        38.3

Research & development

     142,802         128,716         421,077         296,354         14,086        10.9     124,723        42.1

Amortization of intangible assets

     57,100         65,053         179,835         128,571         (7,953     (12.2 )%      51,264        39.9

Integration, acquisition, restructuring & other

     10,226         12,278         34,246         71,125         (2,052     (16.7 )%      (36,879     (51.9 )% 
  

 

 

    

 

 

    

 

 

     

 

 

   

Total

   $ 313,625       $ 305,713       $ 950,149       $ 723,741       $ 7,912        2.6   $ 226,408        31.3
  

 

 

    

 

 

    

 

 

     

 

 

   

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

During the three months ended September 30, 2014, SG&A expenses increased by approximately 3.8% as compared to the same period in 2013.

The year over year increase in SG&A expenses primarily reflects the inclusion of expenses associated with the Motorola Home acquisition. The increase was partially offset as a result of certain information technology and other costs, formerly allocated to SG&A, which have been reclassified effective January 1, 2014 to cost of sales and research and development as a result of the way we review the business.

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 months ended September 30, 2014 increased by approximately 10.9% as compared to the same period in 2013.

R&D expenses for the nine months ended September 30, 2014 increased as compared to the same period in 2013 due to the inclusion of expenses associated with the Motorola Home acquisition, as well as higher allocations of information technology and other costs.

Amortization of Intangible Assets

Our intangible amortization expense relates to finite-lived intangible assets acquired in business combinations or acquired individually. Intangibles amortization expense for the three months ended September 30, 2014 and 2013 was $57.1 million and $65.1 million, respectively. For the nine months ended September 30, 2014 and 2013, intangible amortization expense was $179.8 million and $128.6 million, respectively.

 

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Table of Contents

Integration, Acquisition, Restructuring and Other Costs

During the three months ending September 30, 2014 and 2013, we recorded acquisition-related expenses and integration expenses of $7.2 million and $6.2 million, respectively. Acquisition and integration related expenses declined $5.3 million compared to the prior quarter. During the nine months of 2014 and 2013, we recorded acquisition-related expenses and integration expenses of $31.6 million and $32.8 million, respectively. These expenses primarily related to the acquisition of Motorola Home and consisted primarily of integration related outside services and legal fees.

During the three months ended September 30, 2014 and 2013, we recorded restructuring charges of approximately $3.0 million and $6.1 million, respectively. Restructuring charges during the three months ended September 30, 2014 related primarily to facility rationalization initiatives, resulting in severance and employee termination benefits for 150 employees. During the nine months ended September 30, 2014 and 2013, we recorded restructuring (recovery) charges of approximately $2.6 million and $38.3 million, respectively. The charge recorded in 2014 was related to severance and employee termination benefits and the charges in 2013 were related to severance, employee termination benefits and facilities.

Direct Contribution

The table below sets forth our direct contribution for the three and nine months ended September 30, 2014 and 2013, for each of our segments (in thousands):

 

     Direct Contribution     Increase (Decrease) Between 2014 and 2013  
     For the Three Months Ended
September 30,
    For the Nine Months Ended
September 30,
    For the Three Months Ended
September 30
    For the Nine Months Ended
September 30
 
     2014     2013     2014     2013     $     %     $     %  

Business Segment:

          

CPE

   $ 208,163      $ 158,035      $ 624,732      $ 315,305      $ 50,128        31.7   $ 309,427        98.1

N&C

     134,217        61,763        304,133        187,354        72,454        117.3     116,779        62.3

Other

     (152,945     (131,285     (463,012     (370,327     (21,660     (16.5 )%      (92,685     (25.0 )% 
  

 

 

   

 

 

   

 

 

     

 

 

   

Total

   $ 189,435      $ 88,513      $ 465,853      $ 132,332      $ 100,922        114.0   $ 333,521        252.0
  

 

 

   

 

 

   

 

 

     

 

 

   

Customer Premises Equipment Direct Contribution 2014 vs. 2013

During the three months ended September 30, 2014 direct contribution in our CPE segment increased by approximately 31.7% as compared to the same period in 2013. The direct contribution is favorably impacted by product mix and higher sales.

During the nine months ended September 30, 2014 direct contribution in our CPE segment increased by approximately 98.1% as compared to the same period in 2013. 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 product mix, given, that in the aggregate the contribution margin of former Motorola Home products is greater than that of former ARRIS products.

Network and Cloud Direct Contribution 2014 vs. 2013

During the three months ended September 30, 2014, direct contribution in our N&C segment increased by approximately 117.3% as compared to the same period in 2013. The increase is primarily attributable to the increase in E6000 CCAP and video solutions.

During the nine months ended September 30, 2014, direct contribution in our N&C segment increased by approximately 62.3% as compared to the same period in 2013. The increase is primarily attributable to the inclusion of direct contribution associated with our acquisition of Motorola Home.

 

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Table of Contents

Other Expense (Income)

Interest Expense

Interest expense for the three months ended September 30, 2014 and 2013 was $14.2 million and $25.2 million respectively. For the nine months ended September 30, 2014 and 2013, interest expense was $49.0 million and $48.4 million respectively. During the nine months ended September 30, 2014, optional debt pre-payments were made resulting in the accelerated write-off of deferred financing fees and debt discount of $2.7 million. In addition, interest expense reflects the amortization of deferred finance fees, the debt discount for the term loans and interest paid on term loans and other debt obligations. The three and nine months ended September 30, 2013, interest expense also included the non-cash interest component of our convertible subordinated notes which were fully redeemed during the fourth quarter of 2013.

Interest Income

Interest income during the three months ended September 30, 2014 and 2013 was $0.7 million and $0.8 million, respectively. During the nine months ended September 30, 2014 and 2013, interest income was $1.9 million and $2.3 million, respectively. The income reflects interest earned on cash, cash equivalents, short-term and long-term investments.

