Harmonic Inc. (HLIT) Q2 2013 Earnings Report, Transcript and Summary

Welcome to the second quarter 2013 Harmonic earnings conference call. (Operator Instructions) I will now turn the call over to Carolyn Aver, Chief Financial Officer. Ms. Aver, you may begin.

Thank you. Hello, everybody. With me in our headquarters in San Jose, California is Patrick Harshman, our CEO. I'd like to point out that in addition to the audio portion of this call; we have also provided slides, which you can see by going to the Investor Relations page on harmonicinc.com and clicking on the second quarter earnings call button. I have just got notice that those slides are not yet out, but we expect them to be out momentarily, so stay tuned for that. Now, turning to Slide 2 in the presentation, 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 that actual events or results may differ materially. We refer you to documents that Harmonic files with the SEC, including our most recent 10-Q report and the forward-looking statement section of today's earnings 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 provided 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 earnings 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. 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 the call to over to Patrick.

Well, thank you, Carolyn, and thank you, everyone, for joining us today. Now, turning to our Slide 3, today we reported our results for the second quarter of 2013, which reflect return to the business trajectory we expected coming into the year. All the numbers I'll discuss here exclude the Access operations, which were divested during the first quarter. Revenue was $117.1 million. Business from our international customers contributed 53% and reflected continued strength of international markets, together with some market vertical strengths in our domestic business. Broadcast and media customers represented 40% of revenue this quarter, while cable customers represented 36% and satellite direct to home and telco customers contributed 24% of revenue. We are pleased to be able to outperform the guidance we provided coming into the quarter, as we were coming off a slow start to the year. We did signal that late first quarter demand had continued into April, and we saw that continue through all of the second quarter. Our second quarter bookings of $126.3 million, again significantly exceeded revenues in the quarter, driven in particular by continuing improvements in the Europe, Middle East and Africa region, and strong performance in Latin America. Also, our broadcast and media market or the Omneon acquisition, first gave us a solid position, continue to be strong and notably drove progress in our domestic business, while aggregate demand from U.S. pay-TV service providers continue to be soft. The net positive book-to-bill ratio drove an increase in backlog and deferred revenue to $132.5 million. An increasing backlog is a continuing reflection of our strategic role with our customers, as we move to more projects and increase professional services. Turning now to operating performance, gross margins for the quarter were a strong 54%. This reflects an increase from historical run rate…

Thank you, Patrick. Let's move to Slide 11. As Patrick mentions, we completed the sale of the Access HFC business on March 5th. Accordingly, we have shown that business in the discontinued operation section of our P&L for all periods presented. Our net revenue for the second quarter, as Patrick said, was $117.1 million compared with the $101.7 million for the first quarter of 2013 and $122.1 million in the second quarter of 2012. The results this quarter as Patrick mentioned, were driven by the strength in our video processing products across all markets. Our bookings were $126.3 million, higher than the first quarter bookings of $110.1 million, providing a 1.08 book-to-bill ratio. Backlog and deferred revenue was $132.5 million at the end of Q2 compared to $126.3 million at the end of Q1. Our non-GAAP gross margin was 54% this quarter, an increase from 51% in the previous quarter, also an increase from 50% in the second quarter of 2012. The improvement in gross margin this quarter is principally due to the product mix shift to greater video processing revenue, and in part due to higher product margins particularly in cable edge due additional software licenses sold on existing hardware platforms. Non-GAAP operating expenses for this quarter were $56.1 million, up from $55.2 million in the first quarter of 2013 and up from $52.4 million in the second quarter of 2012. The increase in operating expenses is due to cost related to bringing our new products to market as well as increased cost related to litigation. Our headcount was 1,078, slightly down from 1,096 at the end of the previous quarter and 1,080 at the end of the second quarter of 2012. Non-GAAP net income from continuing operations for this quarter was $5.6 million or $0.05 per diluted share…

Okay. Well, thanks, Carolyn. So summarizing here, during the second quarter, we've returned to our expected quarterly revenue trajectory, while exceeding our gross margin target. These results reflect Harmonic's increasingly strong competitive position and ability to expand market share profitably in a highly competitive environment. Our positive momentum also reflects our customer's confidence in Harmonic and our capacity to continue to deliver industry-leading innovation, support and business partnership. Looking ahead while we clearly have work to do, we feel positive about the future opportunities for the company, and its shareholders. And we believe our value creation agenda, that is our growth strategy and the associated coming technology transitions, our expanded global customer base, and our focus on cash flow and capital structure, focuses on the key elements for success. And with that, we'll end the formal part of the call and open it up to questions.

