UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

For the fiscal year ended December 31, 2006

 

of

 

ARRIS GROUP, INC.

 

A Delaware Corporation
IRS Employer Identification No. 58-2588724
SEC File Number 000-31254

 

3871 Lakefield Drive
Suwanee, GA 30024
(770) 473-2000

 

Securities registered pursuant to Section 12(b) of the Act:
Common stock, $0.01 par value — NASDAQ Global Market System
Preferred Stock Purchase Rights — NASDAQ Global Market System

 

ARRIS Group, Inc. is a well-known seasoned issuer.

 

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.

 

Except as set forth in Item 10, ARRIS Group, Inc. is unaware of any delinquent filers pursuant to Item 405 of Regulation S-K.

 

ARRIS Group, Inc. is a large accelerated filer and is not a shell company.

 

The aggregate market value of ARRIS Group, Inc.’s Common Stock held by non-affiliates as of June 30, 2006 was approximately $1.4 billion (computed on the basis of the last reported sales price per share of such stock of $13.12 on the NASDAQ Global Market System). For these purposes, directors, officers and 10% shareholders have been assumed to be affiliates.

 

As of January 31, 2007, 108,018,876 shares of ARRIS Group, Inc.’s Common Stock were outstanding.

 

Portions of ARRIS Group, Inc.’s Proxy Statement for its 2007 Annual Meeting of Stockholders are incorporated by reference into Part III.

 

 

TABLE OF CONTENTS

 

 

As used in this Annual Report, “we,” “our,” “us,” “the Company,” and “ARRIS” refer to ARRIS Group, Inc. and our consolidated subsidiaries.

 

General

 

Our principal executive offices are located at 3871 Lakefield Drive, Suwanee, Georgia 30024, and our telephone number is (678) 473-2000. We also maintain a website at www.arrisi.com. On our website we provide links to copies of the annual, quarterly and current reports that we file with the Securities and Exchange Commission, any amendments to those reports, and all Company press releases. Investor presentations are also frequently posted on our website. Copies of our code of ethics and the charters of our board committees also are available on our website. We will provide investors copies of these documents in electronic or paper form upon request, free of charge.

 

Glossary of Terms

 

Below are commonly used acronyms in our industry and their meaning:

 

 

Overview

 

We are a global communications technology company specializing in the design and engineering of equipment for broadband networks. We develop, manufacture and supply cable telephony, video and high-speed data equipment, as well as outside plant construction and maintenance equipment for MSOs. We provide products and equipment principally to the cable television market and, more specifically, to operators or MSOs, on a worldwide basis. Our products allow MSOs and broadband service providers to deliver a full range of integrated voice, video and high speed data services to their subscribers. In addition, we are a leading supplier of infrastructure products used by cable system operators in the build-out and maintenance of HFC networks.

 

Industry

 

In recent years, the technology used in cable systems has evolved significantly. Historically, cable systems offered only one-way analog video service. Due to technological advancements and large investments in infrastructure upgrades, these systems have evolved to become two-way broadband systems delivering high-volume, high-speed, interactive services. MSOs have over the years aggressively upgraded their networks to cost-effectively support and deliver enhanced voice, video and data services. As a result, cable operators have been able to use broadband systems to increase their revenues by offering enhanced interactive subscriber services, such as high-speed data, telephony, digital video and video on demand, and to effectively compete against other broadband communications technologies, such as DSL, local multiport distribution service, DBS, FTTH, and fixed wireless. Delivery of enhanced services also has helped MSOs offset slowing basic video subscriber growth, reduce their subscriber churn and compete against alternative video providers; in particular, DBS.

 

A key factor supporting the growth of broadband systems is the powerful growth of the Internet. Rapid growth in the number of Internet users, their desire for ever higher Internet access speeds, and more high-volume interactive services have created demand for our products. Another key factor supporting the growth of broadband systems is the evolution of video services being offered to consumers. Video on demand, high definition television and switched digital video are three key video services expanding the use of MSOs’ broadband systems. The increase in volume and complexity of the signals transmitted through the network and emerging competitive pressures from telephone companies with digital subscriber line and fiber to the premises offerings are pushing cable operators to deploy new technologies as they evolve. Further, cable operators are looking for products and technologies that are flexible, cost effective, easily deployable and scalable to meet future demand. Because the technologies are evolving and the services delivered are growing in complexity and volume, cable operators need equipment that provides the necessary technical capability at a reasonable cost at the time of initial deployment and the flexibility later to accommodate technological advances and network expansion.

 

Capital spending by MSOs on their networks has shifted over the past several years. MSOs have largely completed the upgrades and re-builds required to support advanced services and are now in the process of enabling those services. As a result, spending has shifted away from HFC plant equipment and materials to head-end and

customer premises equipment that enable high speed data, telephony, and digital video services. Global capital spending by cable operators declined to a low of $25 billion in 2003 but grew to an estimated $28 billion in 2004, $32 billion in 2005, and $34 billion in 2006 as a result of increased spending on telephony, high speed data, and digital video driven by competitive pressures (Source: Infonetics Capex Reports-1H06 and ARRIS estimates). Spending on this type of equipment is expected to continue to grow for the foreseeable future (Infonetics Research, Kagan Report, Canadian Imperial Bank of Commerce, ARRIS estimates). Also, cable plant maintenance and extension spending has grown steadily, and is expected to continue growing because of the installed base of the more sophisticated equipment required to support the advanced services.

 

One of the fastest growing services offered by the MSOs is cable telephony. Cable telephony allows MSOs to offer their customers local and long distance residential telephone service. Constant bit rate, or CBR, technology was the technology of choice to offer telephone services until late 2004. Rapid maturation of voice over Internet protocol (VoIP) technology in 2003 and 2004 resulted in PacketCable^tm certified Internet protocol technology as the technology of choice for offering next-generation cable IP telephony services and, as a result, 2005 became a breakout year for the deployment of IP based voice services in the cable market. PacketCable^tm certified Voice over IP, or Cable VoIP, permits cable operators to utilize the ubiquitous IP protocol to deliver toll-quality cable telephony services. The broad adoption of Cable VoIP by the MSOs could potentially cannibalize the deployment of data-only cable modems as the customer premises devices that support VoIP also offer high speed data access on the same equipment. We are a leading supplier of both head-end and customer premises equipment for VoIP services over cable.

 

Data and VoIP services provided by the MSOs are governed by a set of technical specifications promulgated by CableLabs^® in North America and tComLabs^® in Europe. While the specifications developed by these two bodies necessarily differ in a few details in order to accommodate the differences in HFC network architectures between North America and Europe, a significant feature set is common. The primary data standard specification for cable operators in North America is entitled DOCSIS^® Release 2.0 of DOCSIS^® is the current governing standard for data services in North America. The parallel release for European operators is Euro-DOCSIS Release 2.0. DOCSIS 2.0 builds upon the capabilities of DOCSIS 1.1 and adds additional throughput in the upstream portion of the cable plant — from the consumer out to the Internet. In addition to the DOCSIS standards that govern data transmission, CableLabs^® has defined the PacketCable^tm specifications for VoIP. This specification defines the interfaces between network elements such as cable modem termination systems, or CMTSs, multimedia terminal adapters, or MTAs, gateways and call management servers to provide high quality IP telephony service over the HFC network.

 

 

As the charts above indicate, industry analysts are projecting strong growth in both the CMTS and EMTA markets.

 

In the past two years, operators have invested significantly in upgrading their installed base of CMTS to DOCSIS 2.0 and dramatically increasing the amount of bandwidth offered per subscriber. Because of the ever increasing demand for bandwidth from the Internet, driven by applications like video downloads, personalized web pages, sharing of videos and photographs, etc., the demand for more CMTS ports will continue to increase. Further growth opportunities exist in the expansion of cable modem based services in developing markets like India and China.

 

Demand for single family residential Voice over IP subscriber devices (EMTA) is also increasing. Cable operators worldwide have adopted VoIP as the primary method to offer voice services, and deployments have

started in almost all major cities. Price pressures are strong in this market and therefore revenue growth is modest compared to unit growth. However, because of ARRIS’ current leadership position in this market, we expect to be able to maintain cost leadership and to lead in innovations which could expand the size of the market by creating demand in commercial enterprise and multiple-dwelling unit applications.

 

To date, MSOs have offered digital television signals to subscribers using proprietary technologies offered by a limited set of vendors, led principally by Cisco (via its Scientific-Atlanta acquisition) and Motorola. The technologies that have enabled high-speed data and VoIP across the cable plant are, with modification, also applicable to video. MSOs are beginning to investigate Video over IP as an alternative and are engaging the vendor community, including ARRIS, in discussions. The advantage to the operator is to migrate to one common backbone/technology for all services, and to eliminate proprietary video technology. ARRIS is actively developing products to compete in the emerging Video over IP market.