Loss on Foreign Currency

During the three and nine months ended September 30, 2014, we recorded a foreign currency loss of approximately $3.1 million and $3.8 million, respectively. During the three and nine months ended September 30, 2013, we recorded a foreign currency gain of approximately $3.8 million and $2.7 million, respectively. We have US dollar functional currency entities that bill certain international customers in their local currency and foreign functional currency entities that procure in U.S. dollars. Additionally, certain intercompany transactions are denominated in foreign currencies and subject to revaluation. To mitigate the volatility related to fluctuations in the foreign exchange rates, we have entered into various foreign currency contracts. The gain or loss on foreign currency is driven by the fluctuations in the foreign currency exchange rates.

Loss (Gain) on Investments

During the three months ended September 30, 2014 and 2013, we recorded a net loss (gain) on investments, including impairment charges in 2014, of $6.4 million, and $(0.3) million, respectively. During the nine months ended September 30, 2014 and 2013, we recorded a net loss (gain) on investments, including impairment charges in 2014, related to these investments of $11.3 million, and $(1.5) million, respectively.

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. In connection with the Acquisition, we also acquired certain investments in limited liability companies and partnerships that are accounted for using the equity method of accounting. As such our equity portion in current earnings of such companies is included in the loss (gain) on investments.

During the third quarter of 2014, the Company performed an evaluation of its investments and concluded that two private companies had indicators of impairment, and that their fair value had declined. This resulted in other-than-temporary impairment charges of $4.0 million during the quarter ended September 30, 2014. No impairment charges were recorded in 2013.

Other Expense (Income), net

Other expense (income), net for the three months ended September 30, 2014 and 2013 was $(0.1) million and $1.7 million, respectively. For the nine months ended September 30, 2014 and 2013, other expense was $6.5 million and $13.4 million, respectively.

For the nine months ended September 30, 2014, we recorded a $2.1 million write-down in the carrying value of land and building reclassified as held for sale as a result of obtaining a letter of intent for its sale and is included in other expense (income), net.

 

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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 $13.2 million in the nine months ended September 30, 2013 and is recorded as Other expense (income), net.

Income Tax Expense

For the three and nine month periods ended September 30, 2014, we recorded income tax expense of $44.5 million and $48.7 million, respectively as compared to a tax benefit of $28.0 million and $76.6 million, respectively in the same periods in 2013. The change in the income tax expense (benefit) for the three and nine month periods ended September 30, 2014 compared to the three and nine months period ended September 30, 2013, 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. In addition, there were significant and unusual tax charges relating to an estimated increase in acquired net operating losses from the Motorola Home acquisition, less associated valuation allowances, a favorable change in state deferred tax rates due to supply chain related integration planning, an unfavorable accrual of uncertain tax positions relating to dual consolidated losses, a favorable impact of intangibles reattributed and an unfavorable impact from return to provision adjustments.

For the nine month period ended September 30, 2014, the Company recorded a pre-tax book loss of approximately $30.6 million relating to acquisition costs incurred on the Motorola Home acquisition, on which a tax benefit of $10.9 million was recorded. The company also recorded pre-tax book losses of $9.1 million on investments and available for sale assets, generating a tax benefit of $3.3 million during the nine month period ended September 30, 2014. Also during the nine month period ended September 30, 2014, the Company recorded a tax benefit of approximately $18.2 million relating to an estimated increase in acquired net operating losses from the Motorola Home acquisition, a tax expense of approximately $4.4 million on additional liabilities for uncertain tax positions, a $3.8 million benefit on changes in state deferred income tax rates, a $1.8 million benefit on changes to valuation allowances, a benefit of $4.0 million for reattributed intangibles, and an unfavorable charge of $6.2 million for provision to return adjustments. The Company has not yet recorded a favorable impact from research and development credits, as the credit has not yet been reenacted for the 2014 tax year.

During the third quarter of 2014, the Company identified and corrected an immaterial error in the accounting for income taxes related to the prior year ended December 31, 2013. The correction related to the Company’s subsequent consideration of certain tax consequences related to a legal entity and tax restructuring completed in the fourth quarter of 2013. The impact of adjusting these amounts had a non-cash effect, increasing income tax expense and noncurrent income tax liabilities by $9.8 million. In accordance with ASC Topic 250, Accounting Changes and Error Corrections, the Company evaluated the impact on its financial statements for the year ended December 31, 2013 and the expected full year results for the year ending December 31, 2014 and concluded that the results of operations for these periods were not materially misstated. In reaching its conclusion the Company considered both quantitative and qualitative factors. The quantitative factors included calculating the impact of the error on the effected financial statements and assessing materiality. The qualitative factors included, but were not limited to the absences of impact on debt covenants, management compensation and segment reporting. Based on its evaluation, the Company concluded that it is not probable that the judgment of a reasonable person relying on the financial statements would have been changed or influenced by the correction.

 

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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

 

     Nine Months Ended September 30,  
     2014      2013  
     (in thousands, except DSO and turns)  
Key Working Capital Items      

Cash provided by operating activities

   $ 337,091       $ 380,198   

Cash, cash equivalents, and short-term investments

   $ 593,816       $ 666,501   

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

   $ 5,331       $ 28,477   

Accounts receivable, net

   $ 703,566       $ 627,844   

Days Sales Outstanding (“DSOs”)

     47         55 (1) 

Inventory

   $ 368,628       $ 350,919   

Inventory turns

     11.6         9.0 (1) 
Key Financing Items      

Convertible notes at face value

   $       $ 231,972   

Term loans at face value

   $ 1,561,313       $ 1,893,375   

Cash used for debt repayment

   $ 195,903       $ 31,625   
Capital Expenditures    $ 41,759       $ 53,383   

 

(1) 

Using annualized activity from the third quarter 2013, the first full quarter as a combined company following the 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, fund internal growth and execute acquisitions.

