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Executives

Patrick J. Harshman - President, Chief Executive Officer & Director

Robin N. Dickson - Chief Financial Officer

Michael Newman – Investor Relations

Analysts

Mark Sue – RBC Capital Markets

Amir Rozwadowski – Barclays Capital

James Kissner – Jefferies & Company

Greg Mesniaeff – Needham & Co.

Todd Cooper – Stephens, Inc.

Vivek Arya - Merrill Lynch

Blair King – Avondale Partners, LLC

Shubho Ghosh – Thomas Weisel Partners

Larry Harris – CL King & Associates

Paul McWilliams – Indie Research

Robert Bobo – Diamondback Capital

Harmonic, Inc. (HLIT) Q1 2009 Earnings Call May 4, 2009 5:00 PM ET

Operator

My name is Tonya and I will be your conference operator today. At this time I would like to welcome everyone to the Harmonic first quarter 2009 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question-and-answer session. (Operator Instructions) I will now turn the call over to Mr. Patrick Harshman, President and CEO.

Patrick J. Harshman

I’m Patrick Harshman, President and CEO of Harmonic. With me in our headquarters in Sunnyvale, California are Robin Dickson, our Chief Financial Officer and Michael Newman, our Investor Relations spokesman. Thank you all for joining us. Today we announced our results for the first quarter of 2009 a quarter that was challenging but also encouraging.

The key challenge was conservative spending by many of our customers around the globe a continuation of the trend that started in the fourth quarter with a direct impact on our first quarter revenue and our second quarter revenue forecast. An additional short term challenge has been the restructuring and integration of the Scopus business which we acquired late in the first quarter.

Despite these real and continuing challenges however I’m as encouraged today about our business as at any time over the past couple of years. From an operational perspective we’ve been pleased with the continuing strength of our gross margins, our decisive control of operating expenses and our rapid progress in integrating the Scopus business.

From an astral market perspective we’re also encouraged by signs of increasing customer spending, our continuing strong competitive position and several strategically important wins including the first orders for our new Electra 8000 encoder platform, new MCMTS customers, new switch to digital video wins and new mobile and Internet video wins.

Looking ahead we expect the global economic environment to continue to impact our customers’ near term capital spending although we’re cautiously optimistic the environment is beginning to improve.

Additionally recent market developments such as the strong video results just posted by Verizon and AT&T, BSkyB’s record results driven by high definition services and Disney’s entry to Hulu have us convinced that the fundamental market drivers that underpin our growth opportunities remain very much in force.

In the context of these market dynamics, our unique video technology leadership and diversified customer base and strong balance sheet position us to further strengthen our competitiveness and drive sustained long term growth. I’m going to ask Robin to cover the financial aspects of the quarter.

I will then review our key business initiatives in more detail and then we’ll open it up for questions.

Robin N. Dickson

During this call, we may make projections or other forward-looking statements regarding future events or the future financial performance of the company. We must caution you that such statements are only predictions and that actual events or results may differ materially. We refer you to documents that Harmonic files with the SEC including our most recent 10K and 10Q reports.

These documents identify important risk factors that could cause actual results to differ materially from those contained in projections or forward-looking statements. Please note that on this call we will provide you with financial metrics determined on a non-GAAP or pro forma basis.

These items together with the corresponding GAAP numbers and the reconciliation to GAAP are contained in today's earnings press release which we have posted on our website and filed with the SEC on Form 8K. We will also discuss historical financial and other statistical information regarding our business and operations.

Some of this information is included in the press release, and the remainder of the information will be available in the recorded version of this call on our website. Today we announced results for the quarter ended April 3rd, 2009. Our first quarter includes [stub] period results from our recent acquisition of Scopus Video Networks which closed on March 12th.

For the first quarter of 2009 we reported net sales of $67.8 million compared to $87.3 million in the first quarter of 2008. As Patrick indicated in his introduction the cautious approach to capital spending by many of our customers had a direct impact on our first quarter bookings and revenue and our expectations for second quarter revenue.

As you may recall our bookings in the fourth quarter were down significantly from the third quarter and we saw another albeit smaller decline in bookings in Q1. Orders started to pick up in March but not as strongly as the historical seasonal pattern with consequent impact on our Q1 revenue. In April we’ve seen a more robust pace of orders giving us optimism that we hit the bottom during Q1.

As you might expect with our level of customer diversity we saw some pocket of relative strength and areas of significant weakness in our Q1 bookings. Asia performed well, North America was middling with cable a relatively bright spot and running close to last year’s bookings pace. Europe exhibited real weakness especially in Central and Eastern Europe.

Turning to the revenue breakdown international sales represented 52% of revenue for the first quarter of 2009 compared to 39% in the same period of 2008. By market segment cable customers accounted for 57% of revenue, satellite customers 23% and telcos and others 20%. Our largest customer in the first quarter was Comcast representing 16% of our revenue and our only greater than 10% customer in the quarter.

By product category video processing products represented 45% of revenue for the first quarter, adjunct access 35% and software services and other 20%. Even with lower than anticipated revenue we were able to maintain our recent levels of gross margins in part because of a favorable product mix but also from the longer term trends driven by our product strategy to develop more software intensive products.

Our non-GAAP gross margins were 50% in the first quarter. In addition to the continued success of our new products and solutions our flexible sourcing strategy and significant cost reduction efforts helped keep our gross margins steady despite lower revenue levels. A reduction in non-GAAP operating expenses in the first quarter was almost $5 million on a sequential basis.

Some of this reduction reflects a decrease in variable compensation in the first quarter compared with the fourth quarter. Also in light of market conditions we took additional steps to streamline operations and reduce costs but without impacting our R&D capabilities and long term competitiveness.

With respect to headcount we entered this year with just under 700 employees. We added almost 300 people on the acquisition of Scopus but our restructuring there and reductions elsewhere in the company brought us back down to just over 900 employees at the end of the quarter. Since that time we further reduced our headcount to about 860 people today.

The restructuring and integration of Scopus is proceeding very much as planned or even slightly ahead of it and we are on track to realize our projected cost synergies of $8 million to $10 million on an annualized basis. In the first quarter of 2009 we had a number of special charges which were principally related to the Scopus acquisition.