 

Our Principal Products

 

A broadband cable system consists of three principal components:

 

 

We provide cable system operators with a comprehensive product offering for the headend, distribution network and subscriber premises. We divide our product offerings into two categories:

 

Broadband:

 

 

Supplies & CPE:

 

 

Video over IP and Data Products

 

Headend — The heart of a Voice over IP headend is a CMTS. A CMTS, along with a call agent, a gateway, and provisioning systems provide the ability to integrate the Public-Switched Telephone Network, or PSTN and high-speed data services over a HFC network. The CMTS provides the software and hardware to allow IP traffic from the Internet, or traffic used in VoIP telephony, to be converted for use on HFC networks. The CMTS is also responsible for initializing and monitoring all cable modems and EMTAs connected to the HFC network. We provide two products, the C4^® CMTS and the C3^® CMTS, used in the cable operator’s headend that provide VoIP and high-speed data services to residential or business subscribers.

 

Subscriber Premises — Subscriber premises equipment includes DOCSIS 2.0 certified cable modems for high-speed data applications as well as Euro-DOCSIS certified versions and PacketCable Certified EMTAs for VoIP applications in both DOCSIS and Euro-DOCSIS networks. The PacketCable solution builds on DOCSIS 2.0 and its quality of service enhancements to support lifeline telephony deployed over HFC networks. Our Touchstone^® product line provides carrier-grade performance to enable operators to provide all data, telephony and video services on the same network using common equipment. The Touchstone product line consists of the Touchstone CM550 series of cable modems and the Touchstone^® TM402 and TM502 series of telephony modems.

 

Video/IP Products

 

Headend — We market our Video / IP headend equipment under the D5^tm brand name. The first product for the headend is the D5^tm Universal Edge QAM. The D5^tm converts digital video and IP data into radio frequency signals that can be transmitted on the cable service providers’ HFC plant. The D5 is compatible with DOCSIS 2.0 cable modems as well as MPEG-2 and MPEG-4 set top boxes. It is a highly dense device with 48 channels in two rack units (3.5 inches) of rack space. Each channel is capable of transmitting up to 10 TV signals or up to 40 Mbps of data. The D5 Universal Edge QAM is ideal for service providers deploying video on demand and switched digital broadcast services where many unicast channels are required. The D5 Universal Edge QAM is also forward compatible with M-CMTS^tm standards being developed by CableLabs^®. A cable service provider can deploy the D5 Universal Edge QAM today for MPEG-2 digital video applications and convert it to modular CMTS and IPTV applications in the future.

 

Constant Bit Rate Products

 

Historically, we have offered a number of constant bit rate products. These CBR products have included, for headend equipment, our products under the brand name Cornerstone^® Voice, and for subscriber premises, our products marketed under the brand name Cornerstone^® Voice Port. However, since 2004, our customers have been migrating from CBR to VoIP. We expect that CBR product revenues will continue to decline as end of life purchase orders are expected to be completed in 2007.

 

Cable Plant Infrastructure Products

 

We offer a variety of products that are used by MSOs to build and maintain their cable plants. Our products are complemented by our extensive distribution infrastructure, which is focused on providing efficient delivery of products from stocking or drop-ship locations.

 

We believe the strength of our product portfolio is our broad offering of trusted name-brand products and strategic proprietary product lines and our experience in distribution. Our name-brand products are manufactured to our specifications by manufacturing partners. These products include taps, line passives, house passives and premises installation equipment marketed under our Regal^® brand name; MONARCH^® aerial and underground plant construction products and enclosures; Digicon^® premium F-connectors; and FiberTel fiber optic connectivity devices and accessories. Through our product selection, we are able to address substantially all broadband infrastructure applications, including fiber optics, outside plant construction, drop and premises installation, and signal acquisition and distribution.

 

We also resell products from hundreds of strategic supplier-partners, which include widely recognized brands to small specialty manufacturers. Through our strategic suppliers, we also supply ancillary products like tools and safety equipment, testing devices and specialty electronics.

 

Our customers benefit from our inventory management and logistics capabilities and services. These services range from just-in-time delivery, product “kitting,” specialized electronic interfaces, and customized reporting, to more complex and comprehensive supply chain management solutions. These services complement our product offerings with advanced channel-to-market and logistics capabilities, extensive product bundling opportunities, and an ability to deliver carrier-grade infrastructure solutions in the passive transmission portions of the network. The depth and breadth of our inventory and service capabilities enable us to provide our customers with single supplier flexibility.

 

Sales and Marketing

 

We are positioned to serve customers worldwide with a strong sales organization complemented by our sales engineering team. We maintain sales offices in Colorado, Georgia and Pennsylvania in the United States, and in Chile, Hong Kong, the UK, Japan, Korea, The Netherlands, and Spain. Our sales engineering team assists customers in system design and specification and can promptly be onsite to resolve any problems that may arise during the course of a project. Additionally, we have agreements in various countries and regions with VARs, which extend our sales presence into markets without established sales offices. We also maintain an inside sales group that is responsible for regular phone contact with the customer, prompt order entry, timely and accurate delivery, and effective sales administration.

 

Our marketing and product management teams focus on each of the various product categories and work with our engineers and various technology suppliers on new products and product enhancements. These teams are responsible for inventory levels and pricing, delivery requirements, analysis of market demand, and product positioning and advertising.

 

We are committed to providing superior levels of customer service by incorporating innovative customer-centric strategies and processes supported by business systems designed to deliver differentiating product support and value-added services. We have implemented advanced customer relationship management programs to bring additional value to our customers and provide significant value to our operations management. Through these information systems, we can provide our customers with product information ranging from operational manuals to the latest product updates. Through on-going development and refinement, these programs will help to improve our productivity and enable us to further improve our customer-focused services.

 

Customers

 

The vast majority of our sales are to cable system operators worldwide. As the U.S. cable industry continued a trend toward consolidation, the six largest MSOs controlled over 87% of the U.S. cable market (according to Dataxis in the third quarter 2006), thereby making our sales to those MSOs critical to our success. Our sales are substantially dependent upon a system operator’s selection of ARRIS’ network equipment, demand for increased broadband services by subscribers, and general capital expenditure levels by system operators. Our four largest customers (including their affiliates, as applicable) are Comcast, Cox Communications, Liberty Media International, and Time Warner Cable. Over the past year, the affiliates included in our revenues from these customers have changed as a result of mergers and acquisitions. Therefore, the revenue for our customers for prior periods has been adjusted to include, on a comparable basis for all periods presented, the affiliates currently understood to be under common control. Our sales to these customers for years ended December 31, 2006, 2005, and 2004 were:

 

 

No other customer provided more than 10% of total sales for the years ended December 31, 2006, 2005, or 2004.

 

We have executed general purchase agreements (GPAs) with each of these four large customers which detail the commercial terms and conditions. These GPAs do not obligate the customer to a specific volume of business. The vast majority of our sales, whether to customers with GPAs or otherwise, result from periodic purchase orders.

A summary of the status of the GPAs with Comcast, Cox Communications, Liberty Media International and Time Warner Cable, Inc. follows:

 

Comcast.  In 2006, we extended our nonexclusive agreements with Comcast to supply C4^® CMTS equipment and to sell cable television supplies for two-year terms which expire in 2008. Included in the C4^® CMTS purchase agreement is a service agreement. In 2006, we also negotiated an extension to our non-exclusive agreement with Comcast to supply EMTAs. The terms apply to the TTM502G and equivalent successor products, and includes certain pricing commitments in return for a minimum purchase commitment to be achieved by the end of 2008.

 

Cox Communications.  We have sold product to Cox Communications under a series of nonexclusive agreements since 1998. Our current agreement expired on January 1, 2007. However, we continue to sell products to Cox Communications. There have been no material changes in Cox Communications’ purchases of our products since the expiration of the above mentioned agreement. We are currently reviewing our prior terms with Cox Communications in anticipation of renewing the agreement for another year. The earlier agreement comprehensively provided for the supply of all of our products and services and provided that Touchstone^® Telephony Modems were to be offered at favorable pricing based on similarly situated customers that purchase equal or lesser volumes of the same type product.

 

Liberty Media International.  We have a nonexclusive agreement with Liberty Media International to supply our entire line of products for a three-year term expiring in April 2007. Commercial terms include a requirement to supply product based on Liberty’s forecasts (updated quarterly) and most favorable pricing as compared to similarly-situated companies.

 

Time Warner Cable, Inc.  We supply Time Warner Cable ARRIS Touchstone Telephony Modems and C4^® CMTS products. The agreement to supply Touchstone^® Telephony Modems to Time Warner cable expires on December 31, 2007. The agreement to supply C4^® CMTS to Time Warner Cable expires on December 31, 2008; shipments of this product commenced in the third quarter of 2006.

 

International Opportunities

 

Our international revenue is generated from Asia-Pacific, Europe, Latin America and Canada. The Asia-Pacific market primarily includes China, Japan, Korea, Singapore, and Taiwan. The European market primarily includes Austria, Belgium, France, Germany, the Netherlands, Norway, Poland, Portugal, Spain, Sweden and Switzerland. The Latin American market primarily includes Argentina, Brazil, Chile, Mexico and Puerto Rico. Revenues from international customers were approximately 25.1%, 27.1% and 25.2% of total revenues for 2006, 2005 and 2004, respectively.

 

We continue to strategically invest in worldwide marketing and sales efforts, which have yielded some promising results in several regions. We currently maintain international sales offices in Chile, Hong Kong, the UK, Japan, Korea, the Netherlands and Spain.

