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ARRIS GROUP INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Overview On April 17, 2013 we acquired the Motorola Home business from General Instrument Holdings, Inc., a subsidiary of Google, Inc. for $2.4 billion in cash and equity, subject to certain adjustments as provided for in the acquisition agreement (the "Acquisition"). For more detail, see "Item 1 - Business - Acquisition of Motorola Home." As described above, we more than doubled in size as a result of the Acquisition, which had significant effects on virtually every aspect of our business and operations and which make comparisons in this discussion to our historical results difficult. In addition, we have reduced our reportable operating segments from three to two. For more detail, see "Item 1 - Business - New Operating Segments" and Note 11 to Notes to our Consolidated Financial Statements. Readers should consider the size and transformative nature of the Acquisition when reviewing this "Management's Discussion and Analysis of Financial Condition and Results of Operations." Business and Financial Highlights: Business Highlights • Acquired Motorola Home in April 2013. • Significantly expanded our scale • Increased our international presence • Expanded the breath of our product offering • Diversified our customer base • Integrated Motorola Home throughout 2013 including product and site rationalization. • Launched key new products in 2013 notably the E6000 and the XG1 gateway. Financial Highlights • Sales in 2013 were $3.621 billion as compared to $1.354 billion in 2012. This increase is primarily the result of the Acquisition. • Gross margin percentage was 28.2% in 2013, which compares to 34.2% in 2012. The year over year decline reflects the inclusion of the Motorola Home products, which in the aggregate have lower overall margins than the historic ARRIS products. • Total operating expenses (excluding amortization of intangible assets, restructuring charges, acquisition, integration and other costs) in the 2013 were $764.1 million, as compared to $332.0 million in the same period last year. The increase is the result of the inclusion of expenses associated with the Acquisition. • Intangible amortization increased from $30.3 million in 2012 to $193.6 million in 2013 as a result of the Acquisition. • In 2013, we issued 21.2 million shares to partially fund the acquisition of Motorola Home. • We ended 2013 with $513.4 million of cash, cash equivalents, short-term & long-term marketable security investments, which compares to $584.0 million at the end of 2012. We generated approximately $570.9 million of cash from operating activities in 2013 and $84.4 million during 2012. • We ended 2013 with outstanding debt of $1,752.6 million, the current portion of which is $55.0 million. We significantly added to our debt in 2013 to acquire Motorola Home. We repaid $172.4 million of our Term Loans in 2013, including a $125 million optional repayment. • We redeemed our 2% Convertible Notes during the fourth quarter of 2013 for $232.0 million in cash and 3.1 million shares of ARRIS common stock. 32 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Non-GAAP Measures As part of our ongoing review of financial information related to our business, we regularly use non-GAAP measures, in particular non-GAAP net income per share, as we believe they provide a meaningful insight into our business and trends. We also believe that these non-GAAP measures provide readers of our financial statements with useful information and insight with respect to the results of our business. However, the presentation of non-GAAP information is not intended to be considered in isolation or as a substitute for results prepared in accordance with GAAP. Below are tables for 2013, 2012 and 2011 which detail and reconcile GAAP and non-GAAP earnings per share: (in thousands, except per share data) For the Year Ended December 31, 2013 Income Operating Other Tax Net Gross Operating Income (Income) Expense Income Sales Margin Expense (Loss) Expense (Benefit) (Loss) Amounts in accordance with GAAP $ 3,620,902 $ 1,022,748 $ 1,040,761 $ (18,013 ) $ 78,137 $ (47,390 ) $ (48,760 ) Reduction in revenue related to Comcast's investment in ARRIS 13,182 13,182 - 13,182 - - 13,182 Acquisition accounting impacts related to fair value of inventory - 53,782 - 53,782 - - 53,782 Acquisition accounting impacts related to deferred revenue 7,121 5,545 - 5,545 - - 5,545 Product Rationalization - 16,473 - 16,473 - - 16,473 Stock compensation expense - 4,269 (31,520 ) 35,789 - - 35,789 Amortization of intangible assets - - (193,637 ) 193,637 - - 193,637 Restructuring, acquisition, integration and other costs - - (83,046 ) 83,046 - - 83,046 Credit facility - ticking fees - - - (865 ) - 865 Mark-to-market FV adjustment related to Comcast's investment in ARRIS - - - - (13,189 ) - 13,189 Non-cash interest expense - - - (9,926 ) - 9,926 Net tax items - - - - - 152,883 (152,883 ) Non-GAAP amounts $ 3,641,205 $ 1,115,999 $ 732,558 $ 383,441 $ 54,157 $ 105,493 $ 223,791 GAAP net loss per share - diluted $ (0.37 )(1) Non-GAAP net income per share - diluted $ 1.66 Weighted average common shares - basic 131,980 Weighted average common shares - diluted 135,136 (1) Basic shares used as losses were reported for those periods and the inclusion of dilutive shares would be antidilutive 33 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements (in thousands, except per share data) For the Year Ended December 31, 2012 Income Operating Other Tax Net Gross Operating Income (Income) Expense Income Margin Expense (Loss) Expense (Benefit) (Loss) Amounts in accordance with GAAP $ 462,577 $ 375,306 $ 87,271 $ 12,975 $ 20,837 $ 53,459 Acquisition accounting impacts related to deferred revenue 2,899 - 2,899 - - 2,899 Stock compensation expense 3,169 (24,737 ) 27,906 - - 27,906 Amortization of intangible assets - (30,294 ) 30,294 - - 30,294 Restructuring, acquisition, integration and other costs - (12,968 ) 12,968 - - 12,968 Settlement Charge - Pension - (3,064 ) 3,064 - - 3,064 Impairment of investment - - - (533 ) - 533 Non-cash interest expense - - - (12,358 ) - 12,358 Net tax items - - - - 34,615 (34,615 ) Non-GAAP amounts $ 468,645 $ 304,243 $ 164,402 $ 84 $ 55,452 $ 108,866 GAAP net income per share - diluted $ 0.46 Non-GAAP net income per share - diluted $ 0.93 Weighted average common shares - basic 114,161 Weighted average common shares - diluted 116,514 (in thousands, except per share data) For the Year Ended December 31, 2011 Income Operating Other Tax Net Gross Operating Income (Income) Expense Income Margin Expense (Loss) Expense (Benefit) (Loss) Amounts in accordance with GAAP $ 410,513 $ 425,121 $ (14,608 ) $ 13,903 $ (10,849 ) $ (17,662 ) Acquisition accounting impacts related to deferred revenue 3,126 - 3,126 - - 3,126 Stock compensation expense 2,040 (20,015 ) 22,055 - - 22,055 Restructuring, acquisition, integration and other costs - (7,565 ) 7,565 - - 7,565 Amortization of intangible assets - (33,649 ) 33,649 - - 33,649 Impairment of goodwill and intangible assets - (88,633 ) 88,633 - - 88,633 Non-cash interest expense - - - (11,545 ) - 11,545 Impairment of investment - - - (3,000 ) - 3,000 Loss on retirement of debt - - - (19 ) - 19 Net tax items - - - - 52,226 (52,226 ) Non-GAAP amounts $ 415,679 $ 275,259 $ 140,420 $ (661 ) $ 41,377 $ 99,704 GAAP net loss per share - diluted $ (0.15 )(1) Non-GAAP net income per share - diluted $ 0.81 Weighted average common shares - basic 120,157 Weighted average common shares - diluted 122,555 (1) Basic shares used as losses were reported for those periods and the inclusion of dilutive shares would be antidilutive 34 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements In managing and reviewing our business performance, we exclude a number of items required by GAAP. Management believes that excluding these items mentioned below is useful in understanding the trends and managing our operations. Historically, we have publicly presented these supplemental non-GAAP measures in order to assist the investment community to see ARRIS through the "eyes of management," and therefore enhance understanding of ARRIS' operating performance. Non-GAAP financial measures should be viewed in addition to, and not as an alternative to, the Company's reported results prepared in accordance with GAAP. Our non-GAAP financial measures reflect adjustments based on the following items, as well as the related income tax effects: Acquisition Accounting Impacts Related to Deferred Revenue: In connection with our acquisitions of Motorola Home and BigBand, business combination rules require us to account for the fair values of arrangements for which acceptance has not been obtained, and post contract support in our purchase accounting. The non-GAAP adjustment to our sales and cost of sales is intended to include the full amounts of such revenues. We believe the adjustment to these revenues is useful as a measure of the ongoing performance of our business. We have historically experienced high renewal rates related to our support agreements and our objective is to increase the renewal rates on acquired post contract support agreements; however, we cannot be certain that our customers will renew our contracts. Inventory Valuation: In connection with our acquisition of Motorola Home, business combinations rules require the inventory be recorded at fair value on the opening balance sheet. This is different from historical cost. Essentially we were required to write the inventory up to end customer price less a reasonable margin as a distributor. In addition, we have conformed other cost basis inventory valuation policies during the period. We have excluded the resulting adjustments in inventory and cost of goods sold. Product Rationalization: In conjunction with the integration of Motorola Home, we have identified certain product lines which overlap. In the second and fourth quarters of 2013, we made the decision to eliminate certain products. As a result, we recorded expenses related to the elimination of inventory and certain vendor liabilities. We believe it is useful to understand the effects of this item on our total cost of goods sold. Reduction in Revenue Related to Comcast Investment in ARRIS: In connection with our acquisition of Motorola Home, Comcast was given an opportunity to invest in ARRIS. The accounting guidance requires that we record the implied fair value of benefit received by Comcast as a reduction in revenue. Until the closing of the deal, changes in the value of the investment will be marked to market and flow through other expense (income). We have excluded the effect of the implied fair value in calculating our non-GAAP financial measures. We believe it is useful to understand the effects of these items on our total revenues and other expense (income). Stock-Based Compensation Expense: We have excluded the effect of stock-based compensation expenses in calculating our non-GAAP operating expenses and net income measures. Although stock-based compensation is a key incentive offered to our employees, we continue to evaluate our business performance excluding stock-based compensation expenses. We record non-cash compensation expense related to grants of options and restricted stock. Depending upon the size, timing and the terms of the grants, the non-cash compensation expense may vary significantly but will recur in future periods. Restructuring, Acquisition, Integration and Other Costs: We have excluded the effect of acquisition, integration, and other expenses and the effect of restructuring expenses in calculating our non-GAAP operating expenses and net income measures. We will incur significant expenses in connection with our recent acquisition of Motorola Home, which we generally would not otherwise incur in the periods presented as part of our continuing operations. Acquisition and integration expenses consist of transaction costs, costs for transitional employees, other acquired employee related costs, and integration related outside services. Restructuring expenses consist of employee severance, abandoned facilities, and other exit costs. Additionally, we have excluded the effect of a loss on the sale of a product line in calculating our non-GAAP operating expenses and net income measures. We believe it is useful to understand the effects of these items on our total operating expenses. Amortization of Intangible Assets: We have excluded the effect of amortization of intangible assets in calculating our non-GAAP operating expenses and net income measures. Amortization of intangible assets is 35-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements non-cash, and is inconsistent in amount and frequency and is significantly affected by the timing and size of our acquisitions. Investors should note that the use of intangible assets contributed to our revenues earned during the periods presented and will contribute to our future period revenues as well. Amortization of intangible assets will recur in future periods. Impairment of Goodwill and Intangibles: We have excluded the effect of the estimated impairment of goodwill and intangible assets in calculating our non-GAAP operating expenses and net income (loss) measures. Although an impairment does not directly impact the Company's current cash position, such expense represents the declining value of the technology and other intangibles assets that were acquired. We exclude these impairments when significant and they are not reflective of ongoing business and operating results. Non-Cash Interest on Convertible Debt: We have excluded the effect of non-cash interest in calculating our non-GAAP operating expenses and net income measures. We record the accretion of the debt discount related to the equity component non-cash interest expense. We believe it is useful to understand the component of interest expense that will not be paid out in cash. Loss (Gain) on Retirement of Debt: We have excluded the effect of the loss (gain) on retirement of debt in calculating our non-GAAP financial measures. We believe it is useful for investors to understand the effect of this non-cash item in our other expense (income). Impairment of Investment: We have excluded the effect of an other-than-temporary impairment of a cost method investment in calculating our non-GAAP financial measures. We believe it is useful to understand the effect of this non-cash item in our other expense (income). Settlement Charge - Pension: In an effort to reduce volatility and administrative expense in connection with the Company's pension plan, we have offered certain participants an opportunity to voluntarily elect an early payout of their pension benefits. We exclude this charge in Non-GAAP measures, as this is a one-time charge that is not considered by management in their review of financial results. Credit Facility - Ticking Fees: In connection with our acquisition of Motorola Home, the cash portion of the consideration was primarily funded through debt financing commitments. A ticking fee was a fee paid to our banks to compensate for the time lag between the commitment allocation on a loan and the actual funding. We have excluded the effect of the ticking fee in calculating our non-GAAP financial measures. We believe it is useful to understand the effect of this non-cash item in our other expense (income). Mark To Market Fair Value Adjustment Related To Comcast Investment in ARRIS: In connection with our acquisition of Motorola Home, Comcast was given an opportunity to invest in ARRIS. The accounting guidance requires we mark to market the changes in the value of the investment and flow through other expense (income). We have excluded the effect of the implied fair value in calculating our non-GAAP financial measures. We believe it is useful to understand the effects of these items on our total other expense (income). Income Tax Expense (Benefit): We have excluded the tax effect of the non-GAAP items mentioned above. Additionally, we have excluded the effects of certain tax adjustments related to state valuation allowances, research