(Operator Instructions) The first question comes from Simon Leopold with Raymond James.

This is Victor Chiu in for Simon Leopold. I just wanted to just first to drive into what drove the upside in the broadcast and media sales for video processing, because that was a bit of a surprise. What was the upside versus your expectation for the quarter? And what's driving your confidence that you'll see this kind of trend continue, I guess?

Couple of very significant competitive wins, Victor, which I think in different cases the sharp end of the spear, was a little different from a product perspective, but the common theme, is that we're increasingly being able to leverage the breadth of the product offering. As I mentioned the historic Omneon products were really home base in many of the broadcasts accounts. And what's nice was is whether it's a new opportunity for a refresh of the historic Omneon products, now it's called the production and playout products or whether it's a new video distribution opportunity, I think our customers are looking at the breadth of what we're doing, as some of the innovative ideas. The fact that we can really stitch together more end-to-end solutions, as well as the forward-looking aspect of where we're headed from an innovation point of view and it's really carrying the day. So we're excited by the competitive momentum and the fact that with these deals we're able to make them effectively larger, by bringing in a broader cross-section of our portfolio, again, cross the historic Harmonic, Omneon and, in fact, Scopus businesses.

Just the domestic business was kind of the weak link last quarter, but it seemed like this quarter that was better and helped results. Can you kind of speak to that change I guess in there?

Well, it's really back to the point we just discussed, is that real uptick was in particular with the domestic broadcast account. And I think some of that is just project timing and couple of these deals we've been working on for sometime. We saw a couple of big deals of turn. We were able to recognize revenue on a couple of other deals. As I mentioned the pay-TV service provider environment was still somewhat soft for us. But the good news was is that we're still able to deliver strong sequential growth on the basis of really just expanded customer base that we've been slowly and steadily building for ourselves in the domestic market.

Last quarter, I also am just looking back, you also mentioned that there was some revenue recognition changes and possibly some push out sales from last quarter, was that a factor in results for this quarter?

No. Perhaps what you're referring to is that we have some big projects that we said were going to be recognized in the latter part of this year. So that didn't really impact Q2. It is part of what's influencing our guidance for Q3.

And just lastly, really quickly, just a little bit of color around the gross margin, I guess, because that was, I think that's the highest gross margins have been in quite a while despite the mix that you mentioned, so maybe just some of the puts and takes around what was the driver behind the upside there?

Sure. In fact, in Q4 we also had gross margins in the mid-50s, so this is the second quarter out of three that our gross margins have popped up. Look if you think of us traditionally as a 50% gross margin company or traditionally, let's say, in the last couple of years, obviously we started in the 40s and then it moved up, we certainly expected with the sale of the Access business that that low 50% would move to, call it, 52% or 53% and for sometime we've targeted the mid-50s as the place we want to go. I don't think this says we're there yet. I think it shows that when we do well in video processing and PMP, those are definitely our highest gross margin products and it has a big influence on how our margins come out. Also as more and more of our products have more of this software component and we get to quarters where we're delivering a lot of licenses that as well has a big impact on the margins. I think they are really signs of where we think we'll go over the next few years and feel good. So I think we'll have more quarters like this where we have some upside because of the mix. In Q3, I've guided conservatively because we have some of these big projects that have some lower margin components to it and certainly as we begin to share the NSG product, we're going to be back to the razors again. So we're going to be back to shipping a platform upon which for actually several years, we'll be adding components with higher margins. So it will be a mix, but we're definitely moving in the direction that we've been executing against and planning for.

The next question comes from James Kisner with Jefferies LLC.

Just to drill down back on video processing a little bit, what would you say about the software mix within video processing? I know you've been pushing a lot harder on the ProMedia platform for HEVCs. Was there also some software mix improvement within the video processing business in addition to the edge business?

Yes.

