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Harmonic Inc. (NASDAQ:HLIT)

Presentation Conference Call

November 16, 2011 3:30 pm ET

Executives

Patrick Harshman – President, Chief Executive Officer

Carolyn Aver – Chief Financial Officer

Analysts

Nikos Theodosopoulos

Thank you, we’re going to get started here. We’re happy to have in this session Harmonic. Presenting for the Company is Patrick Harshman, the CEO. Carolyn Aver is here also. She’ll be attending the break-out afterwards. So with that, let me turn it over to Patrick.

Patrick Harshman

Okay, thanks very much, Nikos, and thank everybody for joining us today. Before I go further, I do need to mention that we may be making forward-looking statements, and I’d refer all of you to our risk statements and our SEC filings.

We at Harmonic think that we are positioned extremely well in terms of some very exciting dynamics that are happening in the marketplace. We look at an accelerating and opportunity rich video economy where we see more and more content being generated. We see more and more competition between aggregators and service providers of this video content, and of course we see more and more ways that consumers are accessing that content both through fixed, mobile networks, managed networks over the top networks. Underpinning all of this is technology and Harmonic’s strategic ambition is to be the leading provider of the enabling video delivery technology that powers this video economy.

We’re pursuing three distinct growth strategies or three elements of our growth plan: new products and applications, international growth, and expansion of our historical customer base to include media customers, broadcast and media companies. And in my short time here, I’d like to tell you a little bit more about each of these strategic initiatives in a little bit more detail.

We’ll start first with products and applications. We break our product categories down into four areas, each of which I’ll touch on briefly. Video processing – this is perhaps what we’re best known for. This is managing video content. It’s what enables us to help our customers deliver video in high definition formats, low resolution formats to mobile devices, advertising insertion, et cetera. Video production and playout – this is for the content creators in particular who are developing and originating new content, and this product category, representing about 20% of our revenue, came to us through an acquisition of a company called Omneon, closed just about one year ago today. I should have noted that our video processing business is about 40% of our revenue. Going back to the roots of the Company, where we started – cable edge and access – infrastructure technology targeted specifically at cable operators, about a quarter of our business, and our revenue from services and support about 15% of our revenue. We think of ourselves as technology and market leaders in each of these segments, and we see continuing growth opportunities in each of these areas.

Looking back over the past year, video processing has been the fastest grower for us. Our video production and playout line has grown very minimally as we’ve integrated that company, Omneon, over the past year. We’ve seen modest growth from our cable edge and access delivery, although we’ve recently rolled out some very exciting new products there; and our services and support business grows roughly in line with the rests of the business.

Now part of the value proposition of the Company to our customers is our heavy strategic focus on video. We think we’re the largest company out there solely focused on innovative video technology. Our R&D investment is approximately 100 million – we think the largest in the industry against competitors large and small; and this is approximately double from what it was just a couple of years ago, and this is a very powerful message for our customers as is, of course, the fact that we’re drawing now on a very rich array of underlying video technology building blocks spanning historic Harmonic’s business, Omneon business, and our Rhozet business particularly for video on demand over-the-top.

So let’s take a little bit closer look at our video processing business, which is the largest piece of revenue – about 40% of our business. We receive a lot of questions about what does over-the-top mean, what does new media mean, and how does this square up against traditional video delivered to television sets? Our view is that just like we saw standard definition television expand to high definition to address new widescreen televisions, well now with the addition of new video consumption devices – iPads, iPhones, the like, or the tablet devices, PCs – we simply see this as a natural progression or evolution of the market to encompass more and more screens over both fixed and mobile networks. And very schematically what you see here depicted is the way we are positioned here by the white arrow in the blue circle of how we try to work with our customers. The majority of our work is with both media companies and video service providers. The majority of the applications we support is delivery of video over managed networks, cable infrastructure, satellite infrastructure, IPTV telecom networks; but increasingly we’re seeing growing amounts of traffic, albeit still relatively small, are being delivered over-the-top to consumers. And most of our customers look at this market as not an either-or perspective but in a unified way. We’re working with cable operators, for example, who are planning or rolling out services both over their managed cable network, traditional and IP, as well as over-the-top to reach consumers who are away from their living rooms and their television sets.

