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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------------
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2003
of
ARRIS GROUP, INC.
A Delaware Corporation
IRS Employer Identification No. 58-2588724
SEC File Number 001-16631
11450 TECHNOLOGY CIRCLE
DULUTH, GA 30097
(678) 473-2000
ARRIS Group, Inc. (1) has filed all reports required to be filed by Section 13
or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months,
and (2) has been subject to such filing requirements for the past 90 days.
ARRIS Group, Inc. is an accelerated filer (as defined in Rule 21b-2 of the
Exchange Act).
As of August 8, 2003, 74,882,957 shares of the registrant's Common Stock, $0.01
par value, were outstanding.
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ARRIS GROUP, INC.
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2003
INDEX
Page
Part I. Financial Information
Item 1. Financial Statements
a) Consolidated Balance Sheets
as of June 30, 2003 and December 31, 2002 1
b) Consolidated Statements of Operations for the
Three and Six Months Ended June 30, 2003 and 2002 2
c) Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2003 and 2002 3
d) Notes to the Consolidated Financial Statements 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 16
Item 3. Quantitative and Qualitative Disclosures on Market Risk 33
Item 4. Controls and Procedures 33
Part II. Other Information
Item 1. Legal Proceedings 34
Item 4. Submission of Matters to a Vote of Security Holders 35
Item 6. Exhibits and Reports on Form 8-K 36
Signatures 37
Certifications 38
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ARRIS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
JUNE 30, DECEMBER 31,
2003 2002
----------- ------------
(UNAUDITED)
ASSETS
Current assets:
Cash and cash equivalents .............................................. $ 67,217 $ 98,409
Accounts receivable (net of allowances for doubtful accounts of
$18,704 in 2003 and $10,698 in 2002) ................................. 54,942 78,743
Accounts receivable from Nortel Networks ............................... 215 2,212
Other receivables ...................................................... 1,289 3,154
Inventories ............................................................ 105,980 104,203
Investments held for resale ............................................ 103 137
Other current assets ................................................... 12,453 14,834
--------- ---------
Total current assets ............................................ 242,199 301,692
Property, plant and equipment (net of accumulated depreciation of
$46,165 in 2003 and $44,810 in 2002) ................................. 28,093 34,540
Goodwill ................................................................. 150,569 151,265
Intangibles (net of accumulated amortization of $58,978 in 2003 and
$41,506 in 2002) ..................................................... 48,054 64,843
Investments .............................................................. 3,179 4,594
Other assets ............................................................. 9,723 6,478
--------- ---------
$ 481,817 $ 563,412
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ....................................................... $ 28,807 $ 24,253
Accrued compensation, benefits and related taxes ....................... 17,187 23,423
Accounts payable and accrued expenses - Nortel Networks ................ 427 11,303
Current portion of long-term debt ...................................... 184 23,887
Current portion of capital lease obligations ........................... 1,171 1,120
Other accrued liabilities .............................................. 39,828 44,360
--------- ---------
Total current liabilities ....................................... 87,604 128,346
Capital lease obligations, net of current portion ........................ 139 158
Long-term debt ........................................................... 125,000 --
--------- ---------
Total liabilities ............................................... 212,743 128,504
Membership interest - Nortel Networks .................................... -- 114,518
--------- ---------
Total liabilities & membership interest ......................... 212,743 243,022
Stockholders' equity:
Preferred stock, par value $1.00 per share, 5.0 million shares
authorized; none issued and outstanding .............................. -- --
Common stock, par value $0.01 per share, 320.0 million shares
authorized; 74.8 million and 82.5 million shares issued and
outstanding in 2003 and 2002, respectively ........................... 757 831
Capital in excess of par value ......................................... 577,592 603,563
Accumulated deficit .................................................... (305,652) (281,329)
Unrealized holding gain on marketable securities ....................... 90 227
Unearned compensation .................................................. (2,397) (1,649)
Unfunded pension losses ................................................ (1,219) (1,219)
Cumulative translation adjustments ..................................... (97) (34)
--------- ---------
Total stockholders' equity ...................................... 269,074 320,390
--------- ---------
$ 481,817 $ 563,412
========= =========
See accompanying notes to the consolidated financial statements.
1
ARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2003 2002 2003 2002
--------- --------- --------- ---------
Net sales (includes sales to Nortel of $215 and
$371 for the three months and $216 and $1,837
for the six months ended June 30, 2003 and
2002, respectively) $ 101,710 $ 176,502 $ 193,053 $ 348,899
Cost of sales 74,525 116,023 141,124 230,189
--------- --------- --------- ---------
Gross profit 27,185 60,479 51,929 118,710
Operating expenses:
Selling, general and administrative and
development 43,681 68,262 80,921 115,445
Restructuring and impairment charges -- -- 336 --
Amortization of intangibles 8,764 8,708 17,472 17,078
--------- --------- --------- ---------
52,445 76,970 98,729 132,523
--------- --------- --------- ---------
Operating income (loss) (25,260) (16,491) (46,800) (13,813)
Interest expense 2,990 2,102 4,654 4,400
Membership interest -- 2,500 2,418 5,000
Loss (gain) on debt retirement -- 9,276 (28,506) 9,276
Loss on investments 1,037 1,356 1,014 1,570
Loss (gain) in foreign currency (1,486) (4,688) (1,968) (3,862)
Other expense (income), net (32) (5) (89) 192
--------- --------- --------- ---------
Income (loss) from continuing operations before
income taxes (27,769) (27,032) (24,323) (30,389)
Income tax expense (benefit) -- -- -- (6,800)
--------- --------- --------- ---------
Net income (loss) from continuing operations (27,769) (27,032) (24,323) (23,589)
Income (loss) from discontinued operations -- (13,682) -- (19,059)
--------- --------- --------- ---------
Net income (loss) before cumulative effect of
an accounting change (27,769) (40,714) (24,323) (42,648)
Cumulative effect of accounting change -- -- -- 57,960
--------- --------- --------- ---------
Net income (loss) $ (27,769) $ (40,714) $ (24,323) $(100,608)
========= ========= ========= =========
Net income (loss) per common share -
Basic and diluted:
Income (loss) from continuing operations $ (0.37) $ (0.33) $ (0.31) $ (0.29)
Income (loss) from discontinued operations -- (0.17) -- (0.23)
Cumulative effect of an accounting change -- -- -- (0.71)
--------- --------- --------- ---------
Net income (loss) $ (0.37) $ (0.50) $ (0.31) $ (1.24)
========= ========= ========= =========
Weighted average common shares:
Basic and diluted 74,992 82,236 78,509 81,252
========= ========= ========= =========
See accompanying notes to the consolidated financial statements.
2
ARRIS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)
SIX MONTHS ENDED
JUNE 30,
---------------------------
2003 2002
--------- ---------
Operating activities:
Net income (loss) ..................................................... $ (24,323) $(100,608)
Adjustments to reconcile net income (loss) to net cash provided by
(used in) operating activities:
Depreciation ......................................................... 9,670 10,851
Amortization of intangibles .......................................... 17,472 17,078
Amortization of deferred financing fees .............................. 2,154 1,276
Amortization of unearned compensation ................................ 1,285 886
Provision for doubtful accounts ...................................... 7,718 23,025
Loss on disposal of fixed assets ..................................... 5 19
Loss on investments .................................................. 1,014 1,570
Cash proceeds from sale of trading securities ........................ 130 --
Loss (gain) on debt retirement ....................................... (28,506) 9,276
Loss (gain) on sale of discontinued product line ..................... (2,000) 8,536
Cumulative effect of an accounting change - goodwill ................. -- 57,960
Changes in operating assets and liabilities, net of effect of
acquisitions and dispositions:
Accounts receivable ............................................... 18,080 (32,006)
Other receivables ................................................. 1,865 3,757
Inventory ......................................................... (1,446) 28,781
Accounts payable and accrued liabilities .......................... (14,868) 1,925
Income taxes recoverable .......................................... -- (7,563)
Accrued membership interest ....................................... 2,418 5,000
Other, net ........................................................ 420 (7,783)
--------- ---------
Net cash provided by (used in) operating activities ....................... (8,912) 21,980
Investing activities:
Purchases of property, plant and equipment ........................... (2,618) (3,622)
Cash proceeds from sale of Keptel product line ....................... -- 30,000
Cash proceeds from sale of Actives product line ...................... 1,800 --
Cash paid for acquisition ............................................ (558) (835)
--------- ---------
Net cash provided by (used in) investing activities ....................... (1,376) 25,543
Financing activities:
Proceeds from issuance of bonds ...................................... 125,000 --
Redemption of membership interest .................................... (88,430) --
Repurchase and retirement of common stock ............................ (28,000) --
Payments on capital lease obligations ................................ (834) (403)
Payments on debt obligations ......................................... (23,969) --
Deferred financing costs paid ........................................ (5,278) --
Proceeds from issuance of stock ...................................... 607 755
--------- ---------
Net cash provided by (used in) financing activities ....................... (20,904) 352
--------- ---------
Net increase (decrease) in cash and cash equivalents ...................... (31,192) 47,875
Cash and cash equivalents at beginning of period .......................... 98,409 5,337
--------- ---------
Cash and cash equivalents at end of period ................................ $ 67,217 $ 53,212
========= =========
3
SIX MONTHS ENDED
JUNE 30,
-------------------------
2003 2002
-------- --------
Noncash investing and financing activities:
Net tangible assets acquired, excluding cash ............................. $ 1,013 $ 4,577
Net liabilities assumed .................................................. (1,162) (16,595)
Intangible assets acquired, including goodwill ........................... 707 81,426
Noncash purchase price, including 5,185,650 shares of common stock and
fair market value of stock options issued ............................. -- (68,573)
-------- --------
Cash paid for acquisition, net of cash acquired .......................... $ 558 $ 835
======== ========
Supplemental cash flow information:
Interest paid during the period .......................................... $ 665 $ 660
======== ========
Income taxes paid during the period ...................................... $ 45 $ 223
======== ========
See accompanying notes to the consolidated financial statements.
4
ARRIS GROUP, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE 1. ORGANIZATION AND BASIS OF PRESENTATION
ARRIS Group, Inc., the successor to ANTEC Corporation (together with its
consolidated subsidiaries, except as the context otherwise indicates, "ARRIS" or
the "Company"), is a global communications technology company, headquartered in
Duluth, Georgia. ARRIS specializes in the design, engineering, development, and
distribution of products for hybrid fiber-coax broadband networks. The Company
provides its customers with products and services that enable reliable,
high-speed, two-way broadband transmission of telephony, data, and video
services.
ARRIS operates in one business segment, Communications, providing a range of
customers with network and system products and services for hybrid fiber-coax
networks for the communications industry. This segment accounts for 100% of
consolidated sales, operating profit and identifiable assets of the Company.
ARRIS provides a broad range of products and services to cable system operators
and telecommunication providers. ARRIS is a leading developer,
manufacturer/supplier of telephony, data, construction, rebuild and maintenance
equipment for the broadband communications industry. ARRIS supplies most of the
products required in a broadband communication system, including headend and
customer premises equipment for the provision of telephony and high-speed data
over broadband cable networks, and a wide variety of construction, maintenance
equipment, and supplies.
In 2002, ARRIS sold the Keptel and Actives product lines, which have been
accounted for as discontinued operations in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. As a result, these two product lines and
historical results have been reclassified for all periods presented. See further
discussion in Note 5 of Notes to the Consolidated Financial Statements.
The consolidated financial statements furnished herein reflect all adjustments
(consisting of normal recurring accruals) that are, in the opinion of
management, necessary for a fair presentation of the consolidated financial
statements for the periods shown. Additionally, certain prior period amounts
have been reclassified to conform to the 2003 financial statement presentation.
Interim results of operations are not necessarily indicative of results to be
expected from a twelve-month period. These interim financial statements should
be read in conjunction with the Company's most recently audited consolidated
financial statements and notes thereto included in the Company's Annual Report
on Form 10-K for the Company's year ended December 31, 2002, as filed with the
United States Securities and Exchange Commission.
NOTE 2. IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS
In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities, an Interpretation of Accounting Research Bulletin
No. 51. This Interpretation provides clarification on the consolidation of
certain entities in which equity investors do not have sufficient equity at risk
for the entity to finance its activities without additional subordinated
financial support from other parties. Such entities are defined as variable
interest entities ("VIEs"). This Interpretation requires that VIEs be
consolidated by the entity considered to be the primary beneficiary of the VIE.
The Interpretation is effective immediately for newly created VIEs after January
31, 2003 and effective July 1, 2003 for any VIEs created prior to February 1,
2003. The Company adopted Interpretation No. 46 on July 1, 2003 and is currently
assessing the impact it may have on its financial position or results of
operations.