We made inventory provisions arising from rationalization of the product lines as we discontinue certain products and intend to sell some others only on a limited basis. We also had all of the professional fees in connection with the acquisition which are now expenses under the new M&A accounting rules as well as substantial severance costs arising from restructuring and reorganization.

Finally another unusual item in Q1 was a heavy tax provision much of which arose from a recent tax law change in how California companies will be taxed on their out of state business. This resulted in a one time significant charge and for non-GAAP purposes we’ve elected to apply a 35% tax rate to our non-GAAP income a rate we believe is more indicative of our current normalized tax rate.

As a result of the acquisition and tax charges we reported our first GAAP loss for some time. The GAAP net loss for the first quarter of 2009 was $18.8 million or $0.20 a share compared to net income of $13.4 million or $0.14 per diluted share for the same period of 2008.

Excluding the acquisition related charges, the non-cash accounting charges for stock based compensation and the amortization of intangibles as well as the tax adjustment the non-GAAP net income for the first quarter of 2009 was $4.1 million or $0.04 per diluted share compared to $16.6 million or $0.17 per diluted share for the same period of 2008.

As we noted in our press release the inclusion of Scopus results for the short stub period reduced our pre-tax earnings by about $1.1 million or $0.01 a share. We continue to maintain a very strong balance sheet. Although we paid out cash for the Scopus purchase in March we ended the quarter with cash, cash equivalents and short term investments of $262 million.

We continue to have a strong cash position from which to pursue further acquisitions or other initiatives to achieve our strategic goals. Our receivables dropped from $63.9 million at the end of the fourth quarter to $52.7 million at the end of the first quarter reflecting our lower revenue levels. This corresponds to days sales outstanding of 71 days compared to 60 days at the end of Q4.

However this comparison is distorted as we took onto our balance sheet all of the pre-existing Scopus receivables but had only a short stub period of revenue contribution. Our inventory was $38.2 million up $11 million from the end of the 2008 some of which is also due to Scopus inventory coming onto our balance sheet in March.

Finally on the balance sheet our capital spending was $1.5 million in the first quarter and we expect our cap ex to be approximately $7 million to $8 million for the full year. Turning the outlook the fundamental trends and competitive dynamics that have been driving our business remain in force.

However as the result of a couple of weak quarters of bookings we enter the second quarter with our lowest backlog for some time approximately $65 million plus approximately $10 million inherited from Scopus for a total of about $75 million. As we’ve indicated we’ve seen recent signs of improvement in order rates and we look for a positive book-to-bill ratio in Q2.

However given that we always have a significant portion of our bookings subject to some from of revenue deferral we expect a relatively modest sequential increase in revenue for the second quarter of 2009 in a range of $72 million to $78 million.

While we don’t feel comfortable giving full year guidance in this still very uncertain environment recent historical patterns suggest that about 55 of our revenue is recorded in the second half of the year. Whether this pattern will repeat itself in today’s very unusual circumstances remains to be seen and we expect the global economic situation to continue to create substantial uncertainty.

Non-GAAP gross margins and operating expenses for the second quarter are anticipated to be in a range of 47% to 49%. While our long term margin trends are encouraging and our contract manufacturing model provides us flexibility we have seen pricing pressure in some areas which we expect may impact second quarter gross margins.

Still we believe that our consistent gross margin performance in recent periods demonstrates that our product strategy is on the right track and our long term gross margin targets continue to exceed 50%. With respect to operating expenses our GAAP operating expenses in the second quarter are expected to include further charges related to the continuing integration of Scopus.

Keep in mind that the second quarter will also include a full quarter of operating expenses related to Scopus. While we intend to maintain our R&D capability and capacity we have reduced spending in other areas in line with lower volumes of activity in the current environment. non-GAAP operating expenses for the second quarter excluding acquisition related charges, stock based comp and the amortization of intangibles are anticipated to be in a range of $33.5 million to $34.5 million.

Let me make one last point before I conclude. Some of you may ask why we did not make an earlier announcement of our results. The closing of the Scopus deal late in the quarter caused our regular closing process to become much more complex and to take longer. The new rules for purchase accounting and the significant restructuring activities made our task additionally complex.

Rather than try to rush out quickly with preliminary results and run the risk of getting them wrong we decided to wait until we got the numbers nailed down with confidence. When the dust settled although we fell short of our revenue guidance, our gross margins and our operating expenses even with Scopus included were ahead of the guidance we provided you in January.

To summarize we like the increased diversification of our business and revenue which the Scopus acquisition brings us. While there is significant global economic uncertainty and some continuing caution on the part of our customers we have a strong balance sheet and a healthy operating model allowing us operational flexibility and the opportunity to use our strong financial condition to our competitive advantage.

Patrick J. Harshman

Throughout the first quarter we’ve strived to maintain a balanced focus on near term results and the execution of our long term initiatives, investing in leading edge new product development and extending our market presence around the globe.

As a result we’ve strengthened our technology leadership and market share across a broadening range of applications, customers and geographies putting ourselves in a strong position to continue our recent growth as the market recovers. Looking to the future I’d now like to review five key areas of business and investment focus that we believe provides significant mid and long term growth opportunities for Harmonic.

The first area is video [inaudible]. We recently announced our new Electra 800 encoders that are going to redefine the market for MPEG-2 and MPEG-4 encoding increased significant new opportunities for Harmonic. We demonstrated the product at the recent NAB show and have been trialing it with select customers and the response has been very positive.

We expect this product to be used extensively by operators not only for adding new channels but also to buy back bandwidth for channels already deployed. In the cable environment for example upgrading with this technology can reduce the bandwidth required for an HD program by over 30% and it can have a significant bandwidth savings impact for satellite and traditional broadcast operators as well.

Another key and unique attribute of this new platform is support for both MPEG-2 and MPEG-4 formats uniquely enabling pristine re-encoding from one format to another and enabling cable and terrestrial operators to position their networks for the coming transitions from MPEG-2 to MPEG-4.

We’re very pleased, we’ve received our first order from a leading satellite operator for this new product with the application being the upgrade of previous generation MPEG-4 HD encoders. A secondary business focus and growing opportunity is that of enabling multi-screen video services.

