Harmonic, Inc. Q3 2009 Earnings Call Transcript

Oct.29.09 | About: Harmonic Inc. (HLIT)

Harmonic, Inc. (NASDAQ:HLIT)

Q3 2009 Earnings Call

October 28, 2009 5:00 pm ET

Executives

Robin N. Dickson – Chief Financial Officer

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

Michael Newman – Investor Relations Spokesperson

Analysts

Mark Sue – RBC Capital Markets

Amir Rozwadowski – Barclays Capital

Analyst for George C. Notter – Jefferies & Company, Inc.

[Veebek Aria] – Bank of America Merrill Lynch

Blair King – Avondale Partners, LLC

Greg Mesniaeff – Needham & Co.

Analyst for Hasan Imam – Thomas Weisel Partners

Simon Leopold – Morgan Keegan & Co.

Larry Harris – CL King & Associates

Paul McWilliams – Indy Research

Operator

At this time I would like to welcome everyone to the Harmonic third 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) It is now my pleasure to turn the conference over to Robin Dickson, Chief Financial Officer.

Robin N. Dickson

I’m Robin Dickson, Chief Financial Officer of Harmonic. With me at our headquarters at Sunnydale California are Patrick Harshman, our President and CEO and Michael Newman our Investor Relations Spokesperson. Before we start let me remind you that during this call we may make projections or other forward-looking statements regarding future events or the future financial performance of the company. We 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 than those contained in our projections or forward looking statements. Please note that on this call we will provide you with financial metrics that are 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. I’ll now invite Patrick to give his introductory remarks. Then, I will address the financial details for the quarter before we open up to take your questions.

Patrick J. Harshman

Today we announced third quarter results that demonstrate Harmonic continuing strong position in the market place and in particular very encouraging sales growth among our expanding base of international customers. Compared to last year we do continue to see cautious customer spending and we’ve adjusted and focused our business execution accordingly. We’ve continued to carefully manage our operating expenses while at the same time we’ve successfully continue to drive our strategy of aggressive technology leadership across a range of new video applications, customers and geographies.

Geographic expansion and growth of our customer base has been a clear strategic priority and we are excited by our recent progress. Having completed the full integration of the Scopus business, we began to see real sales synergy benefits with both an expanded product offering and strength in local sales presence. Our third quarter business in Europe rebounded sharply from what we saw in the first two quarters of the year. Our business in Latin America, is firmly on tract for year-over-year growth and our third quarter bookings in China and India were both up significantly in fact, well above the levels seen during any prior period over the past several years.

Whiles our strength and local sales presence has certainly contributed to our success in these international markets, the impact of our industry leading technology has also never been more important. The move to high definition video is now becoming a key market driver around the global and our high definition encoder platforms continue to gain strong traction across markets. This was certainly the case in recently announced wins with Deutsche Telekom and Sky Brazil as well as with new wins in China where HDTV is just now being introduced.

We’re working closely with a number of our existing cable, satellite and telco customers who use our new Electra 8000 technology not only for adding new channels but also to more efficiently compress existing HD channels. While our domestic cable customers have been cautious about capital spending this year, our newest generation NSG EdgeQAM continues to gain important market share in video-on-demand, switched digital video, modular CMTS and new IPTV over cable applications.

Looking ahead we see compelling opportunities in each of these application areas. Of course, all these new video services are demanding bandwidth and our cable customers also continue to respond positively to our new superlink WDM technology for provisioning more bandwidth in to the cable network.

Also during the quarter we introduced our new MediaPrism conversion suite for multi screen video delivery to iPhones and other mobile devices and PCs. We’re very encouraged by recent progress with this new solution set. We’ve been an important partner for two large customers who recently deployed new mobile video services and we’re actively engaged in several other high potential mobile video trials. While these mobile video solutions will not represent a significant portion of our revenue in 2009 our sustained investment in technological innovation for mobile video services and growing service provided confidence in the viability of mobile video business models causes us to be optimistic about our growth opportunities in this emerging space.

While we’re still walking before we run with this new suite of software applications enabling mobile video, I do want to highlight our more general success in growing our software and services revenue which is up 15% through the first three quarters of 2009 versus the first three quarters of 2008. In this challenging economy this strong growth is an impressive testament to our focus and success growing new revenue streams from services and software applications.

So, while global spending continues to be softer than a year ago, we remain convinced that by continuing to innovate, by continuing the strength in our competitive position with a growing base of global customers and by keeping our internal business execution firmly on track, we’re positioned extremely well for growth in 2010 and beyond.

I’ll now ask Robin to cover the financial aspects of the quarter.

Robin N. Dickson

Today we announced our results for the quarter ended October 2, 2009. For the third quarter we reported net sales of $83.9 million, up from $81.3 million in the second quarter of 2009. Our lower year-over-year sales reflected continuing lower capital spending by most of our customers around the world. However, during the third quarter of 2009 we saw sequential increases in quarterly revenue and bookings from our international customers.