and development tax credits and provision to return differences. Industry Conditions Overall Focus on Price and Macroeconomic Climate Impact - The global economic downturn and recovery continues to affect the economy and the capital investment strategy of service providers. New household formations began to increase in 2013 however a subdued climate is expected to result in low capital expenditure growth rates in 2014 and the foreseeable future. As a result we do not anticipate material growth in the markets we serve. Competitive Market Regarding Communications and Entertainment Offerings from Non-Cable and Telecom Companies - OTT video services enabled by braodband data services is increasingly providing the same content provided by cable and telecom service providers in an on-demand, location independent format. Consumers are adopting this approach through offerings from providers such as Netflix. Cable and telecom service providers are responding with enhanced on-demand location independent services of their own, providing 36-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements immediate access to a wide array of content anytime, anywhere, on any screen. We may see several impacts from this trend: 1) cable and telecom providers are expected to increase the capacity of their networks to provide their customers with the bandwidth necessary to enable these services, which in turn may lead to greater demand for our products; 2) some consumers may chose to subscribe to only OTT video offerings and reduce their demand for traditional television services which may in turn decrease demand for our video CPE products by our customers, 3) the model by which operators are paid for providing the necessary bandwidth may change over time which may impact the level of their capital expenditures. Convergence of TV, Voice, Data, and Mobile Technologies and Services - Demand for bandwidth by cable subscribers continues to grow as content providers (such as Google, Yahoo, YouTube, Hulu Facebook, Netflix, ABC, CBS, NBC, movie and music studios, and gaming vendors) are offering personalized content across multiple venues. Television today has thus become more readily available across multiple screens - TVs, smartphones, tablets and PCs - and more interactive and personal, further increasing the demands on the network. In addition, viewers are increasingly looking for "similar" experiences across these multiple screens further increasing the challenges in delivering broadband content. As a result we expect to continue to invest in R&D to enable these services and create new products for the operators. We may see increased price pressure as operators must be competitive in their offerings. Network Optimization and Scaling Infrastructure to Keep Up with Growing Demand - Service providers are offering enhanced services, including high-definition television (and soon Ultra HD/4K TV), digital video, interactive and on-demand video services, high-speed Internet and voice over Internet Protocol. As these enhanced broadband services continue to attract new subscribers, we expect that service providers will be required to invest in their networks to expand network capacity and support increased customer demand for personalized services. In the access portion, or "last-mile," of the network, service providers will need to upgrade headends, hubs, nodes, and radio frequency distribution equipment. They will need to take a scalable approach to continue upgrades as new services are deployed. In addition, many international cable operators are still completing the initial upgrades necessary to offer such enhanced broadband services. Finally, as more and more critical services are provided over the service provider network, plant maintenance becomes a more important requirement. Operators must replace network components (such as amplifiers and lasers) as they approach the end of their useful lives. As a result we expect to continue to invest in R&D to enable these services and create new products for the operators. We may see increased price pressure as operators must be competitive in their offerings. Monetization and Targeted Advertising in a Multiscreen World - Google, Yahoo, Facebook, Microsoft and others have introduced easy, interactive ways for advertisers to mount advertising campaigns, measure results in real time, target individual consumers with ads specific to their preferences, and provide consumers with a way to respond to ads in real time. Advertisers, Programmers, and Content Distributors including cable and telecom service providers are evaluating ways to integrate this new advertising paradigm with existing linear television by incorporating next generation advertising insertion servers in their networks and jointly building an advanced advertising platform with consistent technologies, metrics and interfaces across a national footprint. As a result we expect to continue to invest in R&D to enable these services and create new products for the operators. Competition Between MSOs and Telecom Companies Continues and New Entrants are Appearing - Telecom companies are aggressively offering high-speed data services and now also offer a strong suite of video services to the residential market. Counterbalancing these offerings, cable companies are providing IP-based telephone service and DOCSIS 3.0-based (and soon, DOCSIS 3.1-based) ultra high-speed data service. Recently Google has entered the market with fibre to the home services in several markets and has announced plans to expand further. As a result of this competition amongst service providers, we anticipate that our customers will continue to invest in products and services to provide improved service offerings to their subscribers which may lead to strong demand for our products. Competition Between Fixed-line Service Providers and Direct Broadcast Satellite Services Continues- Direct broadcast satellite services are aggressively offering many HDTV channels. DIRECTV and The Dish Network and multiple satellite services around the world are deploying significantly more HDTV channels 37-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements including many local channels. Service providers are responding by reclaiming spectrum through advanced technologies such as switched digital video, statistical multiplexing and capacity upgrades of their networks making bandwidth available for additional HDTV channels. Satellite operators are also providing new generation receivers that provide in home network DVR capabilities. Service providers are responding with competitive set top boxes. We in turn must invest in R&D to create product for these services. We may see increased price pressure as operators must be competitive in their offerings. Service providers are Demanding Advanced Network Technologies and Software Solutions. The increase in volume and complexity of the signals transmitted over broadband networks as a result of the migration to an all-digital, all-IP, on demand network is causing service providers to deploy new technologies. Service providers also are demanding sophisticated network and service management software applications that minimize operating expenditures needed to support the complexity of two-way broadband communications systems. As a result, service providers are focusing on technologies and products that are flexible, cost-effective, compliant with open industry standards, and scalable to meet subscriber growth and effectively deliver reliable, enhanced services. As part of this evolution, some operators (for example Comcast with its Reference Design Kit ("RDK") efforts) are choosing to design portions of the set top box firmware internally. As a result we anticipate that over time operators will migrate to an all IP network and look to enable new platforms and technologies intended to accelerate the deployment of new services. As this occurs, which we believe will be over a multi year period, we anticipate a decline in demand for our traditional set top boxes and an increase in demand in new IP set top boxes, which may impact our sales and gross margin. Consolidation of Vendors Has Occurred and May Continue - In February 2006, Cisco Systems, Inc. acquired Scientific-Atlanta, Inc. In February 2007, Ericsson purchased Tandberg Television. In July 2007, Motorola acquired Terayon Communication Systems. In December 2007, ARRIS acquired C-COR. In 2009, ARRIS acquired Digeo and EGT. In November 2011, ARRIS acquired BigBand Networks. In 2013 ARRIS acquired Motorola Home, In 2013 Pace acquired Aurora Networks. It is likely that other competitor consolidations may occur which could have an impact on future sales and profitability. Consolidation of Customers Has Occurred and May Continue - In 2014 Comcast announced its intention to purchase Time Warner Cable. It is likely that other customer consolidations may occur which could have an impact on future sales and profitability. The specific impact of the above trends is difficult to predict and quantify, but generally: • The pace of new service introduction will continue to increase as will the variety of connected consumer devices. This change will increase the consumption of bandwidth and the demand for ARRIS products. • The need for service providers to expand their networks to meet the increased bandwidth and speed requirements their customers are demanding will continue to grow exponentially, driven by both the competition each provider faces and the proliferation of new services and connected devices. This leads the service providers to ask ARRIS, and ARRIS competitors, for product innovations that decrease the cost per megabit of capacity required. This trend may have an impact on both revenues and margins, depending upon (amongst other things), the life cycle of the technology being deployed and the price points associated with that technology at a point in time. Further, the requirement to continuously innovate is expected to require continued research and development investment. • The anticipated shift by MSOs to an all-IP network is expected to change the mix of ARRIS set top box revenue over time. It is possible that the Company's overall average sales price and gross margin for set tops may decline over time. • Increased competition for services could result in pressure on the pricing of service providers' services, which in turn could negatively impact the level of their capital expenditures and negatively impact their purchases from ARRIS. 38 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Results of Operations Overview As highlighted earlier, we have faced, and in the future will face, significant changes in our industry and business. These changes have impacted our results of operations and are expected to do so in the future. As a result, we have implemented strategies both in anticipation and in reaction to the impact of these dynamics. Below is a table that shows our key operating data as a percentage of sales. Following the table is a detailed description of the major factors impacting the year-over-year changes of the key lines of our results of operations. Key Operating Data (as a percentage of net sales) Years Ended December 31, 2013 2012 2011 Net sales 100.0 % 100.0 % 100.0 % Cost of sales 71.8 65.8 62.3 Gross margin 28.2 34.2 37.7 Operating expenses: Selling, general, and administrative expenses 9.3 11.9 13.7 Research and development expenses 11.8 12.6 13.5 Acquisition, integration and other costs 1.3 0.5 0.3 Impairment of goodwill and intangibles - - 8.1 Amortization of intangible assets 5.3 2.2 3.1 Restructuring charges 1.0 0.5 0.4 Operating income (loss) (0.5 ) 6.5 (1.4 ) Other expense (income): Interest expense 1.9 1.3 1.6 Loss (gain) on investments 0.1 (0.1 ) 0.1 Loss (gain) on foreign currency (0.1 ) 0.1 (0.1 ) Interest income (0.1 ) (0.2 ) (0.3 ) Other expense (income), net 0.4 (0.1 ) (0.1 ) Income (loss) before income taxes (2.7 ) 5.5 (2.6 ) Income tax expense (benefit) (1.3 ) 1.5 (1.0 ) Net income (loss) (1.4 )% 4.0 % (1.6 )% Comparison of Operations for the Three Years Ended December 31, 2013 Net Sales The table below sets forth our net sales for the three years ended December 31, 2013, 2012 and 2011 for each of our business segments described in Item 1 of this Form 10-K (in thousands, except percentages): Net Sales Increase (Decrease) Between Periods For the Years Ended December 31, 2013 vs. 2012 2012 vs. 2011 2013 2012 2011 $ % $ % Business Segment: CPE $ 2,466,618 $ 611,408 $ 382,425 $ 1,855,210 303.4 % $ 228,983 60.0 % N&C 1,174,757 742,255 702,996 432,502 58.3 % 39,259 5.6 % Other (20,473 ) - 3,264 (20,473 ) (100.0 )% (3,264 ) 100 % Total sales $ 3,620,902 $ 1,353,663 $ 1,088,685 $ 2,267,239 167.5 % $ 264,978 24.3 % 39 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements The table below sets forth our domestic and international sales for the three years ended December 31, 2013, 2012 and 2011 (in thousands, except percentages): Net Sales Increase (Decrease) Between Periods For the Years Ended December 31, 2013 vs. 2012 2012 vs. 2011 2013 2012 2011 $ % $ % Domestic $ 2,457,172 $ 1,020,060 $ 748,167 $ 1,437,112 140.9 % $ 271,893 36.3 % International: Americas, excluding U.S 746,146 202,887 195,500 543,259 267.8 % 7,387 3.8 % Asia Pacific 153,674 65,554 59,194 88,120 134.4 % 6,360 10.7 % EMEA 263,910 65,162 85,824 198,748 305.0 % (20,662 ) (24.1 )% Total international 1,163,730 333,603 340,518 830,127 248.8 % (6,915 ) (2.0 )% Total sales $ 3,620,902 $ 1,353,663 $ 1,088,685 $ 2,267,239 167.5 % $ 264,978 24.3 % Customer Premises Equipment Net Sales 2013 vs. 2012 During the year ended December 31, 2013, sales of our CPE segment increased $1,855.2 million or approximately 303.4%, as compared to 2012. The increase is primarily attributable to the inclusion of sales associated with our acquisition of Motorola Home. The sales increase also reflects the introduction of new products, in particular the XG1 gateway. Network & Cloud Net Sales 2013 vs. 2012 During the year ended December 31, 2013, sales in the N&C segment increased $432.5 million or approximately 58.3%, as compared to 2012. The increase in sales is primarily the result of the inclusion of sale associated with our acquisition of Motorola Home. During 2013, sales of our C4 CMTS declined as our new CMTS, the E6000, was introduced. This trend is expected to continue into 2014. Customer Premises Equipment Net Sales 2012 vs. 2011 During the year ended December 31, 2012, sales of our CPE segment increased $229.0 million or approximately 60.0%, as compared to 2011. This increase in sales is primarily attributable to high demand for our DOCSIS3.0 CPE equipment and video gateway products. Network & Cloud Net Sales 2012 vs. 2011 During the year ended December 31, 2012, N&C segment sales increased $39.3 million or approximately 5.6%, as compared to the same period in 2011. The increase is a result of metro Wi-Fi wireless products, for which initial sales of this product began in the fourth quarter of 2011. In addition, the higher sales also reflect the full year sales associated with our late 2011 acquisition of BigBand. Gross Margin The table below sets forth our gross margin for the three years ended December 31, 2013, 2012 and 2011(in thousands, except percentages): Gross Margin Increase (Decrease) Between Periods For the Years Ended December 31, 2013 vs. 2012 2012 vs. 2011 2013 2012 2011 $ % $ % Gross margin dollars $ 1,022,748 $ 462,577 $ 410,513 560,171 121.1 % $ 52,064 12.7 % Gross margin percentage 28.2 % 34.2 % 37.7 % (6.0 ) (3.5 ) 40 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements During the year ended December 31, 2013, gross margin dollars increased and gross margin percentage decreased as compared to 2012. Increase in gross margin dollars was primarily the result of the inclusion of sales associated with our acquisition of Motorola Home. The decrease in gross margin percentage was the result of product mix. The historic gross margin of Motorola Home products was lower than the average of the historic ARRIS business. Also leading to the mix impact was the relative proportion of legacy Motorola Home sales and ARRIS sales; volume of legacy Motorola Home sales were significantly higher. The gross margin for the year ended December 31, 2013 included a $53.8 million impact associated with writing up the historic cost of the Motorola Home inventory to fair value at the date of acquisition (subsequently increasing cost of goods sold) as well as $16.5 million of costs associated with the rationalization of certain products after the acquisition date. Also, the gross margins were impacted by $13.2 million associated with a reduction in sales associated with the accounting for Comcast's investment in ARRIS. We do not expect these items to impact future quarters. During the year ended December 31, 2012, gross margin dollars increased and gross margin percentage decreased as compared to 2011. The increase in gross margin dollars was the result of higher year-over-year sales. Product mix change resulted in the decrease in gross margin percentage. We had higher EMTA sales and lower CMTS sales. EMTA products have lower gross margin than CMTS products. In addition, in 2012, we had more sales of the metro Wi-Fi wireless products which has lower gross margin and lower volume of optics products. Operating Expenses The table below provides detail regarding our operating expenses (in thousands, except percentages): Operating Expenses Increase (Decrease) Between Periods For the Years Ended December 31, 2013 vs. 2012 2012 vs. 2011 2013 2012 2011 $ % $ % SG&A $ 338,252 $ 161,338 $ 148,755 $ 176,914 109.7 % $ 12,583 8.5 % R&D 425,825 170,706 146,519 255,119 149.4 % 24,187 16.5 % Acquisition, integration & other 45,471 6,207 3,205 39,264 632.6 % 3,002 93.7 % Restructuring 37,576 6,761 4,360 30,815 455.8 % 2,401 55.1 % Impairment of goodwill & intangibles - - 88,633 - - % (88,633 ) (100.0 )% Amortization of intangible assets 193,637 30,294 33,649 163,343 539.2 % (3,355 ) (10.0 )% Total $ 1,040,761 $ 375,306 $ 425,121 $ 665,455 177.3 % $ (49,815 ) (11.7 )% Selling, General, and Administrative, or SG&A, Expenses 2013 vs. 2012 The year over year increase in SG&A expenses primarily reflect the inclusion of expenses associated with the Motorola Home acquisition. As a percentage of revenue, SG&A expenses declined 2.6%, with an expense-to-revenue ratio of 9.3% in 2013 as compared with 11.9% in 2012. 