Harmonic's (HLIT) CEO Patrick Harshman on Q2 2016 Results - Earnings Call Transcript

| About: Harmonic Inc. (HLIT)
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Harmonic Inc. (NASDAQ:HLIT) Q2 2016 Results Earnings Conference Call August 9, 2016 5:00 PM ET


Blair King – Director, IR

Patrick Harshman - President and CEO

Harold Covert - CFO


George Notter - Jefferies

Greg Mesniaeff - Drexel Hamilton

Matthew Galinko - Sidoti

Tim Savageaux - Northland Capital

Victor Chiu - Raymond James


Welcome to the Second Quarter 2016 Harmonic Earnings Conference Call. My name is Ana and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded.

I will now turn the call over to Blair King, Director of Investor Relations. Please go ahead.

Blair King

Thank you, Ana. Hello, everyone and thank you for joining us today for Harmonic's second quarter 2016 earnings conference call. My name is Blair King, as Ana just mentioned. And with me here at our headquarters in San Jose today are Patrick Harshman, our CEO; and Hal Covert, our CFO.

I’d like to point out that in addition to the audio portion of this call, we have also provided slides for this webcast, which you can see by going to the Investor Relations Page on harmonicinc.com and clicking on the second quarter 2016 preliminary results call button.

Now turning to Slide 2, let me remind you that during this call, we will provide projections and other forward-looking statements regarding future events or the future financial performance of the company. We must caution you that such statements are only current expectations and actual events or results may differ materially.

We refer you to documents that Harmonic files with the SEC, including our most recent 10-Q and 10-K reports and the forward-looking statement section of today's preliminary results press release. 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 that unless otherwise indicated, the financial metrics we provide you on this call are determined on a non-GAAP basis. These items, together with corresponding GAAP numbers and a reconciliation to GAAP are contained in today's press release, which we have posted on our website and filed with the SEC on Form 8-K. We will also discuss historical, financial and other statistical information regarding our business and operations and 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.

So with all that said, I'll now turn the call over to our CEO, Patrick Harshman. Patrick?

Patrick Harshman

All right. Thanks, Blair, and thank you all for joining us today.

Turning to Slide 3. We executed well on Q2 reporting a quarter characterized by improved demand trends for video products and services, solid integration work with Thomson Video Networks and significant progress on our transformational product initiatives.

Revenue were $110 million, was up 33% sequentially reflecting both our first full quarter of Thomson Video Networks contribution and improved Video products demand worldwide. Bookings were healthy at $117 million up 7% sequentially and 18% year-over-year. This was our third consecutive quarter of book-to-bill greater than one and consequently our backlog in differed revenues grew to a record $190 million.

Gross margin for the quarter was 53% up 200 basis points sequentially reflecting a mix shift to more Video products relative to the first quarter. And finally EPS was breakeven with significant improvement over the first quarter but also reflecting that we're still in the early stages of our TVN related synergy program, and of course continuing to invest heavily in Cable-Edge R&D in anticipation of driving significant growth of that business.

So putting it all together here, our strong order book, positive market demand trends, and strong internal execution enable us to remain confident in delivering the double digit operating profit we targeted in Q4 as we exit the year.

So with that let's now turn to Slide 4, and take a closer look at our Video business. The first key message here is the demand momentum for Video infrastructure continued through the second quarter driven in particular by a resurgence of projects that spend traditional pay TV and live over the top services.

Intense competition between global telecom, cable and satellite direct-to-home operators, as well as over the top business trends and growing Ultra HD market momentum, all reinforce our positive outlook for sustained Video and infrastructure spending.

The second key message about our Video business is that the integration of Thomson Video Networks is going well. Customers are responding positively to our enhanced global presence, scale and strategic focus on high quality video. However, the goals for Thomson remain in line with our pre-acquisition estimates. Our sales teams and product maps are aligned and we are seeing good signs of cross-selling across our customer base and our global synergy in 12 month accretion plans are on track with positive financial impact increasing to the back half of this year and into 2017.

And the third key Video segment message, is that we're seeing growing success transitioning our business to being more software centric. Specifically, our first generation VOS platform for both the software bundles and commercial office set servers and as pure virtual machine software exceeded a record 75% of our video encoding and transcoding sales in the second quarter.

Further evidence that this is a winning strategy was provided by the third party research published during the quarter which indicated Harmonic is the clear market share leader in the global and coding business.

So, leveraging our growing software-momentum and capabilities, during the quarter we introduced our second generation VOS platform. A cloud native application suite for deployment in private and/or public cloud environments. We also announced the software-as-service offering based on this advancement.