 

Proposed Acquisition of Tandberg Television ASA

 

On January 15, 2007, we announced our proposed acquisition of TANDBERG Television ASA through a tender offer for all of TANDBERG Television’s outstanding shares at a price of 96 Norwegian Kroner (NOK) per share comprised of a mix of cash and newly issued ARRIS shares. In the tender offer, TANDBERG Television shareholders will receive no more than NOK 16 in ARRIS shares and at least NOK 80 in cash for each TANDBERG Television share held. The actual number of shares issued will be determined based upon the average closing price of ARRIS common stock as reported on the NASDAQ Global Market for the 10 trading days preceding the second trading day prior to the date of the closing of the transaction. The number of shares to be issued will not exceed 19.9% of our outstanding shares.

 

The tender offer is being conducted pursuant to a Transaction Agreement dated January 15, 2007, and amended February 14, 2007, between ARRIS and TANDBERG Television. The Transaction Agreement provides for, among other things, the making of the tender offer, covenants by both parties, including TANDBERG Television’s covenant to assist us in taking all reasonably necessary steps to close the financing and bank facility,

restrictions on TANDBERG Television’s ability to further market the company, and the payment to us of an $18.0 million termination fee in the event a competing offer is made, the Transaction Agreement is terminated and an alternative transaction is consummated within a set period of time after termination of the Transaction Agreement, or if TANDBERG Television’s board of directors changes its recommendation of the transaction.

 

On February 26, 2007 a third party announced its intent to make a competing all cash offer for all of TANDBERG Television’s outstanding shares at a higher price than our offer of NOK 96. As of the date of this report, we are evaluating the competing offer and our options with respect to the proposed transaction.

 

Research and Development

 

We are committed to rapid innovation and the development of new technologies in the evolving broadband market. New products are developed in our research and development laboratories in Suwanee, Georgia; Cork, Ireland; and Lisle, Illinois. We form strategic alliances with world-class producers and suppliers of complementary technology to provide “best-in-class” technologies focused on “time-to-market” solutions.

 

We believe that our future success depends on our rapid adoption and implementation of broadband local access industry specifications, as well as rapid innovation and introduction of technologies that provide service and performance differentiation. To that end, we believe that the C4^® CMTS product line continues to lead the industry in areas such as fault tolerance, wire-speed throughput and routing, and density. The C3^tm CMTS is designed for small to mid-size operators who are looking for a CMTS that delivers superior RF performance while only occupying one rack unit of space for delivering high-speed data services, including VPN services. The Touchstone^® product line offers a wide-range of DOCSIS^®, Euro-DOCSIS and PacketCable^tm certified products, including Touchstone^® Cable Modems, Touchstone^® Telephony Modems and Touchstone^® Telephony Ports. The D5^tm Universal Edge QAM is the first dense edge QAM to provide a forward path to the modular CMTS of the future. These products are continuously being enhanced to include innovations that improve subscriber experience and help control the MSOs’ operational expenditures. Research and development expenses in 2006, 2005, and 2004 were approximately $66.0 million, $60.1 million, and $63.4 million, respectively. These costs include allocated common costs associated with information technologies and facilities.

 

The following trends impact our current product development activities:

 

 

As a result, our product development activities are directed, primarily, in the following areas:

 

 

 

Intellectual Property

 

We have an aggressive program for protecting our intellectual property. As of January 31, 2007, the program consists of maintaining our portfolio of 86 issued patents (both U.S. and foreign) and pursuing patent protection on new inventions (currently more than 141 U.S. patent applications and U.S. provisional patent applications are pending plus 31 pending foreign applications). In our effort to pursue new patents, we have created a process whereby employees may submit ideas of inventions for review by management. The review process evaluates each submission for novelty, detectability, and commercial value. Patent applications are filed on the inventions that meet the criteria. ARRIS has 45 registered or pending trademarks.

 

Our patents and patent applications generally are in the areas of telecommunications hardware and software and related technologies. Our recent research and development has led to a number of patent applications in technology related to DOCSIS. Our January 2002 purchase of the assets of Cadant^® resulted in the acquisition of 19 U.S. patent applications, seven Patent Convention Treaty (PCT) applications, five trademark applications, one U.S. registered trademark and five registered copyrights. The Cadant^® patents are in the area of CMTS. Our March 2003 purchase of the assets of Atoga Systems resulted in the acquisition of five U.S. patent applications, which also have been filed as PCT applications. Our Atoga patents are in the area of network traffic flow. In August 2003, we acquired various assets of Com21, Inc. Included in those assets were 16 issued U.S. patents plus 18 U.S. patent applications. The Com21 patents cover a wide range of technologies, including wide area networks, fiber and cable systems, automated teller machine networks and CMTS. In 2005, we acquired assets of coaXmedia, Inc. including seven currently pending U.S. patent applications, primarily in the field of providing broadband access in a multi-user environment.

 

For technology that is not owned by us, we have a program for obtaining appropriate licenses with the industry leaders to ensure that the strongest possible patents support the licensed technology. In addition, we have formed strategic relationships with leading technology companies that will provide us with early access to technology and will help keep us at the forefront of our industry.

 

We have a program for protecting and developing trademarks. This program consists of procedures for the use of current trademarks and for the development of new trademarks. This program is designed to ensure that our employees properly use those trademarks and any new trademarks that are expected to develop strong brand loyalty and name recognition. This is intended to protect our trademarks from dilution or cancellation.

 

Product Sourcing and Distribution

 

Our product sourcing strategy centers on the use of contract manufacturers to subcontract production. Our largest contract manufacturers are Solectron, Mitsumi, Plexus Services Corporation, Flextronics, and ASUSTeK Computer Inc. The facilities owned and operated by these contract manufacturers for the production of our products are located in China, Ireland, Mexico, the Philippines, and the United States.

 

We have executed contracts with each of these companies. We provide these vendors with a 6-month or 12-month rolling, non-binding forecast, and we typically have a minimum of 60 days of purchase orders placed with them for products. Purchase orders for delivery within 60 days are generally not cancelable. Purchase orders with delivery past 60 days generally may be cancelled with penalties in accordance with each vendor’s terms. Each contract manufacturer provides us with an 18-month warranty.

 

We distribute a substantial number of products that are not designed or trademarked by us in order to provide our customers with a comprehensive product offering. For instance, we distribute hardware and installation

products that are distributed through regional warehouses in North Carolina, California, Japan, and the Netherlands and through drop shipments from our contract manufacturers located throughout the world.

 

 

Broadcom provides several DOCSIS^® components in our CMTS product line. We also make extensive use of FPGA in our C4^® CMTS.

 

 

Texas Instruments and Microtune provide components used in some of our customer premises equipment, or CPE, products (i.e., EMTAs and cable modems). Our agreements with Texas Instruments include technology licensing and component purchases. Several of our competitors have similar agreements with Texas Instruments for these components.

 

In addition, we purchase software for operating network and security systems or sub-systems, and a variety of routing protocols from different suppliers under standard commercial terms, including source code buy-out arrangements.

 

Although alternate supply and technology arrangements similar to the above are available or could be arranged, an interruption with any of the above companies could have a material impact on our business.

 

Backlog

 

Our backlog consists of unfilled customer orders believed to be firm and long-term contracts that have not been completed. With respect to long-term contracts, we include in our backlog only amounts representing orders currently released for production or, in specific instances, the amount we expect to be released in the succeeding 12 months. The amount contained in backlog for any contract or order may not be the total amount of the contract or order. The amount of our backlog at any given time does not reflect expected revenues for any fiscal period. Our backlog at December 31, 2006 was approximately $92.7 million, at December 31, 2005 was approximately $166.5 million and at December 31, 2004 was approximately $75.6 million. The increase in backlog from 2004 to 2005 was primarily related to the strong demand for our EMTAs. The decline in backlog from 2005 to 2006 reflects a shortening of lead times by our customers and lower orders on hand for CBR equipment as this product nears end of life.

 

We believe that all of the backlog existing at December 31, 2006 will be shipped in 2007.

 

Competition

 

All aspects of our business are highly competitive. The broadband communications industry itself is dynamic, requiring 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. We compete with national, regional and local manufacturers, distributors and wholesalers including some companies that are larger than us. Our major competitors include:

 

 

Various manufacturers, who are suppliers to us of Supplies & CPE products, also sell directly to our customers, as well as through other distributors, into the cable marketplace. In addition, because of the convergence of the cable, telecommunications and computer industries and rapid technological development, new competitors may enter the cable market.

 

Since the introduction in 1996 of the Cornerstone^® Voice product line, we held a substantial portion of the overall CBR cable telephony market. We believe that a substantial number of these CBR lines are no longer in service as operators transition their subscribers to VoIP through attrition and planned migrations. During 2006 we began to phase out this product and migrate our customers to VoIP. We anticipate that CBR product revenues will decline to a sustaining business in 2007 as our customers complete their transition to voice over IP. One of the principal growth markets for us is the high speed data access market into which we sell a CMTS, or, the headend product for data and VoIP services. The largest provider of CMTS products is Cisco, which took an early lead in the initial deployment of data-only CMTS products. Cisco is expected to defend its position via both upgrades to existing products and the introduction of new products. Cisco had not previously developed a carrier-grade telephony CMTS product, but has begun to market the carrier-grade capability. Motorola and Big Band Networks have been emphasizing routing and carrier-grade performance for their CMTS. We believe we have garnered additional market share in the newer generation CMTS products that enable both data and carrier-grade telephony deployments due to our products’ differentiating features, fault tolerance, wire-speed throughput, routing, and density.