2012 vs. 2011 The year over year increase of $12.6 million in SG&A expenses primarily reflect the addition of BigBand as well as $3.1 million expense associated with early pension settlements and higher legal expenses As a percentage of revenue, SG&A expenses declined 1.8%, with an expense-to-revenue ratio of 11.9% in 2012 as compared with 13.7% in 2011. Research & Development, or R&D, Expenses Included in our R&D expenses are costs directly associated with our development efforts (people, facilities, materials, etc.) and reasonable allocations of our information technology and corporate facility costs. 41-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements 2013 vs. 2012 The increase year-over-year in R&D expense reflects the inclusion of expenses associated with the Motorola Home acquisition. As a percentage of revenue, R&D expenses declined 0.8%, with an expense-to-revenue ratio of 11.8% in 2013 as compared with 12.6% in 2012. 2012 vs. 2011 The increase of $24.2 million year-over-year in R&D expense reflects the addition of BigBand and increased headcount, as we continued to aggressively invest in research and development. As a percent of revenue, R&D expenses declined 0.9%, with an expense-to-revenue ratio of 12.6% in 2012 as compared with 13.5% in 2011. Acquisition, Integration and Other Costs During 2013, we recorded acquisition related expenses and integration expenses of $18.6 million and $26.9 million, respectively. These expenses related to the acquisition of Motorola Home and consisted of transaction costs, integration related outside services and legal fees. During 2012, we recorded acquisition-related expenses of $5.9 million. Approximately $0.8 million of these expenses were related to the acquisition of BigBand and $5.1 million were related to the acquisition of Motorola Home and consisted of transaction costs and legal fees. In addition, in March 2012, the Company completed the sale of certain assets of its ECCO electronic connector product line to Eclipse Embedded Technologies, Inc. for approximately $3.9 million. The Company recorded a net loss of $(0.3) million on the sale, which included approximately $0.3 million of transaction related costs. The results of the ECCO product line were deemed immaterial to the overall financial results of the Company, and as such the Company has not reported the results in discontinued operations. During 2011, we recorded acquisition related expenses $3.2 million. These expenses were related to the acquisition of BigBand and consisted of transaction costs, employee related costs, and integration related outside services. Restructuring Charges During 2013, 2012 and 2011, we recorded restructuring charges of $37.6 million, $6.8 million and $4.4 million, respectively. During 2013, ARRIS implemented a restructuring initiative in connection with the Acquisition to rationalize product lines and align our workforce and operating costs with current business opportunities. The charges recorded in 2013 related to severance, termination benefits, write-off of property, plant and equipment and closing facilities. The charges recorded in 2012 related to severance and facilities associated with the continued implementation of the restructuring initiative following the acquisition of BigBand to align our workforce and operating costs with current business opportunities. The majority of the charges recorded in 2011 relate to the restructuring initiative following the acquisition of BigBand. Impairment of Goodwill and Intangible Assets Goodwill relates to the excess of the consideration transferred over the fair value of net assets resulting from an acquisition. Our goodwill is tested for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that the asset is more likely than not impaired. The annual tests were performed in the fourth quarters of 2013, 2012 and 2011, with an assessment date of October 1. No impairment resulted from the review in 2013 or 2012. As a result of the review in 2011, we recognized a total non-cash goodwill impairment loss of $41.2 since we determined that the fair values of our former MCS reporting unit (now included as part of our Cloud Services reporting unit) was less than its respective carrying amount, as a result of a decline in the expected future cash flows for the reporting unit. 42-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Our intangible assets with finite lives are tested for impairment when events or changes in circumstances indicate that impairment may exist. Our indefinite-lived assets for in-process research and development were tested for impairment as of October 1, 2013, consistent with our goodwill impairment assessment. There were no impairment charges related to purchased intangible assets during 2013 and 2012. In 2011, indicators of impairment existed for long-lived assets associated with our former MCS reporting unit ( now included as part of our Cloud Services reporting unit) due to changes in projected operating results and cash flows. As a result of the review in 2011, an impairment loss of $47.4 million before tax ($29.1 million after tax) related to customer relationships was recorded. See Note 5 of Notes to the Consolidated Financial Statements for disclosures related to goodwill and intangible assets. Amortization of Intangible Assets Our intangible amortization expense relates to finite-lived intangible assets acquired in business combinations or acquired individually. Amortization of intangibles was $193.6 million in 2013, as compared with $30.3 and $33.6 million in 2012 and 2011, respectively. The 2013 increase is primarily due to intangible assets acquired in the Acquisition. Direct Contribution The table below sets forth our direct contribution for the three years ended December 31, 2013, 2012 and 2011 (in thousands, except percentages): Direct Contribution Increase (Decrease) Between Periods For the Years Ended December 31, 2013 vs. 2012 2012 vs. 2011 2013 2012 2011 $ % $ % Operating Segment: CPE $ 482,519 $ 66,788 $ 12,973 $ 415,731 622.5 % $ 53,815 414.8 % N&C 258,336 228,798 244,540 29,538 12.9 % (15,742 ) (6.4 )% Other (482,184 ) (165,053 ) (142,274 ) (317,131 ) (192.1 )% (22,779 ) (16.0 )% Total $ 258,671 $ 130,533 $ 115,239 $ 128,138 98.2 % $ 15,294 13.3 % Customer Premises Equipment Direct Contribution 2013 vs. 2012 During 2013, direct contribution in our CPE segment increased by approximately 622.5% as compared to the same period in 2012. The increase is primarily attributable to the inclusion of direct contribution associated with our acquisition of Motorola Home. Further, the direct contribution is favorably impacted by mix, given, that in the aggregate the contribution margin of former Motorola Home products are greater than that of former ARRIS products. Network & Cloud Direct Contribution 2013 vs. 2012 During 2013, direct contribution in our N&C segment increased by approximately 12.9% as compared to the same period in 2012. Despite the higher sales, as a result of the Motorola Home acquisition, direct contribution did not increase proportionally. The contribution was impacted year over year by (1) higher operating expenses associated with investing in the acquired Cloud software portfolio, as well as overlapping investments in next generation CCAP (which is an area of synergy focus); (2) the ramp-up of E6000 CMTS in 2013 resulted in higher shipments of new chassis and line cards, which have lower margin relative to license upgrades of deployed C4 CMTS products shipped in 2012. Customer Premises Equipment Direct Contribution 2012 vs. 2011 During the year 2012, direct contribution in our CPE segment increased by approximately 414.8% as compared to the same period in 2011. The increase is primarily attributable to the increase of direct contribution due to higher sales of our DOCSIS 3.0 CPE equipment and video gateway products. 43-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Network & Cloud Direct Contribution 2012 vs. 2011 During 2012, direct contribution in our N&C segment decreased by approximately 6.4% as compared to the same period in 2011. The decrease reflected a product mix change. Other Expense (Income) The table below provides detail regarding our other expense (income) (in thousands): Other Expense (Income) For the Years Ended Increase (Decrease) December 31, Between Periods 2013 2012 2011 2013 vs. 2012 2012 vs. 2011 Interest expense $ 67,888 $ 17,797 $ 16,939 $ 50,091 $ 858 Loss on debt retirement - - 19 - (19 ) Loss (gain) on investments 2,698 (1,404 ) 1,570 4,102 (2,974 ) Loss (gain) on foreign currency (3,502 ) 786 (580 ) (4,288 ) 1,366 Interest income (2,936 ) (3,242 ) (3,154 ) 306 (88 ) Other expense (income) 13,989 (962 ) (891 ) 14,951 (71 ) Total other expense $ 78,137 $ 12,975 $ 13,903 $ 65,162 $ (928 ) Interest Expense Interest expense reflects the amortization of deferred finance fees, the debt discount for the term loans and the non-cash interest component of our convertible subordinated notes which were fully redeemed during the fourth quarter of 2013, as well as interest paid on the notes and term loans and other debt obligations. Interest expense was $67.9 million in 2013, as compared with $17.8 million and $16.9 million in 2012 and 2011, respectively. Loss on Debt Retirement During 2011, the Company acquired $5.0 million face value of the 2% convertible notes for approximately $5.0 million. The Company allocated $2 thousand to the reacquisition of the equity component of the notes. The Company also wrote-off approximately $33 thousand of deferred finance fees associated with the portion of the notes acquired. As a result, the Company realized a loss of approximately $19 thousand on the retirement of the notes. Loss (Gain) on Investments From time to time, we hold certain investments in the common stock of private and publicly-traded companies, a number of non-marketable equity securities, and investments in rabbi trusts associated with our deferred compensation plans. In connection with the Acquisition, we also acquired certain investments in limited liability companies and partnerships that are accounted for using the equity method of accounting. As such our equity portion in current earnings of such companies is included in the loss (gain) on investments. During the years ended December 31, 2013, 2012 and 2011, we recorded net (gains) losses related to our various investments of $2.7 million, $(1.4) million and $1.6 million, respectively. Loss (Gain) on Foreign Currency During 2013, 2012 and 2011, we recorded foreign currency (gains) losses. We have certain international customers who are billed in their local currency. Additionally, certain intercompany transactions created in conjunction with the Motorola Home acquisition are denominated in foreign currencies and subject to revaluation. To mitigate the volatility related to fluctuations in the foreign exchange rates, we may enter into various foreign currency contracts. The loss (gain) on foreign currency is driven by the fluctuations in the foreign currency exchanges rates. 44 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements During the years ended December 31, 2013, 2012 and 2011, we recorded net (gains) losses on foreign currency of $(3.5) million, $0.8 million and $(0.6) million, respectively. Interest Income Interest income reflects interest earned on cash, cash equivalents, short-term and long-term marketable security investments. During the years ended December 31, 2013, 2012 and 2011, we recorded interest income of $2.9 million, $3.2 million and $3.2 million, respectively. Other Expense (Income) Other expense (income) for the years ended December 31, 2013, 2012 and 2011 were $14.0 million, $(1.0) million and $(0.9) million, respectively. In connection with Comcast's agreement in January 2013 to invest in ARRIS upon the acquisition of Motorola Home, accounting guidance requires that, since the agreed-upon purchase price was less than the market price on the date of agreement, the resulting forward arrangement be marked to market for the difference in fair value. This resulted in a mark-to-market adjustment of $13.2 million in 2013 and was recorded as Other Expense (Income). Income Tax Expense Our annual provision for income taxes and determination of the deferred tax assets and liabilities require management to assess uncertainties, make judgments regarding outcomes, and utilize estimates. To the extent the final outcome differs from initial assessments and estimates, future adjustments to our tax assets and liabilities will be necessary. In 2013, we recorded $47.4 million of income tax benefit for U.S. federal and state taxes and foreign taxes, which was 49.3% of our pre-tax loss of $96.2 million. The effective income tax rate was favorably impacted by $15.4 million in discrete tax events. The most significant 2013 discrete tax events were a reversal of $6.7 million of tax liabilities from uncertain tax positions, mostly attributable to the expiration of certain statutes of limitations in the third and fourth quarters of 2013, and a favorable impact of $8.7 million from global provision-to-return adjustments, including the 2012 credit for research and development, which was not reenacted until first quarter of 2013. Additionally, the Company recorded a pre-tax book loss on an investment in ARRIS by Comcast of approximately $26.4 million and a pre-tax book loss of approximately $10.0 million on certain foreign entities from the Motorola Home acquisition, on which no tax benefit was recorded. Exclusive of the discrete events, the effective income tax rate would have been approximately (17.9)%. In 2012, we recorded $20.8 million of income tax expense for U.S. federal and state taxes and foreign taxes, which was 28.0% of our pre-tax income of $74.3 million. The effective income tax rate was favorably impacted by $4.7 million in discrete tax events. The most