NOTE 3. STOCK-BASED COMPENSATION
The Company uses the intrinsic value method for valuing its awards of stock
options and restricted stock and records the related compensation expense, if
any, in accordance with APB Opinion No. 25, Accounting for Stock Issued to
Employees and related interpretations. No stock-based employee or director
compensation cost for stock options is reflected in net income, as all options
granted have exercise prices equal to the market value of the underlying common
stock on the date of grant. The Company records compensation expense related to
its restricted
5
stock awards and director stock units. The following table illustrates the
effect on net income and earnings per share as if the Company had applied the
fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based
Compensation, to all stock-based employee compensation.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2003 2002 2003 2002
-------- -------- --------- -----------
Net income (loss), as reported ................... $(27,769) $(40,714) $ (24,323) $ (100,608)
Add: Stock-based employee compensation included
in reported net income, net of taxes ........... 809 395 1,285 886
Deduct: Total stock-based employee compensation
expense determined under fair value based
methods for all awards, net of taxes ........... (6,244) (7,496) (13,055) (14,930)
-------- -------- --------- -----------
Net income (loss), pro forma ..................... $(33,204) $(47,815) $ (36,093) $ (114,652)
======== ======== ========= ===========
Net income (loss) per common share:
Basic - as reported ............................ $ (0.37) $ (0.50) $ (0.31) $ (1.24)
======== ======== ========= ===========
Basic - pro forma .............................. $ (0.44) $ (0.58) $ (0.46) $ (1.41)
======== ======== ========= ===========
Diluted - as reported .......................... $ (0.37) $ (0.50) $ (0.31) $ (1.24)
======== ======== ========= ===========
Diluted - pro forma ............................ $ (0.44) $ (0.58) $ (0.46) $ (1.41)
======== ======== ========= ===========
NOTE 4. GUARANTEES
Warranty
ARRIS provides for the estimated cost of product warranties at the time revenue
is recognized. While the Company engages in extensive product quality programs
and processes, including actively monitoring and evaluating the quality of its
suppliers, the estimated warranty obligation is affected by ongoing product
failure rates, material usage and service delivery costs incurred in correcting
a product failure as well as specific product class failures outside of ARRIS'
baseline experience. If actual product failure rates, material usage or service
delivery costs differ from estimates, revisions to the estimated warranty
liability would be required. ARRIS evaluates its warranty obligations on a
product line basis.
Information regarding the changes in ARRIS' aggregate product warranty
liabilities was as follows for the six-month period ended June 30, 2003 (in
thousands):
Balance at December 31, 2002 ......................................... $ 6,031
Accruals related to warranties (including changes in estimates)....... 1,224
Settlements made (in cash or in kind) ................................ (734)
-------
Balance at June 30, 2003 ............................................. $ 6,521
=======
NOTE 5. DISCONTINUED OPERATIONS
Upon evaluation and review of the ARRIS product portfolio, the Company concluded
that the Keptel product line was not core to its long-term strategy and thus
sold the product line on April 24, 2002. Keptel designed and marketed network
interface systems and fiber optic cable management products primarily for
traditional residential and commercial telecommunications applications. The
transaction generated cash proceeds of $30.0 million. Additionally, ARRIS
retained a potential earn-out over a twenty-four month period based on the
achievement of sales targets. The transaction also included a distribution
agreement whereby the Company will continue to distribute Keptel products until
April 2005. Total assets of approximately $31.1 million were disposed of, which
included inventory, fixed assets, intangibles (formerly classified as goodwill),
and other assets. ARRIS incurred approximately $5.0 million of related closure
costs, including severance, vendor liabilities, outside consulting fees, and
other shutdown expenses. During 2002, a net loss of $6.2 million was recorded in
connection with the sale of the Keptel product line. As of June 30, 2003,
approximately $0.9 million related to outside consulting fees remained in an
accrual to be paid. ARRIS expects to complete the remaining payments by the end
of 2003.
6
Upon continued review of ARRIS' product portfolio, the Company sold its Actives
product line on November 21, 2002, for net proceeds of $31.8 million. Total
assets of approximately $20.3 million were disposed of, which included
inventory, fixed assets, and other assets attributable to the product line.
Additionally, ARRIS incurred approximately $7.3 million of related closure
costs, including severance, vendor liabilities, professional fees, and other
shutdown expenses. In connection with the sale, the Company recognized a gain of
approximately $2.2 million in 2002. During the second quarter of 2003, the
Company has reduced its accrual for vendor liabilities by $2.0 million as a
result of settling certain vendor liabilities for amounts less than originally
anticipated. With this adjustment in the second quarter, the Company has now
recognized a cumulative gain of approximately $4.2 million related to the
transaction. As of June 30, 2003, approximately $0.1 million related to
severance, $2.9 million related to vendor liabilities, and $1.0 million related
to other shutdown expenses remained in an accrual to be paid. ARRIS expects to
complete the remaining payments by the end of 2003.
The Company's Keptel and Actives product lines, as a whole, constituted the
majority of its transmission, optical and outside plant product category and
qualified as discontinued operations in accordance with SFAS No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. Accordingly, the results of
these product lines have been reclassified to discontinued operations for all
periods presented. The remaining product lines within the transmission, optical
and outside plant product category have been reclassified to the supplies and
services product category.
Revenues from discontinued operations were $17.6 million and $36.8 for the three
and six months ended June 30, 2002, respectively. The net loss from discontinued
operations, net of taxes, for the three and six months ending June 30, 2002 was
$(13.7) million and $(19.1) million, respectively. During 2002, the Company
recorded a net loss on these disposals of $(4.0) million. During 2003, the
Company recorded a gain of $2.0 million related to the Actives adjustment
described above, resulting in a cumulative net loss of $(2.0) million related to
the disposal of discontinued operations. This $2.0 million gain on disposal of
discontinued operations is offset by an approximately $2.0 million increase in
the accrual for restructuring liabilities.
NOTE 6. RESTRUCTURING AND OTHER CHARGES
On October 30, 2002, the Company announced that it would close its office in
Andover, Massachusetts, which was primarily a product development and repair
facility. The Company decided to close the office in order to reduce operating
costs through the consolidation of its facilities. The closure affected
approximately 75 employees and will be substantially completed by the end of the
third quarter 2003. In connection with these actions, the Company recorded a
charge of approximately $7.1 million in the fourth quarter of 2002. Included in
this restructuring charge was approximately $2.1 million related to remaining
lease payments, $2.7 million of fixed asset write-offs, $2.1 million of
severance, and $0.2 million of other costs associated with these actions. As of
June 30, 2003, approximately $1.6 million related to lease commitments, $0.5
million related to severance, and $0.2 million related to other costs remained
in the restructuring accrual to be paid. ARRIS expects to complete the remaining
payments by the second quarter of 2006 (end of lease).
In the fourth quarter of 2001, ARRIS closed a research and development facility
in Raleigh, North Carolina and recorded a $4.0 million charge related to
severance and other costs associated with closing that facility. This charge
included termination expenses of $2.2 million related to the involuntary
dismissal of 48 employees, primarily engaged in engineering functions at that
facility. Also included in the $4.0 million charge was $0.7 million related to
lease commitments, $0.2 million related to the impairment of fixed assets, and
$0.9 million related to other shutdown expenses. In June 2003, ARRIS took
advantage of an early buyout clause in connection with the remaining lease
payments, which reduced the Company's original estimate of restructuring expense
by approximately $0.4 million. As of June 30, 2003, the Company has no remaining
liabilities related to this closure.
In the third quarter of 2001, the Company announced a restructuring plan to
outsource the functions of most of its manufacturing facilities. This decision
to reorganize was due in part to the ongoing weakness in industry spending
patterns. The plan entailed the implementation of an expanded manufacturing
outsourcing strategy and the related closure of the four factories located in El
Paso, Texas and Juarez, Mexico. As a result, the Company recorded restructuring
and impairment charges of $66.2 million, of which approximately $50.1 million
relates to and is classified in discontinued operations. Included in these
charges was approximately $33.7 million related to the
7
write-down of inventories, and remaining warranty and purchase order
commitments of which approximately $8.6 million was reflected in cost of goods
sold and $25.1 million was reflected in discontinued operations. Additional
charges incurred were approximately $5.7 million related to severance and
associated personnel costs, $5.9 million related to the impairment of goodwill
due to the sale of the power product lines, $14.8 million related to the
impairment of fixed assets, and approximately $6.1 million related to lease
terminations of factories and office space and other shutdown expenses. Of these
charges, approximately $7.5 million is reflected in restructuring expense and
$25.0 million is reflected in discontinued operations. The personnel-related
costs included termination expenses for the involuntary dismissal of 807
employees, primarily engaged in production and assembly functions performed at
the facilities. ARRIS offered terminated employees separation amounts in
accordance with the Company's severance policy and provided the employees with
specific separation dates. Due to unforeseen delays in exiting the facility
after the shutdown, the Company increased its reserve by approximately $2.4
million and $2.0 million during the fourth quarter 2002 and the second quarter
2003, respectively, to discontinued operations. As of June 30, 2003,
approximately $0.1 million related to severance and associated personnel costs,
and $2.4 million related to lease terminations of factories and office space and
other shutdown costs remained in an accrual to be paid. ARRIS expects to
complete the remaining payments by the end of the first quarter 2004.
NOTE 7. INVENTORIES
Inventories are stated at the lower of average, approximating first-in,
first-out, cost or market. The components of inventory are as follows (in
thousands):
JUNE 30, DECEMBER 31,
2003 2002
-------- ------------
(UNAUDITED)
Raw material ..................................... $ 1,897 $ 3,941
Finished goods ................................... 104,083 100,262
-------- --------
Total inventories .............................. $105,980 $104,203
======== ========
NOTE 8. PROPERTY, PLANT AND EQUIPMENT NET
Property, plant and equipment, at cost, consists of the following (in
thousands):
JUNE 30, DECEMBER 31,
2003 2002
-------- -----------
(UNAUDITED)
Land ............................................. $ 1,822 $ 1,822
Building and leasehold improvements .............. 7,088 7,295
Machinery and equipment .......................... 65,348 70,233
-------- --------
74,258 79,350
Less: Accumulated depreciation ................... (46,165) (44,810)
-------- --------
Total property, plant and equipment, net ....... $ 28,093 $ 34,540
======== ========
NOTE 9. GOODWILL AND INTANGIBLE ASSETS
ARRIS adopted SFAS No. 142, Goodwill and Other Intangible Assets, on January 1,
2002. Upon adoption of SFAS No. 142, the Company recorded a goodwill impairment
loss of approximately $58.0 million, primarily related to the Keptel product
line, based upon management's analysis including an independent valuation. The
resulting impairment loss has been recorded as a cumulative effect of a change
in accounting principle on the accompanying Consolidated Statements of
Operations for the six months ended June 30, 2002. The valuation was 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. The
Company's remaining goodwill was reviewed in the fourth quarter of 2002, and
based upon management's analysis including an independent valuation, an
impairment charge of $70.2 million was recorded with respect to its supplies and
services product category.
8
The changes in the carrying amount of goodwill for the year ended December 31,
2002 and for the six months ended June 30, 2003 are as follows (in thousands):
Balance as of December 31, 2001 ...................................... $ 259,062
Transitional impairment charge ....................................... (57,960)
Purchase price allocation adjustment - Arris Interactive L.L.C. ...... 33
Goodwill in connection with Cadant, Inc. acquisition ................. 26,339
Transferred to intangible asset upon adoption of SFAS No. 142 ........ (6,000)
Goodwill impairment charge, October 1, 2002 .......................... (70,209)
---------
Balance as of December 31, 2002 ...................................... $ 151,265
Purchase price allocation adjustments - Cadant, Inc. (see Note 14) ... (696)
---------
Balance as of June 30, 2003 .......................................... $ 150,569
=========
The gross carrying amount and accumulated amortization of the Company's
intangible assets, other than goodwill, as of June 30, 2003 and December 31,
2002 are as follows (in thousands):
JUNE 30, 2003 DECEMBER 31, 2002
-------------------------------------- --------------------------------------
GROSS ACCUMULATED NET BOOK GROSS ACCUMULATED NET BOOK
AMOUNT AMORTIZATION VALUE AMOUNT AMORTIZATION VALUE
-------- ------------ -------- -------- ------------ --------
Existing technology acquired:
Arris Interactive L.L.C. ..... $ 51,500 $(32,761) $ 18,739 $ 51,500 $(24,178) $ 27,322
Cadant, Inc. ................. 53,000 (26,161) 26,839 53,000 (17,328) 35,672
Atoga Systems ................ 683 (56) 627 -- -- --
Pension asset ..................... 1,849 -- 1,849 1,849 -- 1,849
-------- -------- -------- -------- -------- --------
Total ........................ $107,032 $(58,978) $ 48,054 $106,349 $(41,506) $ 64,843
======== ======== ======== ======== ======== ========
Amortization expense recorded on the intangible assets listed in the above table
for the three months ended June 30, 2003 and 2002 was $8.8 million and $8.7
million, respectively. Amortization expense for the six months ended June 30,
2003 and 2002 was $17.5 million and $17.1 million, respectively. The estimated
remaining amortization expense is as follows (in thousands):
2003................ $ 17,531
2004................ $ 28,050
2005................ $ 567
2006................ $ 57
2007................ $ --
NOTE 10. LONG TERM DEBT, CAPITAL LEASE OBLIGATIONS AND MEMBERSHIP INTEREST
Long term debt, capital lease obligations and membership interest consist of the
following (in thousands):
JUNE 30, DECEMBER 31,
2003 2002
----------- ------------
(UNAUDITED)
Capital lease obligations $ 1,310 $ 1,278
Equipment loan 184 --
Membership interest - Nortel Networks -- 114,518
4.5% Convertible Subordinated Notes due 2003 -- 23,887
4.5% Convertible Subordinated Notes due 2008 125,000 --
--------- ---------
Total debt, capital lease obligations and membership interest 126,494 139,683
Less current portion (1,355) (25,007)
--------- ---------
Total long term debt, capital lease obligations and membership interest $ 125,139 $ 114,676
========= =========
On March 18, 2003, the Company issued $125.0 million of 4 1/2% Convertible
Subordinated Notes due 2008 ("Notes due 2008"). The Notes due 2008 are
convertible, at the option of the holder, at any time prior to maturity, into
the
9
Company's common stock at a conversion price of $5.00 per share, subject to
adjustment. The Notes due 2008 will pay interest semi-annually, based on an
annual rate of 4 1/2%, on March 15 and September 15 of each year, commencing
September 15, 2003. The Company used approximately $88.4 million of the proceeds
from the issuance, including the reduction in the forgiveness of the Class B
membership interest, to redeem the Class B membership interest in Arris
Interactive held by Nortel Networks resulting in a gain of approximately $28.5
million, recorded in operations in accordance with SFAS No. 145, Rescission of
FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and
Technical Corrections. The Company used approximately $28.0 million of the
proceeds of the issuance to repurchase and retire 8 million shares of its common
stock held by Nortel Networks at a discount. The Company expects to use the
remaining proceeds for general corporate purposes. As of June 30, 2003, there
were $125.0 million of the Notes due 2008 outstanding.