Specifically I’m talking about the work flow software and video reformatting and storage and streaming solutions for delivering high value video content over the Internet and to mobile devices. We’re seeing growing interest in these solutions from all types of operators including broadcasters, cable operators and particularly telco operators offering both IPTV and wireless services.

Our intensifying activity in this space includes our recent announcements of work with British Telecom Media and Broadcast, Chunghwa Telecom in Taiwan, RaySat who is driving AT&T’s new cruise cast service for delivering video to vehicles and the ThinkPad Group of broadcast stations with whom we did a recent mobile video demonstration.

A third key area of focus is converged edge processing and QAM modulation for cable video and demand, switch digital video, MCMTS and IPTV over cable. We continue to enjoy a very strong technology leadership and market share position in this area and we’re pleased with recent first quarter successes breaking into new MCMTS and switch digital vide accounts.

I also want to note that we see growing interest particularly internationally in our IPTV over cable solution an application area we seeing gaining momentum over the coming year. we continue to invest in innovative next generation edge technology in general and we’re well positioned to take advantage of continuing market opportunities in this area.

A fourth strategic growth driver is the expansion of our customer base to include broadcasters such as the Sinclair Group and video content owners like the BBC, Disney, Fox and Turner. Addressing this market was a strategic drive of our Scopus acquisition and we’ve recently announced two key new products based on Scopus technology that are targeted specifically at video contribution and distribution applications for these customers.

We’re also making good progress expanding our solutions that enable these video content owners to harness Internet delivery. Our Rhozet Group recently announced important new developments through which we will enable content owners to leverage You Tube’s content ID and protection technology.

Through cooperation with Microsoft we’re providing new ways to manage, distribute and store video content. I want to emphasize that our increased focus on video content owners is still relatively new and we’ve got a long way to go. However we are making important progress and we significant mid and long term growth opportunities in this market segment.

The final growth initiative I want to highlight today is our ongoing push into international markets. While many international markets are having a very challenging time in this economic downturn and indeed our business has been correspondingly impacted we continue to have the strategic view that long term growth opportunities in both developed and emerging international markets are tremendous.

Through the Scopus acquisition we’re pleased to have significantly expanded our presence in mainland China, India, Latin America and Russia. We believe that our continuing focus on these and other international markets is key to our long term growth. In summary we continue to see a very cautious approach to spending by customers around the globe and consequently we’ve had a couple of challenging bookings quarters.

Despite this global economic impact on our business however we remain optimistic about the mid and long term growth opportunities in video and confident in our ability to execute on the initiatives I’ve laid out. To this end we remain focused on controlling costs and maintaining our operating efficiencies while making the necessary investments to grow our business over the long term.

With our technology leadership, diversified and growing customer base and strong financial position we believe we will further strengthen our competitiveness and extend our global market share in 2009 and beyond. With that we’ll conclude the formal part of this presentation and Robert and I are now pleased to open it up to your questions.

Question-And-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Sue – RBC Capital Markets.

Mark Sue – RBC Capital Markets

The guidance of $72 million to $78 million how should we look at the Scopus contribution in 2Q? Furthermore any thoughts on how we should look at the trends by customer segment in 2Q, telco, cable and satellite?

Patrick J. Harshman

Mark, we’ve made a couple of comments here that I think are relevant. One is, by customer segment we noted that cable has been relatively strong. Now, we’ve seen pricing pressure and some reduced spending in cable but in large that market has actually been a relative bright point. In contrast I’d say the step down in other customer segments, satellite, broadcast and IPTV has been a little bit more significant.

I would also comment that the customer spending impact that we’ve seen has been somewhat more pronounced overseas particularly in Western and Eastern Europe I think as Robin mentioned. In general therefore, we’ve seen the Scopus business impact somewhat more heavily than parts of the core Harmonic business particularly those parts that are focused on cable.

We won’t be breaking out Scopus revenue and Harmonic revenue going forward but our Q2 guidance takes all those considerations into account as well as the actual bookings that we saw in Q4 and Q1 which particularly in terms of digital video projects is really rolling forward into constituting the backlog that we have for Q2 revenue.

Mark Sue – RBC Capital Markets

That being said, will international be up sequentially? Are you seeing some early trends in terms of bookings for stabilization overall internationally for the second quarter?

Patrick J. Harshman

I don’t expect international to be up sequentially. I think we saw some good strength carrying over from bookings last year. However as we noted I think as a whole international bookings were relatively more challenged than domestic bookings in the past quarter and therefore I think you’ll see the manifestation of that in the second quarter revenue.

Mark Sue – RBC Capital Markets

Robin, just quickly, pricing pressure, I guess it’s on the cable side, is that something that will stabilize? Separately, tax rate for next year.

Robin N. Dickson

On pricing pressure is certainly referring to some things we’ve seen most of which relates to the cable sector. As to when it moderates, I think to some extent that’s a function of where the economy goes from here and I would expect we’ll see some continuation of it.

With respect to the tax rate, we’ve used the 35% rate for our non-GAAP earnings which is I think consistent with what we’ve been guiding to over the last few quarters that our expectation for this year, 2009, would be a mid-30s type of rate and that’s the rate we’re applying now.

Obviously it’s early in the year and the tax rate is very sensitive to the mix of domestic and international revenue as you know, but at this point this seems like the right number to apply and I would expect that we will continue to apply that for the rest of the year unless the mix changes significantly or other factors come into play.

Operator

Your next question comes from Amir Rozwadowski – Barclays Capital.

Amir Rozwadowski – Barclays Capital

Digging a little bit more into the order trend pick up in April, it seems as though by end market we should think about things improving on the cable side of the house. How should we think about your visibility as it stands today?

When we were having this discussion a quarter ago, obviously some of the MSO cap ex plans and the service provider cap ex plans perhaps were not as set at the moment but where we stand today, can you give us a little bit of color in terms of visibility for the year?

Patrick J. Harshman

Just that our visibility still is not great. We’re encouraged by the recent trends that we spoke to I think beginning in late March and heading into April and I’d say we have a feeling and we detect a more general sentiment in the market that things are on the right kind of upward trajectory. However in this market projecting exactly what’s going to happen particularly in the second half of the year still feels like more art than science.