We’re pretty pleased with the success we’re seeing in this area, spanning high definition which continues to be a major growth driver for us both domestically and internationally, as well as all the way to new mobile and web applications. And of course, as I mentioned, our success and our focus spans both our traditional video service provider customers, telecoms, cable operators, satellite direct-to-home operators, and media companies.

An example of a product that has been recently introduced and one we’re really excited about is our Electra 9000 product. This product is unique in the marketplace in that it simultaneously supports and enables delivery of video to everything from wide screens and very high definition Blu-ray kind of quality all the way down to video to small screens. What this means is for one of our service provider customers, you can have for example a single ESPN feed input – Monday Night Football is coming in, and simultaneously this device is delivering that content across a spectrum of resolutions to a spectrum of devices over a spectrum of access networks. This is extremely powerful operationally and cost effective. There’s a significant CAPEX as well as OPEX advantage for our customers. And with this technology and other similar new technology we’ve recently introduced to the marketplace, we expect to not only maintain but in fact strengthen and increase our market leadership in all things related to video processing.

Another highlight in terms of recent news from the Company just a day or two ago, we announced that we have shipped our 2 millionth edgeQAM for the cable industry. This announcement was in the context of the big cable TV technology show which is going on in Atlanta concurrent with this event, and perhaps the most staggering statistic here is this is a product line for us that is nearly 10 years old yet our announcement of shipping one million edgeQAMs was just over a year ago. So we’ve approximately doubled the volume of QAMs shipped into the marketplace in the last year relative to the first eight to nine years of the product’s existence, and I think this really goes to the strong leadership, the continuing leadership and the strong position that Harmonic has in the cable access area. And we see this leadership continuing both in the current edgeQAM product category and over the next several years as this product category evolves to incorporate the so-called SECAP technologies.

So now let me pivot from products and technology and talk about the second really leg of our strategic objective, and that is the growth of our customer base. As I talk to many investors, many people know us exclusively as a supplier of equipment to the cable TV industry, and while cable continues to be a very important part of our customer base, today it represents 45% of our customers’ year-to-date revenue and this is a significant change. Over the past several years, we have made significant effort and inroads into adding leading teleco operators as well as leading satellite direct-to-home operators around the globe to our portfolio of customers, and most recently really with our acquisition of Omneon being a catalyst, we’ve further expanded our customer base to include broadcast and media customers. So far year-to-date, broadcast and media now represents 31% of our revenue, and interestingly growing at a much faster rate than the rest of our business. Our year-to-date business from the broadcast and media sector is 19% year-over-year, and this is on a pro forma apples-to-apples basis relative to our acquisition of the Omneon business just over a year ago. And of course, the success here with broadcast and media is based not only on the sales of the historic Omneon products but actually in 2011 most significantly from our cross-selling of our traditional Harmonic video processing products, our encoding for everything from 3D services, HD services, to mobile and web services for these broadcast and media companies around the globe.

We’re really excited about these customers. There’s an old adage that content is king, and we think that growing and strengthening our strategic position with leading broadcasting media companies around the globe is a significant strategic benefit to our business over the medium and long term.

Here’s just some headlines of the wins that we’ve been able to announce, and you can really see that we’ve been adding a really blue chip list of customers to our growing base of broadcast and media companies around the world – names like the BBC, Crawford Media which does a lot of production for media companies here in the U.S., China SETE, Dubai Media, Vietnam Television. So we’re very excited about all the work we’re doing here in media, and I think it’s a significant strategic change and enhancement for our business.