In 1998, the Company issued $115.0 million of 4 1/2% Convertible Subordinated
Notes due May 15, 2003 ("Notes due 2003"). The Notes due 2003 were convertible,
at the option of the holder, at any time prior to maturity, into the Company's
common stock at a conversion price of $24.00 per share. In 2002, ARRIS exchanged
1,593,789 shares of its common stock for approximately $15.4 million of the
Notes due 2003. Additionally, the Company redeemed $23.9 million and $75.7
million of the Notes due 2003 in 2003 and 2002, respectively, using cash. As of
May 15, 2003, all of the Notes due 2003 were redeemed.
As amended, the Company has in place an asset-based revolving credit facility
(the "Credit Facility") permitting the Company to borrow up to $115.0 million
(which can be increased under certain conditions by up to $25.0 million), based
upon availability under a borrowing base calculation. In general, the borrowing
base is limited to 85% of net eligible receivables (with a cap of $5.0 million
in relation to foreign receivables), subject to a reserve of $10.0 million. In
addition, upon obtaining appropriate asset appraisals the Company may include in
the borrowing base calculation 80% of the orderly liquidation value of net
eligible inventory (not to exceed $60.0 million). The Credit Facility contains
traditional financial covenants, including fixed charge coverage, senior debt
leverage, minimum net worth, and minimum inventory turns ratios. The facility is
secured by substantially all of the Company's assets. The Credit Facility has a
maturity date of August 3, 2004. The commitment fee on unused borrowings is
0.75%. The Credit Facility was amended in January 2003 to provide that the
minimum net worth covenant applied only to the period prior to December 31,
2002.
In March 2003, ARRIS amended its credit facility to permit the Company to issue
up to $125.0 million of the Notes due 2008, to use the proceeds of such notes as
described above. The amendment also reduced the revolving loan commitments by
$10.0 million to $115.0 million. As of June 30, 2003, ARRIS had no borrowings
outstanding under its credit facility and approximately $7.6 million outstanding
under letters of credit. The Company had approximately $38.8 million of
available capacity.
In connection with the acquisition of Arris Interactive in August 2001, Nortel
Networks exchanged its remaining ownership interest in Arris Interactive for 37
million shares of ARRIS common stock and a subordinated redeemable Class B
membership interest in Arris Interactive with a face amount of $100.0 million.
The Class B membership interest earned an accreting non-cash return of 10% per
annum, compounded annually, and was redeemable in approximately four quarterly
installments commencing February 3, 2002, provided that certain availability and
other tests are met under the Company's Credit Facility. Those tests were not
met. In June 2002, ARRIS entered into an option agreement with Nortel Networks
that permitted ARRIS to redeem the Class B membership interest in Arris
Interactive at a discount of 21% prior to June 30, 2003. To further induce the
Company to redeem the Class B membership interest, Nortel Networks offered to
forgive approximately $5.9 million of the amount owed Nortel Networks if ARRIS
redeemed it prior to March 31, 2003. The Company used approximately $88.4
million of the proceeds, including the reduction in the forgiveness of the Class
B membership interest, of Notes due 2008 to redeem the Class B membership
interest at a discount resulting in a gain of approximately $28.5 million,
recorded in operations in accordance with SFAS No. 145, Rescission of FASB
Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections.
In conjunction with the acquisition of Cadant, Inc. and Atoga Systems, the
Company assumed capital lease obligations and an equipment loan related to
machinery and equipment. The leases require future rental payments until 2005.
The balance of the capital lease obligations and equipment loan at June 30, 2003
was approximately $1.3 million and $0.2 million, respectively.
10
ARRIS has not paid cash dividends on its common stock since its inception. The
Company's credit agreement contains covenants that prohibit it from paying such
dividends. In 2002, to implement its shareholder rights plan, the Company's
board of directors declared a dividend consisting of one right for each share of
its common stock outstanding. Each right represents the right to purchase one
one-thousandth of a share of its Series A Participating Preferred Stock and
becomes exercisable only if a person or group acquires beneficial ownership of
15% or more of its common stock or announces a tender or exchange offer for 15%
or more of its common stock or under other similar circumstances.
NOTE 11. COMPREHENSIVE INCOME (LOSS)
Total comprehensive income (loss) for the three-month periods ended June 30,
2003 and 2002 was $(28.2) million and $(41.1) million, respectively. Total
comprehensive income (loss) for the six-month periods ended June 30, 2003 and
2002 was $(24.5) million and $(101.3) million, respectively. Such comprehensive
loss, which is recorded as a separate component of stockholders' equity, is
related to cumulative translation adjustments and unrealized holding gains
(losses) on marketable securities.
NOTE 12. SALES INFORMATION
A significant portion of ARRIS' revenue is derived from sales to Cox
Communications and Comcast (including AT&T Broadband). Sales to these two
customers for the three and six-month periods ended June 30, 2003 and 2002 are
set forth below (in thousands):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
2003 2002 2003 2002
--------- --------- --------- ----------
Comcast (including AT&T Broadband) ..... $ 36,099 $ 77,669 $ 59,903 $ 125,693
% of sales ............................. 35.5% 44.0% 31.0% 36.0%
Cox Communications ..................... $ 19,864 $ 20,312 $ 44,986 $ 52,979
% of sales ............................. 19.5% 11.5% 23.3% 15.2%
ARRIS operates globally and offers products and services that are sold to cable
system operators and telecommunications providers. ARRIS' products and services
are focused in two product categories, Broadband and Supplies & Services,
instead of the previous three categories. As a result of the sale of the
Company's Keptel and Actives product lines in 2002, revenues from the remaining
product lines within the former Transmission, Optical, and Outside Plant product
category are now reported with the Supplies & Services product category. All
prior period revenues have been aggregated to conform to the new product
categories. Consolidated revenues by principal products category for the three
and six-month periods ended June 30, 2003 and 2002 were as follows (in
thousands):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
2003 2002 2003 2002
--------- --------- --------- ----------
PRODUCT CATEGORY
Broadband ........................... $ 66,526 $124,120 $128,182 $238,302
Supplies & Services ................. 35,184 52,382 64,871 110,597
-------- -------- -------- --------
Total sales .................. $101,710 $176,502 $193,053 $348,899
======== ======== ======== ========
11
The Company sells its products primarily in the United States with its
international revenue being generated from Asia Pacific, Europe, Latin America
and Canada. The Asia Pacific market primarily includes China, Hong Kong, Japan,
Korea, and Singapore. The European market primarily includes Austria, Germany,
France, Netherlands, Poland, Portugal, Romania, Spain, and Switzerland. The
Latin American market primarily includes Argentina, the Bahamas, Chile,
Colombia, Mexico, and Puerto Rico. Sales to international customers were
approximately 17.5%, and 24.2% of total sales for the quarters ended June 30,
2003 and 2002, respectively. Sales for the three and six-month periods ended
June 30, 2003 and 2002 are as follows (in thousands):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- --------------------------
2003 2002 2003 2002
-------- -------- -------- --------
INTERNATIONAL REGION
Asia Pacific ............................... $ 9,901 $ 16,611 $ 15,269 $ 27,752
Europe ..................................... 3,785 16,514 12,853 44,826
Latin America .............................. 2,198 6,574 3,530 9,473
Canada ..................................... 1,888 3,086 4,836 4,995
-------- -------- -------- --------
Total international sales .............. 17,772 42,785 36,488 87,046
Total domestic sales ................... 83,938 133,717 156,565 261,853
-------- -------- -------- --------
Total sales .......................... $101,710 $176,502 $193,053 $348,899
======== ======== ======== ========
Total identifiable international assets were immaterial.
NOTE 13. EARNINGS PER SHARE
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share ("EPS") computations for the periods
indicated (in thousands except per share data):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- --------------------------
2003 2002 2003 2002
--------- -------- -------- --------
Basic:
Income (loss) from continuing operations ....... $ (27,769) $ (27,032) $ (24,323) $ (23,589)
Income (loss) from discontinued operations ..... -- (13,682) -- (19,059)
Cumulative effect of an accounting change ...... -- -- -- (57,960)
--------- --------- --------- ---------
Net income (loss) ............................ $ (27,769) $ (40,714) $ (24,323) $(100,608)
========= ========= ========= =========
Weighted average shares outstanding .......... 74,992 82,236 78,509 81,252
========= ========= ========= =========
Basic earnings (loss) per share .............. $ (0.37) $ (0.50) $ (0.31) $ (1.24)
========= ========= ========= =========
Diluted:
Income (loss) from continuing operations ....... $ (27,769) $ (27,032) $ (24,323) $ (23,589)
Income (loss) from discontinued operations ..... -- (13,682) -- (19,059)
Cumulative effect of an accounting change ...... -- -- -- (57,960)
--------- --------- --------- ---------
Net income (loss) ............................ $ (27,769) $ (40,714) $ (24,323) $(100,608)
========= ========= ========= =========
Weighted average shares outstanding .......... 74,992 82,236 78,509 81,252
Net effect of dilutive stock options ......... -- -- -- --
--------- --------- --------- ---------
Total ................................... 74,992 82,236 78,509 81,252
========= ========= ========= =========
Diluted earnings (loss) per share ....... $ (0.37) $ (0.50) $ (0.31) $ (1.24)
========= ========= ========= =========
The 4 1/2% convertible subordinated notes due 2003 and 2008 were antidilutive
for all periods presented. The effects of the options and warrants were not
presented for all periods as the Company incurred net losses during these
periods and inclusion of these securities would be antidilutive.
12
NOTE 14. BUSINESS ACQUISITIONS
ACQUISITION OF ATOGA SYSTEMS
On March 21, 2003, ARRIS purchased the business and certain assets of Atoga
Systems, a Fremont, California-based developer of optical transport systems for
metropolitan area networks. The Company decided to undertake this transaction
because it would expand the Company's existing broadband product portfolio and
is anticipated to have a positive impact on future results of the Company. Under
the terms of the agreement, ARRIS obtained certain inventory, fixed assets, and
existing technology in exchange for approximately $0.4 million of cash and the
assumption of certain lease obligations. Further, the Company retained 28
employees and issued a total of 500,000 shares of restricted stock to those
employees.
The following is a summary of the preliminary purchase price allocation to
record ARRIS' purchase price of the assets and certain liabilities of Atoga
Systems. The purchase price was equal to the net tangible and intangible assets
acquired. The final allocation of the purchase price will be determined after
completion of thorough analyses to identify and determine the fair values of
Atoga Systems' tangible and identifiable intangible assets and liabilities as of
the date the transaction was completed.
(IN THOUSANDS)
Cash paid to Atoga Systems ................................. $ 434
Acquisition costs (legal fees) ............................. 100
Assumption of certain liabilities of Atoga Systems ......... 1,162
------
Adjusted preliminary purchase price ...................... $1,696
======
Allocation of purchase price:
Net tangible assets acquired ............................. $1,013
Existing technology (to be amortized over 3 years) ....... 683
------
Total allocated preliminary purchase price ............... $1,696
======
ACQUISITION OF CADANT, INC.
On January 8, 2002, ARRIS completed the acquisition of all of the assets and
business of Cadant, Inc., a privately held designer and manufacturer of next
generation Cable Modem Termination Systems ("CMTS"). The Company acquired Cadant
because it provided significant broadband product and technology extensions and
would have a positive impact on future results of the Company. As a part of this
transaction:
- ARRIS issued 5,250,000 shares of ARRIS common stock for the
purchase of substantially all of Cadant's assets and certain
liabilities.
- During the second quarter of 2003, 64,350 shares of ARRIS
common stock were returned to ARRIS and retired. This
transaction was pursuant to the terms of a settlement
agreement between ARRIS and the trustee in the liquidation of
CDX Corporation (formerly know as Cadant).
- ARRIS agreed to pay up to 2.0 million shares based upon future
sales of the CMTS product through January 8, 2003. These
targets were not met as of January 8, 2003, and therefore, no
further shares were issued.
13
The following is a summary of the purchase price allocation to record ARRIS'
purchase price of the assets and certain liabilities of Cadant, Inc. for
5,250,000 shares of ARRIS Group, Inc. common stock based on the average closing
price of ARRIS' common stock for 5 days prior and 5 days after the date of the
transaction as quoted on the Nasdaq National Market System. The excess of the
purchase price over the fair value of the net tangible and intangible assets
acquired has been allocated to goodwill.
