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Harmonic Inc. (NASDAQ:HLIT)

Q2 2010 Earnings Call

July 29, 2010 5:00 p.m. ET

Executives

Carolyn Aver - CFO

Patrick Harshman - President & CEO

Analyst

Chris - RBC Capital Markets

Amir Rozwadowski - Barclays Capital

Vivek Arya - Banc of America

Greg Mesniaeff - Needham & Company

George Notter - Jefferies

Blair King - Avondale Partners

Victor Chiu - Morgan Keegan

Jack Monte - UBS

Operator

Good afternoon. My name is Phillip, and I will be your conference operator today. At this time, I would like to welcome everyone to the Harmonic Second Quarter 2010 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)

Thank you. I will now like to turn the call over to our host, Ms. Carolyn Aver, Chief Financial Officer. Ma'am, you may begin your conference.

Carolyn Aver

Thank you very much and good afternoon everyone. I am Carolyn Aver, the new CFO of Harmonic. With me in our headquarters in Sunnyvale, California, are Patrick Harshman, our CEO and Michael Newman, our Investor Relations spokesman. I'd like to point out that in addition to the audio portion of this call; we've also provided slides which you can see by clicking on the front page of harmonicinc.com and going to the events section. Thank you all for joining us.

Before I begin, 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 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 10-K and 10-Q reports. These documents identify important risk factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. Please note on this call we will provide you with financial metrics determined on a non-GAAP or pro forma basis. These items together with corresponding GAAP numbers and a reconciliation to GAAP are contained in today's earnings press release, which we have posted on our website and filed with the SEC on a Form 8-K.

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 a recorded version of this call on our website.

With that, let me turn things over to Patrick.

Patrick Harshman

Well, thank you Carolyn and thank you all for joining us today. Turning to slide three of our presentation, let me begin by saying we're extremely pleased with the way our business is performing. We delivered $95.5 million of revenue, up 18% year-over-year; our non-GAAP gross margins were 51%, reflecting the continuing success of our product strategy.

Our non-GAAP earnings were $0.09, up from $0.03 a year ago. And perhaps most indicative is how we're performing in the market. Our bookings during the quarter were 104 million up 28% from a year ago. The key market dynamic underlying is results, the continuing in global expansion of high-definition video services. We see increase in investment in high-definition services worldwide across all customer segments. And Harmonic has never been better positioned to take advantage of this growing HD opportunity.

Additionally, while HD is a locomotive driving business today, we continued to be encouraged by growing success in newer business areas including converged multi-screen video services. And of course, we remained quite excited about the pending acquisition of Omneon. I am pleased to report that Omneon's business has continued to perform really well and the customers around the world have provided strong positive feedback on the combination. We now expect the deals will close in late Q3 or early in the fourth quarter.

Let's now move to slide four and take a closer look at how the market transition HD is creating a range of growth opportunities for Harmonic. We're excited to see all of our customers, broadcasters, cable operators, satellite, direct-to-home operators and Telcos around the world expanding their HD channel lineups and investing in new encoding systems to do this.

We're also pleased to see video-on-demand content being increasingly migrated to HD formats, which of course drives the need for more edge comp capacity in cable networks.

Delivering this increasing live and on-demand HD content is putting tremendous pressure on Access networks. In response to this bandwidth squeeze, our customers are investing in a range of bandwidth management technologies.

Across our customer base, we've started to see a whole new encoder upgrade cycle where our latest generation HD and standard-definition encoders are being purchased to replace existing encoders, opening up bandwidth for new HD channels in the process. This replacement cycle started to play out for us in the second quarter and will be a key opportunity for us going forward.

We're also seeing renewed cable industry focus on switch digital video rollouts and on HFC network segmentation, trends that underline our continuing strong Edge and Access results and create significant ongoing opportunities for Harmonic.

With events like the World Cup, stimulating expansion of the HD experience around the globe. With new HD technology such as 1080p at 60 frames a second and the 3D gaming market momentum, we see the trends are just highlighted continuing the play out for the foreseeable future.

Turning now to slide five, I would like to highlight a couple of the reason why Harmonic is successfully taking advantage of this market trends. First, our technology position has never been stronger. Our Electra 8000 encoding platform really has become the gold standard of the industry, winning numerous competitive shootouts conducted by our customers over the past several months.

Similarly, in the EdgeQAM area, we've recently disclosed that we've now shift over a million QAMs, a milestone that validates our clear market leadership position in this product category. More generally, our sustained investments in maintaining our video technology leadership has paid dividends in the first half of this year. And we are confident that our strong pipeline of new products and solutions will enable further opportunities.

In addition to developing grade technology, we've also been doing a good job leveraging the sales and marketing investments we've been making to gain further market share. Business with direct-to-home satellite operators represent a 27% of our revenue this quarter, a result to impart to our strategic focus on gaining more international satellite customers.

I am also very encouraged by the progress we've been making with new Telco customers in emerging international markets and continuing progress with broadcasters around the globe. And here I want to note the positive impact of the acquired Scopus sales channels and broadcast products toward developing this broader customer base.

