10-Q 1 tv505738_10q.htm FORM 10-Q

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

 

FORM 10-Q

 

For the quarter ended September 30, 2018

 

of

 

ARRIS INTERNATIONAL PLC

(Exact name of registrant as specified in its charter)

 

 

 

England and Wales   001-37672   98-1241619

(State or Other Jurisdiction

of Incorporation)

 

(Commission

File Number)

 

(I.R.S. Employer

Identification No.)

 

3871 Lakefield Drive, Suwanee, Georgia   30024
(Address of Principal Executive Offices)   (Zip Code)

 

Registrant’s telephone number, including area code: (678) 473-2000

 

 

 

ARRIS International plc (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 International plc is a large accelerated filer and is not a shell company.

 

ARRIS International plc has submitted electronically every interactive data file required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months.

 

As of October 31, 2018, 173,328,693 shares of ARRIS International plc’s Ordinary Shares were outstanding.

 

 

 

 

 

ARRIS INTERNATIONAL PLC

FORM 10-Q

For the Three and Nine Months Ended September 30, 2018

INDEX

 

    Page
Part I. Financial Information  
     
  Item 1. Consolidated Financial Statements (unaudited)  
       
    a) Consolidated Balance Sheets as of September 30, 2018 and December 31, 2017 2
         
    b) Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2018 and 2017 3
         
    c) Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2018 and 2017 4
         
    d) Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2018 and 2017 5
         
    e) Notes to the Consolidated Financial Statements 6
       
  Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 34
       
  Item 3. Quantitative and Qualitative Disclosures About Market Risk 51
       
  Item 4. Controls and Procedures 51
     
Part II. Other Information  
     
  Item 1. Legal Proceedings 51
       
  Item 1A. Risk Factors 54
       
  Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 71
       
  Item 6. Exhibits 72
     
Signatures 73

 

 

 

 

PART I. FINANCIAL INFORMATION

Item 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

ARRIS INTERNATIONAL PLC

CONSOLIDATED BALANCE SHEETS

(in thousands except share and per share data) (unaudited)

 

  

September 30,

2018

  

December 31,
2017

 
ASSETS        
Current assets:          
Cash and cash equivalents  $480,757   $487,573 
Short-term investments, at fair value   39,640    23,874 
Total cash, cash equivalents and short-term investments   520,397    511,447 
Accounts receivable (net of allowances for doubtful accounts of $8,244 in 2018 and $10,230 in 2017)   1,117,641    1,218,089 
Other receivables   235,122    157,845 
Inventories (net of reserves of $63,008 in 2018 and $69,459 in 2017)   717,272    825,211 
Prepaid income taxes   17,717    28,351 
Prepaids   34,125    26,644 
Other current assets   201,111    145,953 
Total current assets   2,843,385    2,913,540 
Property, plant and equipment (net of accumulated depreciation of $395,611 in 2018 and $367,954 in 2017)   289,820    372,467 
Goodwill   2,261,002    2,278,512 
Intangible assets (net of accumulated amortization of $1,896,660 in 2018 and $1,599,573 in 2017)   1,488,580    1,771,362 
Investments   71,747    71,082 
Deferred income taxes   155,193    115,436 
Other assets   76,878    101,858 
Total assets  $7,186,605   $7,624,257 
           
LIABILITIES AND STOCKHOLDERS’ EQUITY          
Current liabilities:          
Accounts payable  $1,100,901   $1,206,656 
Accrued compensation, benefits and related taxes   146,964    155,966 
Accrued warranty   40,772    44,507 
Deferred revenue   115,989    115,224 
Current portion of long-term debt and financing lease obligation   83,785    83,559 
Income taxes payable   4,182    6,244 
Other accrued liabilities   356,002    321,113 
Total current liabilities   1,848,595    1,933,269 
Long-term debt and financing lease obligation, net of current portion   2,053,373    2,116,244 
Accrued pension   32,371    42,637 
Noncurrent deferred revenue   58,553    54,090 
Noncurrent income taxes   112,259    144,665 
Deferred income taxes   60,410    68,888 
Other noncurrent liabilities   67,534    80,430 
Total liabilities   4,233,095    4,440,223 
           
Stockholders’ equity:          
Ordinary shares, nominal value £0.01 per share, 173.9 million and 185.2 million shares issued and outstanding in 2018 and 2017, respectively   2,621    2,768 
Capital in excess of par value   3,439,476    3,387,128 
Accumulated deficit   (494,706)   (225,881)
Accumulated other comprehensive (loss) income   (8,655)   4,552 
Total ARRIS International plc stockholders’ equity   2,938,736    3,168,567 
Stockholders’ equity attributable to noncontrolling interest   14,774    15,467 
Total stockholders’ equity   2,953,510    3,184,034 
Total liabilities and stockholders’ equity  $7,186,605   $7,624,257 

 

See accompanying notes to the consolidated financial statements.

 

 2 

 

 

ARRIS INTERNATIONAL PLC

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands except share and per share data) (unaudited)

 

  

Three Months

Ended September 30,

   Nine Months
Ended September 30,
 
   2018   2017   2018   2017 
Net sales  $1,651,248   $1,728,524   $4,955,498   $4,875,799 
Cost of sales   1,186,059    1,297,369    3,515,871    3,704,029 
Gross margin   465,189    431,155    1,439,627    1,171,770 
Operating expenses:                    
Selling, general and administrative expenses   162,707    114,407    497,263    332,966 
Research and development expenses   156,109    131,593    493,106    397,653 
Amortization of intangible assets   88,306    90,162    293,499    274,819 
Impairment of goodwill           3,400     
Integration, acquisition, restructuring and other costs   5,046    10,836    41,546    30,622 
Total operating expenses   412,168    346,998    1,328,814    1,036,060 
Operating income   53,021    84,157    110,813    135,710 
Other expense (income):                    
Interest expense   23,969    20,211    70,142    63,238 
(Gain) loss on investments   (1,400)   839    (1,718)   8,978 
Interest income   (1,764)   (2,288)   (5,088)   (5,997)
Loss (gain) on foreign currency   2,025    (8,543)   6,034    5,570 
Other (income) expense, net   35    1,434    (25)   2,275 
Income before income taxes   30,156    72,504    41,468    61,646 
Income tax benefit   (15,652)   (14,311)   (22,106)   (12,613)
Consolidated net income   45,808    86,815    63,574    74,259 
Net loss attributable to noncontrolling interest   (1,271)   (1,505)   (5,659)   (5,299)
Net income attributable to ARRIS International plc.  $47,079   $88,320   $69,233   $79,558 
                     
Net income per ordinary share (1):                    
Basic  $0.26   $0.47   $0.38   $0.42 
Diluted  $0.26   $0.47   $0.38   $0.42 
                     
Weighted average ordinary shares:                    
Basic   178,106    187,064    182,132    187,878 
Diluted   179,337    188,941    183,817    190,264 

 

(1)Calculated based on net income attributable to stockholders of ARRIS International plc

 

See accompanying notes to the consolidated financial statements.

 

 3 

 

 

ARRIS INTERNATIONAL PLC

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands) (unaudited)

 

  

Three Months

Ended September 30,

   Nine Months
Ended September 30,
 
   2018   2017   2018   2017 
Consolidated net income  $45,808   $86,815   $63,574   $74,259 
                     
Available-for-sale securities:                    
Unrealized gain (loss) on available-for-sale securities, net of tax of $0 and $(34) for the three months ended September 30, 2018 and 2017, and $0 and $(132) for the nine months ended September 30, 2018 and 2017 respectively       44        260 
Reclassification adjustments recognized in net income, net of tax of $0 and $(5) for the three months ended September 30, 2018 and 2017, and $381 and $(34) for the nine months ended September 30, 2018 and 2017 respectively       7    (662)   68 
Net change in available-for-sale securities       51    (662)   328 
                     
Derivative instruments:                    
Unrealized gain (loss) on derivative instruments, net of tax of $(1,005) and $(145) for the three months ended September 30, 2018 and 2017, and $(4,071) and $153 for the nine months ended September 30, 2018 and 2017 respectively   3,737    195    15,051    (240)
Reclassification adjustments recognized in net income, net of tax of $214 and $7 for the three months ended September 30, 2018 and 2017, and $268 and $(691) for the nine months ended September 30, 2018 and 2017 respectively   (796)   (9)   (990)   1,086 
Net change in derivative instruments   2,941    186    14,061    846 
                     
Pension liabilities:                    
Reclassification adjustments recognized in net income       (6)   28    9 
Net change in pension liabilities       (6)   28    9 
                     
Cumulative translation adjustments   (6,946)   6,382    (26,634)   4,364 
                     
Other comprehensive income (loss), net of tax   (4,005)   6,613    (13,207)   5,547 
                     
Comprehensive income   41,803    93,428    50,367    79,806 
                     
Comprehensive loss attributable to noncontrolling interest   (1,282)   (1,520)   (5,644)   (5,343)
                     
Comprehensive income attributable to ARRIS International plc  $43,085   $94,948   $56,011   $85,149 

 

See accompanying notes to the consolidated financial statements.

 

 4 

 

 

ARRIS INTERNATIONAL PLC

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands) (unaudited)

   Nine months ended September 30, 
  

2018

  

2017

 
         
Operating activities:          
Consolidated net income  $63,574   $74,259 
Depreciation   65,539    65,340 
Amortization of acquired intangible assets   299,136    279,961 
Amortization of deferred financing fees and debt discount   3,620    5,621 
Deferred income taxes   (58,365)   (36,540)
Foreign currency remeasurement of deferred taxes   530    10,170 
Stock compensation expense   63,087    62,851 
Impairment of goodwill   3,400     
Provision for non-cash warrants       8,145 
Recovery for doubtful accounts   (437)   (559)
Loss on disposal of property, plant & equipment and other   1,761    5,876 
(Gain) loss on investments and other   (1,582)   8,978 
Changes in operating assets and liabilities, net of effect of acquisitions and dispositions:          
Accounts receivable   85,636    305,212 
Other receivables   (77,277)   (72,465)
Inventories   104,570    (222,733)
Accounts payable and accrued liabilities   (149,797)   132,437 
Prepaids and other, net   16,845    (14,899)
Net cash provided by operating activities   420,240    611,654 
Investing activities:          
Purchases of investments   (64,454)   (68,250)
Sales of investments   45,638    155,301 
Purchases of property, plant and equipment   (45,621)   (62,389)
Purchases of intangible assets   (423)   (6,422)
Deposit received for the sale of property, plant and equipment   50,000     
Other, net   171    826 
Net cash (used in) provided by investing activities   (14,689)   19,066 
Financing activities:          
Proceeds from issuance of shares, net   9,206    8,623 
Repurchase of shares   (331,622)   (146,965)
Repurchase of shares to satisfy employee minimum tax withholdings   (19,917)   (26,359)
Proceeds from issuance of debt       30,314 
Payment of debt obligations   (65,625)   (98,976)
Payment of financing lease obligation   (640)   (590)
Payment of deferred financing fees and debt discount       (1,462)
Contribution from noncontrolling interest   2,257    3,500 
Net cash used in financing activities   (406,341)   (231,915)
Effect of exchange rate changes on cash, cash equivalents and restricted cash   (4,017)   941 
Net (decrease) increase in cash, cash equivalents and restricted cash   (4,807)   399,746 
Cash, cash equivalents and restricted cash at beginning of period   489,116    981,692 
Cash, cash equivalents and restricted cash at end of period  $484,309   $1,381,438 

 

The following table provides a reconciliation of cash, cash equivalents and restricted cash reported within the Consolidated Balance Sheets to the total of the same such amounts show above (in thousands). Amounts included in restricted cash represent those required to be set aside by contractual agreements, such as rent deposits with landlords, deposits with certain government agencies and cash collateral with certain financial institutions.

 

  

September 30, 

2018

  

September 30, 

2017

  

December 31, 

2017

 
             
Cash and cash equivalents$ 480,757   $1,379,827   $487,573 
Restricted cash included in other current assets   760    23    23 
Restricted cash included in other assets   2,792    1,588    1,520 
Total$ 484,309   $1,381,438   $489,116 

 

See accompanying notes to the consolidated financial statements.

 

 5 

 

 

ARRIS INTERNATIONAL PLC

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Note 1. Organization and Basis of Presentation

 

ARRIS International plc (together with its consolidated subsidiaries and consolidated venture, except as the context otherwise indicates, “ARRIS” or the “Company”) is a global entertainment, communications, and networking technology and solutions provider, headquartered in Suwanee, Georgia. The Company operates in three business segments, Customer Premises Equipment (“CPE”), Network & Cloud (“N&C”) and Enterprise Networks (“Enterprise”) (See Note 15 Segment Information for additional details), specializing in enabling service providers including cable, telephone, and digital broadcast satellite operators and media programmers to deliver media, voice, IP data services and Wi-Fi to their subscribers and enabling enterprises to experience constant, wireless and wired connectivity across complex and varied networking environments. ARRIS is a leader in set-tops, digital video and Internet Protocol Television (“IPTV”) distribution systems, broadband access infrastructure platforms, associated data and voice CPE and wired and wireless enterprise networking. The Company’s solutions are complemented by a broad array of services including technical support, repair and refurbishment, and systems design and integration.

 

The consolidated financial statements include the accounts of the Company and its wholly owned foreign and domestic subsidiaries and consolidated venture in which the Company owns more than 50% of the outstanding voting shares of the entity. All intercompany accounts and transactions have been eliminated.

 

The accompanying financial data as of September 30, 2018 and for the three and nine months ended September 30, 2018 and September 30, 2017 has been prepared by the Company, without audit, pursuant to the rules and regulations of the U.S. Securities and Exchange Commission ("SEC"). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles in the United States ("GAAP") have been condensed or omitted pursuant to such rules and regulations. The December 31, 2017 Consolidated Balance Sheet was derived from audited financial statements but does not include all disclosures required by accounting principles generally accepted in the United States. However, the Company believes that the disclosures are adequate to make the information presented not misleading. These Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2017.

 

In the opinion of management, all normal recurring adjustments necessary to present fairly the consolidated balance sheet as of September 30, 2018, the consolidated statements of operations, the statements of comprehensive income (loss), and the statements of cash flows for the three and nine months ended September 30, 2018 and September 30, 2017 as applicable, have been made. Certain prior year amounts in the financial statements and notes have been reclassified to conform to the fiscal year 2018 presentation. The results of operations for the three and nine months ended September 30, 2018 are not necessarily indicative of the operating results for the full fiscal year or any future periods.

 

Note 2. Impact of Recently Adopted Accounting Standards

 

Adoption of new accounting standards — In May 2014, the FASB issued an accounting standard update, Revenue from Contracts with Customers. The standard requires an entity to recognize revenue to depict the transfer of control of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The FASB issued several amendments to the standard since its initial issuance, including delaying its effective date to reporting periods beginning after December 15, 2017, but permitting companies the option to adopt the standard one year earlier, as well as clarifications on identifying performance obligations and accounting for licenses of intellectual property, among others.

 

 6 

 

 

There are two permitted transition methods under the new standard, the full retrospective method or the modified retrospective method. Under the full retrospective method, the standard would be applied to each prior reporting period presented and the cumulative effect of applying the standard would be recognized at the earliest period shown on the face of the financial statements being presented. Under the modified retrospective method, the cumulative effect of applying the standard would be recognized at the date of the initial application of the standard and the effect of the prior periods would be calculated and shown through a cumulative effect change in retained earnings. ARRIS adopted the standard using the modified retrospective method on January 1, 2018. (See Note 3 Revenue from Contracts with Customers for additional details).

 

In January 2016, the FASB issued an update to amend certain aspects of recognition, measurement, presentation and disclosure of financial instruments. Under this standard, certain equity investments are measured at fair value with changes recognized in current period earnings as opposed to other comprehensive income (loss). This guidance is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2017. ARRIS adopted the standard on January 1, 2018 by recording a cumulative-effect adjustment as of the beginning of the year. The adoption of this guidance did not have a material impact on the Company’s consolidated financial position and results of operations.

 

In August 2016, the FASB issued amended guidance on the classification of certain cash receipts and payments in the statement of cash flows. The primary purpose of the amended guidance is to reduce the diversity in practice that has resulted from the lack of consistent principles on this topic. The amended guidance adds or clarifies guidance on eight cash flow issues, including debt prepayment or debt extinguishment costs, settlement of zero-coupon debt instruments or certain other debt instruments, contingent consideration payments made after a business combination, proceeds from the settlement of insurance claims, proceeds from the settlement of corporate-owned life insurance policies, distributions received from equity method investees, beneficial interests in securitization transactions and separately identifiable cash flows and application of the predominance principle. The guidance is effective for the Company beginning January 1, 2018 for both interim and annual reporting periods, with early adoption permitted. Entities must apply the guidance retrospectively to all periods presented but may apply it prospectively from the earliest date practicable if retrospective application would be impracticable. ARRIS adopted this update as of January 1, 2018. The adoption of this guidance did not have a material impact on the Company’s consolidated financial position and results of operations.

 

In November 2016, the FASB issued new guidance that requires that a statement of cash flows explain the change during the period in the total of cash, cash equivalents, and amounts generally described as restricted cash or restricted cash equivalents. Therefore, amounts generally described as restricted cash and restricted cash equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total amounts shown on the statement of cash flows. The new guidance is effective for interim and annual periods beginning after December 15, 2017. ARRIS adopted this update retrospectively as of January 1, 2018. The adoption of this guidance did not have a material impact on the Company’s consolidated financial position and results of operations.

 

In March 2017, the FASB issued an accounting standard update that requires entities to disaggregate the service cost component from the other components of net periodic benefit costs and present it with other current compensation costs for related employees in the income statement and present the other components elsewhere in the income statement and outside of income from operations if that subtotal is presented. The amendments in this update also allow only the service cost component to be eligible for capitalization when applicable. The accounting standard update is effective for the Company in the first quarter of fiscal 2018. ARRIS adopted this update as of January 1, 2018. The adoption of this guidance did not have a material impact on the Company’s consolidated financial position and results of operations.

 

In May 2017, the FASB issued an accounting standard which amends the scope of modification accounting for share-based payment arrangements. The standard provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting. The accounting standard will be applied prospectively to awards modified on or after the effective date. It is effective for interim and annual periods beginning after December 15, 2017 (January 1, 2018 for the Company). ARRIS adopted this update as of January 1, 2018. The adoption of this guidance did not have a material impact on the Company’s consolidated financial position and results of operations.

 

In August 2018, the FASB issued an accounting standard update related to customer's accounting for implementation costs incurred in a cloud computing arrangement that is a service contract. The standards update aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The capitalized implementation costs of a hosting arrangement that is a service contract will be expensed over the term of the hosting arrangement. The accounting standard is effective for annual and interim periods beginning after December 15, 2019. Early adoption is permitted, including adoption in any interim period. The amendments can be applied either retrospectively or prospectively to all implementation costs incurred after the adoption date. The Company early adopted this standard in the third quarter of 2018 using the prospective method.  The adoption of this guidance did not have a material impact on the Company’s consolidated financial position and results of operations.

 

 7 

 

 

Accounting standards issued but not yet effective — In February 2016, the FASB issued new guidance that will require lessees to recognize most leases on their balance sheets as a right-of-use asset with a corresponding lease liability, and lessors to recognize a net lease investment. Additional qualitative and quantitative disclosures will also be required. This standard is effective for interim and annual reporting periods beginning after December 15, 2018, although early adoption is permitted. The new standard requires a modified retrospective transition through a cumulative-effect adjustment as of the beginning of the earliest period presented in the financial statements, although the FASB recently approved an option for transition relief to not restate or make required disclosures under the new standard in comparative periods in the period of adoption. Along with that transition relief, the FASB also recently approved a practical expedient for lessors to allow for the combined presentation of lease and non-lease revenues when certain conditions are met. 

 

Many factors will impact the ultimate measurement of the lease liability and corresponding right of use asset to be recognized upon adoption. The Company continues to evaluate the impact this guidance will have on its consolidated financial statements. The Company expects to take advantage of the transition relief provided by the amendment to the new guidance which allows us to elect not to restate 2017 and 2018 comparative periods upon adoption and continue to apply existing guidance to such periods. With respect to the other practical expedients, the Company expects to elect the package of three expedients, which allows us not to reassess the existence, the classification or the amount and treatment of initial direct costs for existing leases. The Company does not expect to apply hindsight for the evaluation of lease options (e.g., renewal).  The Company expects to elect not to record on the balance sheet a lease with a term (including reasonably certain renewal or purchase options, or reasonably certain not to terminate) of less than 12 months.  Finally, the Company expects to elect the practical expedient which allows us not to separate lease and non-lease components. This guidance becomes effective January 1, 2019 with early adoption permitted.