I’d say maybe incrementally more confident but really in terms of hard data, I think it’s a relatively challenging visibility environment.

Amir Rozwadowski – Barclays Capital

If we’re looking at some of the challenges that you folks have faced in Eastern and Central Europe, how should we characterize that? Is there issues around pricing? Is there issues around delayed roll outs? How should we think about the drivers there and then what would it take to turn around businesses within those regions?

Robin N. Dickson

I’ll give you one view of it, Amir, and then maybe Patrick can supplement it but currency depreciation has been a major factor. Many Eastern European countries have seen their currencies depreciate significantly. I mean not only against the dollar but against the euro and other major currencies and it certainly seems to me that that is a significant element in either the delaying of orders or in some cases the reduction of capital spending.

It’s not confined of course to Central and Eastern Europe but that is certainly one part of the world where some of the currency depreciation has been the most acute.

Amir Rozwadowski – Barclays Capital

We should think about it as not necessarily a shift in strategy for some of the deployments but more or less dealing with some macro related issues within those regions?

Patrick J. Harshman

I think that’s correct, Amir. I think other than strategic considerations around a very dynamic competitive environment globally, I would say we have not seen any shifts in strategy driven by the economic environment. I think where things have slowed down, the message has been one more of delay or scale back for now as opposed to cancellation or a change in strategy.

Amir Rozwadowski – Barclays Capital

Lastly, if I may just a housekeeping question, can you give us the percentage contributions from the greater than 10% customer?

Robin N. Dickson

The only one we had that was over 10% for the quarter was Comcast which was 16% of revenue.

Operator

Your next question comes from James Kissner – Jefferies & Company.

James Kissner – Jefferies & Company

The first question is where would Scopus fall? Would it all fall in video processing presumably or is some of that split into other areas?

Patrick J. Harshman

No it’s almost all I think, yes it’s almost all of it in video processing. Maybe a little bit in the software category, but it’s almost exclusively video processing.

James Kissner – Jefferies & Company

Returning to edge and access for a minute, just drilling down this quarter’s results, edge and access was pretty weak at least from our standpoint. Is that a division that’s mostly due to various access spending or were edge products also soft?

Patrick J. Harshman

I think it’s important to note that edge and access in general tends to be a little bit more of a book and burn business for us. On a relative basis, actually in terms of bookings both our edge and our access products fared relatively well in terms of what happened in bookings in the first quarter. However overall revenue I’d say was more than typically impacted by the deferred revenue carrying over from 2008, if you follow me.

So there’s not any significant difference in terms of the way the EdgeQAM and our access pieces were impacted. Both businesses actually as I say on a relative basis have stayed relatively healthy and I think you see them from a revenue perspective looking a little weak simply because overall Q1 was a weaker booking quarter.

Robin N. Dickson

And I would add to that James that some of the pick up was pretty late in the quarter and some of the order we got had required deliveries and some deliverables in the second quarter so they weren’t able to turn in time.

James Kissner – Jefferies & Company

Just relatively on the pricing pressure, is it across all product lines or is it in particular areas?

Patrick J. Harshman

I’d say in general, James. With fewer deals on the table everyone’s just a little bit hungrier and so we’ve seen some incremental I’d say notch up in the pricing pressure. I don’t want to have this overstated or misconstrued as a giant change in the business. We’re used to day in, day out this being a very competitive space that we compete in, particularly around cable applications and really we’ve simply seen a continuation of that fairly intense competitive environment.

Operator

Your next question comes from Greg Mesniaeff – Needham & Co.

Greg Mesniaeff – Needham & Co.

I was wondering if we could just drill down a little bit deeper into the cable area. Is it fair to say that the EdgeQAM business in Q1 was at least part of the pricing pressure you had alluded to? Given the recent strength in EdgeQAM shipments to the MSOs, to Comcast, tied to DOCSIS 3.0, is it fair to say that maybe there’s been a little more competitiveness developing in that segment?

Patrick J. Harshman

Greg, I don’t think we saw any significant change in the competitive environment or even the pricing environment turn on in Q1. It has been for some time as you know, for most of the balance of 2008, a very competitive arena and we certainly see that competitiveness around EdgeQAM continue into the first quarter.

More generally I would say across the spectrum of what we do in cable, encoding, stream processing, on demand, the access solutions as well, it has continued to be a competitive environment.

Greg Mesniaeff – Needham & Co.

Moving to the satellite area, that business traditionally has been somewhat lumpy for you and with the recent roll out of the 8000 product, have you seen any of that lumpiness in terms of some of your large customers digesting the new product and perhaps transitioning to it?

Patrick J. Harshman

The product is brand new. We just announced the Electra 8000 a month ago or something in Q1.

Greg Mesniaeff – Needham & Co.

So it’s really not a part of the Q1 story?

Patrick J. Harshman

I think the release of the product and the customer attesting and traction we’re getting is certainly for us a noteworthy development. However we have yet to recognize any revenue from that product and so we’re really at the very beginning of the opportunity that we think that product is going to bring to us which is really next generation compression which we think will in many instances, indeed in the case of the early orders that we’ve received, be associated with a replacement cycle on previous deployed encoders.

Greg Mesniaeff – Needham & Co.

Generally how is the pricing environment for MPEG-4 encoders?

Patrick J. Harshman

No substantial change around that, Greg. That is one area where I think quality of the video signal and the extent of compression really pays dividends for operators. So I don’t want to say there’s no pricing pressure in that area, but around high ended coding is probably among the most benign pricing environment that we participate in just because bandwidth is so precious whether on a terrestrial network or over a satellite network.

Customers of all stripes are really willing to pay for quality in this area.

Operator

Your next question comes from Todd Cooper – Stephens, Inc.

Todd Cooper – Stephens, Inc.

Patrick, will Comcast all digital initiative open up the potential for Harmonic to sell more encoders to Comcast during the duration of that program?

Patrick J. Harshman

I think the short answer is yes, Todd. Going all digital, perhaps you saw in Comcast’s presentation to investors last week and it’s really all about creating more space for both DOCSIS services and advanced video services. We’re quite excited about a larger playing field for more HD channels, more SD channels, more VOD channels. We think it’s a good thing.