Turning now to slide six, while HD is driving the biggest wave of customer spending with us today, we're also making positive strategic progress in developing additional growth engines for our business, which we believe, will impact future growth.

First, I want to highlight the progress we're seeing with our growing technology portfolio that enables delivery of premium video programming over the internet as part of converged multi-screen services. We've continued to win important seed projects in this area across our customer base. Again, with broadcasters, cable operators, satellite operators as well as Telcos. And we continue to believe that this area constitutes a significant growth opportunity for us.

I want to highlight, here in particular, increasing cable industry momentum towards converged IP video services, using the MPEG-4 AVC standard, a move that will create a new wave of video infrastructure investment that plays directly to our technology and IP system deployments ranks.

Another important market trend is that of distributing high quality video content from content donors and origination sites to service provider locations. During the quarter the Comcast media center issued a press release announcing there new service in this area and Harmonics as well as the strategic technology partner.

As with the multi screen area we're well positioned from a technology prospective and we see this distribution trend opening up attractive opportunities across customer segments and across geographies. And finally our new growth drivers, I want to highlight our continuing success in international markets and particularly in the emerging markets we've targeted for growth. You've seen several recent press releases from us announcing our growing success in China and we also continue to be encouraged by the progress we're seeing in India and Latin America.

Another important step in the strategic evolution of our business is our proposed acquisition of Omneon, turning now to slide seven I'd like to provide a brief update on Omneon's business. As you will recall nearly three months ago we announced a definitive agreement to acquire Omneon. A significant step we believe will further accelerate our strategic development into a category defining video market leader.

Similar to Harmonic, Omneon's businesses has been performing very well. First half bookings were 57.8 million up 19% year-over-year as Omneon has been doing a great job exploiting its seamless products and solutions, both in traditional play out and in the newer production and software application areas.

As with Harmonic the key driver of Omneon's business has been and will continue to be this market transition to high definition. Also like Harmonic, Omneon has a strong focus on developing its international business. Through the first half of the year the company has seen strong results from Asia in particular and has benefited from the rebound in advertising spending in the U.S. and elsewhere.

At looking at the full year on a stand alone basis, Omneon now forecasts revenue on a range of 120 - $125 million, up about 18% year-over-year and non-GAAP gross margins in the high 50's and non-GAAP operating margins of somewhere between 6 to 7%. It's clear that Omneon's positive business momentum is continuing, driven by both strong technology and growing market opportunities.

And importantly bookings in the second quarter are up from the first quarter, as a strong market momentum has continued since our announcement of the acquisition. Indicative I think of a tremendous sort of confidence we are getting from Omneon's customers and employees. And to dig deeper into the feedback we've been receiving from customers we'll now turn to slide eight.

As soon as we announced the deal over fifty meeting have been held with both Omneon customers and joint Harmonics- Omneon customers and the feedback has been overwhelmingly positive. There is no question that our customers are in agreement with our strategic vision that the market is heading towards the convergence of video production, play out and delivery.

Customers, I've spoken to have been particularly exited by several integrated technology solutions the two companies plan to put together. Examples of this include integrated concept creation and delivery work flows where we can really streamline our customers operations. An integrated solution for live to on demand services, solutions that span content capture, storage, management, and multi-device streaming. More generally both companies are very well respected by our common customers around the globe and they are exited to see two of the industries best players getting together.

Particularly in international our customers appreciate the fact that we'll now have more local presence and scale. As an example, I recently visited Asia to meet with a number of our key customers and partners in the region. These included Sky Perfect TV in Japan, one of our largest satellite customers in the region and also an Omneon customer. JCOM also in Japan, one of our key cable customers in the region and also an Omneon customer and PCCW in Hong Kong, a strategic IPTV customer of Harmonic and also an Omneon customer.

I can tell you I came back from this trip with even greater confidence and the value of what Harmonic plus Omneon can deliver in the global marketplace. In addition to spending time with our customers, we've also been spending a great deal of time flushing out our integration plan and I'm very confident that we have a solid execution plan in place.

We have identified 2011 cost synergies of approximately 8 to $10 million spanning areas like product manufacturing cost, our two company share or common contracts manufacturer as well as facilities and G&A. okay I'm now going to switch gears, and bring Carolyn back into the call.

I think as all of you know Carolyn joined Harmonic approximately eight weeks ago as our new Chief Financial Officer. In the short of time, Carolyn has done a great job rolling up her sleeves and making a difference in the business, and we're really happy to have her on board.

So Carolyn, I'll now turn the call over to you to tell us more about Harmonic second quarter and our financial outlook as well as the planning integration of Omneon. Carolyn?

Carolyn Aver

Thanks Patrick. I'm really delighted to be a part of the Harmonic team at this very exciting point of time for our company. Moving to slide 10. As Patrick said this was a terrific quarter driven by market demand for our products. We had a very strong bookings quarter, which combined with our backlog entering the quarter drove revenue margins and EPS.