   

Deleverage – reduce our debt obligation.

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.

Accounts receivable increased during the first nine months of 2014 as compared to 2013, primarily as a result of higher sales. 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 2014 as compared to 2013. Inventory turns during the first nine months of 2014 were 11.6 as compared to 9.0 in the same period of 2013.

 

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Term Debt Repayments

In the first nine months of 2014, we repaid $195.9 million of debt, of which $41.2 million is of our term debt, including a $150 million of optional prepayment and $4.7 million of debt assumed and settled in conjunction with the closing of the Seawell acquisition in April 2014.

In the first nine months of 2013, we repaid $31.6 million of our term debt.

Summary of Current Liquidity Position and Potential for Future Capital Raising

We believe our current liquidity position, where we have approximately $593.8 million of cash, cash equivalents, and short-term investments and $5.3 million of long-term marketable securities on hand as of September 30, 2014, together with approximately $247.4 million in availability under our new Revolving Credit Facility, together with the prospects for continued generation of cash from operations are adequate for our short- and medium-term business needs. Our cash, cash-equivalents and short-term investments as of September 30, 2014 include approximately $167.9 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 have subsidiaries in countries that maintain restrictions, such as legal reserves, with respect to the amount of dividends that the subsidiaries can distribute. Additionally, some countries impose restrictions or controls over how and when dividends can be paid by these subsidiaries. While we do not currently intend to repatriate earnings from entities in these countries, if we were to be required to distribute earnings from such countries, the timing of the distribution and the funds available to distribute, would be adversely impacted by these restrictions.

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. 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.

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 September 30, 2014, we had $1,561.3 million face value outstanding under the Term Loan A and Term Loan B Facilities and no amounts drawn under the Revolving Credit Facility and letters of credit totaling $2.6 million issued under the Revolving Credit Facility.

 

    

Rate

   As of September 30, 2014  

Term Loan A

   LIBOR + 1.75 %      1.90

Term Loan B

   LIBOR(1) + 2.50 %      3.25

Revolving Credit Facility(2)

   LIBOR + 1.75 %      Not Applicable   

 

  (1) Includes LIBOR floor of 0.75%
  (2) Includes unused commitment fee of 0.35% and letter of credit fee of 1.75% 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

 

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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 3.75:1 (with an additional scheduled decreases to 3.5:1). As of September 30, 2014, we were in compliance with all covenants under the Credit Agreement.

The Credit Agreement provides for certain step downs in the interest rates paid on the Term Loan A, Term Loan B and Revolving Credit Facility upon achievement of tiered lowered leverage ratios. As a result of our lowered leverage ratio at the end of the second quarter, the interest rate paid on the Term Loan A, Term Loan B and Revolving Credit Facility decreased by 25 basis points. Since inception, we have realized a total 50 basis points decrease in the interest rate paid on the Term Loan A and Revolving Credit Facility and 25 basis points decrease in the interest paid rate on the Term Loan B. There are no further interest rate decreases available to us in the current Credit Agreement.

The Credit Agreement provides terms for mandatory repayments 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

Our contractual obligations are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2013. There has been no material change to our contractual obligations during the first nine months of 2014.

Off-Balance Sheet Arrangements

We do not have any material off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.

Cash Flow

Below is a table setting forth the key line items of our Consolidated Statements of Cash Flows (in thousands):

 

     For the Nine Months Ended
September 30,
 
      2014     2013  

Cash provided by

    

Operating activities

   $ 337,091      $ 380,198   

Investing activities

     (53,238     (1,972,719

Financing activities

     (199,292     2,001,932   
  

 

 

 

Net increase in cash and cash equivalents

   $ 84,561      $ 409,411   
  

 

 

 

Operating Activities:

Below are the key line items affecting cash provided by operating activities (in thousands):

 

     For the Nine Months  Ended
September 30,
 
     2014     2013  

Net income (loss)

   $ 134,451      $ (45,943

Adjustments to reconcile net income to cash provided by operating activities

     274,773        181,716   
  

 

 

 

Net income including adjustments

     409,224        135,773   

(Increase) decrease in accounts receivable

     (70,627     17,793   

(Increase) decrease in inventory

     (38,499     60,345   

Increase in accounts payable and accrued liabilities

     2,592        155,264   

All other – net

     34,401        11,023   
  

 

 

   

 

 

 

Cash provided by operating activities

   $ 337,091      $ 380,198   
  

 

 

   

 

 

 

Net income including adjustments, increased $273.5 million during the first nine months of 2014 as compared to 2013.

Accounts receivable increased by $70.6 million during the first nine months of 2014. This increase was primarily a result of higher sales and payment patterns of our customers.

Inventory increased by $38.5 million during the first nine months of 2014, reflecting robust demand for certain products. The decrease in 2013 reflects the turnaround effect of inventory markup of $57.6 million to fair value in purchase accounting as a result of the Acquisition and the disposal of certain inventory as a result of product rationalization.

 

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Accounts payable and accrued liabilities increased by $2.6 million during the first nine months of 2014. The increase of $155.3 million during the first nine months of 2013 was largely related the increase in accounts payable due to the acquisition of Motorola Home.

All other accounts, net, includes the changes in other receivables, income taxes payable (recoverable), and prepaids. The other receivables represent amounts due from our contract manufacturers for material used in the assembly of our finished goods. The change in our income taxes recoverable account is a result of the timing of the actual estimated tax payments during the year as compared to the actual tax liability for the year. The net change during the first nine months of 2014 was approximately $34.4 million.