significant 2012 discrete tax events were a reversal of $3.4 million of tax liabilities from uncertain tax positions, mostly attributable to the expiration of certain statutes of limitations in the third quarter of 2012, a favorable impact of $0.7 million from global provision-to-return adjustments and $0.6 million from net valuation allowance decreases. Exclusive of the discrete tax events, the effective income tax rate would have been approximately 33.3%. The increase in the effective income tax rate from prior year, exclusive of discrete tax events and the prior year Goodwill impairment, was primarily attributable to the absence of research and development tax credits. While legislation was passed to extend the research and development tax credit in January of 2013, the passage was too late to allow the Company to record the benefit in 2012. However, 2012 tax expense was still favorably impacted by research and development tax credits as a result of the expiration of certain statute of limitations for prior years and certain adjustments for provision-to-return. During the first quarter of 2013, the Company recorded the 2012 impact of the 2013 legislation as a favorable discrete tax event and included the impact of the 2013 credit in its effective income tax rate for 2013. In 2011, we recorded $10.8 million of income tax benefit for U.S. federal and state taxes and foreign taxes, which was 38.1% of our pre-tax loss of $28.5 million. Pre-tax income was negatively impacted by $88.6 million 45-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements as a result of our impairment of goodwill and intangibles, which generated an unfavorable permanent difference between book and taxable income of $22.3 million and an unfavorable timing difference between book and taxable income of $66.3 million. The allocation of a portion of the total impairment of goodwill to tax deductible goodwill favorably impacted income tax expense by $7.3 million. The effective tax rate was favorably impacted by certain discrete tax events. The 2011 discrete tax events included the release of approximately $4.0 million of state valuation allowances in the first quarter of 2011 and the reversal of $2.7 million of tax liabilities from uncertain tax positions mostly attributable to the expiration of certain statutes of limitations in the third quarter of 2011, offset by approximately $3.8 million of tax increases primarily due to non-deductible acquisition costs, and increases in U.S. Federal valuation allowances / other. Exclusive of the impairments and the discrete tax events, the effective income tax rate would have been approximately 29.7%. Financial Liquidity and Capital Resources Overview Following completion of the Motorola Home acquisition, one of our key strategies remains maintaining and improving our capital structure. The key metrics we focus on are summarized in the table below: Liquidity & Capital Resources Data Year Ended December 31, 2013 2012 2011 (in thousands, except DSO and Turns) Key Working Capital Items Cash provided by operating activities $ 570,846 $ 84,401 $ 113,153 Cash, cash equivalents, and short-term investments $ 509,798 $ 530,117 $ 518,779 Long-term U.S corporate bonds $ 3,577 $ 53,914 $ 42,366 Accounts Receivable, net $ 637,059 $ 188,581 $ 152,437 -Days Sales Outstanding 52 46 47 Inventory, net $ 330,129 $ 133,848 $ 115,912 - Turns 9.9 7.1 6.2 Key Financing Items Convertible notes at face value $ - $ 232,050 $ 232,050 Term loans at face value $ 1,752,563 $ - $ - Cash used for redemption of convertible notes $ 232,051 $ - $ 4,984 Cash used for debt repayment $ 172,437 $ - $ - Key Shareholder Equity Items Cash used for share repurchases $ - $ 51,921 $ 109,123 Capital Expenditures $ 71,443 $ 21,507 $ 23,307 In managing our liquidity and capital structure, we have been and are focused on key goals, and we have and will continue in the future to implement actions to achieve them. They include: • Liquidity - ensure that we have sufficient cash resources or other short term liquidity to manage day to day operations. • Growth - implement a plan to ensure that we have adequate capital resources, or access thereto, fund internal growth and execute acquisitions while retiring our convertible notes in a timely fashion. • Deleverage - reduce our debt obligation. 46 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Accounts Receivable & Inventory We use the number of times per year that inventory turns over (based upon sales for the most recent period, or turns) to evaluate inventory management, and days sales outstanding, or DSOs, to evaluate accounts receivable management. Accounts receivable at the end of 2013 increased as compared to the end of 2012, primarily as a result of the inclusion of sales associated with the Motorola Home products, which were not included in 2012. DSOs increased in 2013 as compared to 2012, reflecting a higher international mix of customers (which on average have longer payment terms) as a result of the Acquisition. As part of the Acquisition, we acquired approximately $462.2 million of accounts receivable. Looking forward, it is possible that DSOs may increase dependent upon our customer mix and payment patterns, particularly if international sales increase as customers internationally typically have longer payment terms. Inventory increased in 2013 as compared to 2012. The increase in inventory was primarily as a result of the Motorola Home acquisition. We acquired approximately $270.4 million of inventory upon closing of the Motorola Home transaction in April 2013. Inventory turns were 9.9 in 2013 as compared to 7.1 in the same period of 2012. The turns increased reflecting the additions of inventory from the Motorola Home acquisition. Motorola Home had high inventory turns on average. Accounts receivable at the end of 2012 increased as compared to the end of 2011, primarily as a result of higher sales in the fourth quarter of 2012 as compared to the fourth quarter of 2011. DSOs decreased slightly from 2011 to 2012, primarily the result of payment patterns of our customers and timing of shipments to customers. Inventory increased in 2012 as compared to 2011. The increase in inventory was primarily related to an increase in Network & Cloud inventory level to ensure adequate supply. Inventory turns increased in 2012 as compared to 2011 as a result of the increased inventory levels. Common Share Repurchases During 2013, ARRIS did not repurchase any shares under the previously adopted share repurchase plan. During 2012, we repurchased 4.5 million shares of our common stock for $51.9 million at an average stock price of $11.55. During 2011, we repurchased 10.0 million shares of our common stock for $109.1 million at an average stock price of $10.95. 2.00% Convertible Senior Notes due 2026 As a result of the holding company reorganization undertaken in connection with the Motorola Home acquisition, holders of the convertible notes had the right (i) to require us to repurchase the convertible notes for 100% of the principal amount of the convertible notes, plus accrued and unpaid interest to, but not including the repurchase date and (ii) to convert the convertible notes for the consideration provided for in the indenture governing the convertible notes. See Note 15, Long-Term Indebtedness for further discussion. In the second quarter of 2013, convertible notes in the aggregate principal amount of $68 thousand were tendered in connection with this repurchase right, and $68 thousand of cash-on-hand was used to repurchase these notes. Also in the second quarter of 2013, eleven notes were submitted for conversion, and $11 thousand of cash-on-hand was used to satisfy our obligations on these notes. Following the repurchases and conversions, $232.0 million in aggregate principal amount of the convertible notes remain outstanding. In October 2013, we notified holders of the convertible notes that it would redeem all outstanding notes (the "Redemption") on November 15, 2013 (the "Redemption Date") for cash at a price equal to 100% of the outstanding aggregate principal amount of the notes (the "Redemption Price"). The Redemption Price did not include the interest accrued up to November 15, 2013, which was paid to the holders of the notes of record as of November 1, 2013. The Notes were convertible at the option of the holders from October 15, 2013 until November 15, 2013 for the consideration specified in the Indenture (the "Conversion Option"). Holders of the Notes had an option to 47-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements require us to purchase the Notes for par value on November 15, 2013 (the "Put Option"). Any Notes not surrendered pursuant to the Put Option or the Conversion Option would be redeemed on November 15, 2013 ("Redemption Option"). During the fourth quarter of 2013, pursuant to the "Put Option" we repurchased $30 thousand of the notes. As of November 15, 2013, notes of $231.2 million were surrendered for conversion. Pursuant to the net share settlement provision of the Indenture, we redeemed the Notes for $231.2 million in cash consideration and issued 3.1 million shares of common stock to the Note holders. ARRIS redeemed the remaining notes pursuant to the "Redemption Option" for $744 thousand. Term Debt Repayments In 2013, we repaid $172.4 million of our term debt, including $125 million optional repayment. Summary of Current Liquidity Position and Potential for Future Capital Raising We believe our current liquidity position, where we had approximately $509.8 million of cash, cash equivalents, and short-term investments and $3.6 million of long-term marketable securities on hand as of December 31, 2013, together with approximately $247.5 million in availability under our new Revolving Credit Facility, together with the prospects for continued generation of cash from operations, are adequate for our short- and medium-term business needs. Our cash, cash-equivalents and short-term investments as of December 31, 2013 include approximately $145.7 million held by foreign subsidiaries whose earnings we expect to reinvest indefinitely outside of the United States. We do not expect to need the cash generated by those foreign subsidiaries to fund our domestic operations. However, in the unforeseen event that we repatriate cash from those foreign subsidiaries, in excess of what is owed to the United States parent, we may be required to provide for and pay U.S. taxes on permanently repatriated funds. We have subsidiaries in countries that maintain restrictions, such as legal reserves, with respect to the amount of dividends that the subsidiaries can distribute. Additionally, some countries impose restrictions or controls over how and when dividends can be paid by these subsidiaries. While we do not currently intend to repatriate earnings from entities in these countries, if we were to be required to distribute earnings from such countries, the timing of the distribution and the funds available to distribute, would be adversely impacted by these restrictions. We expect to be able to generate sufficient cash on a consolidated basis to make all of the principal and interest payments under our senior secured credit facilities. Should our available funds be insufficient to support these initiatives or our operations, it is possible that we will raise capital through private or public, share or debt offerings. Senior Secured Credit Facilities In April 2013 we entered into senior secured credit facilities with Bank of America, N.A. and various other institutions, which are comprised of (i) a "Term Loan A Facility" of $1.1 billion, (ii) a "Term Loan B Facility" of $825 million and (iii) a "Revolving Credit Facility" of $250 million. The Term Loan A Facility and the Revolving Credit Facility have terms of five years. The Term Loan B Facility has a term of seven years. Interest rates on borrowings under the senior credit facilities are set forth in the table below. As of December 31, 2013, we had $1,752.6 million face value outstanding under the Term Loan A and Term Loan B Facilities, no borrowings under the Revolving Credit Facility and letters of credit totaling $2.5 million issued under the Revolving Credit Facility. Rate As of December 31, 2013 Term Loan A LIBOR + 2.25 % 2.42% Term Loan B LIBOR(1) + 2.75 % 3.50% Revolving Credit Facility (2) LIBOR + 2.25 % Not Applicable (1) Includes LIBOR floor of 0.75% (2) Includes unused commitment fee of 0.50% and letter of credit fee of 2.25% not reflected in interest rate above. 48 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Borrowings under the senior secured credit facilities are secured by first priority liens on substantially all of our assets and certain of our present and future subsidiaries who are or become parties to, or guarantors under, the credit agreement governing the senior secured credit facilities (the "Credit Agreement"). The Credit Agreement contains usual and customary limitations on indebtedness, liens, restricted payments, acquisitions and asset sales in the form of affirmative, negative and financial covenants, which are customary for financings of this type, including the maintenance of a minimum consolidated interest coverage ratio of not less than 3.5:1 and a maximum consolidated net leverage ratio of 4.25:1 (which decreases to 3.5:1 throughout the first two years of the Credit Agreement). As of December 31, 2013, we were in compliance with all covenants under the Credit Agreement. The Credit Agreement provides terms for mandatory prepayments and optional prepayments and commitment reductions. The Credit Agreement also includes events of default, which are customary for facilities of this type (with customary grace periods, as applicable), including provisions under which, upon the occurrence of an event of default, all amounts outstanding under the credit facilities may be accelerated. Commitments Following is a summary of our contractual obligations as of December 31, 2013 (in thousands): Payments due by period More than Contractual Obligations Less than 1 Year 1-3 Years 3-5 Years 5 Years Total Credit facilities (1) $ 55,000 $ 178,750 $ 825,000 $ 693,813 $ 1,752,563 Operating leases, net of sublease income (2) 20,675 35,534 21,068 24,639 101,916 Purchase obligations (3) 691,357 - - - 691,357 Total contractual obligations (4) $ 767,032 $ 214,284 $ 846,068 $ 718,452 $ 2,545,836 (1) Represents face values of Term Loan A and B which have terms of five years and seven years respectively. (2) Includes leases which are reflected in restructuring accruals on the consolidated balance sheets. (3) Represents obligations under agreements with non-cancelable terms to purchase goods or services. The agreements are enforceable and legally binding, and specify terms, including quantities to be purchased and the timing of the purchase. (4) Approximately $27.5 million of uncertain tax positions have been excluded from the contractual obligation table because we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Of the $27.5 million, we have settled a $2.3 million Israeli uncertain tax position in January of 2014 for $1.6 million. Off-Balance Sheet Arrangements We do not have any material off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. Sources and Uses of Cash The following table summarizes the net increases (decreases) in cash and equivalents for the key line items of our Consolidated Statements of Cash Flows for the periods presented (in thousands): 2013 2012 2011 Cash provided by (used in) Operating activities $ 570,846 $ 84,401 $ 113,153 Investing activities (1,897,632 ) (151,062 ) (134,613 ) Financing activities 1,637,521 (37,511 ) (95,786 ) Net increase (decrease) in cash and cash equivalents $ 310,735 $ (104,172 ) $ (117,246 ) 49 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Operating Activities: Below are the key line items affecting cash from operating activities (in thousands): 2013 2012 2011 Net income (loss) $ (48,760 ) $ 53,459 $ (17,662 ) Adjustments to reconcile net income (loss) to cash provided by operating activities 284,739 80,867 141,077 Net income including adjustments 235,979 134,326 123,415 Decrease (increase) in accounts receivable 9,241 (37,139 ) (22,093 ) Decrease (increase) in inventory 74,111 (21,491 ) (7,144 ) Increase (decrease) in accounts payable and accrued liabilities 247,301 (5,675 ) 433 All other, net 4,214 14,380 18,542 Net cash provided by operating activities $ 570,846 $ 84,401 $ 113,153 2013 vs. 2012 Net income (loss), including adjustments, increased $236.0 million during 2013 as compared to 2012 reflecting the inclusion of Motorola Home as discussed above. Accounts receivable decreased $9.2 million in 2013. Inventory decreased by $74.1 million in 2013. The reduction reflects the turnaround impact associated with writing up the historic cost of the Motorola Home inventory to fair value by $53.8 million and the disposal of certain inventory as a result of product rationalization. Accounts payable and accrued liabilities increased by $247.3 million. The significant component of this change was an increase in accounts payable due to the acquisition of Motorola Home and timing of payments, coupled with higher variable compensation. All other accounts, net, include the changes in other receivables, income taxes payable (recoverable), and prepaids. The other receivables represent amounts due from our contract manufacturers for material used in the assembly of our finished goods. The change in our income taxes recoverable account is a result of the timing of the actual estimated tax payments during the year as compared to the actual tax liability for the year. The net change during 2013 was approximately $4.2 million as compared to $14.4 million in 2012. 