 

The Company has established a project management team to analyze the impact of this standard, including its current accounting policies and practices to identify potential impacts that would result from the application of this standard. The Company’s adoption process of the new standard is ongoing, including evaluating and quantifying the impact on its consolidated financial statements, identifying the population of leases (and embedded leases), implementing a selected technology solution and collecting and validating lease data. The Company expects its lease obligations designated as operating leases (as disclosed in Note 23 to the audited consolidated financial statements in its most recent Annual Report on Form 10-K) will be reported on the consolidated balance sheets upon adoption.

 

In January 2017, the FASB issued an accounting standard update that clarifies the definition of a business to help companies evaluate whether acquisition or disposal transactions should be accounted for as asset groups or as businesses. The accounting standard update will be effective for the Company beginning in the first quarter of fiscal 2019 on a prospective basis. The impact of this accounting standard update will be facts and circumstances dependent, but the Company expects, that in some situations, transactions that were previously accounted for as business combinations or disposal transactions will be accounted for as asset purchases or asset sales under the accounting standard update.

 

In August 2017, the FASB issued an accounting standard which eliminates the requirement to separately measure and report hedge ineffectiveness and requires companies to recognize all elements of hedge accounting that impact earnings in the same income statement line item where the hedged item resides. The standard includes new alternatives for measuring the hedged item for fair value hedges of interest rate risk and eases the requirements for effectiveness testing, hedge documentation and applying the critical terms match method. Finally, the standard introduces new alternatives that permit companies to reduce the risk of material error if the shortcut method is misapplied. The accounting standard is effective beginning January 1, 2019 and is required to be applied prospectively. The Company is currently assessing the potential impact of the adoption of this standard on its Consolidated Financial Statements.

 

 8 

 

 

In February 2018, the FASB issued an accounting standard which allows companies to reclassify stranded tax effects resulting from the U.S. 2017 Tax Cuts and Jobs Act, from accumulated other comprehensive income to retained earnings. The guidance also requires certain new disclosures regardless of the election. The accounting standard is effective in the first quarter of fiscal 2020, and earlier adoption is permitted. The Company is currently assessing the potential impact of the adoption of this standard on its Consolidated Financial Statements.

 

In August 2018, the FASB issued an accounting standard update which amends fair value measurement disclosure requirements aiming to improve the overall usefulness of disclosures to financial statement users and reduce unnecessary costs to companies when preparing the disclosures. This guidance will be effective for interim and annual periods beginning after December 15, 2019 and early adoption is permitted. Adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

In August 2018, the FASB issued an accounting standard update that eliminated certain disclosures about defined benefit plans, added new disclosures, and clarified other requirements. This guidance will be effective for interim and annual periods beginning after December 15, 2020 and early adoption is permitted. There were no changes to interim disclosure requirements. Adoption of this guidance is not expected to have a material effect on the Company’s annual financial statement statements.

 

Note 3. Revenue from Contracts with Customers

 

On January 1, 2018, the Company adopted the new accounting standard Revenue from Contracts with Customers using the modified retrospective transition method. The Company has elected to apply the new standard to contracts that were considered “open” as of January 1, 2018. Results for reporting periods beginning after January 1, 2018 are presented under the new accounting standard, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting under previous guidance. Upon adoption, an initial cumulative effect adjustment of $1.8 million increase was recorded to opening accumulated deficit and a $2.7 million increase in shareholder’s equity attributable to noncontrolling interest.

 

Revenue Recognition

 

ARRIS generates revenue from varying activities, including the delivery of stand-alone equipment, custom design and installation services, and bundled sales arrangements inclusive of equipment, software and services. Revenue is recognized when performance obligations in a contract are satisfied through the transfer of control of the good or service at an amount of consideration expected to receive. The following are required before revenue is recognized:

 

·Identify the contract with the customer. A variety of arrangements are considered contracts; however, these are usually the Master Purchase Agreement and amendments or customer purchase orders.
·Identify the performance obligations in the contract. Performance obligations are identified as promised goods or services in an arrangement that are distinct.
·Determine the transaction price. Transaction price is the amount of consideration the Company expects in exchange for transferring the promised goods or services. The consideration may include fixed or variable amounts or both.
·Allocate the transaction price to the performance obligations. The transaction price is allocated to the performance obligations on a relative standalone selling price basis.
·Recognize revenue as the performance obligations are satisfied. Revenue is recognized when transfer of control of the promised goods or services has occurred. This is either at a point in time or over time.

 

Revenue is deferred for any performance obligations in which payment is received or due prior to the transfer of control of the good or service.

 

Equipment – For the N&C and CPE segments, the Company provides customers with equipment that can be placed within various stages of a broadband system that enable delivery of telephony, video and high-speed data as well as outside plant construction and maintenance equipment. For the Enterprise segment, equipment sales include products for wireless and wired connections to data networks. For equipment sales, revenue is recognized when control of the product has transferred to the customer. This is generally at a point in time when products have been shipped, right to payment has normally been obtained, and risk of loss has been transferred. Additionally, based on historical experience, ARRIS has established reliable estimates related to sales returns and other allowances for discounts. These estimates are recorded as a reduction to revenue at the time the revenue is recognized.

 

 9 

 

 

The Company’s equipment deliverables typically include proprietary operating system software, which isn’t considered separately identifiable. Therefore, ARRIS’s equipment deliverables are considered one distinct performance obligation.

 

Multiple Performance Obligation Arrangements – Certain customer transactions may include multiple performance obligations based on the bundling of equipment, software and services. When a multiple performance obligation arrangement exists, the transaction price is allocated to the performance obligations, and revenue is recognized on a relative standalone selling price basis upon transfer of control.

 

To determine the standalone selling price (“SSP”), the Company first looks to establish SSP through an observable price when the good or service is sold separately in similar circumstances. If SSP cannot be established through an observable price, the Company will estimate the SSP considering market conditions, customer specific factors, and customer class. The Company typically uses a combination of approaches to estimate SSP.

 

Software Sold Without Tangible Equipment – ARRIS sells functional intellectual property (“IP”) licenses that typically do not meet the criteria to be recognized over time. Revenue from a functional IP license is most commonly recognized upon delivery of the license/software to the customer.

 

Standalone Services – Standalone service revenues result from a variety of offerings including:

 

·Maintenance and support services, provided under annual service-level agreements with the Company’s customers. These services represent stand-ready obligations that are recognized over time (on a straight-line basis over the contract period) because the customer simultaneously receives and consumes the benefits of the services as the services are performed.

 

·Professional services and other similar services consist primarily of “Day 2” services to help customers maximize their utilization of deployed ARRIS systems. The services are recognized over time because the customer simultaneously receives and consumes the benefits of the service as the services are performed.

 

·Installation services relate to the routine installation of equipment ordered by the customer at the customer’s site and are distinct performance obligations from delivery of the related hardware. The associated revenues are recognized over time as the services are provided, which is generally a very short period (less than a couple of days).

 

Incentives – Customer incentive programs that include consideration, primarily rebates/credits to be used against future product purchases and certain volume discounts, are classified as variable consideration and reduce the overall transaction price.

 

Value Added Resellers (VAR), Distribution Channels and Retail – ARRIS recognizes revenue upon transfer of control of the goods or services to the VAR, Distributors and Retail customers. Sales through retail and distribution channels are made primarily under agreements or commitments allowing for limited rights of return, primarily for stock rotation purposes, and include various sales incentive programs, such as back-end rebates, discounts, marketing development funds, price protection, and volume incentives.

 

Enterprise sales distributors are granted rights of stock rotation that are limited to contractually specified percentage of the distributors aggregate purchase volume.  These stock rotation rights are subject to expiration 180 days from the time of product shipment by us to the distributor.  Upon shipment of the product, ARRIS reduces revenue for an estimate of potential future stock rotation returns related to the current period product revenue. ARRIS analyzes historical returns, channel inventory levels, current economic trends and changes in customer demand for our products when evaluating the adequacy of the allowance for sales returns, namely stock rotation returns.

 

 10 

 

 

Regarding the various sales incentive programs, the Company can reasonably estimate its backend rebates, discounts and similar incentives due to an established sales history with its customers and records the estimated reserves and allowances at the time the related revenue is recognized. The Company recognizes marketing development funds at the later of when the related revenue is recognized, or the program is offered to the channel partner. ARRIS’s sales incentives to its channel partners are recorded as a reduction to revenue.

 

ARRIS’s estimated allowances for returns due to stock rotation and various sales incentive programs can vary from actual results that could materially impact our financial position and results of operations. Based on the relevant facts and circumstances, the Company believes the methodologies applied to calculate these reserves fairly represents our expected results at the point in time in which they are made.

 

Disaggregation of Revenue

 

The following table summarizes the revenues from contracts with customers by major product line for the three and nine months ended September 30, 2018 (in thousands):

 

   Three months ended
September 30, 2018
   Nine months ended
September 30, 2018
 
CPE:          
Broadband CPE  $448,518   $1,176,886 
Video CPE   492,951    1,647,941 
Sub-total   941,469    2,824,827 
Network & Cloud:          
Networks   458,303    1,390,690 
Software and services   73,732    229,105 
Sub-total   532,035    1,619,795 
Enterprise Networks:          
Enterprise Networks   180,159    522,313 
Other:          
Other   (2,415)   (11,437)
Total net sales  $1,651,248   $4,955,498 

 

Customer Premises Equipment — The CPE segment’s product solutions include Broadband products, such as DSL and DOCSIS gateways and modems, and Video products, such as video gateways, clients and set-tops, that enable service providers to offer voice, video and high-speed data services to residential and business subscribers.

 

Network & Cloud — The N&C segment’s product solutions include cable modem termination system, video infrastructure, distribution and transmission equipment and cloud solutions that enable facility-based service providers to construct a state-of-the-art residential and metro distribution network. The portfolio also includes a full suite of global services that offer technical support, professional services and system integration offerings to enable solution sales of ARRIS’s end-to-end product portfolio.

 

Enterprise Networks — The Enterprise Networks segment focuses on enabling constant, wireless and wired connectivity across complex and varied networking environments. It offers dedicated engineering, sales and marketing resources to serve customers across a spectrum of enterprises—including hospitality, education, smart cities, government, venues, service providers and more.

 

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The following table summarizes the revenues from contracts with customers by geographic areas for the three and nine months ended September 30, 2018 (in thousands):

 

   For the three months ended September 30, 2018 
  

CPE

  

N&C

  

Enterprise

  

Other (1)

  

Total

 
Domestic – U.S.  $533,410   $334,591   $116,691   $(1,315)  $983,377 
                          
Americas, excluding U.S.   206,350    97,785    (1,723)       302,412 
Asia Pacific   30,814    39,670    29,964        100,448 
EMEA   170,895    59,989    35,227    (1,100)   265,011 
Total international   408,059    197,444    63,468    (1,100)   667,871 
Total net revenues  $941,469   $532,035   $180,159   $(2,415)  $1,651,248 

 

   For the nine months ended September 30, 2018 
   CPE   N&C   Enterprise  

Other (1)

   Total 
Domestic – U.S.  $1,546,338   $1,006,903   $323,033   $(6,426)  $2,869,848 
                          
Americas, excluding U.S.   582,564    297,665    5,899    (5)   886,123 
Asia Pacific   82,020    135,013    83,065    (40)   300,058 
EMEA   613,905    180,214    110,316    (4,966)   899,469 
Total international   1,278,489    612,892    199,280    (5,011)   2,085,650 
Total net revenues  $2,824,827   $1,619,795   $522,313   $(11,437)  $4,955,498 

 

(1)Adjustments include acquisition accounting impacts related to deferred revenue

 

Impact of New Revenue Guidance on Financial Statement Line Items

 

The following table compares the reported condensed balance sheet and statement of operations, as of and for the three and nine months ended September 30, 2018, to the pro-forma amounts had the previous guidance been in effect (in thousands):

 

   As Reported
September 30, 2018
   Pro forma – as if
previous accounting
guidance was in
effect
 
Assets          
Accounts receivable  $1,117,641   $1,106,550 
Other current assets   201,111    201,047 
Deferred incomes taxes   155,193    149,971 
Liabilities          
Deferred revenue (current and non-current)  $174,542   $176,002 

 

  

Three Months

Ended September 30, 2018

  

Nine Months

Ended September 30, 2018

 
   As reported   Pro-forma   As reported   Pro-forma 
Revenues                    
Net sales  $1,651,248   $1,655,526   $4,955,498   $4,931,254 
Costs and expenses                    
Cost of sales  $1,186,059   $1,186,059   $3,515,871   $3,515,935 
Income tax benefit   (15,652)   (16,042)   (22,106)   (16,884)
Consolidated net income   45,808    50,477    63,574    34,045 
Net loss attributable to non-controlling interest   (1,271)   (1,292)   (5,659)   (6,422)
Net income attributable to ARRIS International plc   47,079    51,769    69,233    40,467 
Net income per ordinary share:                    
Basic  $0.26   $0.29   $0.38   $0.22 
Diluted  $0.26   $0.29   $0.38   $0.22 

 

 12 

 

 

Pro-forma net sales were $4.3 million higher than and $24.2 million lower than reported net sales in the Consolidated Statements of Operations for the three and nine months ended September 30, 2018, respectively, largely due to the timing of license revenue that is currently being recognized upon delivery of the license as opposed to recognizing ratably over the license term.

 

Other

 

Contract Assets and Liabilities When payments from customers are received in advance of performance, the Company records a contract liability (deferred revenue). When the Company fulfills performance obligations prior to being able to invoice the customer, a contract asset (unbilled receivables) is recorded. Additionally, the balances for these are calculated at the contract level on a net basis.

 

The unbilled receivables are included in Accounts Receivable on the unaudited Consolidated Balance Sheets. As of September 30, 2018, the Company has unbilled receivables of $45.0 million.

 

The changes in the contract asset account relate to license revenue is now being recognized upon delivery instead of being recognized ratably over the license term.

 

The following table summarizes the changes in deferred revenue for the nine months ended of September 30, 2018 (in thousands)

 

Opening balance at January 1, 2018  $168,757 
Deferral of revenue   127,467 
Recognition of unearned revenue   (120,712)
Other   (970)
Balance at September 30, 2018  $174,542 

 

As of the end of the current reporting period, the aggregate amount of the transaction price allocated to performance obligations that are unsatisfied that have a duration of one year or more was $66.4 million. The majority of ARRIS’s contracts that have performance obligations that are unsatisfied are part of contracts have a duration of one year or less.

 

Practical Expedients

 

Sales commissions are incremental contract acquisition costs which are expected to be recovered. The Company has elected to recognize these expenses as incurred due to the amortization period of these costs being one year or less.

 

Costs to obtain or fulfill a contract are incremental costs that are expected to be recovered. The Company has elected to recognize these expenses as incurred due to the amortization period of these costs being one year or less. Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained are recognized in expense when incurred.

 

The Company has elected not to adjust the promised amount of consideration for the effects of a significant financing component when it expects, at contract inception, that the period between when ARRIS transfers a promised good or service to a customer, and when the customer pays will be one year or less.

 

The Company has elected the expedient that states an entity does not need to evaluate whether shipping and handling activities are promised services to its customers. If revenue is recognized for the related good before the shipping and handling activities occur, the related costs of those shipping and handling activities are accrued.

 

The Company has also elected to exclude from the transaction price certain types of taxes collected from a customer and remitted to a third-party (e.g., governmental agency), including sales, use and value-added taxes. As a result, revenue is presented net of these taxes.

 

 13 

 

 

Additionally, the Company has elected for contracts that were modified before the beginning of the earliest reporting period to reflect the aggregate effect of all modifications when identifying the satisfied and unsatisfied performance obligations, determining the transaction price, and allocating the transaction price.

 

Note 4. Business Acquisition

 

Acquisition of Ruckus Wireless and ICX Switch business

On December 1, 2017, ARRIS completed the acquisition of Ruckus Wireless and ICX Switch business (“Ruckus Networks”). The total cash paid was approximately $761.0 million (net of estimated adjustments for working capital and noncash settlement of pre-existing payables and receivables) The purchase agreement provides for customary final adjustments and potential cash payments or receipts that are expected to occur in 2018.

 

With this acquisition, ARRIS expands its leadership in converged wired and wireless networking technologies beyond the home into the education, public venue, enterprise, hospitality, and multi-dwelling unit markets.

 

The preliminary estimated goodwill of $310.8 million arising from the acquisition is attributable to the strategic opportunities and synergies that are expected to arise from the acquisition of Ruckus Networks and the workforce of the acquired business. Goodwill has been preliminarily assigned to our new Enterprise reporting unit as of September 30, 2018. The Company will finalize the assignment during the measurement period. A portion of the goodwill is expected to be deductible for income tax purposes.

 

The following table summarizes the fair value of consideration transferred for Ruckus Networks (in thousands):

 

Cash consideration  $779,743 
Estimated working capital adjustments   (16,371)
Non-cash consideration (1)   (2,359)
Total consideration transferred  $761,013 

 

(1)Non-cash consideration represents a $2.4 million settlement of preexisting payables and receivables between Ruckus Networks and ARRIS.

 

The following is a summary of the estimated fair values of the net assets acquired (in thousands):

 

   Amounts Recognized as
of Acquisition Date (a)
   Adjustments   Amounts Recognized
as of Acquisition
Date (as adjusted)
 
Total estimated consideration transferred  $761,013   $   $761,013 
Cash and cash equivalents   18,958        18,958 
Accounts receivable, net   32,940    (5,999)   26,941 
Inventories   48,897    (461)   48,436 
Prepaids & other   4,836    (1,006)   3,830 
Property, plant & equipment   33,500    (1,637)   31,863 
Intangible assets   472,500    22,200    494,700 
Other assets   39,528    (37,897)   1,631 
Accounts payable and accrued liabilities   (17,216)   1,523    (15,693)
Other current liabilities   (9,666)   (1,988)   (11,654)
Deferred revenue   (47,718)   970    (46,748)
Noncurrent deferred income tax liabilities   (92,233)   (7,643)   (99,876)
Other noncurrent liabilities   (41,347)   39,160    (2,187)
Net assets acquired   442,979    7,222    450,201 
Goodwill  $318,034    (7,222)  $310,812 

 

(a)As previously reported as of December 31, 2017

 

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As a result of measurement period changes for intangible assets, the Company recorded a decrease to previously recorded amortization for quarters ended December 31, 2017 and March 31, 2018 of $1.8 million and $1.0 million, respectively. These adjustments have been recorded prospectively in the first nine months of 2018.  

 

The acquisition was accounted for using the acquisition method of accounting, which requires, among other things, that the assets acquired, and liabilities assumed be recognized at their acquisition date fair values, with any excess of the consideration transferred over the estimated fair values of the identifiable net assets acquired recorded as goodwill. The accounting for the business combination is based on currently available information and is considered preliminary. The Company has not received a final valuation report from the independent valuation expert for acquired property, plant and equipment and intangible assets. In addition, the Company is still gathering information about income taxes and deferred income tax assets and liabilities, accounts receivables, warranty obligations, other assets and accrued liabilities based on facts that existed as of the date of the acquisition. The final accounting for the business combination may differ materially from that presented in these unaudited consolidated financial statements.

 

The $494.7 million of acquired intangible assets are comprised of the following (in thousands):

 

  

Preliminary
Estimated
Fair value

  

Estimated Weighted
Average Life (years)

 
Technology and patents  $217,900    5.4 
Customer contracts and relationships   195,400    10.0 
Tradenames   55,400     indefinite  
Trademarks and tradenames   10,700    10.0 
Backlog   15,300    0.3 
Total estimated fair value of intangible assets  $494,700      

 

The fair value of trade accounts receivable is $26.9 million with the gross contractual amount being $28.1 million. The Company expects $1.2 million to be uncollectible.

 

The Company incurred acquisition related costs of $0.1 million and $0.7 million during the three and nine months ended September 30, 2018, respectively. This amount was expensed by the Company as incurred and is included in the Consolidated Statement of Operations in the line item titled “Integration, acquisition, restructuring and other costs”.

 

The Ruckus Networks business contributed revenues of approximately $522.3 million to the Company’s consolidated results for the nine months ended September 30, 2018.

 

Note 5. Goodwill and Intangible Assets

 

Goodwill

 

As of September 30, 2018, the Company has preliminarily recorded goodwill of $310.8 million related to the Ruckus Networks acquisition. The Company is in the process of assigning the assets and liabilities acquired to each of its identified reporting units and as such, the determination of this goodwill by reporting unit is incomplete as of September 30, 2018.  The Company intends to finalize the assignment of the goodwill from the Ruckus Networks acquisition during fiscal year 2018.