(IN THOUSANDS)
5,250,000 shares of ARRIS Group, Inc.'s $0.01 par value
common stock at $10.631 per common share ....................... $ 55,813
64,350 returned shares of ARRIS Group, Inc.'s $0.01 par value
common stock at $10.631 per common share ....................... (684)
Acquisition costs (banking fees, legal and accounting fees,
printing costs) ................................................ 898
Fair value of stock options to Cadant, Inc. employees ............ 12,760
Assumption of certain liabilities of Cadant, Inc. ................ 14,919
--------
Adjusted purchase price ........................................ $ 83,706
========
Allocation of Purchase Price:
Net tangible assets acquired ................................... $ 5,063
Existing technology (to be amortized over 3 years) ............. 53,000
Goodwill (not deductible for income tax purposes) .............. 25,643
--------
Total allocated purchase price ................................. $ 83,706
========
SUPPLEMENTAL PRO FORMA INFORMATION
Presented below is summary unaudited pro forma combined financial information
for the Company, Atoga Systems, and Cadant, Inc. to give effect to the
transactions. This summary unaudited pro forma combined financial information is
derived from the historical financial statements of the Company, Atoga Systems,
and Cadant, Inc. This information assumes the transaction was consummated at the
beginning of the applicable period. This information is presented for
illustrative purposes only and does not purport to represent what the financial
position or results of operations of the Company, Atoga Systems, and Cadant,
Inc., or the combined entity would actually have been had the transaction
occurred at the applicable dates, or to project the Company's, Atoga Systems',
and Cadant, Inc.'s, or the combined entity's results of operations for any
future period or date. The actual results of Atoga Systems are included in the
Company's operations from March 21, 2003 to June 30, 2003. The actual results of
Cadant, Inc. are included in the Company's operations from January 8, 2002 to
June 30, 2003.
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2003 2002 2003 2002
--------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)
Net sales ........................................... $ 101,710 $ 176,502 $ 193,053 $ 348,899
Gross profit ........................................ 27,185 60,475 51,929 118,706
Operating income (loss) ............................. (25,260) (20,533) (48,313) (23,124)
Income (loss) before income taxes ................... (27,769) (31,153) (25,930) (39,864)
Income (loss) from continuing operations ............ (27,769) (31,153) (25,930) (33,064)
Income (loss) from discontinued operations .......... -- (13,682) -- (19,059)
Net income (loss) before cumulative effect of an
accounting change ................................. (27,769) (44,835) (25,930) (52,123)
Net income (loss) ................................... $ (27,769) $ (44,835) $ (25,930) $(110,083)
========= ========= ========= =========
Net income (loss) per common share:
Basic and diluted ................................. $ (0.37) $ (0.55) $ (0.33) $ (1.35)
========= ========= ========= =========
Weighted average common shares:
Basic and diluted ................................. 74,992 82,236 78,509 81,484
========= ========= ========= =========
14
The following table represents the amount assigned to each major asset and
liability caption of Atoga Systems as of March 21, 2003 and Cadant, Inc. as of
January 8, 2002, as adjusted:
AS OF ACQUISITION DATE
(IN THOUSANDS)
----------------------------
ATOGA SYSTEMS CADANT, INC.
------------- ------------
Total current assets....................... $ 330 $ 782
Property, plant and equipment, net......... $ 683 $ 4,281
Goodwill................................... $ -- $ 25,643
Intangible assets ......................... $ 683 $ 53,000
Total assets............................... $ 1,696 $ 83,706
Total current and long-term liabilities ... $ 1,696 $ 14,919
Total liabilities and membership interest.. $ 1,696 $ 14,919
NOTE 15. LEGAL PROCEEDINGS
ARRIS is a party to three lawsuits brought by or against John Mezzalingua
Associates, Inc. d/b/a PPC, including a suit initiated by Mezzalingua in late
July 2003. The Company intends to vigorously pursue all three lawsuits against
Mezzalingua. Additionally, ARRIS is a defendant in a case with Metal Press, in
which Metal Press alleges that ARRIS breached a requirements contract for
certain products. Discovery is substantially complete, and the Company is in the
process of preparing a motion for summary judgment. ARRIS does not believe that
Metal Press' claims are meritorious and intends to vigorously contest them.
NOTE 16. SUBSEQUENT EVENTS
OPTION EXCHANGE PROGRAM
On June 27, 2003, the Company offered to all eligible employees the opportunity
to exchange certain outstanding stock options for restricted shares of ARRIS
common stock. The Company's Board of Directors and its eight most highly
compensated executive officers during 2002 were not eligible to participate in
the offer. The offer expired on July 25, 2003. On July 28, 2003, ARRIS cancelled
options to purchase approximately 4.7 million shares of common stock and granted
approximately 1.5 million restricted shares in exchange. Employees tendered
approximately 78% of the options eligible to be exchanged under the program. In
accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees,
the Company will record a fixed compensation expense equal to the fair market
value of the shares of restricted stock granted through the offer. This cost
will be amortized over the four-year vesting period for the restricted shares,
and equates to a charge of approximately $0.5 million per quarter. All eligible
options that were not surrendered for exchange are subject to variable
accounting. This variable accounting charge will fluctuate in accordance with
the market price of the ARRIS common stock until such stock options are
exercised, forfeited, or expire unexercised.
COM21
On July 22, 2003, the Company announced that it had entered into a definitive
agreement for the acquisition of certain cable modem termination system (CMTS)
related assets of Com21, including the stock of its Irish subsidiary, for a
purchase price of approximately $2.8 million, subject to the approval of the
U.S. Bankruptcy court and certain other closing conditions. ARRIS will retain
approximately 45 Com21 employees and will issue options to purchase a total of
approximately 90 thousand shares of common stock to those employees. The newly
acquired product line, along with the existing product offerings of ARRIS, will
allow the Company to reach smaller scale cable systems domestically and
internationally. The transaction is expected to be completed during the third
quarter of 2003.
REGISTRATION OF NORTEL SHARES
On July 25, 2003, the Company filed a registration statement with the Securities
and Exchange Commission on Form S-3 related to the registration for resale of 14
million shares of ARRIS common stock held by Nortel Networks. Pursuant to this
registration statement, Nortel Networks, over the next two years, may sell up to
14 million shares of the Company's common stock in one or more offerings.
DIVESTITURE OF ESP
In June 2003, ARRIS entered into a non-binding letter of intent agreement with
an undisclosed buyer to sell its ESP consulting services. During the three and
six-month periods ended June 30, 2003, the ESP product line recorded revenue of
approximately $0.6 million and $1.1 million, respectively, classified in
supplies and services revenue. The ESP transaction is expected to be complete by
the end of the third quarter 2003. Under the terms of the letter of intent, the
Company will recognize a loss on sale in the range of $1.0 million to $2.0
million.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Set forth below is a description of how our business performed during the three
and six-month periods ending June 30, 2003 as compared to the same periods in
2002. During the past two years, we have significantly changed our business
through acquisitions, product line rationalizations and cost reduction actions,
allowing us to focus on our long-term business strategy. As a result of our
acquisitions and dispositions, our business has changed significantly and our
historical results of operations are not as indicative of future results of
operations as they otherwise might suggest.
CAPITAL STRUCTURE ACTIONS
Notes due 2008. On March 18, 2003, we issued $125.0 million of 4 1/2%
convertible subordinated notes due March 15, 2008. These notes are convertible
at the option of the holder into our common stock at $5.00 per share, subject to
adjustment. We are entitled to call the notes for redemption at any time,
subject to our making a "make whole" payment if we call them for redemption
prior to March 15, 2006. In addition, we are required to repurchase the notes in
the event of a "change in control."
We used approximately $88.4 million of the proceeds, including the reduction in
the forgiveness of the Class B membership interest, of the notes issuance to
redeem the entire Class B membership interest in Arris Interactive held by
Nortel Networks. We used approximately $28.0 million of the proceeds of the
issuance to repurchase and retire 8 million shares of our common stock held by
Nortel Networks at a discount. We will use the remaining proceeds for general
corporate purposes.
Credit Facility. On several occasions during 2002 we modified our credit
facility in order to allow us to use existing cash reserves and proceeds of
asset sales to purchase or redeem our outstanding 4 1/2% convertible
subordinated notes due 2003. These modifications imposed certain conditions on
the use of such cash to purchase or redeem additional notes. On March 11, 2003,
we amended the credit facility to permit us to issue up to $125.0 million of new
convertible subordinated notes due 2008 and to use the proceeds of the new notes
to redeem the Class B membership interest in Arris Interactive held by Nortel
Networks and to purchase shares of our common stock held by Nortel Networks,
subject to certain limitations. The amendment also reduced the revolving loan
commitments to $115.0 million.
Membership Interest. In connection with the acquisition of Arris Interactive in
August 2001, Nortel Networks exchanged its remaining ownership interest in Arris
Interactive for 37 million shares of our common stock and a subordinated
redeemable Class B membership interest in Arris Interactive with a face amount
of $100.0 million. The Class B membership interest earned an accreting non-cash
return of 10% per annum, compounded annually, and was redeemable in
approximately four quarterly installments commencing February 3, 2002, provided
that certain availability and other tests are met under our revolving credit
facility. Those tests were not met. The balance of the Class B membership
interest as of December 31, 2002 was approximately $114.5 million. In June 2002,
we entered into an option agreement with Nortel Networks that permitted us to
redeem the Class B membership interest in Arris Interactive at a discount of 21%
prior to June 30, 2003. To further induce us to redeem the Class B membership
interest, Nortel Networks offered to forgive an additional $5.9 million of the
amount owed Nortel Networks if we redeemed it prior to March 31, 2003. We used
approximately $88.4 million of the proceeds of the March 2003 convertible note
offering to redeem the entire Class B membership interest.
Notes due 2003. In May 1998, we issued $115.0 million of 4 1/2% convertible
subordinated notes due May 15, 2003. In 2002, we retired $91.1 million of these
notes through cash repurchases and exchanges for our common stock. During the
first quarter 2003, we repurchased an additional $12.4 million of the notes, and
repurchased the remaining $11.5 million of the notes during the second quarter
2003 on the maturity date on May 15, 2003.
Common Stock. Of the 37 million shares of our common stock that Nortel Networks
received in 2001, it sold 15 million in a registered public offering in June
2002. In order to reduce its holdings further, in March 2003 Nortel Networks
granted us an option to purchase up to 16 million shares at a 10% discount to
market, subject to a
16
minimum purchase price of $3.50 per share for 8 million shares and $4.00 per
share for the remainder. In addition, to the extent that we purchased shares at
a price of less than $4.00 per share, we were obligated to return to Nortel
Networks a portion of the return that was forgiven with respect to the Class B
membership interest, up to a maximum of $2.0 million. Pursuant to this option,
on March 24, 2003, we purchased 8 million shares for an aggregate purchase price
of $28.0 million. Contemporaneously with this transaction, we paid Nortel
Networks $2.0 million, which represented the reduction in the forgiveness of the
Class B membership interest. We did not exercise the option to repurchase the
remaining 8 million shares offered by Nortel Networks, which expired on June 30,
2003. On July 25, 2003, we filed a registration statement with the Securities
and Exchange Commission on Form S-3 related to the registration for resale of
the remaining 14 million shares of ARRIS common stock held by Nortel Networks.
Pursuant to this registration statement, Nortel Networks, over the next two
years, may sell up to 14 million shares of the Company's common stock in one or
more offerings.
PRODUCT PORTFOLIO ACTIONS
Acquisition of Com21. On July 22, 2003, we announced that we had entered into a
definitive agreement for the acquisition of certain cable modem termination
systems (CMTS) related assets of Com21, including the stock of its Irish
subsidiary, for a purchase price of approximately $2.8 million, subject to the
approval of the U.S. Bankruptcy court and certain other closing conditions.
ARRIS will retain approximately 45 Com21 employees and will issue options to
purchase a total of approximately 90 thousand shares of common stock to those
employees. The newly acquired product line, along with our existing product
offerings, will allow us to reach smaller scale systems domestically and
internationally. The transaction is expected to be complete during the third
quarter of 2003. We anticipate the transaction to be slightly dilutive to our
earnings per share during the second half of 2003 and accretive in 2004.
Acquisition of Atoga Systems. On March 21, 2003, we purchased the business and
certain assets of Atoga Systems, a Fremont, California-based developer of
optical transport systems for metropolitan area networks. Under the terms of the
agreement, we obtained certain inventory, fixed assets, and intellectual
property in consideration for approximately $0.4 million of cash and the
assumption of certain obligations. Further, we retained 28 employees and issued
a total of 500,000 shares of restricted stock to those employees. We anticipate
the transaction to be slightly dilutive to our earnings per share in 2003.
Acquisition of Cadant, Inc. On January 8, 2002, we acquired substantially all of
the assets of Cadant, Inc., a designer and manufacturer of next generation CMTS.
Under the terms of the transaction, we issued 5.25 million shares of our common
stock and assumed approximately $14.9 million in liabilities in exchange for the
assets. During the second quarter of 2003, 64,350 shares of ARRIS common stock
were returned to ARRIS and retired in a settlement of claims by ARRIS against
the trustee in the liquidation of CDX Corporation (formerly know as Cadant).