 

The customer premises business consists of voice over IP enabled modems (EMTAs) and cable modems. Motorola is the market leader in cable modems. Leadership position in the customer premises category provides Motorola with volume advantages in manufacturing, distribution and marketing expense. Motorola also was successful in gaining an early leader status in EMTA sales with MSOs that were the first to deploy VoIP. However, as this market accelerated, we have gained significant share. We compete on product performance and our telephony experience and integration capabilities. Cisco via its Scientific-Atlanta acquisition also has had some success in the cable modem market. Cisco also has EMTA products and competes in this market. The EMTA market grew dramatically in 2005 and again in 2006 as VoIP deployments accelerated. We are a relatively small competitor in the cable modem market, but have a significantly larger share of the EMTA market.

 

Specifically, we maintained number one EMTA market share throughout 2005 and 2006 and had over 50% of the world market in the third quarter of 2006 according to Infonetics Research “Broadband CPE Quarterly Worldwide Market Share and Forecasts for 3Q06”.

 

In the supplies distribution business we compete with national distributors, like TVC Communications, Inc., and with several local and regional distributors. Product breadth, price, availability and service are the principal competitive advantages in the supply business. Our products in the supplies distribution business are competitively priced and are marketed with emphasis on quality. Product reliability and performance, superior and responsive technical and administrative support, and breadth of product offerings are key criteria for competition. Technological innovations and speed to market are additional competitive factors.

 

Lastly, some of our competitors, notably Cisco and Motorola, are larger companies with greater financial resources and product breadth than us. This may enable them to bundle products or be able to market and price products more aggressively than we can.

 

Employees

 

As of January 31, 2007, we had 781 full-time employees. We believe that we have maintained a strong relationship with our employees. Our future success depends, in part, on our ability to attract and retain key personnel. Competition for qualified personnel in the cable industry is intense, and the loss of certain key personnel could have a material adverse effect on us. We have entered into employment contracts with our key executive officers and have confidentiality agreements with substantially all of our employees. We also have long-term incentive programs that are intended to provide substantial incentives for our key employees to remain with us.

 

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

 

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

 

 

Several of our customers have accumulated significant levels of debt. In addition, the bankruptcy filing of Adelphia in June 2002 heightened concerns in the financial markets about the viability of the domestic cable industry. These historic events, coupled with the current uncertainty and volatility in the capital markets, has affected the market values of domestic cable operators and may restrict their access to capital in the future. Even if the financial health of our customers remains intact, we cannot assure you that these customers will be in a position to purchase new equipment at levels we have seen in the past.

 

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

 

The markets for broadband communication systems are extremely competitive and dynamic, requiring the companies that compete in these markets to react quickly and capitalize on change. This will require us to retain skilled and experienced personnel as well as to deploy substantial resources toward meeting the ever-changing demands of the industry. We compete with national and international manufacturers, distributors and wholesalers including many companies larger than ARRIS. Our major competitors include:

 

 

The rapid technological changes occurring in the broadband markets 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. The broadband communications industry is further characterized by rapid technological change. In the future, technological advances could lead to the obsolescence of some of our current products, which could have a material adverse effect on our business.

 

Further, many of our larger competitors are in a better position to withstand any significant reduction in capital spending by customers in these markets. They often have broader product lines and market focus and therefore will not be as susceptible to downturns in a particular market. In addition, several of our competitors have been in operation longer than we have been, and therefore they have more 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 telecommunications industry could result in delays or reductions in purchases of products, which would have a material adverse effect on our business.

 

The telecommunications industry has experienced the consolidation of many industry participants, and this trend may continue. For instance, in November 2005, Cox Communications announced a definitive agreement to sell some of its cable television systems to Cebridge Connections; this transaction was completed in May 2006. Also, in April 2005, Adelphia announced that its assets were going to be acquired by Comcast and Time Warner; this transaction was completed in July 2006. 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, depending upon who had the business initially. 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.

 

Mergers among the supplier base also have increased, and this trend may continue. For example, in February 2006, Cisco Systems, Inc. completed its acquisition of Scientific-Atlanta, Inc. Larger combined companies with pooled capital resources may be able to provide solution alternatives with which we would be put at a disadvantage to compete. The larger breadth of product offerings by these consolidated suppliers could result in customers electing to trim their supplier base for the advantages of one-stop shopping solutions for all of their product needs. Consolidation of the supplier base could have a material adverse effect on our business.

 

Acquisitions, including our proposed acquisition of TANDBERG Television, can involve significant risks.

 

We routinely consider acquisitions of, or investments in, other businesses, including acquisitions that could be significant relative to the size of our business, such as our proposed acquisition of TANDBERG Television. There are a number of risks attendant to any acquisition, including the possibility that we will overvalue the assets to be purchased, that any acquired business may have liabilities of which we are unaware or which we are not able to assess at the time of the acquisition, that we will not be able to successfully integrate and retain a significant number of new employees at a single time, our ability to combine and integrate accounting and other systems, and our ability to capitalize on the expected technological and customer opportunities. In addition, we might incur substantial additional indebtedness in order to finance an acquisition, which could require additional payments in the future, and we might issue common stock or other securities to pay for an acquisition, in which event the acquisition may ultimately prove to be dilutive to our current stockholders. As a result, the impact of any acquisition, including the proposed TANDBERG Television acquisition, on our future performance may not be as favorable as expected and actually may be adverse. Further, no assurances can be provided that we will complete any such acquisition.

 

Our proposed acquisition of TANDBERG Television involves several accounting risks.

 

The TANDBERG Television acquisition also involves accounting risks. TANDBERG Television provides financial information in accordance with International Financial Reporting Standards (“IFRS”). We report under U.S. GAAP. Under U.S. securities laws, we will be required to reconcile TANDBERG’s historical financial information to U.S. GAAP. We are also required to file that information, together with pro forma information, with the SEC within seventy-five days following the completion of the acquisition. That reconciliation will be complicated and will require significant internal and external resources. If it is not completed in the required time, we will be in default in our filing obligations with the SEC, and under the indenture governing our outstanding convertible notes, will be in default after 60 days from notice by the Trustee. Such a default under the convertible notes, if appropriate filings are not made within an additional 90 days, will result in interest accruing under the notes at an additional .50% per annum until cured. In addition we will have to convert TANDBERG Television’s IFRS based systems to U.S. GAAP systems and modify some of their practices to conform with U.S. accounting practices. Until this is complete we may not be able to produce complete U.S. GAAP financial information. In addition, following completion of the acquisition, when reported under U.S. GAAP systems, TANDBERG Television’s future results included as part of our consolidated results may not be as attractive as, or consistent with the IFRS results previously disclosed by TANDBERG Television.

 

In addition, because of the differences between IFRS and GAAP, including, for example, differences in software revenue recognition, TANDBERG Television’s historical financial results, when reconciled to GAAP, may show a material difference for the periods presented as compared to IFRS. As a result, with respect to both historical and future financial results immediately following the completion of the acquisition, we may not be able to immediately recognize all of the revenues that were or would be recognized by TANDBERG Television under IFRS, which may have an adverse effect on our financial results and could negatively impact the market price of our common stock.

 

In addition to the proposed TANDBERG Television acquisition, we continue to consider other acquisitions of, or investments in, other businesses, including acquisitions that could be significant relative to the size of our business. There are a number of risks attendant to any acquisition, including the possibility that we will overvalue the assets to be purchased, that any acquired business may have liabilities of which we are unaware or which we are not able to assess at the time of the acquisition, that we will not be able to successfully integrate the acquired business or assets, and that we will not be able to produce the expected level of profitability from the acquired business or assets. In addition, we might incur additional indebtedness in order to finance an acquisition, which could require additional payments in the future, and we might issue common stock or other securities to pay for an acquisition, in which event the acquisition may ultimately prove to be dilutive to our current stockholders. As a result, the impact of any acquisition on our future performance may not be as favorable as expected and actually may be adverse.

 

Following the TANDBERG Television acquisition we will have substantial indebtedness.

 

We will incur substantial indebtedness in order to finance the pending acquisition of TANDBERG Television ASA, which will require substantial payments in the future. Any unexpected changes in the combined business may reduce our ability to pay down the debt in a timely manner or access the capital markets for further refinancing. We may not be able to generate sufficient cash flows to support the debt structure in the future. Additionally, the credit agreement pursuant to which we will borrow most of the indebtedness will contain substantial affirmative and negative covenants (including restrictions on indebtedness, restrictions on dividends and repurchases of securities, restrictions on acquisitions and dispositions of assets, limitations on leverage, minimum interest coverage ratios, limitations on capital expenditures), the violation of which would result in a default and could result in the acceleration of the indebtedness and that will restrict the freedom with which we can operate our business. We will also issue common stock or other securities to pay for this acquisition, in which event the acquisition may ultimately prove to be dilutive to our current shareholders.

 

Our business has primarily come from several key customers. The loss of one of these customers or a significant reduction in sales to one of these customers would have a material adverse effect on our business.