Our new business model designed to expand our addressable market and open the door to new recurring revenue streams. So in the midst of several key trials of this technology with both new cloud partners and several Tier 1 pay TV operators, we're finding this new VOS 2.0 cloud platform to a more robust, simple and scalable and competitive solutions. We expect it to become increasingly important differentiator for Harmonic going forward.

With our newly expanded R&D capability by our Thomson Video Networks, and continuing close customer collaboration, we're driving more innovations and opportunity in the cloud. So in summary here, our Video business is healthy and our full year segment growth and profitability plans are firmly on track.

So let's now turn to our Cable Edge Business on Slide 5. As a reminder our Cable Edge strategy is becoming a leading player in the $2 billion plus CCAP market by delivering truly innovative new DOCSIS technology that we call CableOS. Since our last update, we've continued to make material progress and our confidence in our CableOS program has continued to grow.

So, why are we increasingly confident about driving transformative growth through this initiative? Well first, during the quarter we successfully expanded the number of active customer engagements. We are also passing several more key performance and scalability milestones, bringing us closer to volume deployment readiness.

Second, we expect this momentum to continue through the third quarter and we remain firmly on track to commercially release our CableOS products and make our first revenue shipments in the fourth quarter this year.

And third, we believe our market timing is good. During the second quarter SNL Kagan released a new market sizing study that estimates annual CCAP investments to grow to approximately $2.6 billion. With much of market growth coming via disruptive new network architectures that we believe our CableOS technology will be particularly well suited to address.

Now we understand that many of you are hungry for more details about which customers we're engaged with and why exactly we think we’re going to win here. We ask you to understand that the customer engagement is underway and the unique elements of our technology for which we filed multiple patents are still confidential for competitive reasons. Now that said, based on our progress and trajectory, we now anticipate we will be in a position to make important announcements with more business details later this year.

In the mean time, while demand for our traditional EdgeQAM products improved slightly in our second quarter versus the first. We expect global demand for legacy EdgeQAM technology to continue to soften the back half of this year as cable operators look ahead to the next generation of converged IP video services. So, as a reminder this means that our Cable Edge business will continue to lay on our total company financial results for another quarter or two.

So, in conclusion regarding the future of our Cable Edge business segment and as I outlined in prior calls, it's really all our CableOS success. This is a major program that carry some risk but tremendous upside. We are continuing to invest heavily and are committed to successfully turning our CableOS opportunity into a powerful new business growth engine.

Now before turning the call over to Hal, I want to also update you that we've executed an important engineering collaboration agreement with the customer. The agreement cause for us to receive engineering funding of up to $10 million through 2017, Hal will provide additional details on the accounting treatment.

The condition of the agreement to strict confidentiality so suffice it to say that we see this arrangement is a strong endorsement of Harmonic's innovation leadership and close customer relationships. And also this is an important value creating opportunity for our shareholders

So with that Hal let me turn the call over to you.

Harold Covert

Thank you, Patrick.

We want to thank everyone for joining our call today. During my discussion I will cover two topics, first, our financial results for Q2, 2016 and then our financial goals for Q3 in the year of 2016. Before discussing our financial results, we would like to start with some opening comments.

Q2, 2016 is the first quarter for Harmonic that reflects the full quarter's benefit of the TVN acquisition. TVN is performing in line with pre-acquisition expectations however since Harmonic is pursuing a path to operationally integrate TVN it is not possible to break out financial results for TVN on a standalone basis in typical detail.

Even at the revenue level we are beginning to cross-sell and integrate product lines. We are on track with Harmonic plus TVN synergy goals for 2016 and our annual target for 2017 as well as related to restructuring and integration charges. I will provide more detail in this regard shortly.

As Patrick indicated during the quarter we signed an engineering collaboration agreement with one of our customers. This agreement is focused on development initiatives that have been underway and extend into 2017. The agreement provides Harmonic with funding from our customer up to $10 million to offset associated engineering expenses upon achievement of agreed upon milestones.

Payments will occur when these milestones are achieved in $2 million increments. We received our first payment in July, 2016. The aforementioned funding will flow through the R&D expense line in our income statement as a reduction in R&D expense in sync with related expenditures. In Q2, 2016 we recorded approximately $1.6 million of such expenses along with an offsetting reduction. Overall payments and expenditures related to engineering collaboration agreement are expected to offset each other and therefore will not increase our R&D expense one right.