And with names like Dubai and Vietnam there, that’s a segue into the third element of our growth strategy, and that is driving growth overseas. We for a long time have thought that our market share overseas is much less than what it is domestically, and starting a couple years ago we’ve made a real concerted effort to grow our sales presence and penetration and product orientation towards the opportunities we see overseas. Just a couple of data points here for you – penetration of digital television worldwide is still less than 50%. Sixty percent of the pay television subscribers worldwide are actually based outside of the U.S., and a wider range of industry forecasts suggest very healthy growth of the pay TV business spanning both developed and emerging international markets. We look at all of this and we see a great opportunity for us to get further leverage out of the technology and products that Harmonic has.

Our focus and strategy here has really been paying off. Year-to-date for the first nine months of the year, our business outside of the U.S. is up 16%, and again that’s on a apples-to-apples pro forma basis, so this is real fundamental growth that we’re seeing outside of the U.S. We’ve seen somewhat faster growth than the 16% in BRIC country markets, places like Brazil, China, India, also Africa, parts of eastern Europe; but this past year has also been very strong for us in western Europe and other developed markets, with the one exception of Japan, where it’s understandably – and I think we’re not alone – it’s been a slower than expected year for obvious reasons. But growth overseas continues to be a major area of focus, go-to-market sales and marketing investment, and we continue to have the viewpoint that we will see our international business grow faster than our domestic business for several years to come.

So with that, let me now segue to some financial highlights of the business. This is a chart showing GAAP revenue and gross margin or gross profit, and this is obviously GAAP – not on a pro forma basis. The tail end of 2010 and 2011 revenue here, obviously impacted by the acquisition of the Omneon business. On a pro forma basis, our revenue in 2011 versus 2010 is up about 10% through the first three quarters of the year and, based on the Street numbers that are shown here, is anticipated to be up about 8% year-over-year for the full balance of 2011. Importantly, you can see that while not consistently, 2009 was a tough year. Strengthening and raising our gross margin profile has been a key strategic focus of the Company, very important in our M&A decisions as well as our internal organic R&D investment decisions.

Returning to the theme of our revenue mix, this is a slide or a set of data that particularly for people who knew the Company some years ago is particularly surprising. You’ll see that year-to-date over half the revenue – 55% of the revenue – is outside of the U.S., so we really have become a truly global company. We’re very proud of this continuing progress internationally, and as I mentioned, we expect this trend to continue. We’re very pleased with the diversity that we have across different product categories. As I mentioned at the outset of the presentation, video processing is the largest piece of our business, provisioning of video for HD, multi-screen devices, et cetera. Edge and access continues to be important for us, about a quarter of the revenue. Just about 20% of the revenue, the production and playout products, video origination storage servers for broadcast and media companies, and the remaining approximately 15% of the business associated with services.

And interestingly from a customer market or segment point of view, as I mentioned earlier, cable now represents about 45% of our business. This of course spans both domestic and international cable operators. Broadcast and media companies are now about 30% of the overall revenue and other service providers besides cable – that is telecoms and satellite TV operators delivering video – about 25% of the revenue. So again, this is a profile that looks quite different than before. Very strong continuing strategic focus really across all segments, but in particular on growing our international business, focusing on those product categories which command the highest gross margins, and making sure that we have a balanced coverage across the universe of players who are in the business of delivering, producing, trading video content.

What’s interesting about this pie chart on the market segment, it’s now roughly representative of the video provider landscape out there. You know, cable is still a pretty big number, but if you think about it, the vast majority of people globally who are in a pay television situation are in fact receiving their content through a cable operator over a cable network. Similarly, somewhat north of half that are receiving content from a satellite or a telecom network, and of course broadcast and media is originating all that content and delivering a lot of that content over legacy terrestrial wireless networks and increasingly over-the-top. So we think that this is a very good place to be positioned strategically.

