|Shares Out. (in M):||189||P/E||8.7||6.9|
|Market Cap (in $M):||4,966||P/FCF||7.1||5.6|
|Net Debt (in $M):||1,617||EBIT||0||0|
I believe Arris International PLC’s stock currently represents an attractive risk/reward opportunity. The company was fairly comprehensively written up by zman460 in July of 2016, so this relatively brief writeup will focus on why the idea has not worked out so far, developments since then and the outlook for the next few years. I encourage everyone to read his write-up first for background. Back then the stock traded for around $27.00 and it sits today some 18 months later at around $26.00.
First, the bad news: Yes Arris makes video set top boxes (“STBs” or “video CPE”) for cable companies, telcos and satellite TV providers and this business will be under pressure for years to come due to cord cutting. For those of you still reading, and who can stomach owning a company with a declining business line, there are a lot of offsetting positives. While video STBs are expected to be around 1/3 of 2018 sales, they represent only around 11% of total gross margin dollars. TV services in other parts of the world are still adding subscribers, so when combined with worldwide sales of broadband CPE the CPE segment is only declining low single digits. Margins have been under recent pressure due to elevated DRAM prices, but as readers of my SMCI write-up know I believe this will turn into a margin tailwind starting around the end of 2018. More importantly, Arris’ network infrastructure business should grow for years to come as cablecos transition to higher speed IP-first networks, and this business should be around 56% of annual GM$s in 2018. The company has further diversified by paying what I think was a very attractive price for Brocade’s campus Ethernet switch business + Ruckus Wireless, adding further growth and a long-term call option on CBRS infrastructure. I think earnings power is $4.00+ as DRAM normalizes, so even at a modest 12x earnings multiple the stock could be up 80%+ from here.
If you look back at zman460’s write-up, from the big picture things have played out largely as he expected. While sales at both the CPE segment and the Network & Cloud segment have come in slightly below his expectations, the main delta between his estimated $919M in 2017 adjusted EBITDA and the actual number of $832m was a $100M headwind from elevated DRAM costs plus some other puts and takes like having a partial quarter for the Brocade acquisition at the end of 2017. Gross margins in the CPE segment declined from 15% in 2016 to 12.3% in 2017 and I expect to slightly decline to 11% in 2018 before rebounding to the 14% range by 2020. While the inability to pass along DRAM price increases to customers reveals an unfortunate lack of pricing power in this segment of the business, Arris largely sells CPE at contractual prices that will enable them to benefit from rapid earnings growth in 2019 as DRAM prices ease after relatively flattish pro forma EPS from 2016-2018.
Within the CPE sector the company also makes service provider modems (“broadband CPE”). This segment is still growing as no matter how someone subscribes to the Internet they need some sort of connection equipment at their home. Thus, the overall CPE sector is only shrinking revenue and GM $s at a low single digit level. As cable companies evolve their networks to IP data, Arris is selling them the network infrastructure they need in their Network & Cloud biz. This biz (31% of sales but 56% of GM$s) should grow organically at a 4% CAGR over the next few years after a couple of flattish ones as they absorbed the dis-synergies from the Pace deal.
Arris further diversified away from their video CPE business by acquiring Brocade’s campus Ethernet switching business along with Ruckus Wireless. Brocade was forced to divest these businesses due to its acquisition by the rollup formerly known as Avago which wanted Brocade’s semiconductor business. There was a long time between announcement (February 22nd, 2017) and close (December 1st, 2017) due to review of Avago/Broadcom’s Brocade purchase but the business seems to have held up well. The purchase was consummated for $800M, slightly over 1x the $650M to $700M in sales management expects in 2018 which I view as an attractive multiple for a mid 60% GM business. The price looks even more attractive when you consider that Brocade paid $1.5B for Ruckus standalone (i.e. excluding the wired Ethernet switch business) in 2016. While Brocade’s Ethernet switching business is not the most exciting, I believe consolidation in this market has opened up opportunities and is a nice complement to Ruckus WLAN leadership as corporate IT departments frequently upgrade wired and wireless networks at the same time. Ruckus sells WiFi infrastructure to service providers as well and has some interesting long term opportunities to sell cellular equipment in the emerging 3.5 Ghz CBRS standard. This fits especially well with Arris’ traditional cable customer base, as cable companies entering the wireless market are expected to be some of the leading adopters of CBRS.
There are a lot of moving parts to ARRS, but the below table shows the relative contribution of each of Arris’ segments to revenue and GM. As you can see, I expect that organically their revenue will be approximately flat but GM$s should grow at low single digits. Note that no revenue from CBRS (which could begin contributing in 2020) is included:
Segment 2018 Sales % of Total L-T Growth
Video CPE $ 2,381 33.4% -9.0%
Broadband CPE 1,916 26.8% 5.0%
Network & Cloud 2,186 30.6% 4.0%
Ruckus Wireless 340 4.8% 10.0%
Brocade Switching 220 3.1% 3.0%
Brocade Services 96 1.3% 5.0%
Total $ 7,139 100.0% 0.2%
Segment 2018 GM% 2018 GM $ % of Total GM Growth
Video CPE 11.1% $ 264 13.1% -1.2%
Broadband CPE 11.1% $ 212 10.5% 0.5%
Network & Cloud 51.2% $1,119 55.6% 2.2%
Ruckus Wireless 63.9% $ 217 10.8% 1.1%
Brocade Switching 63.9% $ 141 7.0% 0.2%
Brocade Services 63.9% $ 61 3.0% 0.2%
Total 28.2% $2,014 100.0% 3.0%
In summation, I think that ARRS at around 9x consensus (DRAM-price depressed) 2018E EPS is mispriced as despite set top box exposure the overall business should be able to grow gross margin dollars and earnings. Additionally, I think that by this time next year the company could enter a positive earnings estimate revision cycle as DRAM prices ease which could send earnings up to near $4.00 per share (St. consensus: $3.26) and help the multiple. Long term, if the company can successfully execute on the CBRS opportunity it could further cement itself as a leading cable infrastructure player as declining revenue streams become a smaller part of the business and new revenue streams layer in.
Disclosure: The fund that I work for owns shares of ARRS. We may buy or sell shares of ARRS at any time without notice.