Todd Cooper – Stephens, Inc.

Are any of your cable customers talking about or thinking that they will be able to squeeze four HD channels into a traditional six megahertz analog channel using your new Electra 8000?

Patrick J. Harshman

Particularly with cable operators we’re really at the beginning of doing some show and tell and showing them what we can do. We believe this product will be able to be used in a four to one configuration. That is four HD channels in one six megahertz slot which I think as you probably know would be a dramatic change from today which is typically two or three to one.

Todd Cooper – Stephens, Inc.

One last if I might, do you see Scopus being accretive to the bottom line during 2009?

Robin N. Dickson

I’m still guardedly optimistic, Todd. Obviously the economic picture has darkened a lot since we started working on the deal but I’m encouraged at least that on the cost side and generally the integration side overall, we’re moving very quickly and I think had a good plan in place and we’re executing on it.

We’re getting all the product rationalization decisions made and the way forward made very clear to all concerned both inside and outside the company. So I’m very encouraged on that front. I think really fundamentally it gets down to what the rest of the year looks like on the top line. Certainly had this been business as usual as it was maybe six to nine months ago, I would have said yes without any doubt.

As I say it really comes down to the second half and particularly to how quickly some of the international economies recover. What I said about Central and Eastern Europe applies to a lot of Scopus business and the countries in which they’re well positioned are many of the countries where the going is tough right now.

Todd Cooper – Stephens, Inc.

To be clear Robin you’re guardedly optimistic that it will be accretive by the end of 2009 not necessarily over the course of 2009?

Robin N. Dickson

Yes, I think by the end of 2009 in the third or maybe the fourth quarter, yes. And it could well be the third. As I say I think it comes back really to how quickly the top line recovers.

Operator

Your next question comes from Vivek Arya - Merrill Lynch.

Vivek Arya - Merrill Lynch

Couple of questions, first your second quarter guidance is significantly above your bookings rate and I understand there’s not one to one correlation, but generally I’ve seen the ratio as about one times what your guidance is almost 1.4 times the bookings rate.

First is that a good way of looking at this trend? Secondly is there is what gives you confidence in your Q2 guidance?

Robin N. Dickson

Vivek I think it’s a couple of things. First of all I really would rather look at our backlog coming into the quarter which for the stand alone Harmonic business was about $65 million coming in but we also have coming over from Scopus a backlog number of around $10 million so we came into the quarter with about $75 million.

I think we’ve been encouraged too by the activity we’ve seen and the actual bookings we’ve seen in April and the nature of those bookings with respect to how quickly they might turn into revenue. So I think these are the principal factors we are looking at. We still have a significant slug of deferred revenue. It did not really go down much in the first quarter.

The peak of that backlog that is deferred revenue, that stayed relatively consistent. We still have some of these projects that will become completed or at least substantially completed during the second quarter.

Vivek Arya - Merrill Lynch

Robin, can you give us a sense for how much of that backlog is from international customers? I’m just trying to get a sense for some of the weakness that you’re seeing on the international side, how does that impact sales going forward as you start depleting some of this backlog?

Robin N. Dickson

I think the international picture is a little more nuance than maybe even we suggest. We certainly talked a bit about some of the weak areas such as central and eastern Europe but, we’ve seen some pockets of strength, Asia in particular in general has been performing quite well. We didn’t specifically call out Latin America but we’re continuing to see some pretty decent activity there. So, I wouldn’t want to suggest that international is weak across the board.

I do think as I think Patrick indicated earlier that the balance of revenue in the second quarter will probably shift somewhat towards the US. It was 48% 52%, US International in Q1, I think the revenue might move the other way. So, there are certainly some pockets of international that will still be in recovery mode but we don’t mean to suggest that across the board it is totally bleak.

Vivek Arya - Merrill Lynch

Just one question for you Patrick, as you look at second quarter and all the engagement you have started to see April, can you perhaps give us some more color around these engagements with your cable and satellite and telco verticals? Are these customers saying, “Okay, we have seen the trough, we are ready to spend again?” Is it a question of seasonality? How do we get a better sense for some improvement in engagement?

Patrick J. Harshman

Unfortunately, the visibility is still not what we would hope it would be. The truth is, on a pre-sales kind of technical discussion basis, actually there’s a lot of activity out there based purely on the amount of discussions around the strategic solutions and potential projects. You take a look at it and say this is quite an active time.

I think what’s a little bit unique is the link between planning and looking and evaluating potential projects and actually making the decision, the CFO deciding, “Yes, let’s go ahead with that.” I think that’s actually where we see more resistance or caution than in the past. Our visibility, despite I think fairly good contact at the senior level with most of our large customers, that’s still an area for us that we’re really struggling to understand completely and get our arms around exactly how the CFOs of our customers are thinking.

So, we have seen some pickup in orders, that’s encouraging. We’re seeing a lot of technical engagements. There’s a lot of discussions on this, I mentioned some of the market dynamics, it’s a very active time in the market. What we’re not really clear though on is really how many of these projects actually go forward and with what pace. Unfortunately, we just have to give it a little more time to see how things play out.

Vivek Arya - Merrill Lynch

Just one last question, can you just remind us again how much was Scopus in total standalone in 2008? And, I know you’re not giving specific Scopus guidance for 2009, can you just help us sort of frame is it going to be up, down 10%, 20%, just some order of magnitude so we can model Harmonic standalone and the Scopus contribution this year?

Robin N. Dickson

Scopus did 75% of $6 million of revenue in 2008. So, that was the 2008 revenue. As we said earlier, we’re not going to be separately tracking it. One of the fundamental tenants of this deal was to fully integrate the organization and the product lines in to the Harmonic business so we’re not going to be separately tracking it or separately reporting it. I would say that I think, my own view is that on a relative basis, the Scopus business is probably a little bit weaker than if you like old Harmonic or the core Harmonic simply because of the exposure one to some of the emerging markets that have been particularly beaten up in the last six months.

Perhaps secondly, to pieces of the broadcast sector where broadcasting companies are also under some pressure because of added revenue short falls and so on. Now again, I don’t want to over blow this but I think on a relative basis I think it may be a little bit more challenged than the core business.