On our earnings call three months ago we noted a better tone in Europe which started late in the second quarter and this positive trend has continued in to the third quarter. More recently, as Patrick indicated, we’ve seen an improved environment in some of the larger emerging economies particularly in China and India. International sales represented 52% of revenue for the third quarter of 2009 up from 43% in the previous quarter and 39% in the third quarter of 2008. We’re encouraged to see this growing international activity and additional penetration of new customers. This is a key part of our strategy and is due at least in part to the new sales channels and products we gained with the Scopus acquisition.

By market segment cable customers accounted for 56% of revenue, satellite 21% and telcos and others 23%. This translates in to sequential growth in both our satellite and telco businesses. But, at the same time we saw a sequential decline in revenue among our cable customers. This third quarter decline may seem surprising following the strong performance of the cable market in Q2 and we think it’s mainly due to the unpredictable nature of order timing from quarter-to-quarter as we’ve now seen improved order input in October from several key cable customers.

In the third quarter our largest customer was once again Comcast representing 15% of total revenue while EchoStar contributed 10%. It’s also worth noting that for both the third quarter and year-to-date our top 10 customers represented less than 50% of our revenue showing that our international growth and the Scopus acquisition are helping us to meet our strategic goal of customer diversification.

By product category Edge and Access products represented 39% of revenue for the third quarter. The video processing also 39% and software service and other 22%, essentially unchanged from second quarter. In the third quarter of 2009 our gross margins were somewhat lower than we expected. Primarily due to a combination of product mix and some supply chain factors. For example in the Edge and Access category we saw slightly lower sequential revenues from our Edge devices compared to the previous quarter offset by improved revenues in optical Access products which carry lower margins.

Within the EdgeQAM product line we saw increasing deployments of our new scalable multi-port Octal platform. As with previous generations of EdgeQAMs the new chassis itself carries lower initial gross margins. However, as more of the QAM ports are activated in the future we expect to see a more favorable margin impact at that time.

We also had a more back end loaded quarter than we expected. In addition to the usual forecasting challenges that this brings, we ran in to some lead time fluctuations in our supply chain. As many other companies have experienced, some component suppliers had run down inventories in response to the recession and had some difficulty in ramping up quickly to meet improving demand. While we were able to overcome most of these supply issues without any serious customer consequences we incurred substantially higher freight costs, mainly as a result of expediting air shipments both within the supply chain as well as directly to end customers.

Until recently our non-GAAP gross margins had been holding around 50% driven by the continued success of new products and solutions, our sourcing strategy and ongoing cost reduction efforts. While we don’t expect to get back to these margin levels this year, we do expect our gross margins to improve as the short term supply chain issues are resolved and our software mix and overall volumes increase over the longer term.

We continue to be pleased in our discipline in managing operating expenses which rebound very slightly from the previous quarter at $32.7 million. Having completed the integration of Scopus in to Harmonic, we’re pleased that the anticipated cost synergies have now almost been fully realized. We ended the third quarter with 849 employees, up by seven from the end of Q2.

Our GAAP net income for the third quarter was $2.6 million or $0.03 per diluted share compared to $12 million net income or $0.12 per diluted share the same period of 2008. GAAP results for the third quarter of 2009 included modest restructuring charges related to the recent acquisition and continuing integration of Scopus. Excluding these charges and non-cash accounting charges for stock-based compensation, the amortization of intangibles and tax adjustments, non-GAAP net income for the third quarter of 2009 was $4.5 million or $0.05 per diluted share compared to $15.9 million or $0.17 per diluted share for the same period of 2008. The non-GAAP net income includes a tax charge of 35% in 2009 compared to a nominal rate in 2008.

We continue to maintain a strong balance sheet. We ended the quarter with cash, cash equivalents and short term investments of $253 million. We were in a strong position to pursue further acquisitions or other initiatives to achieve our strategic goals. Our receivables increased to $70.3 million at the end of the third quarter up from $64.5 million at the end of the second quarter. Our DSOs were 77 days, also up from 72 days for the previous period. The higher DSOs reflect the back end loaded quarter with a high proportion of sales coming in September as well as a richer mix of international sales where payment terms are typically longer.

Our inventory was $30.7 million down approximately $3.5 million from the end of the second quarter and down about $7.5 million from the end of the first quarter. The reduction in inventory levels and the improvement in turns reflects our success in integrating and streamlining Scopus production and procurement processes. Finally, our capital spending was $2.3 million in the third quarter and we expect our cap ex to be approximately $8 million for the full year.

Turning to the outlook, the fundamental trends and the competitive dynamics that have been driving our business remain in force but are still muted considerably by the global economic slowdown. While we won’t return to the annual sales levels of 2008 in this calendar year, we have seen sequential improvement in revenue during both Q2 and Q3. We entered the fourth quarter with a total backlog in deferred revenue of approximately $70 million. Q4 of course is a short quarter in part due to the holidays and in part because many of our customers have imposed deadlines for product deliveries in advance of the end of the year.

While the short quarter and lingering component supply problems pose some distinct execution challenges, we believe that Q4 revenues will be at approximately the same level as Q3 within a range of $80 to $86 million. We expect our non-GAAP gross margins for the fourth quarter of 2009 to be in a range of 47% to 49%. While some of the factors which affected gross margins in Q3 may repeat to some extent in Q4 we believe our longer margin term margin trends are positive as a result of our new product introductions and the growing influence of software and services. We believe our product strategy is on the right track and our medium term gross margin target continues to be 50%.