And I am just kind of wondering, I mean it looks to me like if I just do some rough math here, that you were up about, if you look at video processing ex-cable you can kind of back into that. I mean you were up something like 10 million sequentially. And just kind of wondering what the deal size is starting to look like around some of these broadcast and media players. There are guys, I don't want to name names, but for example, like ESPN or something they might come in and buy $5 million worth of product. And then also I am just kind of curious, are these driven more just by new channels or is it driven more by their own over-to-the-top sort of web offerings? Anymore color around just sort of this broadcast and media piece?

Sure. So first, James, the deal size is growing that we're being exposed to and I think it's a combination of a couple of things. I think it's just getting closer, strategically to these companies so we have better insight into really where they're going strategically. And it's becoming more of a partnership. I think that's one aspect of it. The other aspect is that for us technologically and with our sales force for broader solutions set is starting to click together. So we're doing a better job of executing frankly and what the strategy along was, which is coming to market with a broader portfolio that can solve a broaden end-to-end problem. And the third thing, which you just alluded to is, is that it's an interesting time in the market. We see customer doing two things; one going back to the existing infrastructure and trying to reengineer to be more efficient and also to reengineer and to open up new revenue streams. Multiscreen is an interesting component of several of these deals. And as I alluded to you in my prepared remarks, one of the interesting dynamics we're seeing is we're starting to see with a fewer standalone, but perhaps the more interesting multiscreen opportunities for us were actually just a component of a broader opportunity associated with new build out and new kind of service vision that expands both traditional and new media delivering. And the last thing I would say is just competitively, I mean we definitely compete against some good companies, but I think our customers' eyes, particularly in broadcast and media they look at us and we look I think more stable. We're clearly highly focus in investing in this video arena and I think they are impressed with the level of innovation, the level of service and support we're providing to the market. And so I think that there is a little bit of competitive wind at our back as well there.

I guess, sort of related, this has been kind of a, I guess, a home run for you from the standpoint of selling, you said this in the past, the selling video processing into that broadcast and media base, but again production and playout itself is kind of just sort of hanging in there. And I'm just kind of wondering, what do you think about that business? Is that something that we should just expect as a modest grower? Is it a flat business? I mean, I am assuming it's not a declining business longer-term, but what do you think that that piece just seems to kind of sit around $20 million, how should we model that?

So it hasn't heretofore grown the way we would like, but we actually do see it as a grower. And as much you think about Ultra HD, for example, in the context to deliver it to consumer, actually the place where Ultra HD technologies going to happen first is more on that production and playout environment. So there is an example of one of these trends that we're talking about, planning out right across the value chain. And so we do see a number of significant catalysts for that business. And above and beyond being an entry point for the broader offering there. So we've remained quite optimistic and confident in that business. The ChannelPort product that I mentioned in prepared remarks has really established itself as a leading playout server I think in the market. We're definitely seeing an upward trend on that particular product and I think the technology as well as the brand value is growing. So it's taken us a little while, I'd admit, to get everything to click together and I don't want to say, it's the hockey stick from here, James, but we do feel as though the broader offering for broadcast and media, including those production and playout products are starting to get on firmer ground for consistent growth.

And just one more, if I might. In general, obviously your first offering of HEVC is software-based. And do you think maybe is it getting more clear that the HEVC upgrade cycle will be more of a software driven cycle? If you had to guess, perhaps is 70% of that going to be software? And perhaps we should be more focused on bottomline than topline growth, just given that? Or are you feeling pretty confident there's going to be a pretty the reasonably large hardware-based upgrade cycle as well for HEVC?

I think it's a good question, James. And we don't have a perfect crystal ball, but there is no doubt that its software initially. And then probably overtime the software mix will be greater than it has been for the historic encoding technologies. So I think you are right, the bottomline impact is relatively greater than the bump that we saw from prior technology with. The reality is in the short-term, there simply aren't the ASICs out there. So the aggressive and first work is happening now. In general is on more general purpose processors.

The next question comes from Amitabh Passi from UBS.

This is Jim Hillier dialing in for Amitabh. If I look at the cable business, it looks like it was down year-over-year. You did talk about U.S. pay-TV demand remaining somewhat soft. Could you elaborate on what you're seeing in the marketplace overall? UBS: This is Jim Hillier dialing in for Amitabh. If I look at the cable business, it looks like it was down year-over-year. You did talk about U.S. pay-TV demand remaining somewhat soft. Could you elaborate on what you're seeing in the marketplace overall?