Also in connection with the acquisition, we issued options to purchase 2.0
million shares of our common stock and 250,000 shares of restricted stock to
Cadant employees. We also agreed to issue up to 2.0 million additional shares of
our common stock based upon the achievement of future sales targets through
January 2003 for the CMTS product. These sales targets were not achieved and no
additional shares of our common stock will be issued.
Sale of ESP Consulting Services Product Line. In June 2003, we entered into a
non-binding letter of intent agreement with an undisclosed buyer to sell our ESP
consulting services. During the three and six-month periods ended June 30, 2003,
the ESP product line recorded revenue of approximately $0.6 million and $1.1
million, respectively. The ESP transaction is expected to be complete by the end
of the third quarter 2003. Under the terms of the letter of intent, we will
recognize a loss on sale in the range of approximately $1.0 million to $2.0
million.
17
Sale of Actives Product Line. On November 21, 2002, we sold our Actives product
line, excluding receivables and payables, for $31.8 million in net proceeds. The
agreement provided for the transfer of inventory and equipment attributable to
the product lines, plus the transfer of approximately 34 employees. Total assets
of approximately $20.3 million were disposed of, which included inventory, fixed
assets, and other assets attributable to the product line. Additionally, we
incurred approximately $7.3 million of related closure costs, including
severance, vendor liabilities, professional fees, and other shutdown expenses.
In connection with the sale, the Company recognized a gain of approximately $2.2
million in 2002. During the second quarter of 2003, the Company has reduced its
accrual for vendor liabilities by $2.0 million as a result of settling for
amounts less than originally anticipated. With this adjustment in the second
quarter, the Company has now recognized a cumulative gain of approximately $4.2
million related to the sale of this discontinued operation.
Sale of Keptel Product Line. On April 24, 2002, we sold our Keptel product line.
Keptel designed and marketed network interface systems and fiber optic cable
management products primarily for traditional telecommunications residential and
commercial applications. The transaction generated cash proceeds of $30.0
million. Additionally, we retained a potential earnout over a twenty-four month
period based on sales achievements. The transaction also included a distribution
agreement whereby we will continue to distribute Keptel products. Total assets
of approximately $31.1 million were disposed of, which included inventory, fixed
assets, intangibles (formerly classified as goodwill), and other assets. We
incurred approximately $5.0 million of related closure costs, including
severance, vendor liabilities, outside consulting fees, and other shutdown
expenses. The net result of the transaction was a loss on the sale of the
product line of approximately $6.2 million.
COST REDUCTION ACTIONS
During 2001 and 2002, we implemented significant cost reduction actions. In the
third quarter of 2001, we concluded that it would be more cost effective to
outsource manufacturing of our Actives and Keptel product lines. This resulted
in the closure of four factories in Juarez, Mexico and El Paso, Texas. In
conjunction with the purchase of Cadant, we closed our facility in Raleigh,
North Carolina. The Raleigh location was a development facility where
duplicative work to that being done by the Cadant organization was being
performed. In 2001 and 2002, we continuously reviewed our cost structure with
the goal of improving both our effectiveness and efficiency of operations. As a
result, in October 2002, we announced the closure of our development and repair
facility in Andover, Massachusetts and implemented other expense reduction
actions including general reductions in force. These actions were, in part,
facilitated by the simplification of our business model as a result of the
closure of factories and product line rationalizations.
During the second quarter of 2003, we undertook actions to further reduce our
breakeven point. This included a reduction in workforce of approximately 70
employees, as well as other cost saving measures.
INDUSTRY CONDITIONS
Our performance is largely dependent on capital spending for constructing,
rebuilding, maintaining and upgrading broadband communications systems. After a
period of intense consolidation and rapid capital expenditures within the
industry through the fourth quarter of 2000, there was a tightening of credit
availability throughout the telecommunications industry and a broad-based and
severe drop in market capitalization for the sector. This caused broadband
system operators to become more cautious in their capital spending, adversely
affecting us and other equipment providers.
Developments in the industry and in the capital markets over the past two years
have reduced access to funding for new and existing customers, causing delays in
the timing and scale of deployments of our equipment, as well as the
postponement or cancellation of certain projects by our customers. In addition,
during the same period, we and other vendors received notification that several
customers were canceling new projects or scaling back existing projects or
delaying new orders to allow them to reduce inventory levels which were in
excess of their current deployment requirements.
This industry downturn and other factors have adversely affected several of our
largest customers. In June 2002, Adelphia Communications filed bankruptcy at a
time when it owed us approximately $20.2 million in accounts
18
receivable. As a result, we incurred a $20.2 million charge during the second
quarter 2002, of which approximately $18.9 million was reflected in continuing
operations and $1.3 million was reflected in discontinued operations.
In addition, as of August 11, 2003, Cabovisao, a Portugal-based customer owed us
approximately 18.1 million euros in accounts receivable, after receiving a
payment of approximately 0.6 million euros on August 7, 2003. A substantial
portion of the accounts receivable balance is past due. This customer accounted
for approximately 6% of our sales in 2002. Cabovisao and its parent company,
Csii, are in the process of restructuring their financing. On June 30, 2003,
Csii filed for court-supervised restructuring and recapitalization in Canada. We
are continuing to monitor the progress of the financing efforts by Cabovisao and
we are actively negotiating the settlement of the past due amount. Based upon
these negotiations, ARRIS added approximately $6.4 million in incremental
reserves for the Cabovisao receivable in the second quarter of 2003.
Further, in the fourth quarter of 2002 Comcast completed its purchase of AT&T
Broadband. Historically, AT&T Broadband has been our largest customer. AT&T
Broadband, with the deployment of telephony as part of its core strategy, had
been using our CBR telephony products in many of its major markets. Comcast had
announced that its initial priority after its acquisition of AT&T Broadband was
to emphasize video and high-speed data operations and focus on improving the
profitability of its telephony operations rather than subscriber growth. As a
result, we experienced a significant decline in sales of our CBR telephony
product to Comcast in the fourth quarter of 2002, which has continued through
the first two quarters of 2003. On June 27, 2002, Comcast announced that it had
chosen us to provide an initial DOCSIS 1.1 C4 CMTS to be installed at the
headend of a Comcast cable system in the Philadelphia area. On January 13, 2003,
we announced that Comcast had ordered an additional fifty C4 CMTS chassis for
immediate data service deployment and these purchases and deployments continued
through the second quarter of 2003.
SIGNIFICANT CUSTOMERS
A significant portion of ARRIS' revenue is derived from sales to Comcast
(including AT&T Broadband) and Cox Communications. Sales to these two customers
for the three and six-month periods ended June 30, 2003 and 2002 were as follows
(in thousands):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
2003 2002 2003 2002
--------- --------- --------- ----------
Comcast (including AT&T Broadband) ... $ 36,099 $ 77,669 $ 59,903 $ 125,693
% of sales ........................... 35.5% 44.0% 31.0% 36.0%
Cox Communications ................... $ 19,864 $ 20,312 $ 44,986 $ 52,979
% of sales ........................... 19.5% 11.5% 23.3% 15.2%
As described above, we have uncertainties surrounding our future transactions
with Adelphia Communications and Cabovisao. Sales to these two customers for the
three and six-month periods ended June 30, 2003 and 2002 were as follows (in
thousands):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- -------------------------
2003 2002 2003 2002
--------- --------- --------- ----------
Adelphia Communications .............. $ 3,945 $ 5,418 $ 6,766 $ 21,457
% of sales ........................... 3.9% 3.1% 3.5% 6.1%
Cabovisao ............................ $ -- $ 10,290 $ 510 $ 27,933
% of sales ........................... -- 5.8% 0.3% 8.0%
19
COMPARISON OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2003 AND
2002
As the sale of our Actives and Keptel product lines in 2002 represented a
majority of the transmission, optical and outside plant product category, we
have reclassified the results of these product lines to discontinued operations
for all periods presented in accordance with Statement of Financial Accounting
Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets. Our products and services are summarized in the following two product
categories, broadband and supplies & services, instead of the previous three
categories. The balance of the product lines previously reported in the former
transmission, optical and outside plant product category have been combined with
our supplies and services product category. All prior period amounts have been
reclassified to conform to the new product categories.
Net Sales. Our sales for the second quarter 2003 decreased by 42.4% to $101.7
million as compared to the second quarter 2002 sales of $176.5 million, but
increased sequentially 11.3% from the previous quarter's sales of $91.3 million.
For the six-month periods ended June 30, 2003 and 2002, net sales were $193.1
million and $348.9 million, respectively, a decrease of 44.7% year-over-year.
- - Broadband product revenues decreased by $57.6 million, or 46.4%, to
$66.5 million in the second quarter 2003 as compared to revenues of
$124.1 million during the same quarter last year, but marked an
increase of $4.9 million, or 7.9%, from the previous quarter's sales of
$61.7 million. This revenue growth in the second quarter 2003, as
compared to the previous quarter, was the result of higher sales of our
CMTS product line, which increased by over $10.0 million
quarter-over-quarter as our C4 product continues to gain market share.
Partially offsetting this increase was a decline in sales of our CBR
telephony product line, as our customers continue to tightly manage
their inventory levels. Broadband product revenues accounted for
approximately 65.4% of the second quarter 2003 sales, as compared to
70.3% during the same period in 2002. Revenues for the first six months
of 2003 decreased approximately $110.1 million, or 46.2%, to $128.2
million, as compared to $238.3 million for the same period in 2002. The
significant year-over-year decrease for the first half of the year in
broadband product revenue is the result of several factors:
- Sales to Comcast (including AT&T Broadband) for constant bit
rate ("CBR") telephony products declined by approximately
$85.5 million. AT&T Broadband had been our largest customer of
constant bit rate telephony products. In the fourth quarter
2002, Comcast completed its purchase of AT&T Broadband.
Comcast had announced that its initial priority after its
acquisition of AT&T Broadband would be to emphasize video and
high-speed data operations and focus on improving the
profitability of its telephony operations rather than
subscriber growth. As a result, our sales of CBR products to
Comcast have decreased significantly in the first half of
2003.
- Sales internationally for the first half of 2003 declined by
$50.6 million, as compared to the same period in 2002. A
significant portion of this decline is attributable to the
reduced purchases by Cabovisao. Sales to this customer
decreased by approximately $27.4 million year over year.
- - Supplies & services product revenues decreased by approximately $17.2
million, or 32.8%, to $35.2 million in the second quarter 2003 as
compared to revenues of $52.4 million in the same quarter last year,
but marked an increase of $5.5 million, or 18.5%, from the previous
quarter's sales of $29.7 million. Supplies & services product revenues
accounted for approximately 34.6% of the second quarter 2003 sales, as
compared to 29.7% during the same period in 2002. Revenues for the
first six months of 2003 decreased $45.7 million, or 41.3%, to $64.9
million as compared to $110.6 million for the first six months of 2002.
The year-over-year decrease for the first six months of the year in
supplies & services product revenue is the result of several factors:
- A general slowdown in MSO's infrastructure spending
contributed to the decrease in supplies and services sales
year-over-year.
- Revenues have been significantly impacted by the decline in
shipments to Adelphia, which filed for bankruptcy during the
second quarter of 2002. The bankruptcy filing by Adelphia and
the resulting reduced sales to Adelphia accounted for
approximately $10.0 million, or 22.0%, of the overall decrease
in supplies & services product revenue year-over-year.
20
- Sales of power supplies related to CBR products declined as a
direct result of the significant decrease in Comcast's
purchases of telephony products, as described above. Power
supply revenues for the first six months of 2003 were $0.1
million, as compared to revenues of $7.8 million for the same
period in 2002.
International sales decreased by approximately $25.0 million, or 58.5%, to $17.8
million for the three months ended June 30, 2003, as compared to sales of $42.8
million during the same quarter in 2002, and marked a decrease of $0.9 million,
or 5.0% when compared to the previous quarter's international sales of $18.7
million. International revenue for the second quarter 2003 represented
approximately 17.5% of our total revenue for the quarter, as compared to
international revenue of 24.2% of our total revenue for the same period in 2002.
International sales for the six months ended June 30, 2003 decreased $50.6
million, or 58.1%, to $36.5 million as compared to sales of $87.0 million
recorded during the first six months of 2002. The reduced level of international
business is reflective of the tight capital spending market, coupled with the
specific situation with Cabovisao, as previously discussed. Cabovisao accounted
for approximately $27.4 million, or 54.2%, of the decrease in total
international revenues. We have halted shipments to Cabovisao until its
restructuring status is clarified.
Gross Profit. Gross profit decreased by $33.3 million, or 55.1%, to $27.2
million in the second quarter 2003, as compared to $60.5 million in the second
quarter 2002, but marked an increase of $2.4 million, or 9.9% over the first
quarter 2003. Gross profit margins for the quarter ended June 30, 2003 decreased
approximately 7.6 percentage points to 26.7% as compared to 34.3% for the same
quarter of 2002. Gross profit for the six months ended June 30, 2003 was $51.9
million, or 26.9%, as compared to $118.7 million, or 34.0% for the first six
months 2002. This reduction in gross margin reflects two primary factors:
- The reduced sales volume in the first half of 2003, as
compared to the same period in 2002, provided a lower base to
cover our fixed costs leading to a reduction in our gross
margin percentage.
- Our gross margin within the broadband product category
declined as a result of a shift in product mix. Specifically,
we sold less constant bit rate headend equipment in 2003 as
compared to 2002.
