|Shares Out. (in M):||191||P/E||0||0|
|Market Cap (in M):||5,200||P/FCF||9.64||7.56|
|Net Debt (in M):||1,343||EBIT||0||0|
I wrote the below for my membership application in mid-July, before Arris reported Q2. They’ve since reported Q2 and the stock popped ~9%. There is still significant upside in the stock which will play out over the next few quarters. A brief update on Q2 is included at the end of this piece.
Arris develops, produces and sells communications technology to cable and telco services providers / multichannel video programming distributors (“MVPDs”) (i.e. Comcast, Time Warner Cable, AT&T/DirectTV, etc.). The Company segments revenue into Customer Premises Equipment (“CPE”) and Network & Cloud (“N&C”). The stock currently trades at a 10.4% 2016E free cash flow yield, expanding to 13.2% in 2017E, due to uncertainty regarding the trajectory of its CPE business. After netting out excess cash, the stock trades at a 12.0% and 17.0% 2016E and 2017E free cash flow yield, respectively. The market is over concerned with the trajectory of the CPE business and is seriously discounting the growth profile of the N&C business. There is 69% upside over the next ~18 months based on base-case projections and 9% target fee cash flow yield. We think this is a fairly asymmetric opportunity where the stock is fairly valued based on downside projections and 12% free cash flow yield.
CPE products are, as their name suggests, equipment stored in the subscriber’s (“sub’s”) home or place of business, which facilitate connection to the network. Products include set-top boxes (“STBs”), gateways, cable modems and E-MTA and Voice/Data modems. For those of us somewhat new to the space, the 10-K describes all of these products in detail. On a high level, these products receive the signals sent by the service providers and turn them into TV, Phone / (Voice over Internet Protocol or “VoIP”) and internet. The majority of concern around Arris’s business stems from A) an FCC proposal which would open standards to allow customers to purchase cable set-top boxes from third parties vs. currently renting them from MVPDs (more on this below) and B) fear of cord-cutting that would reduce the number of STBs in use. Given that an estimated 40% of 2016E revenue and 23% of gross margin comes from STB’s, this has been a serious concern in the market.
N&C products generally A) sit at service provider hubs where they process, encode, and transmit signals or B) sit in transmission lines where they help assist in the physical transmission of signals to the subs. Products include Cable Modem Termination Systems (“CMTS”), Universal Edge QAMs, Converged Cable Access Platform (“CCAP”); various encoding and compression equipment for video content delivery; optical transmission equipment, fiber nodes and RF amplifiers which enable transportation of signals over the fiber network; and various technical support, network management software and related service offerings for service providers. While the market appears to have focused on the STB headwinds, they missed the growth potential in the N&C segment which will be derived from 1) increasing network requirements driven by ever-increasing data consumption (multi-screening, ultra-HD TVs) and 2) a seemingly inevitable shift of TV broadcast to IP. While only an estimated 32% of 2016E revenue is derived from N&C, due to the higher margins in the business nearly 61% of gross margin comes from N&C. We think the market has been overly focused on the video STB overhang and is seriously discounting the impact of N&C on the bottom line and the growth profile of the segment.
Why the Opportunity Exists
Misunderstood growth profile
Recent uncertainty around Arris’s revenue trajectory is based on 1) customer M&A activity and what that means for Arris’s market share and 2) cord-cutting trends / OTT services and what that means for the current STB market. The bigger picture has been missed, which is that cable cos and telcos are ramping up investment in their networks to shift to DOCSIS 3.1 architecture and also move to an all IP-based infrastructure. Both of these initiatives will require significant investment in network infrastructure. Arris estimates that network infrastructure spending will increase at a ~9.2% CAGR from 2015 to 2017. We estimate Arris to hold ~40% market share in this space which, after adjusting for the Pace acquisition, constitutes about 18% of total revenue and 34% of gross margin. So if OTT services do replace, instead of augment, traditional TV powered by STBs, Arris will be losing CPE revenue at ~18% gross margins and replacing it with N&C revenue at ~52% gross margins which will be needed to meet the data requirements of OTT services (increasing use of streaming services across multiple screens in the home). Putting this in perspective, in order to break-even from a gross margin perspective, Arris would need to replace every dollar it loses on the CPE side with 34.6 cents of revenue on the N&C side. Also, for every STB that is lost to cord-cutting, the requirements of the cable modem that delivers internet for the OTT services will be that much higher.