With respect to operating expense we are pleased with our progress in cost control and executing on the cost synergy targets for the Scopus acquisition. We expect that our non-GAAP operating expenses for the fourth quarter excluding charges for stock-based compensation and the amortization of intangibles to remain relatively flat or slightly up from the third quarter in a range of $33 to $34 million.

In summary, while our business in the third quarter had only modest sequential growth, it does show that the momentum is gradually heading in the right direction. We are well placed with 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. We continue to be successful at penetrating new international sales opportunities and demonstrating that our acquisition of Scopus is starting to get real traction on the sales front.

By investing in technology leadership and supporting our diversified and growing customer base, we believe that we will further strengthen our competitiveness and expand our global market presence in 2010 and beyond. This concludes the formal part of our presentation. Patrick and I are now pleased to open it 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

I’m still trying to understand why the actual results were different than those projected. Was there a longer evaluation cycle with your customers in the US? Was it a broad based weakness in North America cable or was it just Comcast? And, did you recover some of the deals that had slipped in to this current quarter?

Robin N. Dickson

Mark, our guidance for the quarter was $82 to $88 million and we are comfortably in that range, admittedly slightly below the midpoint but we’re comfortably in that range. So, I think from a revenue perspective if it was any surprise it was perhaps the strength of the international business which was very encouraging and admittedly some relative weakness of the domestic customers.

Mark Sue – RBC Capital Markets

If I take $4 million from the high end of your guidance can I say $2 million was due to North America being down sequentially and another $2 million related to supply chain? Is that kind of how we can look at it?

Robin N. Dickson

As I said in the prepared remarks we don’t really believe that we missed any shipments as a result of supply chain problems. It certainly caused us some additional costs which are reflected in the gross margins but from a revenue perspective I don’t want to give the impression that we saw that as a limitation on the top line. I think you’re right to observe that domestic sales were as I said, relatively a little bit weaker than we expected but commensurate with that, international sales were I think on the other hand a little bit stronger than we expected.

Mark Sue – RBC Capital Markets

Then by all accounts the macro seems to be better in North America, cable cap ex seems to be healthy. Is there something going on from a technology shift point of view? Are they looking at other options when it comes to deployments? Any color there on North American cable would be helpful.

Patrick J. Harshman

We’re not seeing any meaningful change in the technology or competitive landscape in cable. We believe that our technology and competitive position is as strong as ever. The response to our newest products has been quite positive and we’re quite confident we have not lost any market share and in some instances we believe we’ve gained market share. I think we’re still in the middle of the reporting season and there’s a number of customers coming at this market with exposure to the US cable market but at least from what little I’ve seen is that we’re somewhat unique that our third quarter revenue was up and I don’t think people are pointing to and I have not seen any indication of a tremendous strength in US cable in general in this third quarter. We feel that we still have just seen somewhat cautious spending from US cable operators.

We have continued to gain we think our fair share or somewhat more of what spending was there and we’re really pleased that we’ve been focused on and executing on a more general diversified customer model that gives us exposure to a lot of other markets and customers around the globe.

Operator

Your next question comes from Amir Rozwadowski – Barclays Capital.

Amir Rozwadowski – Barclays Capital

Just trying to reconcile your commentary about the improved bookings in sort of the month of October and the thought process of perhaps just slight sequential growth or sort of in line revenues for the fourth quarter. How much of that is being impacted by some of these component supply problems and how should we think about sort of when will you be able to move past those supply problems?

Patrick J. Harshman

Let me try to take that Amir. I think perhaps we’ve left the wrong impression. We wanted to point to some of the supply chain challenges we had in non-linear demand throughout the third quarter as really trying to give you some granularity as to where some of the gross margin went in the third quarter. While there still may be some issues in the fourth quarter we see that as largely a third quarter event.

I think in any event, that is I think distinct from customer demand. We did acknowledge that we’ve actually seen some pretty good order activity from some of our cable customers at the beginning of Q4 and frankly, we just chalk that up to the vagaries of timing of certain projects and we’ve seen some projects kind of moving forward here in October. I think that’s certainly an encouraging sign but we don’t necessarily take it as an indication of what’s going to happen for the remainder of the quarter.

In fact, we don’t think it’s going to be a down quarter from a demand point of view but on the other hand I’d say our view is somewhat cautious that it’s probably not going to be dramatically different from a demand perspective than the third quarter.

Amir Rozwadowski – Barclays Capital

Okay, so the thought process is more along the lines that you’ve seen this pickup in certain take rates but if we are to interpret your guidance certainly it doesn’t seem to carry over that pick up in take rates in to your guidance for the fourth quarter?

Patrick J. Harshman

I think that’s right. I think by highlight the early Q4 activity I think we’re trying to say we don’t read in to and we wouldn’t suggest you read too much in to the fact that domestic cable was light in Q3. We had a quite strong bookings quarter in Q2 and we’ve seen some early activity in Q4. We chalk it up a little bit more towards just the actual timing and ebb and flow of spending around projects that we’re positioned for. That being said, I think given the overall tone of this year and the cautious approach to spending, we’re not expecting this quarter, unlike some in past years, to end with a big bang.