In addition, we generated 10 million of cash and reduced DSO. As we've discussed we saw a continuation of the strong momentum of revenue in bookings. For the second quarter of 2010, we reported net revenues of 95.5 million, up 18% from the 81.3 million in the second quarter of 2009, and up 13% from the 84.8 million in the first quarter of 2010.

For the first six months of this year, our net revenues were 180.4 million, up 21% from the 149 million in the same period last year. Total bookings in the second quarter were 104 million, up 27% from 81 million for the second quarter of 2009 resulting in another quarter of building backlog. Now let's take a look at slide 12 where we can see our revenue mix.

Domestic customers represented 25% of total revenue for the second quarter, and were a big factor in our bookings as well. Revenue for Europe was up both year-over-year and sequentially, and we have not yet signs of a slowdown among our customers there.

Cable customers accounted for 56% of revenue in the quarter. Satellite customers, 27% and Telcos and others were 17%. The stronger than usual demand in the global satellite market was the result of both projects completed during the quarter as well as new orders received and shipped in the quarter across all regions.

We would however expect to see the cable portion of this mix increased next quarter as a result of the strong cable orders we received during Q2. Our largest customer was again Comcast, representing 16% of total revenue in the second quarter.

By product category, video process and sales were particularly strong representing 52% of revenues for the second quarter. Edge and Access products represented 35%, and services and support 12%. You will recall that we have revised our product categories to include software in the video processing category, rather than combining it with services and support.

It has become increasingly difficult to clearly separate software and hardware in our video processing solution. In addition, this presentation allows us to show separately services and support, which now have exceeded 10% of our revenue.

On slide 13, we look at our operating performance. We continue to sustain strong growth margins this quarter. Our non-GAAP gross margin was 51%, comparable with the previous quarter, and up from 45% in the same period of 2009. Operating expenses were 35.5 million up about a half a million from last quarter, and our operating margin with 13%.

Headcount remained relatively flat at 848 employees. The year-over-year increase in revenue and margins have a positive impact on our net income as well. Our non-GAAP net income for the second quarter was 9.1 million or $0.09 per diluted share, up from non-GAAP net income of 3.1 million or $0.03 per diluted share for the same period of 2009. We have reported a non-GAAP provision for income taxes of 30% which we believe is the normalized tax rate given our current mix of international revenue and profitability. We're pleased that our international reorganization in 2008 is paying off in lower taxes.

On slide 14, we'll take a look at the balance sheet which also continues to be strong. At the end of the second quarter, we had cash and cash equivalent short-term investments of 278 million, up from 268 million at the end of Q1. After closing the Omneon deal, we expect to have cash in excess of a 100 million. Our inventory was 42.8 million up from 39.6 million from the end of the first quarter.

This inventory increase mainly reflects our preparations to facility increases in our backlog, and our forecast expectations as we move into the second half of the year. Our receivables balance increased modestly to 71.4 million resulting in DSOs of 68 days down from 75 days last quarter. We are pleased to see this return to our target range of 60 to 70 days.

Finally, our capital spending was 2.9 million in the second quarter. We expect CapEx to be in the range of 16 to 18 million for the remainder of 2010, which includes approximately 14 million for additional leasehold improvements and equipment for our new headquarters facility. We begin moving into the new building tomorrow.

On slide 15, we'll take a look at our outlook for the rest of this year. We entered into the second half of the year with a very strong backlog. Taking into account our backlog and business momentum, we expect net revenues for the third quarter of 2010 to be in the range of 95 to 98 million.

For the full-year of 2010, we are targeting net revenues in the range of 370 to 375 million. The planned introduction and continued development of a number of new important product releases in the second half of 2010 are expected to moderate gross margins and increase operating expenses. Non-GAAP gross margins for the third quarter are anticipated to be in the range of 48 to 50% and non-GAAP operating expenses are expected to be 36 to 37 million.

These anticipated results exclude any financial impact of or related to the proposed acquisition of Omneon. In addition, they also do not include approximately $750,000 of move related expenses that we will incur in the third quarter.

On slide 16, we wanted to take a look at what to expect from Omneon. We believe the deal will be completed by the middle of the fourth quarter. We've cleared any hard (inaudible) and are working through the regulatory approval process.

As some of you may know, I have considerable experience in acquisition and the business modeling and integration planning for Omneon is the first thing I focus on since joining the company. The first phase of integration is focused on integrating manufacturing and operations, co-locating the Sunnyvale employees and integrating the G&A function.

Detailed integration plans are in place to achieve full integration in each of these areas within 60 days of close. We've built a bottom's up combined company model that has identified 8 million to $10 million of cost synergies for 2011, principally from these three areas. We do expect additional acquisition-related charges of approximately 5 million to $6 million in the Q3, Q4 timeframe.

We'll try to provide specific guidance for the combined company after closing, and once we've greater insight into the purchase accounting, including the potential reductions for Omneon, deferred revenue balance, which would be typical of course in the situation like this.

On slide 17, I would like to take a look at 2011 business outlook. We see a number of encouraging signs. First of all, our core business has excellent momentum. Excluding the impact of Omneon, we expect to see low double-digit revenue growth and operating margins of around 15%. The addition of Omneon will extend our addressable market and further accelerate our growth.