 

 15 

 

 

The changes in the carrying amount of goodwill for the year to date period ended September 30, 2018 are as follows (in thousands):

 

   CPE   N & C   Enterprise   Total 
Goodwill  $1,386,680   $1,003,654   $318,034   $2,708,368 
Accumulated impairment losses       (429,856)       (429,856)
Balance as of December 31, 2017  $1,386,680   $573,798   $318,034   $2,278,512 
Changes in year 2018:                    
Goodwill acquired, net           (7,222)   (7,222)
Impairment       (3,400)       (3,400)
Other   (7,341)   453        (6,888)
Balance as of September 30, 2018  $1,379,339   $570,851   $310,812   $2,261,002 
                     
Goodwill   1,379,339    1,004,107    310,812    2,694,258 
Accumulated impairment losses       (433,256)       (433,256)
Balance as of September 30, 2018  $1,379,339   $570,851   $310,812   $2,261,002 

 

In addition, during the nine months ended September 30, 2018, the Company recorded partial impairment of goodwill of $3.4 million related to our Cloud TV reporting unit, respectively, of which $1.2 million is attributable to the noncontrolling interest. This impairment was a result of the indirect effect of a change in accounting principle related to the adoption of new accounting standard Revenue from Contracts with Customers, resulting in changes in the composition and carrying amount of the net assets of our Cloud TV reporting unit. The partial impairment was included in impairment of goodwill on the Consolidated Statements of Operations.

 

Intangible Assets

 

The gross carrying amount and accumulated amortization of the Company’s acquired intangible assets as of September 30, 2018 and December 31, 2017 are as follows (in thousands):

 

   September 30, 2018   December 31, 2017 
   Gross
Amount
   Accumulated
Amortization
   Net Book
Value
   Gross
Amount
   Accumulated
Amortization
   Net Book
Value
 
Definite-lived intangible assets:                              
Customer relationships  $1,759,668   $908,648   $851,020   $1,672,470   $780,655   $891,815 
Developed technology, patents & licenses   1,479,200    914,538    564,662    1,521,893    771,200    750,693 
Trademarks, trade and domain names   75,672    58,631    17,041    87,472    41,885    45,587 
Backlog   15,300    14,843    457    35,000    5,833    29,167 
Sub-total   3,329,840    1,896,660    1,433,180    3,316,835    1,599,573    1,717,262 
                               
Indefinite-lived intangible assets:                              
Tradenames   55,400        55,400             
In-process research and development               54,100        54,100 
Sub-total   55,400        55,400    54,100        54,100 
Total  $3,385,240   $1,896,660   $1,488,580   $3,370,935   $1,599,573   $1,771,362 

 

 16 

 

 

As of September 30, 2018, the Company preliminarily recorded intangible assets (other than goodwill) of $494.7 million related to the Ruckus Networks acquisition. In-process research and development of $4.1 million was reclassified to become a definite-lived asset upon completion of the associated research and development efforts during the quarter ended June 30, 2018.

 

Amortization expense is reported in the consolidated statements of operations within cost of sales and operating expenses. The following table presents the amortization of acquired intangible assets (in thousands):

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
                 
Cost of sales  $890   $871   $2,668   $2,293 
Selling, general and administrative expenses   986    950    2,969    2,849 
Amortization of acquired intangible assets (1)   88,305    90,162    293,499    274,819 
Total  $90,181   $91,983   $299,136   $279,961 

 

(1)Reflects amortization expense for the intangible assets acquired through business combinations.

 

The estimated total amortization expense for finite-lived intangibles for each of the next five fiscal years is as follows (in thousands):

 

 

2018 (for the remaining three months)  $89,861 
2019   332,979 
2020   321,134 
2021   186,348 
2022   149,089 
Thereafter   353,769 

 

Note 6. Investments

 

ARRIS’s investments consisted of the following (in thousands):

 

   As of September 30, 2018   As of December 31, 2017 
Current Assets:          
Available-for-sale securities  $39,640   $23,874 
Noncurrent Assets:          
Available-for-sale securities   5,996    5,718 
Equity method investments   22,217    22,021 
Cost method investments   9,986    10,092 
Other investments   33,548    33,251 
Total classified as non-current assets   71,747    71,082 
Total  $111,387   $94,956 

 

Available-for-sale securities - ARRIS’s investments in debt and marketable equity securities are categorized as available-for-sale and are carried at fair value. Realized gains and losses on available-for-sale securities are included in net income. Unrealized gains and losses on available-for-sale debt securities are included in the Consolidated Balance Sheets as a component of accumulated other comprehensive income (loss).

 

The amortized costs and fair value of available-for-sale securities were as follows (in thousands):

 

   September 30, 2018   December 31, 2017 
   Amortized
Costs
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair
Value
   Amortized
Costs
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
   Fair
Value
 
Certificates of deposit (non-U.S.)  $39,640   $   $   $39,640   $12,809   $   $   $12,809 
Corporate bonds                   11,003    86    (24)   11,065 
Corporate obligations   14            14    13            13 
Money markets   37            37    38            38 
Mutual funds   87        (1)   86    65    14        79 
Other investments   5,898    531    (570)   5,859    4,941    744    (97)   5,588 
Total  $45,676   $531   $(571)  $45,636   $28,869   $844   $(121)  $29,592 

 

 17 

 

 

The following table represents the breakdown of the available-for-sale investments with gross unrealized losses and the duration that those losses had been unrealized (in thousands):  

 

   September 30, 2018 
   Less than 12 months   12 months or more   Total 
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
 
Certificates of deposit (non-U.S.)  $39,640   $   $   $   $39,640   $ 
Corporate obligations   14                14     
Money markets   37                37     
Mutual funds   86    (1)           86    (1)
Other investments   5,859    (570)           5,859    (570)
Total  $45,636   $(571)  $   $   $45,636   $(571)

 

   December 31, 2017 
   Less than 12 months   12 months or more   Total 
   Fair
value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
 
Certificates of deposit (non-U.S.)  $12,809   $   $   $   $12,809   $ 
Corporate bonds   11,065    (24)           11,065    (24)
Corporate obligations   13                13     
Money markets   38                38     
Mutual funds   79                79     
Other investments   5,588    (97)           5,588    (97)
Total  $29,592   $(121)  $   $   $29,592   $(121)

 

As of September 30, 2018, for fixed income securities that were in unrealized loss positions, the Company has determined that (i) it does not have the intent to sell any of these investments, and (ii) it is more likely than not that it will not be required to sell any of these investments before recovery of the entire amortized cost basis.

 

The sale and/or maturity of available-for-sale securities resulted in the following activity (in thousands):

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
   2018   2017   2018   2017 
                 
Proceeds from sales  $31,876   $5,000   $45,638   $155,301 
Gross gains       1    5    13 
Gross losses                

 

The contractual maturities of the Company’s available-for-sale securities as of September 30, 2018 are shown below. Actual maturities may differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties (in thousands):

 

   September 30, 2018 
   Amortized Cost   Fair Value 
Within 1 year  $39,640   $39,640 
After 1 year through 5 years        
After 5 years through 10 years        
After 10 years   6,036    5,996 
Total  $45,676   $45,636 

 

Other-than-temporary investment impairments - ARRIS evaluates its investments for any other-than-temporary impairment on a quarterly basis considering all available evidence, including changes in general market conditions, specific industry and individual entity data, the financial condition and the near-term prospects of the entity issuing the security, and the Company’s ability and intent to hold the investment until recovery. For the three and nine months ended September 30, 2018, ARRIS concluded that no other-than-temporary impairment losses existed.

 

 18 

 

 

For the three months ended September 30, 2017, the Company concluded that no other-than-temporary impairment losses existed. For the nine months ended September 30, 2017, the Company concluded that one private company had indicators of impairment, as the cost basis exceeded the fair value of the investments resulting in other-than-temporary impairment charges of $2.8 million. These charges are reflected in the Consolidated Statements of Operations.

 

Classification of securities as current or non-current is dependent upon management’s intended holding period, the security’s maturity date and liquidity consideration based on market conditions. If management intends to hold the securities for longer than one year as of the balance sheet date, they are classified as non-current.

 

Note 7. Fair Value Measurement

 

Fair value is based on the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. U.S GAAP establishes a fair value hierarchy that is based on the extent and level of judgment used to estimate the fair value of assets and liabilities. To increase consistency and comparability in fair value measurements, the FASB has established a fair value hierarchy that prioritizes observable and unobservable inputs used to measure fair value into three broad levels. An asset or liability’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the measurement of its fair value. The three levels of input defined by U.S GAAP are as follows:

 

Level 1: Quoted prices (unadjusted) in active markets that are accessible at the measurement date for assets or liabilities.

Level 2: Observable prices that are based on inputs not quoted on active markets but corroborated by market data.

Level 3: Unobservable inputs are used when little or no market data is available.

 

The following table presents the Company’s investment assets (excluding equity and cost method investments) and derivatives measured at fair value on a recurring basis as of September 30, 2018 and December 31, 2017 (in thousands):

 

   September 30, 2018 
   Level 1   Level 2   Level 3   Total 
Certificates of deposit (non-U.S.)  $   $39,640   $   $39,640 
Corporate obligations       14        14 
Money markets   37            37 
Mutual funds   86            86 
Other investments       5,859        5,859 
Interest rate derivatives — asset derivatives       24,480        24,480 
Interest rate derivatives — liability derivatives                
Foreign currency contracts — asset position       3,806        3,806 
Foreign currency contracts — liability position       (605)       (605)

 

   December 31, 2017 
   Level 1   Level 2   Level 3   Total 
Certificates of deposit (non-U.S.)  $   $12,809   $   $12,809 
Corporate bonds       11,065        11,065 
Corporate obligations       13        13 
Money markets   38            38 
Mutual funds   79            79 
Other investments       5,588        5,588 
Interest rate derivatives — asset derivatives       10,156        10,156 
Interest rate derivatives — liability derivatives       (4,024)       (4,024)
Foreign currency contracts — asset position       405        405 
Foreign currency contracts — liability position       (8,802)       (8,802)

 

In addition to the financial instruments included in the above table, certain nonfinancial assets and liabilities are measured at fair value on a nonrecurring basis in accordance with applicable authoritative guidance. This includes items such as nonfinancial assets and liabilities initially measured at fair value in a business combination (but not measured at fair value in subsequent periods) and nonfinancial long-lived asset groups measured at fair value for an impairment assessment. In general, nonfinancial assets including goodwill, other intangible assets and property and equipment are measured at fair value when there is an indication of impairment and are recorded at fair value only when any impairment is recognized.

 

 19 

 

 

During the nine months ended September 30, 2018, the Company recorded partial impairment of goodwill of $3.4 million related to our Cloud TV reporting unit, of which $1.2 million is attributable to the noncontrolling interest, respectively. During the fourth quarter of 2017, the Company recorded partial impairments of goodwill and indefinite-lived tradenames of $51.2 million and $3.8 million, respectively, acquired in the ActiveVideo acquisition and included as part of the Cloud TV reporting unit, of which $19.3 million is attributable to the noncontrolling interest. See Note 5 Goodwill and Intangible Assets for further discussion.

 

The Company believes the principal amount of debt as of September 30, 2018 approximated fair value because of interest-bearing rates that are adjusted periodically, analysis of recent market conditions, prevailing interest rates, and other Company specific factors. The Company has classified the debt as a Level 2 item within the fair value hierarchy.

 

Note 8. Derivative Instruments and Hedging Activities

 

Overview

 

ARRIS is exposed to financial market risk, primarily related to foreign currency and interest rates. These exposures are actively monitored by management. To manage the volatility related to certain of these exposures, the Company enters a variety of derivative financial instruments. Management’s objective is to reduce, where it is deemed appropriate to do so, fluctuations in earnings and cash flows associated with changes in foreign currency and interest rates. ARRIS’s policies and practices are to use derivative financial instruments only to the extent necessary to manage exposures. ARRIS does not hold or issue derivative financial instruments for trading or speculative purposes.

 

The Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a specific risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives also may be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting. In accordance with the FASB’s fair value measurement guidance, the Company made an accounting policy election to measure the credit risk of its derivative financial instruments that are subject to master netting agreements on a net basis by counterparty portfolio.

 

Cash Flow Hedges of Interest Rate Risk

 

The Company’s senior secured credit facilities, which are comprised of (i) a “Term Loan A Facility”, (ii) a “Term Loan A-1 Facility”, (iii) a “Term Loan B-3 Facility”, and (iv) a “Revolving Credit Facility”, have variable interest rates based on LIBOR. (See Note 15 Indebtedness for additional details.) As a result of exposure to interest rate movements, during 2015, the Company entered into various interest rate swap arrangements, which effectively converted $625.0 million of its variable-rate debt based on one-month LIBOR to an aggregate fixed rate of 2.25% plus a leverage-based margin.  During 2016, due to additional exposure from the Term Loan A-1 Facility, the Company added additional interest rate swap arrangements which effectively converted $450.0 million of the Company’s variable-rate debt based on one-month LIBOR to an aggregate fixed rate of 0.98% plus a leverage-based margin.  Total notional amount of these swaps as of September 30, 2018 was $1,075.0 million and each swap matures on March 31, 2020.

 

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During the nine months ended September 30, 2018, the Company entered into new forward-starting interest rate swap arrangements which effectively will convert $1,075.0 million of the Company’s variable-rate debt based on one-month LIBOR to an aggregate fixed rate of 2.63% plus a leverage-based margin for the period beginning March 31, 2020 and ending June 30, 2022. ARRIS has designated these swaps as cash flow hedges, and the objective of these hedges is to manage the variability of cash flows in the interest payments related to the portion of the variable-rate debt designated as being hedged.

 

The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

 

The effective portion of changes in the fair value of derivatives designated and that qualify as cash flow hedges is recorded in Accumulated Other Comprehensive Income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. During 2018, such derivatives were used to hedge the variable cash flows associated with debt. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three and nine months ended September 30, 2018, approximately $0.1 million and $0.5 million in income has been recorded related to hedge ineffectiveness by the Company.

 

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest payments are made on the Company’s variable-rate debt. Over the next 12 months, the Company estimates that an additional $9.6 million may be reclassified as a decrease to interest expense.

 

The table below presents the impact the Company’s derivative financial instruments had on Consolidated Statement of Operations (in thousands):

  

Location of
Gain(Loss)
Reclassified from

AOCI into Income

 

Three months ended

September 30,

  

Nine months ended

September 30,

 
     2018   2017   2018   2017 
Gain (Loss) Recognized in OCI on Derivatives (Effective Portion)  Interest expense  $4,742   $340   $19,122   $(394)
Amounts Reclassified from Accumulated OCI into Income (Effective Portion)  Interest expense   (1,010)   (17)   (1,258)   1,777 

 

The following table indicates the location on the Consolidated Balance Sheets in which the Company’s derivative assets and liabilities designated as hedging instruments have been recognized and the related fair values of those derivatives (in thousands):

 

   Balance Sheet Location  September 30, 2018   December 31, 2017 
            
Interest rate derivatives — asset derivatives  Other current assets   9,560    3,590 
Interest rate derivatives — asset derivatives  Other assets   14,920    6,566 
Interest rate derivatives — liability derivatives  Other accrued liabilities       (3,053)
Interest rate derivatives — liability derivatives  Other noncurrent liabilities       (971)

 

Credit-risk-related Contingent Features

 

Each of ARRIS’s agreements with its derivative counterparties contains a provision where the Company could be declared in default on its derivative obligations if repayment of the underlying indebtedness is accelerated by the lender due to the Company's default on the indebtedness. As of September 30, 2018, and December 31, 2017, the fair value of derivatives, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was a net asset position of $24.5 million and $6.1 million, respectively. As of September 30, 2018, the Company has not posted any collateral related to these agreements nor has it required any of its counterparties to post collateral related to these or any other agreements.

 

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Non-designated hedges of foreign currency risk

 

The Company has U.S. dollar functional currency entities that bill certain international customers in their local currency and foreign functional currency entities that procure in U.S. dollars. ARRIS also has certain predictable expenditures for international operations in local currency. Additionally, certain intercompany transactions are denominated in foreign currencies and subject to revaluation. To mitigate the volatility related to fluctuations in the foreign exchange rates for certain exposures, ARRIS has entered into various foreign currency contracts. As of September 30, 2018, the Company had forward contracts with notional amounts totaling 15 million euros which mature throughout 2018, forward contracts with a total notional amount of 40 million Australian dollars which mature throughout 2018 and 2019, forward contracts with notional amounts totaling 41 million Canadian dollars which mature throughout 2018 and 2019, forward contracts with notional amounts totaling 20 million British pounds which mature throughout 2018 and forward contracts with notional amounts totaling 475.4 million South African rand which mature throughout 2018 and 2019.

 

The Company’s objective in using foreign currency derivatives are to add stability to foreign currency gains and losses recorded as other expense (income) and to manage its exposure to foreign currency movements. To accomplish this objective, the Company uses foreign currency option and foreign currency forward contracts as part of its foreign currency risk management strategy. The Company’s foreign currency derivative instruments economically hedge certain risk but are not designated as hedges, and accordingly, all changes in the fair value of the instruments are recognized as a loss (gain) on foreign currency in the Consolidated Statements of Operations. The maximum time frame for ARRIS’s derivatives is currently twelve months.

 

The following table indicates the location on the Consolidated Balance Sheets in which the Company’s derivative assets and liabilities not designated as hedging instruments have been recognized and the related fair values of those derivatives (in thousands):

 

   Balance Sheet Location  September 30, 2018   December 31, 2017 
        
Foreign exchange contracts — asset derivatives  Other current assets  $3,806   $405 
Foreign exchange contracts — liability derivatives  Other accrued liabilities   (516)   (8,202)
Foreign exchange contracts — liability derivatives  Other non-current liabilities   (89)   (600)

 

The change in the fair values of ARRIS’s derivatives not designated as hedging instruments recorded in the Consolidated Statements of Operations were as follows (in thousands):

 

   Statement of Operations Location  Three months ended
 September 30,
   Nine months ended
 September 30,
 
     2018   2017   2018   2017 
Foreign exchange contracts  (Gain) loss on foreign currency  $(1,606)  $3,155   $(10,488)  $19,474 

 

Note 9. Pension Benefits

 

Components of Net Periodic Pension Cost (in thousands):

 

   U.S. Pension Plans   Non-U.S. Pension Plans 
  

Three months ended

September 30,

   Three months ended
September 30,
 
  

2018

  

2017 

  

2018 

  

2017 

 
Service cost  $   $   $158   $154 
Interest cost   345    434    101    113 
Return on assets (expected)   (62)   (224)   (68)   (75)
Amortization of net actuarial loss(gain)   253    138         
Net periodic pension cost  $536   $348   $191   $192 

 

   U.S. Pension Plans   Non-U.S. Pension Plans 
  

Nine months ended

September 30,

  

Nine months ended

September 30,

 
  

2018

  

2017

  

2018

  

2017

 
Service cost  $   $   $475   $462 
Interest cost   1,036    1,302    303    339 
Return on assets (expected)   (186)   (672)   (205)   (225)
Amortization of net actuarial loss(gain)   759    414         
Net periodic pension cost  $1,609   $1,044   $573   $576 

 

 

 22 

 

 

Employer Contributions

 

All the amounts in the tables above, other than service cost, were recorded in Other (income) expense, net on the Consolidated Statements of Operations. No minimum funding contributions are required in 2018 under the Company’s U.S. defined benefit plan. For the three and nine months ending September 30, 2017, $1.4 million was contributed.

 

During the three and nine months ended September 30, 2018, the Company made a minimum funding contribution of $0.2 million and $1.7 million, respectively, related to its Taiwan pension plan. During the three and nine months ended September 30, 2017, the Company made a minimum funding contribution of $0.3 and $0.9 million, respectively, related to its Taiwan pension plan.

 

In late 2017, the Company commenced the process of terminating its U.S. defined benefit pension plan. In July 2018, the Company received a favorable IRS Letter of Determination approving the Plan’s termination. Election notices for participants not currently receiving a benefit are in process of distribution. Based on the most recently available information, the Company expects the final accumulated benefit obligation to approximate $21.5 million and intends to distribute all plan assets including earnings thereon, by the end of 2019. The plan's deferred actuarial losses remaining in accumulated other comprehensive income (loss) at that time will be recognized as expense.