During 2002, a charge of $2.1 million was recorded to write off the balance of
the power product line inventory. This product line was sold in late 2001. Also
impacting gross margin were severance charges of $0.2 million in the six months
ended June 30, 2003, as compared to charges of $0.7 million recorded during the
first six months of 2002.
Selling, General, Administrative and Development ("SGA&D") Expenses. SGA&D
expenses decreased by approximately $24.6 million, or 36.0%, to $43.7 million
during the second quarter 2003 from $68.3 million during the second quarter
2002. SGA&D expenses for the six months ended June 30, 2003 decreased by $34.5
million, or 29.9%, to $80.9 million, as compared to $115.4 million for the first
six months 2002. The year-over-year decrease in SGA&D expenses for the first six
months of the year is the result of several factors:
- Expenses related to our provision for doubtful accounts
decreased by approximately $15.3 million to $7.7 million for
the six months ended June 30, 2003, as compared to expense of
$23.0 million during the first half of 2002. Expenses in 2003
included incremental reserve charges of $6.4 million in
connection with our Cabovisao accounts receivable, and
expenses in 2002 included a charge of approximately $18.9
million related to a reserve established for our Adelphia
receivables.
- The elimination of the Nortel Networks' agency fee in 2003
accounted for approximately $7.7 million of the year-over-year
decrease. The agreement with Nortel Networks for international
agency fees terminated in December 2002.
- The remaining decrease was a result of the overall reduced
headcount levels, the closure of our Andover facility, and
aggressive operating expense management.
21
Restructuring and Impairment Charges. In the first quarter of 2003, ARRIS
evaluated the restructuring accruals related to previously closed facilities
within our broadband product category. Upon review, we recorded an additional
restructuring charge of $0.3 million during the first quarter as a result of a
change to the initial estimates used. During the first six months of 2002, no
restructuring charges were recorded.
Amortization of Intangibles. Intangibles amortization expense for the
three-month periods ended June 30, 2003 and 2002 was $8.8 million and $8.7
million, respectively. Intangibles amortization expense for the year-to-date
periods ended June 30, 2003 and 2002 was $17.5 million and $17.1 million,
respectively. The majority of our intangibles represent existing technology
acquired as a result of the Arris Interactive L.L.C. acquisition in the third
quarter 2001, the Cadant, Inc. acquisition in the first quarter 2002, and the
Atoga Systems' acquisition in the first quarter 2003.
Interest Expense. Interest expense for the quarters ended June 30, 2003 and 2002
was $3.0 million and $2.1 million, respectively. Interest expense for the first
half of 2003 was $4.7 million, as compared to $4.4 million recorded during the
same period in 2002. Interest expense for all periods reflects the cost of
borrowings on our revolving line of credit, amortization of deferred finance
fees, and the interest paid on our convertible subordinated notes. As of June
30, 2003 and 2002, we did not have a balance outstanding under our credit
facility. The balance of our outstanding convertible subordinated notes was
$125.0 million at June 30, 2003, as compared to $99.6 million outstanding as of
June 30, 2002.
Membership Interest Expense. In conjunction with the acquisition of Arris
Interactive L.L.C., we issued to Nortel Networks a subordinated redeemable Class
B membership interest in Arris Interactive with a face amount of $100.0 million.
This membership interest earned a return of 10% per annum, compounded annually.
During the first quarter 2003, we redeemed the entire Class B membership
interest in Arris Interactive held by Nortel Networks, at a discount, and,
therefore, the membership interest ceased. For the three-month periods ended
June 30, 2003 and 2002, we recorded membership interest expense of $0 and $2.5
million, respectively. For the six-month periods ended June 30, 2003 and 2002,
we recorded membership interest expense of $2.4 million and $5.0 million,
respectively.
Gain on Debt Retirement. During the first quarter 2003, ARRIS redeemed the
entire Class B membership interest in Arris Interactive held by Nortel Networks
for approximately $88.4 million. This discounted redemption resulted in a gain
of approximately $28.5 million during the first half of 2003.
During the second quarter 2002, we exchanged 1,593,789 shares of our common
stock for approximately $15.4 million of the convertible subordinated notes due
2003. The exchanges were recorded in accordance with SFAS No. 84, Induced
Conversions of Convertible Debt, which requires the recognition of an expense
equal to the fair value of additional shares of common stock issued in excess of
the number of shares that would have been issued upon conversion under the
original terms of the notes. As a result, in connection with these exchanges, we
recorded a non-cash loss of approximately $8.7 million, based upon a weighted
average common stock value of $9.10 (as compared with a common stock value of
$24.00 per share in the original conversion ratio for the notes). In connection
with the exchanges, we also incurred associated fees of $0.6 million, resulting
in an overall net loss of $9.3 million.
Loss (Gain) on Investments. We hold certain investments in the common stock of
publicly traded companies totaling approximately $0.1 million and $0.2 million
at June 30, 2003 and 2002, respectively, which are classified as trading
securities. Changes in the market value of these securities and gains or losses
on related sales of these securities are recognized in income and resulted in
net pre-tax gain of approximately $0.1 million during the second quarter 2003
and a pre-tax loss of $0.4 million during the second quarter 2002. During the
six months ended June 30, 2003, we recognized a pre-tax gain of $0.1 million as
compared to a pre-tax loss of $0.6 million during the first half of 2002.
We hold certain investments in the common stock of publicly traded companies
totaling approximately $1.5 million and $1.6 million at June 30, 2003 and 2002,
respectively, which are classified as available for sale. Changes in the
22
market value of these securities are recorded in other comprehensive income.
These securities are also subject to a periodic impairment review; however, and
the impairment analysis requires significant judgment.
In addition, we hold a number of non-marketable equity securities totaling
approximately $1.7 million and $11.0 million at June 30, 2003 and 2002,
respectively, which are classified as available for sale. These non-marketable
equity securities are subject to a periodic impairment review; however, there
are no open-market valuations, and the impairment analysis requires significant
judgment. During the second quarter 2003, we recorded a charge of approximately
$1.1 million in relation to the impairment of the carrying value of an
investment in a start-up company, which raised a new round of financing at a
substantial discount in early July 2003. During the second quarter 2002, we
wrote off a $1.0 million investment in a technology start-up company, as it was
unable to raise further financing and filed for bankruptcy during the second
quarter 2002.
Loss (Gain) in Foreign Currency. During the second quarter 2003, we recorded a
foreign currency gain of approximately $(1.5) million, as compared to a foreign
currency gain of $(4.7) million for the second quarter 2002. The first six
months of 2003 included a foreign currency gain of approximately $(2.0) million,
as compared to a gain of $(3.9) million for the first six months of 2002. The
foreign currency gains are primarily driven by the fluctuation of the value of
the euro, as compared to the U.S. dollar, as we have several European customers
whose receivables and collections are denominated in euros.
Other Expense (Income). Other expense (income) for the three-month periods ended
June 30, 2003 and 2002 was $(32) thousand and $(5) thousand, respectively. Other
expense (income) for the six-month periods ended June 30, 2003 and 2002 was
$(89) thousand and $192 thousand, respectively. The other expense (income) for
all periods was primarily related to interest income and bank charges.
Income Tax (Benefit) Expense. During the first quarter 2002, we recorded an
income tax benefit of $6.8 million as a result of a change in tax legislation,
allowing us to carry back losses for five years versus the previous limit of two
years. As we are in a cumulative loss position for tax purposes, we did not
incur income tax expense (benefit) during the subsequent periods.
Discontinued Operations. In 2002, ARRIS sold the Keptel and Actives product
lines, which have been accounted for as discontinued operations in accordance
with Statement of Financial Accounting Standards ("SFAS") No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. As a result, these two
product lines and historical results have been reclassified accordingly for all
periods presented. Revenues from the discontinued operations were $17.6 million
and $36.8 million, respectively, for the three and six-month periods ended June
30, 2002. The net loss from discontinued operations, net of taxes, for the three
and six-month periods ended June 30, 2002 was $(13.7) million and $(19.1)
million, respectively.
Cumulative Effect of an Accounting Change - Goodwill. We adopted SFAS No. 142,
Goodwill and Other Intangible Assets, on January 1, 2002. Under the transitional
provisions of SFAS No. 142, we recorded a goodwill impairment loss of
approximately $(58.0) million. The impairment loss has been recorded as a
cumulative effect of a change in accounting principle on the accompanying
Consolidated Statement of Operations in the six months ended June 30, 2002.
Net Income (Loss). A net loss of $(27.8) million or $(0.37) per diluted share
was recorded for the quarter ended June 30, 2003, all of which was related to
continuing operations. A net loss of $(40.7) million or $(0.50) per diluted
share was recorded for the quarter ended June 30, 2002, of which $(27.0) million
or $(0.33) per diluted share related to continuing operations and $(13.7)
million or $(0.17) per diluted share related to discontinued operations.
A net loss of $(24.3) million or $(0.31) per diluted share was recorded for the
six months ended June 30, 2003, all of which was related to continuing
operations. A net loss of $(100.6) million or $(1.24) per diluted share was
recorded for the six months ended June 30, 2002, of which $(23.6) million or
$(0.29) per diluted share related to continuing operations, approximately
$(19.0) million or $(0.23) per diluted share related to discontinued operations,
and $(58.0) million or $(0.71) per diluted share related to a cumulative effect
of an accounting change.
23
MATERIAL COMMITMENTS
In the ordinary course of our business we enter into contracts with landlords,
suppliers and others that involve multi-year commitments on our part. Of those,
the most significant (financially) is the lease for our headquarters in Duluth,
Georgia. That lease requires annual payments of $1.5 million, subject to
adjustment, through 2009.
We also are party to various multi-year contracts with vendors. These contracts
generally do not require minimum purchases by us. The two most significant of
these are with Solectron and Mitsumi for contract manufacturing and are filed as
exhibits to previous reports filed with the Securities and Exchange Commission.
Lastly, we have several multi-year commitments that are not related to the
ordinary operation of our business. These include registration rights agreements
with Nortel Networks and Liberty Media. Although our monetary commitments under
these agreements may not be significant, they could impact our business in other
ways that investors might consider significant.
Contractual Obligations and Commercial Commitments
Following is a summary of our contractual obligations and commercial
commitments, excluding routine items such as purchase orders, as of June 30,
2003:
PAYMENTS DUE
---------------------------------------------------
CONTRACTUAL OBLIGATIONS 7/1/03 - 1/1/06 -
12/31/05 12/31/07 AFTER 1/1/08 TOTAL
-------- -------- ------------ -------
(IN MILLIONS)
Current portion of long-term debt ...... $ 0.2 $ -- $ -- $ 0.2
Long term debt ......................... -- -- 125.0 125.0
Operating leases ....................... 19.5 8.3 7.2 35.0
Sublease income ........................ (1.8) -- -- (1.8)
Capital leases ......................... 1.3 -- -- 1.3
------ ----- ------ ------
Total contractual cash obligations ..... $ 19.2 $ 8.3 $132.2 $159.7
------ ----- ------ ------
FINANCIAL LIQUIDITY AND CAPITAL RESOURCES
Financing
As amended, we have in place an asset-based revolving credit facility permitting
us to borrow up to $115.0 million (which can be increased under certain
conditions by up to $25.0 million), based upon availability under a borrowing
base calculation. In general, the borrowing base is limited to 85% of net
eligible receivables (with a cap of $5.0 million in relation to foreign
receivables), subject to a reserve of $10.0 million. In addition, upon obtaining
appropriate asset appraisals, we may include in the borrowing base calculation
80% of the orderly liquidation value of net eligible inventory (not to exceed
$60.0 million). The facility contains traditional financial covenants, including
fixed charge coverage, senior debt leverage, minimum net worth, and minimum
inventory turns ratios. The credit facility was amended in January 2003 to
provide that the minimum net worth covenant applied only to the period prior to
December 31, 2002. During the second half of 2003, it is possible that we could
be in violation of the fixed charge coverage ratio; however, we are currently in
negotiations with our lender to obtain a waiver in the event that we do not meet
this covenant. We currently do not have any borrowings under this facility and
have not for the past seven quarters. The facility is secured by substantially
all of our assets. The credit facility has a maturity date of August 3, 2004.
The commitment fee on unused borrowings is 0.75%.
On March 11, 2003, ARRIS amended its credit facility to permit the Company to
issue up to $125.0 million of subordinated convertible notes due 2008, to use
the proceeds of such notes to redeem the Class B membership interest in Arris
Interactive held by Nortel Networks and to purchase shares of the ARRIS common
stock held by Nortel Networks, subject to certain limitations. The amendment
also reduced the revolving loan commitments to $115.0 million.
24
As of June 30, 2003, we had no borrowings outstanding under our credit facility
and approximately $7.6 million outstanding under letters of credit. We had
approximately $38.8 million of available capacity. We were in compliance with
all covenants mandated by the credit facility.
Cash Flow
Cash levels decreased by approximately $31.2 million during the first six months
of 2003 as compared to an increase of approximately $47.9 million during the
same period in 2002. Operating activities in the first half of 2003 used
approximately $8.9 million in cash, and investing activities and financing
activities used approximately $1.4 million and $20.9 million, respectively, in
cash flow. Operating, investing, and financing activities in the first half of
2002 provided approximately $22.0 million, $25.5 million, and $0.4 million,
respectively, in cash flow.
