Near an All-Time High, Is Arris Group Still a Buy?

Since Arris Group (NASDAQ: ARRS  ) provided guidance for its second quarter well above analysts' expectations, shares are trading closer to their all-time high price. At around $29, the company trades at a trailing P/E over 600 on a GAAP basis. Shares are up about 76% over the last year since the acquisition of Motorola Home closed.

Looking at the company's cash flow, however, you can see why shares have rocketed skyward. In the four quarters since closing the acquisition of Motorola Home, Arris' free cash flow has climbed 535% compared to the previous four quarters. At this rate, the acquisition will pay for itself in just a few years.

Compared to more stable cash cows that Arris competes with, like Cisco Systems (NASDAQ: CSCO  ) , Arris is priced more inexpensively compared to its cash flow.

Let's take a look at what's going on with Arris' cash flow, and see if it makes a good buy for investors.

Cash flow
As mentioned, the acquisition of Motorola Home added a huge boost to the top line and cash flow. Now more than a full year since the acquisition closed, we have a better picture of how Motorola Home impacts the company's operations.

ARRS Free Cash Flow (TTM) Chart

ARRS Free Cash Flow (TTM) data by YCharts

Over the last 12 months, Arris generated $4.49 billion in revenue, resulting in $4.1 million in net income. Looking at free cash flow, however, the company does much better, with $477 million in cash generated. That means it turned 10.6% of its revenue into free cash flow.

Comparatively, Cisco Systems is much more efficient at turning its revenue into cash flow. The company generated $11.42 billion in FCF in the 12 months ending Jan. 25 on revenue of $47.87 billion. That's 23.9% of revenue turned into free cash flow.

How Arris increased cash flow
In an effort to understand the quality of Arris Group's ballooning cash flow, we'll have to take a deeper dive into the cash flow statement.

Arris naturally saw an increase in depreciation and inventories as a result of the the Motorola Home acquisition. The company also saw an increase in accounts payable that doesn't seem out of the ordinary, considering a similar increase in accounts receivable.

Line Item

Contribution to Free Cash Flow (TTM)

Net income

$6.690 million

Depreciation

$75.001 million

Change in inventories

$110.864 million

Change in accounts payable

$177.416 million

Change in accounts receivable

$177.585 million

Source: ARRIS Group's 10-Q and 10-K

Overall, the percentage of cash flow coming from more questionable sources -- like last year's $32.5 million related to Comcast's investment in the company -- has decreased significantly. Additionally, the company has once again turned profitable, with net income of $40.8 million in the first quarter and $6.7 million over the trailing 12 months.

Valuation
On a price-to-FCF basis, Arris is priced relatively inexpensively. With a market cap around $4.15 billion, Arris is trading at just 8.7 times free cash flow. Comparatively, Cisco is trading at 10.5 times its free cash flow from 2013.

With much stronger growth expected from the smaller Arris Group, the set-top box maker appears to be undervalued compared to its biggest competitor. Arris is trading at a 20% discount on a price-to-FCF basis, which is nearly consistent with the consensus target price from analysts of $33.78 -- 16.5% upside -- compared to Cisco's price target of just $23.84 -- 2.7% upside.

Still time to buy
Although Arris is trading within 10% of its all-time high, it still looks appealing from a cash-flow basis. With management's strong outlook for the second quarter and encouraging comments for the third quarter, cash flow should remain strong through 2014. Not to mention, the shift toward IP-delivered television strongly favors the company's future.

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