Investing Activities:

Below are the key line items affecting investing activities (in thousands):

 

     For the Nine Months  Ended
September 30,
 
     2014     2013  

Purchases of property, plant and equipment

   $ (41,759   $ (53,383

Sale of property, plant and equipment

     19        90   

Purchases of investments

     (40,901     (104,546

Sales of investments

     29,319        393,234   

Acquisitions, net of cash acquired

     84        (2,208,114
  

 

 

   

 

 

 

Cash used in investing activities

   $ (53,238   $ (1,972,719
  

 

 

   

 

 

 

Purchases of Property, Plant and Equipment This represents capital expenditures which are mainly for test equipment, laboratory equipment, and computing equipment.

Sale of Property, Plant and Equipment–This represents the cash proceeds we received from the sale of property, plant and equipment.

Purchases and Sales of InvestmentsThis represents purchases and sales of securities

Acquisitions, Net of Cash Acquired – This represents cash investments we have made in our acquisitions.

Financing Activities:

Below are the key line items affecting our financing activities (in thousands):

 

     For the Nine Months Ended  
     September 30,  
     2014     2013  

Proceeds from issuance of debt

   $      $ 1,925,000   

Cash paid for debt discount

            (9,853

Payment of debt obligations

     (195,903     (31,625

Early redemption of convertible notes

            (79

Deferred financing costs paid

            (42,356

Excess income tax benefits from stock-based compensation plans

     14,651        6,416   

Repurchase of shares to satisfy minimum tax withholdings

     (29,605     (12,522

Proceeds from issuance of common stock

     11,565        166,951   
  

 

 

   

 

 

 

Cash (used in) provided by financing activities

   $ (199,292   $ 2,001,932   
  

 

 

   

 

 

 

Proceeds From Issuance of Debt – As part of the Motorola Home acquisition, we entered into senior secured credit facilities which include Term Loan A facility of $1.1 billion with a term of five years and Term Loan B facility of $0.8 billion with a term of seven years.

 

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Cash Paid for Debt Discount - This represents amounts paid to lenders in the form of upfront fees which have been treated as a reduction in the proceeds received by the Company and are considered a component of the discount on the Term Loans A and B.

Payment of Debt Obligations – This represents the payment of the term loans under the senior secured credit facilities plus the payment of debt assumed and settled in conjunction with the closing of the SeaWell acquisition in April 2014.

Early Redemption of Convertible Notes – As a result of the holding company reorganization undertaken in connection with the Motorola Home acquisition, holders of the senior notes had the right to require us to repurchase the convertible senior notes for 100% of the principal amount plus accrued and unpaid interest or to convert the convertible senior notes for the consideration. This represents the portion of the convertible senior notes that were tendered pursuant to the repurchase right and surrendered pursuant to the conversion right.

Deferred Financing Costs Paid – This represents the finance fees related to the issuance of the senior secured credit facilities. These costs will be amortized over the life of the term loans and revolving credit facility or written-off on an accelerated basis if optional prepayments are made on the debt.

Excess Income Tax Benefits from Stock-Based Compensation Plans—This represents the cash that otherwise would have been paid for income taxes if increases in the value of equity instruments also had not been deductible in determining taxable income.

Repurchase of Shares to Satisfy Minimum Tax Withholdings—This represents the shares withheld to satisfy the minimum tax withholding when restricted stock vests.

Proceeds from Issuance of Common Stock – This represents cash proceeds related to the exercise of employee stock options, offset by expenses paid related to issuance of common stock. It also represents cash proceeds from shares issued to Comcast in relation to the Acquisition.

Interest Rates

As described above, all indebtedness under our senior secured credit facilities bears interest at variable rates based on LIBOR plus an applicable spread. We entered into interest rate swap arrangements to convert a notional amount of $600.0 million of our variable rate debt based on one-month LIBOR to a fixed rate. The objective of these swaps 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.

Foreign Currency

A significant portion of our products are manufactured or assembled in China, Mexico and Taiwan, and we have research and development centers in Argentina, China, India, Ireland, Israel and Sweden. Our sales into international markets have been and are expected in the future to be an important part of our business. These foreign operations are subject to the usual risks inherent in conducting business abroad, including risks with respect to currency exchange rates, economic and political destabilization, restrictive actions and taxation by foreign governments, nationalization, the laws and policies of the United States affecting trade, foreign investment and loans, and foreign tax laws.

We have certain international customers that are billed in their local currency and certain international operations that procure in U.S. dollars. In addition, we have certain predicable expenditures for international operations in local currency. We use a hedging strategy and enter into forward or currency option contracts based on a percentage of expected foreign currency revenues and expenses. The percentage can vary, based on the predictability of the revenues denominated in the foreign currency.

 

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Financial Instruments

In the ordinary course of business, we, from time to time, will enter into financing arrangements with customers. These financial arrangements include letters of credit, commitments to extend credit and guarantees of debt. These agreements could include the granting of extended payment terms that result in longer collection periods for accounts receivable and slower cash inflows from operations and/or could result in the deferral of revenue.

We execute letters of credit and bank guarantees in favor of certain landlords, customers and vendors to guarantee performance on contracts. Certain financial instruments require cash collateral, and these amounts are reported as restricted cash. As of September 30, 2014 and December 31, 2013, we had approximately $1.0 million and $1.1 million outstanding, respectively, of restricted cash.

Cash, Cash Equivalents, and Short-Term Investments

Our cash and cash equivalents (which are highly-liquid investments with an original maturity of three months or less) are primarily held in demand deposit and money market deposit accounts that pay taxable interest. We hold short-term investments consisting of debt securities classified as available-for-sale, which are stated at estimated fair value. These debt securities consist primarily of commercial paper, certificates of deposits, and U.S. government agency financial instruments.