Our financial results for bookings, revenue and operating profit for Q2 were ahead of or in line with our plan. From a revenue standpoint approximately $4 million of revenue that we originally anticipated recognizing in Q1, 2016 was recorded in Q2 and we achieved expectations for Harmonic and TVN revenue even if we exclude the 4 million. Our goal is to record the remaining $1 million of roll over revenue for Q1, 2016 in the second half of the year. This revenue is related to the establishment of fair market value for software elements.

During Q2, 2016 we continue to make enhancements to our business processes that effectively address our transition to a higher content of software revenue from an accounting standpoint. In the second half of 2016, we expect to recognize software product revenue more in line with how we have traditionally reported product revenue i.e. upon shipment or when acceptance criteria are satisfied.

We ended Q2, 2016 with backlog and deferred revenue of $190.4 million. This is a record level for the company and enhances our visibility as we strive to achieve sequential revenue growth in Q3 and Q4 of 2016

One last point before discussing our Q2 financial results, as part of our strategic plan to reposition our Cable Edge segment in the marketplace and dedicate our resources to our new CableOS products during the quarter we decided to discontinue certain legacy products. This decision was influenced by continued customer traction that we experienced in Q2, 2016 around our strategic initiatives.

These legacy products would require additional R&D resources and focused effort to continue selling. Given our planned launch of our new CableOS products in Q4 2016 we did not deem the use of our resources for these products to be in our best interest. In conjunction with this decision, we recorded a 4.5 million charge related to inventory.

This charge is included in our GAAP financial results for Q2 but not in our non-GAAP financial results due to its infrequent nature. As you will hear when we discuss our financial goals for 2016, our Cable Edge revenue is expected to be higher than our original financial goals including the impact of this decision.

Turning to our Q2, 2016 financial results. During our call today and in our Q2, 2016 SEC filings Harmonic's financial results will include TVN on a fully consolidated basis. We will provide selected pro forma financial variation for TVN as a note to our financial statements in our SEC filings as required by GAAP. Please note that our financial results and guidance discussed during this call are based on non-GAAP measurements. These non-GAAP measurements reflect Harmonic's traditional approach for reporting such information as well as taking certain TVN purchase price accounting adjustments into consideration.

A table reconciling GAAP and non-GAAP measurements is included in our Q2, 2016 earnings press release. Bookings for Q2, 2016 were $117.3 million compared to $109.6 million in Q1, 2016 and $99.3 million in Q2, 2015. Our bookings for the quarter were in line with our expectations on a geographic and product basis. Non-GAAP revenue for Q2, 2016 was $109.5 million versus $82.5 million in Q1, 2016 and $103.1 million in Q2, 2015. As noted earlier Q2, 2016 revenue included approximately $4 million of roll over revenue from Q1, 2016.

In Q2, 2016 we had good sequential revenue growth in both our Video and Cable Edge segments. In particular with a full quarter of TVN revenue of approximately $18 million our Video revenue increased sequentially by $24.8 million. In Q2, 2016 we did not have any 10% customers. Our year-over-year revenue increase was related to TVN. For Q2, 2016 non-GAAP Video revenue was $90.5 million compared to $65.7 million in Q1, 2016 and $78.2 million in Q2, 2015. We expect our Video revenue continue to grow sequentially in Q3 and Q4 of 2016.

Cable Edge revenue in Q2, 2016 was 19 million versus $16.8 million in Q1, 2016 and $24.9 million in Q2, 2015. Revenue for Q2, 2016included a large shipment of mostly hardware to one customer that represented approximately one third of our total Cable Edge revenue for the quarter. We anticipate that follow-on license revenue related to this shipment will materialize in 2017. The year-over-year decrease in Cable Edge revenue is due to the transition to new CCAP Technology.

Non-GAAP gross margin as a percent of revenue for Q2, 2016 was 53.5% versus 51.1% in Q1, 2016 and 53.2% in Q2, 2015. Although our gross margin as a percent of revenue increased sequentially we are behind our first half of 2016 plan due to a combination of Video revenue mix and the aforementioned Cable Edge revenue content.

Non-GAAP operating expenses for Q2, 2016 were $57.7 million compared to $50.5 million in Q1, 2016 and $49.6 million in Q2, 2015. The increase sequentially and year-over-year operating expenses was due to TVN being part of Harmonic for the entire quarter as opposed to just one month as in Q1 2016.

Our operating expenses for Q2 2016 were in line with our plan. Our non-GAAP operating profit for Q2 2016 was $0.9 million compared to a loss of $8.4 million in Q1 2016 and a profit of $5.3 million in Q2 2015.