Operating activities used cash of $8.9 million during the first half of 2003. A
net loss used $(24.3) million in cash flow during this period. Other non-cash
items such as depreciation, amortization, provisions for doubtful accounts, a
loss on disposal of fixed assets, and a loss on investments accounted for
positive adjustments of approximately $39.3 million during 2003. A gain on the
retirement of debt and a gain on the sale of a discontinued product line
accounted for adjustments to net income of $(28.5) million and $(2.0) million,
respectively. Cash proceeds from the sale of trading securities provided $0.1
million in cash flow. Decreases in both accounts receivable and other
receivables, and an increase in accrued membership interest provided positive
cash flows of approximately $22.4 million. An aggregate change in various other
assets and liabilities also provided positive cash flows of approximately $0.4
million. These net cash inflows were offset by an increase in inventory, and a
decrease in accounts payable and accrued liabilities aggregating approximately
$16.3 million during the six months ended June 30, 2003.
Operating activities provided cash of approximately $22.0 million during the
first half of 2002. A net loss used $(100.6) million in cash flow during this
period. Other non-cash items such as depreciation, amortization, provisions for
doubtful accounts, losses on investments, a loss on debt retirement, a loss on
the sale of a discontinued product line, and cumulative effect of an accounting
changes accounted for positive adjustments of approximately $130.5 million
during the first six months of 2002. Decreases in other receivables and
inventory provided positive cash flow of $3.8 million and $28.8 million,
respectively. Increases in accounts payable, accrued liabilities, and accrued
membership interest also provided positive cash flows of $6.9 million. These net
cash inflows were offset by an increase in accounts receivable of $32.0 million,
an increase in income taxes recoverable of $7.6 million, and an aggregate change
in various other assets and liabilities of approximately $7.8 million.
Days sales outstanding ("DSO") were approximately 56 days at June 30, 2003 as
compared to 66 days outstanding at the close of the second quarter 2002. Trade
accounts receivables at the end of the second quarter 2003 were approximately
$55.2 million. Included in this balance at June 30, 2003 was approximately 18.6
million euros due from Cabovisao (prior to reserves for doubtful accounts), of
which a substantial portion is past due. Cabovisao and its parent company are
currently in the process of restructuring their financing. See Risk Factors for
further discussion.
Inventory at June 30, 2003 was $106.0 million, as compared to $104.3 million at
the end of the first quarter 2003. Inventory turns were approximately 2.8 times
at June 30, 2003, as compared to 3.8 times at the close of the second quarter
2002.
Cash flows used by investing activities were approximately $1.4 million for the
six months ended June 30, 2003 as compared to cash flows provided of $25.5
million during the same period in 2002. The investments made during 2003
included $2.6 million related to capital expenditures and approximately $0.6
million for fees primarily related to the Atoga Systems' acquisition, offset
with the final proceeds of $1.8 million related to the sale of the Actives
product line. The investments during the first half of 2002 included $3.6
million spent on capital assets and approximately $0.8 million for fees related
to the Cadant acquisition, offset with proceeds of $30.0 million related to the
sale of the Keptel product line.
Cash flows used in financing activities were $20.9 million for the first half of
2003. Proceeds from the issuance of convertible subordinated notes due 2008
provided $125.0 million in cash, and proceeds from the issuance of common stock
provided $0.6 million. These cash inflows were offset with a cash use of
approximately $88.4 million
25
to redeem the Nortel Networks membership interest, $28.0 million used to
repurchase and retire 8 million shares of common stock held by Nortel Networks,
and $23.9 million to repurchase a portion of the convertible subordinated notes
due 2003. Other uses of cash included payments on capital lease obligations, an
equipment loan, and deferred financing activities of $0.8 million, $0.1 million,
and $5.3 million, respectively. Cash flows provided in financing activities were
$0.4 million for the first half of 2002, resulting from the proceeds from
issuance of common stock of $0.8 million offset by capital lease payments of
$0.4 million.
Based upon current levels of operations, we expect that sufficient cash flow
will be generated from operations so that, combined with cash on hand and other
financing alternatives available, including bank credit facilities, we will be
able to meet all of our current debt service, capital expenditure and working
capital requirements.
Foreign Currency
A significant portion of our products are manufactured or assembled in Mexico,
the Philippines, and other countries outside the United States. Our sales into
international markets have been and are expected in the future to be an
important part of our business. These foreign operations are subject to the
usual risks inherent in conducting business abroad, including risks with respect
to currency exchange rates, economic and political destabilization, restrictive
actions and taxation by foreign governments, nationalization, the laws and
policies of the United States affecting trade, foreign investment and loans, and
foreign tax laws.
We have certain international customers who are billed in their local currency.
Beginning in 2002, we implemented a hedging strategy to mitigate the monetary
exchange fluctuations from the time of invoice to the time of payment, and have
entered into forward contracts based on a percentage of expected foreign
currency receipts. The percentage can vary, based on the predictability of cash
receipts. We regularly review our accounts receivable in foreign currency and
purchase additional forward contracts when appropriate. As of June 30, 2003, we
had one foreign currency forward purchase contract outstanding. We have recorded
a liability of approximately $0.1 million at June 30, 2003, to adjust the
forward contract to its current fair value. Additionally, during the second
quarter 2003, we purchased a 5.0 million euro put contract with an expiration of
October 31, 2003. The contract was purchased as part of our internal hedging
strategy to reduce the risk associated with our euro receivables. The contract
was purchased for approximately $0.2 million and the fair value adjustment as of
June 30, 2003 was a loss of approximately $0.1 million.
Financial Instruments
In the ordinary course of business, we, from time to time, will enter into
financing arrangements with our vendors and customers. These financial
instruments include letters of credit, commitments to extend credit and
guarantees of debt. These agreements could include the granting of extended
payment terms that result in longer collection periods for accounts receivable
and slower cash inflows from operations and/or could result in the deferral of
revenue. As of June 30, 2003, we had approximately $7.6 million outstanding
under letters of credit with our banks.
Investments
In the ordinary course of business, we may make strategic investments in the
equity securities of various companies, both public and private. We hold certain
investments in the common stock of publicly traded companies totaling
approximately $0.1 million at June 30, 2003, which are classified as trading
securities. Changes in the market value of these securities and gains or losses
on related sales of these securities are recognized in income. We recorded a net
pre-tax gain of approximately $0.1 million during the second quarter 2003 and a
pre-tax loss of $0.4 million during the second quarter 2002 related to these
investments. During the six months ended June 30, 2003, we recognized a pre-tax
gain of $0.1 million as compared to a pre-tax loss of $0.6 million during the
first half of 2002.
We hold certain additional investments in the common stock of publicly traded
companies totaling approximately $1.5 million at June 30, 2003, which are
classified as available for sale. In addition, we hold a number of
non-marketable equity securities totaling approximately $1.7 million, which are
classified as available for sale. At June 30, 2003, we had unrealized losses
related to these available for sale securities of approximately $0.3 million
included in comprehensive income.
We offer a deferred compensation arrangement, which allows certain employees to
defer a portion of their earnings and defer the related income taxes. These
deferred earnings are invested in a "rabbi trust," and are accounted for in
accordance with Emerging Issues Task Force 97-14, Accounting for Deferred
Compensation Arrangements Where Amounts Earned Are Held in a Rabbi Trust and
Invested. A rabbi trust is a funding vehicle used to protect deferred
26
compensation benefits from events (other than bankruptcy). The investment in the
rabbi trust is classified as a current asset on our balance sheet. At June 30,
2003, we had a cumulative unrealized gain related to the rabbi trust of
approximately $0.4 million included in comprehensive income.
Capital Expenditures
Capital expenditures are made at a level designed to support the strategic and
operating needs of the business. ARRIS' capital expenditures were $1.5 million
and $2.6 million for the three and six months, respectively, ended June 30,
2003, as compared to $2.4 million and $3.6 million for the same periods in 2002.
We had no significant commitments for capital expenditures at June 30, 2003.
Management expects to invest approximately $6.0 million in capital expenditures
for the year 2003.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Management's Discussion and Analysis of Financial Condition and Results of
Operations discusses ARRIS' Consolidated Financial Statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements and the reported amounts of revenues and expenses
during the reporting period. On an on-going basis, management evaluates its
estimates and judgments, including those related to customer incentives, product
returns, bad debts, inventories, investments, intangible assets, income taxes,
financing operations, warranty obligations, restructuring costs, retirement
benefits, and contingencies and litigation. Management bases its estimates and
judgments on historical experience and on various other factors that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions.
Our critical accounting policies are disclosed extensively in our Form 10-K for
the year ended December 31, 2002, as filed with the United States Securities and
Exchange Commission. That discussion is incorporated herein by reference.
FORWARD-LOOKING STATEMENTS
Certain information and statements contained in this Management's Discussion and
Analysis of Financial Condition and Results of Operations and other sections of
this report, including statements using terms such as "may," "expect,"
"anticipate," "intend," "estimate," "believe," "plan," "continue," "could be,"
or similar variations or the negative thereof, constitute forward-looking
statements with respect to the financial condition, results of operations, and
business of ARRIS, including statements that are based on current expectations,
estimates, forecasts, and projections about the markets in which we operate and
management's beliefs and assumptions regarding these markets. In this report,
these statements include, among others, statements regarding the impact of
acquisitions and divestitures, future amounts of capital expenditures, and
estimates of contractual commitments. These and any other statements in this
document that are not statements about historical facts are "forward-looking
statements." We caution investors that forward-looking statements made by us are
not guarantees of future performance and that a variety of factors could cause
our actual results to differ materially from the anticipated results or other
expectations expressed in our forward-looking statements. Important factors that
could cause results or events to differ from current expectations are described
in the risk factors below. These factors are not intended to be an
all-encompassing list of risks and uncertainties that may affect the operations,
performance, development and results of our business. In providing
forward-looking statements, ARRIS expressly disclaims any obligation to update
publicly or otherwise these statements, whether as a result of new information,
future events or otherwise except to the extent required by law.
27
RISK FACTORS
OUR BUSINESS IS DEPENDENT ON CUSTOMERS' CAPITAL SPENDING ON BROADBAND
COMMUNICATION SYSTEMS, AND REDUCTIONS BY CUSTOMERS IN CAPITAL SPENDING COULD
ADVERSELY AFFECT OUR BUSINESS.
Our performance has been largely 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 will affect the amount of capital spending, and therefore,
our sales and profits, including:
- - general economic conditions;
- - availability and cost of capital;
- - other demands and opportunities for capital;
- - regulations;
- - demands for network services;
- - competition and technology; and
- - real or perceived trends or uncertainties in these factors.
Developments in the industry and in the capital markets over the past two years
have reduced access to funding for new and existing customers, causing delays in
the timing and scale of deployments of our equipment, as well as the
postponement or cancellation of certain projects by our customers. In addition,
during the same period, we and other vendors received notification from several
customers that they were canceling new projects or scaling back existing
projects or delaying new orders to allow them to reduce inventory levels which
were in excess of their current deployment requirements.
Further, several of our customers have accumulated significant levels of debt
and have recently announced, or are expected to announce, financial
restructurings, including bankruptcy filings. For example, Adelphia has been
operating under bankruptcy since the June 2002. Even if the financial health of
that company and other customers improve, we cannot assure you that these
customers will be in a position to purchase new equipment at levels we have seen
in the past. In addition, Adelphia's bankruptcy filing has further heightened
concerns in the financial markets about the domestic cable industry. This
concern, coupled with the current uncertainty and volatile capital markets, has
affected the market values of domestic cable operators and may further restrict
their access to capital.
DEVELOPMENTS RELATING TO CABOVISAO MAY ADVERSELY AFFECT OUR BUSINESS AND RESULTS
OF OPERATIONS.
Cabovisao, a Portugal-based MSO, accounted for approximately 6% of our total
sales in 2002. As of August 11, 2003, Cabovisao owed us approximately 18.1
million euros in accounts receivable after receiving a payment of approximately
0.6 million euros on August 7, 2003. Cabovisao and its parent company, Csii, are
in the process of restructuring their financing. On June 30, 2003, Csii filed
for court-supervised restructuring and recapitalization in Canada. We are
continuing to monitor the progress of the financing efforts by Cabovisao and we
are actively negotiating the settlement of the past due amount. Based upon these
negotiations, ARRIS added approximately $6.4 million in incremental reserves for
the Cabovisao receivable in the second quarter of 2003. We will not deliver
further products to Cabovisao until we have a satisfactory payment plan with
Cabovisao and are considering what actions should be taken regarding the
situation. We cannot assure you that Cabovisao will pay us according to a
schedule, if at all, or that we will make any sales to Cabovisao in the future.
28
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 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 us. Our major competitors include:
- - ADC Telecommunications, Inc.;
- - Broadband Services, Inc.;
- - Cisco Systems, Inc.;
- - Juniper Networks, Inc.;
- - Motorola, Inc.;
- - Riverstone Networks, Inc.;
- - Scientific-Atlanta, Inc.;
- - Tellabs, Inc.;
- - Terayon Communications Systems, Inc.; and
- - TVC Communications, Inc.
The rapid technological changes occurring in the broadband markets may lead to
the entry of new competitors, including those with substantially greater
resources than ours. 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 long-standing and established relationships with domestic and foreign
broadband service providers. We may not be able to compete successfully in the
future, and competition may harm our business.
OUR BUSINESS HAS PRIMARILY COME FROM SEVERAL KEY CUSTOMERS. THE LOSS OF ONE OF
THESE CUSTOMERS OR A SIGNIFICANT REDUCTION IN SERVICES TO ONE OF THESE CUSTOMERS
WOULD HAVE A MATERIAL ADVERSE EFFECT ON OUR BUSINESS.