 

Our four largest customers (including their affiliates, as applicable) are Comcast, Cox Communications, Liberty Media International, and Time Warner Cable. For the year ended December 31, 2006, sales to Comcast accounted for approximately 38.6%, sales to Cox Communications accounted for approximately 9.9%, sales to Liberty Media International accounted for approximately 10.0%, and sales to Time Warner Cable accounted for approximately 9.1% of our total revenue. The loss of any of these customers, or one of our other large customers, or a significant reduction in the products or services provided to any of them would have a material adverse impact on our business.

 

In addition, more so than historically, 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. This has made it more difficult for us to forecast sales and plan accordingly.

 

The broadband products that we develop and sell are subject to technological change and a trend towards open standards, which may impact our future sales and margins.

 

The broadband products we sell are subject to continuous technological evolution. Further, the cable industry has and will continue to demand a move towards open standards. The move towards open standards is expected to increase the number of MSOs that will offer new services, in particular, telephony. This trend also is expected to

increase the number of competitors and drive capital costs per subscriber deployed down. These factors may adversely impact both our future revenues and margins.

 

Products currently under development may fail to realize anticipated benefits.

 

Rapidly changing technologies, evolving industry standards, frequent new product introductions and relatively short product life cycles characterize the markets for our products. The technology applications that we currently are developing may not ultimately be successful.

 

Even if the products in development are successfully brought to market, they may not be widely used or we may not be able to successfully capitalize on their technology. To compete successfully, we must quickly design, develop, manufacture and sell new or enhanced products that provide increasingly higher levels of performance and reliability. However, we may not be able to successfully develop or introduce these products if our products:

 

 

Furthermore, our competitors may develop similar or alternative technologies that, if successful, could have a material adverse effect on us. Our strategic alliances are based on business relationships that have not been the subject of written agreements expressly providing for the alliance to continue for a significant period of time. The loss of a strategic relationship could have a material adverse effect on the progress of new products under development with that third party.

 

Our success depends in large part on our ability to attract and retain qualified personnel in all facets of our operations.

 

Competition for qualified personnel is intense, and we may not be successful in attracting and retaining key personnel, which could impact our ability to maintain and grow our operations. Our future success will depend, to a significant extent, on the ability of our management to operate effectively. In the past, competitors and others have attempted to recruit our employees and in the future, their attempts may continue. The loss of services of any key personnel, the inability to attract and retain qualified personnel in the future or delays in hiring required personnel, particularly engineers and other technical professionals, could negatively affect our business.

 

We are substantially dependent on contract manufacturers, and an inability to obtain adequate and timely delivery of supplies could adversely affect our business.

 

Many components, subassemblies and modules necessary for the manufacture or integration of our products are obtained from a sole supplier or a limited group of suppliers. Our reliance on sole or limited suppliers, particularly foreign suppliers, and our reliance on subcontractors involves several risks including a potential inability to obtain an adequate supply of required components, subassemblies or modules and reduced control over pricing, quality and timely delivery of components, subassemblies or modules. Historically, we have not generally maintained long-term agreements with any of our suppliers or subcontractors. An inability to obtain adequate deliveries or any other circumstance that would require us to seek alternative sources of supply could affect our ability to ship products on a timely basis. Any inability to reliably ship our products on time could damage relationships with current and prospective customers and harm our business.

 

Our international operations may be adversely affected by any decline in the demand for broadband systems designs and equipment in international markets.

 

Sales of broadband communications equipment into international markets are an important part of our business. The entire line of our products is marketed and made available to existing and potential international customers. In addition, United States broadband system designs and equipment are increasingly being employed in international markets, where market penetration is relatively lower than in the United States. While international

operations are expected to comprise an integral part of our future business, international markets may no longer continue to develop at the current rate, or at all. We may fail to receive additional contracts to supply equipment in these markets.

 

Our international operations may be adversely affected by changes in the foreign laws in the countries in which our manufacturers and assemblers have plants.

 

A significant portion of our products are manufactured or assembled in China, Ireland, Mexico, the Philippines, and other countries outside of the United States. The governments of the foreign countries in which our products are manufactured may pass laws that impair our operations, such as laws that impose exorbitant tax obligations or nationalize these manufacturing facilities.

 

We face risks relating to currency fluctuations and currency exchange.

 

We may encounter difficulties in converting our earnings from international operations to U.S. dollars for use in the United States. These obstacles may include problems moving funds out of the countries in which the funds were earned and difficulties in collecting accounts receivable in foreign countries where the usual accounts receivable payment cycle is longer.

 

We are exposed to various market risk factors such as fluctuating interest rates and changes in foreign currency rates. These risk factors can impact our results of operations, cash flows and financial position. We manage these risks through regular operating and financing activities and periodically use derivative financial instruments such as foreign exchange forward and option contracts. There can be no assurance that our risk management strategies will be effective.

 

Our profitability has been, and may continue to be, volatile, which could adversely affect the price of our stock.

 

We have experienced several years with significant operating losses. Although we have been profitable in the last eight quarters, we may not be profitable or meet the level of expectations of the investment community in the future, which could have a material adverse impact on our stock price. In addition, our operating results may be adversely affected by the timing of sales or a shift in our product mix.

 

We may face higher costs associated with protecting our intellectual property.

 

Our future success depends in part upon our proprietary technology, product development, technological expertise and distribution channels. We cannot predict whether we can protect our technology or whether competitors can develop similar technology independently. We have received and may continue to receive from third parties, including some of our competitors, notices claiming that we have infringed upon third-party patents or other proprietary rights. We are currently a party in proceedings in federal court in California and in Texas, in which one of our customers has been sued for patent infringement and has sued us and several other suppliers for indemnification, and we may become involved in similar litigation involving other customers. Any of these claims, whether with or without merit, could result in costly litigation, divert the time, attention and resources of our management, delay our product shipments, or require us to enter into royalty or licensing agreements. If a claim of product infringement against us is successful and we fail to obtain a license or develop non-infringing technology, our business and operating results could be materially and adversely affected. In addition, the payment of any necessary licensing fees or indemnification costs associated with a patent infringement claim could also materially adversely affect our operating results.

 

We do not intend to pay cash dividends on our common stock in the foreseeable future.

 

We currently intend to continue our policy of retaining earnings to finance the growth of our business. In addition, the payment of dividends in certain circumstances may be prohibited by the terms of our current and future indebtedness. As a result, we do not anticipate paying cash dividends on our common stock in the foreseeable future.

 

We have anti-takeover defenses that could delay or prevent an acquisition of our company.

 

We have a shareholder rights plan (commonly known as a “poison pill”). This plan is not intended to prevent a takeover, but is intended to protect and maximize the value of stockholders’ interests. This plan could make it more difficult for a third party to acquire us or may delay that process.

 

We have the ability to issue preferred shares without stockholder approval.

 

Our common shares may be subordinate to classes of preferred shares issued in the future in the payment of dividends and other distributions made with respect to common shares, including distributions upon liquidation or dissolution. Our Amended and Restated Certificate of Incorporation permits our board of directors to issue preferred shares without first obtaining stockholder approval. If we issued preferred shares, these additional securities may have dividend or liquidation preferences senior to the common shares. If we issue convertible preferred shares, a subsequent conversion may dilute the current common stockholders’ interest.

 

As of December 31, 2006 we have no unresolved comments.

 

We currently conduct our operations from 15 different locations; two of which we own, while the remaining 13 are leased. These facilities consist of sales and administrative offices and warehouses totaling approximately 500 thousand square feet. Our long-term leases expire at various dates through 2023. We believe that our current properties are adequate for our operations. A summary of our principal leased properties that are currently in use is as follows:

 

 

We own the following properties:

 

 

From time to time, ARRIS is involved in claims, disputes, litigation or legal proceedings incident to the ordinary course of its business, such as employment matters, environmental proceedings, contractual disputes and intellectual property disputes. Except as described below, ARRIS is not part to or has not been part to, during a period covering the previous 12 months, any governmental, legal or arbitration proceedings, including such proceedings which are pending or threatened of which ARRIS is aware, which may have, or have had in the recent past, significant effects on ARRIS’ financial position or profitability.

 

Currently, ARRIS is a party in two related proceedings pending in federal court in Texas and California. ARRIS has sought to clarify its intellectual property rights to the following four United States Patents: No. Re 35,774 (revised no. 5,347,304); No. 5,586,121; No. 5,818, 845; and No. 5,828,655 (the “Patents”). In both suits, ARRIS is seeking that the court declares that it has a nonexclusive license to, and has the ability to gain ownership rights in, the Patents. ARRIS’ allegations are based on the provisions of a 11 January 1999, license agreement (“License Agreement”) between the Patents’ former owner, Hybrid Networks, Inc. (“HNI”), and ARRIS’ predecessor in

interest, Com21, Inc. (“Com21”). The License Agreement, which bound both parties’ successors, provided Com21 with a nonexclusive license to use, and a right-of-first-refusal to purchase the Patents. Subsequently, ARRIS purchased certain assets of Com21, including all of Com21’s IP assets for the cable modem termination systems business, which, ARRIS has now alleged, includes the rights under the License Agreement. Thus, ARRIS has argued in both cases that it has succeeded to Com21’s licensing and ownership rights to the Patents under the terms of the License Agreement. HNI has sued or has made other claims against other customers of ours, and these customers either have or are expected to request indemnification from us.