Higher sequential revenue and gross margin more than offset our increase in operating expenses for the quarter. The year-over-year decline in operating profit is related to higher operating expenses. Upon achievement of our synergy goals we will reduce operating expenses as a percent of revenue in both Q3 and Q4 2016.

We had breakeven non-GAAP EPS Q2 2016 versus an $0.11 loss in Q1 2016 and a $0.05 profit in Q2 2015. Again the revenue and gross margin results that we achieved in Q2 2016 were the reason for the sequential improvement. As in the case of operating profit the year-over-year decreased in EPS was due to higher operating expenses.

We had 77.3 million share of common stock outstanding as of the end of Q2 2016 versus 77 million as of the end of Q1 2016 and $89.4 million as of the end of Q2 2015.

Now turning to our balance sheet. We ended Q2 2016 with $65.3 million in cash compared to $76.2 million as of the end of Q1 2016 and $105.1 million as of the end of Q2 2015. During the quarter we incurred approximately $3.5 million of cash outflow related to the TVN purchase. The remaining decrease in cash was essentially due to an increase in accounts receivable which reflects our sequential revenue growth of $27 million.

As of the end Q2 2016 on a year-to-date basis we have incurred approximately $11 million of cash outflow related to TVN restructuring and integration expense. In the second half of 2016 we anticipate that cash requirements for TVN restructuring and integration expense will be offset by positive cash flow from operations.

Our days sales outstanding at the end of Q2 2016 were 86 days versus 105 days at the end of Q1 2016 and 67 days at the end of Q2 2015. We anticipate that we will continue to improve DSO throughout the second half of 2016.

Out days inventory on hand were 58 days at the end of Q2 2016 compared to 94 at the end of Q1 2016 and 61 at the end of Q2 2015. The sequential decline was primarily the result of the sales legacy Cable Edge products during the quarter and inventory write off previously discussed. We anticipate that we will continue improve days inventory on hand throughout the second quarter of 2016.

At the end of Q2 2016 we had $190.4 million of backlog and deferred revenue compared to $180 million as of the end of Q1 2016 and $120.7 million as of the end of Q2 2015. We believe that our backlog is in an appropriate level to support quarterly revenue generation in the $100 million plus range with our historical mix of product and service revenue.

Staffing at the end of Q2 2016 was 1,403 compared to 1,418 at the end of Q1 2016 and 1,019 at the end of Q2 2015. We had approximately 438 people as a result of the TVN acquisition.

Now turning to our financial goals for the second half of 2016. First we would like to point out some highlights. One, we achieved sequential revenue growth in Q3 and Q4 2016 and year-over-year revenue growth for our Video business. Two, achieve double-digit non-GAAP operating profit in Q4 2016. Three, exit 2016 with annualized synergy savings of approximately $20 million to $22 million as of the Harmonic plus TVN combination.

Four, contain our estimated 2016 restructuring and integration change for the Harmonic plus TVN combination within the range of $22 million to $24 million which includes approximately $2 million to $3 million for depreciation and write off of fixed assets and the related cash charge within the $20 million to $22 million range.

Five, exit 2016 with $65 million to $70 million in cash on hand. By achieving this goal it essentially means that we will have funded the majority of the projected restructuring and integration charge related to TVN from cash flow from operations. Six, continue to achieve planned milestones related to the development and deployment of our new CableOS products and services. And finally seven, position the company to generate double-digit non-GAAP operating profit in 2017.

For Q3 2016 our financial goals are; Revenue 105 to 110 which includes Video revenue of 93 to 96 and Cable-Edge of 12 million to 14 million. Keep I mind that if you normalize our revenue for Q1 and Q2 2016 by moving $4 million from Q2 to Q1 and taking the midpoint of our revenue goal for Q3 our revenue profile for Q1 through Q3 2016 would be as follows. Q1 $86.5 million, Q2 105.5 million and Q3 $107.5 million.

Gross margin as a percent of revenue 53% to 54% which includes Video gross margin percent of 54.5% to 55.5% and Cable-Edge gross margin percent of 40% to 41%. Operating expenses 54 million to 55 million, operating profit 2 million to 4 million, EPS $0.01 to $0.03, common shares of stock outstand approximately 78 million, cash on hand at the end of the quarter 60 million to 65 million.

And then for the full year of 2016 our financial goals are; Revenue 410 million to 420 million which includes Video revenue of 350 million to 355 million including approximately the 60 million of revenue associated with TVN and Cable-Edge revenue of 60 million to 65 million. Our initial revenue goal was 400 million to 415 million with 345 million to 355 million of Video revenue which includes 55 million to 60 million of TVN revenue and 55 million of 60 million of Cable-Edge revenue.