With 58 million of first half 2010 bookings, we would anticipate Omneon to be between 120 million and 125 million in revenue for 2010, reflecting a continuation of their historical 18% growth rate.

Omneon has higher gross margins than Harmonics. So, we expect the combination to have a positive impact on our gross margin over the long-term. With the target synergies identified, we anticipate the combined operating margin to be in the 15% range for 2011.

With that, I'll turn the call back over to Patrick for some closing comments.

Patrick Harshman

Thanks Carolyn. So, in summary, we believe the progress we reported to you today offers clear indication that our strategic direction, that is focusing on the technology and services will enable HD and other next generation premium video services, while also addressing an ever broadening base of customers, is driving success for us.

We continue to see great opportunities for the company and we continue to believe that the combination with Omneon will further solidify our position as the leading provider of mission critical video delivery infrastructure to media companies around the world.

With that, I'll end the formal part of our presentation and open it up to your questions.

Question-and-Answer Session

Operator

(Operator Instructions) And you do have a question. Your first question is from the line of Mark Sue with RBC Capital Management, I'm sorry Capital Market.

Chris - RBC Capital Markets

Hi, this is Chris for Mark Sue. Can you give us some color on what the new financial model look like after the integration of Omneon?

Carolyn Aver

Yeah, and I think what we are tying to guide you to now, before we have all the details and disclose all of the numbers of Omneon is that we would say that Harmonic for 2011 would see revenue growth in as I said the low double digits. We would expect that Omneon would likely continue to grow at their more historical growth rates and we don't have a gross margin target yet but we would say that after synergies the combined companies can generate 15% operating margin.

We will move them to our tax structure over the course of the next several quarters. That involves a series of things. So I'm not certain that we can achieve a 30% tax rate for them beginning immediately, but you looked at 30 and 40% blended rate moving to 30 over time, that would give you good since where it might be.

Chris - RBC Capital Markets

Okay great that's very helpful. Just one more. You mentioned in your prepared remarks that the Cable segment would increase as a percentage of revenue in the next quarter. Can you give us a since of where this segment is going past Q3?

Patrick Harshman

We see broad opportunities in cable. As you know, it's the largest segment that we address. It is the largest opportunity in terms of the breadth of our product line. We continue to see good opportunities in high definition encoding, stream processing. I talked about the work with the Comcast media center moving content around national back bone fiber networks is an increasing opportunity. I also mentioned growing activity around the convergence.

And of course in the edge and access area, we just -- we see more pressure on access area, we see more pressure on them -- on access capacity, we see continuing opportunities for the HFC access piece at that and we see good opportunities around our edgeQAM product, both in expansion of the traditional VOD footprint and also as I mentioned we see continuing momentum around Switched Digital Video.

So really for us to see is the full package, the full compliment of technologies and we think our cable customers are doing very well and we think they're increasingly truing Harmonic to help them really right across the board.

Chris - RBC Capital Markets

Great thank you.

Operator

Your next question is from the line of Amir Rozwadowski with Barclays Capital.

Amir Rozwadowski - Barclays Capital

Thank you very much and good afternoon Patrick and Carolyn.

Patrick Harshman

Hi Amir.

Carolyn Aver

Hi.

Amir Rozwadowski - Barclays Capital

I was wondering if we could on that, on the theme of cable side Patrick is, it seems as though if we look at some of your larger customers in the cable arena, there does seem to be a sense of restrained CapEx from a broader perspective for them. Can you give us a little bit of color in terms of reconciling that, what seems like from your perspective as sort of healthy spending on your area versus where they are being more restrained in terms of their spending.

Patrick Harshman

Yeah, it's a part to understand, the Cable CapEx pie is a big pie and Harmonic traditionally plays in a relatively small piece of that. Historically building new plant, digging up streets, set top boxes, consumer electronics, the customer premises equipment, those are all major, major CapEx categories where Harmonics doesn't participate.

In our view and I think the cable operator's view is a lot of that fundamental investment has happened. When they have built is a fantastic platform and now the job or the opportunity is to roll out new services that ride on top of that platform.

You know services like HD, like internet video services, like video on demand, HD video on demand, 3D et cetera. We think that's where the opportunity is for their business, higher margin and higher value services, and that's really where our products fit in.

And I think if you look at the discussions of our large customers, you will see that underneath flat or maybe even declining CapEx is actually shift somewhere the investments are coming, and I think as recently as yesterday Comcast talked about their spending and you saw actually an increase in plan spending and what I think they call strategic, strategic areas.

Amir Rozwadowski - Barclays Capital

Great, and then if we think about sort of your own investments internally, it seems as though you had mentioned that you are investing in for new product platforms, it's going to 10% of your gross margins at least the near-term and then expand your OpEx, what areas are or should we consider that you are investing right now, and what types of products are these?