Historically, our big domestic service provider customers are each on their own right are historically quite cyclical in terms of big ways, a big push-on, the upgrade to digital video, MPEG-2 to MPEG-4 or standard definition to HD. And we've been clear that there is, I think, a little bit of anticipation in the market right now for what those next big waves are going to be. There is a lot of looking forward to this Ultra HD, in the cable space in particular, there is a lot of looking forward to CCAP. And what we think that those are going to be significant incremental growth drivers for us in the domestic business. There is a little bit of awaiting for that to kind of happen in the big way with the domestic service providers. That being said, there is certainly ongoing business. In this past quarter, we had what I would characterize is as the decent quarter with service provider, particularly around encoding and transcoding variety of services, high-end HD upgrades, transcoding and we've been I think competitively moving nimbly and taking advantage of I think good competitive opportunities. Now if you look more deeply, if you cross-correlate the numbers you just cited, also, with our product breakdowns, you'll see that the major step down relative to year ago is actually in the edge product line. And there is a couple of things playing out. First, we do think that the market is softer just cyclically in terms of our overall edge demand, that's number one. Number two, we do believe that some of our customers are looking ahead to this new NSG Pro CCAP platform and that's kind of put a little bit of a damper on edge sales. And number three, as Carolyn outlined in her comments, all the revenue we saw of somewhat higher percentage was actually software licenses, Cloud licenses that we've sold. And those come with quite a good bottomline impact, but a smaller topline impact. And so that also has a appearance of compressing, well, not the appearance, it actually compresses the topline. So those three things together conspire to make this a particularly soft quarter on the edge. I want to emphasize that we think we've now lost a step competitively. And as we've said we expect that demand to bounce back and particularly as we get the new NSG Pro really out there in the market.

And also in terms of OpEx, in looking at your guidance, it appears to be coming down in the third quarter, despite the somewhat higher revenue outlook. Can you discuss what's driving that, and ultimately where you see OpEx trending as a percentage of sales? UBS: And also in terms of OpEx, in looking at your guidance, it appears to be coming down in the third quarter, despite the somewhat higher revenue outlook. Can you discuss what's driving that, and ultimately where you see OpEx trending as a percentage of sales?

Sure. So as I mentioned in my remark about Q2. We had a couple of non-headcount related costs that impacted this quarter. One of those is costs related to these new technologies that Patrick talked about, that whether it's prototypes and early demo units, or a variety of things, that won't continue. Some of that will continue for the next couple of quarters, but overtime that comes back down again. Secondly, we have some litigation costs, resulting from a lawsuit that we've been in and this was particularly expensive quarter and that particular activity is related to that lawsuit. Again, we expect that to come down, again next quarter. So I think those two things in general, just as it relates to guidance are what's, driving our guidance. On an overall basis, we haven't given a target of OpEx to revenue, but as we focus on getting our gross margins up, we're equally focused on managing our OpEx, so that we can ultimately deliver an operating margin that we think is appropriate for this size of business. So I'm not quiet ready to give you a target yet, but I would say it's an area that we think we'll continue to improve. We don't think we'll go up from here certainly and we're working that continue to drive focus around how we bring that more and more in mind.

The next question comes from Kiera Kilkowski with Bank of America Merrill Lynch.

Just a few quick ones for me. First, you spoke about it a little bit in your script, that you said that demand was improving in Europe a little bit this quarter. I was wondering if you could talk about if that was product-specific or a little bit more across the board. Second, if you could give us some color within your international revenue, how much of that is from developed versus developing? And next I just have a follow-up when you're done.

Sure. The strength or the return to strength that we're seeing in Europe is really right across our products. So it's not product specific. And in fact, it's across different customer categories as well. So I would characterize it is as broad. And regarding margin versus developed international markets that in this past quarter it's a little bit above. I also mentioned we had a particularly strong quarter and we have a good pipeline in Latin America. And so I would definitely characterize that as continuing success that we're seeing in developed markets. More generally, on past calls, I've talked about growing success in Southeast Asia. So we remain encouraged by what we're seeing in developed markets and it continues to be a key area of focus for us. That being said, no doubt about it, part of the resurgence of our European business is resurgence of what I would call the developed markets, in places like Germany, Northern Europe, the U.K. et cetera, particularly major media hubs. So at least in the current quarter and our immediate outlook, I wouldn't say there is a big difference in the demand profile we're seeing between developed and emerging or developing international markets.