Amir Rozwadowski – Barclays Capital

Lastly if I may, I was wondering about sort of the reception on the Electra 8000 and some of the projects that you have going on there? It seems as though you’ve already tapped some service providers that traditionally may have not looked at that product but are now looking to work with the product and I was wondering if you could give us a little bit of color there?

Patrick J. Harshman

Well, we continue to be very excited about the product and I highlighted a couple of releases. I think one of the really neat things about the product is within one hardware platform we’ve brought together top notch HD encoding as well as SD encoding or a mix of the two both mpeg2 and mpeg4. What that means is it’s the same product that we’re working with our top tier direct-to-home satellite operators with who are delivering services in mpeg4. The same product is also being put to work in cable environments where today it’s going to be mpeg2 and in a very dense fashion, we’ve been talking about four HD channels in one so called analog channel slot.

I think in addition to the video quality and the compression efficiency today, the other thing that the product brings to cable is a migration path to mpeg4 which I think is increasingly viewed as something that’s coming down the road by the cable industry. Of course, the product is also seeing good traction in telecom. I highlighted a win that we were able to publicly disclose and discuss which is with Deutsche Telekom. We’re pleased about that and more generally we see this as a great product for IPTV telecom providers and we’re getting good traction in that space as well. I think that’s part of the strength that you see in the telco and other segments this past quarter.

Operator

Your next question comes from Analyst for George C. Notter – Jefferies & Company, Inc.

Analyst for George C. Notter – Jefferies & Company, Inc.

I guess I was curious, is it safe to say that your cable business at this point is the vast majority of that is Edge and Access at this point? Is there any video processing, I guess so I can get a general feel for the split between video processing and Edge and Access in there?

Patrick J. Harshman

We don’t break it out exactly that way but I think if you do look at our numbers you can see cable is quite a bit more than just Edge and Access. I think Edge and Access we said was 39% of our business. That’s 100% in cable but of course cable was responsible for 56% of the business so obviously another approximately 20% of the revenue was non Edge and Access business with cable.

As discussed in the last call, that spans a range of technologies probably most prominently encoding in both high definition and standard definition. Looking forward I also highlighted in the prepared remarks mobile video. We certainly see a lot of cable interest in mobile video, video delivery to PCs, that’s becoming an interesting area for us and on-demand is also an area o revenue contribution and we believe growth in the cable space.

Analyst for George C. Notter – Jefferies & Company, Inc.

I guess as a follow up you show the cable operators doing a lot of work on the analog [inaudible], obviously Comcast has been very vocal about that and DOCSIS 3.0 I guess is another strategic area. I’m just wondering, if at some point do we see an inflection point on the video processing side of the business for cable? Could next year be a big growth year for cable as they expand their channel counts? It just seems to me that cable operators are still pretty far behind in terms of their widely available HD channel counts or is there a reason to believe just given that maybe their doing less decoding and reencoding that perhaps this is sort of going to be a trickle as a sort of slow rule for video processing equipment sales to cable?

Patrick J. Harshman

I think it remains difficult to predict exactly when but I think there’s no doubt there’s a couple of areas where you’re going to see substantial investment. I think it’s very clear, this is an over generalization but the industry is still trailing what direct-to-home satellite is doing in HD. I think a big part of the all digital programs you mentioned is really clearing out bandwidth for more aggressive deployment of high definition video both broadcast as well as on demand and we think that obviously drives opportunities for several different of our product lines.

Certainly another part of that is DOCSIS 3.0 and one of the things that will happen there is IPTV and as I mentioned a moment ago we’re also excited about the associated video opportunities around that. I think I’d hold back from kind of predicting exactly when and if it will happen in kind of a big bang fashion that you’ll see a wave of investment. But, there’s no doubt that the reason for provisioning all this bandwidth whether it be native end peg bandwidth with all analog reclamation or pinning up more DOCSIS capacity, it’s really all in the end so that more video can be delivered over the network and we think it’s clear there’s going to be tremendous growth opportunities for companies like us delivering end video processing capability.

Operator

Your next question comes from [Veebek Aria] – Bank of America Merrill Lynch.

[Veebek Aria] – Bank of America Merrill Lynch

Is it fair to think that for your cable customers DOCSIS 3.0 upgrades are becoming a bigger priority than just expanding the number of HD channels? I’m trying to see if the trends you are noting is because the spending is shifting elsewhere or is this just sort of a temporary cap ex type issue that could be resolved as their spending resumes?

Patrick J. Harshman

I think the DOCSIS 3.0 clearly has been a key priority and I think it’s clear the spending there has been good. I think probably the number one competitive battle in the broader landscape when you think about not only direct-to-home satellite but in particular about telecom operators entering the video space, I think the number one battlefield today is high speed data. So, it’s not surprising to us to have seen relative strong cap ex focus on DOCSIS 3.0.

However, we think in the history of our experience at least with cable operators is that you do see waves of investment and waves of focus. We were just talking about a moment ago, we believe that focus on more HD, focus on expanded VOD platforms and more generally we think the industry is taking strong note of the cablevision court victory and we think there’s going to be a lot of focus on network based PVR time shifted, time delayed TV pushing video to other platforms once this DOCSIS infrastructure is in place.