Our two largest customers are Comcast (primarily through the recently acquired
AT&T Broadband business) and Cox Communications. For the six months ended June
30, 2003, sales to Comcast (including AT&T Broadband) accounted for
approximately 31.0% of our total revenues, while sales to Cox Communications
accounted for approximately 23.3%. We currently are the exclusive provider of
telephony products for both Cox Communications and, in eight metro areas,
Comcast, as successor to AT&T Broadband. In addition, we have one other customer
who accounted for more than 5% each of our total revenues for the first half of
2003. The loss of Cox Communications, Comcast, or any of our other large
customers, or a significant reduction in the services provided to any of them
would have a material adverse impact on our business. In addition, as a result
of the merger of Comcast with AT&T Broadband in late 2002, we have experienced
interruptions in purchasing by the resulting Comcast entity in 2003. Comcast has
announced that its initial priority after its acquisition of AT&T Broadband will
be to emphasize video and high-speed data operations and focus on improving the
profitability of its telephony operations at the expense of subscriber growth.
As a result, we experienced a significant decline in sales of our CBR telephony
product to Comcast in the fourth quarter of 2002, which has continued into 2003.
29
OUR CREDIT FACILITY IMPOSES FINANCIAL COVENANTS THAT MAY ADVERSELY AFFECT THE
REALIZATION OF OUR STRATEGIC OBJECTIVES.
We and certain of our subsidiaries have entered into a revolving credit facility
providing for borrowing up to a committed amount of $115.0 million, with
borrowing also limited by a borrowing base determined by reference to eligible
accounts receivable and, subject to certain conditions, eligible inventory. As
of June 30, 2003, the borrowing base was $38.8 million. The credit facility
imposes, among other things, covenants limiting the incurrence of additional
debt and liens and requires us to meet certain financial objectives. During the
second half of 2003, it is possible that we could be in violation of the fixed
charge coverage ratio; however, we are currently in negotiations with our lender
to obtain a waiver in the event that we do not meet this covenant. The credit
facility has a maturity date of August 3, 2004. As of August 11, 2003, we had no
borrowings outstanding under the credit facility. Any acceleration of the
maturity date of the credit facility could have a material adverse effect on our
business.
WE HAVE SIGNIFICANT STOCKHOLDERS THAT MAY NOT ACT CONSISTENTLY WITH THE
INTERESTS OF OUR OTHER STOCKHOLDERS.
As of August 11, 2003, Nortel Networks owned approximately 18.7% of our common
stock and Liberty Media Group beneficially owned approximately 10.3% of our
common stock. These respective ownership interests result in both Nortel
Networks and Liberty Media having a significant influence over us. Nortel
Networks and Liberty Media may exert their respective influences or sell their
respective shares at a time or in a manner that is inconsistent with the
interests of our other stockholders. Any sales of substantial amounts of our
common stock in the public market, or the perception that such sales might
occur, could have a depressive effect on the market price of our common stock.
WE HAVE ANTI-TAKEOVER DEFENSES THAT COULD DELAY OR PREVENT AN ACQUISITION OF OUR
COMPANY.
On October 3, 2002, our board of directors approved the adoption of 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 shareholders' interests. This poison pill could make it more difficult
for a third party to acquire us or may delay that process.
WE MAY DISPOSE OF EXISTING PRODUCT LINES OR ACQUIRE NEW PRODUCT LINES IN
TRANSACTIONS THAT MAY ADVERSELY IMPACT US AND OUR FUTURE RESULTS.
On an ongoing basis, we evaluate our various product offerings in order to
determine whether any should be sold or closed and whether there are businesses
that we should pursue acquiring. Future acquisitions and divestitures entail
various risks, including:
- - the risk that acquisitions will not be integrated or otherwise perform
as expected;
- - the risk that we will not be able to find a buyer for a product line
while product line sales and employee morale will have been damaged
because of general awareness that the product line is for sale; and
- - the risk that the purchase price obtained will not be equal to the book
value of the assets for the product line that we sell.
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 currently under development by us
may not be successfully developed. Even if products under development are
successfully completed, they may not be widely used or we may not be able to
successfully exploit these technology applications. 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:
- - are not cost-effective;
- - are not brought to market in a timely manner;
30
- - fail to achieve market acceptance; or
- - fail to meet industry certification standards.
Furthermore, our competitors may develop similar or alternative new technology
applications 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 partner could
have a material adverse effect on the progress of new products under development
with that partner.
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 is expected to continue. We and one or
more of our competitors may each supply products to businesses that have merged,
such as AT&T Broadband and Comcast, or will merge in the future. Consolidations
could result in delays in purchasing decisions by the merged businesses, and we
could play either a greater or lesser role in supplying the communications
products to the merged entity. These purchasing decisions of the merged
companies could have a material adverse effect on our business. For example, we
experienced delays while the Comcast and AT&T Broadband deal was pending, and
have experienced slowdowns since the transaction was completed. Mergers among
the supplier base also have increased, and this trend may continue. The 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.
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 executives, marketing, engineering, and sales
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
31
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 PRODUCTS ARE MANUFACTURED.
A significant portion of our products are manufactured or assembled in Mexico
and the Philippines and other countries outside of the United States. The
governments of the foreign countries in which we have plants 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 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 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 past, 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 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. 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 adversely affected. See Part II, Item 1, with respect to pending patent
litigation.
32
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to various market risks, including interest rates and foreign
currency rates. The following discussion of our risk-management activities
includes "forward-looking statements" that involve risks and uncertainties.
Actual results could differ materially from those projected in the
forward-looking statements.
In the past, we have used interest rate swap agreements with large creditworthy
financial institutions, to manage our exposure to interest rate changes. These
swaps would involve the exchange of fixed and variable interest rate payments
without exchanging the notional principal amount. During the quarter ended June
30, 2003, we did not have any outstanding interest rate swap agreements.
A significant portion of our products are manufactured or assembled in Mexico,
the Philippines, and other countries outside the United States. Our sales into
international markets have been and are expected in the future to be an
important part of our business. These foreign operations are subject to the
usual risks inherent in conducting business abroad, including risks with respect
to currency exchange rates, economic and political destabilization, restrictive
actions and taxation by foreign governments, nationalization, the laws and
policies of the United States affecting trade, foreign investment and loans, and
foreign tax laws.
We have certain international customers who are billed in their local currency.
Changes in the monetary exchange rates may adversely affect our results of
operations and financial condition. To manage the volatility relating to these
typical business exposures, we may enter into various derivative transactions,
when appropriate. We do not hold or issue derivative instruments for trading or
other speculative purposes. The euro is the predominant currency of those
customers who are billed in their local currency. Taking into account the
effects of foreign currency fluctuations of the euro versus the dollar, a
hypothetical 10% weakening of the U.S. dollar (as of June 30, 2003) would
provide a gain on foreign currency of approximately $1.7 million. Conversely, a
hypothetical 10% strengthening of the U.S. dollar would provide a loss on
foreign currency of approximately $1.7 million. As of June 30, 2003, we had no
material contracts, other than accounts receivable, denominated in foreign
currencies.
We regularly review our accounts receivable in foreign currency and purchase
forward contracts when appropriate. As of June 30, 2003, we had one foreign
currency forward contract outstanding. The contract was for 1.5 million euros
and was due July 31, 2003. The contract was taken out in anticipation of
receiving a substantial euro payment from one of our customers, which we
received on a timely basis. The fair value adjustment at June 30, 2003 was a
loss of approximately $0.1 million. Additionally, during the second quarter 2003
we purchased a 5.0 million euro put contract with an expiration of October 31,
2003. The contract was purchased as part of our internal hedging strategy to
reduce the risk associated with our euro receivables. The contract was purchased
for approximately $0.2 million and the fair value adjustment as of June 30, 2003
was a loss of approximately $0.1 million.
ITEM 4. CONTROLS AND PROCEDURES
(a) Evaluation of Disclosure Controls and Procedures. Our Chief Executive
Officer and Chief Financial Officer have evaluated the effectiveness of our
disclosure controls and procedures (as such term is defined in Rules 13a-14(c)
and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the
"Exchange Act") as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"). Based on such evaluation, such
officers have concluded that, as of the Evaluation Date, our disclosure controls
and procedures are effective in alerting them on a timely basis to material
information relating to our company (including our consolidated subsidiaries)
required to be included in our reports filed or submitted under the Exchange
Act.
(b) Changes in Internal Controls. Since the Evaluation Date, there have not
been any significant changes in our internal controls or in other factors that
could significantly affect such controls.
33
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Mezzalingua Litigation. ARRIS is a party to three lawsuits brought by or against
John Mezzalingua Associates, Inc. d/b/a PPC, including a suit initiated by
Mezzalingua in July 2003 in the Federal Court for the Western District of
Wisconsin.
In the first lawsuit, John Mezzalingua Associates, Inc. d/b/a/ PPC v. Antec
Corp., No. 3:01CV-482-J-25-HTS (M.D. Fla., Jacksonville Div., filed May 4,
2001), Mezzalingua alleged that ARRIS' Digicon product infringed on a design
patent owned by Mezzalingua. Following a verdict in Mezzalingua's favor,
Mezzalingua was awarded approximately $1.9 million in damages plus post-judgment
interest. ARRIS stopped selling the allegedly infringing product and appealed
the judgment. The appeal is pending.
In the second lawsuit, Arris International, Inc. and Randall A. Holliday v. John
Mezzalingua Associates, Inc. d/b/a/ PPC, No. 01-WM-2061 (D. Colo. filed October
17, 2001), ARRIS and Mr. Holliday alleged that Mezzalingua's EX product
infringes on two utility patents issued to Mr. Holliday and licensed to ARRIS.
Mezzalingua counterclaimed on various grounds, including antitrust and unfair
competition. Discovery has concluded on the primary claims and the parties have
pending motions for summary judgment. A trial date has been set for April 2004.
In the third lawsuit, Mezzalingua Associates, Inc. d/b/a PPC, Inc. v. Arris
International, Inc., No. 03-C-0353-C (W.D. Wis. filed July 1, 2003), Mezzalingua
alleged that certain of ARRIS' Digicon products infringe on a utility patent
issued to Mezzalingua on May 6, 2003. The Court preliminarily enjoined ARRIS'
further sale of the product. ARRIS stopped selling the allegedly infringing
product and instead is selling a new product. Mezzalingua has advised ARRIS that
it may challenge this new product as well.
ARRIS intends to vigorously pursue all three lawsuits. However, ARRIS cannot
provide any assurances as to the outcome of the litigation or that, if the
outcome is unfavorable, the aggregate adverse results will not be material to
ARRIS and its business.
Metal Press Litigation. ARRIS is a defendant in a case entitled Metal Press S.A.
de C.V. v. ARRIS International, Inc. f/k/a/ Antec Corporation, No.
1:01-CV-2435-CAP (N.D. Ga., Atlanta Div., filed September 13, 2001). In general,
Metal Press alleges that ARRIS breached a requirements contract for certain
products. Discovery is substantially complete, and ARRIS is in the process of
preparing a motion for summary judgment. ARRIS does not believe that Metal
Press' claims are meritorious and intends to vigorously contest them.
34
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Annual Meeting of Shareholders of ARRIS Group, Inc., held on May 22,
2003:
An election of nine Directors was held, and the shares so present were voted as
follows for the election of each of the following:
Number of Number of
Shares Shares
Voted For Withheld
------------- -------------
Alex B. Best 57,280,519 5,010,332
Harry L. Bosco 57,387,731 5,903,120
John (Ian) Anderson Craig 55,356,536 6,934,315
Randy K. Dodd 57,280,173 5,010,678
Matthew B. Kearney 57,280,219 5,010,632
William H. Lambert 56,017,049 6,273,802
John R. Petty 56,384,807 5,906,044
Larry Romrell 41,937,073 20,353,778
Robert J. Stanzione 56,808,904 5,481,947
A proposal was made to approve the ESPP amendment, increasing the number of
shares reserved for issuance from 800,000 shares to 1,800,000 shares, and the
shares so present were voted as follows:
Number of Shares Number of Shares Number of Shares
Voted For Voted Against Withheld
- ---------------------------------------------------------------------------------------------------
Approval of the ESPP amendment 60,600,432 656,860 1,033,559
A proposal was made to approve the option exchange amendments, and the shares so
present were voted as follows:
Number of Shares Number of Shares Number of Shares
Voted For Voted Against Withheld
- ---------------------------------------------------------------------------------------------------
Approval of the option exchange
amendments 52,834,359 8,323,730 1,132,762
35
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
Exhibit No. Description of Exhibit
- ----------- ----------------------
31.1 Section 302 Certification of Chief Executive Officer
31.2 Section 302 Certification of Chief Financial Officer
32.1 Section 906 Certification of Chief Executive Officer
32.2 Section 906 Certification of Chief Financial Officer
Reports on Form 8-K
FILING DATE ITEMS REPORTED
04-01-03 Item 5 and Item 7
04-24-03 Item 7 and Item 9
06-13-03 Item 5 and Item 7
36
SIGNATURES
Pursuant to the requirements the Securities Exchange Act of 1934, the Registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
ARRIS GROUP, INC.
/s/ Lawrence A. Margolis
-----------------------------------
Lawrence A. Margolis
Executive Vice President,
Chief Financial Officer
Dated: August 13, 2003
37