Arris to become a full infrastructure player under CommScope’s wing

There were mixed reactions to news that the much-anticipated acquisition of Arris by CommScope had been agreed. Most of the negative comments from investment analysts related to the low profitability of Arris’s heartland business in set-top boxes (STBs), but in reality, Arris has been making strategic acquisitions to diversify its business and boost its margins, and some of those products will prove highly strategic for its parent.

The $7.4bn deal is likely to see an acceleration in Arris’s move away from STBs. There is a slim chance the deal could give Arris sufficient scale for a remarkable turnaround in its core activity, better able to compete with Samsung, Humax and Huawei. But it is more probable that the combined company will be remodelled around network infrastructure, bringing together several complementary assets, including Arris’s Ruckus Wireless acquisition and CommScope’s Airvana.

When M&A rumors first swirled a few weeks ago, the two firms were similar in size, Arris with a market cap of a little over $4.3bn and CommScope valued at $4.7bn. When the deal was announced on November 8, they had traded places, with Arris shooting up to a $5bn valuation, while CommScope’s was flat. The deal coincided nicely with the latest set of quarterly results from Arris, showing that the $7.4bn purchase offer (including repayment of debt) is some 4.5 time quarterly Arris revenue as of Q3, down slightly by 4.5% from the previous quarter to $1.65bn, while revenue for the first nine months came in just shy of $5bn.

So, let’s break out its segmented earnings from the quarter and dissect what CommScope sees. As mentioned, Arris’ STB/CPE business is in trouble, with gross margin falling by 27.5% from the previous quarter to $62.1m, while the Network and Cloud division also incurred a surprise gross margin slip of 1% to $199.1m – albeit on net sales of around half the size that of CPE.

Arris decided not to break out revenues for individual business sectors this quarter, but in Q2, CPE revenue was down 12.8% to just over $1bn, contributing to a total revenue dive of $327.6m year on year to $1.9bn for the first six months of 2018. On that run rate, the CPE sector could be on course for a full year revenue drop of over $600m.  The $7.4bn acquisition offer from CommScope suddenly looks even more appealing from the Arris point of view.

Meanwhile, Arris’s smaller Network and Cloud division is enjoying healthy growth and this is where CommScope sees real value, with revenue up 15.5% to $1.1bn for the period ended June 2018. For the 12 months ended September 2018, the CPE sector accounted for $3.9bn in revenue from Arris’ total $6.7bn, while Network and Cloud contributed $2.2bn.

Net income for the third quarter suffered, falling to $47m from $88.3m in Q3 last year.

CommScope is no spring chicken itself mind you. Founded 42 years ago, the company is enduring a recovery process after its share price plummeted aggressively earlier this year when it decided to talk openly about a turbulent market outlook.

We mustn’t leave a stone unturned, so it could even be feasible for CommScope to initiate a bargain sale of the flailing CPE business to a set-top rival or private equity firm if it successfully completes the takeover of Arris.

From the cellular perspective, a merged Arris and CommScope entity would form an interesting portfolio to address indoor wireless deployers, whether traditional operators or new entrants such as cablecos.

It will bring together a carrier WiFi platform heavily geared to the cable sector, but also implemented in the home; antennas from outdoor base stations to indoor Distributed Antenna Systems (DAS); virtualized and conventional 4G small cells for home and enterprise; and a wide range of cable equipment including set-tops, modems and other units. Arris’ E6000 edge router has been widely deployed globally and is one of the leading devices for cable’s Converged Cable Access Platform (CCAP.) All of this with a growing dose of cloud management to help bring all the elements together in an indoor HetNet (heterogenous network).

It’s worth noting that Arris expanded from its cable equipment base into carrier WiFi when it acquired Ruckus Wireless (itself offloaded when its former parent, Brocade, was acquired by Broadcom). And CommScope – best known for base station antennas and DAS – added small cells, including an indoor enterprise virtualized RAN solution, when it acquired specialist supplier Airvana in 2015. Other similar deals have taken place, such as DAS provider Corning’s purchase of enterprise small cell vendor Spidercloud.

The sale will have also been influenced by the import tariffs being imposed by President Trump, meaning a critical period for the electronics industry with Arris and Technicolor two companies directly in the crosshairs. Complete set tops are currently exempt from tariffs so the dangers are not quite so immediate, yet tariffs levied on electronic components will certainly impact the value of the set top industry globally.

A further caveat for consolidation in the legacy set top industry are the rumored plans for an Amazon-made streaming DVR dedicated to interoperating with smartphones, much like Chromecast, as well as its own Fire tablets. TiVo shares immediately slumped 10% back in late August but the long term target is really Roku, the frontrunner in the dongle streaming space with 50% compared to Chromecast’s 22%, while Amazon Fire has 15% and Apple TV 12%.