As I said a moment ago, I think it’s premature to comment on the level of overall spending. We believe we’re going to see spending slosh back more towards the video capability that will actually utilize a lot of this bandwidth that’s been provision in the last year to 18 months.

[Veebek Aria] – Bank of America Merrill Lynch

Next, on the operating expense side, do you see any opportunity for cost cuts or do you think that op ex will probably stay around current levels for the next several quarters?

Robin N. Dickson

It’s our intention to keep it very flat over the next few quarters assuming that there’s no major change in the general macroeconomic environment. But, certainly for the foreseeable future I think flat is the really the operating term and operating assumption.

[Veebek Aria] – Bank of America Merrill Lynch

Also, I think on the positive side, you guys still have a very solid balance sheet and I think right now it’s over half of your market cap. Why not take advantage of the weak stock price to do a buy back or do you think there are other accretive uses of your cash?

Robin N. Dickson

Well, we’re always reviewing opportunities to use the cash. As we’ve said many times before, the prevailing sentiment here is that we use it as you say for accretive opportunities and we’re certainly spending a fair amount of time and energy looking at a number of varied possibilities and that is certainly our preference is to use it for M&A purposes or similar.

[Veebek Aria] – Bank of America Merrill Lynch

Just one final question, let’s assume that next year there isn’t a major recovery and I know you’re not guiding for 2010 but let’s say sales only grow in the mid to high single digits at best. Do you think you can stay cash flow positive even in that kind of revenue trajectory?

Robin N. Dickson

Yes, I believe so. If we see even modest sales growth and we do as we said we would which is continue to contain our operating costs, I don’t see why we wouldn’t be generating at least a modest positive cash flow.

[Veebek Aria] – Bank of America Merrill Lynch

There’s no pricing pressure or any other thing that could impact your gross margins? I guess that’s the way I should have asked the question?

Robin N. Dickson

Well, pricing pressure is a constant I think in some product areas. As we all know there is over time pricing pressure. It’s often related to higher unit volumes at the same time and of course in our case we are usually able to keep ahead of the technology curve and keep introducing new and improved products with additional features and so on, that’s how we compete. I guess I would say that I don’t see anything extraordinary in the pricing environment.

Patrick J. Harshman

I think that’s right.

Operator

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

Blair King – Avondale Partners, LLC

I have just one question, returning back to the gross margin topic, Robin I think in the recent quarters with the gross margin being depressed one of the reasons that you’ve cited for gross margin compression has been volume related. Now, it appears that the volume is starting to improve and I understand you’ve got some short term issues you have to deal with but as we think in to 2010 should we still be thinking about gross margins in the 49% to 50% range with your goal of potentially even exceeding 50%?

Robin N. Dickson

Yes, I think that’s reasonable given some improvement in overall volumes. As Patrick highlighted the mix of our product is changing, gradually but changing positively in a direction of higher margin software and services products. Again, hopefully with the resolution of some of the shorter term issues like for example we saw in the third quarter with freight, yes I’m comfortable as I said in the prepared remarks that we should be able to get back to in the vicinity of 50% in the medium term which I would certainly define as next year.

Operator

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

Greg Mesniaeff – Needham & Co.

When you look at the US business and kind of the softness there can you comment on the EdgeQAM environment in the quarter? We have seen obviously a fairly robust DOCSIS 3.0 upgrade level activity going on at the CMTS and various infrastructure points and I can’t help but wonder that there clearly has been some activity at least in the EdgeQAM area particularly with some of the MSOs. I’m just kind of wondering has there been any kind of changes to the previous robust profile that you’ve seen in that activity and what has changed?

My second part of my question is if you could maybe give us some color as to the initial uptake on the Electra 8000? I know you’ve been in some trials and I’m kind of wondering what currently the pipeline for that looks like?

Robin N. Dickson

First of all on the Edge and Access our revenues in absolute dollars from Edge and Access were actually up in the third quarter over the second quarter, very modestly but nevertheless were up and significantly up over the first quarter. We don’t see any weakness or concern there with respect to Edge and Access. One other thing perhaps we didn’t point out but you may remember, in the second quarter we had a fairly substantial chunk of revenue that came in to the quarter as a result of completing a major project we had been working on.

That was a cable customer and in fact, if you were to just take that out of the numbers in Q2 and as perhaps an extraordinary type item then in fact the third quarter from the cable market perspective of the domestic perspective is really pretty flat with Q2. So maybe you’re over doing perhaps the suggestion that US sales were weak. This is just one of the things that happens with some of the vagaries of revenue recognition and I think if you look at the underlying trends and were to either apply that over a number of quarters that the project took or just take it out of the numbers completely then I think trends look a lot more reasonable than the absolute numbers might suggest. I think the second part of your question was around Electra 8000. I think Patrick has already commented on that to some extent but I’ll pass that question over to him.

Patrick J. Harshman

The 8000 continues I think get an excellent reception domestically, internationally and across the different customer segments. We started shipping the product in earnest several months ago and it’s definitely flowing. We have the product driving live systems today and we have a healthy pipeline of engagements, trials, demos and in discussions. We continue to be quite excited about that product and we think it’s really going to help us maintain and perhaps even extend our global market share lead in the encoding space.

