Arris (ARRS) is a leading maker of cable infrastructure equipment based in the United States. Major products include cable modems in subscriber homes, cable modem termination systems (CMTS) at the head-end needed to bridge RF/Ethernet signals from the cable modems onto the fiber-coaxial backbone of the network, and QAM tuners needed to transmit digital streams as analog signals over the cable. The leading US cable operators, Comcast and Times Warner Cable, account for 32% and 21% of 2009 revenue respectively. The industry is highly competitive, and competitors include Cisco, Aurora and Big Band Networks. In this industry, Arris has a reputation for equipment which is value-oriented, providing the greatest boost to bandwidth for the capex.
In the cable world, the dominant transmission protocol in use worldwide is the DOCSIS standard. The latest DOCSIS 3.0 standard was finalized in 2008. It enables a dramatic jump in cable bandwidth over DOCSIS 2.0 for a modest capital outlay, and cable companies were expected to invest heavily in new DOCSIS 3.0 equipment, if only to maintain parity with competing telephone companies which have been leapfrogging the cable companies in bandwidth with their fiber-optic network rollout. However, these infrastructure investment plans were delayed for some companies by the financial crisis and recession. With the gradual recovery of the economy, I believe that the cable industry is at the beginning of a technology replacement cycle which will significantly boost ARRS’s earnings.
Many value investors do not like to invest in technology companies, believing that rapid technological change in the industry means that little or no economic moat is present. However, with an adequate understanding of the underlying technological and economic issues, there is no reason why telecom company cannot be a buy at a sufficiently cheap price point. There are plenty of tech companies that have done very well over the long-term, including bellwethers such as Microsoft, Cisco, and Google. Still, there must be some consideration of whether technological obsolescence is a credible risk. Alternatives to cable technology include FIOS (an all-fiber network, as opposed to hybrid fiber-coaxial networks), powerline networking, and satellite technology. Powerline networking is still in its infancy, and it is too early to forecast its impact. Suffice to say that current regulations on power companies do not encourage utilities to make investments on the underlying infrastructure. Satellite technology has known weaknesses, including a bottleneck at the satellite that limits bandwidth, and a stutter due to signal latency during transmission. Satellite is best suited for one-way transmission of TV signals, or internet access at modest speeds for far-flung rural areas that cannot be wired up economically. FIOS is a credible threat, but many telecom analysts believe that Verizon’s return on investment on its FIOS rollout is abysmal, while Verizon itself has already halted its FIOS expansion. In any event, Arris already has products geared towards fiber optic technology. Back in 2000-2001, it provided the equipment for Reliance Communications to roll out a fiber optic network in India. In short, I believe that despite competing technologies, the fiber-coaxial network of the cable industry presents that best economics for triple play services for the foreseeable future. Even in the long-term future, when demand for bandwidth has grown so much as to warrant an all-fiber network, Arris is likely to be able to transition to that scenario gracefully, given its current portfolio of fiber optic products and the likely slow pace of the transition.
What about nearer term cyclical threats to ARRS? Will the company fare well in a recession? There is much play in the media over recent declines in cable subscriber counts, with pundits suggesting that this is the beginning of a secular decline in cable caused by mass migration of TV viewers to the Internet-based video streams such as Hulu and Netflix. There are several problems with this thesis. Firstly, as a recent Lex column has pointed out, early adopters of technology are usually richer than the general population, and are able to maintain their cable subscriptions even in a downturn. Secondly, telecom industry sponsored surveys suggest that current Internet video offerings are not rich enough to significantly tempt viewers away from cable TV. I believe that the recent dip in subscribers are probably due to lower income subscribers dropping their cable service, and is cyclical in nature. In the 2008-2009 economic downturn, despite a drop in subscriber count, Comcast has stepped up its deployment of DOCSIS 3.0, which more than compensated for declining revenues from other cable companies. As a result, ARRS actually reported stable revenues through the 2008-2009 recession. In addition, ARRS has built up a cash position of about $640M, which puts it in a position to ride out even a steep drop in revenues.
The following is my personal valuation of ARRS. From 2006-2009, the net income of ARRS ranged from $90M to $140M (excluding goodwill writedowns). In addition, there are non-cash expenses that should be added back to obtain free cash flow earnings, including a non-cash interest expense of nearly $10M a year (FASB mandates that convertible debt be expensed as an increase to the interest paid on the income statement to account for the cost of the embedded call option), and non-cash amortization of intangibles of $2M-$40M annually. Adding back these non-cash expenses, from 2006-2009, FCF ranged from $105M-$140M. Management has projected earnings of $110M in 2010, a little off analyst expectations, resulting in a drop in the share price. In addition, the numbers mask an improving revenue mix, with larger amounts coming from international sales, diversifying ARRS’s revenue base. In 2010, 35% of revenue came from international sales, compared to 26% in 2009. Management has explicitly identified pursuing international sales as a strategic priority, and has appointed new heads of development in both China and Korea. I am comfortable in projecting a minimum FCF of $100M annually, and a conservative PE of 10, for a $1B value from income. Adding the $640M in cash to the valuation gives a net value of $1.64B, or a per share target of $13.30. This is a conservative price target that does not take into account probable increases in revenue due to demand for cable infrastructure taking off.
There are, of course, some risks involved in this investment. ARRS is, after all, an infrastructure company with lumpy revenues, and some volatility with the business cycle should be expected. Also, ARRS has a poison pill that prevents takeovers, and $200M in convertible long-term debt that converts at $16.09 per share, and may act as at least a short term ceiling to the stock price. Still, I believe that the pros abundantly outweigh the cons here, and that cable companies worldwide will strongly support ARRS, both for its value-oriented products, and as a counterweight to the Cisco’s market power.
Disclosure : I own shares in ARRS.