 

Note 10. Guarantees

 

Warranty

 

ARRIS provides warranties of various lengths to customers based on the specific product and the terms of individual agreements. The Company provides for the estimated cost of product warranties based on historical trends, the embedded base of product in the field, failure rates, and repair costs at the time revenue is recognized. Expenses related to product defects and unusual product warranty problems are recorded in the period that the problem is identified. 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 could be affected by changes in ongoing product failure rates, material usage and service delivery costs incurred in correcting a product failure, as well as specific product failures outside of ARRIS’s baseline experience. If actual product failure rates, material usage or service delivery costs differ from estimates, revisions (which could be material) would be recorded to the warranty liability.

 

The Company offers extended warranties and support service agreements on certain products. Revenue from these agreements is deferred at the time of the sale and recognized on a straight-line basis over the contract period. Costs of services performed under these types of contracts are charged to expense as incurred, which approximates the timing of the revenue stream.

 

Information regarding the changes in ARRIS’s aggregate product warranty liabilities for the nine months ended September 30, 2018 was as follows (in thousands):

 

Balance at December 31, 2017  $76,089 
Warranty reserve at acquisition adjustment   827 
Accruals related to warranties (including changes in assumptions)   24,958 
Settlements made (in cash or in kind)   (33,790)
Balance at September 30, 2018  $68,084 

 

The decline in the warranty accrual resulted from lower sales volume of CPE products, accompanied by settlement of warranty claims for amounts less than their previously recorded value.

 

 23 

 

 

Note 11. Inventories

 

The components of inventory were as follows, net of reserves (in thousands):

 

  

September 30,

2018

   December 31,
2017
 
Raw material  $91,547   $149,328 
Work in process   6,416    5,416 
Finished goods   619,309    670,467 
Total inventories, net  $717,272   $825,211 

 

Note 12. Property, Plant and Equipment

 

Property, plant and equipment, at cost, consisted of the following (in thousands):

 

  

September 30,

2018

  

December 31,

2017

 
Land  $26,652   $68,562 
Buildings and leasehold improvements   201,834    205,534 
Machinery and equipment   456,945    466,325 
    685,431    740,421 
Less: Accumulated depreciation   (395,611)   (367,954)
Total property, plant and equipment, net  $289,820   $372,467 

 

In February 2018, the Company announced an agreement to sell its manufacturing facility in New Taipei City, Taiwan, along with certain manufacturing fixed assets. The aggregate consideration for the acquired assets is $75.3 million ($69.0 million for the facility and land, plus $6.3 million for the manufacturing fixed assets). As a condition of sale, the Company will indemnify the buyer for certain environmental obligations up to $7.0 million. The assets are classified as held for sale and measured at their carrying amount. Total assets held for sale at September 30, 2018 were $58.1 million, which is reported in the Consolidated Balance Sheets as a component of “Other current assets.” The sale is expected to close in the fourth quarter of 2018.

 

Note 13. Restructuring, Acquisition and Integration

 

Restructuring

 

The following table represents a summary of and changes to the restructuring accrual, which is primarily composed of accrued severance and other employee costs and contractual obligations that related to excess leased facilities (in thousands):

 

   Employee
severance &
termination
benefits
   Contractual
obligations
and other
   Total 
Balance at December 31, 2017  $4,379   $3,302   $7,681 
Restructuring charges   35,979    124    36,103 
Cash payments / adjustments   (32,624)   (910)   (33,534)
Balance at September 30, 2018  $7,734   $2,516   $10,250 

 

Employee severance and termination benefits – During the three and nine months ended September 30, 2018, ARRIS recorded restructuring charges of $4.3 million and $36.0 million related to severance and employee termination benefits for 1,069 employees. These restructuring initiatives affected all segments, except Enterprise Networks, during the period. The liability for these initiatives is expected to be settled in 2018.

 

In 2017, ARRIS recorded restructuring charges of $13.3 million related to severance and employee termination benefits for 195 employees. This restructuring initiative affected all segments. The liability for the initiative has been materially settled as of June 30, 2018.

 

 24 

 

 

 

In 2016, ARRIS completed its acquisition of Pace. ARRIS initiated restructuring plans resulting from the combination that focuses on the rationalization of personnel, facilities and systems across the ARRIS organization. The estimated cost recorded during 2016 was approximately $96.3 million. The restructuring plan affected approximately 1,545 employees across the company. The remaining liability is expected to be settled in 2018.

 

This amount is included in the Consolidated Statement of Operations in the line item titled “Integration, acquisition, restructuring and other costs”.

 

Contractual obligations ARRIS has accruals representing contractual obligations that relate to excess leased facilities. A liability for such costs is recognized and measured initially at fair value on the cease-use date based on remaining lease rentals, adjusted for the effects of any prepaid or deferred items recognized, reduced by the estimated sublease rentals that could be reasonably obtained even if it is not the intent to sublease. The fair value of these liabilities is based on a net present value model using a credit-adjusted risk-free rate. The liability will be paid out over the remainder of the leased properties’ terms, which continue through 2021. Actual sublease terms may differ from the estimates originally made by the Company. Any future changes in the estimates or in the actual sublease income could require future adjustments to the liabilities, which would impact net income in the period the adjustment is recorded. 

 

Acquisition

 

During the three and nine months ended September 30, 2018, acquisition expenses were approximately $0.1 million and $0.7 million, respectively. During the three and nine months ended September 30, 2017, acquisition expenses were approximately $2.0 million and $6.7 million, respectively. These expenses related to the acquisition of the Ruckus Networks and consisted of banker and other fees.

 

Integration

 

Integration expenses of approximately $0.7 million and $4.7 million were recorded during the three and nine months ended September 30, 2018, respectively. Integration expenses of approximately $0.3 million and $1.9 million were recorded during the three months and nine months ended September 30, 2017, respectively. These expenses related to integration-related outside services following the Ruckus Networks and Pace acquisitions.

 

Note 14. Indebtedness

 

The following is a summary of indebtedness and lease financing obligations (in thousands):

 

   As of September 30, 2018   As of December 31, 2017 
Current liabilities:          
Term A loan  $19,550   $19,550 
Term A-1 loan   62,500    62,500 
Term B-3 loan   5,450    5,450 
Lease finance obligation   1,003    870 
Current obligations   88,503    88,370 
Current deferred financing fees and debt discount   (4,718)   (4,811)
    83,785    83,559 
Noncurrent liabilities:          
Term A loan   351,900    366,562 
Term A-1 loan   1,125,000    1,171,875 
Term B-3 loan   531,375    535,463 
Revolver        
Lease finance obligation   60,258    61,032 
Noncurrent obligations   2,068,533    2,134,932 
Noncurrent deferred financing fees and debt discount   (15,160)   (18,688)
    2,053,373    2,116,244 
Total  $2,137,158   $2,199,803 

 

 25 

 

 

Senior Secured Credit Facilities

 

On December 20, 2017, the Company entered into a Fourth Amendment (the “Fourth Amendment”) to its Amended and Restated Credit Facility dated June 18, 2015, as previously amended on December 14, 2015, April 26, 2017, and October 17, 2017 (the “Credit Agreement”). The Fourth Amendment provided for a new Term B-3 Loan facility in the principal amount of $542.3 million, the proceeds of which (along with cash on hand) were used to repay in full the existing Term B Loan facility. Under the terms of the Fourth Amendment, the maturity date of the new Term B Loan facility remains April 26, 2024, but the new Term B Loan facility has an interest rate of LIBOR (as defined in the Credit Agreement) plus a percentage ranging from 2.00% to 2.25% for Eurocurrency Loans (as defined in the Credit Agreement) or the prime rate (as determined in accordance with the Credit Agreement) plus a percentage ranging from 1.00% to 1.25% for Base Rate Loans (as defined in the Credit Agreement), in either case depending on ARRIS’s consolidated net leverage ratio. The Fourth Amendment also increased to $500 million the amount of cash that can be used to offset indebtedness in the calculation of the consolidated net leverage ratio for purposes of determining the applicable interest rate. All other material terms of the Credit Agreement remained unchanged.

 

On October 17, 2017, the Company entered into the Third Amendment and Consent (the “Third Amendment”) to the Credit Agreement. Pursuant to the Third Amendment, ARRIS (i) incurred “Refinancing Term A Loans” of $391 million, (ii) incurred “Refinancing Term A-1 Loans” of $1,250 million, and (iii) obtained a “Refinancing Revolving Credit Facility” of $500 million, the proceeds of which were used to refinance in full the existing Term A Loans, the existing Term A-1 Loans and the existing Revolving Credit Loans outstanding under the Credit Agreement immediately prior to the effectiveness of the Third Amendment. The existing Term B Loans were not refinanced and remained outstanding.

 

The Third Amendment extended the maturity date of the Term A Loans and the Revolving Credit Facility to October 17, 2022. Pursuant to the Third Amendment, the Company is subject to a minimum consolidated interest coverage ratio test, which is unchanged from the Credit Agreement. In addition, the Company is subject to a maximum consolidated net leverage ratio test of not more than 4.0:1.0, subject to a step-down to 3.75:1.00 commencing with the fiscal quarter ending March 31, 2019. The amount of unrestricted cash used to offset indebtedness in the calculation of the consolidated net leverage ratio was also increased from $200 million to $500 million. The interest rates under the Third Amendment were not changed.

 

On April 26, 2017, ARRIS entered into a Second Amendment (the “Second Amendment”) to the Credit Agreement. The Second Amendment provided for a new Term B Loan facility in the principal amount of $545 million, the proceeds of which (along with cash on hand) were used to repay the existing Term B Loan facility. Under the terms of the Second Amendment, the new Term B-2 Loan has a maturity date of April 2024 and an interest rate of LIBOR plus a percentage ranging from 2.25% to 2.50% for Eurocurrency Rate Loans (as defined in the Credit Agreement), or the prime rate plus a percentage ranging from 1.25% to 1.50% for Base Rate Loans (as defined in the Credit Agreement), in either case depending on the Company’s consolidated net leverage ratio.

 

Interest rates on borrowings under the senior secured credit facilities are set forth in the table below.

 

 

   Rate  As of September 30, 2018
Term A Loan  LIBOR + 1.75  %   3.99%
Term A-1 Loan  LIBOR + 1.75  %   3.99%
Term B-3 Loan       LIBOR + 2.25 %   4.49%
Revolving Credit Facility (1)  LIBOR + 1.75  %   Not Applicable

 

(1)Includes unused commitment fee of 0.30% and letter of credit fee of 1.75% not reflected in interest rate above.

 

The Credit Agreement provides for adjustments to the interest rates paid on the Term A Loan, Term A-1 Loan, Term B-3 Loan and Revolving Credit Facility based upon the achievement of certain leverage ratios.

 

Borrowings under the senior secured credit facilities are secured by first-priority liens on substantially all the assets of ARRIS and certain of its present and future subsidiaries who are or become parties to, or guarantors under, the Credit Agreement governing the senior secured credit facilities. The Credit Agreement provides terms for mandatory prepayments and optional prepayments and commitment reductions. The Credit Agreement also includes events of default, which are customary for facilities of this type (with customary grace periods, as applicable), including provisions under which, upon the occurrence of an event of default, all amounts outstanding under the credit facilities may be accelerated. The Credit Agreement contains usual and customary limitations on indebtedness, liens, restricted payments, acquisitions and asset sales in the form of affirmative, negative and financial covenants, which are customary for financings of this type, including the maintenance of a minimum interest coverage ratio and a maximum leverage ratio. As of September 30, 2018, ARRIS complied with all covenants under the Credit Agreement.

 

 26 

 

 

During the three and nine months ended September 30, 2018, the Company made mandatory payments of approximately $21.9 million and $65.6 million, respectively, related to the senior secured credit facilities.

 

Other

 

As of September 30, 2018, the scheduled maturities of the contractual debt obligations for the next five years are as follows (in thousands):

 

2018 (for the remaining three months)  $21,875 
2019   87,500 
2020   87,500 
2021   87,500 
2022   1,297,738 
Thereafter   513,662 

 

Note 15. Segment Information

 

The “management approach” has been used to present the following segment information. This approach is based upon the way the management of the Company organizes segments for making operating decisions and assessing performance. Financial information is reported on the basis that it is used internally by the chief operating decision maker (“CODM”) for evaluating segment performance and deciding how to allocate resources to segments. The Company’s chief executive officer has been identified as the CODM.

 

As of January 1, 2018, the Company has changed the composition of its measurement of segment profit and loss (direct contribution) used by the Company’s chief operating decision maker. Beginning in 2018, the Company charges bonus, equity compensation and certain other costs which are now directly aligned with each of its segments within its measurement of segment profit and loss (direct contribution). These costs historically were included as part of “Corporate and Unallocated Costs”. Consequently, the Company’s segment information for the 2017 period has been restated to reflect such change.

 

Our CODM manages the Company under three segments:

·Customer Premises Equipment (“CPE”) – The CPE segment’s product solutions include set-top boxes, gateways, and subscriber premises equipment that enable service providers to offer voice, video and high-speed data services to residential and business subscribers.
·Network & Cloud (“N&C”) – The N&C segment’s product solutions include cable modem termination system, video infrastructure, distribution and transmission equipment and cloud solutions that enable facility-based service providers to construct a state-of-the-art residential and metro distribution network. The portfolio also includes a full suite of global services that offer technical support, professional services and system integration offerings to enable solutions sales of ARRIS’s end-to-end product portfolio.
·Enterprise Networks (“Enterprise”) The Enterprise segment focuses on enabling constant, wireless and wired connectivity across complex and varied networking environments. It offers dedicated engineering, sales and marketing resources to serve customers across a spectrum of enterprises—including hospitality, education, smart cities, government, venues, service providers and more.

 

These operating segments were determined based on the nature of the products and services offered.  The measures that are used to assess the reportable segment’s operating performance are sales and direct contribution. Direct contribution is defined as gross margin less direct operating expense. The “Corporate and Unallocated Costs” category of expenses include corporate sales and marketing, home office general and administrative expenses. “Corporate and Unallocated Costs” also includes corporate sales and marketing for the CPE and N&C segments. Marketing and sales expense related to the Enterprise segment are considered a direct operating expense for that segment and are not included in the “Corporate and Unallocated Costs.” These expenses are not included in the measure of segment direct contribution and as such are reported as “Corporate and Unallocated Costs” and are included in the reconciliation to income (loss) before income taxes. A measure of assets is not applicable, as segment assets are not regularly reviewed by the CODM for evaluating performance or allocating resources.   

 

 27 

 

 

The table below represents information about the Company’s reportable segments (in thousands):

 

  

Three Months Ended

September 30,

  

Nine Months Ended

September 30,

 
   2018   2017   2018   2017 
Net sales to external customers:                    
CPE  $941,469   $1,174,750   $2,824,827   $3,385,689 
N&C   532,035    556,863    1,619,795    1,498,271 
Enterprise   180,159        522,313     
Other (1)   (2,415)   (3,089)   (11,437)   (8,161)
Total   1,651,248    1,728,524    4,955,498    4,875,799 
Direct contribution:                    
CPE   62,152    121,982    197,636    344,746 
N&C   199,137    198,955    628,957    483,714 
Enterprise   16,395        59,697     
Segment total   277,684    320,937    886,290    828,460 
Corporate and unallocated costs   (131,311)   (135,782)   (437,032)   (387,309)
Amortization of intangible assets   (88,306)   (90,162)   (293,499)   (274,819)
Impairment of goodwill           (3,400)    
Integration, acquisition, restructuring and other   (5,046)   (10,836)   (41,546)   (30,622)
Operating income   53,021    84,157    110,813    135,710 
Interest expense   23,969    20,211    70,142    63,238 
(Gain) loss on investments   (1,400)   839    (1,718)   8,978 
Interest income   (1,764)   (2,288)   (5,088)   (5,997)
Loss (gain) on foreign currency   2,025    (8,543)   6,034    5,570 
Other expense (income), net   35    1,434    (25)   2,275 
Income before income taxes  $30,156   $72,504   $41,468   $61,646 

 

(1)Adjustments related acquisition accounting impacts related to deferred revenue

 

The compositions of our corporate and unallocated costs that are reflected in the Consolidated Statement of Operations were as follow (in thousands):

 

  

Three Months Ended

September 30,

   Nine Months Ended
September 30
,
 
   2018   2017   2018   2017 
Corporate and unallocated costs:                    
Cost of sales  $16,141   $16,792   $70,322   $44,815 
Selling, general and administrative expenses   92,276    92,895    286,766    268,741 
Research and development expenses   22,894    26,095    79,944    73,753 
Total  $131,311   $135,782   $437,032   $387,309 

 

 28 

 

 

Note 16. Sales Information

 

Revenues from external customers are attributed to individual countries on an end-customer basis, based on domicile of the purchasing entity, if known, or the location of the customer’s headquarters if the specific purchasing entity within the customer is unknown. ARRIS sells a majority its products in the United States. The Company’s non-U.S. revenue is generated from Asia Pacific, Canada, Europe, Middle East and Latin America. Sales to customers outside of United States were approximately 40.4% and 42.1% of total sales for the three and nine months ended September 30, 2018, respectively. For the three and nine months ended September 30, 2017, sales to customers outside of United States were approximately 34.5% and 34.1%, respectively.

 

The table below set forth our sales based on geography of our customers (in thousands):

 

   Three Months Ended
September 30
,
   Nine Months Ended
September 30
,
 
   2018   2017   2018   2017 
U.S.  $983,377   $1,131,723   $2,869,848   $3,211,278 
Non-U.S.                    
Americas, excluding U.S.   302,412    283,769    886,123    832,630 
Asia Pacific   100,448    105,135    300,058    265,508 
EMEA   265,011    207,897    899,469    566,383 
Total non-U.S.   667,871    596,801    2,085,650    1,664,521 
Total sales  $1,651,248   $1,728,524   $4,955,498   $4,875,799 

 

Note 17. 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

September 30,

  

Nine Months Ended

September 30,

 
   2018   2017   2018   2017 
Basic:                    
Net income attributable to ARRIS International plc  $47,079   $88,320   $69,233   $79,558 
                     
Weighted average shares outstanding   178,106    187,064    182,132    187,878 
Basic earnings per share  $0.26   $0.47   $0.38   $0.42 
                     
Diluted:                    
Net income attributable to ARRIS International plc  $47,079   $88,320   $69,233   $79,558 
                     
Weighted average shares outstanding   178,106    187,064    182,132    187,878 
Net effect of dilutive equity awards   1,231    1,877    1,685    2,386 
Total   179,337    188,941    183,817    190,264 
Diluted earnings per share  $0.26   $0.47   $0.38   $0.42 

 

Potential dilutive shares include unvested restricted and performance awards and warrants.

 

For the three months ended September 30, 2018 and 2017, approximately 1.2 million and 1.0 million of the equity-based awards, respectively, were excluded from the computation of diluted earnings per share. For the nine months ended September 30, 2018 and 2017 approximately 1.0 million and 1.7 million of the equity-based awards, respectively, were excluded from the computation of diluted earnings per share. These exclusions are made if the exercise price of these equity-based awards is in excess of the average market price of the shares for the period, or if the Company has net losses, both of which have an anti-dilutive effect.

 

During the nine months ended September 30, 2018, the Company issued 2.0 million ordinary shares related to the vesting of restricted shares, as compared to 2.6 million shares for the twelve months ended December 31, 2017.

 

 29 

 

 

The warrants have a dilutive effect in those periods in which the average market price of the shares exceeds the current effective conversion price (under the treasury stock method) and are not subject to performance conditions. There is no incremental vesting in the first nine months of 2018. The dilutive effect of outstanding vested shares was immaterial.

 

The Company has not paid cash dividends on its shares since its inception. Any future determination to pay dividends will be at the discretion of the Board of Directors and will be dependent on then-existing conditions, including the Company’s financial condition, results of operations, capital requirements, contractual and legal restrictions, business prospects and other factors that the Board considers relevant. The Credit Agreement governing the Company’s senior secured credit facilities contains restrictions on the Company’s ability to pay dividends on its ordinary shares.

 

Note 18. Income Taxes

 

ARRIS is subject to the U.K. statutory tax rate and a territorial corporate tax system. The U.K. statutory rate for 2018 is 19% as compared to 19.25% in 2017. The statutory rate in the U.K. decreased from 20% to 19% effective April 1, 2017. The Company’s statutory rate for 2017 represented the blended rate that was in effect for the year ended December 31, 2017 based on the 20% statutory rate that was effective for the first quarter of 2017 and the 19% rate effective for the remainder of 2017.

