Harmonic Inc (HLIT) 2004 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by.

Welcome to the Harmonic Incorporated Second Quarter Earnings Conference Call.

During the presentation, all participants will be in a listen-only mode.

Afterwards, we'll conduct a question and answer session.

At that time, if you have a question please press the "1" followed by the "4" on your telephone.

As a reminder, this conference is being recorded, Thursday, July 22, 2004.

I'd like to turn the conference over to Anthony Ley, Chairman, President and Chief Executive Officer.

Thank you.

Good afternoon.

I'm Tony Ley, President and CEO of Harmonic.

With me in our headquarters in Sunnyvale, California are Robin Dickson, our Chief Financial Officer and Michael Newman, our Investor Relations Spokesman.

Thank you all for joining us.

As most of you know, Harmonic designs, manufactures and markets fiber optic and digital head-end systems for delivering video, voice and data over cable satellites and teleco networks.

Today we announced the results for the second quarter of 2004.

We're pleased with our revenue growth in the second quarter particularly in international markets and our improving financial performance.

We saw growing demand from our international and domestic customers, who continue to deploy more optical nodes and digital head-end equipment or vision more digital channels, video-on-demand, high definition programming, telephony and IP services.

We also continued to extend our technology leadership with the introduction of new encoders and newer optical transmission systems.

Across our different markets, we are helping customers migrate to next generation network transmission and video compression technologies.

While the timing of deployments remains difficult to predict, intensifying competition between different operators to capture and retain subscribers continues to drive our business.

As is our custom, Robin will now review the financial results.

Afterwards I'll discuss significant events that have occurred during the quarter.

Robin?

Thanks, Tony.

Good afternoon, everyone.

During this call, we may make projections or other forward-looking statements regarding future events or the future financial performance of the company.

We must caution you that such statements are only predictions and that actual events or results may differ materially.

We refer you to the documents that the company files with the SEC, including our most recent 10-K and 10-Q reports.

These documents identify important risk factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements.

Please also know, that on this call, we will provide you with several 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 Web site 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 today's press release, and the remainder of the information will be available in a recorded version of this call on our Web site.

Today, we announced our results for the second quarter ended July 2, 2004.

We reported net sales of $57 million, up 37% from $41.7 million in the second quarter of 2003, and up 3% from $55.1 million in the first quarter of 2004.

Our Convergent Systems division, which designs, manufactures, and markets digital head-end systems, had divisional net sales of $33.3 million in the second quarter of 2004, up 23% from 27.1 million in the same period of 2003.

Our broadband access networks division which designs, manufactures and markets fiber optics products had divisional net sales of $23.7 million in the second quarter of '04, up 62% from $14.6 million in the same period of 2003.

On a sequential basis, Convergent Systems was down by $2.5 million in the quarter.

This reflects what we'd indicated on our call, three months ago in April.

We expect significant -- several significant projects to drive Convergent Systems this year, but at the time of these orders and subsequent delivery and acceptance was difficult to predict with accuracy.

This is exactly what happened.

We had some delays, but at the same time, other projects proceeded, notably our completion of initial customer acceptance testing for Sky Perfect in Japan.

BAN had a strong quarter up $4.4 million sequentially from Q1, partly following the seasonal patterns but also benefiting from continued upgrades for hybrid fiber coax networks worldwide, as well as network enhancements such as note splitting for the continuing roll out of new interactive services, including business services.

In the second quarter, our largest customers were Comcast and Sky Perfect, up 22% and 11% of total sales respectively.

By market segment, sales to our cable customers represented 67% of revenue in the quarter, satellite customers represented 24%, and other segments, principally Teleco and broadcast customers, represented 9%.

International sales were 44% of total sales in the second quarter, up from 33% in the first quarter.

We were pleased to see improving sales in certain parts of Continental Europe although the increase in international sales in the second quarter comes mainly from the Sky Perfect project.

Gross margins on a non-GAAP basis were 40% in the second quarter, down slightly from 41% in the first quarter of 2004, but up significantly from 32% in the second quarter of last year.

The sequential decline reflects mainly the quarter's mix of product sales, which had a heavier concentration of BAN products compared both to recent quarter and also to some extent to our expectations.

I can confirm that our transition to one primary contract manufacturer is essentially complete and on schedule.

As always, the sides of transitions had unexpected issues with timing delays and unplanned costs but we are now where we expected to be and we look forward to fully realizing the benefits of these new arrangements.

These contract manufacturing changes, the success of our new products, our sustained cost control efforts, and higher sales levels should allow us to resume gross margin improvement in the second half of this year.

Our gross margins were slightly disappointing but I'm pleased that non-GAAP operating expenses were $21.8 million in the second quarter of '04 down on a sequential base from $22.8 million in the first quarter

The decrease reflects primarily a smaller number of days in Q2 compared to Q1, you may recall that our previous two quarters were longer than the normal 13-week quarter because of the vagaries of the accounting calendar.

At the end of June, we had 570 employees, up eight from the end of March.

We expect to continue to hire very selectively in the anticipation of growth in coming periods.

Just as in Q1, we're also very pleased to achieved positive non-GAAP income in the second quarter.

Non-GAAP net income was $500,000 or 1 penny per share.

This compares to a non-GAAP net loss of $6.6 million or 11 cents per share for the same period of 2003.

And please note that in this current second quarter, we have excluded from our non-GAAP results a credit of $1.2 million, related to sale of previously reserved inventory, as well as non-cash accounting charges for the amortization of intangibles.

The GAAP net loss which includes both of these items was $1.8 million or 2 cents per share for the second quarter of '04 compared to a net loss of $11.7 million or 19 cents per share for the same period of 2003.

Once again, a reconciliation between GAAP and non-GAAP results are in our press release on our website and in our 8-K filing today with the SEC.

Finally, our Q2 revenue on both our non-GAAP and GAAP net income are in the middle of the ranges of guidance we provided on our April conference call.

Turning to the balance sheet, we had cash, cash equivalents and short-term investments of 92.2 million at the end of second quarter of 2004 compared to 108.4 million at the end of March.

This sequential decrease in our cash position primarily represents increased working capital requirements, which I'll discuss shortly.

Also, as many of you are aware, we still have various tax liabilities remaining from our acquisition of DiviCom four years ago.

As we indicated in April, we have made payments of $4.8 million in Q2 under the terms of these tax-sharing agreements.

The timing of the remaining payments is still uncertain, but I expect to pay the balance of approximately $50 million gradually over the next one to two years with no significant payments likely in Q3.

There will be no impact on our tax provision as a result of any of these payments.

Now with respect to working capital, our receivables were $39.1 million at the end of Q2 compared to 32.4 million at the end of March.

Day sales outstanding was 63 days up from 53 at the end of March, but still very much within the normal range for Harmonic.

The increase principally represents the timing of shipments during the second quarter and compares favorably with 76-day sales outstanding at the same time last year.

Inventory was $30.4 million at the end of Q2, up slightly from $28.3 million at the end of March, as we continue to prepare for anticipated demands in the second half of the year.

Our capital spending in Q2 was approximately $1 million and we expect CapEx for the full year to be around $5 million.

During the quarter we also took a more aggressive position with respect to capturing discounts for early payment to suppliers, usually within 10 days.

As a result, accounts payable is over $3 million lower than it otherwise would have been.

Approximately $12 million represented by these changes in accounts receivable inventory and accounts payable was frankly a little bit more than we expected but it should be put in the context of the second quarter, which lays the foundation for a stronger second half.

In summary, we do see strength in our business, bans benefiting from domestic operators continuing to make targeting improvements to their net worth as well as continuation to improvement of programs both here and abroad.

Convergent Systems is driven much more by large projects including head-end equipment for digital channels, high definition and video-on-demand.

As well as Teleco deployments for all of which there is typically less certainty about the timing of orders and also project completion.

Tony will expand in more detail on the opportunities, but I expect that we could see revenues for the second half of $125 to $130 million compared to $112 million in the first half.

This would put our revenues for the year somewhere around $240 million, or over 30% growth year-on-year.

It is more difficult to pin down the third and fourth quarters individually, but in Q3, revenue of $59 to $63 million is our expectation at this point.

Based on these projected Q3 revenues, I expect that we can earn 3 to 5 cents on a non-GAAP basis or a 2 cents net loss to break even on a GAAP basis.

That's all for me.

Tony?

Thanks, Robin.

The central growth driver in our business is the competition between satellite, cable, and Teleco operators, which is now really intensified especially around digital video.

Satellite continues to gain subscribers based on picture quality and channels availability but is faced with limited transponder capability that can only be increased by adding very expensive satellites.

The opportunity for Harmonic is to replace the existing encoders with ones one squeeze more channels into available bandwidth.

Of course MPEG-2 and the new VC 9 and H2 64 standards.

Cable companies are competing by focusing on interactive services, leading to the rollouts of the triple player, video, voice and data services, including the rollouts of voiceover IP.

To accomplish this, cable operators have been improving the two-way capability of their networks by no spacing and by adding the corresponding transmitters and though note splitting.

In order to have comparable channel line up and picture quality as well as HD and content on demand, the cable companies are also investing in digital head-ends those around encoders.

In the Teleco world, the market for wireline and wireless is saturated.

But multimedia services are seen as a growth area.

This has been compelling domestic Telecos like Verizon to move toward deployment of STTP, which creates a new market for optical transmission and digital head-end products and is also been driving international Telecos to begin deploying video over DSL, which also requires a digital head-ends.

Now we believe this competitive situation between cable, satellite, and Telecos will continue to drive growing demands for optical transmission and digital head-end products in years to come.

During the second quarter, our band business for our cable customers showed strong growth.

We're very pleased with the diversity of our cable customers and the strength they showed both domestically and internationally.

While there are few rebuilds, demand is strong for our fiber products that facilitate the interactive services and we see this with many cable operators, including so just Cox and EchoStar in particular.

In addition to our traditional cable business, Time Warner announced the deployment of our commercial services solution for high-speed access and virtual private network services.

Based on CWD technology, the commercial services solution works over the existing cable infrastructure, which supplies broadband and television services to residential customers.

And it extends its reach to businesses.

Time Warner has deployed the service in a host of school districts that had formerly been using T1 service the now has 100 megabyte capability and wider applications.

Today's cable network sparks thousands of networks and schools and government facilities that require very high-speed communication.

Respect this, market sate significant opportunity for cable operators.

In addition to our commercial services solution, we recently introduced other exciting new optical and digital products for our cable customers.

Our new GIGALight DW transmission system can transmit up to 40-wavelengths fiber over long distances, with each wavelength delivering 10 gigabytes per second.

Among its main applications is moving data video traffic from head-end to hubs.

It's fully integrated with our services gateway, the NSG product, it's managed by our analacs (ph) digital service manager and it's optimized video over IP transport as operators prepare for deployments of the next wave of on-demand services.

We also announced the introduction of our new Ion multi-channel MPEG-2 encoder, a modular one-rack unit with high channel density architecture to support a range of applications, including all digital cable head-ends.

Ion's native IP architecture provides greater scalability and reduced costs.

The Ion is for constant adaptive bit rates applications in cable and Teleco head-ends and complements our high-end MV50 and MV100 encoders.

I'm pleased to say the market acceptance has been very enthusiastic.

Following the successful commercial deployment of charters, all-digital system in the Los Angeles area, there is growing interest among cable operators worldwide in encoding technology for saving bandwidth, providing AHD, and improving video quality.

During the second quarter, we've announced the Videotron, one of Canada's largest cable operators, expanded the channel capacity of his cable network.

Using our high performance MPEG-2 encoders, Videotron distributes its program in a digital video format without compromising the existing analog television channels.

And with satellite market, our relationships with EchoStar, DIRECTV, Sky Perfect, and other satellite broadcasters around the world continued to be very strong.

Our satellite customers see that subscriber base is growing and continue to expand their systems to offer more digital channels, as well as, high definition on local channels as they compete head-to-head with cable.

We continue to improve the encoding efficiency of our MPEG-2 encoders and the improvement in the MPEG-2 encoders has significant and immediate value today.

We expect to see increasing shipments of MPEG-2 encoders to satellite customers in the second half of 2004.

In the Teleco arena, we continue to work with operators so as they decide how they can best offer competitive array of quality digital video service.

As demonstrated by recent public announcements by major Telecos and by their interest of Supercomm Trade Show, they're very serious about rolling out dual band and pay TV services in the coming years.

At Supercomm, we demonstrated both our video over DSL and FTTP related technologies.

Our encoders are currently deployed by Telecos to provide television over DSL in the UK, Japan, and Canada, and they are actively engaged in a number of FTP projects in the U.S.

We continue to work with Teleco operators on future deployments of the advanced encoding standards.

At Supercomm, we demonstrated some of our capabilities with H.264 and Microsoft's VC-9, which has significant benefits for the Telecos as DSL bandwidth is so limited.

Over the long term, we believe the Teleco market will provide major opportunities for our both digital head-end and fiber optic products and we expect to see significant Teleco revenues in 2005.

In the summary, the second quarter has established our position for a strong second half.

Our international markets are showing signs of improvement.

We continue to see intensifying competition between cable and satellite operators.

Major Teleco operators are planning to offer digital video services in order to stay competitive.

We're very pleased about the continuing success of our new products, our cutting edge development work, and the growing recognition of our capabilities across different markets.

We believe Harmonic is strongly positioned to help across the competitive challenges added from customers.

And while the timing of customer deployments remains difficult to predict, we expect to face competition along with the ever increasing bandwidth and technical requirements for new services, we'll continue to drive growing demand for our fiber optic and digital products in the second half of 2004 and beyond.

This concludes the formal part of our presentation.

And now Rob and I will be pleased to entertain any questions you may have.

Thank you.

Ladies and gentlemen, if you would like to register a question, please press the "1" followed by the "4" on your telephone.

You'll hear a three-tone prompt to acknowledge your request and if your question has been answered, and you'd like to withdraw your registration, please press the "1" followed by the "3."

If you're using a speakerphone, please lift your hand set before entering your request.

One moment please for the first question.

Our first question comes from Alan Bezoza from Friedman Billings, Ramsey.

Please proceed with your question.

Hi, Tony, hi Robin.

Couple of questions.

First, on Sky Perfect, what percent of completion would you say that project is at this point?

Something like 40%, 50% probably something that we're looking

And do you think that will last probably another quarter or two probably the second half of the year?

I would say it should mostly the -- you can never be sure of a thing of this magnitude.

It's a very large system, but it should be right time during the second half.

OK.

And then, when you look at international, if you back down Sky Perfect, there was up a little bit, I think, quarter-to-quarter.

Where were the -- you know you kind of highlighted a lot of international where did you see some kind of pick up?

Was it some of the distressed -- previously distressed companies like NTL, TeleWestern - was that the majority of some of the pickup you've seen?

I'm not so sure just in the second quarter, but in general, we're seeing a lot more life in the UK and certain parts of Central Europe, in Latin America, and of course China and Japan continue.

So it's pretty diversified.

And then in the U.S., maybe you can do the same as anyone that they seen exceptionally strong?

There're a lot of people out there that, you know, the upgrade is done, we're not spend any more on optical transport.

Maybe give us some confidence in Comcast that how are they tracking and then how do you see them tracking?

If you look at this quarter, in the optical space, one of the good things about this quarter, our customer base was very diversified.

Comcast was more a part that it has been in the past.

And I think this reflects the fact that everywhere, in order to bring on the interactive services, you have to go back and make changes in the network.

So, although the rebuilds are done, the rebuilds are in the sets of outside plant.

So we'll have these interactive services to get ready and particular for telephony, we have to get on with the node splitting and all equipment that goes with that and we're seeing that right across the board both here and internationally.

And how about, lastly, at the NSG server level, that it seems like that was a little weaker this quarter than I would have expected, given the weakness in CS in general.

Is there anything you can point to there?

I think this is a classical market where there is a tremendous roll-out to begin with but then it goes into less critical working and see the customers take up the demand.

We're in that phase now and we see some recent evidence that the demand is going to increase the capacity of the install base before too long and then at that point we think the market will come back to us but we hold a significant part of the market.

So we're lot to the general market and that general market has been big quiet so far this year but we do anticipate quite a pickup in the next 12 months.

Is that big piece in Comcast as the sources still mostly on the band side?

It's slightly, fairly evenly divided, Alan.

Yes.

Yes.

OK.

Great thanks.

I appreciate it.

Our next question comes from the line Nikos Theodosopoulos from UBS.

Please proceed with your question.

Yes.

Thank you.

In terms of the guidance for next quarter, any feel for how the two reported segments will trend?

I mean will they both be up?

Or is it too difficult to tell at thIS point?

And the second question would be on the inventory, the sequential improvement I think last quarter -- or I'm sorry -- the sequential increase last quarter I think you said is related to Convergent Systems.

Is that where the increase was again this quarter? and can you comment on what parts of Convergent is driving the inventory increase?

Yes, that the two parts of that question, Nikos are fairly interrelated.

As we said earlier, we see some pretty significant projects in the pipeline for Convergent.

The timing is very hard to call.

And at the same time as a result, we want to be ready to move whenever our customers want to move, and so to some extent we have been building ahead.

The inventory increase in the nearly both in the first and second quarter for the most part but was in Convergent Systems division.

And at the same time, the goals we see in the second half over the first half is mostly associated in our minds today at least with Convergent Systems, so I would expect than to be flattish over the remainder of the year relative to the second quarter.

Particularly we don't expect any of the Teleco initiatives that particularly to start paying out until '05.

OK.

And just as a follow-up on that, I mean, how do you handicap the conference level that these projects will come through?

Are they similar to count the sky perfect deal, where the orders are in house?

You just haven't announced them?

Or are the orders where you just have a very high confidence that you will win them even though you don't have any orders yet?

It's really a bit of everything.

Some of it is in house.

Some of it is very high degrees of probability based on what customers have told us.

Some more of it is a little bit further out.

There really is a little bit of everything.

I think what we feel good about is in the -- during the second quarter, many of these timely have been moving either toward shrewish and then in a sense of purchase order or contract and dollars are getting close.

OK.

All right.

Thanks a lot.

Our next question comes from Greg Mesniaeff from Calyon.

Please proceed with your question.

Yes, thanks.

And just a quick follow-up, you mentioned Rob and Sky Perfect was I believe the 11% in the quarter and you also mentioned that satellite was 24% of revenues.

Could you give us some color as to who some of the other customers in satellite were and which ones, were in the US, if any?

Well, I suppose I could describe it as the usual suspects, I mean clearly are given the size, both EchoStar and DIRECTV, I mean we had ongoing business with both of them nothing remarkable in the second quarter on either front Sky Perfect was certainly the biggest element of the satellite market segment number in the second quarter.

I could point to a few other overseas projects.

We completed one for a France satellite operator actually so you could deliver services to a DSL provider.

We put that in satellite bucket but it arguably controlling the other bucket.

So these are some of the examples of the bigger things we did during the quarter.

And you mentioned that the Comcast business was pretty much evenly split between band and CS right?

Yes.

I think its still a little bit towards the CS as Comcast continue with the on demand deferments and we start to buy encoders from us, as well so I think there was little bit towards CS probably 60/40, as I think about the numbers.

And just as a final wrap up, any data points you can share with us that would give us reason to think that -- or will allow us to establish a potential timeline for HD deployment at the MSN level?

Its really being rolled out gradually quite consistently in quite a wide spread manner.

We sell most of the encoders that people buy and they are buying them satellite customers buy them and our cable customers buy them.

Good.

Thank you.

Our next question come from the line of Steven Kamman from CIBC World Markets.

Please proceed with your question.

Steve?

Sorry.

I'm fumbling with the phone, without much luck sorry about that.

Question on any chance of further digital roll outs in Charter and Long Beach, just trying to figure, yes, I know you did Long Beach is there any chance of doing any roll outs there or any possibility of other players kind of doing that in the near term?

And then second question is on MPEG 4 Windows Media 9.

It seems to be splitting with Teleco is going Windows Media 9 and the cable guy is going MPEG 4.

Is that a reasonable assumption?

And can you talk about your marketing position there?

Certainly.

With respect to the all-digitial head-ends, which is properly close to the truth and future in the cable industry, I would say that Charter is very quickly out of gate with the system that is actually now I think being used commercially by them in Los Angeles region.

We have a lot of trial systems out right across the U.S. cable industry at this time and we're pretty sure that some of those will come in the second half.

Charter may or may not, you know, be one of those, we're not permitted to address that part of the question.

But the interest is there and its widespread and its is one of the reason that that we're confident about to going forward.

In terms, of let's see, Windows Media 9, VC9 and 264, you are right in the sense that I think people have been in the business for long time with pay television are really going with the 264 standard in general.

The Teleco industry has found the offering from Microsoft attractive.

But I would suggest to you that these are very early days.

And both standards are going to exist.

And it's hard to predict who's going to end up where.

For people like ourselves, what we've done of course is to make an encoder that from a hardward platform view you can run either of these standard MPEG OMS Media 9 codes and we are now are tuning them up to get to the point where the bandwidth reduction and the bit rate reduction is really significant.

Any evidence of near term traction there?

Is that still in '05 or '06?

No, we have equipment in the United Kingdom and it will be playing 264 commercially I can give -- certainly playing within the UK in August.

Good stuff.

And then last question, any signs of life at Adelphia?

Well, Adelphia business is still quite strong and quite consistent for us for two quarters.

But it's been mainly on the band side and we have high hopes on head side as well.

Thanks very much.

The next question comes from the line of Dennis Gallagher from Schwab Soundview.

Please proceed with your question.

Thank you.

Probably just one question sort of following up to some of your earlier comments on satellite.

Obviously, it appears that business from EchoStar and DIRECTV are perhaps down, given how much of your satellite is now Sky Perfect?

What's the trajectory, do you think, in terms of high definition and additional local channels over the next couple of quarters for those customers?

Well, lets say in general, we're very confident about our increase in our business in satellite in the second half and into next year.

And we tried to become more confident, they have a number of issues in terms of wanting to supply more channels, pickup deals with HD rollout, wealthy channels, and it's put a lot of pressure on the systems and we're very confident that market is going to be going forward more than it has been.

And we believe but we're quite well positioned in some of those accounts.

OK.

Thank you.

Our next question comes from the line of Chet White from Merriman Curhan Ford and Company.

Please proceed with your question.

Hi.

Thank you very much.

I was wondering if you could just clarify one thing and comment about it.

You noted that you said you expect some Teleco deployments in a material way in the second half of '05, was that correct?

Or did you identify that half?

Well, there were a couple of things that I think referred to - yes.

When I was talking '05, I was talking more to the band FTTP possibilities.

I do think with respect to the second half of '04 you will see some Teleco activity, which maybe revolves more around head-ends for DSL.

So again, we're working on number of fronts as far as Teleco is concerned.

But from the timing perspective, I think, we've said, I certainly being saying before, I would expect to see more revenue this year from DSL head-end deployments when I do from FTTP.

I see.

And then could you talk about into the recent comments on Verizon, I guess, you noted that there was an opportunity in both the band and head-end division.

So was that -- since that is FTTP, are you thinking that is a '05 type of opportunity and is it also a head-end opportunity still for you?

Yes, I put that in the more general context from just Verizon I'm just -- just, Verizon as an example, there are clearly opportunities, when we get into these FTTP systems, and it does gets technical at some point because it depend on the way they rollout the television.

But if it's the architecture of the sort that Verizon has gone forward, which has basically an RF video overlay, we supply for those sources systems and we supply for video transmission product.

And then of course, it doesn't matter, who you are.

Basically, if you're going to supply television, you're going to have to have a digital head-end.

And FTTP or any fiber market, no matter how they get the signals to the subscriber represents an opportunity for digital head-end.

I see.

Thank you very much.

Our next question comes from the line of Erik Zamkoff from the Independent Research Group.

Please proceed with your question.

Hi, good afternoon.

I was wondering if you could take a little bit of time to talk about the gateway competitive scenario.

Particularly, are you seeing Cisco out there in any of your accounts, and how have you been doing competitively with Cisco?

Also on the convergent system side -- if you could talk a little bit about potential opportunity going forward on the VOD side?

Are you seeing a slowdown in VOD spend, particularly at Comcast?

I know that Cox was a significant customer last quarter and they dropped out of the 10%.

You know, is it a competitive situation, or is it a slowdown in VOD deployments that's driving the decline here?

As far as the NSG is concerned it holds as thinking a very large part has been still in the market.

And with reference to Cisco, we are not aware of any business that they've been able to capture with their products at this time.

They may have done so but we haven't seen them in any of our accounts.

In terms of the VOD markets, in general, as I tried to indicate, we took off a great deal of equipment being installed.

And of course the operators would fairly accept this when they put it in.

You never want a situation that it's raining on a Friday night and you order video or something and it doesn't come.

It will never happen if you haven't done in the right capacity.

So starting to go over the fair amount of capacity and now they are busy learning how to -- in my view, learning how to market the services and rolling out the offerings, which include many more things than just video to get the customer base involved.

And that just seems we're proceeding.

And from -- so the market going forward will depend on some parameters, the first of course is the continuing rollout of digital set-top boxes.

The amounts of edge capacity required just depend on the number of set-tops and that of course is preceding our place.

And then the second thing is how far are you from peak demand.

And we are getting anecdotal evidence back now but people see that they're going to be approaching the peak demand before too long.

And that at that point, we'll go on extending the systems that are already installed.

And one follow on question, gross margins going forward now that you are fully moved to a single contract manufacturer, can we expect, given your guidance, that margins continue to expand, and if possible, can you give a range?

And on the OPEX line, I noticed a fairly significant decline in R&D as well as a decline in SG&A.

How would you model that going forward?

Does that decline continue?

Does it flatten out, or does it grow?

OK.

Well, first of all, just a footnote to the VOD question, I would also add that we're beginning to see the first rumblings of interest internationally in VOD from substantial revenue perspective at this point it's pretty modest.

But we're starting to get engaged with a number of operators in actually both in Europe and Asia about VOD deployments.

So that's just another I just add that as an extra dimension to it.

On the gross margin question, I'm pretty optimistic about the second half.

I mean, as I said in the prepared remarks, the second quarter was a little bit tilted towards band in terms of revenue and generally band gross margins are somewhat lower than convergent systems, and given that we expect these ratio to turn around a bit in the second half, I'm optimistic therefore that gross margins just simply from a product mix perspective will improve.

I do think we have the contract manufacturing transition virtually behind us and so we should be realizing the benefits of that in the second half.

So I'm pretty optimistic.

I don't care particularly to put precise numbers on it, but I said before, I do believe we can get it up in a range of low-to mid-40s and make some progress towards that in the second half.

On the operating expenses, a lot of the reduction in Q2 was what I would call structural.

We came from what was almost a 14-week quarter in Q1 to a regular 13-week quarter in Q2.

And the payroll benefits of a few less days in the quarter, the principal reason for the fact that out backs fell and as they fell across the board, R&D and SG&A.

I would expect those to start trending up again from where we were in Q2 we've as I said, we've added eight people in the second quarter and we expect to continue to hire very selectively as we go forward.

But I do think the combination of the increased revenues were planning to improve gross margins and some increase but hopefully modest and OPEX gets us toward the kind the earning ranges -- that are provided at least for the third quarter.

OK.

Thanks.

Have a good day.

Thank you;

Eric.

Our next question comes from Daniel Ernst from Rodman & Renshaw.

Please proceed with your question.

Hi.

Good afternoon.

Two questions on -- first on Next-Gen compression.

You talked about rolling out newer forms of MPEG-2 encoding that to get you additional balance you talked about how that compares quantitatively with MPEG-4 or Windows Media 9 compression and why would customers be doing that right now with the pending adoption of other Next-Gen standard coming out.

And then secondly on Windows Media 9, you said you have a product rolling out, H264 in August.

Can you give us an idea of when you'll have commercial availability of the Windows Media 9 products, are they going to have a broader follow-up?

Certainly.

On the MPEG-2, even if everybody wanted to jump straight to the new standard, the problem the operator has got is the install set top of box base of MPEG-2 only.

So if you got to say -- if you take, I don't know, take one of these satellite operators they've got 10 million boxes out there, so that's base is a little difficult to change.

And that's the real issue and the same with the cable operators.

They can't really suddenly switch to a new standard again because they've got hundreds and hundreds of millions of dollars worth of set top boxes out there.

So from that point of view in order to maximize the capability of the existing infrastructure, improvements in MPEG-2 -- are really all they can use right now.

And that's why in terms of economic value, today with respect to the MPEG-2 world is where the dollars are.

That being said, when you have a greenfield situation such as Teleco's or if you have a new satellite operator or any new operator that comes in starts all over again, then it would make sense to move to the new encoding standards.

What when we can get now and we're talking Harmonic very high quality video, we're talking baseball games, 60-inch TV's, perfect pictures, we can get down below 2 megabytes now on MPEG-2 and we are pushing on down a bit.

But I have to tell you you're really on the (inaudible) side and we have to do an extraordinary amount of algorithm work to make any improvement.

Our one strength is we do have the people with knowledge and the ability to do this and it's why we lead the business.

When we move to the new algorithms, the belief is that it in the fullness of time and this is not overnight and may up the bit rate by a factor of two.

So if you think of that was swing around 2 megabyte today after a few years work we will probably be down to 1 megabyte.

But we should be able to start with these new algorithms significantly below the 2 megabytes of MPEG-2.

So that's the interest.

We have both programs running.

I would say theirs is lot of difference from our point of view we probably because we have it was customers with the MPEG-4.

We tend to drive this little harder and we should moving to -- running video over the customers in August.

The Windows Media 9 is very close behind it.

So the...

Daniel back with your question.

The deployments that we've been hearing for Windows Media 9 based windows media systems then will arguably not have your equipment in it if your product isn't quite ready yet?

That statement is not correct, if I may say so.

OK.

The handicap in both of these areas is set top box.

Because we can supply encoders but it doesn't mean anything if the customer cannot ship set top boxes and the low cost -- the sort of standard set top cost boxes are not available.

The customer start shipping with is designed to make up his own set top box and that's an unusual situation.

So let me put it this way.

When the set up top boxes are available for rollout, we're quite certain we'll have both the Windows Media 9 and the H264 for available at the same time.

Good.

Looking forward to seeing it.

Please come to the IPC show in September Amsterdam and we'll show it to you.

Excellent.

Sounds like a party.

The second broader question, if you work look into 2005 and you have a lot of things in the hopper, you've got domestic, VOD penetration, domestic HD roll out, you've got European rebuild, you've got Asian green field, you've got both domestic and international Teleco DSL and domestic Teleco fiber to the premise, there's a lot of potential there.

If we were to put 100% handicap on all those and they could all come in, what would be the scale of that?

No, I feel very happy to guide. let's put it this way.

It never all comes in we will...

Sure.

As much as we would like to we won't get all the market.

We're in the process of looking at that now in fact.

It's really a quarter too soon but we do feel at the moment quite about next year for all the reasons you've just been going into.

But in 2004, if we get to the top end of the range, you just guided to looking at over 30% year-over-year growth, coming off of relatively weak '03 but it sounds like the number of things in '05 is equally as compelling.

I mean is there potential to achieve similar growth?

I would hate -- you know, at this stage, to be quite honest, I believe that we're behind at this time.

It's hard for us to guess for the next three to six months.

It's a long time between now and end of next year and it does depends when you get to this level, it does depend on the states of the economy and -- the U.S. economy and the world economy, and we're not quite sure is even if the customers have the need and the requirement needed to convince those, they have to put up the money.

So, a lot of things have to happen.

I have never changed my belief that this area we're in is fundamentally a very good place to be.

It's one where you can win because of your products and your service and Harmonic is good at these things, and this tremendous competition, which you ran through just then, is causing people to spend money.

So, I do think there's a good chance particularly next year, but its very early and we haven't tried yet to go into it.

Fair enough.

Thank you very much.

Next question comes from the line of April Horace from Janco Partners.

Please proceed with your question.

Good afternoon.

I just have one quick question on -- Comcast rolled out HD VOD in two markets.

How does that affect you guys and where do you benefit with an HD rollout of VOD?

It helps us in two ways.

First, we make HD encoders, so almost certainly, if they're going to put some real time stuff encoded on service, they'll need encoders, and secondly, the sound capacity of the MSG deployment that we have with them because the way it works is, of course, that you have to supply a much higher data rate for the HD stream, which means the number of streams that you can provide through and MSG typically is 160.

Standard definition form is going to go down by a fraction of four or five.

So, to cover the same number of customers ordering stuff at the same time on demand, you'll need four to five times the install base if you're going to move them all over HD.

It, of course, doesn't happen, but you can see HD is a big driver for our business.

It eats up the capacity of anything you've installed.

Four or five times, wow, that's a lot.

OK.

Do you know what they're provisioning that at?

Historically they've always said 10% of digital or 10% of digital subscribers, which is really more like 15% based on the set-top box ratio.

Do you know how they're going to provision the HD offering?

No.

I simply do not know.

OK.

And then, one last question on Verizon and AFCI.

I know that you guys are partners with AFCI and there's been rumblings about AFCI and Verizon.

Could you describe the relationship that you guys have with Verizon and how it's connected to AFCI and if it's dependent on AFCI as well?

Well, what we've said publicly at this stage is that we are involved in certain video products that involves the fiber to the premises business, but all sorts of legal and other reasons, we really aren't at liberty to say anymore at this time.

I apologize but we simply can't.

I understand.

That's all I got.

Thank you.

You'll find that's the general case for many large operators who starts in those video in the sense that they are willing to describe what they're doing on the equipment front until they announce this which cities or which regions they're going to have video available.

OK.

Great.

That's all I've got.

We have a follow-up question from Nikos Theodosopoulos from UBS.

Please proceed with your question.

Yes.

Can you just -- real simple question, can you talk about the interest income and share count?

If I read it right, it looks like interest income was negative in the quarter where it was positive in the prior quarters, maybe I'm reading that wrong, and just a comment on the share count why it fell sequentially?

OK.

Well, the only thing I would say is you're reading it slightly wrong.

It's interest and other income as expense and we did have some other expense in the quarter.

The most important element of which was some foreign exchange losses.

So, that helped us in Q1 and moved against us in Q2.

So that line does fluctuate to some extent.

We do hedge some of our foreign currency exposure, but as a practical matter generally not possible to hedge all of it.

That's where the negative came from, from the other element.

Do you have the break up of what the interest income was and comp -- the other?

I don't have it in front of me.

I mean, the simple way to do the interest is like most companies we have a very conservative investment policy, we have somewhere between 90 and $100 million in cash.

The kind of treasury and very high quality other securities, you know, you're talking in the 1% to 2% range.

That's the kind of math I would do to get a number.

I don't have it in front of me.

OK.

I can do that.

All right.

And on the share count?

The share count on -- let's see.

Sorry, what was the question?

The question...

It looked like the share count declined slightly sequentially.

Well, the diluted number on the non-GAAP would go down because I believe we had a lower average share price in the second quarter compared to the first.

OK.

The basic number, I believe, went up.

I think it went from 71.7 to 71.8.

So they looked like 71.7 to 71.8, so the basic number went up, as you would expect, with modest option exercises and the like.

OK.

All right.

Thank you.

OK.

Our next question comes from Alan Bezoza of Friedman, Billings & Ramsey.

Please proceed with your question.

Yes.

One follow-up, I mean we all know that Windows Media 9 and some of the other stuff are long-term project and, obviously, we're not going to change set-top boxes but in the near term there is a certain problem in the cable machine where the high definition TV has really consumed bandwidth, and there's obviously a large number of different solutions, one is changing encoding, another is upgrading the megahertz, another one is segmenting the network.

There is a ton of different ways to expand capacity.

How do you compare basically encoding versus maybe going to 1,000 megahertz in time Warner's case or all digital in some of the small systems that Charter talks about?

It's an open-ended question.

Yes, it is kind of open-ended but I figured last question here.

I think, first, what's your point in terms of HD, of course is a major headache for operators.

And first of all, in the new encoding standards, the industry will make available standard definition advance encoding.

Encoders this year, HD is a bigger challenge, so it's going to take a bit longer.

So what an operators is faced with is you have to find something in the nine megabytes per channel for the high definition as against two for standard digital.

And six megahertz slot for an analog terminal.

But I think it really depends on what he wants to do with his system.

But if it's video, there's no question the simplest thing to do is to put in a digital head-end because we can get up to 16, 18 to 1.

So when you have one analog channel, we can provide one 16 or 18 digital channels in the 6-megahertz bandwidth and the picture quality is better -- very, very much better.

So in terms -- if video is the main player is out in the system, it pays, clearly, to go to compression.

Yes, but the analog channels though -- and that kind of...

It depends.

It's a separate question of how long the analog channels are going to survive in a competitive world.

And, of course, there are going to be some people who will insist on not having a set-top box.

So I think that most systems are going to have a minimum event -- a minimum number of analog channels to satisfy people who just don't want to get involved with satellite technology.

But the majority of people are going to have set-top boxes without any satellite.

I think it really will be that simple.

We'll see how it plays out.

The other observation I would make is that increasing the bandwidth of the plant is pretty expensive, you know, it cruise back in the streets and there's kind if this slightly heavy technology.

Just putting in compression is really a zero absolute, and it's all in your head going forward.

OK.

Thanks guys.

This is a reminder, ladies and gentlemen, to register for a question, press the "1" followed by the "4" on your telephone.

Our next question comes from the line of Paul McWilliams from PMWC.

Please proceed with your question.

Hi guys.

Robin, would you mind repeating your guidance?

OK.

I first spoke about revenue for the second half as a whole.

And I said that we could see revenues for the second half of $125 to $130 million for the second half and that compares to about 112 million in the first half.

I then spoke to Q3.

We do find it difficult to be very precise about the quarters, but I then spoke to Q3 where I expected that we could see anything from $59 to $63 million in revenue and corresponding non-GAAP earning dollars of 3 to 5 cents and corresponding GAAP earnings of a 2 cents net loss to break even.

Thank you.

You mentioned band would be flat, were you referencing dollars or percentage?

It isn't flattish.

I mean, I think we can see a continuation kind of at the level that band was at in the second quarter.

I was addressing absolute dollars.

OK.

Thank you.

You mentioned at one of the analyst conferences that you guys are looking at what you might call applications management, as is currently down on networks in the WAN/LAN edge.

Is that something you've made any progress with?

I suspect you must be confusing us with somebody else.

I don't ever recall us talking about that sort of stuff.

Tony, do you?

It's not in our data work.

No, I was talking about more in the triple play aspect of managing the voice to make sure that the quality was there.

I'm sorry.

We don't play in that space at all.

Sorry.

OK.

I didn't know if I did confuse it.

Thank you.

Thank you everybody.

Thank you very much for participating in today's conference call.

We look forward to speaking to you again next quarter.

Thank you and good day.

Ladies and gentlemen, that does conclude the conference call for today.

We thank you for you participation, and ask that you please disconnect your lines.