We hold cost method investments in private companies. These investments are recorded at $10.3 million and $15.3 million as of September 30, 2014 and December 31, 2013, respectively. See Note 5 of Notes to the Consolidated Financial Statements for disclosures related to the fair value of our investments.

We have two rabbi trusts that are used as funding vehicles for various deferred compensation plans that were available to certain current and former officers and key executives. We also have deferred retirement salary plans, which were limited to certain current or former officers of a business acquired in 2007. We hold investments to cover the liability.

ARRIS also funds its nonqualified defined benefit plan for certain executives in a rabbi trust.

Capital Expenditures

Capital expenditures are made at a level designed to support the strategic and operating needs of the business. ARRIS’ capital expenditures were $41.8 million in the first nine months of 2014 as compared to $53.4 million in the first nine months of 2013. Management expects to invest approximately $55 million in capital expenditures for the fiscal year 2014.

Critical Accounting Policies and Estimates

The accounting and financial reporting policies of ARRIS are in conformity with U.S. generally accepted accounting principles, which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Management has discussed the development and selection of the Company’s critical accounting estimates with the audit committee of the Company’s Board of Directors and the audit committee has reviewed the Company’s related disclosures.

Our critical accounting policies and estimates are disclosed in our Form 10-K for the year ended December 31, 2013, as filed with the SEC. Our critical accounting estimates have not changed in any material respect during the nine months ended September 30, 2014.

Forward-Looking Statements

Certain information and statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations and other sections of this report, including statements using terms such as “may,” “expect,” “anticipate,” “intend,” “estimate,” “believe,” “plan,” “continue,” “could be,” or similar variations or the negative thereof, constitute forward-looking statements with respect to the financial condition, results of operations, and business of ARRIS, including statements that are based on current expectations, estimates, forecasts, and

 

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projections about the markets in which we operate and management’s beliefs and assumptions regarding these markets. These and any other statements in this document that are not statements about historical facts are “forward-looking statements.” We caution investors that forward-looking statements made by us are not guarantees of future performance and that a variety of factors could cause our actual results to differ materially from the anticipated results or other expectations expressed in our forward-looking statements. Important factors that could cause results or events to differ from current expectations are described in the risk factors set forth in Item 1A, Part II, “Risk Factors.” These factors are not intended to be an all-encompassing list of risks and uncertainties that may affect the operations, performance, development and results of our business. In providing forward-looking statements, ARRIS expressly disclaims any obligation to update publicly or otherwise these statements, whether as a result of new information, future events or otherwise except to the extent required by law.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There have been no material changes with respect to the information appearing in Part II, Item 7A., “Quantitative and Qualitative Disclosures About Market Risk,” of our Annual Report on Form 10-K for the year ended December 31, 2013.

Item 4. CONTROLS AND PROCEDURES

(a) Evaluation of Disclosure Controls and Procedures. Our principal executive officer and principal financial officer evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report (the “Evaluation Date”). Based on that evaluation, such officers concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective as contemplated by the Act.

(b) Changes in Internal Control over Financial Reporting. Our principal executive officer and principal financial officer evaluated the changes in our internal control over financial reporting that occurred during the most recent fiscal quarter. Based on that evaluation, our principal executive officer and principal financial officer concluded that, except with respect to the Motorola Home acquisition described below, there had been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

On April 17, 2013, we completed the acquisition of the Motorola Home business. See Note 3 Business Acquisitions of the Notes to the Consolidated Financial Statements for additional information. Total assets of the Motorola Home business represented approximately 89% of our consolidated total assets as of December 31, 2013, and net sales related to the Motorola Home business represented approximately 59% of our consolidated net sales for the fiscal year ended December 31, 2013. From the completion of the acquisition through December 31, 2013, under a transitional services agreement, the Seller continued to provide a substantial portion of the accounting and other reporting functions with respect to the acquired business. Effective January 1, 2014, we assumed direct control of a majority of these functions with respect to the acquired business, although we continued to use the seller’s systems. We completed transition of the accounting and related functions for the acquired business to our systems in the second quarter of 2014, and we will continue to review the impact of any future changes to our internal controls over financial reporting.

PART II. OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

We have been, and expect in the future to be a party to various legal proceedings, investigations or claims. In accordance with applicable accounting guidance, we record accruals for certain of our outstanding legal proceedings when it is probable that a liability will be incurred and the amount of loss can be reasonably estimated. We evaluate, at least on a quarterly basis, developments in our legal proceedings or other claims that could affect the amount of any accrual, as well as any developments that would result in a loss contingency to become both probable and reasonably estimable. When a loss contingency is not both probable and reasonably estimable, we do not record a loss accrual.

 

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If the loss (or an additional loss in excess of any prior accrual) is reasonably possible and material, we disclose an estimate of the possible loss or range of loss, if such estimate can be made. The assessment whether a loss is probable or reasonably possible and whether the loss or a range of loss is estimable, involves a series of complex judgments about future events. Even if a loss is reasonably possible, we may not be able to estimate a range of possible loss, particularly where (i) the damages sought are substantial or indeterminate, (ii) the proceedings are in the early stages, or (iii) the matters involve novel or unsettled legal theories or a large number of parties. In such cases, there is considerable uncertainty regarding the ultimate resolution of such matters, including the amount of any possible loss. Accordingly, with respect to the proceedings described below, we are currently unable to reasonably estimate the possible loss or range of possible loss. However, because the results in litigation are unpredictable, an adverse resolution of one or more of such matters could have a material adverse effect on our business, financial position, results of operations or cash flows.