 

The cases are summarized as follows:

 

Hybrid Patents, Inc. v. Charter Communications, Inc., Case No. 2:05-CV-436 (E.D. Tex). Charter Communications, Inc. (“Charter”) is one of ARRIS’ customers, in ARRIS’ business of selling cable modem termination systems. Hybrid Patents, Inc. (“Hybrid Patents”) claims that it succeeded in interest as owner of the Patents from HNI. On 13 September 2005, Hybrid Patents sued Charter in this case for infringement of the Patents. Charter responded by bringing a third-party claim for indemnification against ARRIS and nine of Charter’s other suppliers, alleging that ARRIS and/or the other suppliers were responsible for any infringement due to products which infringed the Patents that any or all of them sold to Charter. After ARRIS answered, and filed a third-party claim against Hybrid Patents in which ARRIS asserted its rights to the Patents, Hybrid Patents brought a third-party claim for direct and contributory patent infringement against ARRIS. ARRIS has denied, and will continue to deny, that it is liable for any patent infringement claims. The Texas court is currently considering a motion to transfer the case to the California jurisdiction, brought by Charter and ARRIS.

 

ARRIS International, Inc. v. Hybrid Patents, Inc., Hybrid Networks, Inc., HYBR Wireless Industries, Inc., London Pacific Life & Annuity Company, and Carol Wu, Trustee of the Estate of Com21, Inc., Case No. 03-54533MM, Chapter 7, Adversary Proceeding in Bankruptcy, Adv. No. 06-5098MM (Bankr. N.D. Cal.). ARRIS brought this claim after learning that its customer, Charter, was being sued for infringement of the Patents in Texas, but before being joined as a party in the Texas litigation. In this suit, ARRIS seeks that the bankruptcy court declare that Com21 passed all of its rights under the License Agreement to its successor in interest, ARRIS, and that ARRIS thus has a nonexclusive license to, and ownership rights in, the Patents. The court is currently considering a motion to dismiss the case, and a motion to transfer the case to the Texas jurisdiction, brought by Hybrid Patents, HYBR Wireless Industries, Inc., and London Pacific Life & Annuity Company.

 

Commencing in 2005, Rembrandt Technologies, LP filed a series of at least seven lawsuits in the Federal Court for the Eastern District of Texas against Charter Communications, Inc, Time Warner Cable, Inc., Comcast Corporation and others alleging patent infringement related to the cable systems operators’ use of data transmission, video, cable modem, voice-over-internet, and other technologies and applications. Although ARRIS is not a defendant in any of these lawsuits, its customers are, and its customers either have requested indemnification from, or are expected to request indemnification from, ARRIS and the other manufacturers of the equipment that is alleged to infringe. ARRIS is party to a joint defense agreement with respect to one of the lawsuits and has various understandings with the defendants in the remaining lawsuits with respect to cost sharing. The first of the lawsuits is scheduled to be tried in July 2007. The defendants are vigorously contesting the lawsuits, although it is premature to assess the likelihood of a favorable outcome. In the event of an adverse outcome, ARRIS could be required to indemnify its customers, pay royalties, and/or cease using certain technology.

 

During the fourth quarter of 2006, no matters were submitted to a vote of our company’s security holders.

 

Executive Officers of the Company

 

The following table sets forth the name, age as of February 28, 2007, and position of our executive officers.

 

 

Robert J. Stanzione has been Chief Executive Officer since January 1, 2000. From 1998 through 1999, Mr. Stanzione was President and Chief Operating Officer of ARRIS. Mr. Stanzione has been a director of ARRIS since 1998 and has been the Chairman of the Board of Directors since May 2003. From 1995 to 1997, he was President and Chief Executive Officer of Arris Interactive L.L.C. From 1969 to 1995, he held various positions with AT&T Corporation. Mr. Stanzione has served as a director of Symmetricon, Inc. since May 2005. Mr. Stanzione also serves on the boards of the National Cable Telecommunications Association and the Georgia Cystic Fibrosis Foundation.

 

Lawrence A. Margolis has been Executive Vice President, Strategic Planning, Administration, and Chief Counsel since March 2004 and has served as the Secretary of ARRIS since 1992. Mr. Margolis was the Chief Financial Officer from 1992 to March 2004. Prior to joining ARRIS, Mr. Margolis was Vice President, General Counsel and Secretary of Anixter, Inc., a global communications products distribution company, from 1986 to 1992 and General Counsel and Secretary of Anixter from 1984 to 1986. Prior to 1984, he was a partner at the law firm of Schiff Hardin & Waite.

 

David B. Potts has been the Chief Financial Officer since March 2004, and has been Chief Information Officer since the acquisition of Arris Interactive L.L.C. in August 2001. Prior to being named Chief Financial Officer in 2004, Mr. Potts was the Senior Vice President of Finance. Before joining ARRIS, he was Chief Financial Officer of Arris Interactive L.L.C. from 1995 through 2001. From 1984 through 1995, Mr. Potts held various executive management positions with Nortel Networks including Vice President and Chief Financial Officer of Bell Northern Research in Ottawa and Vice President of Mergers and Acquisitions in Toronto. Prior to Nortel Networks, Mr. Potts was with Touche Ross in Toronto. Mr. Potts is a member of the Institute of Chartered Accountants in Canada.

 

Ronald M. Coppock has been President of ARRIS Worldwide Sales since November 2003. Prior to his current role, Mr. Coppock was President of International Sales since January 1997 and was formerly Vice President International Sales and Marketing for TSX Corporation. Mr. Coppock has been in the cable television and satellite communications industry for over 20 years, having held senior management positions with Scientific-Atlanta, Pioneer Communications and Oak Communications. Mr. Coppock is an active member of the American Marketing Association, Kappa Alpha Order, Cystic Fibrosis Foundation Board, and the Auburn University Alumni Action Committee.

 

Bryant K. Isaacs has been President of ARRIS New Business Ventures since December 2002. Prior to the sale of the Actives product line, Mr. Isaacs was President of ARRIS Network Technologies since September 2000. Prior to joining ARRIS, he was Founder and General Manager of Lucent Technologies’ Wireless Communications Networking Division in Atlanta from 1997 to 2000. From 1995 through 1997, Mr. Isaacs held the position of Vice President of Digital Network Systems for General Instrument Corporation where he was responsible for developing international business strategies and products for digital video broadcasting systems.

 

James D. Lakin has been President of ARRIS Broadband since the acquisition of Arris Interactive L.L.C. in August 2001. From October 2000 through August 2001, he was President and Chief Operating Officer of Arris Interactive L.L.C. From November 1995 until October 2000, Mr. Lakin was Chief Marketing Officer of Arris Interactive L.L.C. Prior to 1995, he held various executive positions with Compression Labs, Inc. and its successor General Instrument Corporation.

 

Robert Puccini has been President of ARRIS TeleWire Supply since 1999. Prior to his appointment to President, Mr. Puccini served as Chief Financial Officer of TeleWire for two years and has served as Vice President, Project Management for ARRIS’ AT&T account. Mr. Puccini brings 20 years of experience in the cable television industry to ARRIS TeleWire Supply. He has held various accounting and controller positions within the former Anixter and ANTEC Corporations. Mr. Puccini is a CPA.

 

Marc S. Geraci has been Vice President, Treasurer of ARRIS since January 2003 and has been with ARRIS and the former ANTEC Corporation since 1994. He began with ARRIS as Controller for the International Sales Group and in 1997 was named Chief Financial Officer of that group. Prior to joining ARRIS, he was a broker/dealer on the Pacific Stock Exchange in San Francisco for eleven years and, prior to that, in public accounting in Chicago for four years. Mr. Geraci is a CPA.

 

Daniel Owens has been Vice President, Controller of ARRIS since August 2005. From 1999 to 2005, he held various accounting positions, including Vice President of Finance at InterCept, Inc. Mr. Owens began his career in public accounting at Ernst & Young LLP. Mr. Owens is a CPA.

 

Board Committees

 

Our Board of Directors has three committees: Audit, Compensation, and Nominating and Corporate Governance. The charters for all three committees are located on our website at www.arrisi.com. The Board believes that each of its members, with the exception of Mr. Stanzione, is independent, as defined by the SEC and NASDAQ rules. The Board has identified John Petty as the lead independent director and audit committee financial expert, as defined by the SEC. Additionally, the Board has identified Matthew Kearney as an audit committee financial expert.

 

ARRIS’ common stock is traded on the Nasdaq Global Select Market under the symbol “ARRS.” The following table reports the high and low trading prices per share of the Company’s common stock as listed on the NASDAQ Global Market System:

 

 

We have not paid cash dividends on our common stock since our inception. On October 3, 2002, to implement our shareholder rights plan, our board of directors declared a dividend consisting of one right for each share of our common stock outstanding at the close of business on October 25, 2002. Each right represents the right to purchase one one-thousandth of a share of our Series A Participating Preferred Stock and becomes exercisable only if a person or group acquires beneficial ownership of 15% or more of our common stock or announces a tender or exchange offer for 15% or more of our common stock or under other similar circumstances.