Gross margin as a percent of revenue 53% to 54% which includes Video gross margin as a percent of revenue of 55% to 56% and Cable-Edge gross margin as a percent of revenue of 40% to 41%.

Our Cable-Edge gross margin as a percent of revenue is approximately 5 percentage points below our initial plan as a result of shifting product with a content of hardware revenue than anticipated. We believe that associated license revenue will follow in 2017. Our initial gross margin goals as a percent of revenue was approximately 55% with 55% to 57% for Video and 45% to 47% for Cable-Edge.

Operating expense 212 million to 216 million which includes approximately $4 million related to TVN that was incurred in March of 2016. Our initial operating plan for 2016 assume that the TVN transaction would close in Q2 2016 as opposed to February 29, 2016. Our initial goal for operating expenses was 208 million to 212 million.

Operating profit 5 million to 10 million which includes a loss in March in 2016 of approximately 2 million related to TVN and a shortfall of approximately 4 million related to Cable-Edge gross margin as a percent of revenue as previously discussed. Our initial operating profit goal for 2016 was 14 million to 16 million.

EPS $0.01 to $0.06. Our initial goal was $0.09 to $0.12. Common shares of stock outstanding approximately 78 million to 79 million. Our initial goals for common shares of stock outstanding was approximately 80 million.

Capital expenditures 14 million to 16 million, our initial goal for capital expenditures was approximately 15 million. Cash on hand at yearend 65 million to 70 million are initial goal for cash on hand at yearend was 50 million to 60 million. Non-GAAP tax rate approximately 15% which is in line with our initial goal.

In closing, we realize that our financial goals for 2016 include strong sequential performance in the fourth quarter of the year. With that in mind as I indicated in my opening remarks, we are making good progress in enhancing our business processes as our revenue generation profile continues to transition to more software content. Most important with our record backlog and deferred revenue we're heading into the second half of 2016 with momentum. Our projected 2016 revenue for our Cable Edge segment is higher than our initial financial guidance ranges.

And although gross margin as a percent of revenue is lower due to the hardware mix, we expect we will add a license revenue to follow on 2017.Our projected Video segment financial performance for 2016 is in line with our initial financial guidance ranges and reflects double-digit year-over-year increases for both revenue and gross margin dollars.

I will now turn the call back over to Patrick.

Patrick Harshman

Okay, thanks Hal. Please turn to slide 12 where I want to conclude by emphasizing that we remain very focused on executing the strategic priorities was previously outlined. Our Video business is the market share leader in video encoding and related systems for the world leading pay TV and media companies.

We’re increasing the value of this business by leading the industry transformation to software based video infrastructure and the next generation of high quality over the top services. Through our acquisition of Thompson Video Networks we’re accelerating the execution of the strategy combining innovative software approaches from Thompson and Harmonic into compelling customer offerings.

Expanding our global footprint and driving greater profitability. From a stronger customer demand and competitive wins we’ve seen through the first half of the year to validate that we’re on track here. We’re also investing our Cable Edge business that is poised for significant growth with a release of our new CableOS platform. For most of 2016 will be spend - bringing this CableOS product to market, positive customer engagements and the pending cable architectural shift give us confidence in the growth potential of this business.

And finally I want to confirm that our entire organization is focused on the execution of these strategic initiatives. Driving competitive wins that will translate into top line growth and margin expansion, delivering on approximately $20 million of annualized synergies, and positioning the company to exit 2016 with double digit operating profit and be poised for new phase of profitable growth.

So with that let’s now open the call up for your questions.

Question-and-Answer Session


[Operator Instructions] And we have a question from George Notter from Jefferies. Please go ahead.

George Notter

Hi, guys. Thanks very much, and thank you for all the detail on the call. I guess I had a few questions. I guess maybe this is more housekeeping. But, on the $10 million nonrecurring engineering deal, I guess I'm curious if you could say anything about, which side of the business is that on? Is it on the Cable Edge side, or is it video? I guess I'm also curious if you could tell us what genre of customer that might be, a cable operator or otherwise.

And I'm also curious about anything you can say on what technologies are involved or whether or not that technology would be exclusive to the partner there or something that you can leverage across other customers. Maybe I'll just start with that and come back for a follow up.

Patrick Harshman

Well, I think all around the questions, George I'm very sorry at this point I can’t answer any of them. As I mentioned we are bound by a very strict confidentiality agreement. So at this point just have to - I guess trust us that this is a exciting a very positive for the business and very positive for shareholders. And we look forward to a point in the future when we can disclose more.