Due to the nature of our business, it is subject to patent infringement claims, including current suits against us or one or more of our wholly-owned subsidiaries or one or more of our customers who may seek indemnification from us. We believe that we have meritorious defenses to the allegation made in the pending cases and intend to vigorously defend these lawsuits; however, we are unable currently to determine the ultimate outcome of these or similar matters. In addition, we are a defendant in various litigation matters generally arising out of the normal course of business. Except as described below, ARRIS is not party (nor have indemnification claims been made with respect) to any proceedings that are, or reasonably are expected to be, material to its business, results of operations or financial condition. However, since it is difficult to predict the outcome of legal proceedings, it is possible that the ultimate outcomes could materially and adversely affect our business, financial position, results of operations or cash flows. Accordingly, with respect to these proceedings, we are currently unable to reasonably estimate the possible loss or range of possible loss.

AIP v. MSOs, C.A. 12-cv-01690 et al., District of Delaware. On December 11, 2012, AIP filed several suits against service providers alleging infringement of four U.S. patents. The complaint requests unspecified damages for infringement and injunction against future infringement. This case has been stayed pending Inter Partes Review at the United States Patent and Trademark Office. The Patent Trial and Appeals Board recently ruled all claims of the patent are invalid. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify one or more of the MSOs and/or pay damages for utilizing certain technology.

Bear Creek Technologies v. MSOs, C.A. 2:11-cv-00103, District of Delaware. In February 2011, Bear Creek sued MSOs, Telcos and other VoIP service providers for infringement of US Patent No. 7,889,722, relating to EMTAs. Certain of our customers have requested that we provide indemnification. The complaint requests unspecified damages for past infringement and injunction against future infringement. This case has been stayed pending reexamination of the patent by the United States Patent and Trademark Office. All claims of the patent have been rejected in the re-exam and that rejection is currently under appeal by the patent owner. To date, no evidence of damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify the MSOs and/or pay damages for utilizing certain technology.

Broadband iTV v. Time Warner Cable (TWC) et al., C.A. 1:14-cv-00169, District of Hawaii. On April 9, 2014, Broadband iTV filed suit against TWC alleging infringement of U.S. Patent No. 7,631,336 relating to media sharing. The complaint requests unspecified damages for past infringement and an injunction. An Inter Partes Review has been filed on this patent with the United States Patent and Trademark Office and is awaiting action. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify TWC and/or pay damages for utilizing certain technology.

C-Cation v. ARRIS et al., C.A. 14-cv-00059, Eastern District of Texas. On February 4, 2014, C-Cation filed suit against TWC, ARRIS, Cisco and Casa alleging infringement of U.S. Patent No. 5,563,883 relating to channel management. ARRIS has filed a Petition for Inter Partes Review at the United States Patent and Trademark Office and is awaiting action on the Petition. The complaint requests unspecified damages for past and future infringement. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to pay damages for utilizing certain technology.

 

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Constellation Technologies v. TWC, 2:13-cv-01079, U.S. District Court, Eastern District of Texas; and ARRIS v. Constellation Technologies and Rockstar Consortium, 14-cv-00114 (UNA), U.S. District Court, District of Delaware. On December 11, 2013, Constellation Technologies sued TWC alleging infringement of six US patents acquired from Nortel through Rockstar Consortium. The complaint alleges unspecified damages for past infringement. On January 30, 2014 ARRIS filed suit against Constellation Technologies and Rockstar Consortium alleging that the entire Nortel patent portfolio is the subject of a previous license to ARRIS, that Rockstar’s licensing tactics amount to unfair competition, as well as asking for a declaration of non-infringement of eight U.S. patents 5,471,474; 5,761,197; 6,128,298; 6,128,649; 6,130,893; 6,321,253; 7,154,879; and 8,464,299 formerly part of the Nortel portfolio. Several MSOs have asked ARRIS (and other suppliers) to indemnify them. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify one or more of the MSOs and/or pay damages for utilizing certain technology.

Custom Media Technologies v. MSOs, C.A. 13-cv-01425, District of Delaware. On August 15, 2013, Custom Media Technologies LLC filed a claim against several MSOs alleging infringement of US Patent No. 6,269,275. The complaint requests damages for past and future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify one or more MSOs and/or pay damages for utilizing certain technology.

Dragon Intellectual Property v. MSOs, C.A. 13-cv-02069; 13-cv-02063, etc., District of Delaware (RGA). Dragon IP filed suit against several MSOs alleging infringement of US Patent No. 5,930,444. The complaint requests unspecified damages for infringement and injunction against future infringement. A Petition for Inter Partes Review of the asserted patent has been filed with the United States Patent and Trademark Office. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify the MSOs and/or pay damages for utilizing certain technology.

EON Corp. IP Holdings v. AT&T, C.A. 11-cv-01555, District of Puerto Rico. On June 14, 2011, EON filed suit against AT&T alleging infringement of six U.S. patents. The complaint requests unspecified damages for infringement and injunction against future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify AT&T and/or pay damages for utilizing certain technology.

FutureVision.com v. MSOs, C.A. 13-cv-00855, District of Delaware. On May 16, 2013, FutureVision.com filed suit against several service providers alleging infringement of U.S. Patent No. 5,877,755 relating to an interactive broadband multimedia systems. FutureVision.com subsequently filed suit on July 2, 2014 against several additional service providers. The complaint requests unspecified damages for past and future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify one or more of the MSOs and/or pay damages for utilizing certain technology.

Innovative Wireless Solutions v. ARRIS, C.A. 13-cv-01857, District of Delaware (RGA). On November 6, 2013, Innovative Wireless filed suit against ARRIS alleging infringement of three US Patents: 5,912,895; 6,327,264; and 6,587,473. The complaint requests unspecified damages for infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS or its suppliers may be required to pay damages for utilizing certain technology.

Intellectual Ventures I and II v. AT&T, C.A. 12-cv-00193 and 13-cv-01631, District of Delaware. On February 16, 2012, Intellectual Ventures filed a claim against AT&T alleging infringement of several US patents. The complaint requests damages for past and future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify AT&T and/or pay damages for utilizing certain technology.