Operator

Your next question comes from Blair King – Avondale Partners, LLC.

Blair King – Avondale Partners, LLC

Just a couple of questions, the first one would be just with regard to the EdgeQAM again, there certainly appears to be several ongoing DOCSIS 3.0 upgrade opportunities around the globe with lots of cable operators in addition to some talked about SDV expansion opportunities and a seemingly continued focus on video on demand. I was just thinking that perhaps one of the concerns around the Harmonic relationship with CISCO is something that’s talked about particularly for the 3.0 deployments and I was hoping you might shed some light on how Harmonic might plan to maintain and perhaps even enhance its leadership position in that EdgeQAM space?

Patrick J. Harshman

We do feel as though we have a very strong position Blair. We feel as though we’re number one in terms of deployments and continue to be number one in terms of technology. And, as I mentioned earlier, although overall orders were down a relative let’s say strategic highlight of the past quarter was adding a couple of new Qwest customers both to the list of customers working with us or MCMTS deployments as well as switched digital video deployments.

I think in general you see an operator trend, I don’t want to overstate it but there is a trend towards opening up these ecosystems and using best of class products. Now, I think in the CMTS area that’s still a minority of deployments. We have no illusion that the majority of DOCSIS deployments will become MCMTS any time soon. But, for those operators for whom it is the right architecture, we think we’ve got a very strong solution and we’ve continued to do well in that area through the first quarter.

More generally, our position in switch digital video, I think from a technology perspective is quite strong. I’m very happy to see some new wins there. And, I think our position in VOD is really unquestioned in the market. Lastly, as I mentioned in the prepared remarks we see IPTV over cable as another very exciting and important coming application. So, at least as we think about EdgeQAM, we’re thinking about the portfolio of these solutions and we also discussed the portfolio of these applications with operators as they weigh the value in their particular context as a unified Edge architecture that handles maybe not just one but multiple of these services.

Blair King – Avondale Partners, LLC

A last question if I can, on the ProView 7000 decoder, in terms of product mix can you talk about how relative that product is to the overall video segment or processing segment? Then, how much incremental impact you might expect from a gross margin perspective at least if now that you’ve sort of integrated that IRD piece of the component in to the product? Or, if there is any margin impact at all?

Patrick J. Harshman

For those listening, let me give you a little background context, this is a new product based largely on Scopus technology. It’s a new product area for us but it’s a very highly synergistic from a system solution point of view with the rest of our video processing solution. Scopus’ gross margins were in generally very much aligned with Harmonics, I think very high 40s and therefore the addition of this product in to the mix and product category in to the mix, we don’t expect to have an appreciable change one way or another on our overall company gross margins.

This product category accounted for about 40% to 45% of Scopus’ business. So, if you kind of put that together with Robin’s answer on the last question, you maybe get a sense that it was one of the biggest single part of the Scopus business and on a relative basis we’re looking for a comparable contribution. More generally, it’s a big part of our strategic push in to doing more work with broadcasters. This is particularly applicable to content owners and broadcasters who are doing this so called primary distribution of video to the cable head end or the IPTV head end, etc. So, it’s an important product for us those couple of [inaudible].

Blair King – Avondale Partners, LLC

One last question maybe to Robin, Robin last quarter on the gross margins inside, it was primarily related to lack of volume which I guess would be the same case or similar turning in to the second quarter but the gross margins obviously is higher than what you had expected coming in to the first quarter and I’m just wondering if you can talk a little bit more about what you had going on within that gross margin mix and what were some of the steps you took to improve your gross margin and can we expect that to just continue on through the year? Or, was there something special that happened outside of your view when you gave guidance for the first quarter?

Robin N. Dickson

We had a little bit more favorable product mix perhaps than we had expected, the video processing and the software piece, software and other piece up 20% so that was helpful to the quarter. We also as we saw things not improving in the first quarter from a general macro perspective, we also I think got a little more aggressive on the cost reduction side as well and so that played in to it a little bit also. So, I think it was a little bit of product mix, some cost reduction and putting pressure on our own vendors and suppliers too, not just our own internal costs but some of our outside costs as well. I think that all [inaudible] as well.

Blair King – Avondale Partners, LLC

Would you still anticipate gross margins potentially moving in to the mid 50s, or I guess low 50s percentage range as volumes start to improve?

Robin N. Dickson

Yes, I think the long term trends are very favorable. Some of the new things we’re doing that Patrick mentioned, not only some of our more familiar products like Electra encoder but particularly as we move in to some of the mobile and Internet space that he was talking about are quite software intensive and I’m optimistic that over the next several quarters we can continue to push gross margins in the right direction.

Short term I think it’s just mostly about maybe a slightly less favorably product mix and pricing pressure and so forth. Then also, just absorbing the Scopus operations and while we’re on track to get all of the cost reduction done, the second quarter is probably the most challenging while we continue to work our way through the plan there.

Operator

Your next question comes from Shubho Ghosh – Thomas Weisel Partners.

Shubho Ghosh – Thomas Weisel Partners

I was actually wondering if you could shed some more light around the gross margins? Actually, I was looking at your non-GAAP of course you beat your guidance of 47 to 49 of course going in to the details the reasons why you did that were something that I’d like to go in to. I did see a Scopus product discontinuance of $5.9 million, now the question is, is this a one-time deal and do you expect any of this to kind of come in to the non-GAAP portion going in to Q2? The second is, if I just look at it from an apples-to-apples pure GAAP perspective, gross margins were down from 49.8% to 37.5% so what is your confidence of this improving going forward and of course reasons why this happened in the first place?

Robin N. Dickson

Well, I think some of the answer lies in my answer to the last question but specifically to address the product discontinuance I think one of the things we’ve done well and done quickly here is to address very effectively the product roadmap for the combined company. In doing so, and this really should come as no surprise to anyone who is familiar with the two companies, there is or was some degree of product overlap between the two companies.

We’ve figured out how we’re going to deal with that overlap, which products will remain, which ones will not and which ones will take on different shapes and forms as we go forward and in doing so we came to the decisions quickly and we were able to during the first quarter address the inventory of those products and to write it down, write down the inventory appropriately of both products we will not sell in the future or we will sell only on a limited basis to certain customers for certain applications.