George Notter

Can you at least…

Harold Covert

George the only thing I would add to that - is that the payments are based on milestone and we did hit our first set of milestones in the July timeframe and received the first payment. So the activity is underway.

George Notter

Got it. Okay. And can you just answer the one about exclusivity? Is there a way to leverage this technology across other customers as well?

Patrick Harshman

We can’t answer in explicitly George I am sorry.

George Notter


Patrick Harshman

But I would tell you we wouldn't do any deal that didn't make good sense for the business.

George Notter

Got it. Okay. And then also, I was just curious about your comments about product discontinuances. Is that affecting revenue materially here? Is it -- did it show up in this quarter? Was it something that's more prospective looking? Is it in the full year guidance? How should we think about that?

Harold Covert

Yes, I’ll tell you but it boiled down to quite simply was that as I indicated in my comments our revenue for Cable Edge is prior than our initial guidance by roughly 5 million. So we had some products that didn't have much activity and to sell those products in today’s environment we would had to put more R&D and sales opportunity thought was justified given the opportunity that we have with CableOS.

So we made a decision to basically discontinue those products again and that didn’t have much activity to begin with. They had no impacts on our overall revenue generation at this point and going forward and the we don't think there’s any other costs related to those type of products. So that would have to be addressed at a later point.

Patrick Harshman

All right. It sounds like we may have missed – lost George there so why don’t we move on.


Our next question is from Greg Mesniaeff from Drexel Hamilton. Please go ahead.

Greg Mesniaeff

Yes, thanks. Besides breaking out revenues by video and Cable Edge, can you give us some color as to geographic mix and/or mix by type of customer?

A – Harold Covert

Yes, I mean there is some geographic information that will be included in our 10-Q filing tomorrow. But we’re following our traditional pattern of roughly about half of our revenue and bookings in the Americas and then 30% or so in Europe and the balance in Asia. So I don't think there's any real changes to those patterns at this point.

Greg Mesniaeff

Okay. And as far as cable operators versus broadcasters, any difference to your historical trends or patterns?

A – Harold Covert

No, I would say that it's pretty much in line with our historical pattern, service provider is roughly about 60% or so and then the balance is media and broadcast. And again our patterns have held pretty consistent throughout the first half of the year.

Greg Mesniaeff

Got it. Any greater than10% customer?

A – Harold Covert

Not, not this quarter. No.

Greg Mesniaeff

Okay, got it. Okay I'll stop there and I'll come back. Thanks.


Our next question is from Matthew Galinko from Sidoti. Please go ahead.

Matthew Galinko

Hey, good afternoon, guys. Patrick, you highlighted pay -- I guess Ultra HD adoption as a catalyst for some of those trends maybe you're seeing in the video business. I was wondering if there's anything you could -- anything specific you could highlight, where that's -- whether geographically or any customers you could talk about that are -- that might be driving that.

Patrick Harshman

It’s a good question. I want also to clarify that it's one of the several drivers that we see of the stronger video demand top of aggressive competition between tortious service providers, investment and over the top .And indeed we are starting to see slower than we had at one time expected but nonetheless a steady increase in 4K or Ultra HD activity.

And we’ve had a couple of interesting press releases speaking about what we're doing there including a couple months back with a content producer I’d call Sneaky TV you'll probably also seeing some of the advertising some of our service providers talking about one or two channels better programming available in Ultra HD.

And indeed what we’re seeing is really right across the globe we're seeing large service providers looking to add a couple of Ultra HD channels to their packages with our portfolios. So on one hand it’s a service providers on the other hand people like the broadcast to many companies we’ve mentioned in a couple of press releases starting to produce more of the content.

So this is a little bit the pattern, we saw if you go back several years ago with HD it’s the flywheel starting to move, more content getting produced and for us that's an opportunity. And then more service provider starting to offer initially a couple of channels and then growing.

As you may have also seen in our most recent press release about what we plan on showing at the upcoming big event in Amsterdam, the IBC Show over the top streaming of Ultra HD is becoming a theme for us and it’s a definitely an area where we’re seeing customer interest and we're doing some interesting early work.

So in summary it's still a relatively modest contribution to the revenue but it's definitely starting to move and grow and it's part of why we’re optimistic about the sustained demand trends in video infrastructure in general.

Matthew Galinko

Got it. And maybe if I could just ask a two-part follow on, you highlighted that 75% of your encoding business this quarter was in your VOS. So, I guess, can you single out or break out at all how much of that was hardware versus the software? And I guess secondly, I guess -- maybe we'll just stick with that one for now.