Arris’s head-line reported revenue growth for CPE and N&C in 2015 were -15% and 1.5%, respectively and -9.9% in total. I think the market looks at the CPE sales decline in 2015 and assumes it is in a downward spiral. Looking at full year historical revenue numbers for Pace, Motorola Home (major 2015 and 2013 acquisitions, respectively) and Arris allows you to get a sense for industry growth (this is difficult to discern from Arris’s reporting alone, due to the acquisitions). From this perspective, 2014 is more of an anomaly than 2015. 2014 revenue jumped 15.2% over 2013, providing a very tough comp for 2015. Management agrees in their filings, citing strong demand in 2014 as well as new product introductions that drove revenue (XG1 and Verizon Media Server on CPE side and E6000 CCAP on N&C side). In 2015, “the decline was driven by sales of new product introductions and platform transitions implemented by certain customers during 2014 which did not recur, as well as telco customer subscriber growth challenges in 2015 as several of these customers look to reevaluate or change their video strategy” (2015 10-K). In fact, 2015 revenue grew 1.5% over 2013 when combining all businesses. So while 2015 experienced significant revenue decline, this was mostly due to 1) the huge surge in 2014 customer orders, which was not replaced in 2015 and 2) the delay in customer spending in 2015 due to M&A overhang, which should pick-up once transactions are closed. With this in mind, the projections we use for 2016 and 2017 are fairly conservative, as discussed further below.
The Shift to IP
Consumers continue to consume more data (i.e. streaming video on tablets and using higher definition TVs, which use substantially more data). They are also connecting with more devices. The best way to handle the increase in required bandwidth is to shift to an all-IP based infrastructure, which is where service providers have begun to and are continuing to invest. The shift to IP allows for more efficient two-way communication and increased data transmission. Moving to IP requires buying new infrastructure equipment (Arris’s E6000 CCAP for example) which send IP signals as well as updating STBs to receive IP signals. When CMTS and CCAP equipment are shipped, about 50% of their total capacity is “turned on” and to get the additional 50% “turned on” the network provider must pay Arris a licensing fee to open it up. Gross margin on the original chassis is about 50%, but is nearly 100% on the licensing fee. As more capacity is required on deployed chassis, Arris will benefit from these licensing fees.
As more data is being sent to the home and to various devices in the home, more network extenders will also be required to maintain high data speeds across the home (using higher band spectrum with smaller reach). Increased sales of network extenders will add to CPE revenue and help replace lost revenue as traditional STBs are lost to cord-cutting. Arris will be at the forefront working with customers to deliver new products that deal with increased data requirements and new network infrastructure. I encourage a skim through of the investor day presentation from March 16th, 2016 for a more complete overview of all of the ways Arris is developing new products to meet new customer demands.
Overhang Due to FCC STB Proposal
On January 27th, 2016 the FCC released a proposal (https://apps.fcc.gov/edocs_public/attachmatch/DOC-337449A1.pdf) which would create new standards such that consumers could buy 3rd party set top boxes and still access service provider content (not just content access but VOD, program guides and VDR services too). Arris fell 9% on the day (vs. 0.54% for the SP500). The general fear is that opening up the STB market to retail could seriously disrupt Arris’s STB sales, which account for 59% of 1Q16 CPE revenue, 40% of total revenue and 28% of total gross margin. While a potential channel shift could certainly pose issues for Arris in the longer term, the market reaction is overblown for the following reasons:
1. Retail margins are likely better than existing sales to service providers (service providers are the ones earnings out-sized returns, not the STB manufacturers). Barclay’s cites an average monthly rental fee for STBs at $7.43/month/sub and average cost of $150-200/STB. Assuming a 35% tax rate and service providers depreciating the STBs over 5 years, the service providers earn a ~29% IRR. This is vs. an estimated ~18% gross margin Arris earns selling STBs. Here is a small case study that illustrates that Arris could in fact benefit from selling to retailers or direct to consumers.
a. Assuming a 10% cost of capital for a consumer, they would be indifferent renting for 5 years at $7.43/month vs. owning over a 5 year life and purchasing at $353. Assuming retailers would mark-up STBs 40% (or 29% GM; this is admittedly a broad estimate), Arris could sell the same STB to a retailer at $252 for the consumer to get the same end-price. This would double Arris’s GM per unit from $36 (18% at $200 selling price) to $88 (35% at $252 selling price).