Patrick Harshman

We're investing right across the Board, and then we continue to push the edge on encoding, on transcoding. A lot of the software-based applications as well as the Edge & Access. You know probably the most specific and significant driver of near-term moderation in gross margins is our plan to rollout a new edgeQAM platform later in this quarter, and as with the case when we rolled up the current platform a year, 18 months ago, the initial shipments come with a lower margin, putting out new hardware and new platform, and then over time as we deployed blades into that platform as we deployed new software applications on top of that platform. The margins significantly improved. I think you've seen strong margins for us in the Edge & Access categories.

This year as we've really take advantage of the last generation platform, and so we are exciting about getting this next-generation edgeQAM platform out there.

Amir Rozwadowski - Barclays Capital

Great and then lastly Carolyn if we look at sort of the cost synergies that you outline I guess the 8 to 10 million do you have a sense of how much of that will fall into the COGS line versus OpEx?

Carolyn Aver

As there is a good piece of falls in the COGS because of the component of that is on the manufacturing operation side. We both use Plexus as our contract manufacturer and we have the ability to achieve some important synergies in the combination of how we manage that and where we manage that, so there is certainly a significant chunk that is related to that. There is another piece that's related to facilities cost, and that can spread equally across all areas. And then I'd say, so I'd say probably more than half in COGS and the other piece in OpEx. There is also a pretty good amount of synergies in the G&A line really in auditors and insurance and all of the duplicative cost that you have in the G&A area. There will be a few million in that area as well.

Amir Rozwadowski - Barclays Capital

Perfect, it's perfect, thank you very much for the incremental color.

Patrick Harshman

Thanks.

Operator

Your next question comes from the line of Vivek Arya with Banc of America.

Vivek Arya - Banc of America

Thank you. Hi guys. Couple of questions, first from your guidance it looks like fourth quarter would be sort of flattish versus on the third quarter if my math is right. Is it conservatism? Is it based on any specific information? You know just in general what could be sort of the upside or downside factors here?

Patrick Harshman

I think we're still getting a feel for what it's going to happen later in the year. Second quarter was exceptionally strong, frankly stronger than we anticipated. We are heading in Q3 with a lot of momentum behind us and so we think we have got good visibility on the third quarter and good momentum.

I don't if I would call it conservatism to that but I think we are really waiting to see how the fourth quarter will evolve but I would point out that with this guidance we have substantially increased our guidance for the full year and we are quite pleased with our business, if in fact we do end up where we predicted which is something on the order of 16% growth year-over-year.

Vivek Arya - Banc of America

Pat, can you remind us seasonally what trends have you seen in the fourth quarter versus the third quarter?

Patrick Harshman

It's a little bit all over the map, very often last year we had a very strong fourth quarter. Of course the previous year was very weak. I think that it can be either strong or weak and I think at this point it's hard to predict.

Vivek Arya - Banc of America

All right and secondly I know you have outlined some cost synergies normally on next year. Any kind of top line synergies that you could perhaps point to that where you may have started some work and that could be possible upside.

Patrick Harshman

Absolutely we haven't quantified that and I think it's pretty mature to quantify it. We definitely been talking to a lot of customers and the response. As I have mentioned in the prepared remarks has been quite positive. I think there is a lot of interest in doing business with the combined company as I said. We are both really liked by our customers, customers just like seeing us come together and have a lot of confidence in what the two companies can do in general and in particular we see several solution areas that there has been a very strong response to it.

So, I think we need to get a little bit closer, we need this to let the companies come together before we start getting quantitative about that but we are looking forward to getting this been closed and really getting into our 2011 planning process in earnest.

Vivek Arya - Banc of America

Got it and just one last one maybe if you could just give us a conceptual gross margin range to model for the combined company. I understand all the details that have not been hammered but just how should we think about the combined gross margins including all the cost synergies that you mentioned before.

Carolyn Aver

Well our gross margins obviously are, we target to be around the 50% range. I think we have said that Harmonics are in the high 50s and approaching 60%. So, I think when you put that together and you look at the combined revenue contribution. You would imagine that there are going to start in lowish 50 range.

So, sure as I think you know Harmonic is how to build overtime to bring our gross margins up. We have done that well over the last few years. We think we can continue to do that, so longer term not modeling for next year, longer-term we certainly want to see mid-50s or higher.

I don't if we are going to get there before 2011.

Vivek Arya - Banc of America

Got it and just since you are on the topic of longer-term, is it unreasonable to expect high teens operating margin to even 20% at some point down the road or is that still far to look out right now.

Carolyn Aver

I don't think we want to predict that at this point but I think there are times in the past that we have been at that level and you know what scale. I think we certainly would like to achieve those.

Vivek Arya - Banc of America

Okay, thanks and good luck.

Carolyn Aver

Thank you.

Patrick Harshman

Thank you.

Operator

Your next question is from the line of Greg Mesniaeff with Needham & Company.

Greg Mesniaeff - Needham & Company

Yes, thank you and congratulations on a really solid quarter.

Patrick Harshman

Thanks Greg.

Greg Mesniaeff - Needham & Company

A question on the HD replacement cycle that you alluded to Patrick, there appears to be a nice several quarter perhaps longer growth driver for you guys. Looking at that, at your product set there, would you say that, how would you split that among MPEG-2 and MPEG-4? Are you seeing, or if you could just give us kind of your take on that?