 

The Tax Cuts and Jobs Act of 2017 (the “Act”) enacted on December 22, 2017 introduced significant changes to U.S. income tax law including, but not limited to, a reduction to the U.S. statutory tax rate from 35% to 21%, creation of new taxes on certain foreign-sourced earnings and certain intercompany payments, introduction of limits on interest deductibility, and increased limitations on certain executive compensation. Since the Act was passed late in the fourth quarter of 2017, and ongoing guidance and accounting interpretation are expected during 2018, except as noted below, the Company considers the accounting of the impacts of the Act to be incomplete due to additional work necessary to (1) determine re-measurement of any changes to deferred tax assets and liabilities associated with any acquisition accounting adjustments made within the acquisition accounting measurement period and (2) assess any forthcoming guidance. Any subsequent adjustment to these amounts is recorded to tax expense in the quarter of 2018 when the analysis is complete.

 

As the Company obtains and analyzes more information and interprets the Act and any additional guidance issued by the U.S. Treasury Department, the Internal Revenue Service (IRS), and other standard-setting bodies, the Company may adjust the provisional amounts. Those adjustments may materially affect the provision for income taxes and effective tax rate in the period in which the adjustments are made. The only significant adjustments made during the nine months ended September 30, 2018 were a direct result of the acquisition accounting adjustments made during the quarters.  As a result of the change to the fair value of certain assets and liabilities, the gross deferred tax amounts associated with those assets and liabilities also changed.  The fair value adjustments are as of the Ruckus acquisition date, December 1, 2017, resulting in the gross deferred tax impacts being measured at the applicable enacted tax rate of 35% on that date.  These deferred tax impacts were then remeasured to 21% to reflect the enacted rate as of December 22, 2017.  As a result of these acquisition accounting measurement period adjustments, the Company recorded discrete tax benefit of $2.9 million during the nine months ended September 30, 2018. No adjustments were made to fair value, and therefore there were no discrete tax impacts during the three months ended September 30, 2018.

 

During the third quarter of 2018, the Company finalized the impact of the one-time transition tax for the deemed repatriation of the earnings of the ARRIS controlled foreign corporations. The finalization of the 2017 earnings and profits amounts increased the transition tax from $(0.2) million benefit to $0.3 million tax expense. The Company has recorded current tax on its global intangible low-taxed income (“GILTI”) relative to the 2018 operations and has elected to account for GILTI as period costs when incurred. The Company will complete our analysis within the measurement period in accordance with Staff Accounting Bulletin No. 118.

 

For the period ended September 30, 2018, the Company changed its indefinite reinvestment assertion to reflect deferred income taxes on a portion of the unremitted earnings of certain subsidiaries. This change resulted in an additional $2.4 million of tax expense.

 

 30 

 

 

The Company reported the following operating results for the periods presented (in thousands):

 

  

Three Months Ended

September 30

   Nine Months Ended
September 30
,
 
   2018   2017   2018   2017 
Income before income taxes  $30,156   $72,504   $41,468   $61,646 
Income tax benefit   (15,652)   (14,311)   (22,106)   (12,613)
Effective income tax rate   (51.9)%   (19.7)%   (53.3)%   (20.5)%

 

The Company’s effective income tax rate fluctuates based on, among other factors, the level and location of income. The difference between the U.K. federal statutory income tax rate, 19% and 19.25%, respectively, and our effective income tax rate for the 2018 and 2017 periods is primarily due to the benefits of other foreign income tax regimes and the U.S. federal research and development credits.

 

The Company’s effective income tax rate for the nine months ended September 30, 2018 was impacted by $1.5 million of expense related to excess book deductions for stock based compensation, $4.7 million of expense related to changes in permanent reinvestment assertions, offset by $12.4 million of benefit related to the release of uncertain tax positions due to settlement of audits and the expiration of statute of limitations, $2.8 million of benefit related to the effects of tax rate changes in the US, and $4.2 million of benefit related to an internal restructuring to move certain Ruckus Networks intangible property into the U.S.

 

The Company’s effective income tax rate for the nine months ended September 30, 2017 was impacted by $8.0 million of expense related to the intra-entity sale of an asset, offset by $9.8 million of benefit related to a decrease of interest related to uncertain tax positions and the release of uncertain tax positions due to settlement of audits and expiration of statute of limitations, and a $1.2 million of benefit related to excess tax deductions for stock-based compensation.

 

Note 19. Shareholders’ Equity

 

The following table provides a reconciliation of the beginning and ending carrying amounts of total equity, equity attributable to shareholders of ARRIS International plc and equity attributable to noncontrolling interest (in thousands):

 

   Ordinary
Shares
   Capital in
Excess of
Par Value
   Accumulated
Deficit
   Accumulated
Other
Comprehensive
Income (Loss)
   Total ARRIS
International
plc
stockholders’
equity
   Non-
controlling
Interest
   Total
stockholders’
equity
 
Balance, December 31, 2017  $2,768   $3,387,128   $(225,881)  $4,552   $3,168,567   $15,467   $3,184,034 
Net income           69,233        69,233    (5,659)   63,574 
Other comprehensive income, net of tax               (13,207)   (13,207)   15    (13,192)
Compensation under stock award plans       63,087            63,087        63,087 
Issuance of ordinary shares and other   28    (10,739)           (10,711)       (10,711)
Repurchase of ordinary shares, net   (175)       (336,930)       (337,105)       (337,105)
Contribution from noncontrolling interest                       2,257    2,257 
Cumulative effect adjustment to opening balance (1)           (1,128)       (1,128)   2,694    1,566 
Balance, September 30, 2018  $2,621   $3,439,476   $(494,706)  $(8,655)  $2,938,736   $14,774   $2,953,510 

 

(1) Cumulative adjustment related to the adoption of accounting standards.

 

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Note 20. Accumulated Other Comprehensive Income (Loss)

 

The following table summarizes the changes in accumulated other comprehensive income (loss) by component, net of taxes (in thousands):

 

   Available-for
sale securities
   Derivative
instruments
   Pension
obligations
   Cumulative
translation
adjustments
   Total
Accumulated
Other
Comprehensive
Income (Loss)
   Less AOCI
attributable
to Non-
controlling
Interest
   Total ARRIS
International
plc AOCI
 
Balance, December 31, 2017  $662   $5,589   $(8,993)  $7,243   $4,501   $51   $4,552 
Other comprehensive income before reclassifications       15,051        (26,619)   (11,568)   (15)   (11,583)
Amounts reclassified from accumulated other comprehensive income (loss)   (662)   (990)   28        (1,624)       (1,624)
Net current-period other comprehensive income (loss)   (662)   14,061    28    (26,619)   (13,192)   (15)   (13,207)
Balance as of September 30, 2018  $   $19,650   $(8,965)  $(19,376)  $(8,691)  $36   $(8,655)

 

   Available-for
sale securities
   Derivative
instruments
   Pension
obligations
   Cumulative
translation
adjustments
   Total
Accumulated
Other
Comprehensive
Income (Loss)
   Non-
controlling
Interest
   Total ARRIS
International
plc AOCI
 
Balance, December 31, 2016  $137   $671   $(6,810)  $9,281   $3,279   $12   $3,291 
Other comprehensive income before reclassifications   260    (240)       4,321    4,341    43    4,384 
Amounts reclassified from accumulated other comprehensive income (loss)   68    1,086    9        1,163        1,163 
Net current-period other comprehensive income (loss)   328    846    9    4,321    5,504    43    5,547 
Balance as of September 30, 2017  $465   $1,517   $(6,801)  $13,602   $8,783   $55   $8,838 

 

Note 21. Repurchases of ARRIS Shares

 

The table below sets forth the purchases of ARRIS shares for the quarter ended September 30, 2018:

 

Period 

Total
Number of
Shares
Purchased (1)

   Average
Price
Paid
Per
Share
   Total Number of
Shares
Purchased as
Part of Publicly
Announced Plans
or Programs
   Approximate
Dollar Value of
Shares That May
Yet Be Purchased
Under the Plans
or Programs
(in thousands)
 
July 2018   2,189,251   $25.53    1,957,982    350,010 
August 2018   3,944,817   $24.84    3,941,214    252,103 
September 2018 (2)   2,454,677   $26.16    2,454,677    562,894 

 

(1)An aggregate of 234,872 shares shown in the table above were subject to equity awards that were cancelled for cash to satisfy employee minimum tax withholding obligations that arose on the vesting of the applicable restricted stock units.

 

(2)Includes an aggregate of 210,654 shares (approximately $5.5 million) pending settlement as of September 30, 2018.

 

Upon completing the combination in connection with the Pace acquisition, ARRIS International plc conducted a court-approved process in accordance with section 641(1)(b) of the U.K. Companies Act 2006, pursuant to which the Company reduced its stated share capital and thereby increased its distributable reserves or excess capital out of which ARRIS may legally pay dividends or repurchase shares. Distributable reserves are not linked to a U.S. GAAP reported amount.

 

In 2016, the Company’s Board of Directors approved a $300 million share repurchase authorization replacing all prior programs. In early 2017, the Board authorized an additional $300 million for share repurchases. In March 2018, the Board authorized an additional $300 million for repurchases and an additional $375 million again in August 2018.

 

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During the first quarter of 2018, the Company repurchased 1.0 million shares of its ordinary shares for $25.0 million at an average share price of $25.35. During the second quarter of 2018, the Company repurchased 4.0 million shares of its ordinary shares for $99.9 million at an average share price of $25.29. During the third quarter of 2018, the Company repurchased 8.4 million shares of its ordinary shares for $212.2 million at an average share price of $25.40. The remaining authorized amount for share repurchases under these repurchase authorizations was $562.9 million as of September 30, 2018.

 

Since the end of the third quarter through November 8, 2018, the Company has repurchased an additional 0.6 million ordinary shares for approximately $16.0 million. The remaining authorized amount for share repurchases under these repurchase authorizations was $546.9 million as of November 8, 2018.

 

Unless terminated earlier by a Board resolution, this repurchase authorization will expire when ARRIS has used all authorized funds for repurchase. However, U.K. law also generally prohibits a company from repurchasing its own shares through “off market purchases” without prior approval of shareholders when such company is not traded on a recognized investment exchange in the U.K. This shareholder approval lasts for a maximum period of five years. Prior to and in connection with the Pace combination, the Company obtained approval to purchase its own shares. This authority to repurchase shares terminates in January 2021, unless otherwise reapproved by the Company’s shareholders.

 

Note 22. Commitments and Contingencies

 

Legal Proceedings

 

The Company accrues a liability for legal contingencies when it believes that it is both probable that a liability has been incurred and that it can reasonably estimate the amount of the loss. The Company reviews these accruals and adjusts them to reflect ongoing negotiations, settlements, rulings, advice of legal counsel and other relevant information. To the extent new information is obtained and the Company’s views on the probable outcomes of claims, suits, assessments, investigations or legal proceedings change, changes in the Company’s accrued liabilities would be recorded in the period in which such determinations are made. Unless noted otherwise, the amount of liability is not probable, or the amount cannot be reasonably estimated; and, therefore, accruals have not been made.

 

Due to the nature of the Company’s business, it is subject to patent infringement claims, including current suits against it or one or more of its wholly-owned subsidiaries, or one or more of our customers who may seek indemnification from us, alleging infringement by various Company products and services. The Company believes that it has meritorious defenses to the allegation made in its pending cases and intends to vigorously defend these lawsuits; however, it is currently unable to determine the ultimate outcome of these or similar matters. Accordingly, with respect to these proceedings, we are currently unable to reasonably estimate the possible loss or range of possible losses. In addition, the Company is a defendant in various litigation matters generally arising out of the normal course of business. (See Part II, Item 1 “Legal Proceedings” for additional details)


Note 23. Subsequent Event

 

Proposed Transaction with CommScope

 

On November 8, 2018, the Company entered into a Bid Conduct Agreement (the “Acquisition Agreement”) with CommScope Holding Company, Inc. (“CommScope”) providing for the acquisition of all of the ordinary shares of the Company by CommScope (the “Acquisition”). The Acquisition is to be implemented by way of a court-approved scheme of arrangement (the “Scheme”) under Part 26 of the United Kingdom Companies Act 2006. At the effective time of the Acquisition, each ordinary share of the Company automatically will be transferred to CommScope in exchange for the right to receive $31.75 per ordinary share in cash, without interest.

 

The completion of the Acquisition is subject to various closing conditions, including, among other things, (i) the receipt of certain approvals of the Company shareholders, (ii) the sanction of the Scheme by the High Court of Justice of England and Wales, (iii) the receipt of certain required regulatory approvals or elapse of certain review periods with respect thereto, including those in the U.S., the European Union, Chile, Mexico, Russia and South Africa, and (iv) the absence of any law, order or injunction prohibiting the Acquisition. For additional information regarding certain risks related to the Acquisition see the information under the caption “Risk Factors,” which is located in Item 1A of Part II of this Quarterly Report on Form 10-Q.

 

 33 

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview

 

ARRIS is a global leader in entertainment, communications and networking technology. Our mission is to “redefine connectivity” in a rapidly evolving global communications industry. Our innovative offerings combine hardware, software, and services to enable advanced video experiences and constant connectivity featuring high bandwidth, speeds and reliability. Our products and services are utilized by the world’s leading service providers, commercial enterprises and the hundreds of millions of people they serve.

 

We are headquartered in Suwanee, Georgia and operate in three business segments: Customer Premises Equipment (“CPE”), Network & Cloud (“N&C”) and Enterprise Networks (“Enterprise”).  We enable service providers including cable, telephone, and digital broadcast satellite operators and media programmers to deliver media, voice, and IP data services and Wi-Fi to their subscribers and enable enterprises to experience constant, wireless and wired connectivity across complex and varied networking environments. We are a leader in set-tops, digital video and IPTV distribution systems, broadband access infrastructure platforms, associated data and voice CPE and wired and wireless enterprise networking. Our solutions are complemented by a broad array of services including technical support, repair and refurbishment, and system design and integration.

 

Comparisons to our prior period results are impacted by the acquisition of Ruckus Networks on December 1, 2017.

 

Proposed Transaction with CommScope

 

On November 8, 2018, we entered into a Bid Conduct Agreement (the “Acquisition Agreement”) with CommScope Holding Company, Inc. (“CommScope”) providing for the acquisition of all of our ordinary shares by CommScope (the “Acquisition”). The Acquisition is to be implemented by way of a court-approved scheme of arrangement (the “Scheme”) under Part 26 of the United Kingdom Companies Act 2006. At the effective time of the Acquisition, each ordinary share automatically will be transferred to CommScope in exchange for the right to receive $31.75 per ordinary share in cash, without interest.

 

The completion of the Acquisition is subject to various closing conditions, including, among other things, (i) the receipt of certain approvals of our shareholders, (ii) the sanction of the Scheme by the High Court of Justice of England and Wales, (iii) the receipt of certain required regulatory approvals or elapse of certain review periods with respect thereto, including those in the U.S., the European Union, Chile, Mexico, Russia and South Africa, and (iv) the absence of any law, order or injunction prohibiting the Acquisition. We cannot guarantee that the Acquisition will be completed or that, if completed, it will be exactly on the terms as set forth in the Acquisition Agreement. For additional information regarding certain risks related to the Acquisition see the information under the caption “Risk Factors,” which is located in Item 1A of Part II of this Quarterly Report on Form 10-Q.

 

Business and Financial Highlights

 

Business Highlights

 

·On November 8, 2018 we announced that we have entered into a definitive agreement for CommScope to purchase ARRIS for a cash price of $31.75, a premium of 27% over the volume weighted average closing price of ARRIS’s common stock for the 30 trading days ending October 23, 2018 (1), subject to shareholder approval and certain closing conditions, including necessary regulatory approvals.

·We have made significant progress in the integration of the Ruckus business operations, which were acquired in December of 2017.
·Revenues in the first nine months of 2018 increased with the inclusion of Enterprise sales and strong sales in N&C, primarily for CMTS products, which were offset by a decline in CPE sales. We continue to see growing Broadband CPE demand and strong network capacity demand.
·International revenues reflect strong growth as operators invested in broadband and video capabilities and were 42% of total revenues in the first nine months of 2018.
·In the first nine months of 2018, we repurchased approximately 13.3 million ordinary shares for $337.1 million and added $675.0 million of additional share repurchase authority. Through November 8, 2018, we have repurchased an additional 0.6 million ordinary shares for $16.0 million.

 

(1)The day prior to news of the market rumors regarding a potential transaction leaking to the media.


Financial Highlights

 

·Sales in the third quarter and first nine months of 2018 were $1,651.2 million and $4,955.5 million, respectively, as compared to $1,728.5 million and $4,875.8 million in the same periods in 2017.
·Gross margin percentage was 28.2% in the third quarter of 2018, which compares to 24.9% in the third quarter of 2017. The increase in the margin reflects changes in product mix, in particular the inclusion of Enterprise Networks, which is helping offset memory and other product cost increases in our CPE products.
·Total operating expenses (excluding amortization of intangible assets, impairment of goodwill, integration, acquisition, restructuring charges and other costs) in the third quarter of 2018 were $318.8 million, as compared to $246.0 million in the same period last year. The increase primarily reflects the incremental expense associated with our acquisition of Ruckus Networks. In addition, we increased our investment in sales and marketing and research and development for the Enterprise segment to help grow sales and market share. During 2018, the Company has implemented restructuring activities that has affected approximately 1,000 employees, including the closure of our factory in Taiwan, which has and will lower operating expense.
·We ended the third quarter of 2018 with $520.4 million of cash, cash equivalents and marketable security investments. We generated approximately $420.2 million of cash from operating activities through the first nine months of 2018, which compares to $611.7 million during the same period in 2017. Inventories have declined $107.6 million from the beginning of the year.

 

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·We ended the third quarter of 2018 with long-term debt of $2,095.8 million, at face value, the current portion of which is $87.5 million. We made mandatory payments of $65.6 million in the first nine months of 2018.

 

Comparison of Operations for the Three and Nine Months Ended September 30, 2018 and 2017

 

Net Sales

 

The table below sets forth our net sales for each of our segments (in thousands, except percentages):

 

   Net Sales   Increase (Decrease) Between 2018 and 2017 
   For the Three Months
Ended September 30,
   For the Nine Months
Ended September 30,
   For the Three Months
Ended September 30
   For the Nine Months
Ended September 30
 
   2018   2017   2018   2017   $   %   $   % 
Segment:                                
CPE  $941,469   $1,174,750   $2,824,827   $3,385,689   $(233,281)   (19.9)%  $(560,862)   (16.6)%
N&C   532,035    556,863    1,619,795    1,498,271    (24,828)   (4.5)%   121,524    8.1%
Enterprise   180,159        522,313        180,159    100.0%   522,313    100.0%
Other (1)   (2,415)   (3,089)   (11,437)   (8,161)   674    21.8%   (3,276)   (40.1)%
Total sales  $1,651,248   $1,728,524   $4,955,498   $4,875,799   $(77,276)   (4.5)%  $79,699    1.6%

 

(1)Adjustments related to acquisition accounting impacts related to deferred revenue

 

The table below sets forth sales based on geography of our customers (in thousands, except percentages):

 

   Net Sales   Increase (Decrease) Between 2018 and 2017 
   For the Three Months
Ended September 30,
   For the Nine Months
Ended September 30,
   For the Three Months
Ended September 30
   For the Nine Months
Ended September 30
 
   2018   2017   2018   2017   $   %   $   % 
U.S.  $983,377   $1,131,723   $2,869,848   $3,211,278   $(148,346)   (13.1)%  $(341,430)   (10.6)%
Non-U.S.                                        
Americas, excluding U.S.   302,412    283,769    886,123    832,630    18,643    6.6%   53,493    6.4%
Asia Pacific   100,448    105,135    300,058    265,508    (4,687)   (4.5)%   34,550    13.0%
EMEA   265,011    207,897    899,469    566,383    57,114    27.5%   333,086    58.8%
  Total non-U.S.   667,871    596,801    2,085,650    1,664,521    71,070    11.9%   421,129    25.3%
Total sales  $1,651,248   $1,728,524   $4,955,498   $4,875,799   $(77,276)   (4.5)%  $79,699    1.6%

 

Customer Premises Equipment Net Sales 2018 vs. 2017

 

During the three and nine months ended September 30, 2018, sales in the CPE segment decreased approximately 19.9% and 16.6%, respectively, as compared to the same period in 2017. The decrease is primarily attributable to video sales, due to lower cable and telco demand in the United States. We anticipate the continued overall trend towards more demand for broadband CPE and less video CPE as operators adopt all IP networks and continue their investment in higher speed internet services and better in-home Wi-Fi capabilities, although there will continue to be variability in mix quarter to quarter.