Patrick Harshman

Okay. Let me first clarify that for us what we've developed is software and what we do is we offered a package to lever the customer likes. We can do a deal where we put that software onto the commercial off-the-shelf server and ship it as a box. But to be clear we didn't do a lick of hardware engineering there. We just package the software with the box. And then some customers are saying you know what I’ve got my own blade servers just ship me the software and I’ll take that and I'll install it myself. We're ready to go either way and that’s the great and the exciting news.

As it turns out and I’ll tell you frankly a little surprising to us still the majority of customers are asking for us to package it with an off-the-shelf server. And I think our gross margin trend it's indicative of the fact that you see that that hardware box we're passing through being part of the revenue basically neutral from a gross margin dollar perspective. But I’ll tell you a couple of our largest customers are starting to tip towards just taking the software run on their own hardware, they’ve got volume purchasing on blade servers and they’ve also got the operational know-how.

So I think it's going to be an interesting space to watch over the next several quarters of where they're ready to go as fast as the market will allow us. But I want to emphasize it's all the same code base for us. It's just a simply a matter of where and how it gets bound with off-the-shelf hardware. Did I answer your question?

Matthew Galinko

Fair enough. It does. And if I could just get the follow up in there -- apologize for hogging, but in terms of the strength in VOS, again, this quarter and just terms of in the mix, is -- I guess you kind of alluded to it in your -- in my first question. But, is that kind of -- is it operationally driven, where customers are pushing towards the newer platform, or is it looking for features like being able to encode Ultra HD content, or what would you say the primary driver of strength in the VOS is at this point?

Patrick Harshman

The primary driver is actually the functionality we're delivering on top of the platform. You are right. Everything from Ultra HD to amazingly well compressed standard definition and high-definition content. I think the real innovation here is that we’re now doing that on commercial off-the-shelf the Intel, Xeon and i7 chips which is really a revolution in the industry to deliver this kind of pristine compression on these off-the-shelf platforms.

Now of course customers like the fact strategically that this is a running on Intel and even if they’re getting server from us today many of them have strategic plans to pivot to their own their own data center infrastructure going forward.

So I’d say that that overall architecture is a secondary benefit but the first and foremost is just the great compression and the other functionality that we’re including in these offerings. So this is the highest performing platform regardless of what the underlying hardware chipset is in the industry that were delivering.

And the fact that we can do it on these commercially available Intel chips is all the more amazing and I think call it more powerful in the marketplace.

Matthew Galinko

Excellent, thank you.


And we have a question from Tim Savageaux from Northland Capital. Please go ahead.

Tim Savageaux

Okay. I think that's me. Good afternoon. And some questions on the service provider front, if we can -- and pardon me if I missed some of this. I'm hopping on the call late. But, if you could talk to sort of organic trends on the cable spending side in particular across both your Edge and video businesses. You've seen pretty strong indications really through the first half here of kind of a pretty robust spending environment amongst North American cable operators.

I wonder if kind of that's what you're seeing and if you have any outlook there. I ask because it's obviously tough to get kind of organic -- an organic sense of what's happening with your service provider business as you fold in Thomson. And I guess I'd ask the same question about kind of U.S. satellite providers. Thanks.

Patrick Harshman

Okay, Tim I’ll take that perhaps Hal will jump in. The business is good with cable I guess is the headline there. The dynamics on the two sides of our business are indeed different. We’ve got the market leading EdgeQAM platform where EdgeQAM are needed we think we’re winning business and we had a modestly up quarter in legacy EdgeQAM.

That being said cable operators are embarking on a big architectural transition and frankly we’re positive although looking ahead with their investments to this next generation CCAP and in our particular case as we get closer and closer to General: In no apparent distress. Awake, alert, and oriented x3. Mood and affect appropriate. Availability of our new cable less platform naturally we see customers pulling back a little bit and waiting looking ahead to that platform.

So that’s what’s behind the commentary about softening Cable-Edge demand in the second quarter of year as we transition from legacy EdgeQAM to our new CableOS launch. On the other side of the equation things have been going well for us in the digital video front with cable operators. Frankly there was real slowdown last year but the combination of the Ultra HD we were just talking about and some real significant advancements that we’ve made around compressing high definition content and some of the interesting things we’re doing around over-the-top. We’ve got good momentum with cable operators in the video front worldwide.

And of course the subscription numbers that you’ve seen for cable as well as the boarder pay TV space are not bad. I think it’s clear that while cord cutting is a threat I think it’s not one that is turning out in the short term to be that damaging to our service provider businesses, customer’s business and they are responding to the threat.