Just a quick look at the balance sheet – the Company has a strong cash position, just over 140 million U.S. and no debt. And no news on our guidance. This is simply a reflection of what we reported on our third quarter earnings call. We expect fourth quarter revenue in the range of 135 to 145 million, gross margins in the 49.5 to 51.5% range, and importantly and noted here at the bottom of the slide, this guidance contemplates some impact of what’s going on in Thailand. For our business, we see some impact in both the disc drive situation, manifested here actually more in terms of gross margin impact as the price of available disc drives has gone up, also some revenue impact associated with our then and current best estimate that we will be unable to secure all of the optical components we need for our access product line.

So in summary, we continue to see a substantial market opportunity there, and we as a company are focused on attacking this market from a point of view of pushing the agenda of our customers and enabling new services through new technology, continued new technology investment, and service capabilities. We’re very focused on expanding—extending and expanding the customer segments we address, and in particular I’ve highlighted our strong focus on broadcast and media companies to complement our focus on the traditional service provider categories. And international expansion continues to be very important and we see it as a great opportunity for our company.

Our technology and competitive position has never been stronger. Talk to anyone in the industry and they’ll tell you that Harmonic is a true technology leader. This is at the product level, the base technology as well as at the system level; and therefore we have really a tremendous brand and really blue chip customer relationships right around the globe. As we look at some of the headwinds that we think some of our competitors are experiencing, we do think that from a competitive position above and beyond our own internal roadmaps, we think that there is some competitive tailwinds that we’re hoping will further aid us in 2012. And we really do believe that this a company that has an ability to execute both from a product perspective and from a business perspective. As we’ve grown into a greater scale company, we continue to see opportunities to strengthen our business model, strengthen our market leadership, and fundamentally grow our top and bottom line.

And with that, Nikos, I’ll conclude my remarks.

Question and Answer Session

Nikos Theodosopoulos

Yeah, we have a few minutes. Does anybody have a question in the audience? Any questions?

One question I had was on the 9000 product. I think the title you had was video for iPhones or something like that.

Patrick Harshman

HDTV to iPhones – it’s kind of the Swiss army knife of—

Nikos Theodosopoulos

Right, multiple formats, multiple screen sizes. Who is the buyer of that product? I mean, do mobile operators ultimately get involved with that, or is it further back in the network? Who is making the decision between—

Patrick Harshman

Our initial prime target is the existing service provider community. Just about every one of our traditional service provider customers now is expanding their multi-screen agenda to include not only standard definition, high definition but smaller devices. I mean, let me just to give you an example, and not to associate Harmonic necessarily with these initiatives, but Cablevision announced earlier in the year an initiative to deliver video not only to televisions in the home but also to iPads and iPhones within the home. And as you know, this instigated somewhat of an argument for a while over content rights, et cetera; but take an application like that—so their mission, therefore, is to take, as I said in my example, Monday Night Football and be able to deliver it to your television in your living room but also over your in-home wireless network to your iPad on the back patio or in the kitchen. DirectTV announced a similar service just a couple of weeks ago where, I think, 80 of the broadcast channels that they’re delivering over the satellite are now being simultaneously delivered over-the-top and delivered to any device in the home.

So the way a lot of the initial trials have gone is a separate infrastructure has been built transcoding just for the mobile devices, sitting side by side encoders for the same exact content going to the television.

Nikos Theodosopoulos

But the spending is being done by the same—

Patrick Harshman

By the same exact operator, exactly.

Nikos Theodosopoulos

Is there a business opportunity at some point, whether it’s high def TV or streaming media that’s maybe not broadcast but other types of media, to work with mobile operators?

Patrick Harshman

Absolutely. I mean, one of the things that’s nice about this part of the business is that the technology is extensible across different customer types and different delivery networks. That same product is equally interesting to satellite, teleco and cable operators, and in fact to mobile operators. and in fact in the example that I just gave you – think of a DirectTV kind of application – there they would be taking the same content in to be processed by this one device, this one appliance, Ethernet output that would go to a switch, one stream would go to a CDN for delivery over the Internet, the other out port of the switch would go for satellite delivery. So to your question, that could very easily in our mind, and we hope over time, to encompass mobile operators, over-the-top only kind of service providers who use that same exact video processing technology to deliver these range of resolutions and formats over whatever that delivery network is – wire line or wireless.