And just a quick follow-up; brought a new head of sales on and I think you said in June. Do you think that we're going to have to see some changes there or you think that the sales process is going to stay pretty much the same?

Look, nothing is broken. We delivered pretty good results. So largely without George, that being said there is always room from improvement. And kidding aside, continuous improvement is something we're very much focused on. And as we get to the next tier of scale and as our business around the world grows, as our customer base expands, which is very much of our strategy, someone with George's experience in terms of, his last job was managing $2 million of revenue. He has got extensive experience doing business around the globe with both enterprise as well as service provider customers. I think he is going to really help the sales force as well as the company take it to the next level. And I'm excited about what he is bringing to us. And I should also add that's across direct as well as channel sales.

The next question is the follow-up question from James Kisner with Jefferies LLC.

I just wanted to jump in here with one more on CCAP. And you alluded to this, that of course there's going to be some more hardware near term, but do you have any kind of sense for like how CCAP deployments might roll out? Do you think there could be a, sort of, compressed period where there is just a lot of activity as operators upgrade or do you think it's going to be pretty gradual? And just wondering what the potential is for either wait-for effects or, perhaps, relatively big hits to gross margins in the short-term perhaps with upside in revenue. It just seems like there's some divergent outcomes that are possible here. Can you help us out a little bit on what you think about CCAP and how it rolls out, and how it might impact your business model?

Look, we're excited about the interest and the momentum behind our NSG Pro platform. That being said, it packs so much capability and that, while I think all of our customers are responding positively to how that aligns where they eventually want to be. And not all of our customers are ready to actually take that step immediately. So I see the rollout at for the next couple of quarters is being more gradual. That being said and, Carolyn, you can add anything to it, I think it will have a gross margin impact. I mean I highlighted one of the unique differentiators is that we can cover the whole spectrum without getting too technical. There is huge amount of capacity. I don't see any of the initial deployments actually landing up all of that capacity. So kind of inherently, we'll be over provisioning from the hardware capability perspective, will be putting a tremendous licensing resource, if you will, out in the field. And so I think that there will certainly be a margin impact and much as we saw a year ago with some of the more hardware intensive deployments that we talked about then and here we are a year later reaping some of the benefits in terms of the greater license sale. So the crystal ball isn't perfect, but my prognostication is more gradual, with some margin impact along the way and certainly the guidance we provide it contemplates that.

Yes, maybe I would just add one thing and that is in addition to other things, that Patrick said, which would have an impact while we're in the days of shipping the downstream product. In the first couple of quarters that we ship it before we've kind of ramped to our full day production, those early units also carry a higher cost to lower gross margin. It's just the nature of rolling out a new platform. So I think we'll see it in a couple of steps. I think there will be definitely some impact and we've tried to put that in our guidance. As we rollout the initial earlier units, we'll get improvement as we go to a more automated production of the units, which will be the case then for the rest of our products life. But then we'll get more benefit as we either ship more licenses in those products or ultimately deliver the two-way cards. So it will be a stair step function here over the next period of time as we get through those phases.

The next question is from Randy Baron with Pinnacle.

Carolyn, I just wanted to drill down on the open market purchases. You said $10.7 million, post-tender. Is that as of until June 30, or is that until today's call?

$10.7 million was in the quarter.

And what's the purchases been done through today?

Through today the total are Patrick's numbers. In the quarter so far, we've purchased a couple of million dollars worth.

We have no further questions at this time. I'd like to turn the call back over to Mr. Harshman for any closing remarks.

Okay. Well, I'd simply like to thank everyone again for joining the call. And I want to let you know that we appreciate your support. We're looking forward to continuing momentum we've built in this quarter, to build shareholder value through continuing execution of our strategy. And we look forward to speaking with everyone again very soon. Thank you.

Thank you. Ladies and gentlemen, this concludes the second quarter 2013 Harmonic earnings conference call. Thank you for participating. You may now disconnect.