So we’ve seen a resurgence actually in spending not only in cable but also in satellite direct-to-home as well as telecom and while our largest customers are notoriously reticent to allow publicity I think you can go to some of the press releases we’ve made over the past couple of months Claro in Chile, America Mobile operation, Airtel in India. In Finland a very significant over-the-top project et cetera.

So we see satellite direct-to-home as well as telecom operators following sue with cable and making investments and expanding and upgrading the video infrastructure.

Harold Covert

So I’ll just add a few numbers to Patrick’s comments. In quarter one and quarter two we did, quarter one we did 17, quarter two we did 19 in our Cable Edge business and our guidance is 12 to 14 in Q3 so we had a strong first half. Our initial guidance for the full year was 12 million to 14 million for the first three quarters so again the first half was stronger than we had initially anticipated and that’s why we boosted our guidance from up by $5 million from our initial goals.

We do expect our Q4 cable edge business to tick back up again from the Q3 level that I just mentioned primarily driven by just again the legacy sales at a fairly flat level relative to Q3 and then we are anticipating shipments of our new CableOS products in Q4. So we’re looking for again an uptick as we exit the year in our Cable Edge business.

Tim Savageaux

Okay, thanks.


Our next question is from Simon Leopold from Raymond James. Please go ahead.

Victor Chiu

Hi, this is Victor Chiu in for Simon Leopold. I'm sorry if I missed this before, but what's driving the lower gross margin and the higher operating expenses relative to your prior guidance? I'm just trying to reconcile the new guidance that you gave relative to what you gave last quarter.

Patrick Harshman

Yes, I would say, let me just start with the operating expenses because it’s a little bit easier. We closed TVN earlier than we had anticipated, we closed in February as opposed to in Q2. That added about 4 million to our operating expense guidance for the full year. If you take that $4 million out of the equation we were essentially right in line with our initial guidance. So OpEx again I think is straightforward.

On the gross margin side we do expect to get in line with our initial guidance for our video business, I mean it’s fundamentally tracking along that path now and as we get into the back half of the year and have full recognition of software revenue we think we’ll be again right in line with the initial guidance.

On the CableOS side we gave guidance of 40% to 41% gross margin versus our initial guidance of 45% to 47% primarily due to the mix. The hardware mix is a bit stronger than we had anticipated although as I indicated during the prepared comments we believe that our license revenue will follow those hardware shipments as head into 2017 so we’re looking for an uptick from that standpoint again next year.

So I would just summarize by saying that, our Video business is essentially right on track with our initial guidance again with the earlier closing of TVN taking into consideration and our Cable Edge business is tracking from a top line standpoint off slightly from a gross margin standpoint again due to the content of revenue I just mentioned.

Victor Chiu

Okay. And there is no impact to revenue from the discontinuation of the products that you spoke about.

Patrick Harshman

No, actually those were products that we had not had much activity on in their current configuration and to change would have to put R&D and additional sales focus on it and it just didn’t make sense for us and it did not impact our overall plans for our Cable Edge revenue in 2016.

Victor Chiu

Okay. Thank you.


And we have a question from Greg Mesniaeff from Drexel Hamilton. Please go ahead.

Greg Mesniaeff

Yes, thank you. On the somewhat higher OpEx levels we're going to see in the second half of this year, is that something we can expect as a kind of a stable benchmark going forward beyond into next year from the TVN integration, or is that something that's just really part of this year's transitional-related stuff?

Patrick Harshman

Well I think there is a couple of different ways to look at it Greg. The first one is that as we execute forward we believe that we’ll have a lower level in OpEx than we had in Q2 and in Q3 so we’re going to have a lower level in Q4 as we exit the year first point.

The second point, as a percent of revenue our OpEx in Q3 and Q4 will be lower and particular in Q4 we’ll be at probably I think the lowest point that Harmonic has had for OpEx as a percent of revenue in a number of years and I think the most important point is with the operating expense run rate that we expect to have we will be in a position to generate double-digit operating profit in 2017 without a significant increase in revenue.

So I think the expenses are about where we targeted them to be and again with the exit rate that we’re planning for the year we’re going to be in great shape from a percent of revenue standpoint as well as generating double-digit operating profit heading into 2017.

Greg Mesniaeff

Got it. Thank you.

Patrick Harshman

Okay, well thank you all very much for joining us. We'll call it an afternoon there. Please know that we’re committed to continuing this momentum looking forward to a good Q3, a good rest of the year. We appreciate your continued interest and support. Good day everybody.


Thank you ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.

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