Needless to say this is all based on very rough estimates, but is illustrative of the additional margin that could be generated through the retail channel. Potentially as a hedge against the potential shift to retail, Arris started sponsoring a NASCAR driver, Carl Edwards, in mid-2014 along with a few other drivers in related circuits. Arris has seen the retail channel as important for some time, and any shift should be manageable, especially given the long lead-time they’ll likely have as outlined below.
2. This is not the first time the FCC has proposed 3rd party boxes be able to access service provider content and past attempts have not moved the needle significantly in terms of STB sales through the service providers. Below is the timeline of the CableCARD system, which was an early predecessor to the new proposal.
1996 - The Communications Act requires FCC to enable 3rd party devices to access service provider systems
1998 - The FCC’s first order is printed requiring service providers to allow 3rd parties to access their content, so long as the device was secure and wouldn’t cause harm to the network
2003 - The FCC creates the CableCARD standard to solve the access issue. The CableCARD is a standardized piece of hardware provided by service providers to their customers which connects within a STB and allows decryption and access of the service provider’s content. Use of the CableCARD requires a technical standard among content delivery that will take years to implement
2007 - 11 years after the initial directive and 9 years after the FCC order, the CableCARD was deployed
The main issue with the practicality of the CableCARD is that by the time the standards were set for how the system would work and everyone had the technology in place to go to market, consumers were using different technology, rendering the CableCARD fairly useless (the original FCC proposal only required one-way communication, whereas most consumers use two-way communication today to use video guides, on-demand and VDR services). According to the FCC, using the latest data available in their 2016 video competition report (http://transition.fcc.gov/Daily_Releases/Daily_Business/2016/db0509/DA-16-510A1.pdf) there were 617k third-party STBs in use among the top 10 cable companies vs. 53mm deployed using service-provider STBs in 2015. That’s 1.16% market share and the number of third-party STBs in use was actually down from 620k in 2014. The new proposal basically takes the CableCARD idea and transforms it to make service providers comply to how consumers interact with content today. The reality is that it will like take years for all parties to agree on the technological standards and then perform actual engineering required to make the new device work. By the time the technology required for this proposal is implemented, it is very possible that the manner in which consumers consume content has changed and renders it much less impactful. Even if the retail channel does become much more widely used for STBs, Arris will likely benefit from higher retail margins as described above.
Arris estimates the international TAM at ~$19bn. They do roughly ~$2bn in international sales, so roughly 10.5% market share. After completing the acquisition of Pace, Arris restructured its organization creating a new international operations group to focus on growing their market share. Roughly 60% of the Company’s TAM is international vs. 30% of current revenue, so they see big upside here and believe they can grow international revenue faster than the 2.3% estimated 2015 to 2017 international TAM CAGR. Given the Pace presence and existing technology, now combined with the Arris R&D platform, this seems defensible.
Cisco Exit of Market to Technicolor and Implications
In July of 2015, Cisco sold its STB/CPE business to Technicolor at a 0.4x trailing revenue multiple and 4.9x post-synergy EBITDA multiple. The transaction worked well on both sides. Cisco was able to rid itself of a lower-margin business and refocus on working with the service providers on delivering content. Cisco retained a 5.2% ownership interest in Technicolor post-transaction ($600mm deal, $450mm cash and $150mm in stock) which gives them some upside should the CPE business do exceedingly well. Technicolor gets scale, which is very important in the CPE business from an economies of scale perspective on the production side and in being able to serve a service providers full foot-print. Technicolor expects $100mm in synergies from a combined business that likely produced ~$100mm in EBITDA pre-synergies on $3.3bn in sales at transaction close. They’ll also double market-share to roughly 15%, versus ~22% for combined Arris and Pace. Technicolor stock popped 17% on the announcement, if that is any indication of market sentiment around the transaction and the Company’s double-down on CPE. A larger, more focused competitor will likely produce some headwinds from Arris on the CPE side of the house, but in the longer-term having a more consolidated market could mean more pricing power with Arris and Technicolor controlling roughly 40% of the CPE market.