Patrick Harshman

I don't know if you are asking what the breakdown is. We're seeing a clear replacement cycle across both technologies. I think it's important to remember that we often think about satellite and even IPTV as being primarily being MPEG-4.

I think that's true from an HD perspective but actually if you step back worldwide, most of the satellite content, in particular that's delivered out there is actually standard definition MPEG-2. And certainly in the cable world it's all standard definition and high definition MPEG-2.

And the replacement cycles we're starting to see play out is not just replacing high definition encoders that have been deployed over the last couple of years. It's also Standard Definition that occurs there. Squeeze the standard definition stuff down as much as you can to create room for additional HD channels. So we're seeing pretty good opportunities and pretty good activity across standard definition and high definition and across MPEG-2 and MPEG-4.

Greg Mesniaeff - Needham & Company

So really you're seeing growth in the entire matrix if you will, all four quadrants.

Patrick Harshman

That's right. That's right. Most of the new incremental channels that are going on there are MPEG-4 HD, except for in cable where its high definition MPEG-2. But in the service of those things and the service of adding new channels we see scrutiny right across the board in terms of squeezing down the already existing stuff and so yes, from a replacement cycle, from getting more efficient on what's already up there, its really hitting all four quadrants. And there our 8000 product which simultaneously supports the same platform, same hardware. It supports MPEG-2, MPEG-4, HD and SD. We've really hit the sweet spot with that product.

Greg Mesniaeff - Needham & Company

And you also alluded to a new edgeQAM product to be released in the quarter. I was wondering if you can give us a little bit of color on that, whether the focus is on density or on form factor, physical form factor or price or what are the variables.

Patrick Harshman

We haven't formally announced the product Greg. So we've noticed the right thing to do to kind of give you visibility that we're putting a new platform out there from a gross margin point of view, I prefer to hold off until we have the formal product launch to disclose the specific salient competitive advantages of the product.

Greg Mesniaeff - Needham & Company

Got you. And just quickly, if you can repeat, what was the geographic revenue mix breakdown. You mentioned U.S. was 25%. What were the other regions?

Carolyn Aver

No, geographic, U.S was 52%.

Patrick Harshman

That's right. And international was 48%.

Greg Mesniaeff - Needham & Company

Got it. Okay. Thanks a lot.

Patrick Harshman

All right, thank you very much.

Operator

Your next question comes from the line of George Notter with Jefferies.

George Notter - Jefferies

Hi thanks very much guys. I wanted to ask about, your guidance for 2011, number one, I guess I'm trying to figure out why guide for 2011 right now. Traditionally the company has been in the mode of guiding one quarter at a time or even six months at a time but here we're still six months away from next year, you're putting some numbers out there. I understand there's a little bit different angle here because of the Omneon acquisition but I'm just wondering, has visibility really improved or is there something else fundamentally that I'm missing about the business or is it just simply the fact that we're getting ready to close the Omneon deal?

Carolyn Aver

I can't speak to history obviously, although we've talked about it quite a bit. I think it's a combination of certainly the Omneon deal and secondly I think that the street is in a point now why they are starting to put out their 2011 numbers and we'd like to have some sort of -- help the street in some way get those numbers. We don't want them to get ahead. Given the strong growth we don't want them ahead of where we feel comfortable today. Backlog obviously makes us have some more comfort as we get into the second half of this year but we also do see some of these cycles having longer term impacts and are giving us some insight to the beginning of where we think next year is going to be.

George Notter - Jefferies

Got it, okay. And then just as a reminder, can you tell me what the operating margin guidance for Harmonic standalone would be for next year? I think you said 15% but did I miss that?

Carolyn Aver

I did it, yes. 15% is correct.

George Notter - Jefferies

Okay, for Heritage harmonic and then as we layer in Omneon, you also think the business would be a 15% operating margin business?

Carolyn Aver

That's correct.

George Notter - Jefferies

Okay, and then just getting back to sort of the fundamentals of the business we tend to think about your business as being a second derivative business, particularly in the video processing side, the pace of new HD channel additions on a second derivatives basis is important, the pace of upgrades. I guess I'm trying to figure out why now we're seeing a real acceleration in the rate of HD channel adds or the rate of upgrade activities there. Something fundamentally you see going on that's changing -- that's creating an acceleration in the market?

Patrick Harshman

HD is certainly acceleration overseas. So I guess its one important point. Up until very recently it's been largely U.S. phenomenon and so we're very encouraged to see HD really starting to make a move overseas.

And secondarily as I'm trying to highlight, we think about the HD opportunity as broader than just new HD encoders for incremental channels. So what we're starting to see is some kind of ripple and follow-on effects.

Switch Digital Video is getting a lot more attention now I think as you know. I think it's largely an out cropping of the fact that as more HD channels are being added in the cable environment, it's starting to run out of space.

