We upgrade our recommendation for Arris Group Inc. (ARRS) to Neutral based on its current valuation, which has fallen by nearly 24% in the past one year and is now trading at significantly low multiples compared to peers with respect to several valuation metrics. The company reported a mixed financial result for the third quarter of 2010 and provided a disappointing fourth quarter outlook. We believe margin pressure will continue in the near future due to near completion of DOCSIS 3.0 deployment by large U.S. cable MSOs.
Meanwhile, Arris has diversified its offering into digital video market. In order to prevent competitive threat, cable operators are gradually shifting toward an all-IP triple-play converged architecture that will offer cost-effective solutions to their customers. In this respect, Arris’ innovative IP video gateway solutions may become a major growth driver for the company.
Arris is gradually diversifying its operations in the international (outside of U.S.) markets. In the third quarter of 2010, international businesses represented 35.4% of total revenue compared to just 26% in the year-ago quarter. Management forecasted that international sales will account for more than 40% in 2011. We believe significant gorwth opportunity in Asia, particularly in China, will help the company to achieve this target. Geographic diversification will reduces Arris’ dependance on U.S. cable operators.
Nevertheless, Arris is solely dependent on cable operators for its revenue. The lack of industry diversification may result in limited business prospects since potential shifts in industry dynamics may adversely impact cable TV service providers. This is evident from the fact that large telecom carriers in the U.S. are increasingly expanding their high-speed fiber based network and the satellite TV providers are also upgrading their networks. Cable MSOs are gradually losing their basic video customers to low-cost satellite TV/Internet video service providers.
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