On April 26, 2015, Arris announced the acquisition of Pace, a UK-based provider of CPE equipment (and to a lesser extent N&C equipment) with a focus on the international market. Arris paid $2.07bn for Pace, ~$640mm in cash and ~$1.430bn in Arris shares (47.7mm shares, or 24% pro forma ownership). Arris funded the cash portion, along with taxes and expenses, through a new $800mm term loan, with leverage increasing modestly to 2.5x post-transaction. Pace shareholders received a 29% premium based on the pre-announcement share prices of both companies and a stake in a larger, more-diverse competitor. Arris received an international footprint and also was able to lower its tax rate from 35% to 25% due to the shift from US to UK domicile. Arris also anticipates roughly $200mm in run-rate synergies (vs. $241mm in Pace 2014 EBITDA) from the transaction. While the initial reaction in Arris shares was very positive (up 22%), the stock gave up those gains and then some over the next 3-4 months.
The medium-term negative reaction in the stock price can likely be linked to sell-side research quoting the transaction as expensive and potentially forced-selling from previous Pace shareholders who may have been restricted from owning non-UK-listed equities. The headline figure quoted by research is that Arris paid 0.9x trailing revenue for Pace while Technicolor paid closer to 0.4x for Cisco’s CPE business just a few months later. This doesn’t give credit to the synergies nor the tax-savings of the deal. Arris will earn roughly $289mm in normalized 2016 EBT. Due to the 10% drop in tax-rate, they’ll save $29mm per year, and at a 10% discount rate in perpetuity, that’s worth $289mm (very rough estimate, admittedly). If you use 2017 estimated EBT, that’s worth $410mm. Pro-forma for synergies, Pace would add ~$441mm in EBITDA, based on 2014 EBITDA of $241mm and $200mm in synergies. Netting the $289mm in tax-savings from the purchase price and using synergy-adjusted EBITDA, Arris paid 4.1x EBITDA – well below the 4.9x Technicolor paid for Cisco’s CPE business, on a synergy adjusted basis as well. Even giving no credit to the tax-savings, they paid 4.8x, which basically marks the deal at fair value based on the Technicolor/Cisco multiple with the tax-savings as free-upside. Pace generated $2.62bn in sales in 2014 vs. an estimated $1.6bn for Cisco’s CPE business, so Arris is getting 62% more foot-print as well. Taking a closer look at the transaction leaves you more comfortable with the price Arris paid for the deal, at much lower multiples than the top-line multiples quoted by research.
Arris sells to the large cable and telco companies. Pre-Pace acquisition, Comcast and TWC comprised 21% and 14% of sales (~$1bn and $688mm in 2015, respectively). The exact timing of revenue can be somewhat lumpy and subject to capex spending at the cable cos / telcos. There has also been a lot of activity on the M&A front, which has added to choppiness in capex spending (AT&T / DirectTV, Charter / TWC, Altice / Cablevision, etc.). Over the medium to longer-term, revenue is driven on the CPE-side by competition between customers to provide new products with better functionality and refreshing equipment that has been in the market for a number of years. Similarly, on the N&C side, competition to deliver faster internet speeds and deliver more bandwidth drive customer investment in the network. I’ve found that if you try to go customer-by-customer to understand individual product trajectories at each customer, you’ll lose the forest for the trees attempting to find out how much Arris product is in each customer strategy, how that will change over time and how much of a subscriber base that corresponds to. As an example, in a recent Q&A session with management, Charter executives were very bullish on moving their platform to fully digital in order to free up more spectrum for high-speed data (from traditional analog). This replaced previous uncertainty about their plans and will accelerate the refresh cycle for updated STBs. Cisco and Humax are the suppliers for Charter’s Worldbox, which is the STB they will focus on deploying. These will replace some Arris equipment used by TWC. However, the Worldbox uses a cloud-based video guide (Spectrum Guide) developed with ActiveVideo, a JV between Charter and Arris. Despite this headwind on the STB side, Arris has the opportunity to increase N&C sales of CCAP and related network infrastructure products as Charter rolls out its full digital and eventually IP-based network. So you see that deriving Arris revenue on a customer-by-customer basis is fairly complex. While understanding customer strategies is important, it’s more useful from a sales-projections standpoint to get comfortable with the high-level drivers of cable/telco capex spending as it relates to CPE equipment and network infrastructure and Arris’s market share of that overall pie.
Despite our top-down revenue forecasting approach, below are some updates on customer spending patterns that add some comfort around our projections.