MediaTube et al v. Bell Canada et al, C.A. T-705-13, Canadian Federal Court. On April 23, 2013, MediaTube Corp. filed a claim against Bell Canada entities alleging infringement of a Canadian patent. The complaint requests damages for past and future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify Bell Canada and/or pay damages for utilizing certain technology.

 

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Motorola Mobility v. Microsoft, C.A. 11-cv-01408, Western District of Washington. Motorola filed suit against Microsoft alleging infringement of multiple Motorola patents. Microsoft counterclaimed alleging infringement of several Microsoft patents, including two patents asserted against General Instrument products. It is premature to assess the likelihood of an unfavorable outcome. With respect to the liability attributable to Motorola Home products in this matter, a subsidiary of Google has agreed to indemnify ARRIS.

Spherix v. Verizon, C.A. 14-cv-0721, Eastern District of Virginia. On June 11, 2014, Spherix filed suit against Verizon alleging infringement of four patents alleged to cover various Verizon products or services. The complaint requests unspecified damages for past infringement and injunction against future infringement. To date, no evidence of damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify the MSOs and/or pay damages for utilizing certain technology.

Sprint Communications v. MSOs, C.A. 11-cv-2686, District of Kansas. On December 19, 2011, Sprint filed suit against several MSOs alleging infringement of several patents alleged to cover various aspects of voice services. The complaint requests unspecified damages for past infringement and injunction against future infringement. To date, no evidence of damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify the MSOs and/or pay damages for utilizing certain technology. With respect to the liability attributable to Motorola Home products in this matter, a subsidiary of Google has agreed to indemnify ARRIS.

Steelhead Licensing v. Comcast, C.A. 13-cv-02076, District of Delaware (RGA). On December 20, 2013, Steelhead filed suit against Comcast alleging infringement of US Patent No. 8,082,318. The complaint requests unspecified damages for infringement and injunction against future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify Comcast and/or pay damages for utilizing certain technology.

TransVideo Electronics v. TWC, C.A. 12-cv-01740, District of Delaware (RGA). On December 20, 2013, TransVideo filed suit against TWC alleging infringement of US Patent Nos. 5,594,936 and 5,991,801. The complaint requests unspecified damages for infringement and injunction against future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify TWC and/or pay damages for utilizing certain technology.

Two Way Media v. Bell Canada et al, C.A. T-809-14, Canadian Federal Court. On April 2, 2014, Two Way Media filed a claim against Bell Canada entities alleging infringement of a Canadian patent. The complaint requests damages for past and future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify Bell Canada and/or pay damages for utilizing certain technology.

United Access Technologies v. AT&T, C.A. 11-cv-00338, District of Delaware. On April 15, 2011, United Access Technologies filed suit against AT&T alleging infringement of three U.S. patents. The complaint requests unspecified damages for past and future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify AT&T and/or pay damages for utilizing certain technology.

US Ethernet Innovations v. AT&T, C.A. 10-cv-05254, Northern District of California. On November 19, 2010, US Ethernet Innovations filed suit against a multitude of parties alleging infringement of four U.S. patents, for which we believe ARRIS is indemnified by another supplier. The complaint requests unspecified damages for infringement and injunction against future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify AT&T.

 

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Wireless Handover OY v. AT&T, C.A. 13-cv-00507, Northern District of Texas. On January 31, 2013, Wireless Handover filed suit against AT&T alleging infringement of U.S. Patent No. 7,953,407. The complaint requests unspecified damages for infringement and injunction against future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify AT&T.

In the acquisition agreement entered into in connection with the acquisition of the Motorola Home business, a subsidiary of Google agreed to indemnify, defend and hold harmless ARRIS and various related parties with respect to, among other things, any losses suffered by ARRIS as a result of a court order involving, or the settlement of, certain agreed-upon litigation, including the two lawsuits described above that reference this indemnification obligation. There are various limitations upon this obligation, the most significant of which is that ARRIS was responsible for 50% of the first $50.0 million (i.e., $25.0 million) of losses attributable to past infringements as well as 50% of the first $50.0 million (i.e., $25.0 million) of future royalty payments and the costs of devising and implementing redesigns intended to avoid infringement. As a result of the settlement of Motorola Mobility’s litigation with TiVo in the third quarter of 2013, these particular obligations for contribution by ARRIS have been exhausted and ARRIS has made the payments for which it is responsible.

From time to time third parties demand that we or our customers enter into a license agreement with respect to patents owned, or allegedly owned, by the third parties. Such demands cause us to dedicate time to study the patents and enter into discussions with the third parties regarding the merits and value, if any, of the patents. These discussions, may materialize into license agreements or patent claims asserted against us or our customers. If asserted against our customers, our customers may request indemnification from us. It is not possible to determine the impact of any such demands and the related discussions on ARRIS’ business, results of operations or financial condition.

Item 1A. Risk Factors

Our business is dependent on customers’ capital spending on broadband communication systems, and reductions by customers in capital spending adversely affect our business.

Our performance is primarily dependent on customers’ capital spending for constructing, rebuilding, maintaining or upgrading broadband communications systems. Capital spending in the broadband communications industry is cyclical and can be curtailed or deferred on short notice. A variety of factors affect capital spending, and, therefore, our sales and profits, including:

 

   

general economic conditions;

   

customer specific financial or stock market conditions;

   

availability and cost of capital;

   

governmental regulation;

   

demands for network services;

   

competition from other providers of broadband and high-speed services;

   

acceptance of new services offered by our customers; and

   

real or perceived trends or uncertainties in these factors.