 

Network and Cloud Net Sales 2018 vs. 2017

 

During the three and nine months ended September 30, 2018, sales in the N&C segment decreased approximately (4.5)% and increased approximately 8.1%, respectively, as compared to the same period in 2017. During the three months ended September 30, 2018, the decrease was primarily attributable to less CMTS product sales. During the nine months ended September 30, 2018, the increase was primary due to increased CMTS product sales, partially offset by lower Access Technologies products sales.

 

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Enterprise Networks Net Sales 2018 vs. 2017

 

During the three and nine months ended September 30, 2018, sales in the Enterprise segment were $180.2 million and $522.2 million, respectively. In the quarter, revenues were reduced by an adjustment in estimated channel rebates of approximately $9.0 million because of a true-up based upon a retrospective review of rebate activity. Revenues were not included in the same period of 2017, as the acquisition of Ruckus Networks was completed in the fourth quarter of 2017.

 

Gross Margin

 

The table below sets forth our gross margin (in thousands, except percentages):

 

   Gross Margin   Increase (Decrease) Between 2018 and 2017 
   For the Three Months
Ended September 30,
   For the Nine Months
Ended September 30,
   For the Three Months
Ended September 30
   For the Nine Months
Ended September 30
 
   2018   2017   2018   2017   $   %   $   % 
                                 
Gross margin dollars  $465,189   $431,155    1,439,627    1,171,770    34,034    7.9%   267,857    22.9%
Gross margin percentage   28.2%   24.9%   29.1%   24.0%        3.3         5.1 

 

During the three and nine months ended September 30, 2018, gross margin dollars increased as a result of the Ruckus Networks acquisition and changes in product mix. The Ruckus Networks acquisition impacted gross margin for 2018, due to a proportionately higher average gross margin than the historic ARRIS business. We also had higher sales of CMTS licenses in 2018 which have higher margins than the average consolidated gross margin. This increase is offset by continued pressure on gross margin primarily relating to memory pricing and other component costs, particularly in the CPE segment which are expected to continue in the near term and could make it difficult to return to historical gross margin levels. We do anticipate some improvement in component pricing in 2019. In addition, we have implemented initiatives to mitigate the effects of higher component costs with price adjustments and actions to lower operating costs. Regarding tariffs, we currently expect to pass a significant portion of the cost on to customers and are in the process of shifting the manufacturing locations for impacted products to locations that would not be subject to the proposed tariffs. The gross margin for the three and nine months ended September 30, 2018 included $17.0 million of increased costs associated with writing up the historic cost of the Ruckus Networks inventory to fair value at the date of acquisition (subsequently increasing cost of sales). In addition, during the three and nine months ended September 30, 2018, the gross margins were impacted by $2.4 million and $11.4 million, respectively, associated with a reduction in sales related to the acquisition accounting impacts of deferred revenue.

 

During the three and nine months ended September 30, 2017, gross margins were also impacted by $3.1 million and $8.1 million, respectively, associated with a reduction in sales associated with the fair value of warrants issued to customers.

 

Operating Expenses

 

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

 

   Operating Expenses   Increase (Decrease) Between 2018 and 2017 
   For the Three Months
Ended September 30,
   For the Nine Months
Ended September 30,
   For the Three Months
Ended September 30
   For the Nine Months
Ended September 30
 
   2018   2017   2018   2017   $   %   $   % 
Selling, general and administrative  $162,707   $114,407   $497,263   $332,966   $48,300    42.2%  $164,297    49.3%
Research and development   156,109    131,593    493,106    397,653    24,516    18.6%   95,453    24.0%
Amortization of intangible assets   88,306    90,162    293,499    274,819    (1,856)   (2.1)%   18,680    6.8%
Impairment of goodwill           3,400                3,400    100.0%
Integration, acquisition, restructuring & other other   5,046    10,836    41,546    30,622    (5,790)   53.4%   10,924    35.7%
Total  $412,168   $346,998   $1,328,814   $1,036,060   $65,170    18.8%  $292,754    28.3%

 

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

 

Our selling, general and administrative expenses include sales and marketing costs, including personnel expenses for sales and marketing staff expenses, advertising, trade shows, corporate communications, product marketing expenses and other marketing expenses. In addition, general and administrative expenses consist of personnel expenses and other general corporate expenses for corporate executives, finance and accounting, human resources, facilities, information technology, legal and professional fees.

 

SG&A expenses increased for the three and nine months ended September 30, 2018 compared to the prior year as result of the inclusion of incremental expense related to our acquisition of Ruckus Network.

 

Research & Development, or R&D, Expenses

 

R&D expenses consist primarily of personnel expenses, payments to suppliers for design services, product certification expenditures to qualify our products for sale into specific markets, prototypes, other consulting fees and reasonable allocations of our information technology and corporate facility costs. R&D expenses are recognized as they are incurred.

 

During the three and nine months ended September 30, 2018, R&D expenses increased as compared to the same period in 2017. The increase is primarily the result of the inclusion of incremental expenses related to our acquisition of Ruckus Networks, which were partially offset by lower costs resulting from workforce reductions.

 

Amortization of Intangible Assets

 

Our intangible amortization expense relates to finite-lived intangible assets primarily acquired in business combinations. Intangibles amortization expense for the three months ended September 30, 2018 and 2017 was $88.3 million and $90.2 million, respectively. The decrease was as a result of certain intangible assets becoming fully amortized in 2018. For the nine months ended September 30, 2018 and 2017, intangible amortization expense was $293.5 million and $274.8 million, respectively. The increase is primarily due to the incremental amortization expense from acquired intangibles associated with the Ruckus Networks acquisition.

 

Impairment of Goodwill

 

During the nine months ended September 30, 2018, we recorded partial impairment of goodwill of $3.4 million from our Cloud TV reporting unit, of which $1.2 million is attributable to the noncontrolling interest. This impairment was a result of the indirect effect of a change in accounting principle related to the adoption of new accounting standard Revenue from Contracts with Customers, resulting in changes in the composition and carrying amount of the net assets of our Cloud TV reporting unit.

 

Integration, Acquisition, Restructuring and Other

 

During the three and nine months ended September 30, 2018, we recorded integration, acquisition, restructuring, and other costs of $5.0 million and $41.5 million, respectively.

 

During the three and nine months ended September 30, 2018, we recorded acquisition related expenses and integration expenses of $0.7 million and $5.4 million, respectively. These expenses related to the acquisition of Ruckus Networks and consisted of integration related outside services and other fees.

 

Restructuring expense of $4.3 million and $36.1 million were recorded during the three and nine months ended September 30, 2018, respectively. This primarily related to a restructuring plan that affected approximately 1,000 employees across the company, including those employees impacted by the planned sale of our factory in Taiwan.

 

During the three and nine months ended September 30, 2017, we recorded acquisition related expenses and integration expenses of $2.3 million and $8.6 million, respectively. These expenses related to the acquisition of the Ruckus Wireless and ICX Switch product lines and consisted primarily of banker fees and other fees.

 

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Restructuring charges of $8.5 million and $22.0 million were recorded during the three and nine months ended September 30, 2017, respectively, related to employee termination benefits, voluntary retirement offering, facility closures and non-cash write-off of property, plant and equipment.

 

Direct Contribution

 

Beginning in 2018, certain costs previously recorded or classified as part of “Corporate and Unallocated Costs”, including bonus, equity compensation and certain other direct costs are now reported within each operating segment. Consequently, our segment information for the 2017 period has been restated to reflect such change.

 

The table below sets forth our direct contribution, which is defined as gross margin less direct operating expenses (in thousands, except percentages).

 

   Direct Contribution   Increase (Decrease) Between 2018 and 2017 
   For the Three Months
Ended September 30,
   For the Nine Months
Ended September 30,
   For the Three Months
Ended September 30
   For the Nine Months
Ended September 30
 
   2018   2017   2018   2017   $   %   $   % 
Segment:                                
CPE  $62,152   $121,982   $197,636   $344,746   $(59,830)   (49.0)%  $(147,110)   (42.7)%
N&C   199,137    198,955    628,957    483,714    182    0.1%   145,243    30.0%
Enterprise   16,395        59,697        16,395    100.0%   59,697    100.0%
        Total  $277,684   $320,937   $886,290   $828,460   $(43,253)   (13.5)%  $57,830    7.0%

 

Customer Premises Equipment Direct Contribution 2018 vs. 2017

 

During the three and nine months ended September 30, 2018, the CPE segment direct contribution decreased by approximately 49.0% and 42.7%, respectively, as compared to the same period in 2017. The direct contribution was negatively impacted by lower sales and product mix, as well as lower gross margin. Memory pricing and component costs continued to depress gross margins. We have implemented initiatives to mitigate the effects of these higher component costs with price adjustments and actions to lower operating costs. Further, the proposed tariffs would apply to certain products and we are expecting to pass those tariffs along to customers, which could alter customer spending and prices. Our CPE reporting unit has approximately $1.4 billion of goodwill as of September 30, 2018. The estimated fair value of our CPE reporting unit is closely aligned with the ultimate amount of revenue and operating income that it achieves, and while we continue to believe that the CPE reporting unit fair value is in excess of its carrying value, a prolonged or continued erosion in the direct contribution in the CPE segment could result in an impairment of goodwill associated with this business.

 

Network and Cloud Direct Contribution 2018 vs. 2017

 

During the three and nine months ended September 30, 2018, direct contribution in our N&C segment increased by approximately 0.1% and 30.0%, respectively, as compared to the same period in 2017. The increase was primarily attributable to higher sales and the mix of product, including the sale of more CMTS products, in-particular licenses. We anticipate modestly lower direct contribution in the fourth quarter of 2018, resulting from a change in mix, with higher hardware sales anticipated.

 

Enterprise Networks Direct Contribution 2018 vs. 2017

 

During the three and nine months ended September 30, 2018, direct contribution in our Enterprise segment was approximately $16.4 million and $59.7 million, respectively.


Corporate and Unallocated Costs

 

There are expenses that are not included in the measure of segment direct contribution and as such are reported as “Corporate and Unallocated Costs” and are included in the reconciliation to income (loss) before income taxes. The “Corporate and Unallocated Costs” category of expenses includes corporate sales and marketing, and home office general and administrative expenses. “Corporate and Unallocated Costs” also includes corporate sales and marketing for the CPE and N&C segments. Marketing and sales expense related to the Enterprise segment are considered a direct operating expense for that segment and is not included in the “Corporate and Unallocated Costs.”

 

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The composition of our corporate and unallocated costs that are reflected in the consolidated statement of operations were as follows (in thousands, except percentages):

 

   Direct Contribution   Increase (Decrease) Between 2018 and 2017 
   For the Three Months
Ended September 30,
   For the Nine Months
Ended September 30,
   For the Three Months
Ended September 30
   For the Nine Months
Ended September 30
 
   2018   2017   2018   2017   $   %   $   % 
Cost of sales  $16,141   $16,792   $70,322   $44,815   $(651)   (3.9)%  $25,507    56.9%
Selling, general and administrative   92,276    92,895    286,766    268,741    (619)   (0.1)%   18,025    6.7%
Research and development   22,894    26,095    79,944    73,753    (3,201)   (12.3)%   6,191    8.3%
Total  $131,311   $135,782   $437,032   $387,309   $(4,471)   (3.3)%  $49,723    12.8%

 

During the three and nine months ended September 30, 2018, corporate and unallocated costs decreased by approximately (3.9)% and increased by approximately 56.9%, respectively, as compared to the same period in 2017. Included in the cost of sales in nine months ended September 30, 2018 is $17.0 million associated with the step-up in the underlying net book value of Ruckus Networks inventory acquired in the acquisition to fair market value as of the acquisition date. The increase also reflected the inclusion of incremental expense related to our acquisition of Ruckus Networks.

 

Supplemental Information - Adjusted Direct Contribution and Other Costs (Non-GAAP Measure)

 

ARRIS reports its financial results in accordance with accounting principles generally accepted in the United States (“GAAP” or referred to herein as “reported”). However, management believes that certain non-GAAP financial measures provide management and other users with additional meaningful financial information that should be considered when assessing our ongoing performance.

 

In addition to direct contribution, which is our measure of segment profit and loss, executive management has begun using additional measures to evaluate the operating performance of our operating segments. We are using “Adjusted Direct Contribution”, which is defined as direct contribution less allocated facility costs, sales and marketing costs, plus stock-based compensation and depreciation. These costs are allocated to each of our operating segments, based upon expense type using various methods such as revenue, headcount, or actual estimated resource usage.

 

The table below sets forth the reconciliation of operating income (loss) to our adjusted direct contribution, along with other supplemental costs disclosures:

 

   Three months ended September 30, 2018 
   CPE   N&C   Enterprise   Corporate &
Unallocated
   Total 
                     
Operating income (loss)  $12,233   $173,577   $103   $(132,892)  $53,021 
Add:                         
Amortization of intangible assets   47,096    24,724    15,669    817    88,306 
Integration, acquisition, restructuring, and other costs   2,823    836    623    764    5,046 
Direct contribution  $62,152   $199,137   $16,395   $(131,311)  $146,373 
Adjustments:                         
Allocated costs   (19,344)   (28,662)   (5,533)   53,539     
Stock compensation expense   5,298    7,917    3,343    3,770    20,328 
Depreciation expense   7,107    7,000    3,149    4,174    21,430 
Adjusted direct contribution  $55,213   $185,392   $17,354   $(69,828)  $188,131 

 

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   Three months ended September 30, 2017 
   CPE   N&C   Enterprise   Corporate &
Unallocated
   Total 
                     
Operating income (loss)  $56,414   $166,885   $(2,282)  $(136,860)  $84,157 
Add:                         
Amortization of intangible assets   63,258    26,089         815    90,162 
Integration, acquisition, restructuring, and other costs   2,310    5,981    2,282    263    10,836 
Direct contribution  $121,982   $198,955   $   $(135,782)  $185,155 
Adjustments:                         
Allocated costs   (20,916)   (30,148)       51,064     
Stock compensation expense   5,973    8,954        5,286    20,213 
Depreciation expense   9,801    7,337        5,199    22,337 
Adjusted direct contribution  $116,840   $185,098   $   $(74,233)  $227,705 

 

   Nine months ended September 30, 2018 
   CPE   N&C   Enterprise   Corporate &
Unallocated
   Total 
Operating income (loss)  $11,991   $541,211   $(1,131)  $(441,258)  $110,813 
Add:                         
Amortization of intangible assets   160,965    74,608    55,479    2,447    293,499 
Impairment of goodwill       

3,400

            

3,400

 
Integration, acquisition, restructuring, and other costs   24,680    13,138    5,349    1,779    41,546 
Direct contribution  $197,636   $628,957   $59,697   $(437,032)  $449,258 
Adjustments:                         
Allocated costs   (58,894)   (86,167)   (16,642)   161,703     
Stock compensation expense   16,523    24,335    10,215    12,014    63,087 
Depreciation expense   21,782    20,470    9,872    13,415    65,539 
Adjusted direct contribution  $177,047   $587,595   $63,142   $(249,900)  $577,884 

 

   Nine months ended September 30, 2017 
   CPE   N&C   Enterprise   Corporate &
Unallocated
   Total 
Operating income (loss)  $143,689   $393,263   $(8,590)  $(392,652)  $135,710 
Add:                         
Amortization of intangible assets   193,375    78,999        2,445    274,819 
Integration, acquisition, restructuring, and other costs   7,682    11,452    8,590    2,898    30,622 
Direct contribution  $344,746   $483,714   $   $(387,309)  $441,151 
Adjustments:                         
Allocated costs   (60,981)   (87,975)       148,956     
Stock compensation expense   17,857    27,935        16,160    61,952 
Depreciation expense   28,367    22,096        14,877    65,340 
Adjusted direct contribution  $329,989   $445,770   $   $(207,316)  $568,443 

 

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Other Expense (Income)

 

The table below provides detail regarding our other expense (in thousands, except percentages):

 

   Other Expense (Income)   Increase (Decrease) Between 2018 and 2017 
   For the Three Months
Ended September 30,
   For the Nine Months
Ended September 30,
   For the Three Months
Ended September 30
   For the Nine Months
Ended September 30
 
   2018   2017   2018   2017   $   %   $   % 
Interest expense  $23,969   $20,211   $70,142   $63,238   $3,758    18.6%  $6,904    10.9%
(Gain) loss on investments   (1,400)   839    (1,718)   8,978    (2,239)   (266.9)%   (10,696)   (119.1)%
Interest income   (1,764)   (2,288)   (5,088)   (5,997)   524    22.9%   909    15.2%
Loss (gain) on foreign currency   2,025    (8,543)   6,034    5,570    10,568    123.7%   464    8.3%
Other (income) expense, net   35    1,434    (25)   2,275    (1,399)   (97.6)%   (2,300)   (101.1)%
Total  $22,865   $11,653   $69,345   $74,064   $11,212    96.2%  $(4,719)   (6.4)%

 

Interest Expense

 

Interest expense includes the amortization of debt issuance costs (deferred finance fees and debt discounts) related to our term loans and interest expense paid on notes and term loans and other debt obligations. Interest expense for the three months ended September 30, 2018 and 2017 was $24.0 million and $20.2 million respectively. For the nine months ended September 30, 2018 and 2017, interest expense was $70.1 million and $63.2 million, respectively. The increase reflects the net impact of LIBOR increases after consideration from our interest rate derivatives.

 

In connection with the Second Amendment to the Credit Agreement, (see Note 14 Indebtedness of Notes to the Consolidated Financial Statements for additional details) we expensed approximately $2.5 million of debt issuance costs and wrote off approximately $0.3 million of existing debt issuance costs associated with certain lenders who were not party to the amended Term Loan B Facility, which were included as interest expense in the Consolidated Statements of Operations for the three and nine months ended September 30, 2017.

 

(Gain) Loss on Investments

 

We hold certain investments in equity securities of private and publicly-traded companies and investments in rabbi trusts associated with our deferred compensation plans and certain investments in limited liability companies and partnerships that are accounted for using the equity method of accounting. As such, our equity portion in current earnings of such companies is included in the (gain) loss on investments.

 

During the three months ended September 30, 2018 and 2017, we recorded net (gain) loss related to these investments of $(1.4) million and $0.8 million, respectively. During the nine months ended September 30, 2018 and 2017, we recorded a net (gain) loss related to these investments of $(1.7) million, and $9.0 million, respectively. The reduction in losses for the three and nine months ended September 30, 2018, as compared to same periods of the prior year reflect the wind-down of development activities for one of our equity method investments.

 

Loss on Foreign Currency

 

During the three months ended September 30, 2018 and 2017, we recorded a foreign currency loss (gain) of approximately $2.0 million and $(8.5) million, respectively. During the nine months ended September 30, 2018 and 2017, we recorded a foreign currency loss of approximately $6.0 million and $5.6 million, respectively. We have U.S. dollar functional currency entities that bill certain international customers or have liabilities payable in their local currency. Additionally, certain intercompany transactions are denominated in foreign currencies and subject to remeasurement. To mitigate the volatility related to fluctuations in the foreign exchange rates, we enter into various foreign currency contracts. The loss (gain) on foreign currency is driven by the fluctuations in the foreign currency exchange rates.

 

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Interest Income

 

Interest income during the three months ended September 30, 2018 and 2017 was $1.8 million and $2.3 million, respectively. During the nine months ended September 30, 2018 and 2017, interest income was $5.1 million and $6.0 million, respectively. The income reflects interest earned on cash, cash equivalents, and short-term and long-term marketable security investments.

 

Other (Income) Expense, net

 

Other (income) expense, net for the three months ended September 30, 2018 and 2017 was $0.1 million and $1.4 million, respectively. For the nine months ended September 30, 2018 and 2017, other (income) expense was $(0.1) million and $2.3 million, respectively.

 

Income Tax Expense

 

Our effective income tax rate fluctuates based on, among other factors, the level and location of income. The U.K. statutory rate for 2018 is 19% as compared to 19.25% in 2017. The difference between the U.K. statutory income tax rate of 19% and our effective income tax rate for the 2018 and 2017 periods is primarily due to the benefits of other foreign income tax regimes and the U.S. federal research and development credits.

 

Our effective income tax rate for the nine months ended September 30, 2018 was impacted by $1.5 million of expense related to excess book deductions for stock based compensation, $4.7 million of expense related to changes in permanent reinvestment assertions, offset by $12.4 million of benefit related to the release of uncertain tax positions due to settlement of audits and the expiration of statute of limitations, $2.8 million of benefit related to the effects of tax rate changes in the U.S., and $4.2 million of benefit related to an internal restructuring to move certain Ruckus Networks intangible property into the U.S.

 

Our effective income tax rate for the nine months period ended September 30, 2017 was impacted by $8.0 million of expense related to the intra-entity sale of an asset, offset by $9.8 million of benefit related to a decrease of interest related to uncertain tax positions and the release of uncertain tax positions due to settlement of audits and expiration of statute of limitations, and a $1.2 million of benefit related to excess tax deductions for stock-based compensation.