Greg Mesniaeff – Needham & Co.

Patrick being that that product is both mpeg2 and mpeg4 do you foresee the opportunities for the product as more of a satellite refresh sale or more heavily skewed towards the eventual change over from mpeg2 to mpeg4 among the cable operators.

Patrick J. Harshman

I’d say the opportunities are comparable Greg. The encoding efficiencies are such that they do provide on the mpeg4 side anybody, satellite or telco for example who’s deployed previous generation HD, this is an opportunity to really claw back some significant bandwidth at the same video quality by using much more efficient compression. At the same time I think and the I think the industry thinks that there is still a lot of HD work to be done in the cable environment. While I think the fact that the product can transition from mpeg2 to mpeg4 is a nice added feature. I think the thing that is really selling it and getting our cable customers excited is the fact that it’s a fantastic quantum leap forward in mpeg2 compression efficiency. Just in an mpeg2 cable world I think customers are looking at it and realizing how many more HD channels they can fit in a fixed slot of bandwidth and we see that as a substantial opportunity as well.

Operator

Your next question comes from Analyst for Hasan Imam – Thomas Weisel Partners.

Analyst for Hasan Imam – Thomas Weisel Partners

I was just wondering do you break down at this point the percentage of revenues from Scopus? And, also what is the margin impact on Scopus? Has it been a little bit of a drag to overall margins and has that kind of contributed the margin weakness in Q3?

Robin N. Dickson

We don’t track Scopus either products or customers separately. There’s just too much overlap and we’ve integrated Scopus completely in to our existing organization so it is not being run as a separate unit. I think the best thing I can point to is the growing momentum we seem to have in international sales and while clearly some of that can be attributed perhaps an improving economic environment at least in some countries and maybe a little bit more customer confidence, there’s no question in our minds that some of it can be attributed to the fact that we’re now getting some significant traction from the Scopus sales channels on some of the products.

To your margin question, there’s really no significant difference and I certainly wouldn’t want to attribute any margin fluctuations to the effect of the Scopus products. As you may remember from their standalone days, Scopus’ margins were actually very comparable to our margins and we’ve seen no fundamental change in that relationship.

Analyst for Hasan Imam – Thomas Weisel Partners

In that case if I were to look at the reasons for the gross margin weakness this quarter you mentioned product mix and supply chain issues regarding freight costs, could you perhaps quantify, give a percentage if you will to what caused it? What percentage came from product mix versus supply chain freight?

Robin N. Dickson

Well, if you look at our second quarter and take out that large project that I mentioned earlier that was a very specific low margin project in Q2, if you take that out our adjusted non-GAAP gross margin was 48%, this quarter it’s 47%. So, first of all in our view we’re not talking about really material differences. Clearly, that’s not the direction we would have preferred to go but we’re talking about 100 basis points. I’d say roughly, and this is very roughly, you could attribute perhaps a third to half of it to the freight issue and most of the rest of it to the various product mix issues that I mentioned earlier.

Operator

Your next question comes from Simon Leopold – Morgan Keegan & Co.

Simon Leopold – Morgan Keegan & Co.

Just a quick follow up on the discussion about gross margin issues, is you’re international business typically a similar or lower gross margin than your US?

Robin N. Dickson

I’m not sure there’s really any major differences. I mean clearly in some parts we see higher margins but we’re also working with some very large customers and also to some degree with distributors an integrators as well where the margins can be lower. I would say broadly speaking, and we don’t break it down but broadly there is no significant difference between domestic and international.

Simon Leopold – Morgan Keegan & Co.

I think I recall in the March quarter you talked about the relative strength of the dollar had pressured some of your international sales and that was one of the reasons for a little bit light sales in the March quarter. I’m just wondering if particularly the improvement we’re seeing in international this quarter and the strength there is because of the relatively weaker dollar?

Robin N. Dickson

I don’t remember the currency charts exactly off the top of my head but I think the effect of the dollar weakening has been most pronounced in recent weeks so I don’t think it had an enormous effect on the quarter but I do grant you that theoretically you’re right and it’s possible that we could see more favorable effects in the fourth quarter on the revenue and the gross margins.

Simon Leopold – Morgan Keegan & Co.

Then just looking out to the fourth quarter, what kind of assumptions in terms of your segments, video processing, Edge and Access software, what kind of assumptions are you making for mix shifts and customer shifts versus the third quarter?

Robin N. Dickson

Nothing too dramatic. I think we see a fourth quarter profile that isn’t too different from Q3. It maybe gets a little closer back to 50/50 domestic international but we don’t see substantial changes in any of the breakdowns that we provide to you either products, or geographies or markets.

Simon Leopold – Morgan Keegan & Co.

I guess one aspect that is kind of puzzling to me is the third quarter is usually a good quarter for cable spending and then seasonably down in the fourth quarter. So I guess what I’m struggling with is okay, cable was weak for you guys in the third quarter, should it be up sequentially in the fourth quarter? And if so, why the non-seasonal pattern?