2012 vs. 2011 Net income including adjustments, as per the table above, increased $10.9 million during 2012 as compared to 2011 reflecting higher sales and lower operating expense as discussed above. Accounts receivable increased $37.1 million in 2012. These increases were primarily related to higher sales in the fourth quarter of 2012 as compared to the fourth quarter of 2011, and also are impacted by the payment patterns of our customers. It is possible that both accounts receivable and DSOs may increase in future periods, particularly if we have an increase in international sales, which tend to have longer payment terms. Inventory increased by $21.5 million in 2012 primarily as a result of the effort to increase our inventory to ensure adequate supply of our Network and Cloud product offerings. Accounts payable and accrued liabilities decreased by $5.7 million in 2012. Account payables increased due to increased purchases resulting from higher sales. Accrued liabilities decreased as a result over higher variable compensation payments made in 2012. 50-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Investing Activities: Below are the key line items affecting investing activities (in thousands): 2013 2012 2011 Purchases of property, plant and equipment $ (71,443 ) $ (21,507 ) $ (23,307 ) Sale of property, plant and equipment 120 139 84 Acquisitions/other (2,208,114 ) - (130,227 ) Purchases of investments (112,756 ) (418,956 ) (277,937 ) Sales of investments 479,781 286,013 296,774 Proceeds from equity investments 14,780 - - Sale of product line - 3,249 - Net cash used in investing activities $ (1,897,632 ) $ (151,062 ) $ (134,613 ) Purchases of Property, Plant and Equipment - Represents capital expenditures which are mainly for test equipment, laboratory equipment, and computing equipment. It also represents expenditures related to the Motorola Home acquisition. Sale of Property, Plant and Equipment - Represents the cash proceeds we received from the sale of property, plant and equipment. Acquisitions/Other - Represents cash investments we have made in our various acquisitions. In 2013, we paid $2,286 million cash for the acquisition of Motorola Home. In 2011, we paid $ 162.4 million cash, or $53.1 million net of cash and marketable securities acquired, for the acquisition of BigBand Networks Purchases and Sales of Investments - Represents purchases and sales of securities. Proceeds from dividend on equity investment - Represents the dividend proceeds we received from our equity investments. Sale of Product Line - Represents the cash proceeds we received from the sale of our ECCO product line. Financing Activities: Below are the key items affecting our financing activities (in thousands): 2013 2012 2011 Proceeds from issuance of debt $ 1,925,000 $ - $ - Cash paid for debt discount (9,853 ) - - Payment of debt obligations (404,409 ) - - Early retirement of convertible notes (79 ) - (4,984 ) Deferred financing cost paid (42,724 ) - - Repurchase of common stock - (51,921 ) (109,123 ) Proceeds from issuance of common stock 175,072 20,304 22,985 Repurchase of shares to satisfy minimum tax withholdings 7,178 (9,443 ) (8,332 ) Excess tax benefits from stock-based compensation plans (12,664 ) 3,549 3,668 Net cash provided by (used in) financing activities $ 1,637,521 $ (37,511 ) $ (95,786 ) Proceeds From Issuance of Debt - As part of the Motorola Home acquisition, we entered into senior secured credit facilities which comprised of Term Loan A facilities of $1.1 billion with a term of five years and Term Loan B facilities of $0.8 billion with a term of seven years. 51-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Cash Paid for Debt Discount - Represents amounts paid to lenders in the form of upfront fees, which have been treated as a reduction in the proceeds received by the Company and are considered a component of the discount on the Term Loans A and B. Payment of Debt Obligation - Represents the payment of the convertible debt and the senior secured credit facilities term loans. Early Retirement of Convertible Notes - As a result of the holding company reorganization undertaken in connection with the Acquisition, holders of the convertible notes had the right to require us to repurchase the convertible notes for 100% of the principal amount plus accrued and unpaid interest or to convert the convertible senior notes for the consideration provided for in the indenture governing the convertible notes. This represents the portion of the convertible notes that were tendered pursuant to the repurchase right and surrendered pursuant to the conversion right. During 2011, the Company acquired $5.0 million face value of the convertible notes for approximately $5.0 million. The Company allocated $2 thousand to the reacquisition of the equity component of the convertible notes. The Company also wrote off approximately $33 thousand of deferred finance fees associated with the portion of the convertible notes acquired. As a result, the Company realized a loss of approximately $19 thousand on the retirement of the convertible notes. Deferred Financing Costs Paid - Represents the finance fees related to the issuance of the senior secured credit facilities. These costs will be amortized over the life of the term loans and revolving credit facility. Repurchase of Common Stock - Represents the cash used to buy back the Company's common stock. Proceeds from Issuance of Common Stock - Represents cash proceeds related to the exercise of stock options by employees, offset with expenses paid related to the issuance of common stock. It also represents cash proceeds from shares issued to Google and Comcast in relation to the Acquisition. Repurchase of Shares to Satisfy Minimum Tax Withholdings - Represents the minimum shares withheld to satisfy the minimum tax withholding when restricted stock vests. Excess Tax Benefits from Stock-Based Compensation Plans - Represents the cash that otherwise would have been paid for income taxes if increases in the value of equity instruments also had not been deductible in determining taxable income. Income Taxes During 2013, approximately $2.8 million of U.S. federal tax benefits were obtained from tax deductions arising from equity-based compensation deductions, all of which resulted from 2013 exercises of non-qualified stock options and lapses of restrictions on restricted stock awards. During 2012, approximately $2.9 million of U.S. federal tax benefits were obtained from tax deductions arising from equity-based compensation deductions, all of which resulted from 2012 exercises of non-qualified stock options and lapses of restrictions on restricted stock awards. During 2011, approximately $4.0 million of U.S. federal tax benefits were obtained from tax deductions arising from equity-based compensation deductions, all of which resulted from 2011 exercises of non-qualified stock options and lapses of restrictions on restricted stock rewards. Additionally, significant uncertainty remains with regard to how much U.S. Federal and State deferred income tax assets will ultimately arise from the acquisition of Motorola Home and be realized by ARRIS. Google, Inc. has not yet filed all income tax returns due for the tax period ending with this acquisition on April 16, 2013, and has yet to finalize certain very complex calculations that materially impact the deferred tax assets that we could ultimately realize. At this time, we believe that it has recorded its best available estimate regarding these deferred income tax assets, given the information that is currently available. However, it is possible that the amount of deferred income tax assets ultimately recorded by us will be materially different from the amounts recorded today. Interest Rates As described above, all indebtedness under our senior secured credit facilities bears interest at variable rates based on LIBOR plus an applicable spread. We entered into interest rate swap arrangements to convert a notional 52-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements amount of $600.0 million of our variable rate debt based on one-month LIBOR to a fixed rate. The objective of these swaps is to manage the variability of cash flows in the interest payments related to the portion of the variable rate debt designated as being hedged. Foreign Currency A significant portion of our products are manufactured or assembled in China, Mexico and Taiwan, and we have research and development centers in China, India, Ireland, Israel, Russia and Sweden. Our sales into international markets have been and are expected in the future to be an important part of our business. These foreign operations are subject to the usual risks inherent in conducting business abroad, including risks with respect to currency exchange rates, economic and political destabilization, restrictive actions and taxation by foreign governments, nationalization, the laws and policies of the United States affecting trade, foreign investment and loans, and foreign tax laws. We have certain international customers who are billed in their local currency, and we have certain predictable expenditures for international operations in local currency. Additionally, certain intercompany transactions created in conjunction with the Motorola Home acquisition are denominated in foreign currencies and subject to revaluation. We use a hedging strategy and enter into forward or currency option contracts based on a percentage of expected foreign currency exposure. The percentage can vary, based on the predictability of exposures denominated in the foreign currency. Financial Instruments In the ordinary course of business, we, from time to time, will enter into financing arrangements with customers. These financial arrangements include letters of credit, commitments to extend credit and guarantees of debt. These agreements could include the granting of extended payment terms that result in longer collection periods for accounts receivable and slower cash inflows from operations and/or could result in the deferral of revenue. We execute letters of credit and bank guarantees in favor of certain landlords and vendors to guarantee performance on contracts. Certain financial instruments require cash collateral, and these amounts are reported as restricted cash. As of December 31, 2013 and 2012, we had approximately $1.1 million and $4.7 million outstanding, respectively, of restricted cash. Cash, Cash Equivalents, and Investments Our cash and cash equivalents (which are highly-liquid investments with an original maturity of three months or less) are primarily held in money market funds that pay taxable interest. We hold short-term investments consisting of mutual funds and debt securities classified as available-for-sale, which are stated at estimated fair value. The debt securities consist primarily of commercial paper, certificates of deposits, short term corporate obligations and U.S. government agency financial instruments. We hold cost method investments in private companies. These investments are recorded at $15.3 million and $6.0 million as of December 31, 2013 and 2012, respectively. See Note 7 of Notes to the Consolidated Financial Statements for disclosures related to the fair value of our investments. We have two rabbi trusts that are used as funding vehicles for various deferred compensation plans that were available to certain current and former officers and key executives. We also have deferred retirement salary plans, which were limited to certain current or former officers of C-COR. We hold investments to cover the liability. ARRIS also funds its nonqualified defined benefit plan for certain executives in a rabbi trust. Capital Expenditures Capital expenditures are made at a level designed to support the strategic and operating needs of the business. Capital expenditures were $71.4 million in 2013 as compared to $21.5 million in 2012 and $23.3 million in 2011. We had no significant commitments for capital expenditures at December 31, 2013. Management expects to invest approximately $60.0 million in capital expenditures for the year 2014. 53 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Deferred Income Tax Assets - Including Net Operating Loss Carryforwards and Research and Development Credit Carryforwards, and Capitalized Research and Experimentation Costs and Valuation Allowances Deferred income tax assets represent amounts available to reduce income taxes payable on taxable income in future years. Such assets arise because of temporary differences between the financial reporting and tax bases of assets and liabilities, as well as from net operating loss and tax credit carryforwards. We evaluate the recoverability of these future tax deductions and credits by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. If we conclude that deferred tax assets are more-likely-than-not to not be realized, then we record a valuation allowance against those assets. We continually review the adequacy of the valuation allowances established against deferred tax assets. As part of that review, we regularly project taxable income based on book income projections by legal entity. Our ability to utilize our state deferred tax assets is dependent upon our future taxable income by legal entity. During 2011, we merged certain historical loss generating legal entities into a historically profitable legal entity, resulting in a release in 2012 of approximately $1.2 million of state valuation allowances. During 2013, the state valuation allowance increased by $4.0 million, primarily due to state research and development credits, which are not expected to be utilized because of available net operating losses. The 2013 federal valuation allowance increased by $135.6 million, due to the acquisition of Motorola Home in April 2013. The increase results from recording $386.5 million in U.S. federal net operating losses which the company currently does not expect to utilize. Additionally, significant uncertainty remains with regard to how much U.S. federal and state deferred income tax assets will ultimately arise from the acquisition of Motorola Home and be realized by ARRIS. Google, Inc. has not yet filed all income tax returns due for the tax period ending with this acquisition on April 16, 2013, and has yet to finalize certain very complex calculations that materially impact the deferred tax assets that ARRIS could ultimately realize. At this time, the Company believes that it has recorded its best available estimate regarding these deferred income tax assets, given the information