 

Non-GAAP Measures

 

ARRIS reports its financial results in accordance with accounting principles generally accepted in the United States (“GAAP” or referred to herein as “reported”). However, management believes that certain non-GAAP financial measures provide management and other users with additional meaningful financial information that should be considered when assessing our ongoing performance. Our management regularly uses our supplemental non-GAAP financial measures internally to understand, manage and evaluate our business and make operating decisions. These non-GAAP measures are among the factors management uses in planning for and forecasting future periods. Non-GAAP financial measures should be viewed in addition to, and not as an alternative to, the Company’s reported results prepared in accordance with GAAP (in thousands, except per share data):

 

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   For the Three Months
Ended September 30, 2018
   For the Three Months
Ended September 30, 2017
   For the Nine Months
Ended September 30, 2018
   For the Nine Months
Ended September 30, 2017
 
   Amount   Per Diluted
Share
   Amount   Per Diluted
Share
   Amount   Per Diluted
Share
   Amount   Per Diluted
Share
 
                                 
Sales  $1,651,248        $1,728,524        $4,955,498        $4,875,799      
Highlighted items:                                        
Acquisition accounting impacts of deferred revenue   2,400                  11,401               
Reduction in revenue related to warrants            3,064                  8,145      
Adjusted sales  $1,653,648        $1,666,828        $4,966,899        $4,883,944      
                                         
Net income attributable to ARRIS  International plc  $47,079   $0.26   $88,320   $0.47   $69,233   $0.38   $79,558   $0.42 
Highlighted items:                                        
Impacting gross margin:                                        
International plc                                        
Stock-based compensation expense  International plc   3,660    0.02    3,897    0.02    10,722    0.06    10,644    0.06 
Reduction in revenue related to warrants attributable to ARRIS  International plc           3,064    0.01            8,145    0.04 
Acquisition accounting impacts of deferred revenue  International plc   2,400    0.02            11,401    0.06         
Acquisition accounting impacts of fair valuing inventory  International plc                   16,971    0.09    908     
Impacting operating expenses:                                        
International plc                                        
Integration, acquisition, restructuring and other costs   5,046    0.03    10,836    0.06    41,546    0.23    30,622    0.16 
Amortization of intangible assets  International plc   88,306    0.49    90,162    0.48    293,499    1.60    274,819    1.44 
Impairment of goodwill  International plc                   3,400    0.02         
Stock-based compensation expense  International plc   16,668    0.09    16,316    0.08    52,365    0.28    51,308    0.27 
Noncontrolling interest share of Non-GAAP adjustments   (885)       (711)       (4,073)   (0.02)   (2,326)   (0.01)
Impacting other expense (income):                                        
Impairment of investments           (1,821)   (0.01)           929     
Debt amendment fees                           2,782    0.02 
Remeasurement of deferred taxes   519        3,569    0.02    540        8,508    0.04 
Impacting income tax expense:                                        
Income tax expense (benefit)   (40,666)   (0.23)   (62,698)   (0.33)   (102,594)   (0.56)   (116,884)   (0.61)
Total highlighted items   75,048    0.42    62,614    0.33    323,777    1.76    269,454    1.41 
Adjustment net income   122,127   $0.68    150,934   $0.80    393,010   $2.14    349,012   $1.83 
Weighted average ordinary shares - basic        178,106         187,064         182,132         187,878 
Weighted average ordinary shares - diluted        179,337         188,941         183,817         190,264 

 

Our non-GAAP financial measures reflect adjustments based on the following items, as well as the related income tax effects:

 

Acquisition Accounting Impacts Related to Deferred Revenue:    In connection with the accounting related to our acquisitions, business combination rules require us to account for the fair values of deferred revenue arrangements for post contract support in our purchase accounting. The non-GAAP adjustment to our sales and cost of sales is intended to include the full amounts of such revenues as if these purchase accounting adjustments had not been applied. We believe the adjustment to these revenues is useful as a measure of the ongoing performance of our business.

 

Reduction in Revenue Related to Warrants:    We entered into agreements with two customers for the issuance of warrants to purchase up to 14.0 million of ARRIS’s ordinary shares. Vesting of the warrants is subject to certain purchase volume commitments, and therefore the accounting guidance requires that we record any change in the fair value of warrants as a reduction in revenue. Until final vesting, changes in the fair value of the warrants will be marked to market and any adjustment recorded in revenue. We have excluded the effect of the implied fair value in calculating our non-GAAP financial measures. We believe it is useful to understand the effects of these items on our total revenues and gross margin.

 

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Stock Compensation Expense: We have excluded the effect of stock compensation expense in calculating our non-GAAP operating expenses and net income (loss) measures. Although stock compensation is a key incentive offered to our employees, we continue to evaluate our business performance excluding stock compensation expenses. We record non-cash compensation expense related to grants of restricted stock units. Depending upon the size, timing and the terms of the grants, the non-cash compensation expense may vary significantly but will recur in future periods.

 

Acquisition Accounting Impacts Related to Inventory Valuation:    In connection with the accounting related to our acquisitions, business combinations rules require the acquired inventory be recorded at fair value on the opening balance sheet. This is different from historical cost.  Essentially, we are required to write the inventory up to end customer price less a reasonable margin as a distributor. We have excluded the resulting adjustments in inventory and cost of sales as the historic and forward gross margin trends will differ as a result of the adjustments. We believe it is useful to understand the effects of this on cost of goods sold and margin.

 

Integration, Acquisition, Restructuring and Other Costs: We have excluded the effect of acquisition, integration, and other expenses and the effect of restructuring expenses in calculating our non-GAAP operating expenses and net income (loss) measures. We incurred expenses in connection with the ActiveVideo, Pace and Ruckus Networks acquisitions, which we generally would not otherwise incur in the periods presented as part of our continuing operations. Acquisition and integration expenses consist of transaction costs, costs for transitional employees, other acquired employee related costs, and integration related outside services. Restructuring expenses consist of employee severance and abandoned facilities. We believe it is useful to understand the effects of these items on our total operating expenses.

 

Amortization of Intangible Assets: We have excluded the effect of amortization of intangible assets in calculating our non-GAAP operating expenses and net income (loss) measures. Amortization of intangible assets is non-cash and is inconsistent in amount and frequency and is significantly affected by the timing and size of our acquisitions. Investors should note that the use of intangible assets contributed to our revenues earned during the periods presented and will contribute to our future period revenues as well. Amortization of intangible assets will recur in future periods.

 

Impairment of Goodwill: We have excluded the effect of the estimated impairment of goodwill in calculating our non-GAAP operating expenses and net income (loss) measures. Although an impairment does not directly impact our current cash position, such expense represents the declining value of the technology that was acquired. We exclude these impairments when significant and they are not reflective of ongoing business and operating results.

 

Noncontrolling Interest Share of Non-GAAP Adjustments: The joint venture formed for the ActiveVideo acquisition is accounted for by ARRIS under the consolidation method. As a result, the consolidated statements of operations include the revenues, expenses, and gains and losses of the noncontrolling interest. The amount of net income (loss) related to the noncontrolling interest is reported and presented separately in the consolidated statement of operations. We have excluded the noncontrolling share of any non-GAAP adjusted measures recorded by the venture, as we believe it is useful to understand the effect of excluding this item when evaluating our ongoing performance.

 

Impairment of Investments:    We have excluded the effect of an other-than-temporary impairment of a cost method investment in calculating our non-GAAP financial measures. We believe it is useful to understand the effect of this non-cash item in our other expense (income).

 

Debt Amendment Fees:    In 2017, we amended our credit agreement. This debt modification allowed us to improve the terms and conditions of the credit agreement, extend the maturities of Term Loan B. We have excluded the effect of the associated fees in calculating our non-GAAP financial measures. We believe it is useful to understand the effect of this item in our interest expense.

 

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Remeasurement of Deferred Taxes:    We record foreign currency remeasurement gains and losses related to deferred tax liabilities in the United Kingdom. The foreign currency remeasurement gains and losses derived from the remeasurement of the deferred income taxes from GBP to USD. We have excluded the impact of these gains and losses in the calculation of our non-GAAP measures. We believe it is useful to understand the effects of this item on our total other expense (income).

 

Net Tax Items:    We have excluded the tax effect of the non-GAAP items mentioned above. Additionally, we have excluded the effects of certain tax adjustments related to tax and legal restructuring, state and non-U.S. valuation allowances, benefits for releases of uncertain tax positions due to settlement, change in law or statute of limitations and provision to return differences.

 

Financial Liquidity and Capital Resources

 

One of our key strategies is to ensure we have adequate liquidity and the financial flexibility to support our strategy, including acquisitions and share repurchases. In addition to our cash flow activities discussed below, we also focus on key metrics which are summarized in the table below:

 

   As of September 30,
2018
   As of December 31,
2017
 
   (in thousands, except DSO and Turns) 
Cash, cash equivalents, and short-term investments  $520,397   $511,447 
Accounts Receivable, net  $1,117,641   $1,218,089 
-Days Sales Outstanding   65    63 
Inventory, net  $717,272   $825,211 
- Turns   6.2    7.2 
Term loans at face value  $2,095,775   $2,161,400 
Financing lease obligation  $61,261   $61,901 

 

Overview

 

In managing our liquidity and capital structure, we remained focused on key goals, and we have and will continue in the future to implement actions to achieve them. They include:

 

·Liquidity – ensure that we have sufficient cash resources or other short-term liquidity to manage day to day operations.
·Growth – implement a plan to ensure that we have adequate capital resources, or access thereto, to fund internal growth and execute acquisitions.
·Share repurchases – use a portion of cash from operating activities to repurchase our ordinary shares subject to market conditions.
·Deleverage – reduce our debt obligation.

 

Accounts Receivable & Inventory

 

We use the number of times per year that inventory turns over (based upon sales for the most recent period or turns) to evaluate inventory management and days sales outstanding, or DSOs, to evaluate accounts receivable management.

 

Accounts receivable at the end of the third quarter of 2018 decreased as compared to the end of the fourth quarter of 2017, primarily due to the timing of purchases by customers.

 

Inventory decreased in 2018 as compared to 2017, reflecting the consumption of certain inventory built in late 2017 and timing of customer requirements.

 

Term Loans

 

In the nine months ended September 30, 2018, we repaid $65.6 million of our term debt which reflects mandatory repayments.

 

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Share Repurchases

 

Upon completing the Pace combination, we conducted a court-approved process in accordance with section 641(1)(b) of the U.K. Companies Act 2006, pursuant to which we reduced our stated share capital and thereby increased our distributable reserves or excess capital out of which we may legally pay dividends or repurchase shares. Distributable reserves are not linked to a U.S. GAAP reported amount.

 

In 2016, our Board of Directors approved a $300 million share repurchase authorization replacing all prior programs. In early 2017, the Board authorized an additional $300 million for share repurchases. In March 2018, the Board authorized an additional $300 million for repurchases and an additional $375 million again in August 2018. Unless terminated earlier by a Board resolution, these repurchase authorizations will expire when ARRIS has used all authorized funds for repurchase. The remaining authorized amount for share repurchases under this plan was $562.9 million as of September 30, 2018. However, U.K. law also generally prohibits a company from repurchasing its own shares through “off market purchases” without prior approval of shareholders when such company is not traded on a recognized investment exchange in the U.K. This shareholder approval lasts for a maximum period of five years. Prior to and in connection with the Pace combination, we obtained approval to purchase our own shares. This authority to repurchase shares terminates in January 2021, unless otherwise reapproved by our shareholders.

 

During the first quarter of 2018, we repurchased 1.0 million ordinary shares for approximately $25.0 million at an average share price of $25.35. During the second quarter of 2018, we repurchased 4.0 million ordinary shares for approximately $99.9 million at an average stock price of $25.29. During the third quarter of 2018, we repurchased 8.4 million shares of its ordinary shares for $212.2 million at an average share price of $25.40. Since the end of the third quarter through November 8, 2018, we have repurchased an additional 0.6 million ordinary shares for approximately $16.0 million. The remaining authorized amount for share repurchases under these purchase authorizations was $546.9 million as of November 8, 2018.

 

During the third quarter of 2017, we repurchased 0.7 million ordinary shares for approximately $20.0 million at an average share price of $26.91. During the first nine months of 2017, we repurchased 5.7 million ordinary shares for approximately $147.0 million at an average share price of $24.09.

 

Summary of Current Liquidity Position and Potential for Future Capital Raising

 

We believe our current liquidity position, where we have approximately $520.4 million of cash, cash equivalents, and short-term investments on hand as of September 30, 2018, together with approximately $498.5 million in availability under our Revolving Credit Facility, and our prospects for continued generation of cash from operations are adequate for our short- and medium-term business needs. Our cash, cash-equivalents and short-term investments as of September 30, 2018 include approximately $340.2 million held by all non-U.S. subsidiaries. Of that amount, $62.2 million was held by non-U.S. subsidiaries legally owned by ARRIS U.S. entities. The Tax Act imposed a mandatory transition tax on previously accumulated earnings of those non-U.S. subsidiaries and a tax on a portion of their current earnings, therefore significantly reducing tax impacts on future remittances.  We have recorded a deferred tax liability of $5.4 million for the additional tax that would be paid when the previously accumulated earnings are remitted. 

 

We expect to be able to generate sufficient cash on a consolidated basis to make all the principal and interest payments under our senior secured credit facilities. Should our available funds be insufficient to support these initiatives or our operations, it is possible that we will raise capital through private or public, share or debt offerings.

 

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Senior Secured Credit Facilities

 

For information regarding our credit facilities, see Note 14 Indebtedness of Notes to the Consolidated Financial Statements.

 

Interest rates on borrowings under the senior secured credit facilities are set forth in the table below. As of September 30, 2018, we had $371.5 million, $1,187.5 million and $536.8 million principal amounts outstanding under the Term A Loan, Term A-1 Loan and Term B-3 Loan Facilities, respectively. No borrowings under the Revolving Credit Facility and letters of credit totaling $1.5 million are issued under the Revolving Credit Facility.

 

   Rate  As of September 30, 2018
Term A Loan  LIBOR + 1.75 %  3.99%
Term A-1 Loan  LIBOR + 1.75 %  3.99%
Term B-3 Loan  LIBOR (1) + 2.25 %  4.49%
Revolving Credit Facility (1)  LIBOR + 1.75 %  Not Applicable

 

(1)Includes unused commitment fee of 0.30% and letter of credit fee of 1.75% not reflected in interest rate above.

 

The Credit Agreement contains usual and customary limitations on indebtedness, liens, restricted payments, acquisitions and asset sales in the form of affirmative, negative and financial covenants, which are customary for financings of this type, including the maintenance of a minimum interest coverage ratio and a maximum leverage ratio. As of September 30, 2018, we complied with all covenants under the Credit Agreement.

 

Off-Balance Sheet Arrangements

 

We do not have any material off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K.

 

Sources and Uses of Cash

 

Below is a table setting forth the key line items of our Consolidated Statements of Cash Flows (in thousands):

 

   Nine months ended September 30, 
   2018   2017 
Cash provided by (used in):          
Operating activities  $420,240   $611,654 
Investing activities   (14,689)   19,066 
Financing activities   (406,341)   (231,915)
Effect of exchange rate changes   (4,017)   941 
Net (decrease) increase in cash and cash equivalents  $(4,807)  $399,746 

 

Operating Activities:

 

Below are the key line items affecting cash provided by operating activities (in thousands):

 

   Nine months ended September 30, 
   2018   2017 
Consolidated net income  $63,574   $74,258 
Adjustments to reconcile net income to cash provided by operating activities   376,689    409,842 
Net income including adjustments   440,263    484,100 
Decrease in accounts receivable   85,636    305,212 
Decrease (increase) in inventory   104,570    (222,733)
(Decrease) increase in accounts payable and accrued liabilities   (149,797)   132,437 
All other, net   (60,432)   (87,362)
Cash provided by operating activities  $420,240   $611,654 

 

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Consolidated net income (loss), including adjustments, as per the table above, decreased $43.8 million during the first nine months of 2018 as compared to 2017. It should be noted that the net income reflected in the first nine months of 2018 includes: 1) turnaround effect of inventory step-up in fair market value of $17.0 million, and 2) inclusion of the acquisition of Ruckus Networks. These items were either not present or were insignificant in the first nine months of 2017.

 

Accounts receivable decreased by $85.6 million during the first nine months of 2018. The decrease was primarily due to purchasing and payment patterns of our customers.

 

Inventory decreased by $104.6 million during the first nine months of 2018, reflecting consumption of certain inventory built in late 2017 and timing of customer requirements. In the first nine months of 2018, there was a $17.0 million reduction related to turnaround effect of inventory markup in acquisition accounting. We anticipate inventory will further decline in 2018.

 

Accounts payable and accrued liabilities decreased by $149.8 million during the first nine months of 2018. The change was a decrease in accounts payable reflecting timing of payments and accrued expenses.

 

All other accounts, net, includes the changes in other receivables, income taxes payable (recoverable), and prepaids. The other receivables represent amounts due from our contract manufacturers for material used in the assembly of our finished goods. The change in our income taxes recoverable account is a result of the timing of the actual estimated tax payments during the year as compared to the actual tax liability for the year. The net change during the first nine months of 2018 was approximately $60.4 million as compared to $87.4 million during the same period in 2017.

 

Investing Activities:

 

Below are the key line items affecting investing activities (in thousands):

 

   Nine months ended September 30, 
   2018   2017 
Purchases of investments  $(64,454)  $(68,250)
Sales of investments   45,638    155,301 
Purchases of property, plant and equipment   (45,621)   (62,389)
Purchases of intangible assets   (423)   (6,422)
Deposit proceeds for sale of property, plant and equipment   50,000     
Other, net   171    826 
Cash (used in) provided by investing activities  $(14,689)  $19,066 

 

Purchases and sales of investments - Represent purchases and sales of securities and other investments.

 

Purchases of property, plant and equipment Represents capital expenditures which are mainly for test equipment, laboratory equipment, and computer and networking equipment and facilities.

 

Purchase of intangible assets - Represent primarily the purchase of technology licenses.

 

Deposit proceeds for sale of property, plant and equipment Represents a deposit received as prepayment for the pending sale of our manufacturing facility and equipment in Taiwan.

 

Other, net - Represent dividend proceeds received from equity investments.

 

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Financing Activities:

 

Below are the key line items affecting our financing activities (in thousands):

 

   Nine months ended September 30, 
   2018   2017 
Proceeds from issuance of shares, net  $9,206   $8,623 
Repurchase of shares   (331,622)   (146,965)
Repurchase of shares to satisfy employee minimum tax withholdings   (19,917)   (26,359)
Proceeds from issuance of debt       30,314 
Payment of debt obligations   (65,625)   (98,976)
Payment of financing lease obligation   (640)   (590)
Payment of deferred financing fees and debt discount       (1,462)
Contribution from noncontrolling interest   2,257    3,500 
Cash used in financing activities  $(406,341)  $(231,915)

 

Proceeds from issuance of shares, net – Represents cash proceeds related to the vesting of restricted stock units, offset by expenses paid related to issuance of shares.

 

Repurchase of shares Represents the cash used to buy back the Company’s ordinary shares.

 

Repurchase of shares to satisfy employee minimum tax withholdings - Represents the shares withheld and cancelled for cash, to satisfy the employee minimum tax withholding when restricted stock units vest.

 

Proceeds from issuance of debt – Represents the proceeds from new borrowings for our “Term Loan B-2 Facility” upon the amendment to our amended and restated credit facility in 2017.

 

Payment of debt obligations – Represents the mandatory payment of the term loans under the senior secured credit facilities.

 

Payment of lease financing obligation Represents the amortization related to the portion of the sale of building that did not qualify for sale-leaseback accounting.

 

Payment of deferred financing costs and debt discount — Represents the financing costs in connection with the execution of our senior secured credit facility under the Amended Credit Agreement. The costs have been deferred and will be recognized over the terms of the credit agreements. It also represents amounts paid to lenders in the form of upfront fees, which have been treated as a reduction in the proceeds received by the ARRIS and are considered a component of the discount of our senior secured credit facility under the Amended Credit Agreement.

 

Contribution from noncontrolling interest Represents the equity investment contributions by the non-controlling interest in a joint venture formed for the ActiveVideo acquisition.