Robin N. Dickson

I think it’s mainly just order timing. I think customers in general, and this is not a particularly related to cable but I think it’s certainly true of many cable customers that their projects are being very carefully reviewed and only released to purchase orders after some pretty tight scrutiny. And I think we’ve seen some of these process at work all year. Sometimes things happened, sometimes they don’t and some of the things that do happen even later than either we think or even the various divisions and systems think.

That may not sound like a great explanation but I think it’s the best one that we’ve got. I’d also say again don’t forget that from a revenue perspective we did have that big project come in Q2 that was really taken way back in 2008 and so I think if you adjust the revenue for that or at least make some allowances for that then you’re really looking at a cable segment that was really a lot more like flat than weak or substantially down.

Simon Leopold – Morgan Keegan & Co.

The project in Q2 was that primarily Edge and Access, that’s EdgeQAM business?

Robin N. Dickson

No, it was more on the video processing side.

Operator

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

Larry Harris – CL King & Associates

I have a few questions but they’re not specifically related to the quarter. First, the cable operators are certainly more interested in IP video and I was wondering if there are specific products that you have that could benefit from that deployment and if there are other products where you might have to upgrade or redesign based on an IT type transition?

Patrick J. Harshman

There’s a number of opportunities at IPTV in the cable environment presents us. I think before I get in to products I’ll just highlight the fact that we’ve been so successful and active in IPTV in the telecom domain that I think the company experience and expertise before we even get in to a product I think puts the company in a particularly good position. In no particular order I’ll start with the EdgeQAM and some of the unique IPTV architectures that are so called direct to edge solution based on EdgeQAM enables.

You may recall last quarter we announced what we still believe to be the largest live deployment of IPTV in the world with SK Telecom in Korea based on our Edge technology for delivering IPTV. The first area of opportunity is in the Edge. Then behind that is variations of more traditional video processing and some of the new software capabilities. I highlighted our MediaPrism suite of solutions which is really designed to deliver both broadcast and on-demand video to a variety of different screens from everything from a television to a PC to a mobile device.

As our customers are thinking about IPTV I think that’s really a big part of the promise of it. They’re not going to use IPTV just to recreate the existing service but in fact to deliver a richer service that is going to target multiple devices. I see our whole range of capture, start over, streaming capabilities and of course transcoding capabilities to render incoming video stream in different formats in different devices. There’s a range of technologies there and all together we think it constitutes a really exciting opportunity for the company.

Larry Harris – CL King & Associates

The other question that I have, it’s been publicly reported that your EdgeQAMs are being installed in New York City in conjunction with CISCO CMTS equipment for TimeWarner Cable. I was wondering if as we look ahead over the next 12 months or so that you could see a significant increase or an increase in demand for EdgeQAMs as part of a modular CMTS solutions?

Patrick J. Harshman

First, I want to emphasis that you haven’t heard that from us I don’t think specifically about New York City. I think it’s no comment on New York City. But, more generally I think modular CMTS opportunities in general and in the context of the CISCO system in particular was a strong component of the EdgeQAM revenue we saw in 2008. We continue to be active and quite successful this year and we continue to see it as an important element of the broad EdgeQAM opportunity that we have in front of us.

Larry Harris – CL King & Associates

Do you think it can increase?

Patrick J. Harshman

It certainly can. I think it remains to be seen. I don’t want to oversell the modular CMTS architecture. I think it make sense for some network providers and not for others. I think the jury is really still out on high widely the architecture will be adopted. We think to the extent its adopted we’re in a great position but I think we need to wait a bit longer and see exactly what the penetration will be. I think as you point out there’s a number of leading operators that are increasingly appreciating the advantages of the architecture.

Operator

Your next question comes from Paul McWilliams – Indy Research.

Paul McWilliams – Indy Research

I’m trying to put a finer line on some things here and rather than look at the sequential as you have through most of this, let’s take a look at the year-over-year. Year-over-year revenues are down $7.6 million and I understand m any things have changed in the economy worldwide. Edge and Access is down $10.3 million so more than 100% of your total down. Cable is down $10.8 and the US is down $15.4. This would lead me to believe that had it not been for Scopus we would see a fairly significant year-over-year total down. I’m trying to put a finer line on what shareholders have gotten of value in this Scopus acquisition. Can you give me something there? I realize you don’t track it as a separate line item but you have to have some degree of feel for it. And, is it mostly or all video processing, am I understanding that correctly?

Patrick J. Harshman

Yes you are. I think you have yourself just put a line under it. I think you can take a look at it, the relative strength of the video processing number compared to the Edge and Access number to which there is no contribution from Scopus. I think that difference there speaks to itself and I think it’s clear from a product perspective the contribution of Scopus is clear. As we said as well in our prepared remarks, you look at the strength in international and while it’s simply not possible to finely attribute this win in India, this win in China, this win in Western Europe is attributable or not because we’re selling in general this customers a mixed bag of products from Harmonic and what was Scopus, I think if you look at it in aggregate, which we do, there’s a clear marked strength there that although international sales has been a focus of ours I think it’s quite clear that we need to attribute a significant portion of that strength, particular in the emerging markets to what Scopus has brought to us.

Paul McWilliams – Indy Research

Carrying that thought forward than Edge and Access is down then year-over-year roughly 24% so would it be anywhere near accurate to say that had it not been for Scopus aggregate might be down close to that 24%?

