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Disappointing Deal for Arris Group?

One analyst wonders if Arris will get enough long-term growth from C-COR's equipment for cable providers

With revenue growth drivers like cable telephony flattening out, Arris Group’s (ARRS) proposed acquisition of C-COR Inc. (CCBL) seems more like a desperate bid for diversification than a smart strategic choice.

On Sept. 23, the Suwanee (Ga.)-based cable technology provider announced it agreed to acquire C-COR for $730 million, in a deal comprised of 51% cash and 49% stock. Under terms approved by both companies’ boards, C-COR shareholders would be entitled to receive $13.75 in cash or 0.9642 shares of Arris, or a pro-rationed combination of both, for each C-COR common share they own. The cash price of $13.75 per share represents a 19% premium to the 30-day average trading price of C-COR and a 39% premium to its closing price on Sept. 21.

C-COR shares surged nearly 22% to $12.02 on the news. But Arris shares went the opposite way, falling 16% to close at $11.99 on Sept. 24.

The merger would create the largest pure-play provider of equipment to the cable industry. Over the past 12 months, Arris’ and C-COR’s combined sales totaled $1.2 billion. Arris said the deal would allow it to improve its competitive position in the cable products industry, diversify its portfolio and widen its profit margins.

The explosion in traffic of integrated voice over Internet protocol (VoIP), data and high-definition video signals, and eventually mobile phone signals as well, over cable networks is driving the need for greater bandwidth, which Arris’ devices and services provide.

With a device called the Universal Edge QAM that it recently launched, Arris can deliver a range of multimedia services over hybrid fiber optic/coaxial, or HFC, networks. Combining this device with C-COR’s video transmission products will enable Arris to offer customers end-to-end switched digital video, leveling the playing field for it to compete with Motorola/Cisco Systems, CIBC World Markets said in a Sept. 24 research note. C-COR’s transport business will enable it to provide more complete video/broadband transmission service to cable customers, the note said. (CIBC does investment banking with Arris and makes a market in its securities.)

While the proposed deal seems sound financially and is likely to give a modest boost to Arris’ 2008 earnings, it raises some questions from a strategic standpoint, says Eric Buck, an equities analyst at Brean Murray Carret & Co.

Compared to Tandberg Television, which Arris tried to acquire and lost to a higher bid from Ericsson (ERICY) in February, C-COR has minimal exposure to switched digital video technology.

“I thought Arris would make an acquisition that was video-focused and would get them new customers outside the cable market -- particularly the satellite and telco marketplace -- and might diversify them geographically,” said Buck, who has a hold rating on Arris and doesn’t cover C-COR.

But the bulk of C-COR’s revenue is in transports, devices such as radio frequency amplifiers that connect to coaxial and fiber-optic cables. That’s a segment that Arris exited five years ago when it sold its business to Scientific Atlanta -- now part of Cisco Systems (CSCO) -- for a price that was only 85% of sales, Buck said.

In the future, the cable industry will have more growth opportunities in big video-centric applications such as switch digital video and digital ad insertions, Buck said. C-COR is far from being a market leader in that area, which currently represents just 10% to 15% of its total business, Buck said.

“Arris could have spent its cash and shares in an area that probably would have been more dilutive in the near term, but had more growth opportunities in the longer term,” he said.

At the moment, Arris’ sales are heavily concentrated with Comcast (CMCSA), which accounts for more than 40% of its revenue and will provide 80% of its year-over-year growth this year. It has been about two years since Comcast first entered and began ramping up its presence in the cable telephony market, and it’s typically after 18 to 24 months that growth in that sector starts to flatten, Buck said. That means Arris is sorely in need of another source of growth.

Although Comcast will probably continue to represent a large portion of Arris’ sales, buying C-COR would reduce Arris’ product concentration in the cable telephony market, said CIBC, which has a sector perform opinion on Arris stock. The addition of C-COR’s video-on-demand, switched digital video, and RF amplification products would give Arris more exposure to markets with better mid-to-long term growth prospects than its embedded multimedia terminal adapters, which facilitate delivery of high-speed data with VoIP services.

Harmonic Inc. (HLIT), another provider of fiber optic and digital communications systems for delivering video, voice and data over cable, satellite, and wireless networks, would have been a much better strategic choice for Arris, but the company was probably either too expensive or not interested in being acquired, Buck said.

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