The upgrade cycles, I think that's also just an opportunity the technology has afforded us. And historically in the encoding business, anytime that we can come with significant enough advances in the compression efficiency, for a satellite operator to add a couple more channels in the existing transponder, it pays dividends to replace those encoders and historically even in the days of just MPEG-2 standard definition, we went through several rounds of upgrade cycles simply because compression efficiency just got better and better.

The good news right now for us is that we've both from a standard definition as well as the high-definition; the state-of-the-art of the product has advanced to such a point that there is a material advantage now. And I think any time that you can simply replace encoders to get better compression efficiency, it's always a winner to do that and to clear out the additional bandwidth.

So international effects, I think a number of derivative affects following on from the continuing growth of HD services here in the U.S. are all really conspiring to land down I think underlying strength to the business right now.

George Notter - Jefferies

Okay. And just one last house keeping. I thought the deal was supposed to close in Q3. Now you're seeing mid-Q4. What exactly has changed there?

Carolyn Aver

We're just going through the sort of normal regulatory procedures. We still think it certainly could close in Q3 but it could spill over to Q4 and we just wanted to update guidance on that. I want to go back to your question sort of as I reflect on it, on guidance versus target.

I don't want you to construe that what I'm trying to do is give specific guidance for 2011. I think that we're trying to help set interim term targets of growth in margins that we think you all ought to think about as you build your models but not prepared to sort of call that specific guidance at this point.

George Notter - Jefferies

Got it. Okay. Thanks very much.

Carolyn Aver

Yeah.

Patrick Harshman

Thank you.

Operator

Your next question comes from the line of Blair King with Avondale Partners.

Blair King - Avondale Partners

Hi guys, thanks for taking the call. Patrick, it's been probably several quarters since we've heard much out of Harmonic relative to the Telco space and you mentioned it I think in your remarks and obviously, some pretty good sequential strength in that end market. So if you could give an update with regard to what's going on in the Telco segment that would be really helpful?

Patrick Harshman

Yeah, the incremental activity that we're seeing is actually in a number of emerging markets where we're seeing smaller Telcos, perhaps tier-2 Telcos if you will, places like Asia, places like Eastern Europe, the Middle East start to get into IPTV. And this is really a follow-on activity to move a lot of their tier-1s internationally made over the past couple of years.

So, we've seen kind of a second wave starting to happen among those smaller to medium sized Telcos in some of these emerging markets and we've been fortunate enough to be able to pick up a lot of that business as it evolved.

And now of course, there is a certain amount of ongoing business that has continued to happen with a number of the tier-1s that we've won in other parts of Asia and Western Europe, and new HD ads, for example, early trials and activity around mobile work.

I think last quarter we announced a nice mobile video win with Swisscom as an example. So, it's a little bit of a balance of things. But I would say the extra lift that we're seeing right now with some of these Telcos in emerging markets is starting to get into the video game.

Blair King - Avondale Partners

And then lastly, you had also made some comments about the converged multi-screen activity and some IPTV delivery activity within the cable space I guess here in the United States. Recognizing that that's probably a relatively small piece of your business today, I'm certain that you've got some confidence in that growing through 2011 and really just, anything you can give us that might help understand how that scales through 2011 relative to the size of your business would be also helpful.

Patrick Harshman

Look, frankly speaking, there's still lot of questions about how fast this segment will grow. I think what's becoming increasingly clear is there is no question at all that converged services that deliver video and not only into the television set but to iPads and iPhones and PCs, TV, anywhere kind of initiatives are continuing to bubble up really to the top of the strategic agenda or menu of our large customers, really across customer categories, certainly including Cable and including cable operators here in the U.S.

Exactly how fast these services will be rolled out and in the investment behind that, I think we're still waiting to see. And frankly I don't see an explosion of activity in 2011 but I do see a steady way up. I do see a growing contribution to our business in 2011. And our main objective right now is to be right there, to be viewed as a key business as well as technology partner and so far I think were doing a good job of that. So we'll keep you posted on your progress in that area.

Blair King - Avondale Partners

That's great, thank you Patrick.

Patrick Harshman

Thank you, Blair.

Operator

(Operator Instructions). Your next question come from the line of Simon Leopold with Morgan Keegan.

Victor Chiu - Morgan Keegan

Hi, this is Victor of Simon Leopold. I wanted to ask, another cable TV expo supplier reported last night a sharp slowdown in DOCSIS 3 that had a pretty material impact on their business. I just kind of wanted to ask you if you had a sense around this ship and if there is any impact in your business that you're seeing?

Patrick Harshman

I think we all know that the spending in any particular category kind of waxes and wanes. It's certainly true in video processing equipments and I don't think none of us are surprised to see the fact that maybe the CMTS spending is temperately a little slower than it was in the past quarter. I believe the CMTS DOCSIS is a great business and we believe that cable operators will continue to spend strongly in that area.

All that being said, on our side of the fence if you will I think new video services competing in terms of number of HD channels et cetera continues to be very high on the agenda of our cable customers and we'll continue to see a lot of strategic and in fact investment focus around the services that we're enabling.