that is currently available. However, it is possible that the amount of deferred income tax assets ultimately recorded by ARRIS will be materially different from the amounts recorded today. Foreign valuation allowances increased by $6.3 million, also as a result of certain foreign deferred income tax assets acquired from Motorola Home, which are more-likely-than-not to not be realized. As of December 31, 2013, we had net operating loss, or NOL, carryforwards for U.S. federal, U.S. state, and foreign income tax purposes of approximately $435.6 million, $174.5 million, and $47.9 million, respectively. The U.S. federal NOLs expire through 2031. Foreign NOLs related to our Irish subsidiary in the amount of $20.9 million have an indefinite life. Other significant foreign NOLs arise from our Dutch subsidiaries ($5.0 million, expiring during the next 9 years), our French branch ($6.1 million, no expiration), our U.K. branch ($7.0 million, no expiration), and our Israeli subsidiary ($7.6 million, no expiration). The net operating losses are subject to various limitations on how and when the losses can be used to offset against taxable income. Approximately $73.8 million of post-apportioned and $78.7 million of pre-apportioned U.S. state NOLs, and $5.2 million of the foreign NOLs are subject to valuation allowances because we do not believe the ultimate realization of the deferred tax assets associated with these U.S. federal, state and foreign NOLs is more-likely-than-not. As of December 31, 2012, we had net operating loss, or NOL, carryforwards for U.S. federal, U.S. state, and foreign income tax purposes of approximately $47.0 million, $186.7 million, and $40.8 million, respectively. The U.S. federal NOLs expire through 2030. Foreign NOLs related to our Irish subsidiary in the amount of $19.9 million have an indefinite life. Other significant foreign NOLs arise from our Dutch subsidiaries ($6.8 million, expiring during the next 7 years), our French branch ($5.9 million, no expiration), and our U.K. branch ($7.1 million, no expiration). The net operating losses are subject to various limitations on how and when the losses can be used to offset against taxable income. Approximately $44.1 million of post-apportioned and $60.9 million of pre-apportioned U.S. state NOLs, and $3.2 million of the foreign NOLs are subject to valuation allowances because we do not believe the ultimate realization of the deferred tax assets associated with these U.S. federal and state NOLs is more-likely-than-not. During 2013, we used approximately $3.3 million of U.S. federal NOLs to offset against taxable income. We did not record the usage of any pre-apportioned or post-apportioned U.S. state NOLs to offset against taxable income. 54-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements During 2012, we utilized approximately $3.3 million of U.S. federal NOLs, $10.8 million of post-apportioned and $21.9 million of pre-apportioned U.S. state NOLs to offset against taxable income. We used approximately $1.5 million of U.S. federal NOLs and $14.7 million of U.S. state NOLs to reduce taxable income in 2011. During the tax year ending December 31, 2013, we utilized $5.5 million of U.S. federal research and development tax credits, to offset against U.S. federal income tax liabilities. During the tax years ending December 31, 2012, and 2011, we utilized $1.2 million and $12.1 million, respectively of U.S. federal and state research and development tax credits, to offset against U.S. federal and state income tax liabilities. As of December 31, 2013, ARRIS has $17.7 million of available U.S. federal research and development tax credits and $20.9 million of available U.S. state research and development tax credits. The remaining unutilized U.S. federal research and development tax credits can be carried back one year and carried forward twenty years. The U.S. state research and development tax credits carry forward and will expire pursuant to the various applicable state rules. Approximately $5.2 million of U.S. federal research and development tax credits and $11.1 million of state research and development tax credits are subject to valuation allowances because we do not believe the ultimate realization of the related deferred tax assets is more-likely-than-not. Since the acquisition of C-COR Incorporated in 2007, ARRIS has generally reported taxable income in excess of its pre-tax net book income for financial reporting purposes. A significant reconciling item between the taxable income and the pre-tax net book income has been the book amortization expense relating to the separately stated intangible assets arising from the C-COR transaction. Additionally, each tax year we include in its taxable income all items of revenue that are deferred for financial reporting purposes. Other significant reconciling items between taxable income and pre-tax net book income are certain reserves that are recorded as expenses for pre-tax net book income purposes which are not deductible for income tax purposes until they are paid. As of the date of the acquisition of the Motorola Home business, we have recorded $793.7 million of deferred income tax assets attributable to capitalized research and experimentation costs. These deferred income tax deductions are available to reduce U.S. federal and state taxable income in future years, based on a straight-line method over a ten year life. The costs are amortized over the remaining lives on a straight-line basis, with the final amortization occurring in 2021. We obtain significant benefits from U.S. federal research and development tax credits, which are used to reduce the Company's U.S. Federal income tax liability. During December of 2010, Congress passed legislation that provides for an extension of these tax credits so that the Company can continue to calculate and claim research and development tax credits for the 2010 and 2011 tax years. The federal research and development credit expired on December 31, 2011. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law. Under this act, the federal research and development credit was retroactively extended for amounts paid or incurred after December 31, 2011 and before January 1, 2014. The effects of these changes in the tax law resulted in a tax benefit which was recognized in the first quarter of 2013, the quarter in which the law was enacted. The legislation has now expired again as of December 31, 2013. Until the legislation is extended, we cannot record the benefit of, or use the U.S. federal research and development tax credits to reduce its U.S. federal income tax liability. Defined Benefit Pension Plans ARRIS sponsors a qualified and a non-qualified non-contributory defined benefit pension plan that cover certain U.S. employees. As of January 1, 2000, we froze the qualified defined pension plan benefits for its participants. These participants elected to enroll in ARRIS' enhanced 401(k) plan. Due to the cessation of plan accruals for such a large group of participants, a curtailment was considered to have occurred. During the fourth quarter of 2012, in an effort to reduce the volatility and administration expense in connection with our pension obligation, we notified eligible employees of a limited opportunity to voluntarily elect an early payout of their pension benefits. These payouts were approximately $7.7 million and was funded from existing pension assets. We accounted for the lump-sum payments as a settlement and recorded a noncash pension settlement charge of approximately $3.1 million in the fourth quarter of 2012. 55-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements The U.S. pension plan benefit formulas generally provide for payments to retired employees based upon their length of service and compensation as defined in the plans. Our investment policy is to fund the qualified plan as required by the Employee Retirement Income Security Act of 1974 ("ERISA") and to the extent that such contributions are tax deductible. For 2013, the plan assets were comprised of approximately 43%, 3% and 54% of equity securities, debt securities and money market funds, respectively. For 2012, the plan assets were comprised of approximately 61% and 39% of equity and debt securities, respectively. For 2014, the plan's current target allocations are 39% equity securities, 18% debt securities, and 43% money market funds. Liabilities or amounts in excess of these funding levels are accrued and reported in the consolidated balance sheets. We have established a rabbi trust to fund the pension obligations of the Chief Executive Officer under his Supplemental Retirement Plan including the benefit under our non-qualified defined benefit plan. In addition, we have established a rabbi trust for certain executive officers and certain senior management personnel to fund the pension liability to those officers under the non-qualified plan. Effective June 30, 2013, ARRIS amended the Supplemental Retirement Plan. This amendment effectively froze entry of any new participants into the Supplemental Plan and, for existing participants, a freeze on any additional benefit accrual after June 30, 2013. The participant's benefit will continue to be distributed in accordance with the provisions of the Supplemental Plan but the final benefit accrual was frozen as of June 30, 2013. A curtailment gain of approximately $0.3 million, which represents the difference in the projected benefit obligation and the accumulated benefit obligation at June 30, 2013, offsets the existing plan loss and lowers future pension expense. The investment strategies of the plans place a high priority on benefit security. The plans invest conservatively so as not to expose assets to depreciation in adverse markets. The plans' strategy also places a high priority on earning a rate of return greater than the annual inflation rate along with maintaining average market results. The plan has targeted asset diversification across different asset classes and markets to take advantage of economic environments and to also act as a risk minimizer by dampening the portfolio's volatility. The weighted-average actuarial assumptions used to determine the benefit obligations for the three years presented are set forth below: 2013 2012 2011 Assumed discount rate for plan participants 4.50 % 3.75 % 4.50 % Rate of compensation increase N/A 3.75 % 3.75 % The weighted-average actuarial assumptions used to determine the net periodic benefit costs are set forth below: 2013 2012 2011 Assumed discount rate plan participants 3.75 % 4.50 % 5.50 % Rate of compensation increase 3.75 % 3.75 % 3.75 % Expected long-term rate of return on plan assets 6.00 % 6.00 % 7.50 % The expected long-term rate of return on assets is derived using the building block approach which includes assumptions for the long term inflation rate, real return, and equity risk premiums. No minimum funding contributions are required in 2014 for the plan. Other U.S. Benefit Plans ARRIS has established defined contribution plans pursuant to the Internal Revenue Code Section 401(k) that cover all eligible U.S. employees. We contribute to these plans based upon the dollar amount of each participant's contribution. We made matching contributions to these plans of approximately $10.9 million, $5.7 million, and $5.0 million in 2013, 2012 and 2011, respectively. We have a deferred compensation plan that does not qualify under Section 401(k) of the Internal Revenue Code and is available to our key executives and certain other employees. Employee compensation deferrals and matching contributions are held in a rabbi trust. The total of net employee deferrals and matching contributions, which is reflected in other long-term liabilities, were $2.9 million and $2.7 million at December 31, 2013 and 2012, respectively. Total expenses included in continuing operations for the matching contributions were approximately $0.1 million in both 2013 and 2012. 56-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements We previously offered a deferred compensation arrangement, that allowed certain employees to defer a portion of their earnings and defer the related income taxes. As of December 31, 2004, the plan was frozen and no further contributions are allowed. The deferred earnings are invested in a rabbi trust. The total of net employee deferral and matching contributions, which is reflected in other long-term liabilities, was $2.6 million and $2.1 million at December 31, 2013 and 2012, respectively. We also have a deferred retirement salary plan, which was limited to certain current or former officers of C-COR. The present value of the estimated future retirement benefit payments is being accrued over the estimated service period from the date of signed agreements with the employees. The accrued balance of this plan, the majority of which is included in other long-term liabilities, was $1.8 million and $2.0 million at December 31, 2013 and 2012, respectively. Total expense (income) included in continuing operations for the deferred retirement salary plan were approximately $(0.3) million and $(0.2) million for 2013 and 2012, respectively. Our wholly-owned subsidiary located in Israel is required to fund future severance liabilities determined in accordance with Israeli severance pay laws. Under these laws, employees are entitled upon termination to one month's salary for each year of employment or portion thereof. We record compensation expense to accrue for these costs over the employment period, based on the assumption that the benefits to which the employee is entitled, if the employee separates immediately. We fund the liability by monthly deposits in insurance policies and severance funds. The value of the severance fund assets are primarily recorded in other non-current assets on the Company's consolidated balance sheets, which was $3.6 million and $3.8 million as of December 31, 2013 and 2012, respectively. The liability for long-term severance accrued on the Company's consolidated balance sheets was $3.9 million and $4.2 million as of December 31, 2013 and 2012. Other Benefit Plans Outside of the U.S. In connection with the Acquisition, the Company assumed a pension liability related to a defined benefit plans in Taiwan, which had a balance of $28.1 million as of December 31, 2013. Critical Accounting Policies The accounting and financial reporting policies of ARRIS are in conformity with U.S. generally accepted accounting principles. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Management has discussed the development and selection of the critical accounting estimates discussed below with the audit committee of the Board of Directors and the audit committee has reviewed the related disclosures. a) Revenue Recognition ARRIS generates revenue as a result of varying activities, including the delivery of stand-alone equipment, custom design and installation services, and bundled sales arrangements inclusive of equipment, software and services. The revenue from these activities is recognized in accordance with applicable accounting guidance and their related interpretations. Revenue is recognized when all of the following criteria have been met: • When persuasive evidence of an arrangement exists. Contracts and customer purchase orders are used to determine the existence of an arrangement. For professional services evidence that an agreement exists includes information documenting the scope of work to be performed, price, and customer acceptance. These are contained in the signed Contract, Purchase Order, or other documentation that shows scope, price and customer acceptance. • Delivery has occurred. Shipping documents, proof of delivery and customer acceptance (when applicable) are used to verify delivery. • The fee is fixed or determinable. Pricing is considered fixed or determinable at the execution of a customer arrangement, based on specific products and quantities to be delivered at specific prices. This determination includes a review of the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment or future discounts. 