Several of our customers have accumulated significant levels of debt. These high debt levels, coupled with the continued turbulence in the capital markets, may impact their access to capital in the future. Even if the financial health of our customers remains intact, these customers may not purchase new equipment at levels we have seen in the past or expect in the future. While there has been improvement in the U.S. and global economy over the past year, we cannot predict the impact, if any, of any softening of the national of global economy or of specific customer financial challenges on our customer’s expansion and maintenance expenditures.

 

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The markets in which we operate are intensely competitive, and competitive pressures may adversely affect our results of operations.

The markets in which we participate are dynamic, highly competitive and require companies to react quickly and capitalize on change. We must retain skilled and experienced personnel, as well as deploy substantial resources to meet the changing demands of the industry and must be nimble to be able to capitalize on change. We compete with international, national and regional manufacturers, distributors and wholesalers including some companies that are larger than we are. We list our major competitors in Part I, Item 1, “Business” of our Annual Report on Form 10-K for the year ended December 31, 2013.

In some instances, notably our software products, our customers themselves may be our competition as they may develop their own software. The rapid technological changes occurring in broadband may lead to the entry of new competitors, including those with substantially greater resources than our own. Because the markets in which we compete are characterized by rapid growth and, in some cases, low barriers to entry, smaller niche market companies and start-up ventures also may become principal competitors in the future. Actions by existing competitors and the entry of new competitors may have an adverse effect on our sales and profitability. In the future, technological advances could lead to the obsolescence of some of our current products, which could have a material adverse effect on our business.

Further, several of our larger competitors may be in a better position to withstand any significant, sustained reduction in capital spending by customers. They often have broader product lines and market focus and therefore are not as susceptible to downturns in a particular market. In addition, several of our competitors have been in operation longer than we have been, and therefore they have more established relationships with domestic and foreign broadband service users. We may not be able to compete successfully in the future, and competition may negatively impact our business.

Consolidations in the broadband communication systems industry could result in delays or reductions in purchases of products, which would have a material adverse effect on our business.

The broadband communication systems industry has historically experienced, and continues to experience, the consolidation of many industry participants. For example, Comcast recently announced its proposed acquisition of Time Warner Cable and AT&T has announced its proposed acquisition of DIRECTV. When consolidations occur, it is possible that the acquirer will not continue using the same suppliers, thereby possibly resulting in an immediate or future elimination of sales opportunities for us or our competitors. Even if sales are not reduced, consolidation can also result in pressure from customers for lower prices, reflecting the increase in the total volume of products purchased or the elimination of a price differential between the acquiring customer and the company acquired. Consolidations also could result in delays in purchasing decisions by the merged businesses. The purchasing decisions of the merged companies could have a material adverse effect on our business.

We may have difficulty in forecasting our sales.

Because a significant portion of the purchases by our customers are discretionary, accurately forecasting sales is difficult. In addition, in recent years our customers have submitted their purchase orders less evenly over the course of each quarter and year and with shorter lead times than they have historically. This, coupled with the significant increase in the size of our operations as a result of the Motorola Home acquisition, has made it even more difficult for us to forecast sales and other financial measures, which can result in us maintaining inventory levels that are too high or too low for our ultimate needs.

The broadband communications industry on which our business is focused is significantly impacted by technological change and open architecture solutions.

The broadband communication systems industry has gone through dramatic technological change resulting in service providers rapidly migrating their business from a one-way television service to a two-way communications network enabling multiple services, such as high-speed Internet access, residential telephony services, business telephony services and Internet access, digital television, video on demand and advertising services. New services, such as home security, power monitoring and control, HD television, 3-D television and 4K (or HD) television that are or may be offered by service providers, are also based on, and will be characterized by, rapidly evolving technology. The development of increasing transmission speed, density and bandwidth for Internet traffic has also enabled the provision of high quality, feature length video over the Internet. This so called over-the-

 

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top IP video service enables content providers such as Netflix and Hulu and portals like Google to provide video services on-demand, by-passing traditional video service providers. As these service providers enhance their quality and scalability, traditional broadband service providers are moving to match them and provide even more competitive services over their existing networks, as well as over-the-top IP video for delivery not only to televisions but to computers, tablets, and telephones in order to remain competitive. Our business is dependent on our ability to develop products that enable current and new customers to exploit these rapid technological changes. We believe the continued growth of over-the-top IP video represents a shift in the traditional video delivery paradigm, and we cannot predict the effect it will have on our business.

In addition, the broadband communication systems industry has and will continue to demand a move toward open standards. The move toward open standards is expected to increase the number of service providers that will offer new services. This trend is expected to increase the number of competitors and drive down the capital costs per subscriber deployed. These factors may adversely impact both our future revenues and margins.

The completion of the Motorola Home acquisition will continue to have a significant impact on our operations and financial statements going forward.

In April 2013, we completed our acquisition of the Motorola Home business, which was significantly larger than our business prior to the Acquisition. For the year ended December 31, 2012, Motorola Home had net sales of approximately $3.3 billion and total assets of approximately $2.5 billion, compared with our net sales of approximately $1.4 billion and total assets of $1.4 billion for the year ended December 31, 2012. In addition, we significantly increased our long-term debt in connection with the Acquisition. Given the significant increase in the size of our business as a result of the acquisition and the increase in our long-term debt, our historical results are not indicative of our combined operations going forward.

The anticipated benefits from acquiring the Motorola Home business may not be realized.

We acquired the Motorola Home business with the expectation that the transaction would result in various benefits, including, among other things, enhancing our current and future product offerings, strengthening our ability to capitalize on and manage changing industry trends and broadening our customer base.

The acquisition involves the combination of two companies that previously operated independently. The difficulties of combining Motorola Home’s operations with ours include:

 

   

combining the best practices of two companies, including research and development and sales functions;