 

As of January 31, 2007, there were approximately 368 record holders of our common stock. This number excludes shareholders holding stock under nominee or street name accounts with brokers or banks.

 

 

Below is a graph comparing total stockholder return on the Company’s stock from December 31, 2001 through December 31, 2006, with the Standard & Poor’s 500 and the Index of NASDAQ U.S. Stocks of entities in the industry of electronics and electrical equipment and components, exclusive of computer equipment, (SIC 3600-3699), prepared by the Research Data Group, Inc.. The stock performance graph assumes the investment of $100 on December 31, 2001 and reinvestment of all dividends. Notwithstanding anything to the contrary set forth in any of our filings under the Securities Act of 1933, or the Securities Exchange Act of 1934 that might incorporate future filings, including this Annual Report on Form 10-K, in whole or in part, the Performance Graph presented below shall not be incorporated by reference into any such filings.

 

 

 

The selected consolidated financial data as of December 31, 2006 and 2005 and for each of the three years in the period ended December 31, 2006 set forth below are derived from the accompanying audited consolidated financial statements of ARRIS, and should be read in conjunction with such statements and related notes thereto. The selected consolidated financial data as of December 31, 2004, 2003 and 2002 and for the years ended December 31, 2003 and 2002 is derived from audited consolidated financial statements that have not been included in this filing. The historical consolidated financial information is not necessarily indicative of the results of future operations and should be read in conjunction with ARRIS’ historical consolidated financial statements and the related notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this document. See Note 18 of the Notes to the Consolidated Financial Statements for a summary of our quarterly consolidated financial information (in thousands, except per share data).

 

 

Overview

 

Our long-term goal is to continue to strengthen our position as a leading provider of broadband access products and services worldwide. Our primary market and focus is cable providers, or MSOs. Our customers, the MSOs, seek new cost effective revenue generating services that they can market and sell to their subscribers. The key new services at this time are digital video, high speed data and IP telephony. Through internal development and various acquisitions that we have made and plan to make in the future, we market and sell products that deliver these services to the MSOs, and to potentially other operators such as Satellite and Telcos.

 

Industry Conditions

 

Our performance is largely dependent on our customers’ capital spending in constructing, rebuilding, maintaining and upgrading broadband communications systems necessary for the provision of new voice, data, and video services. The cable market has evolved and changed significantly over the past few years. In developing a strategy to achieve our long-term goals we have considered the following key developments that have or may impact us:

 

Increase in Spending by MSOs on New Revenue-Generating Services

 

While reducing overall capital expenditures, MSOs have increased their expenditures on equipment which allows them to create new revenue-generating opportunities, including high-speed data, telephony and digital video. We anticipate future increases in expenditures by the MSOs on new technologies, which allow them to capitalize on these opportunities.

 

Cable Operator Demand of Open Standards for Equipment and Services Related to High-Speed Data, Telephony and, Digital Video

 

Each of the key new revenue-generating services (high-speed data, telephony and digital video) were originally made available to the MSOs by various companies using proprietary products; however, next-generation products are being developed and deployed in compliance with open standards established by the cable industry:

 

 

We expect that MSOs will continue to create and demand open interfaces for all services in the future.

 

We also expect that MSOs will seek to offer other new services in the future. For example:

 

 

Consolidation of Our Customer Base

 

Consolidation of our customers has, and may in the future; affect their purchases of our products. In the fourth quarter of 2002, Comcast completed its purchase of AT&T Broadband. Since the acquisition, we have not shipped material quantities of CBR telephony product to Comcast as its focus turned to video and high-speed data, most recently VoIP. In 2004, Liberty Media International increased its holdings in international properties making them one of the largest MSOs in the world. As a result, we entered into a global Master Purchase agreement with Liberty and its affiliates for all ARRIS products. In 2004, Adelphia Communications announced that, as part of its bankruptcy proceedings, it planned to sell its cable properties. In 2005, Adelphia announced that it would seek court

approval to sell its cable properties to Time Warner Cable and Comcast, which closed in 2006. It is possible that the sale of properties may have an impact on our future sales. Time Warner Cable and Comcast historically have been among our larger customers.

 

It also is possible that other customer consolidations may occur that could have an impact on future sales of our products.

 

Decline in Spending by the MSOs on “Two-Way Plant Upgrades”

 

A significant portion of the MSOs have completed, or are nearing completion of, their “two-way” plant upgrade programs. We, as well as our competitors (in particular, Cisco / Scientific-Atlanta, Motorola and TVC), have sold significant amounts of equipment to the MSOs over the past five years in support of their upgrade programs. These sales were predominant of our Supplies & CPE products as well as our former Transmission, Optical and Outside Plant products. There is recent interest in additional plant upgrades to increase the amount of usable spectrum from the typical 750 or 860 MHz to create room for new services such as wideband data and more HD channels. However, it is not clear how widely the industry will pursue this option in 2007.

 

Consolidation of Competitors

 

In the fourth quarter of 2005, Cisco Systems announced that they would acquire Scientific-Atlanta. The acquisition was completed in February of 2006. Both Cisco and Scientific-Atlanta are key competitors of ARRIS. It also is possible that other competitor consolidations may occur that could have an impact on future sales and profitability.

 

Our Strategy and Key Highlights

 

Taking into consideration the industry conditions, to achieve our goal of increasing our position as a leading worldwide provider of broadband access products and services, we have implemented a long-term business strategy that includes the following key elements:

 

 

Below is a summary of some of our key trends, actions and highlights relative to these strategies:

 

“Everything IP, Everywhere” is taking hold as MSOs globally have embraced VoIP and are now rapidly deploying this key new service.

 

 

 

 

 

We continue to invest significantly in research and development.

 

 

 

In November 2006, we issued Convertible Notes to supplement our cash position in anticipation of potential future acquisitions.

 

 

In January 2007, we announced our intention to purchase TANDBERG Television

 

 

Results of Operations

 

Overview

 

As highlighted earlier, we have faced, and in the future will face, significant changes in our industry and business. These changes have impacted our results of operations and are expected to do so in the future. As a result, we have implemented strategies both in anticipation and in reaction to the impact of these dynamics. These strategies were outlined in the Overview to the MD&A.

 

Below is a table that shows our key operating data as a percentage of sales. Following the table is a detailed description of the major factors impacting the year over year changes of the key lines of our results of operations.

 

Key Operating Data (as a percentage of net sales)

 

 

Comparison of Operations for the Three Years Ended December 31, 2006

 

Net Sales

 

The table below sets forth our net sales for the three years ended December 31, 2006, 2005, and 2004, for each of our product categories described in Item 1 of this Form 10-K (in millions except percentages):

 

The table below sets forth our domestic and international sales for the three years ended December 31, 2006, 2005, and 2004 (in millions except percentages):

 

 

Broadband Net Sales 2006 vs. 2005

 

During the year ended December 31, 2006, sales of our Broadband products increased $49.2 million or approximately 15.6%, as compared to 2005. This increase in Broadband sales resulted from several components:

 

 

Supplies & CPE Net Sales 2006 vs. 2005

 

Supplies & CPE product sales increased $162.0 million or approximately 44.3% in the year ended December 31, 2006 as compared to the same period in 2005.

 

 

Broadband Net Sales 2005 vs. 2004

 

During 2005, sales of our Broadband products increased by $14.9 million or 5.0% as compared to 2004.

 

 

Supplies & CPE Net Sales 2005 vs. 2004

 

Supplies & CPE product revenue increased by approximately $175.5 million or 92.5% in 2005 as compared to 2004.

 

 

Gross Margin

 

The table below sets forth our gross margin for the three years ended December 31, 2006, 2005, and 2004, for each of our product categories (in millions except percentages):

 

 

The table below sets forth our gross margin percentages for the three years ended December 31, 2006, 2005, and 2004, for each of our product categories:

 

 

Our overall gross margins are very dependent upon, among other factors, achievement of planned cost reductions, product mix, and price reductions granted to customers.

 

Broadband Gross Margin 2006 vs. 2005

 

The increase in Broadband gross margin dollars and percentages in 2006 as compared to 2005 was related to the following factors:

 

 

Supplies & CPE Gross Margin 2006 vs. 2005

 

The increase in Supplies & CPE gross margin dollars and the decrease in gross margin percentage in 2006 as compared to 2005 were related to the following factors:

 

 

 

Broadband Gross Margin 2005 vs. 2004

 

The increase in Broadband gross margin dollars and the decrease in percentages in 2005 as compared to 2004 were related to the following factors:

 

 

Supplies & CPE Gross Margin 2005 vs. 2004

 

The increase in Supplies & CPE gross margin dollars and percentages in 2005 as compared to 2004 was related to the following factors:

 

 

Operating Expenses

 

The table below provides detail regarding our operating expenses (in millions except percentages):

 

 

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

 

2006 vs. 2005

 

Several factors contributed to the $12.8 million increase year over year:

 

 

 

2005 vs. 2004

 

Several factors contributed to the $5.8 million increase year over year:

 

 

Research & Development 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 facility costs.