 

Interest Rates

 

As described above, all indebtedness under our senior secured credit facilities bears interest at variable rates based on LIBOR plus an applicable spread. We entered into interest rate swap arrangements to convert a notional amount of $1,075.0 million of our variable rate debt based on one-month LIBOR to a fixed rate. This objective of these swaps is to manage the variability of cash flows in the interest payments related to the portion of the variable rate debt designated as being hedged.

 

Foreign Currency

 

A significant portion of our products are manufactured or assembled in Brazil, China, Mexico and Taiwan, and we have research and development centers in Canada, China, France, India, Ireland, Israel, Singapore, Sweden, Taiwan and United Kingdom. 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.

 

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We have certain international customers who are billed in their local currency and certain international operations that procure in U.S. dollars. We also have certain predicable expenditures for international operations in local currency. Additionally, certain intercompany transactions are denominated in foreign currencies and subject to revaluation. We use a hedging strategy and enter into forward or currency option contracts based on a percentage of expected foreign currency revenues and expenses. The percentage can vary, based on the predictability of the revenues denominated in the foreign currency.

 

Financial Instruments

 

In the ordinary course of business, we, from time to time, will enter into financing arrangements with customers. These financial arrangements 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.

 

Capital Expenditures

 

Capital expenditures are made at a level designed to support the strategic and operating needs of the business. ARRIS’s capital expenditures were $45.6 million in the first nine months of 2018 as compared to $62.4 million in the first nine months of 2017. Management expects to invest approximately $65 million to $70 million in capital expenditures for the year 2018.

 

Critical Accounting Policies and Estimates

 

Our critical accounting policies and estimates are disclosed in our Form 10-K for the year ended December 31, 2017, as filed with the SEC. Our critical accounting policies and estimates have not changed in any material respect during the nine months ended September 30, 2018, except for the following:

 

Revenue Recognition:

 

Adoption of the new standard related to revenue recognition. Refer to Note 2 Impact of Recently Adopted Accounting Standards and Note 3 Revenue from Contracts with Customers for additional details.

 

Goodwill:

 

As of October 1, 2017 (the date of our annual impairment testing), the fair value of our CPE reporting unit exceeded its carrying amount by 34% and, accordingly, did not result in a goodwill impairment. Over the last twelve months, near-term trends impacting revenue and gross margin, including higher product costs associated with memory and other components have decreased the amount by which the fair value exceeds the carrying amount to less than 10%, such that our CPE reporting unit could be at risk of failing the impairment test if future projections are not realized. Further, the proposed tariffs may also have an adverse impact on our business. The estimated fair value of our CPE reporting unit is closely aligned with the ultimate amount of revenue and operating income that it achieves over the projection period. At this time, our projections assume limited revenue growth and some recovery in gross margins over current levels in subsequent years, which is dependent on product cost improving and ability to pass on increased costs through price increases. Our CPE reporting unit has approximately $1.4 billion of goodwill as of September 30, 2018.

 

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 thereof, constitute forward-looking statements with respect to the financial condition, results of operations, and business of ARRIS and the proposed transaction with CommScope, 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. 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 set forth in Item 1A, Part II, “Risk Factors.” 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, we expressly disclaim 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.

 

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Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

There have been no material changes with respect to the information appearing in Part II, Item 7A., “Quantitative and Qualitative Disclosures About Market Risk,” of our Annual Report on Form 10-K for the year ended December 31, 2017.

 

Item 4. CONTROLS AND PROCEDURES

 

(a) Evaluation of Disclosure Controls and Procedures. Management, with the participation and supervision of our principal executive officer and principal financial officer evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report (the “Evaluation Date”). Based on that evaluation, our principal executive officer and principal financial officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were effective as contemplated by the Act.

 

(b) Changes in Internal Control over Financial Reporting. Management, with the participation and supervision of our principal executive officer and principal financial officer evaluated the changes in our internal control over financial reporting that occurred during the most recent fiscal quarter. Except as described below, based on that evaluation, our principal executive officer and principal financial officer concluded, that there had been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. During the quarter ended December 31, 2017 we acquired Ruckus Networks and are in the process of integrating the acquired business into our overall internal control over financial reporting process.  We expect to include Ruckus Networks in the annual assessment of internal control over financial reporting as of December 31, 2018. In addition, we implemented certain changes to our internal controls to ensure we adequately evaluated our contracts and properly assessed the impact of the new accounting standard related to revenue recognition on our financial statements to facilitate its adoption on January 1, 2018. 

 

PART II. OTHER INFORMATION

 

Item 1. LEGAL PROCEEDINGS

 

We have been, and expect in the future to be, a party to various legal proceedings, investigations or claims. In accordance with applicable accounting guidance, we record accruals for certain of our outstanding legal proceedings when it is probable that a liability will be incurred, and the amount of loss can be reasonably estimated. We evaluate, at least on a quarterly basis, developments in our legal proceedings or other claims that could affect the amount of any accrual, as well as any developments that would result in a loss contingency to become both probable and reasonably estimable. When a loss contingency is not both probable and reasonably estimable, we do not record a loss accrual.

 

If the loss (or an additional loss in excess of any prior accrual) is reasonably possible and material, we disclose an estimate of the possible loss or range of loss, if such estimate can be made. The assessment whether a loss is probable or reasonably possible and whether the loss or a range of loss is estimable, involves a series of complex judgments about future events. Even if a loss is reasonably possible, we may not be able to estimate a range of possible loss, particularly where (i) the damages sought are substantial or indeterminate, (ii) the proceedings are in the early stages, or (iii) the matters involve novel or unsettled legal theories or a large number of parties. In such cases, there is considerable uncertainty regarding the ultimate resolution of such matters, including the amount of any possible loss. We are currently unable to reasonably estimate the possible loss or range of possible loss for any of the matters identified below. The results in litigation are unpredictable and an adverse resolution of one or more of such matters not included in the estimate provided, or if losses are higher than what is currently estimated, it could have a material adverse effect on our business, financial position, results of operations or cash flows.

 

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Due to the nature of our business, we are subject to patent infringement claims, including current suits against us or one or more of our wholly-owned subsidiaries or one or more of our customers who may seek indemnification from us. We believe that we have meritorious defenses to the allegations made in the pending cases and intend to vigorously defend these lawsuits; however, we are unable currently to forecast the ultimate outcome of these or similar matters. In addition, we are a defendant in various litigation matters generally arising out of the normal course of business. Except as described below, we are not party to (nor have indemnification claims been made with respect to) any proceedings that are, or reasonably are expected to be, material to its business, results of operations or financial condition. However, since it is difficult to predict the outcome of legal proceedings, it is possible that the ultimate outcomes could materially and adversely affect our business, financial position, results of operations or cash flows. Accordingly, with respect to these proceedings, we are currently unable to reasonably estimate the possible loss or range of possible loss.

 

ChanBond v. MSOs,   C.A. 15-cv-00848, et al, District of Delaware (RGA). On September 21, 2015, ChanBond filed suit against several MSOs alleging infringement of three U.S. Patents. Certain of our customers have requested that we provide indemnification. Requests for Inter Partes Review (“IPR”) by ARRIS of the asserted patents were denied on procedural grounds. The complaint requests unspecified damages for infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to indemnify the MSOs and/or pay damages for utilizing certain technology.

 

Chrimar v. Ruckus Wireless, Inc., C.A. 16-cv-00186, Northern District of California. On July 1, 2015, Chrimar filed suit against Ruckus alleging infringement of four U.S. Patents. The case has been stayed pending completion of IPR proceedings contesting the validity of the patents. All four of these IPRs have resulted in a final written decision invalidating the asserted claims, however Chrimar has filed a notice of appeal. The complaint requests unspecified damages for infringement and injunction against future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, we may be required to pay damages for utilizing certain technology.

 

Hera Wireless et al. v. ARRIS, C.A. 1:17-cv-00948, District of Delaware. On July 14, 2017, Hera Wireless filed suit against ARRIS alleging infringement of three U.S. patents. IPR petitions have been filed against all asserted patents. The complaint requests unspecified damages for infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to pay damages for utilizing certain technology.

 

In Re ARRIS Cable Modem Consumer Litigation, C.A. 5:17-cv-01834, Northern District of California. On March 31, 2017, Carlos Reyna, on behalf of himself and others similarly situated filed a putative class action lawsuit against ARRIS alleging that the SB6190 modem which includes the Intel Puma 6 chipset is defective. Other state court complaints have been filed but are stayed pending the outcome of the California action. The plaintiff alleges violation of the California Song-Beverly Consumer Warranty Act, California Consumer Legal Remedies Act, California False Advertising Law, and California Unfair Competition Law. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, we may be required to pay damages.

 

RealTime Adaptive Streaming v. EchoStar et al., C.A. 17-cv-02097, District of Colorado. On November 6, 2017, RealTime Adaptive Streaming filed an amended complaint alleging that ARRIS products infringe two U.S. patents. The complaint requests unspecified damages for infringement and injunction against future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to pay damages for utilizing certain technology.

 

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Rovi et al. v. Comcast et al., C.A. 1:16-cv-09826, Southern District of New York; 337-TA-1001, International Trade Commission. On April 1, 2016, Rovi filed suit against Comcast and several equipment vendors (including ARRIS and Pace) alleging infringement of 15 U.S. patents alleged to cover various program guide technology. On April 6, 2016, Rovi filed a complaint in the International Trade Commission (ITC) alleging infringement of seven U.S. patents (the same as those asserted in the New York suit). The ITC found Comcast in violation of two patents by various remote programming features (both of which have now been ruled invalid by the Patent Trial and Appeal Board), while also finding that ARRIS set-top boxes do not infringe the patents. In an example of what we believe is clear administrative authority overreach, the ITC thereby issued an exclusion order against Comcast from causing non-infringing set-top boxes to be imported for use in Comcast’s system. Comcast has removed from its network the remote programming feature held infringing by the ITC, and U.S. Customs and Border Protection has ruled to allow importation of set-top products for use in Comcast’s redesigned network. ARRIS and Comcast are appealing the ITC verdict. Until the matter is resolved, there remains a risk that U.S. Customs and Border Protection improperly applies the ITC’s exclusion order, which could then result in delays on the delivery of ARRIS’s products.

 

Rovi et al. v. Comcast et al., 337-TA-1103, International Trade Commission. On February 8, 2018, Rovi filed a new complaint in the International Trade Commission (ITC) alleging Comcast infringes eight U.S. patents controlled by Rovi and its affiliates. The ITC investigation has been terminated with respect to five of the patents. While ARRIS has been properly excluded from being a party to the complaint, in the event that the ITC finds Comcast to have committed a violation with respect to the patents, and again oversteps its bounds with respect to jurisdiction, ARRIS may be barred from importing set top boxes into the U.S. based on Comcast’s purely domestic activity, over which ARRIS has no control, and which bar would have a materially adverse impact on our results.

 

Sprint Communications v. TWC,  C.A. 11-cv-2686 etc., District of Kansas. On December 19, 2011, Sprint filed suit against several MSOs alleging infringement of several patents alleged to cover various aspects of voice services. Certain of our customers have requested that we provide indemnification. The complaint requests unspecified damages for past infringement and injunction against future infringement. At an initial trial, Sprint was awarded $140 million in damages from Time Warner Cable. It is premature to assess the likelihood of an unfavorable outcome on any indemnity claims. In the event of an unfavorable outcome, ARRIS may be required to indemnify the MSOs and/or pay damages for utilizing certain technology. With respect to any liability attributable to Motorola Home in this matter, a subsidiary of Google has agreed to indemnify ARRIS.

 

TQ Delta v. MSOs,   C.A. 15-cv-00611; 15-cv-00615, etc., District of Delaware. On July 17, 2015, TQ Delta filed suit against several MSOs alleging infringement of several U.S. patents. Certain of our customers have requested that we provide indemnification. The case has been stayed pending the outcome of IPR proceedings. All of the asserted patents now have final written decisions by the Patent Trial and Appeal Board invalidating all asserted claims as a result of the IPRs. TQ Delta has filed a notice of appeal. The complaint requests unspecified damages for past and future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, we may be required to indemnify the MSOs and/or pay damages for utilizing certain technology.

 

TQ Delta v. 2Wire Inc.,    C.A. 13-cv-01835, District of Delaware. On November 4, 2013, TQ Delta filed suit against 2Wire alleging infringement of several U.S. patents. The complaint requests unspecified damages for past infringement and an injunction against future infringement. To date, no evidence of infringement or damages has been introduced. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, we may be required to pay damages for utilizing certain technology.

 

XR Communications v. Ruckus Wireless, Inc.,  XR Communications v. ARRIS, C.A. 4:18-cv-01992, Northern District of California; and 8:18-cv-00192, Central District of California. On April 21, 2017, XR Communications filed suit against Ruckus in the Central District of California alleging infringement of three U.S. patents. The case was subsequently transferred to the Northern District of California. On February 2, 2018 XR Communications filed suit against ARRIS alleging infringement of the same three U.S. patents. IPR petitions have been filed against all three patents, and the litigation has been stayed pending completion of the IPR proceedings. The complaints request unspecified damages for past and future infringement. It is premature to assess the likelihood of an unfavorable outcome. In the event of an unfavorable outcome, ARRIS may be required to cease using and/or pay damages for utilizing certain technology.

 

In the acquisition agreement entered into in connection with the acquisition of the Motorola Home business, a subsidiary of Google agreed to indemnify, defend and hold harmless ARRIS and various related parties with respect to, among other things, any losses suffered by ARRIS as a result of a court order involving, or the settlement of, certain agreed-upon litigation, including the Sprint lawsuit described above, that reference this indemnification obligation. There are various limitations upon this obligation.

 

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From time to time third parties demand that we or our customers enter into license agreements with respect to patents owned, or allegedly owned, by the third parties. Such demands cause us to dedicate time to study the patents and enter into discussions with the third parties regarding the merits and value, if any, of the patents. These discussions, may materialize into license agreements or patent claims asserted against us or our customers. If asserted against our customers, our customers may request indemnification from us. It is not possible to determine the impact of any such demands and the related discussions on ARRIS’s business, results of operations or financial condition.

 

Item 1A. RISK FACTORS

 

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

 

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

 

demand for network services;
general economic conditions;
foreign currency fluctuations;
competition from other providers of broadband and high-speed services;
customer specific financial or stock market conditions;
availability and cost of capital;
governmental regulations;
customer acceptance of new services offered; and
real or perceived trends or uncertainties in these factors.

 

Several of our customers have accumulated significant levels of debt. These high debt levels, coupled with the volatility in the capital markets, may impact their access to capital in the future, or reduce the amounts they spend on purchasing additional equipment from us. Even if the financial health of our customers remains intact, these customers may not purchase new equipment at levels we have seen in the past or expect in the future. We cannot predict the impact, if any, of any softening or downturn in the national or global economy or of specific customer financial challenges on our customers’ expansion and maintenance expenditures.

 

Uncertainties associated with the transaction with CommScope could adversely affect our business, results of operations and financial condition.

 

On November 8, 2018, we entered into the Acquisition Agreement under which we will be acquired by CommScope. Completion of the Acquisition is subject to various closing conditions, including but not limited to, obtaining necessary approvals and consents from our shareholders and various regulatory agencies, including the High Court of Justice of England and Wales, the European Commission and other antitrust authorities. The regulatory agencies from which the parties will seek certain of these clearances have broad discretion in administering the governing regulations. As a condition to their clearance of the Acquisition, agencies may impose requirements, limitations or costs or require divestitures or place restrictions on the conduct of the parties’ business. These requirements, limitations, costs, divestitures or restrictions could jeopardize or delay the consummation of the Acquisition or may reduce the anticipated benefits of the Transaction. There can be no assurance that the parties to the Acquisition Agreement will receive the necessary approvals for the transaction or receive them within the expected timeframe.

 

The announcement and pendency of the Acquisition, as well as any delays in the expected timeframe, could cause disruption in and create uncertainties, which could have an adverse effect on our business, results of operations and financial condition, regardless of whether the Acquisition is completed. These risks include:

 

an adverse effect on our relationships with vendors, customers, and employees;
a diversion of a significant amount of management time and resources towards the completion of the Acquisition;
being subject to certain restrictions on the conduct of our business;
possibly foregoing certain business opportunities that we might otherwise pursue absent the pending Acquisition; and
difficulties attracting and retaining key employees.

 

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Failure to complete the Acquisition could adversely affect our business and the market price of our ordinary shares.

 

There is no assurance that the closing of the Acquisition will occur. The Acquisition may be terminated under certain specified circumstances, including, but not limited to, a termination of the Acquisition Agreement by us to enter into an agreement for a “superior proposal” or the occurrence of an “intervening event.” If the Acquisition Agreement is terminated by us under certain circumstances, we may be required to pay the buyer a termination fee of $58 million, except that the termination fee shall be $29 million if the Scheme is not sanctioned by the High Court of Justice of England and Wales or the requisite shareholder approvals are not obtained. Payment of this termination fee may require us to use available cash that would otherwise be used for general purposes or strategic initiatives, which could adversely affect our business, results of operations or financial condition.

 

The Acquisition Agreement contains provisions that limit our ability to pursue alternatives to the Acquisition.

 

Under the Acquisition Agreement, we are restricted, subject to certain exceptions, from soliciting, knowingly encouraging, or furnishing information with regard to, any inquiry, proposal or offer for a competing acquisition proposal with any person. We may terminate the Acquisition Agreement and enter into an agreement with respect to a superior proposal only if specified conditions have been satisfied, including a determination by our board of directors (after consultation with our financial advisor and legal counsel) that such proposal would result in a transaction more likely to promote our success for the benefit of our shareholders than the Acquisition, and such a termination would result in us being required to pay the termination fee referenced above. These provisions could discourage a third party that may have an interest in acquiring all or a significant part of our business from considering or proposing that acquisition, even if such third party were prepared to pay consideration with a higher value than the value of the consideration in the Acquisition.

 

Potential litigation instituted against us and our directors challenging the proposed Acquisition may prevent the Acquisition from becoming effective within the expected timeframe or at all.

 

Potential litigation related to the Acquisition may result in injunctive or other relief prohibiting, delaying or otherwise adversely affecting our ability to complete the Acquisition. Such relief may prevent the Acquisition from becoming effective within the expected timeframe or at all. In addition, defending against such claims may be expensive and divert management's attention and resources, which could adversely affect our business.

  

Changes to United States tax, tariff and import/export regulations may have a negative effect on global economic conditions, financial markets and our business.

 

We import a significant amount of our products and components from our partner manufacturers in China. The Office of the U.S. Trade Representative (the “USTR”) recently enacted tariffs ranging from 10% to 25% on imports into the U.S. of a broad array of Chinese products that includes many of our broadband CPE products. The current 10% tariff on many of these products is scheduled to increase to 25% effective January 1, 2019. The administration has also indicated that it is considering proposing an additional lot of products that would be subject to tariffs, which list may include more of our products. While we currently have agreement to pass on over 80% of the current tariff costs to our customers, it could reduce the amount of impacted products that customers in the U.S. will purchase, the timing of those purchases and may impact cash flow due to the timing of payments for the tariffs and collection from our customers.  We are in the process of shifting the manufacturing locations for impacted products to locations that would not be subject to the proposed tariffs, manufacturing in such locations may increase our manufacturing costs and it will take time, likely in excess of six months, for us to fully establish manufacturing in the locations for all impacted products. 

 

As evidenced by the USTR proposed tariffs, the current administration, along with Congress, has created significant uncertainty about the future relationship between the United States and other countries with respect to the trade policies, treaties, taxes, government regulations and tariffs that would be applicable. In addition to the potential direct impact to us of proposed tariffs as discussed above, these developments, or the perception that any of them could occur, may have a material adverse effect on global economic conditions and the stability of global financial markets, and may significantly reduce global trade and, in particular, trade between the impacted nations and the United States. Any of these factors could depress economic activity and restrict our access to suppliers or customers and have a material adverse effect on our business, financial condition and results of operations.

 

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Our gross margins and operating margins will vary over time, and our aggregate gross margin may decrease from historical levels.

 

We expect our product gross margins to vary over time, and the aggregate gross margin we have achieved in recent years may continue to decrease and be adversely affected in the future by numerous factors, including customer, product and geographic mix shifts, the introduction of new products, customer acceptance of designed products with a lower cost to us, fluctuations in our license sales or services we provide, changes in the actions of our competitors, currency fluctuations that impact our costs or the cost of our products and services to our customers, tariffs, increases in material, labor, or inventory carrying costs, and increased costs due to changes in component pricing, such as flash memory and multilayer ceramic capacitors, for our CPE products. We will continue to focus on increasing revenues and operating margins and managing our operating expenses; however, no assurance can be provided that we will be able to achieve all or any of these goals.

 

The markets on which our business is focused is significantly impacted by technological change.