I don’t expect to see any significant inventory charges going forward. Those decisions are made and I think we’re ready to move forward with the new product road map. Also in cost of sales there are some severance charges at Scopus and we expect to see some more of that in the second quarter so there will be some additional charges there as well as possibly charges relating to facilities as we made or are able in fact to close a couple of offices here and there.

Shubho Ghosh – Thomas Weisel Partners

Also, if I may ask a question, op ex, you’re guiding non-GAAP guidance to go up sequentially about $6 million, how should we basically look at this as spread between SG&A and R&D?

Robin N. Dickson

It’s probably relatively evenly split between the two. Most of the increase of course, is related to the fact that we will have a full quarter of Scopus R&D and SG&A on our books and aside from that we don’t expect to see any significant expense change in the baseline numbers. But, obviously with Scopus on the books the number goes up and I would say that I don’t have the numbers in front of me but I would anticipate that the split between R&D and SG&A taken together is probably relatively even.

Shubho Ghosh – Thomas Weisel Partners

One last question on revenue, on the revenue side basically if you could firstly summarize one more time if you don’t mine the reason for the shortfall in revenue and going forward? Plus, the impact from satellite, if any, from the Charter bankruptcy and I noticed [Equistar] is no longer part of the top 10 customer mix, is there some weakness that you are seeing in satellite in general?

Robin N. Dickson

Well, if you look at revenue in the quarter, our satellite business is actually pretty robust. Yes, I agree we had no 10% customers in satellite including [Equistar] but nevertheless, 23% of our revenue which is a relatively high percentage, came from the satellite segment which I hope maybe underlines the fact that we do have more than one satellite customer, we have a number internationally and I think we’ve seen quite a lot activity internationally in the more developed markets around HD, something that’s maybe taken a little while to come together but we were starting to see the fruits of some of our wins there in the first quarter.

It is true that the first quarter was not so strong from an orders perspective on satellite and that probably bodes for a relatively light second quarter and I think as both of us have indicated we expect to see probably more strength in the second quarter from a revenue perspective coming from cable. I think you had one other question there which I must admit I’ve forgotten.

Shubho Ghosh – Thomas Weisel Partners

In general your thoughts on I suppose revenue shortfall in Q1 below your guidance and in terms of we know of course that you do lower bookings in general shortfall but are there any more specifics you have on that?

Robin N. Dickson

I don’t think so. I think we’ve had some discussion on the call about some of the weakness in certain international markets, that’s been discussed I think on many occasions. That’s certainly one factor. Besides that from a market segment perspective the mix is really all that different from what we’ve seen recently, cable in the high 50s, satellite at around just over 20, telco 20, I mean that mix actually isn’t all that much different. I think it’s perhaps more some particular geographies may be more challenged than others.

Some people have noted too a relatively light start on some of the Edge and access products I think particularly in the optics area where as you know there are hardly any new housing starts and some of the upgrade activity has been postponed and is postponed. But, those I think are the main trends that we’ve discussed in the last hour.

Operator

Your next question comes from Larry Harris – CL King & Associates.

Larry Harris – CL King & Associates

I wanted to delve a bit further in to the satellite area, particularly domestically, there were some major efforts and I know you probably don’t want to discuss specific customers but major effort last year on the part of the two largest satellite operators in the US. Do you think that their pace of spending in 2009 will be less than it was in 2008?

Patrick J. Harshman

I think we don’t want to get in trouble and say too much specific because this is a relatively small customer group you are asking about Larry. Let me answer a little bit more broadly by saying in general we expect spending to be down across the board. I think across all customer groups we’ve seen slower spending certainly in the first quarter, the fourth quarter. Although we’re encouraged by some signs of pick up, I don’t think that Q2 is going to be through the roof and it remains to be seen what’s going to happen in the second half.

Nonetheless, it’s very probably that even more aggressive spending in the last half is not going to cover fully the weakness in the first half so I think across the board we’re expecting spending to be down somewhat.

Larry Harris – CL King & Associates

One other question and that is Amazon launched HD video on demand, YouTube has updated their website, they now have full length videos, has that had a positive impact on your software business? And, is there any benefit if they see greater number of visits to their sites?

Patrick J. Harshman

We think these are extremely important trends for our business. They have not yet manifested themselves I would say in even a revenue in the first quarter or even in a significant way in the second quarter but these changes that you’re alluding to and I put Disney joining Hulu in there as well, are quite fundamental.

There is a lot of activity in the industry now around formulating the appropriate strategic response. We find ourselves – I mentioned earlier I’d say almost an increase pace of strategic and technology discussions, certainly a fair amount of the discussions are around opportunities and plans for addressing or augmenting or in some way related to this almost quickening pace of change in innovation in broadband video. But, to be fair I would characterize it as a middle to longer term growth driver for the business as opposed to something we expect to have impact in the second quarter.

Operator

Your next question comes from Paul McWilliams – Indie Research.

Paul McWilliams – Indie Research

Kind of a couple of questions here, on the Scopus, if we use 2008 as a template, the $75.7 million they shipped then, what percentage of that will be wound down as overlapping business, essentially discontinued but that might be too hard of a word?

Patrick J. Harshman

From a product perspective, maybe a little bit north of 40%. You may recall that maybe a high level, a little over half their business was towards this contribution, distribution space of broadcasters and video content owners, very strategically interesting to us and very complimentary. Maybe a little less than half their business was tired of their service providers, much like our customers but in emerging markets.

For the latter category what we are doing is we’re discontinuing those products. We’re using Harmonics’ products but we’re having that same sales force work in eastern Europe and in Russia and in India and some of the other markets where they were particularly strong.

Paul McWilliams – Indie Research

I had taken from the initial conference call when you guys went through this that there was about a 25% overlap? So, should I be thinking now did you say about 50% would be discontinued?

Patrick J. Harshman

I estimated just a little bit north of 40% Paul. So yes, I regret that I don’t remember that discussion but as we’ve dug in to it I think 40% is about the number in terms of product overlap that we see.

Paul McWilliams – Indie Research

Then I take it from Robin’s comments that quite a bit of the Scopus technology is going to be integrated with Harmonic’s technology and create new product lines. Is that really why you’re not breaking out the Scopus?