 

2006 vs. 2005

 

Several factors contributed to the $6.0 million increase year over year:

 

 

2005 vs. 2004

 

Several factors contributed to the $3.3 million reduction year over year:

 

 

 

Restructuring and Impairment Charges

 

During 2006 and 2005, we recorded restructuring and impairment charges of $2.2 million and $1.3 million, respectively, which predominately relate to changes in estimates related to real estate leases associated with the previous consolidation of certain facilities. The adjustment recorded in 2006 relates primarily to a vacant property in Georgia. This lease has approximately two years remaining. Given the limited time left on the lease and the information we have gained through our advisors and continued marketing efforts, we have concluded we will be unsuccessful in subletting the facility. It is possible that if the TANDBERG Television acquisition closes we may consolidate resources in this facility at which point we would revise our estimates.

 

During 2004, we consolidated two facilities in Georgia, giving us the ability to house many of our core technology, marketing, and corporate headquarter functions in a single building. This consolidation resulted in a restructuring charge of $6.2 million. Also during 2004, we adjusted our reserves related to previously closed facilities. This adjustment was due to a change in estimates and resulted in a restructuring charge of approximately $1.1 million. Lastly, our office in Fremont, California was closed at the end of 2004. This resulted in a restructuring charge of $0.3 million, of which $0.2 million related to severance charges and $0.1 million related to lease commitments.

 

Impairment of Goodwill

 

On an annual basis, we review our goodwill based upon our analysis and an independent valuation. The valuation is determined using a combination of the income and market approaches on an invested capital basis, which is the market value of equity plus interest-bearing debt. Independent valuations were performed in the fourth quarters of 2006, 2005, and 2004, and no impairment was indicated.

 

Amortization of Intangibles

 

Our intangibles amortization expense represents amortization of existing technology acquired as a result of the Arris Interactive L.L.C. acquisition in 2001, the Cadant, Inc. acquisition in 2002, the Atoga and Com21 acquisitions in 2003 and the CoaXmedia Broadband LLC acquisition in 2005. As of August 2004, the intangibles with respect to the Arris Interactive L.L.C. acquisition were fully amortized, as of January 2005, the intangibles associated with Cadant, Inc. were fully amortized, and as of August 2006, the intangibles associated with Com21 were fully amortized.

 

Other Expense (Income)

 

The table below provides detail regarding our other expense (income) (in millions):

 

Interest Expense

 

Interest expense reflects the amortization of deferred finance fees, and the interest paid on our convertible subordinated notes and capital leases.

 

Loss (Gain) on Debt Retirement

 

During 2004, we called $50.0 million of the Notes due 2008 for redemption, and holders of the Notes elected to convert the Notes into 10.0 million shares of common stock rather than have the notes redeemed. Under the indenture’s terms for redemptions, we made a make-whole interest payment of approximately 0.5 million common shares, resulting in a charge of $4.4 million during the first quarter of 2004.

 

In May 2005, we called the remaining $75.0 million of the Notes for redemption and the holders of the Notes elected to convert the notes into 15.0 million shares of common stock rather than have the Notes redeemed. Under the indenture’s terms for redemptions, we made a make-whole interest payment of approximately 0.3 million shares resulting in a charge of $2.4 million during the second quarter of 2005. As of December 31, 2005, the Notes had been fully converted.

 

Loss on Investments and Notes Receivable

 

We hold certain investments in the common stock of publicly-traded companies, a number of non-marketable equity securities, and an investment in a rabbi trust associated with our deferred compensation plan. For further discussion on the classification and the accounting treatment of these investments, see the Investments section within Financial Liquidity and Capital Resources contained herein. During the years ended December 31, 2006, 2005, and 2004, we recorded net losses related to these investments of $29 thousand, $0.1 million, and $1.3 million, respectively.

 

During 2004, we recorded a charge of $0.1 million in relation to a short-term note receivable that we deemed to be fully impaired. The note, which was due from an unrelated private company, became due in October 2004, and the company was unable to repay the note.

 

Loss (Gain) in Foreign Currency

 

During 2006, 2005 and 2004, we recorded foreign currency losses (gains) related to our international customers whose receivables and collections are denominated in their local currency. We have implemented a hedging strategy to mitigate the monetary exchange fluctuations.

 

Income Tax Expense

 

Our annual provision for income taxes and determination of the deferred tax assets and liabilities require management to assess uncertainties, make judgments regarding outcomes and utilize estimates. To the extent the final outcome differs from initial assessments and estimates, future adjustments to our tax assets and liabilities will be necessary. In 2006, we recorded $34.8 million of income tax benefits for U.S. federal and state taxes and foreign taxes. Current tax expense of $3.7 million attributable to U.S. federal and state taxes and foreign taxes was more than offset by the reversal of approximately $31 million of valuation allowances, as ARRIS emerged from its cumulative net loss position, and $7.8 million in newly defined research and development tax credit benefits.

 

In 2005, we recorded $0.5 million of income tax expense for foreign taxes and Alternative Minimum Tax in the United States. As we were in a cumulative net loss position for tax purposes, we had sufficient net operating loss carryforwards to offset our taxable income.

 

In 2004, we recorded income tax expense of $0.1 million related to foreign income taxes, as we were in a cumulative loss position for tax purposes.

 

Discontinued Operations

 

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, certain product lines have been accounted for as discontinued operations upon their disposal in 2002 and historical results have been reclassified accordingly.

 

During 2004, we recorded income from discontinued operations of approximately $1.8 million with respect to the discontinued product lines as a result of changes in estimates related to real estate, vendor liabilities, and other accruals. Additionally, we recognized a partial recovery of $0.9 million with respect to inventory previously written off associated with an Argentinean customer, of which approximately $0.3 million related to the discontinued operations of Actives and Keptel. The net result of the above transactions in 2004 was a gain of $2.1 million in discontinued operations.

 

In 2005 and 2006, we recorded income of $0.2 million each year related to our reserves for discontinued operations. These adjustments were the result of the resolution of various vendor liabilities, taxes and other costs.

 

Financial Liquidity and Capital Resources

 

Overview

 

As highlighted earlier, one of our key strategies is to maintain and improve our capital structure. The key metrics we focus on are summarized in the table below:

 

Liquidity & Capital Resources Data

 

 

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:

 

 

Below is a description of key actions taken and an explanation as to their potential impact:

 

Inventory & Accounts Receivable Programs

 

We use turns to evaluate inventory management and days sales outstanding, or DSOs, to evaluate accounts receivable management. From the table above, you will note improvements, particularly as evidenced by the 2006

turns of 6.1 and DSOs of 41 days. Both inventory and accounts receivable increased year over year as a result of the growth in our revenues.

 

Looking forward, we do not anticipate a further reduction in DSOs. It is possible that DSOs may increase, particularly if the international component of our business increases as customers internationally typically have longer payment terms. Inventory turns may modestly improve in the future.

 

Redemption of the 2008 Notes

 

In February 2004, our stock price had risen to the levels required under the indenture where we were entitled to redeem, in full or in part, the Notes due 2008. At that time, we gave notice of a partial redemption of $50.0 million (with a “make whole” payment, described elsewhere, to be paid in stock). All redeemed note holders chose to convert their notes into stock, resulting in the issuance of 10.0 million shares of ARRIS common stock.

 

In May 2005, our stock price had risen to the levels required under the indenture where we were entitled to redeem, in full or in part, the balance of the Notes. We called the remaining $75.0 million of the Notes for redemption and the holders of the Notes elected to convert the notes into 15.0 million shares of common stock rather than have the Notes redeemed. We made a make-whole interest payment of approximately 0.3 million shares resulting in a charge of $2.4 million during the second quarter 2005.

 

Issuance of the 2026 Notes

 

On November 6, 2006, we issued $276.0 million of 2% convertible senior notes due 2026. The notes are convertible, at the option of the holder, at any time prior to maturity, based on an initial conversion rate of 62.1504 shares per $1,000 base amount, into cash up to the principal amount and, if applicable, shares of our common stock, cash or a combination thereof. Interest is payable on May 15 and November 15 of each year. We may redeem the notes at any time on or after November 15, 2013, subject to certain conditions. As of December 31, 2006, there were $276.0 million of the notes outstanding. We issued the notes to fund future acquisitions.

 

Summary of Current Liquidity Position and Potential for Future Capital Raising

 

We believe our current liquidity position, where we have approximately $549.2 million of cash, cash equivalents, and short-term investments on hand as of December 31, 2006, together with the prospects for continued generation of cash from operations are adequate for our short-and medium-term business needs. However, a key part of our overall long-term strategy may be implemented through additional acquisitions. In January 2007 we announced our intention to purchase TANDBERG Television for approximately $1.2 billion based on current exchange rates. We plan to fund the acquisition with a combination of cash, common stock and a new term loan. Post the acquisition we anticipate having $100.0 million of cash and access to a $25.0 million undrawn revolving credit facility to provide the necessary liquidity for the business. We believe that the post acquisition liquidity, together with the prospects for continued generation of cash from operations should be adequate for our short- and medium-term business needs, post acquisition. In addition, in order to be prepared to make future acquisitions generally or in connection with particular acquisitions, or to reduce long term debt, it is possible that we will raise capital through private, or public, share or debt offerings. We believe we have the ability to access the capital markets on commercially reasonable terms.

 

Contractual Obligations

 

Following is a summary of our contractual obligations as of December 31, 2006: