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Article by DailyStocks_admin    (02-25-09 05:34 AM)

The Daily Magic Formula Stock for 02/24/2009 is Harmonic Inc. According to the Magic Formula Investing Web Site, the ebit yield is 20% and the EBIT ROIC is 50-75%.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


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BUSINESS OVERVIEW

OVERVIEW

We design, manufacture and sell versatile and high performance video products and system solutions that enable service providers to efficiently deliver the next generation of broadcast and on-demand services, including high-definition television, or HDTV, video-on-demand, or VOD, network personal video recording and time-shifted TV. Historically, the majority of our sales have been derived from sales of video processing solutions and edge and access systems to cable television operators and from sales of video processing solutions to direct-to-home satellite operators. We also provide our video processing solutions to telecommunications companies, or telcos, broadcasters and Internet companies that offer video services to their customers.

INDUSTRY OVERVIEW

Demand for Broadband and Digital Video Services

The delivery to subscribers of television programming and Internet-based information and communication services is converging, driven in part by advances in technology and in part by changes in the regulatory and competitive environment. Viewers of video increasingly seek a more personalized and dynamic video experience that can be delivered to a variety of devices ranging from wide-screen HDTVs to mobile devices, including cellular phones. Today, there are a number of developing trends which impact the broadcasting and television business and that of our service provider customers, which deliver video programming. These trends include:

On-Demand Services

The introduction of digital video recorders and network-based VOD services is leading to changes in the way subscribers watch television programming. Subscribers are increasingly utilizing “time-shifting” and “ad-skipping” technology. Further advances in technology are likely to accelerate these trends, with cable, satellite and telco operators announcing initiatives, often in conjunction with network broadcasters, to increasingly personalize subscribers’ video viewing experience.

High-Definition Television

The increasing popularity of HDTV and home theater equipment is putting pressure on broadcasters and pay-TV providers to offer additional HDTV content and higher quality video signals for both standard and high definition services. For example, DIRECTV offered approximately 90 national HDTV channels to its subscribers at the end of 2007, and other service providers are also rapidly introducing expanded HDTV offerings.

The Internet and Other Emerging Distribution Methods

Several companies, including Google, Yahoo! and Apple, have recently announced their entry into the video distribution business and enable their customers to download video content to PCs and mobile devices. We believe it is likely that the entry of these companies into the video distribution business will further change traditional video viewing habits and distribution methods.

Mobile Video

Several telcos in the U.S. and abroad have launched video services to cellular telephones and other mobile devices. Certain cable operators have entered into agreements with mobile phone operators that are likely to lead to further expansion of mobile video services.

These trends are expected to increase the demand from service providers for sophisticated digital video systems and optical network products, which are required to acquire video content from a variety of sources and deliver it to the subscriber.

The Market Opportunity

Personalized video services, such as VOD, and the increasing amounts of high definition content, as well as an increasing amount of data being transmitted over communications networks, will require greater bandwidth to the home in order to deliver maximum choice and flexibility to the subscriber. In addition, the delivery of live television and downloadable content to cellular telephones and other mobile devices creates bandwidth constraints and network management challenges. The demand for more bandwidth-intensive video, voice and data content has strained existing communications networks and created bottlenecks, especially in the headends and in the last mile of the communications infrastructure where homes connect to the local network. The upgrade and extension of existing networks or the construction of completely new network environments to facilitate the delivery of high-speed broadband video, voice and data services requires substantial expenditure and often the replacement of significant portions of the existing infrastructure. As a result, service providers are seeking solutions that maximize the efficiency of existing available bandwidth and cost-effectively manage and transport digital traffic within networks, while minimizing the need to construct new networks for the distribution of video, voice and data content.

Competition and Deregulation

Competition among traditional service providers in the cable and satellite markets has intensified as offerings from non-traditional providers of video, such as telcos, Internet companies and mobile operators, are beginning to attract subscribers. The economic success of existing and new operators in this increasingly competitive environment will depend, to a large extent, on their ability to provide a broader range of offerings that package video, voice and data services for subscribers. These services all need to be delivered in a highly reliable manner with easy access to a service provider’s network. This increasingly competitive environment led to higher capital spending by many of the market participants in 2007, in an effort to deploy attractive packages of services and to capture high revenue-generating subscribers. Similar competitive factors and the liberalization of regulatory regimes in foreign countries have led to the establishment abroad of new or expanded cable television networks, the launch of new direct broadcast satellite, or DBS, services and particularly, the entry of telephone companies into the business of providing video services.

Our Cable Market

To address increasing competition and demand for high-speed broadband services, cable operators have introduced digital video, voice and data services. By offering bundled packages of broadband services, cable operators are seeking to obtain a competitive advantage over telephone companies and direct broadcast satellite, or DBS, providers and to create additional revenue streams. Cable operators have been upgrading and rebuilding their networks to offer digital video, which enables them to provide more channels and better picture quality than analog video, allowing them to better compete against the substantial penetration of DBS services. These upgrades to digital video allow cable operators to roll out HDTV and interactive services, such as VOD, on their digital platforms. Capital spending on upgrades includes investment in digital video equipment that can receive, process and distribute content from a variety of sources in increasingly complex headends. For example, VOD services require video storage equipment and servers, systems to ingest, store and intelligently distribute increasing amounts of content, complemented by edge devices capable of routing, multiplexing and modulation for delivering signals to individual subscribers over a hybrid fiber-coax, or HFC, network. Additionally, the provision of HDTV channels requires deployment of high-definition encoders and significantly more available bandwidth than the equivalent number of standard definition channels. In order to provide more bandwidth for such services, operators are adopting bandwidth optimization techniques such as switched digital video, new standards such as DOCSIS 3.0, as well as making enhancements to their optical networks, including the segmentation of nodes and the extension of bandwidth from 750 MHz to 1 GHz. Although U.S. cable capital expenditures have generally declined in recent years, principally due to lower expenditures for network construction, certain cable operators increased their capital spending in 2007 and have indicated that they will spend comparable amounts in 2008.

Our Satellite Market

Satellite operators around the world have established digital television services that serve millions of subscribers. These services are capable of providing up to several hundred channels of high quality standard definition video as well as increasing numbers of high definition channels. DBS services, however, operate mostly in a one-way environment. Signals are transmitted from an uplink center to a satellite and then beamed to dishes located at subscribers’ homes. This method is suited to the delivery of broadcast television, but does not lend itself easily to two-way services, such as Internet access or VOD. As cable operators expand the number of channels offered and introduce services such as VOD and HDTV, DBS providers are seeking to protect and expand their subscriber base in a number of ways. Domestic DBS operators have made local channels available in all major markets in standard definition format and are steadily adding local channels in high definition. Advances in digital video compression technology allow DBS operators to cost-effectively add these new channels and to further expand their video entertainment offerings. Certain operators have also begun to introduce VOD services which are delivered either by satellite or a terrestrial broadband connection. These new services, particularly HDTV, pose continuing bandwidth challenges and are expected to require ongoing capital expenditures for satellite capacity and other infrastructure by such operators.

Our Telco Market

Telcos are also facing increasing competition and demand for high-speed residential broadband services as well as saturation of fixed-line and basic mobile services. Consequently, many telcos around the world have added, or are planning to add, video services as a competitive response to cable and satellite and as a potential source of revenue growth. However, the telcos’ legacy networks are not well equipped to offer video services. The bandwidth and distance limitations of the copper-based last mile present difficulties in providing multiple video services to widespread geographic areas. Multi-channel video, especially HDTV, delivered over DSL lines has significant bandwidth constraints, but the use of video compression technology at very low bit rates and improvements in DSL technology have allowed many operators to introduce video services using the Internet Protocol (IPTV). Many major telcos are now implementing plans to rebuild or upgrade their networks to offer bundled video, voice and data services including initial mobile video services to hand-held devices such as cellular telephones.

Other Markets

In the terrestrial broadcasting market, operators in many countries are now required by regulation to convert from analog to digital transmission in order to free up broadcast spectrum. The conversion to digital transmission often provides the opportunity to deliver new services, such as HDTV and data transmission. These broadcasters are faced with similar requirements to cable and satellite providers in that they need to convert analog signals to digital signals prior to transmission and must also effectively manage the available bandwidth to maximize their revenue streams. Similarly, operators of wireless broadcast systems require encoding for the conversion of analog signals to digital signals.

Current Industry Conditions

The telecommunications industry has seen considerable restructuring and consolidation in recent years. For example:


? In 2007, AT&T acquired Bell South.

? In 2007, Time Warner Cable was spun out of Time Warner.

? In 2006, Adelphia Communications sold its cable systems out of bankruptcy to Comcast and Time-Warner Cable, the largest U.S. multi-system operators, or MSOs.

? In 2008, Liberty Media acquired a controlling stake in DIRECTV from News Corp., following the sale of DIRECTV by Hughes to News Corp. a few years previously.

? In 2006, NTL and Telewest, the major cable operators in the UK, merged to form Virgin Media.

Regulatory issues, financial concerns and business combinations among our customers are likely to significantly affect the industry, capital spending plans, and our business for the foreseeable future.

PRODUCTS

Harmonic’s products generally fall into two principal categories, video processing solutions and edge and access products. In addition, we provide network management software and have recently introduced and acquired new application software products. We also provide technical support services to our customers worldwide. Our video processing solutions provide broadband operators with the ability to acquire a variety of signals from different sources, in different protocols, and to organize, manage and distribute this content to maximize use of the available bandwidth. Our edge products enable cable operators to deliver customized broadcast or narrowcast on-demand services to their subscribers. Our access products, which consist mainly of optical transmission products, node platforms and return path products, allow cable operators to deliver video, data and voice services over their networks.

Video Processing Products

DiviCom encoders. We offer a line of high performance encoders, which provide compression of video, audio and data channels. Using sophisticated signal pre-processing, noise reduction and encoding algorithms, these encoders produce high-quality video and audio at low data transmission rates. Our encoders are available in the standard and high definition formats in both MPEG-2 and the newer MPEG-4 AVC/H264, or MPEG-4, video compression standards. Compliance with these widely adopted standards enables interoperability with products manufactured by other companies, such as set-top boxes and conditional access systems.

Statistical multiplexing solutions. We offer a variety of solutions which enable our customers to efficiently combine video streams generated by encoders into a single transport stream at the required data rate. These channel combinations, or “pools” can be in standard definition, high definition, or a combination of both. An important product for these applications is our DiviTrackIP which enable operators to combine inputs from different physical locations in a single multiplex.

Stream processing products. Our ProStream platform and other processing products offer our customers a variety of capabilities which enable them to manage and organize digital streams in a format best suited to their particular delivery requirements and subscriber offerings. Specific applications include multiplexing, scrambling, re-encoding, rate-shaping and splicing. Our products for these applications include our ProStream 1000 and 2000.

Decoders and descramblers. We provide integrated receivers-decoders to allow service providers to acquire content distributed from satellite and terrestrial broadcasters for distribution to their subscribers. These products are available in both standard and high definition formats. The Pro Stream 1000 can also be used as a bulk descrambler to enable operators to deliver up to 128 channels of video and efficiently descramble the content at small or remote headends.

Edge and Access Products

Edge products. Our Narrowcast Services Gateway family, or NSG, is a fully integrated edge gateway, which integrates routing, multiplexing and modulation into a single package for the delivery of VOD services to subscribers over cable networks. The NSG is usually supplied with Gigabit Ethernet inputs, allowing the cable operator to use bandwidth efficiently by delivering IP signals from the headend to the edge of the network for subsequent modulation onto the HFC network. The most recent NSG product, the high-density NSG 9000, may also be used in switched digital video and M-CMTS applications as well as large-scale VOD deployments.

Transmitters and optical amplifiers. Our MAXLink transmitters and optical amplifiers operate at a wavelength of 1550 nm and serve long-haul applications. The MAXLink Plus further increases the channel capacity of cable and other networks and can transmit over distances in excess of 200 kilometers. The PWRLink series provides optical transmission primarily at a headend or hub for local distribution to optical nodes and for narrowcasting, which is the transmission of programming to a select set of subscribers. Our METROLink Dense Wave Division Multiplexing, or DWDM, system allows operators to expand the capacity of a single strand of fiber and also to provide narrowcast services directly from the headend to nodes. This ability can significantly reduce the size of hubs and the associated building and equipment maintenance costs.

Optical nodes and return path equipment. Our family of PWRBlazer optical nodes supports network architectures which meet the varying demands for bandwidth delivered to a service area. By the addition of modules providing functions such as return path transmission and DWDM, our configurable nodes are easily segmented to handle increasing two-way traffic over a fiber network without major reconstruction or replacement of our customers’ networks. Our return path transmitters support two-way transmission capabilities by sending video, voice and data signals from the optical node back to the headend. These transmitters are available for either analog or digital transport.

IP transmission equipment. Our FLXLink Commercial Services solution allows an operator to leverage its existing network by providing high-speed services on a wavelength of a shared fiber to individual customers or to multiple-dwelling units. This solution comprises data transport capability at various speeds and network interface units to connect to the subscriber’s internal wiring.

Software Products

Management and control software. Our NMX Digital Service Manager gives service providers the ability to control and visually monitor their digital video infrastructure at an aggregate level, rather than as just discrete pieces of hardware, reducing their operational costs. Our NETWatch management system operates in broadband networks to capture measurement data and our software enables the broadband service operator to monitor and control the HFC transmission network from a master headend or remote locations. Our NMX Digital Service Manager and NETWatch software is designed to be integrated into larger network management systems through the use of simple network management protocol, or SNMP.

Application software. Our ClearCut software provides operators with high-quality digital storage of real-time broadcasts for on-demand services, and our ProStream 8000 solution allows operators to present on-screen mosaics with several channels tiled within a single video stream. Our Armada and Streamliner products enable the intelligent management of an operator’s video-on-demand assets and the distribution of these assets to subscribers. Our CarbonCoder products, acquired in our recent purchase of Rhozet Corporation, are software-based transcoding solutions that facilitate the creation of multi-format video for internet, mobile and broadcast applications.

Technical and support services

We provide consulting, implementation and maintenance services to our customers worldwide. We draw upon our expertise in broadcast television, communications networking and compression technology to design, integrate and install complete solutions for our customers. We offer a broad range of services and support including program management, budget analysis, technical design and planning, parts inventory management, building and site preparation, integration and equipment installation, end-to-end system testing, comprehensive training and ongoing maintenance. Harmonic also has extensive experience in integrating our products with numerous third-party products and services.

CEO BACKGROUND

Anthony J. Ley was elected Chairman of the Board of Directors in February 1995. Mr. Ley serves as Chief Executive Officer of Collabrx, a privately-held biotech services company. From November 1988 to May 2006, Mr. Ley served as Harmonic’s President and Chief Executive Officer. From 1963 to 1987, Mr. Ley was employed at Schlumberger Limited, both in Europe and the U.S., holding various senior business management and research and development positions, most recently as Vice President, Research and Engineering at Fairchild Semiconductor/Schlumberge r in Palo Alto, California. Mr. Ley holds an M.A. in Mechanical Sciences from the University of Cambridge and an S.M.E.E. from the Massachusetts Institute of Technology, is named as an inventor on 29 patents and is a Fellow of the I.E.T. (U.K.) and a senior member of the I.E.E.E.

Patrick Harshman joined us in 1993 and was appointed President and Chief Executive Officer in May 2006. In December 2005, he was appointed Executive Vice President responsible for the majority of our operational functions, including the unified digital video and broadband optical networking divisions as well as global manufacturing. Prior to the consolidation of our product divisions, Mr. Harshman held the position of President of the Convergent Systems division and, for more than four years, was President of the Broadband Access Networks division. Prior to this, Mr. Harshman held key leadership positions in marketing, international sales, and research and development. Mr. Harshman earned a Ph.D. in Electrical Engineering from the University of California, Berkeley and completed an Executive Management Program at Stanford University.

Harold Covert has been a director since June 2007. Since October 2007, Mr. Covert has served as Chief Financial Officer of Silicon Image, Inc., a semiconductor company. From October 2005 to August 2007, Mr. Covert was Executive Vice President and Chief Financial Officer of Openwave Systems Inc., a software applications and infrastructure company. Prior to Openwave, Mr. Covert was Chief Financial Officer at Fortinet Inc. from December 2003 to September 2005, and Chief Financial Officer at Extreme Networks, Inc. from July 2001 to October 2003. Mr. Covert is a Director and Chairman of the Audit Committee at both JDS Uniphase Corporation and Thermage, Inc. Mr. Covert holds a B.S. in Business Administration from Lake Erie College and an M.B.A. from Cleveland State University and is also a Certified Public Accountant.

Patrick Gallagher has been a director since October 2007. Mr. Gallagher is currently Chairman of Macro4 Plc, a global software solutions provider listed on the London Stock Exchange and Chairman of Ubiquisys which has developed and supplies femtocells for the global 3G mobile wireless market. Mr. Gallagher is also Vice Chairman of Golden Telecom Inc., a provider of integrated communications services in Russia and the CIS. He was Executive Vice Chairman and served as Chief Executive Officer of FLAG Telecom Group, a global telecommunications company which owns and manages a subsea optical fiber network, from 2003 until 2006. From 1985 to 2002, Mr. Gallagher held senior management positions at BT Group, including as Group Director of Strategy & Development, President of BT Europe and a member of the BT Executive Committee. Mr. Gallagher holds a B.A. in Economics with honors from Warwick University.

E. Floyd Kvamme has been a director since 1990. Since 1984, Mr. Kvamme has been a General Partner and now serves as a Partner Emeritus of Kleiner Perkins Caufield & Byers, a venture capital firm. Mr. Kvamme is also a director of National Semiconductor Corporation and Power Integrations, Inc., as well as several private companies. Mr. Kvamme holds a B.S.E.E. from the University of California, Berkeley and an M.S.E. from Syracuse University.

William F. Reddersen has been a director since July 2002. Now retired, Mr. Reddersen spent 31 years at BellSouth Corp. and AT&T Inc. From 1998 to 2000, Mr. Reddersen was Executive Vice President of Corporate Strategy at BellSouth, and from 1991 to 1998, he was responsible for BellSouth’s broadband strategy and business market operations. Mr. Reddersen serves on the board of Otelco, Inc. and one private company. Mr. Reddersen holds a B.S. in Mathematics from the University of Maryland and an M.S. in Management from the Massachusetts Institute of Technology, where he was a Sloan fellow.

Lewis Solomon has been a director since January 2002. Mr. Solomon is Chairman and CEO of SCC Company, a consulting firm specializing in technology. Mr. Solomon also co-founded Broadband Services, Inc. (BSI), an outsource provider of supply chain management, network planning, and fulfillment services and was Chief Executive Officer from 1999 to 2004. From 1983 to 1988, he served as the Executive Vice President of Alan Patricof Associates, a global venture capital firm. Mr. Solomon also spent 14 years at General Instrument Corporation, ultimately as Senior Vice President and Assistant to the Chief Executive Officer. Mr. Solomon is a director of Anadigics Inc., and several private companies. Mr. Solomon holds a B.S. in Physics from St. Joseph’s College and a M.S. in Industrial Engineering from Temple University.

David R. Van Valkenburg has been a director since October 2001. Mr. Van Valkenburg currently serves as Chairman of Balfour Associates, Inc., a firm providing counsel to chief executive officers, boards of directors and private equity funds and Chairman and President of privately-held Zero Point Corporation, a computer network engineering company. From 1995 to 2000, he was Executive Vice President of MediaOne Group, Inc. While at MediaOne Group, Mr. Van Valkenburg was seconded to Telewest Communications, PLC (UK) where he served as Chief Executive Officer and Chief Operating Officer from 1997 to 1999. He has also held the position of President at both Multivision Cable TV Corporation and Cox Cable Communications Inc. Mr. Van Valkenburg serves on the boards of directors of several private companies. He holds a B.A. from Malone College, an M.S. from the University of Kansas, and an M.B.A. from Harvard University.

MANAGEMENT DISCUSSION FROM LATEST 10K

OVERVIEW

We design, manufacture and sell versatile and high performance video products and system solutions that enable service providers to efficiently deliver the next generation of broadcast and on-demand services, including high-definition television, or HDTV, video-on-demand, or VOD, network personal video recording and time-shifted TV. Historically, the majority of our sales have been derived from sales of video processing solutions and edge and access systems to cable television operators and from sales of video processing solutions to direct-to-home satellite operators. We also provide our video processing solutions to telecommunications companies, or telcos, broadcasters and Internet companies that offer video services to their customers.

Harmonic’s net sales increased 26% in 2007 from 2006, and decreased 4% in 2006 from 2005. The increase in sales in 2007 compared to 2006 was primarily due to stronger demand from our domestic and international satellite operators and our domestic cable operators, and sales of our recently introduced products. The decrease in sales in 2006 compared to 2005 was primarily due to lower FTTP product sales and sales of third party products in 2006. We believe that the improvement in the industry capital spending environment has been, in part, a result of the intense competition between cable and satellite operators to offer more channels of digital video and new services, such as VOD and HDTV, and in part the result of the entry of telephone companies into the business of delivering video services to their subscribers. We also believe that the improvement has been due to more favorable conditions in industry capital markets and the completion or resolution of certain major business combinations, financial restructurings and regulatory issues.

Historically, a majority of our net sales have been to relatively few customers, and due in part to the consolidation of ownership of cable television and direct broadcast satellite systems, we expect this customer concentration to continue for the foreseeable future. In 2007, sales to Comcast and EchoStar accounted for 16% and 12% of net sales, respectively. Sales to Comcast accounted for 12% and 18% of net sales in 2006 and 2005, respectively.

Sales to customers outside of the U.S. in 2007, 2006, and 2005 represented 44%, 49%, and 40% of net sales, respectively. A significant portion of international sales are made to distributors and system integrators, which are generally responsible for importing the products and providing installation and technical support and service to customers within their territory. Sales denominated in foreign currencies were approximately 7%, 11% and 7% of net sales in 2007, 2006 and 2005, respectively. We expect international sales to continue to account for a significant portion of our net sales for the foreseeable future.

In 2007, net sales increased by 26% compared to 2006, primarily due to stronger demand from domestic and international satellite operators and from domestic cable operators, and sales of our recently introduced products. The improved gross margin percentage was primarily due to higher gross margins from new products and an increase in the proportion of net sales from software, which has higher margins that our hardware products. In addition, in 2007 we continued to reduce our sales of FTTP products which have significantly lower gross margins than our other products. Our operating results for 2007 also included a charge of $6.4 million for the expected settlement of the securities class action lawsuit and a net credit of $0.3 million consisting of a $1.8 million credit from a revised estimate of expected sublease income due to the extension of a sublease of a building to the lease expiration which was partially offset by a charge of $0.4 million from a change in estimated sublease income for a Sunnyvale building and a charge of $0.5 million from the closure of the manufacturing and research and development activities of BTL.

In 2006, net sales decreased by 4% compared to 2005 which was primarily due to lower FTTP sales and sales of third party products. Harmonic reported net income of $1.0 million in 2006 which was primarily the result of higher gross margins. The improved gross margin percentage was primarily due to higher gross margins from new products and an increase in the proportion of net sales from software and services. In addition, we reduced our sales of FTTP and third party products which have significantly lower gross margins than our other products. Cost of sales and operating expenses include an expense for stock-based compensation of $5.7 million related to the adoption of SFAS 123(R).

Restructuring charges totaling $3.0 million were recorded in 2006 as a result of a management reorganization and a Sunnyvale campus consolidation.

Prior to 2006, Harmonic was organized into two operating divisions, Broadband Access Networks, or BAN, for fiber optic systems and Convergent Systems, or CS, for digital headend systems. Effective January 1, 2006, an organizational restructuring combined the Company’s CS division and BAN division into a single segment with financial results reported as a single segment as of the first quarter of 2006.

Our quarterly and annual results may fluctuate significantly due to delays in project completion, revenue recognition policies and the timing of the receipt of orders. Harmonic often recognizes a significant portion, or the majority, of its revenues in the last month of the quarter. Harmonic establishes its expenditure levels for product development and other operating expenses based on projected sales levels, and expenses are relatively fixed in the short term. Accordingly, variations in timing of sales can cause significant fluctuations in operating results. In addition, because a significant portion of Harmonic’s business is derived from orders placed by a limited number of large customers, the timing of such orders, delays in project completion and revenue recognition policies can also cause significant fluctuations in our operating results. Harmonic’s expenses for any given quarter are typically based on expected sales and if sales are below expectations, our operating results may be adversely impacted by our inability to adjust spending to compensate for the shortfall.

In the fourth quarter of 2005, due to an organizational restructuring that combined our product development, marketing and manufacturing operations into a single segment, Harmonic reduced its workforce by approximately 40 employees and recorded severance charges of approximately $1.1 million. The acquisition of Entone in the fourth quarter of 2006 increased our headcount by 43 employees, primarily in research and development. The acquisition of Rhozet in July 2007 increased our headcount by 18 employees, primarily in research and development.

In May 2006, our Board of Directors appointed Patrick J. Harshman as President and Chief Executive Officer, replacing Anthony Ley, who retired after 18 years. Mr. Ley carries on as chairman of our Board of Directors and has a consulting agreement with Harmonic through June 2008. Following Dr. Harshman’s appointment, we announced a reorganization of our senior management, resulting in a charge of approximately $1 million in severance costs in the second quarter of 2006.

In 2001 and 2002 excess facilities charges totaling $52.6 million were recorded due to Harmonic’s reduced headcount, difficult business conditions and a weak local commercial real estate market. The excess facilities charges were for facilities that we no longer occupied, that we did not intend to occupy and that we planned to sublease. In 2003, the excess facilities liability was reduced by $3.3 million due to a revision in the assumptions as to the unoccupied portion of a building.

In the fourth quarter of 2005, the excess facilities liability was decreased by $1.1 million due to subleasing a portion of the unoccupied portion of one building for the remainder of the lease. Although we entered into new subleases for approximately 60,000 square feet of space in 2004, approximately 30,000 square feet of space in 2005 and approximately 65,000 square feet of space in 2006, in the event we are unable to achieve expected levels of sublease rental income, we will need to revise our estimate of the liability, which could materially impact our financial position, liquidity, cash flows and results of operations.

In the third quarter of 2006, we completed our facilities rationalization plan resulting in more efficient use of our Sunnyvale campus and vacated several buildings, some of which were subsequently subleased. This resulted in a net charge for excess facilities of $2.1 million in the third quarter of 2006.

In the third quarter of 2007, we recorded a credit of $1.8 million from a revised estimate of expected sublease income due to the extension of a sublease of a Sunnyvale building to the lease expiration. In addition, in 2007 we recorded a restructuring change of $0.4 million on a reduction in estimated sublease income for a Sunnyvale building, and a charge of $0.5 million from the closure of the manufacturing and research and development activities of Broadcast Technology Limited.

On December 8, 2006, Harmonic completed its acquisition of Entone Technologies, Inc. pursuant to the terms of the Agreement and Plan of Merger, or Entone Agreement dated August 21, 2006, for a total purchase consideration of $48.9 million. The purchase consideration consisted of a payment of $26.2 million, the issuance of 3,579,715 shares of Harmonic common stock with a value of $20.1 million, issuance of 175,342 options to purchase Harmonic common stock with a value of $0.2 million and acquisition related costs of $2.5 million. Under the terms of the Entone Agreement, Entone spun off its consumer premises equipment, or CPE, business into a separate private company prior to the closing of the merger. As part of the terms of the Entone Agreement, Harmonic purchased a convertible note with a face amount of $2.5 million in the new spun off private company in July 2007.

On July 31, 2007, Harmonic completed its acquisition of Rhozet Corporation, pursuant to the terms of the Agreement and Plan of Merger, or Rhozet Agreement, dated July 25, 2007. Under the Rhozet Agreement, Harmonic paid or will pay an aggregate of approximately $15.5 million in total merger consideration, comprised of approximately $2.5 million in cash, 1,105,656 shares of Harmonic’s common stock in exchange for all of the outstanding shares of capital stock of Rhozet, and approximately $2.8 million of cash which was paid in the first quarter of 2008, as provided in the Rhozet Agreement, to the holders of outstanding options to acquire Rhozet common stock. In addition, in connection with the acquisition, Harmonic incurred approximately $0.7 million in transaction costs. Pursuant to the Rhozet Agreement, approximately $2.3 million of the total merger consideration, consisting of cash and shares of Harmonic common stock, are being held back by Harmonic for at least 18 months following the closing of the acquisition to satisfy certain indemnification obligations of Rhozet’s shareholders pursuant to the terms of the Rhozet Agreement.

In the fourth quarter of 2007, we sold and issued 12,500,000 shares of common stock in a public offering at a price of $12.00 per share. our net proceeds from the offering were approximately $141.8 million, which was net of underwriters’ discounts and commissions of approximately $7.4 million and related legal, accounting, printing and other costs totaling approximately $0.7 million. The net proceeds from the offering are expected to be used for general corporate purposes, including payment of existing liabilities, research and development, the development or acquisition of new products or technologies, equipment acquisitions, strategic acquisitions of businesses, general working capital and operating expenses. The offering was made pursuant to our Registration Statement on Form S-3 (File No. 333-123823) filed with the SEC on April 4, 2005, and declared effective by the SEC on April 22, 2005 and the related prospectus supplement filed with the SEC on October 31, 2007.

Critical Accounting Policies, Judgments and Estimates

The preparation of financial statements and related disclosures requires Harmonic to make judgments, assumptions and estimates that affect the reported amounts of assets and liabilities, the disclosure of contingencies and the reported amounts of revenue and expenses in the financial statements and accompanying notes. Material differences may result in the amount and timing of revenue and expenses if different judgments or different estimates were made. See Note 1 of Notes to Consolidated Financial Statements for details of Harmonic’s accounting policies. Critical accounting policies, judgments and estimates which we believe have the most significant impact on Harmonic’s financial statements are set forth below:


? Revenue recognition;

? Allowances for doubtful accounts, returns and discounts;

? Valuation of inventories;

? Impairment of goodwill or long-lived assets;

? Restructuring costs and accruals for excess facilities;

? Assessment of the probability of the outcome of current litigation;

? Accounting for income taxes; and

? Stock-Based Compensation.

Revenue Recognition

Harmonic’s principal sources of revenue are from sales of hardware products, software products, solution sales, services and hardware and software maintenance agreements. Harmonic recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the sale price is fixed or determinable, collection is reasonably assured, and risk of loss and title have transferred to the customer.

We generally use contracts and customer purchase orders to determine the existence of an arrangement. Shipping documents and customer acceptance, when applicable, are used to verify delivery. We assess whether the sales price is fixed or determinable based on the payment terms associated with the transaction and whether the price is subject to refund or adjustment. We assess collectibility based primarily on the creditworthiness of the customer as determined by credit checks and analysis, as well as the customer’s payment history.

We evaluate our products to assess whether software is more-than-incidental to a product. When we conclude that software is more-than-incidental to a product, we account for the product as a software product. Revenue on software products and software-related elements are recognized in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition.” Significant judgment may be required in determining whether a product is a software or hardware product.

Revenue from hardware product sales is recognized in accordance with the provisions of Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition” (“SAB 104”). Subject to other revenue recognition provisions, revenue on product sales is recognized when risk of loss and title has transferred, which is generally upon shipment or delivery, based on the terms of the arrangement. Revenue on shipments to distributors, resellers and systems integrators is generally recognized on delivery or sell-in. Allowances are provided for estimated returns and discounts. Such allowances are adjusted periodically to reflect actual and anticipated experience.

Distributors and systems integrators purchase our products for specific capital equipment projects of the end-user and do not hold inventory. They perform functions that include importation, delivery to the end-customer, installation or integration, and post-sales service and support. Our agreements with these distributors and systems integrators have terms which are generally consistent with the standard terms and conditions for the sale of our equipment to end users and do not provide for product rotation or pricing allowances, as are typically found in agreements with stocking distributors. We have long-term relationships with most of these distributors and systems integrators and substantial experience with similar sales of similar products. We have had extensive experience monitoring product returns from our distributors and accordingly, we have concluded that the amount of future returns and allowances can be reasonably estimated in accordance with Statement of Financial Accounting Standards (“SFAS”) 48, “Revenue Recognition When Right of Return Exists”, and SAB 104. With respect to these sales, we evaluate the terms of sale and recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been provided, the sales price is fixed or determinable, collectibility is reasonably assured, and risk of loss and title have transferred.

When arrangements contain multiple elements, Harmonic evaluates all deliverables in the arrangement at the outset of the arrangement based on the guidance in Emerging Issues Task Force (“EITF”) No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). If the undelivered elements qualify as separate units of accounting based on the criteria in EITF 00-21, which include that the delivered elements have value to the customer on a stand-alone basis and that objective and reliable evidence of fair value exists for undelivered elements, Harmonic allocates the arrangement fee based on the relative fair value of the elements of the arrangement. If a delivered element does not meet the criteria in EITF 00-21 to be considered a separate unit of accounting, revenue is deferred until the undelivered elements are fulfilled. We establish fair value by reference to the price the customer is required to pay when an item is sold separately using contractually stated, substantive renewal rates, where applicable, or the average price of recently completed stand alone sales transactions. Accordingly, the determination as to whether appropriate objective and reliable evidence of fair value exists can impact the timing of revenue recognition for an arrangement.

For multiple element arrangements that include both hardware products and software products, Harmonic evaluates the arrangement based on EITF 03-5, “Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software.” In accordance with the provisions of EITF 03-5, the arrangement is divided between software-related elements and non-software deliverables. Software-related elements are accounted for as software. Software-related elements include all non-software deliverables for which a software deliverable is essential to its functionality. When software arrangements contain multiple elements and vendor specific objective evidence, or VSOE, of fair value exists for all undelivered elements, Harmonic accounts for the delivered elements in accordance with the “Residual Method” prescribed by SOP No. 98-9. In arrangements where VSOE of fair value is not available for all undelivered elements, we defer the recognition of all revenue until all elements have been delivered. Fair value of software-related elements is based on separate sales to other customers or upon renewal rates quoted in contracts when the quoted renewal rates are deemed to be substantive.

We also enter into solution sales for the design, manufacture, test, integration and installation of products to the specifications of Harmonic’s customers, including equipment acquired from third parties to be integrated with Harmonic’s products. These arrangements typically include the configuration of system interfaces between Harmonic product and customer/third party equipment, and optimization of the overall solution to operate with the unique features of the customer’s design and to meet customer-specific performance requirements. Revenue on these arrangements is generally recognized using the percentage of completion method in accordance with SOP 81-1, “Accounting for Performance of Construction/Production Contracts.” We measure performance under the percentage of completion method using the efforts-expended method based on labor hours expended in proportion to total estimated hours, based on current estimates of labor hours to complete the project. Management believes that for each such project, labor hours expended in proportion to total estimated hours at completion represents the most reliable and meaningful measure for determining a project’s progress toward completion. If the estimated costs to complete a project exceed the total contract amount, indicating a loss, the entire anticipated loss is recognized. Deferred revenue includes billings in excess of revenue recognized, net of deferred costs of sales. Our application of percentage-of-completion accounting is subject to our estimates of labor hours to complete each project. In the event that actual results differ from these estimates or we adjust these estimates in future periods, our operating results, financial position or cash flows for a particular period could be adversely affected.

Revenue from hardware and software maintenance agreements is recognized ratably over the term of the maintenance agreement. First year maintenance typically is included in the original arrangement and renewed on an annual basis thereafter. Services revenue is recognized on performance of the services and costs associated with services are recognized as incurred. Fair value of services such as consulting and training is based upon separate sales of these services.

Significant management judgments and estimates must be made in connection with determination of the revenue to be recognized in any accounting period. Because of the concentrated nature of our customer base, different judgments or estimates made for any one large contract or customer could result in material differences in the amount and timing of revenue recognized in any particular period.

Allowances for Doubtful Accounts, Returns and Discounts

We establish allowances for doubtful accounts, returns and discounts based on credit profiles of our customers, current economic trends, contractual terms and conditions and historical payment, return and discount experience, as well as for known or expected events. If there were to be a deterioration of a major customer’s creditworthiness or if actual defaults, returns or discounts were higher than our historical experience, our operating results, financial position or cash flows could be adversely affected. At December 31, 2007, our allowances for doubtful accounts, returns and discounts totaled $8.2 million.

Valuation of Inventories

Harmonic states inventories at the lower of cost or market. We write down the cost of excess or obsolete inventory to net realizable value based on future demand forecasts and historical demand. If there were to be a sudden and significant decrease in demand for our products, or if there were a higher incidence of inventory obsolescence because of rapidly changing technology and customer requirements, we could be required to record additional charges for excess and obsolete inventory and our gross margin could be adversely affected. Inventory management is of critical importance in order to balance the need to maintain strategic inventory levels to ensure competitive lead times against the risk of inventory obsolescence because of rapidly changing technology and customer requirements.

Impairment of Goodwill or Long-lived Assets

We perform an evaluation of the carrying value of goodwill on an annual basis and of intangibles and other long-lived assets whenever we become aware of an event or change in circumstances that would indicate potential impairment. We evaluate the recoverability of intangible assets and other long-lived assets on the basis of undiscounted cash flows from each asset group. If impairment is indicated, provisions for impairment are determined based on fair value, principally using discounted cash flows. Changes in industry and market conditions or the strategic realignment of our resources could result in an impairment of identified intangibles, goodwill or long-lived assets. There can be no assurance that future impairment tests will not result in a charge to earnings. Our review of intangibles in 2006 determined that the remaining balance of $1.0 million of the intangibles acquired as a result of the BTL acquisition in February 2005 had been impaired based on the discontinuance of the decoder product line obtained in the acquisition. At December 31, 2007, our carrying values for goodwill and intangible assets totaled $45.8 million and $17.8 million, respectively.

Restructuring Costs and Accruals for Excess Facilities

To determine our excess facility accruals we estimate expected sublease rental income on each excess facility. In the event we are unable to achieve expected levels of sublease rental income, we will need to revise our estimate of the liability which could materially impact our operating results, financial position or cash flows. At December 31, 2007, our accrual for excess facilities totaled $16.0 million.

Assessment of the Probability of the Outcome of Current Litigation

Harmonic records accruals for loss contingencies when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. Based on a tentative agreement to resolve its outstanding securities class action lawsuit, Harmonic believes that a probable and estimable liability has been incurred, and, accordingly, has recorded a provision of $6.4 million in its statement of operations for the year ended December 31, 2007. In other pending litigation, Harmonic believes that it either has meritorious defenses with respect to those actions and claims or is unable to predict the impact of an adverse action and, accordingly, no loss contingencies have been accrued. There can be no assurance, however, that we will prevail. An unfavorable outcome of these legal proceedings or failure to settle the securities litigation on the terms proposed could have a material adverse effect on our business, financial position, operating results or cash flows.

Accounting for Income Taxes

In preparation of our financial statements, we estimate our income taxes for each of the jurisdictions in which we operate. This involves estimating our actual current tax exposures and assessing temporary differences resulting from differing treatment of items, such as reserves and accruals, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. Based on our judgment that the likelihood that our deferred tax assets in the United States and certain foreign jurisdictions will be recovered from future taxable income is not more likely than not, we have maintained a full valuation allowance at December 31, 2007 in such jurisdictions.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Overview
Harmonic designs, manufactures and sells versatile and high performance video products and system solutions that enable service providers to efficiently deliver the next generation of broadcast and on-demand services, including high-definition television, or HDTV, video-on-demand, or VOD, network personal video recording and time-shifted TV. Historically, the majority of our sales have been derived from sales of video processing solutions and edge and access systems to cable television operators and from sales of video processing solutions to direct-to-home satellite operators. We also provide our video processing solutions to telecommunications companies, or telcos, broadcasters and Internet companies that offer video services to their customers.
In the third quarter and first nine months of 2008, Harmonic had net sales of $91.5 million and $268.1 million, respectively, which represented increases of 11% and 20%, respectively, in each period, compared to the third quarter and first nine months of 2007. The increase in sales in the third quarter of 2008 compared to the corresponding periods in 2007 was primarily due to stronger demand from our domestic satellite and cable customers for products and solutions related to VOD and HDTV. The increase in sales in the first nine months of 2008 compared to the corresponding periods in 2007 was primarily due to stronger demand from our domestic and international satellite and cable customers for products and solutions related to VOD and HDTV, and sales to new customers worldwide. Gross margins increased in the third quarter and first nine months of 2008 compared to the corresponding periods in 2007 due to favorable margins from lower average product costs due to increased manufacturing volumes and product design innovations and lower expenses for excess and obsolete inventories.
Historically, a majority of our net sales have been to relatively few customers, and due in part to the consolidation of ownership of cable television and direct broadcast satellite systems, and we expect this customer concentration to continue for the foreseeable future. In the third quarter of 2008 sales to Comcast and EchoStar accounted for 24% and 10% of net sales, respectively. In the third quarter of 2007, sales to Comcast and EchoStar accounted for 16% and 15% of net sales, respectively. In the first nine months of 2008, sales to Comcast and EchoStar accounted for 20% and 12% of net sales, respectively. In the first nine months of 2007, sales to Comcast accounted for 18% of net sales.
Sales to customers outside of the U.S. in the third quarter and first nine months of 2008 represented 39% and 43% of net sales, respectively, compared to 46% and 44% for the comparable periods in 2007. A significant portion of our international sales are made to distributors and system integrators, which are generally responsible for importing the products and providing installation and technical support and service to customers within their territory. Sales denominated in foreign currencies were approximately 5% of net sales in the first nine months of 2008 compared to 7% for the comparable period of 2007. We expect international sales to continue to account for a significant portion of our net sales for the foreseeable future.
Harmonic historically has recognized a significant portion, or the majority, of its revenues in the last month of the quarter. Harmonic establishes its expenditure levels for product development and other operating expenses based on projected sales levels, and expenses are relatively fixed in the short term. Accordingly, variations in timing of sales can cause significant fluctuations in operating results. Harmonic’s expenses for any given quarter are typically based on expected sales and if sales are below expectations, our operating results may be adversely impacted by our inability to adjust spending to compensate for the shortfall. In addition, because a significant portion of Harmonic’s business is derived from orders placed by a limited number of large customers, the timing of such orders can also cause significant fluctuations in our operating results.
On December 8, 2006, Harmonic completed its acquisition of the video networking software business of Entone Technologies, Inc. for a total purchase price of $49.0 million. The purchase price consisted of a payment of $26.2 million, the issuance of 3,579,715 shares of Harmonic common stock with a value of $20.1 million, the issuance of 175,342 options to purchase Harmonic common stock with a value of $0.2 million, and $2.5 million of transaction costs. Prior to the closing of the acquisition, Entone spun off its consumer premises equipment, or CPE, business into a separate private company.
On July 31, 2007, Harmonic completed its acquisition of Rhozet Corporation, pursuant to the terms of the Agreement and Plan of Merger, or Rhozet Agreement, dated July 25, 2007. Under the Rhozet Agreement, Harmonic paid or will pay an aggregate of approximately $15.5 million in total merger consideration, comprised of approximately $2.5 million in cash, 1,105,656 shares of Harmonic’s common stock in exchange for all of the outstanding shares of capital stock of Rhozet, and approximately $2.8 million of cash which was paid in the first quarter of 2008, as provided in the Rhozet Agreement, to the holders of outstanding options to acquire Rhozet common stock. In addition, in connection with the acquisition, Harmonic incurred approximately $0.7 million in transaction costs. Pursuant to the Rhozet Agreement, approximately $2.3 million of the total merger consideration, consisting of cash and shares of Harmonic common stock, are being held back by Harmonic for at least 18 months following the closing of the acquisition to satisfy certain indemnification obligations of Rhozet’s shareholders pursuant to the terms of the Rhozet Agreement.
In the fourth quarter of 2007, we sold and issued 12,500,000 shares of common stock in a public offering at a price of $12.00 per share. Our net proceeds from the offering were approximately $141.8 million, which was net of underwriters’ discounts and commissions of approximately $7.4 million and related legal, accounting, printing and other costs totaling approximately $0.7 million. The net proceeds from the offering have been or may in the future be used for general corporate purposes, including payment of existing liabilities, research and development, the development or acquisition of new products or technologies, equipment acquisitions, strategic acquisitions of businesses, general working capital and operating expenses. The offering was made pursuant to our Registration Statement on Form S-3 (File No. 333-123823) filed with the SEC on April 4, 2005, and declared effective by the SEC on April 22, 2005, and the related prospectus supplement filed with the SEC on October 31, 2007.
In 2001 and 2002, excess facilities and fixed asset impairment charges totaling $52.6 million were recorded due to the Company’s reduced headcount, difficult business conditions and a weak local commercial real estate market. In the fourth quarter of 2005, the excess facilities liability was decreased by $1.1 million due to subleasing a portion of the unoccupied portion of one building for the remainder of the lease. In the third quarter of 2006, we completed our facilities rationalization plan resulting in more efficient use of our Sunnyvale campus and vacated several buildings, some of which were subsequently subleased. This resulted in a net charge for excess facilities of $2.1 million in the third quarter of 2006. In the third quarter of 2007, we recorded a net credit of $1.4 million resulting primarily from an extension of a subleased building to the lease expiration. During the second quarter of 2008, the Company recorded a charge in selling, general and administrative expenses for excess facilities of $1.2 million from a revised estimate of expected sublease income of a Sunnyvale building. The lease terminates in September 2010 and all sublease income from this building has been eliminated from the calculation of the estimated liability. During the third quarter of 2008, the Company recorded a charge in selling, general and administrative expenses for excess facilities of $0.2 million from a revised estimate of expected sublease income of two buildings in England. The leases terminate in October 2010 and all sublease income has been eliminated from the estimated liability. In the event we are unable to achieve expected levels of sublease rental income, we will need to revise our estimate of the liability, which could materially impact our financial position, liquidity, cash flows and results of operations.
Adverse economic conditions in markets in which we operate and into which we sell our products can harm our business. Recently, economic conditions in the countries in which we operate and sell products have become increasingly negative, and global financial markets have experienced a severe downturn stemming from a multitude of factors, including adverse credit conditions impacted by the subprime-mortgage crisis, slower economic activity, concerns about inflation and deflation, increased energy costs, decreased consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns and other factors. Economic growth in the U.S. and in many other countries slowed in the fourth quarter of 2007, remained slow for the first three quarters of 2008, and is expected to slow further or recede in the fourth quarter of 2008 in the U.S. and internationally. During challenging economic times, and in tight credit markets, many customers may delay or reduce capital expenditures. This could result in reductions in sales of our products, longer sales cycles, difficulties in collection of accounts receivable, excess and obsolete inventory, gross margin deterioration, slower adoption of new technologies, increased price competition and supplier difficulties.
The Company is in the process of expanding its international operations and staff to better support its expansion into international markets. This expansion includes the implementation of an international structure that includes, among other things, a research and development cost-sharing arrangement, certain licenses and other contractual arrangements by and among the Company and its wholly-owned domestic and foreign subsidiaries. The Company’s foreign subsidiaries have acquired certain rights to sell the Company’s existing intellectual property and intellectual property that will be developed or licensed in the future. As a result of these changes and an expanding customer base internationally, the Company expects that an increasing percentage of its consolidated pre-tax income will be derived from, and reinvested in, its international operations. The Company anticipates that this pre-tax income will be subject to foreign tax at relatively lower tax rates when compared to the United States federal statutory tax rate.
Critical Accounting Policies, Judgments and Estimates
The preparation of financial statements and related disclosures requires Harmonic to make judgments, assumptions and estimates that affect the reported amounts of assets and liabilities, the disclosure of contingencies and the reported amounts of revenue and expenses in the financial statements and accompanying notes. Material differences may result in the amount and timing of revenue and expenses if different judgments or different estimates were made.
Our significant accounting policies are described in Note 1 to the annual consolidated financial statements as of and for the year ended December 31, 2007, included in our Annual Report on Form 10-K filed with the SEC on March 17, 2008 and notes to condensed consolidated financial statements as of and for the three and nine month periods ended September 26, 2008, included herein. Our most critical accounting policies have not changed since December 31, 2007, except that in the second quarter of 2008 we revised our critical accounting policy related to the accounting for income taxes, and includes the following:
• Revenue recognition;

• Allowances for doubtful accounts, returns and discounts;

• Valuation of inventories;

• Impairment of long-lived assets;

• Restructuring costs and accruals for excess facilities;

• Assessment of the probability of the outcome of current litigation;

• Accounting for income taxes, and

• Stock-based compensation.
In preparing our financial statements, we estimate our income taxes for each of the jurisdictions in which we operate. This involves estimating our actual current tax exposures and assessing temporary and permanent differences resulting from differing treatment of items, such as reserves and accruals, for tax and accounting purposes.

Our income tax policy is to record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in our accompanying condensed consolidated balance sheets, as well as operating loss and tax credit carryforwards. We follow the guidelines set forth in Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes,” or SFAS 109, regarding the recoverability of any tax assets recorded on the balance sheet and provide any necessary allowances as required. Determining necessary allowances requires us to make assessments about the timing of future events, including the probability of expected future taxable income and available tax planning opportunities. In the first nine months of 2008, our discrete valuation release totaled $19.0 million, of which $16.1 million was recorded as a benefit to the provision for income taxes and $2.9 million as a reduction to goodwill. In addition, during the first nine months of 2008, an adjustment of $2.9 million was recorded to Additional Paid in Capital due to the realization of excess tax benefits from stock-based compensation. In accordance with SFAS 109, we have evaluated our need for a valuation allowance based on historical evidence, trends in profitability, expectations of future taxable income and implemented tax planning strategies. In periods following the release of our valuation allowance our expectation is that the Company will experience a substantial increase in our effective tax rate.
We are subject to examination of our income tax returns by various tax authorities on a periodic basis. We regularly assess the likelihood of adverse outcomes resulting from such examinations to determine the adequacy of our provision for income taxes. We adopted the provisions of FIN 48 as of the beginning of 2007. Prior to adoption, our policy was to establish reserves that reflected the probable outcome of known tax contingencies. The effects of final resolution, if any, were recognized as changes to the effective income tax rate in the period of resolution. FIN 48 requires application of a more-likely-than-not threshold to the recognition and de-recognition of uncertain tax positions. If the recognition threshold is met, FIN 48 permits us to recognize a tax benefit measured at the largest amount of tax benefit that, in our judgment, is more than 50 percent likely to be realized upon settlement. If further requires that a change in judgment related to the expected ultimate resolution of uncertain tax positions be recognized in earnings in the quarter of such change.
We file annual income tax returns in multiple taxing jurisdictions around the world. A number of years may elapse before an uncertain tax position is audited and finally resolved. While it is often difficult to predict the final outcome or the timing of resolution of any particular uncertain tax position, we believe that our reserves for income taxes reflect the most likely outcome. We adjust these reserves and penalties as well as the related interest, in light of changing facts and circumstances. Changes in our assessment of our uncertain tax positions or settlement of any particular position could materially impact our income tax rate, financial position and cashflows.

CONF CALL

Patrick Harshman

Thank you and good afternoon everyone. I am Patrick Harshman, the President and Chief Executive Offices of Harmonic, with me in our headquarters here in California are Robin Dickson, our Chief Financial Officer and Michael Newman, our Investor Relations Spokesman. Thank you all for joining us.

Today we announced the results for the third quarter of 2008, the quarter which we delivered both the highest revenue and bookings in Harmonic’s history. These operating results demonstrate our products and solutions continue to be selected by an increasing number of both incumbent and emerging video service providers around the world. This continuing market momentum confirms the strength of our products in core technology, the ongoing success of our global strategy and the focus and excellence of our worldwide team.

Looking ahead to 2009, the global economic environment clearly creates some uncertainty. However, we are convinced the fundamental market and technology drivers that underpin our opportunities that transports, more video being delivered in more formats, to more devices over more networks by competitive operators remain in force. We, therefore, continue to be confident about our strong market position and long term growth opportunities and we continue to move forward with our innovative product development programs that powerfully address these fundamental market trends.

I will now ask Robin to cover the financial aspects of the quarter and I will then review some of our recent business developments and strategic initiatives in more detail. Robin.

Robin Dickson

Thank you Patrick and good afternoon everyone. During this call, we may make projections or other forward-looking statements regarding future events of the future financial performance of the Company. We must caution you that such statements are only predictions and that actual event or results may differ materially.

We refer you to the documents that Harmonic files with the SEC including our most recent 10-K and 10-Q reports. These documents identify important risks factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements.

Please note that on this call, we will provide you with financial metrics determined on a non-GAAP or pro forma basis. These items together with the corresponding GAAP numbers and the reconciliation to GAAP are contained in today’s earnings press release, which we have posted on our website and filed with the SEC on Form 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 will be available in a recorded version of this call on our website.

Today, we announce results for the third quarter ended September 26, 2008. We reported net sales for the quarter of $91.5 million, up 11% from $82.3 million in the third quarter of 2007. For the first nine months of 2008, our net sales worth $268.1 million up 20% from $223.8 million in the same period of 2007. In the third quarter, our international sales represent 39% of total sales and 43% on a year-to-date basis.

By market, our Cable customers in the third quarter accounted for 63% of total revenue, satellite customers 22% and telecoms and other customers 15%. The same numbers in a year-to-date basis are 62% for Cable, 20% satellite and 18% telcos and others. Our largest customers in the third quarter were Comcast and Equistar, representing 24% and 10% respectively of our total revenue.

We have given both quarterly and year-to-date numbers for the revenue mix. As important to take a longer view of our revenue growth and now to focus unduly on the quarter-to-quarter fluctuations and mix that an evitable feature of our business.

Our year-to-date revenue growth of 20% is distributed broadly across our customer base both by geography and market. Both domestic and international revenue are grown steadily, with domestic up 22% year-over-year and international up 16% both on a year-to-date basis.

Similarly, market segment growth is also broad based. At year-to-date, Cable is up 19%, satellite 22% and telco and other 18%. But we aim to do more to further diversify our customer base were pleased with our progress so far.

In addition to our strong revenue, one of the most notable features of the third quarter was a very strong order input particularly in August and September. We had a book to bill ratio for the quarter of around 1.2 and the bookings were quite broadly distributed across all geographies, product lines and markets.

By product category, video processing products represented 35% of revenue in the third quarter, edge and the access products 47% and software services and other, 18%. The third quarter had the highest revenue of any quarter of this year from our edge device products, reflecting the increasing of option of our universal edge plan by customers all over the world.

We maintain our non-GAAP gross margins at 50% in the third quarter, in spite of higher freight costs and the strengthening dollar. While the universal edge client was important to our revenue growth, it is also part of the year-over-year improvement in gross margins. It is a great example of our many new products and solutions that provide exceptional value to customers and more sustainable gross margin benefits to Harmonic.

Our non-GAAP operating expenses in the third quarter were up on a sequential basis by about $300,000 to $30.8 million. As we had indicated on our July conference call, we started to accelerate hiring for several key projects and we added 21 people during the third quarter bringing our total headcount to 695 at the end of September.

Our operating margin on a non-GAAP basis was over 16% for both the third quarter and on a year-to-date basis, marking the fourth consecutive quarter in excess of 15%. Below the operating line, our results for the third quarter included the charge of approximately $800,000 for the impairment of a $1 million investment in Lehman Brothers’ debt. Aside from this one instance, we believe that our cash and marketable securities are conservatively invested and in particular well diversified to withstand current conditions in the markets.

GAAP net income for the third quarter of 2008 was $12 million or $0.12 per diluted share, compared to $9.4 million or $0.12 per diluted share for the same period of 2007. We exclude charges for the investment impairment, stock based compensation expense, the amortization of intangibles and the excess facilities and also a credit for the reversal of evaluation allowance against the deferred tax assets. Non-GAAP net income for the third quarter was $15.9 million or $0.17 per diluted share, up from $11.9 million or $0.15 per diluted share of the same period of 2007.

Our operating performance continues to strengthen our balance sheet. At the end of September, we had cash, cash equivalents and short term investments of $293.4 million, up from $288.2 million at the end of June.

Our receivables were $75.9 million with DSOs of 76 days. This is higher in Q2 but it primarily reflects the timing of shipments in the third quarter following the strength in orders of the quarter progressed. We expect DSOs to come down slightly in future quarters, although in the current environment, we expect to see some pressure from customers for easier credit.

As we normally do, we will review these requests very strictly on a case-by- case basis and in addition, we are monitoring all of our receivables very carefully in this credit challenged time.

Net inventory was $32.5 million about flat with the previous quarter, and finally capital expenditures were about $2 million in the third quarter, and we continues to expect CapEx of approximately $8 million for the full year.

With respect to the outlook, we came into the fourth quarter with strong order backlog and deferred revenue of close to $100 billion. And so far in Q4, we have seen a reasonably good level of new bookings. So with this start, our current visibility into Q4 is quite good and we are holding to our statements in September that we expect to be at the high-end of our second half revenue range, which we announced at the end of July.

Beyond that quarter, the picture is less clear. As you might expect and most of our customers tell us that they are reassessing their capital expenditure plans for 2009 in the light of current conditions.

So while we have been in the practice of providing grow in six-month guidance, making projections that include any part of 2009 would be quite difficult. So taking these factors into consideration with decided to provide guidance for the fourth quarter only.

We currently anticipate that our net sales for the fourth quarter will be in the range of $92 million to $95 million. Our gross margins are expected to be 47% million to $49% on a GAAP basis. Non-GAAP gross margins for the same period, excluding stock based compensation and amortization intangibles are anticipated to be in a range of 49% to 51%.

While external operating performance has allowed us to step up reinvestment in our business. We believe that for now, we are stacked appropriately for current business levels and for major projects. In the fourth quarter anticipate an increase on non-GAAP operating expenses of up to $500,000 over the $30.8 million reported in Q3 mainly as the result of our recent hiring. Our expectation for non-GAAP operating margin in Q4 is within a range of 15% to 17%.

Finally, on the fourth quarter we expect to continue to have a nominal tax rate for the fourth quarter of about 6% to7%. At this point, we are unable to add anymore positions to our previous forecast of a mid-30s tax rate for all of 2009.

In summary, we are very pleased with our performance in the third quarter, while the significant global economic uncertainty, we have a strong balance sheet and had made study improvements in our competitive position and our operational flexibility. In a longer term, we are very optimistic about our industry and our opportunities for continuing profitable growth. Patrick?

Patrick Harshman

Thanks, Robin. Our strong results reflect robust video delivery market place and it continued with strengthening of our competitive position, allowing us to take advantage of compelling opportunities across a broadening range of applications, customers, and geographies, and particular operators around the globe. We continue to see healthy fundamentals and intensifying competition from direct to home satellite, Telco IPTV and new internet-based video service providers.

Cables competitive response continues to feature more high-definition programming, more on demand capability, and higher speed internet access that can flexibly support increasingly popular IP-based video services. Our powerful solutions in compelling development roadmaps for each of these applications continue to set us apart in the market, enabling us to deepen our relationships with existing Cable customers and penetrate new accounts worldwide, for example, we were pleased to recently announce that Germany’s largest Cable operator, KDG, selected a broad suite of encoding, re-encoding, multiplexing and scrambling products, and that Russia’s largest Cable operator, NCN, recently selected our encoding in video processing, edgeQAM and on-demand software solutions.

Our latest edgeQAM base solutions for VOD and high-speed data continues to be a key driver of our growing business with Cable operators worldwide, and a recent first significant order for a new IPTV over Cable solution is an important milestone in emergence of this additional Cable growth initiative.

We also continue to extend our competitive and technology footprint with incumbent a new satellite operator around the globe. We recently announced the Direct TV, the world’s largest direct home satellite operator has expanded its deployment of our video processing solutions to support its new national high-definition services. And we recently announced that Portugal Telecom implemented our latest compression and stream processing solutions for its nationwide satellite direct to home television service. These announced wins are indicative of our ongoing success in building new and expanding relationships with leading satellite operators in Americas, Europe and Asia.

With a growing array of high-definition, standard definition and lower resolution video program is being delivered over satellites around the globe. In the satellite transponder bandwidth continuing to be a precious commodity, we see strong long term demand for our continuing video compression, innovations and new product releases.

We also continue to be pleased with our expanding customer and technology footprint in the emerging global IPTV market where we involve new IPTV customers and follow-on business from existing Telco accounts. We have recently won new IPTV customers in Asia, the Americas and Europe with both our compression and on-demand technologies providing important competitive differentiation.

We also announced recently that one of our existing customers, Bell Aliant has selected us for its MPEG-4 upgrade to enhance its IPTV video service for customers throughout the Atlantic Provinces of Canada. Underlying our growing competitive success and strong gross margins, these are continuing execution in delivering powerful and high value new products and technologies to have application across video delivery markets. A Rhozet Transcoding Technology, for example, continues to help us expand our customer base in new directions, including recently announced wins with Adobe, Independent Television News, a leading news and content Company in the UK, MTV Germany and 3 Italia, a leading mobile operator in Europe.

We also recently unveiled a new ion high-definition encoder, a new StreamLiner of 2000 Flash memory video servers and a new ProStream 4000 multi-screen transcoder for Sync-and-Go video delivery to mobile phones, personal computers, and personal media players. In addition, we have recently successfully completed performance testing with Microsoft of our ProStream 2000 splicer for digital advertisement insertion within the Microsoft to Mediaroom, IPTV environment.

In summary, our powerful and growing portfolio of new video delivery products and solutions and our strategy of addressing a broadening range of global customers continue to drive our growth, strong gross margins, and profitability. By continuing to introduce innovative products that enable our customers to address the key trends towards more high definition, on-demand and any time, any where video a new creative and cost effective ways.

We feel increasingly well positioned in this market place. What a global economic environment clearly creates of uncertainties. Our technology leadership, diverse customer base, strong operating performance, and strong balance sheet have placed such an excellent position to further strengthen our competitive position and we remain confident about our long term growth opportunities.

Well this concludes the formal part of our presentation, and now Rob and I will be pleased to entertain any questions that you might have.

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