The Backbone of a Megatrend

Full details of the little company cashing in on broadband Internet expansion.

The key moneymaking opportunity with broadband Internet expansion is, as I mentioned earlier, consumption. Currently, Internet consumption is doubling every 18 to 24 months.

And as the Internet reaches more and more people at faster and faster speeds, consumers will devour broadband products like HD video on demand, voice over Internet protocol (Internet telephone), live Internet broadcasts like March Madness, Netflix, and online gaming at a record pace.

That's why multiple systems operators (MSOs) such as Comcast are doing everything they can to meet consumers' insatiable demand for high-speed Internet services right now.

But faster download speeds mean cable companies will have to continually improve their networks. And Arris Group's [NASDAQ: ARRS] head ends, hubs, nodes, and other devices are the most efficient way for them to do that.

About the business

Arris manufactures the infrastructure needed to create broadband networks. This includes selling MSOs the physical equipment that will help them turbo-charge their networks as well as helping them with digital advertising.

Accounting for about three-fourths of revenue, the biggest part of Arris' business is its broadband communication systems unit. This part of the business helps send and receive data at high speeds, and it's what enables cable operators to provide voice over Internet protocol, video over IP, and high-speed data services.

All this is made possible through Arris' Cable Modem Termination Systems (CMTS). Cable operators need these pieces of equipment at their hubs to provide subscribers with broadband services. Arris has increased its CMTS market share over the past five years, even as industry giant Cisco's has dropped.

Arris is also dominant in Embedded Multimedia Terminal Adapters (EMTA) -- think broadband cable modems and voice over Internet protocol -- where it's been No. 1 globally for more than five years.

Perhaps most importantly, Arris' products conform to the latest international telecom standard, version 3.0 of the Data over Cable System Interface Specification (DOCSIS) -- the crucial telecommunications standard I mentioned earlier.

This keeps Arris' products relevant and sought-after as cable operators seek to upgrade their networks. In addition to its send-and-receive business, Arris' access, transport, and supplies business offers hybrid fiber-coaxial equipment, such as head ends, hubs, repeaters, and terminals, that make up much of the networks' physical infrastructure. That business accounts for about 16% of Arris' revenue and has a 24% gross margin. The high margin media and communication systems business (7% of revenue) helps MSOs with ad insertion, digital advertising, and video on demand.

Why you must invest now

In the race to provide the fastest connection speeds and the most reliable networks, MSOs have no choice but to continually reinvest in Arris' offerings or risk falling behind and losing valuable subscribers.

Sure, they can delay major capital expenditures for a while, but eventually they have to pay up or risk going the way of dial-up.

Because of these dynamics, they tend to invest at a rate just fast enough to barely leap-frog their competitors. But that rate of investment is increasing as the federal government steps in to boost U.S. Internet speeds to be the fastest in the world.

The FCC is determined to improve America's embarrassingly low ranking in world. And the $16 billion it's paying out with the Connect America Fund will give at least 100 million U.S. homes access to download speeds of 100 Mbps.

This ultra-fast Internet network is becoming a reality thanks to Arris' DOCSIS 3.0-compliant equipment. Arris is an indispensible ally in the effort to revolutionize our broadband networks.

But right now, only 0.8% of Americans have access to connections faster than 25 Mbps (even if you include universities and companies), and about a quarter of the population has speeds above 5 Mbps. We're a long way from 100 Mbps.

That makes now the perfect time to invest in Arris. We're still in the early stages here; high-speed Internet will continue to reshape our economy and our lives for decades.

Revolutionary new technologies -- such as smart grids that cut power-plant emissions while lowering consumers' energy costs and networks that connect first responders, law enforcement, and hospitals to help save lives -- all depend on faster broadband access.

And for cable companies that have invested in connections to our homes and businesses, upgrading to the DOCSIS 3.0 specification with Arris is the fastest and most cost-effective way to meet the demand for 100 Mbps speeds.

Plus, this need for speed isn't limited to the United States. Developed and emerging countries alike want the economic and social benefits that come with faster broadband. It's a global trend, and you can see it in Arris' sales. International sales accounted for 26% of total revenue in 2009, and that proportion rose to 37% in the first half of 2010. When looking at Arris' prospects, the market is missing this demand shift.

So, what is Arris really worth?

Already, Arris is profiting from the industry move to DOCSIS 3.0. The product shift to selling more DOCSIS 3.0-compliant CMTS and EMTAs has bumped Arris' gross margin to more than 40% in 2009 from about 35% in 2008. The company's EBIDTA (a way of calculating cash flow with Earnings Before Interest, Taxes, Depreciation, and Amortization) is about $150 million.

It's a bit surprising that a company so dominant in its core businesses has a market cap of just $1.4 billion -- clearly, Arris has room to grow.

But for now, with roughly half its market cap in cash and short-term investments and just $205 million in debt, it has an enterprise value of $983 million. That puts Arris' EV/EBITDA ratio (a ratio used to determine the value of a company) at just 6.5, which suggests that this business is incredibly cheap right now.

It might even be an attractive acquisition target for a larger competitor, such as Cisco, or one of its primary customers, such as Time Warner Cable or Comcast.

Using a free-cash-flow-to-firm model, top Motley Fool analyst Nick Crow values Arris as high as $15 per share, which is nearly 33% higher than its recent $11.30 price.

Risks and when to sell

Arris has to compete for business, which is tough because the industry it serves is pretty concentrated. Think about it: How many choices do you have for broadband access? It's limited, I'm sure. That's frustrating for Arris, too, as it leads to high levels of customer concentration.

In the first half of 2010, Comcast made up 21% of Arris' revenue, and Time Warner accounted for 17%. Together, they made up 53% of sales in 2009. Losing one of its major customers to a rival is the most obvious risk for Arris. As the MSO industry consolidates, each operator gains bargaining power and could force price concessions, compressing Arris' margins.

What's more, the operators tend to be highly leveraged, and as we witnessed during the credit crunch, even good companies can lose access to capital. If this happens to Arris' customers, they won't make any capital expenditures, and Arris' revenue will go out the window.

You should sell Arris if it loses either of its major customers. Or if its top two customers ever make up more than 70% of its sales. Likewise, if competition forced price concessions without a commensurate increase in volume, you should also consider selling.

This isn't a buy-and-hold-forever business. I expect you to profit because Arris' stock is cheap relative to its worth. But should it become overvalued, you should sell and pocket your profit.

The Foolish Bottom Line

Arris gives you a compelling opportunity to invest in the megatrend of growing broadband consumption. Industry competition, the national broadband plan, and a global push for increased bandwidth speeds act as catalysts to unlock the stock's value.

For now, the stock is cheap relative to its potential. But that won't be the case for long, so buy into broadband while it's still a bargain!

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