57 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements • Collectability is reasonably assured. We assess the ability to collect from customers based on a number of factors that include information supplied by credit agencies, analyzing customer accounts, reviewing payment history and consulting bank references. Should a circumstance arise where a customer is deemed not creditworthy, all revenue related to the transaction will be deferred until such time that payment is received and all other criteria to allow us to recognize revenue have been met. Revenue is deferred if any of the above revenue recognition criteria is not met as well as when certain circumstances exist for any of our products or services, including, but not limited to: • When undelivered products or services that are essential to the functionality of the delivered product exist, revenue is deferred until such undelivered products or services are delivered as the customer would not have full use of the delivered elements. • When required acceptance has not occurred. • When trade-in rights are granted at the time of sale, that portion of the sale is deferred until the trade-in right is exercised or the right expires. In determining the deferral amount, management estimates the expected trade-in rate and future value of the product upon trade-in. These factors are periodically reviewed and updated by management, and the updates may result in either an increase or decrease in the deferral. Equipment - We provide operators with equipment that can be placed within various stages of a broadband system that allows for the delivery of telephony, video and high-speed data as well as outside plant construction and maintenance equipment. For equipment sales, revenue recognition is generally established when the products have been shipped, risk of loss has transferred, objective evidence exists that the product has been accepted, and no significant obligations remain relative to the transaction. Additionally, based on historical experience, ARRIS has established reliable estimates related to sales returns and other allowances for discounts. These estimates are recorded as a reduction to revenue at the time the revenue is initially recorded. Software Sold Without Tangible Equipment - ARRIS sells internally developed software as well as software developed by outside third parties that does not require significant production, modification or customization. For arrangements that contain only software and the related post-contract support, we recognize revenue in accordance with the applicable software revenue recognition guidance. If the arrangement includes multiple elements that are software only, then the software revenue recognition guidance is applied and the fee is allocated to the various elements based on vendor-specific objective evidence ("VSOE") of fair value. If sufficient VSOE of fair value does not exist for the allocation of revenue to all the various elements in a multiple element software arrangement, all revenue from the arrangement is deferred until the earlier of the point at which such sufficient VSOE of fair value is established or all elements within the arrangement are delivered. If VSOE of fair value exists for all undelivered elements, but does not exist for one or more delivered elements, the arrangement consideration is allocated to the various elements of the arrangement using the residual method of accounting. Under the residual method, the amount of the arrangement consideration allocated to the delivered elements is equal to the total arrangement consideration less the aggregate fair value of the undelivered elements. Under the residual method, if VSOE of fair value exists for the undelivered element, generally post contract support ("PCS"), the fair value of the undelivered element is deferred and recognized ratably over the term of the PCS contract, and the remaining portion of the arrangement is recognized as revenue upon delivery. If sufficient VSOE of fair value does not exist for PCS, revenue for the arrangement is recognized ratably over the term of support. Standalone Services - Installation, training, and professional services are generally recognized as service revenue when performed or upon completion of the service when the final act is significant in relation to the overall service transaction. The key element for Professional Services in determining when service transaction revenue has been earned is determining the pattern of delivery or performance which determines the extent to which the earnings process is complete and the extent to which customers have received value from services provided. The delivery or performance conditions of our service transactions are typically evaluated under the proportional performance or completed performance model. 58 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Incentives - Customer incentive programs that include consideration, primarily rebates/credits to be used against future product purchases and certain volume discounts, have been recorded as a reduction of revenue when the shipment of the requisite equipment occurs. Value Added Resellers - ARRIS typically employs the sell-in method of accounting for revenue when using a Value Added Reseller ("VAR") as our channel to market. Because product returns are restricted, revenue under this method is generally recognized at the time of shipment to the VAR provided all criteria for recognition are met. There are occasions, based on facts and circumstances surrounding the VAR transaction, where ARRIS will employ the sell-through method of recognizing revenue and defer that revenue until payment occurs. Multiple Element Arrangements - Certain customer transactions may include multiple deliverables based on the bundling of equipment, software and services. When a multiple element arrangement exists, the fee from the arrangement is allocated to the various deliverables, to the extent appropriate, so that the proper amount can be recognized as revenue as each element is delivered. Based on the composition of the arrangement, we analyze the provisions of the accounting guidance to determine the appropriate model that is applied towards accounting for the multiple element arrangement. If the arrangement includes a combination of elements that fall within different applicable guidance, ARRIS follows the provisions of the hierarchal literature to separate those elements from each other and apply the relevant guidance to each. For multiple element arrangements that include software or have a software-related element that is more than incidental and does involve significant production, modification or customization, revenue is recognized using the contract accounting guidelines by applying the percentage-of-completion or completed-contract method. We recognize software license and associated professional services revenue for certain software license product installations using the percentage-of-completion method of accounting as we believe that our estimates of costs to complete and extent of progress toward completion of such contracts are reliable. For certain software license arrangements where professional services are being provided and are deemed to be essential to the functionality or are for significant production, modification, or customization of the software product, both the software and the associated professional service revenue are recognized using the completed-contract method. The completed-contract method is used for these particular arrangements because they are considered short-term arrangements and the financial position and results of operations would not be materially different from those under the percentage-of-completion method. Under the completed-contract method, revenue is recognized when the contract is complete, and all direct costs and related revenues are deferred until that time. The entire amount of an estimated loss on a contract is accrued at the time a loss on a contract is projected. Actual profits and losses may differ from these estimates. For arrangements that fall within the software revenue recognition guidance, the fee is allocated to the various elements based on VSOE of fair value. If sufficient VSOE of fair value does not exist for the allocation of revenue to all the various elements in a multiple element arrangement, all revenue from the arrangement is deferred until the earlier of the point at which such sufficient VSOE of fair value is established or all elements within the arrangement are delivered. If VSOE of fair value exists for all undelivered elements, but does not exist for one or more delivered elements, the arrangement consideration is allocated to the various elements of the arrangement using the residual method of accounting. Under the residual method, the amount of the arrangement consideration allocated to the delivered elements is equal to the total arrangement consideration less the aggregate fair value of the undelivered elements. Using this method, any potential discount on the arrangement is allocated entirely to the delivered elements, which ensures that the amount of revenue recognized at any point in time is not overstated. Under the residual method, if VSOE of fair value exists for the undelivered element, generally PCS, the fair value of the undelivered element is deferred and recognized ratably over the term of the PCS contract, and the remaining portion of the arrangement is recognized as revenue upon delivery, which generally occurs upon delivery of the product or implementation of the system. Many of ARRIS' products are sold in combination with customer support and maintenance services, which consist of software updates and product support. Software updates provide customers with rights to unspecified software updates that ARRIS chooses to develop and to maintenance releases and patches that we choose to release during the term of the support period. Product support services include telephone support, remote diagnostics, email and web access, access to on-site technical support personnel and repair or replacement of hardware in the event of damage or failure during the 59 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements term of the support period. Maintenance and support service fees are recognized ratably under the straight-line method over the term of the contract, which is generally one year. We do not record receivables associated with maintenance revenues without a firm, non-cancelable order from the customer. VSOE of fair value is determined based on the price charged when the same element is sold separately and based on the prices at which our customers have renewed their customer support and maintenance. For elements that are not yet being sold separately, the price established by management, if it is probable that the price, once established, will not change before the separate introduction of the element into the marketplace is used to measure VSOE of fair value for that element. b) Goodwill and Intangible Assets Goodwill Goodwill relates to the excess of consideration transferred over the fair value of net assets resulting from an acquisition. Our goodwill is tested for impairment on an annual basis, or more frequently if events or changes in circumstances indicate that the asset is more likely than not impaired. Our annual goodwill impairment test are performed in the fourth quarter, with a testing date of October 1, which aligns with the timing of the Company's annual strategic planning process, which enables the Company to incorporate the reporting units' long-term financial projections which are generated from the annual strategic planning process as a basis for performing our impairment testing. For purposes of impairment testing, our reporting units are based on our organizational structure, the financial information that is provided to and reviewed by segment management and aggregation criteria applicable to component businesses that are economically similar. For goodwill, we perform a quantitative two-step impairment test. In the first step, we compare the fair value of each reporting unit to its carrying amount. We determine the fair value of each reporting unit using a weighting of fair values derived from an income approach using discounted cash flows and a market approach. Under the income approach, we calculate the fair value of a reporting unit based on the present value of estimated future cash flows. The discounted cash flow analysis requires us to make various judgmental assumptions, including assumptions about future cash flows, growth rates and weighted average cost of capital (discount rate). The assumptions about future cash flows and growth rates are based on the current and long-term business plans of each reporting unit. Discount rate assumptions are based on an assessment of the risk inherent in the future cash flows of the respective reporting units. Under the market approach, we estimate the fair value based upon Market multiples of revenue and earnings derived from publicly traded companies with similar operating and investment characteristics as the reporting unit. The weighting of the fair value derived from the market approach ranges from 0% to 50% depending on the level of comparability of these publicly-traded companies to the reporting unit. When market comparables are not meaningful or not available, we may estimate the fair value of a reporting unit using only the income approach. We considered the relative strengths and weaknesses inherent in the valuation methodologies utilized in each approach and consulted with a third party valuation specialist to assist in determining the appropriate weighting. In order to assess the reasonableness of the calculated fair values of our reporting units, we also compare the sum of the reporting units' fair values to our market capitalization and calculate an implied control premium (the excess of the sum of the reporting units' fair values over the market capitalization). We evaluate the control premium by comparing it to the fair value estimates of the reporting unit. If the implied control premium is not reasonable in light of the analysis, we will reevaluate the fair value estimates of the reporting unit by adjusting the discount rates and/or other assumptions. If the fair value of the reporting unit exceeds the carrying amount of the net assets assigned to that unit, goodwill is not impaired, and no further testing is required. If the fair value of the reporting unit is less than the carrying amount, we must perform the second step of the impairment test to measure the amount of impairment loss, if any. In the second step, the reporting unit's fair value is assigned to all of the assets and liabilities of the reporting unit, including any unrecognized intangible assets, in a hypothetical analysis that calculates the implied fair value of goodwill in the same manner as if the reporting unit was being acquired in a business combination. If the implied fair value of the reporting unit's goodwill is less than the carrying amount, the difference is recorded as an impairment loss. The valuation methodologies described above have been consistently applied for all years discussed below. 