Patrick J. Harshman

I think that’s certainly one piece of it. It’s an important piece. I mean we are developing new products, we’ve announced two already that are already hybrids of the two company’s technology.

Paul McWilliams – Indie Research

In looking at Comcast and going back to their three priorities for the year which were all digital, DOCSIS 3.0 and business services. On the all digital, do you know about what percentage of their footprint is already simulcast?

Patrick J. Harshman

Just simulcast but not all digital?

Paul McWilliams – Indie Research

Yes, to where they’re sending on the channel in both digital and analog?

Patrick J. Harshman

Paul, it’s a relatively high number. I don’t know the exact number.

Paul McWilliams – Indie Research

But well north of 50%?

Patrick J. Harshman

I believe so, yes.

Paul McWilliams – Indie Research

So the real opportunity there for you is when they bring in new channels to the space they are freeing up not necessarily encoding the analog that they’re discontinuing?

Patrick J. Harshman

That’s correct.

Paul McWilliams – Indie Research

At one point in time business services was a real focus with your band product division, I believe when you were running that division. Is that still a focus for you?

Patrick J. Harshman

Not so much Paul.

Paul McWilliams – Indie Research

In modular versus integrated CMTS, what are the real advantage of modular beyond being able to put the [SDD] in the QAM with the modular with the EdgeQAM function, is there any other advantages?

Patrick J. Harshman

There are a couple. In some instances there is an efficiency to working with existing CMTS’ in the field. Because, I’ve mentioned previously on these calls, actually a number of the modulars [inaudible] we have done have actually been in the context of DOCSIS 2.0 so I think that’s one driver. The second one is the one that you highlighted which is moving towards a unified Edge.

Paul McWilliams – Indie Research

Are there any advantages though in the ability to dynamically find channels at the modular versus at the integrated [inaudible]?

Patrick J. Harshman

I don’t think there is any relative advantage Paul other than this issue that you just mentioned of working some legacy CMTS. But, going forward channel bonding capability exists in both the integrated as well as the modular architecture.

Paul McWilliams – Indie Research

Last question here, and I really don’t know how to ask this properly but it’s a question that I’ve got to ask and it kind of comes in two parts. If I look at your number and try and take out what I think Scopus is, the miss from midpoint of guidance to Q1 is somewhere in the neighborhood of oh say $8 to $10 million. Is there any drivers, or two drives, there drivers that really change that? That you really had on your mind that you were going to get that just didn’t happen? And, if that’s the case, were they delayed?

Patrick J. Harshman

I think Paul probably the biggest thing is the delta in terms of the bookings we expected, about half of our business we expect is book and burn business and simply we had forecasted, our sales force had forecasted greater bookings than we saw materialize. In generally as I commented earlier, we tend to think that this is delay rather than fundamental changes or strategic shifts by our customers and we certainly don’t think we have loss any market share in the process. But, we simply saw a lower level of spending overall.

I would tell you a second theory point and I don’t want to overstate it but Robin earlier mentioned the fact that we’re still carrying a far amount of deferred revenue in to the second quarter and there probably are a couple of projects that we saw at the beginning of the quarter that were in our deferred revenue category that we didn’t expect to become revenue in the first quarter and for a couple of different regions on a couple of different projects, those projects did not get completed and therefore did not get recognized.

Paul McWilliams – Indie Research

In looking towards the future and I understand why you didn’t issue a revised guidance this time and I appreciate at you wanting to be accurate but in looking towards the future what would be your policy on providing revised guidance either up or down?

Robin N. Dickson

Paul, I don’t we have a policy. This is the first time this has happened to us for quite some time and we don’t have a policy to be honest. It is something we would discuss on a case-by-case basis with our audit committee and our lawyers but there is no formal policy.

Paul McWilliams – Indie Research

I’m going to ask the question kind of again in a different way. If you were to miss by say 5%, do you think under most circumstances on the revenue line that you might most likely revise your guidance?

Robin N. Dickson

Paul, again I think it’s very specific to the context and the circumstances and I don’t like to pad answers to the question. I think it’s highly dependent on the circumstances and different companies have different approaches and I’d say it’s not something that happens to us very often. We certainly take it very seriously and think about it hard but I don’t want to predict what the answer might be.

Operator

Your next question comes from Robert Bobo – Diamondback Capital.

Robert Bobo – Diamondback Capital

I was just hoping we could get a little more color on the Electra 8000 cycle? When you expect to start seeing some booking activity on that product? I know it was just recently launched. And, what the trajectory might look like through the year and if your expectations are markedly differently across vertical and geography for that product.

Patrick J. Harshman

We’re quite excited about the product recently announced. It’s beginning to be tested. I don’t expect a meaningful revenue contribution even in the second quarter but we do expect some more wins. I think I mentioned that we had our first bookings beginning in the first quarter and we’re optimistic that trend will continue in the second quarter and we expect good contribution to the business in the second half of the year.

The two marked verticals where I think the impact will be greatest will be cable. I talked earlier about the very significant impact this can have in terms of spectrum requirements of high definition programming in particular in the cable spectrum and also the impact that we expect in the satellite world where again, bandwidth is always at a premium and we now see an environment where the first high definition impact foreign coders are now getting up to three plus years old and we think that there is a good opportunity to upgrade those coders and delivery significant bandwidth savings over what the space currently occupied by the HD that’s up there on the satellites today.

Robert Bobo – Diamondback Capital

Is there any way to quantify the install base that you think is potentially a target for an upgrade? Obviously, you’ve given us detail over the years regarding your various exposures but I have frankly no grasp on what the install base of current Electra equipment is out there in the field.

Patrick J. Harshman

The number is in the thousands, let’s say the high thousands, certainly not hundreds of thousands. But, I also want to explain that our target market for this product is not only Harmonic encoders but also competitor encoders from an upgrade and replacement point of view.

Operator

There are no further questions at this time. Do you have any closing remarks.

Patrick J. Harshman

Thank you very much. Just to say thank you very much to everyone for participating in this call. We appreciate the discussion and we look forward to talking to you all again very soon.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Harmonic, Inc. Q1 2009 Earnings Call Transcript
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