Patrick J. Harshman

I don’t think it’s entirely unreasonable Paul. I think we have a somewhat concentrated collection of large cable operators. Our video processing products in general go to a more diverse array of customers and is inherently more international. I think that even without Scopus I think we would probably see our video processing numbers not quite as effective just because the statistics work better and we’d be benefiting in any event from some of the recovery we’re seeing in some international markets. But, with that being said, that’s maybe a secondary consideration and I think your gross analysis is not unreasonable.

Paul McWilliams – Indy Research

Another large US provider to the cable market reported this week, without mentioning names, they reported their revenue down 7.4% year-over-year and they’re if you had to classify them more Edge and Access orientated as a percentage of revenue and they’re also more integrated CMTS versus your modular CMTS and they spoke directly of great successes with CMTS. Are you losing anything in your Edge and Access? Are you seeing more deals going integrated than going modular? I’m trying to understand what’s going on here in these dynamics and I want to get a fair understanding.

Patrick J. Harshman

For us the so called modular CMTS, last there and this year represents less than 105 of our Edge and Access business so it’s an interesting and somewhat exciting new application but I think in scale we’ve been consistent about this, it certainly is dramatically smaller than the Edge contribution from VOD, the [HFC] business and perhaps switched video and IPTV in aggregate. Look, the CMTS business has been a great business to be in. I think it’s held up relatively well and we certainly think it’s a great place to be and that’s not to take anything away from the companies who participate directly in that space.

I think if you look at companies, other companies out there who have reported or have provided forecasts for the quarter kind of largely serving the cable industry who are not in CMTS, I think you see some much more significant changes to the overall revenue profile. I think from that perspective what we have seen in our view is not at all out of synch with what we’re seeing and hearing from the broader industry about relative cable spending and/or the focus of that spending.

Paul McWilliams – Indy Research

Backlog and deferred revenue, I believe it ended last quarter at $75 million, is that correct?

Robin N. Dickson

I think it was around $73 Paul.

Paul McWilliams – Indy Research

So it’s down just slightly?

Robin N. Dickson

Very slightly, yes.

Paul McWilliams – Indy Research

You mentioned your op ex you hope to hold that flat going forward for a while now. When do you expect that would be in the mid 30% of revenue 35%ish which is kind of the target I believe you’re going for?

Robin N. Dickson

Well, I think that is function of how things turn out over the next few months. I think our view at the moment is that the business has at least stabilized and is showing certainly in international in particular some signs of improvement. I think if we continue to see that pattern then our inclination will be to allow the revenues to grow, keep the expenses as flat as we can and allow things to come back in to line naturally if you like.

Now clearly, if that does not happen then and we see continued signs of weakness in our customer base and customer spending well in to 2010 then I think it would be not unreasonable to look at the expense base and consider whether that’s still the appropriate level. But again, I’m optimistic that we’re going to see the former rather than the later and that some point in 2010 things are going to come back more in to line with our traditional typical operating model.

Paul McWilliams – Indy Research

A real quick one here, have you had any senior sales or marketing executives depart during this year?

Patrick J. Harshman

No.

Paul McWilliams – Indy Research

The last one here and this is general, Patrick you talk very clearly and very optimistically about some of the things that are going right and I agree. I like what you are doing in software, I like what you are doing in video processing, I think you’re probably best to [inaudible] and that’s critical going forward but in light of the aggregate results that we’re working with here today, what’s not going right, what’s weak?

Patrick J. Harshman

Paul, I don’t want at all give the perception that we think we do everything perfectly and right and there aren’t any points of weakness. That being said, the big difference between this year and last year is our customer spending. Now, that doesn’t mean if this is the new normal we don’t need to adjust and we’ve adjusted quite significantly I think and we’re prepare to continue to adjust to the market. That being said, we don’t feel as though we’ve lost any significant market share, our customer spending as just simply been down. In fact, we’re actually pleased in those areas where we’ve been able to grow despite this by expanding our customer base and by getting in to new product lines whether they are internally developed software solutions or some of the contribution distribution products that we acquired from Scopus.

Paul McWilliams – Indy Research

Generally speaking are you more optimistic today than you were at this time last year?

Patrick J. Harshman

Frankly, yes I am. I think this time last year the storm clouds were just kind of coming in although the business was going quite well. Now, is about maybe the time we started to see some real warning signs out there in the macro economy. There was a fair amount of uncertainty that was starting to build. I think right now, not that there’s not uncertainty about the short term but I think that we’ve seen the worst and while we don’t know exactly what the level of spending will be we think our customers are going to spend more and we know that we’re even better positioned from a technology perspective, from a competitive position and from a breadth of customer perspective. We can’t invent customer spending in 2010 but to the extent it’s going to come back and we believe it will, we just don’t know how strongly, we think we’re extremely well positioned to take advantage of it.

Operator

There are no additional questions.

Patrick J. Harshman

With that I’d like to thank you all for your participation on the call today and we look forward to the fourth quarter and to speaking with you all again soon.

Operator

This does conclude the Harmonic third quarter 2009 earnings call. You may now all disconnect.

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