Nikos Theodosopoulos

In this encoding market, traditional and the new multi-screen multi-format, what’s your share let’s say versus a Motorola, especially since Motorola is—the assets of that business are moving on to Google, and does that create disruption? I mean, what’s your view on the potential to take share as that happens?

Patrick Harshman

Well for me, there’s two parts of the question. Let me generalize a little bit, and I would say from our view, a couple of our historic large competitors are dealing with a variety of distractions and maybe strategic shifts, and that’s benefiting us. We think internally there’s a little bit of loss of focus, and from the customer perspective there is questions – where does this go? And we think that that certainly is starting to play to our advantage competitively.

Nikos Theodosopoulos

Do you have some examples of that, or maybe not mentioning customers specifically?

Patrick Harshman

I can just simply tell you those are very real conversations that I have with senior executives of customers, and we think it’s creating opportunities for us. Somewhat separate from that is this multi-screen business, and there quite honestly we have seen our large competitors not be the aggressors. When I think about the competitive environment there, I’m actually more cognizant of a number of smaller companies who are a little bit more active. It’s somewhat ironic given the history of Harmonic usually competing against larger players. In the multi-screen area, we find ourselves being the larger player and up against, more often than not a number of small start-ups pointed at various niches in this space. So put differently, Nikos, we really see Harmonic as the clear leader of scale addressing the multi-screen opportunity and it’s a position that we expect to leverage.

Nikos Theodosopoulos

Okay. Just on the Omneon acquisition, I think the Street—the numbers you’re putting up this year are not quite what the Street was looking at in the beginning of the year. What do you attribute to that – is it the integration, is it the market size, the sales force? What’s your assessment of that?

Patrick Harshman

We had indeed hoped for greater revenue growth out of the Omneon products. We attribute most of it actually to integration issues. I think particularly in the U.S., the capital spending environment has been a little bit disappointing, so I think that that’s part of the equation as well as perhaps a more challenging integration period, or longer than at least I anticipated. That being said, I think we’ve made tremendous integration progress. We integrated the whole sales force, cross-trained, et cetera, and today we’re in a very different place than we were nine months ago. We really think that we’re hitting on, if not all cylinders, nearly all cylinders; and we believe that going into 2012 we’re going to be executing in the marketplace much better than we were this year.

I would however, Nikos, note that going back to a statistic that I pointed out, the other plank of the Omneon acquisition was to give us more sales exposure to the media and broadcast universe; and here, that has actually played out much as we had hoped. The fact that the overall company business with broadcast and media companies has grown 19% year-to-date while the Omneon products themselves are roughly flat clearly suggests that we’ve done a very good job of bringing our video processing products into that arena, and here the Omneon sales force, the Omneon relationships with the leading domestic and international broadcast and media companies has really met our expectations.

Nikos Theodosopoulos

Just one last question – hard disc drive, typically you don’t associate with Harmonic. How are you impacted, what percentage of your business is that?

Patrick Harshman

Most of the Omneon products, which today is about 20% of the revenue, is based on a hard drive. You know, we’re mostly a software company in that realm, but we’re using IT hardware that our custom software rides on, so both our server product and our media goods storage product is based on hard drives. Our view for the fourth quarter, and it’s no different than what we shared on our guidance call and it is subject to change - as you know, it’s a dynamic situation – but our current view is that we’re going to be able to cover our fourth quarter demand albeit at a higher price to us, and therefore we took that into account in the somewhat more conservative margin guidance that we gave for the quarter.

Nikos Theodosopoulos

Okay, thank you Patrick. The Company will be hosting a breakout downstairs.

Patrick Harshman

All right. Thank you, Nikos, and thanks everyone for joining us today.

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