1. Comcast increased cable spending from 13.9% of cable sales in 2014 to 15% in 2015 (14% YoY increase) and guided to 15% of sales in 2016. The increase in expenditure is due in part to increased spending on CPE equipment (X1 platform and wireless gateways) and infrastructure with focus on increase network capacity.
2. Time Warner also increased spending in 2015 to 18.8% of cable sales vs. 18% in 2014. On their Q4 2015 call, management didn’t provide 2016 guidance, but suggested the same growth levers would be pulled in 2016: investing in network capacity (specifically cited increased data use per customer), increasing replacement of old, worn-out STBs with new, more functional STBs, and spending on line extensions to reach additional customers. As mentioned above, Charter management has changed how they will invest in the TWC assets, but they will invest nonetheless.
1. As part of AT&T’s recent acquisition of DirectTV, they shifted strategy from U-verse to satellite video and then offered a streaming service from DirectTV. The shift to satellite video hurt Arris based on its involvement in U-verse (but likely benefited Pace, a big DTV supplier) and the introduction of a new streaming service introduced additional fears that STB’s are trending down. While more OTT-services offered by cable cos and telcos could hurt STB’s in the long-run, any lost revenue would likely be replaced by network infrastructure equipment and improved cable modems required to handle the substantially increased network demand of substantial IP-driven services. Management has also commented on a variety of new projects they are working with AT&T on that should help replace lost revenue.
2. Frontier recently acquired about 20% of Verizon’s FiOS footprint and plans to ramp up investment in those assets, specifically working on transferring those customers to full IP service.
3. As mentioned above, Verizon sold about 20% of their FiOS network to Frontier and in general management has seen Verizon ramping down investment in the FiOS network.
4. Spectrum Auction: It is worth noting that there is a spectrum auction underway which AT&T and Verizon may be holding back cable capex dollars for in order to potentially bid on spectrum. As this auction concludes (likely 2H 2016) there may be more demand from the telcos for Arris products.
Top-line revenue is difficult to forecast in the medium-term because of a concentrated customer base that has some discretion in terms of when they buy from Arris. In the short-term, revenue is guided by customer bookings and in the long-term can be guided by market-share as a percentage of total market.
The acquisition of Motorola Home in 2013 and the recent acquisition of Pace make revenue look choppy over the past few years (47% growth in 2014, 9.9% decline in 2015, 38% estimated growth in 2016). If you combine the results of Pace, Motorola and Arris historically, you get to 15% growth, 12% decline and 5% decline in 2014, 2015 and 2016, respectively. Investors look at the 2015 decline and are weary about the company’s growth outlook. Arris had substantial organic growth of 60% in 2014 due to 1) on the CPE side: new product introductions and strong underlying demand / refresh cycles at telcos/cablecos and 2) on the N&C side: the introduction of the new E6000 CCAP. These new products hitting the market in 2014 spiked sales, which wasn’t replaced in 2015. As mentioned above, looking past the revenue spike in 2014, 2015 still grew over 2013 when combining revenues from all businesses acquired since then. 2016 will likely experience similar M&A headwinds as 2015 and the ceding of market share as customers diversify their supplier base from the newly combined company. We view 2016 as the trough with the company returning to growth in 2017 once these headwinds subside.
Although revenue is difficult to predict in the medium-term, the CPE market should grow slowly over the long-term. As infrastructure shifts to an all-IP architecture and as new technologies develop generally, new CPE equipment will replace older equipment. As the largest player in the CPE space, and the biggest spender in R&D, Arris is well-positioned to capture existing and new market share as new technology is developed for and required by customers.
For 2016 and 2017, revenue is forecasted based on a reduction in market share from 22% in 2015 to 19.5% in 2016 and thereafter due to customers shifting reliance on the new combined company and CPE TAM of $23.1bn in 2016 growing to $23.4bn in 2017, based on the 2016 investor day presentation. The ~9% CPE segment revenue decrease to $4.51bn in 2016 (vs. combined Arris and Pace CPE revenue of $4.97bn in 2015) is in line with recent results. This builds to $6.6bn of 2016 revenue for CPE and N&C segments, at the bottom range of the $6.6bn to $6.8bn guidance which was reaffirmed on the Q1 2016 call. CPE revenue continues to experience headwinds from AT&T and spending delays due to customer M&A activity. As this is resolved and reaches a bottom, uncertainty should be removed from the stock.