60 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements The goodwill recorded in the Consolidated Balance Sheets as of December 31, 2013 and December 31, 2012 was $935.6 million and $194.1 million, respectively. The increase in goodwill during 2013 was due primarily to our acquisition of the Motorola Home business. There was no impairment of goodwill resulting from our annual impairment testing in 2013 and 2012. In 2011, a goodwill-impairment charge of $41.2 million before tax ($33.9 million after tax) was recorded for our former MCS reporting unit (now included in the Cloud Services reporting unit.) We performed a sensitivity analysis for goodwill impairment with respect to each of our respective reporting units and determined that neither a hypothetical 10% decline in the fair value, nor a 100 basis point increase in the discount rate, nor a 100 basis point decrease in the terminal growth rate of each of reporting units as of October 1, 2013 would result in an impairment of goodwill for any reporting unit. As of December 31, 2013, we have no reporting units that are at risk of failing step one of the goodwill impairment test. Assumptions and estimates about future cash flows and discount rates are complex and often subjective. They are sensitive to changes in underlying assumptions and can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and our internal forecasts. Our assessment includes significant estimates and assumptions including the timing and amount of future discounted cash flows, the discount rate and the perpetual growth rate used to calculate the terminal value. Our discounted cash flow analysis included projected cash flows over a ten-year period, using our three-year business plans plus an additional seven years of projected cash flows based on the most recent three-year plan. These forecasted cash flows took into consideration management's outlook for the future and were compared to historical performance to assess reasonableness. A discount rate was applied to the forecasted cash flows. The discount rate considered market and industry data, as well as the specific risk profile of the reporting unit. A terminal value was calculated, which estimates the value of annual cash flow to be received after the discrete forecast periods. The terminal value was based upon an exit value of annual cash flow after the discrete forecast period in year ten. Examples of events or circumstances that could reasonably be expected to negatively affect the underlying key assumptions and ultimately impact the estimated fair value of our reporting units may include such items as the following: • a prolonged decline in capital spending for constructing, rebuilding, maintaining, or upgrading broadband communications systems; • rapid changes in technology occurring in the broadband communication markets which could lead to the entry of new competitors or increased competition from existing competitors that would adversely affect our sales and profitability; • the concentration of business we receive from several key customers, the loss of which would have a material adverse effect on our business; • continued consolidation of our customers base in the telecommunications industry could result in delays or reductions in purchases of our products and services, if the acquirer decided not to continue using us as a supplier; • new products and markets currently under development may fail to realize anticipated benefits; • changes in business strategies affecting future investments in businesses, products and technologies to complement or expand our business could result in adverse impacts to existing business and products; • volatility in the capital (equity and debt) markets, resulting in a higher discount rate; and • legal proceeding settlements and/or recoveries, and its effect on future cash flows. As a result, there can be no assurance that the estimates and assumptions made for purposes of the annual goodwill impairment test will prove to be accurate predictions of the future. Although management believes the assumptions and estimates made are reasonable and appropriate, different assumptions and estimates could materially impact the reported financial results. 61-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements Intangible Assets We make judgments about the recoverability of purchased intangible assets with finite lives whenever events or changes in circumstances indicate that impairment may exist. Examples of such circumstances include, but are not limited to, operating or cash flow losses from the use of such assets or changes in our intended uses of such assets. Recoverability of purchased intangible assets with finite lives is measured by comparing the carrying amount of the asset to the future undiscounted cash flows the asset is expected to generate. In determining future undiscounted cash flows, we have made a "policy decision" to use pre-tax cash flows in our evaluation, which is consistently applied. To test for recovery, we group assets (an "asset group") in a manner that represents the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. We review indefinite-lived assets for impairment annually or whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Our indefinite-lived intangible assets for in-process research and development were tested for impairment during the fourth quarter, as of October 1, 2013. Recoverability of indefinite-lived intangible assets is measured by comparing the carrying amount of the asset to the future discounted cash flows the asset is expected to generate. If the asset is considered to be impaired, the amount of any impairment is measured as the difference between the carrying amount and the fair value of the indefinite-lived intangible asset. As of December 31, 2013, the carrying amount of in-process research and development was $71.1 million. Completion of the associated research and development efforts would cause the indefinite-lived in-process research and development asset to become a finite-lived asset. As such, prior to commencing amortization the assets will be tested for impairment. Because indefinite-lived intangible assets are initially recognized at fair value, any decrease in the fair value of the intangible asset will result in an impairment charge. The company uses discounted cash flows in the determination of the fair value of its indefinite-lived intangible assets. As such, a decrease in cash flows for the projects, as well as, an increase in interest rate changes affecting the discount rate used in the test without any offsetting increase in cash flows, could cause the discounted cash flows to decrease, resulting in an impairment charge. Assumptions and estimates about future values and remaining useful lives of our purchased intangible assets are complex and subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends and internal factors such as changes in our business strategy and our internal forecasts. There were no impairment charges related to purchased intangible assets during 2013 and 2012. In the fourth quarter of 2011, an impairment loss of $47.4 million before tax ($29.1 million after tax) related to customer relationships in our former MCS reporting unit (now included as part of the Cloud Services reporting unit) was recorded. Our ongoing consideration of all the factors described previously could result in additional impairment charges in the future, which could adversely affect our net income. c) Allowance for Doubtful Accounts and Sales Returns We establish a reserve for doubtful accounts based upon our historical experience and leading market indicators in collecting accounts receivable. A majority of our accounts receivable are from a few large cable system operators, either with investment rated debt outstanding or with substantial financial resources, and have very favorable payment histories. Unlike businesses with relatively small individual accounts receivable from a large number of customers, if we were to have a collection problem with one of our major customers, it is possible the reserve that we have established will not be sufficient. We calculate our reserve for uncollectible accounts using a model that considers customer payment history, recent customer press releases, bankruptcy filings, if any, Dun & Bradstreet reports, and financial statement reviews. Our calculation is reviewed by management to assess whether additional research is necessary, and if complete, whether there needs to be an adjustment to the reserve for uncollectible accounts. The reserve is established through a charge to the provision and represents amounts of current and past due customer receivable balances of which management deems a loss to be both probable and estimable. In the past several years, two of our major customers encountered significant financial difficulty due to the industry downturn and tightening financial markets. In the event that we are not able to predict changes in the financial condition of our customers, resulting in an unexpected problem with collectability of receivables and our actual bad debts differ from estimates, or we 62-------------------------------------------------------------------------------- Table of Contents Index to Financial Statements adjust estimates in future periods, our established allowances may be insufficient and we may be required to record additional allowances. Alternatively, if we provided more allowances than are ultimately required, we may reverse a portion of such provisions in future periods based on our actual collection experience. In the event we adjust our allowance estimates, it could materially affect our operating results and financial position. We also establish a reserve for sales returns and allowances. The reserve is an estimate of the impact of potential returns based upon historic trends. Our reserves for uncollectible accounts and sales returns and allowances were $1.9 million and $1.6 million as of December 31, 2013 and 2012, respectively. d) Inventory Valuation Inventory is reflected in our financial statements at the lower of average cost, approximating first-in, first-out, or market value. We continuously evaluate future usage of product and where supply exceeds demand, we may establish a reserve. In reviewing inventory valuations, we also review for obsolete items. This evaluation requires us to estimate future usage, which, in an industry where rapid technological changes and significant variations in capital spending by system operators are prevalent, is difficult. As a result, to the extent that we have overestimated future usage of inventory, the value of that inventory on our financial statements may be overstated. When we believe that we have overestimated our future usage, we adjust for that overstatement through an increase in cost of sales in the period identified as the inventory is written down to its net realizable value. Inherent in our valuations are certain management judgments and estimates, including markdowns, shrinkage, manufacturing schedules, possible alternative uses and future sales forecasts, which can significantly impact ending inventory valuation and gross margin. The methodologies utilized by ARRIS in its application of the above methods are consistent for all periods presented. We conduct physical inventory counts at all ARRIS locations, either annually or through ongoing cycle-counts, to confirm the existence of our inventory. e) Warranty We offer warranties of various lengths to our customers depending on product specifics and agreement terms with our customers. We provide, by a current charge to cost of sales in the period in which the related revenue is recognized, an estimate of future warranty obligations. The estimate is based upon historical experience. The embedded product base, failure rates, cost to repair and warranty periods are used as a basis for calculating the estimate. We also provide, via a charge to current cost of sales, estimated expected costs associated with non-recurring product failures. In the event of a significant non-recurring product failure, the amount of the reserve may not be sufficient. In the event that our historical experience of product failure rates and costs of correcting product failures change, our estimates relating to probable losses resulting from a significant non-recurring product failure changes, or to the extent that other non-recurring warranty claims occur in the future, we may be required to record additional warranty reserves. Alternatively, if we provided more reserves than we needed, we may reverse a portion of such provisions in future periods. In the event we change our warranty reserve estimates, the resulting charge against future cost of sales or reversal of previously recorded charges may materially affect our operating results and financial position. f) Income Taxes Considerable judgment must be exercised in determining the proper amount of deferred income tax assets to record on the balance sheet and also in concluding as to the correct amount of income tax liabilities relating to uncertain tax positions. Deferred income tax assets must be evaluated quarterly and a valuation allowance should be established and maintained when it is more-likely-than-not that all or a portion of deferred income tax assets will not be realized. In determining the likelihood of realizing deferred income tax assets, management must consider all positive and negative evidence, such as the probability of future taxable income, tax planning, and the historical profitability of the entity in the jurisdiction where the asset has been recorded. Significant judgment must also be utilized by 63 -------------------------------------------------------------------------------- Table of Contents Index to Financial Statements management in modeling the future taxable income of a legal entity in a particular jurisdiction. Whenever management subsequently concludes that it is more-likely-than-not that a deferred income tax asset will be realized, the valuation allowance must be partially or totally removed. There is significant uncertainty surrounding how much deferred income tax assets will ultimately arise from the acquisition of Motorola Home and be available for utilization by ARRIS. As of December 31, 2013, the Seller has not completed the preparation and the related filing of the final income tax returns for the income tax year ending with the acquisition by ARRIS on April 16, 2013. At this time, we have recorded its best estimate of the deferred income tax assets, given the information that is currently available. Uncertain tax positions occur, and a resulting income tax liability is recorded, when management concludes that an income tax position fails to achieve a more-likely-than-not recognition threshold. In evaluating whether or not an income tax position is uncertain, management must presume the income tax position will be examined by the relevant taxing authority that has full knowledge of all relevant information and management must consider the technical merits of an income tax position based on the statutes, legislative intent, regulations, rulings and case law specific to each income tax position. Uncertain income tax positions must be evaluated quarterly and, when they no longer fail to meet the more-likely-than-not recognition threshold, the related income tax liability must be derecognized. Forward-Looking Statements Certain information and statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations and other sections of this report, including statements using terms such as "may," "expect," "anticipate," "intend," "estimate," "believe," "plan," "continue," "could be," or similar variations thereof, constitute forward-looking statements with respect to the financial condition, results of operations, and business of ARRIS, including statements that are based on current expectations, estimates, forecasts, and projections about the markets in which we operate and management's beliefs and assumptions regarding these markets. Any other statements in this document that are not statements about historical facts also are forward-looking statements. We caution investors that forward-looking statements made by us are not guarantees of future performance and that a variety of factors could cause our actual results to differ materially from the anticipated results or other expectations expressed in our forward-looking statements. Important factors that could cause results or events to differ from current expectations are described in the risk factors set forth in Item 1A, "Risk Factors." These factors are not intended to be an all-encompassing list of risks and uncertainties that may affect the operations, performance, development and results of our business, but instead are the risks that we currently perceive as potentially being material. In providing forward-looking statements, ARRIS expressly disclaims any obligation to update publicly or otherwise these statements, whether as a result of new information, future events or otherwise except to the extent required by law. |