Victor Chiu - Morgan Keegan

Great. Also I noticed that there was a lot of upside from video processing this quarter. Can you just give us a little color around specific applications I guess that were driving that this quarter.

Patrick Harshman

Video processing business is really doing well doing well for us across cross customer categories. I think you also noticed and we mentioned that a number of satellite products kind of converged if you will in the past quarter and those satellites -- out business with satellite is largely all about video processing a little bit of our service business there. But I think you can certainly interpret the relative strength of our video processing in the second quarter to be somewhat correlated with the strength of the satellite direct to home business in the quarter.

Victor Chiu - Morgan Keegan

Thank you.

Patrick Harshman

All right. Well, thank you.

Operator

Your next question comes from the line of Jack Monte with UBS.

Jack Monte - UBS

Hi, thanks for taking my question. Just to begin, a little bit about gross margins. I believe, if I'm looking at it correctly that gross margin guidance got ticked down by about a 100 basis points on a range and I was just curious what the drivers of that change were?

Carolyn Aver

Certainly. I think we talked a little bit about, we are coming into a new product cycle for one of our products, and that those cycles tend to be lower gross margin when they first come out because they have a larger hardware component and then over the life of that product cycle, we end up delivering more software and firmware into the appliance, and therefore getting higher gross margins. So, two things are happening over the last couple of quarters.

We've clearly benefited from the back end to that cycle where we've had higher gross margins and more of a firmware software component, and now we are moving into a say as where that's going to flood back again to so a little bit more hardware component. So, it's an estimate we will, but it depends on the timing of the release, and the number of things, but we just wanted to signal that there is -- if we love the rains where it was -- I was worried everybody was going to end up at the high end of the range and the reality as we think gross margins will be down a bit this quarter. Where they land, still it depends on when the product comes out and how much we ship and a number of other factors, but we did want to signal that you should expect them to be a little bit lower this quarter.

Jack Monte - UBS

I guess looking out further into the fourth quarter and really, there is a lot of moving pieces, but with the organic business you think the launch will be sufficiently fire enough along that margins get improved a little bit at that point of time, or do you think there still be bit of a drag there?

Carolyn Aver

I suspect that there can still be a bit of drag, and again that also depends on when in the quarter it gets released.

Jack Monte - UBS

Okay and then shipping gears, so cable is expected to tick up. it sounds like satellite may take down after strong bit of, strong bit of revenues and new projects recognizing revenues in the past quarter, and I was just curious was there any thought process on the -- at the Telco business that you wanted investors to think about, that business be flattish or is that going to be down as well with cable being much stronger. Thanks.

Patrick Harshman

I think we were encouraged by the activity around Telco and in the short-term we think we will continue to see the level of business that we saw in this past quarter.

Jack Monte - UBS

Great, thank you very much.

Patrick Harshman

Thank you, so I think we've got time for one more question. Operator?

Operator

Your next question comes from the line of George Notter of Jefferies.

George Notter - Jefferies

Hi. Thanks a lot for the follow-up. I just -- I wanted to ask about the I-CMAP architecture. It's getting more -- I guess focus in the CMPS base or two models, an integrated model or modular model both have implications for the edgeQAM space. Obviously we are now pulling video into the IP domain, and I guess how do you sort of pass that out in terms of how it impacts your business?

Patrick Harshman

Look, I think there is a lot of strategic discussions about where and how for these new services will be delivered. I think there is no question, but that the industry is eventually driving towards and IP delivery architecture. I think that's a converged services.

I think definitely QAM is a big part of that. How exactly is this packaged in the I-CMAP architecture that you just spoke to is, it's certainly one way of envisioning the way the future of the CMTS and edgeQAM will come together.

I think as you know and those close to the industry know we're very actively involved in all those conversations, and we continued to kind of work with one side of our brain, we're very involved in this long-term strategic directional thinking and on the other hand we are very active kind of making the business, making the services that need to be delivered today happen.

The thing is our position and the edge part of the network has never been stronger. I think we as a company bring tremendous institutional knowledge expertise and what it needs to deliver IP services over access networks after all we have had unprecedented success with IPTV in the telecom sphere.

While I can't say we know for sure exactly how and where things are going to end up from an architecture and privatization point of view. We feel very good about where we stand from a core technology position from a system expertise position and from a customer relationship position. And it's just an exciting time to be working in the industry and I think we'll all continue to watch the evolution of some of these ideas and trends.

George Notter - Jefferies

Got it. Great. Thanks very much.

Patrick Harshman

Thank you George, and with that we will wrap it up, just before we assign off here I want to tell you again how good we feel about the way our business is going. We are very excited about the results that we have been able to announce to you today. More importantly we are excited about the momentum that we see in the business, the momentum we see in the market place, the way our customers are responding to our latest products and solutions, the way our customers are responding to our vision around the combination with Omneon. We see a lot of good opportunities and we are really having a good time running this business and we look forward to keeping you update to date on our latest progress. Thanks everybody.

Operator

This concludes today conference call. You may now disconnect.

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Source: Harmonic Inc. Q2 2010 Earnings Call Transcript
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