Harmonic Inc (HLIT) 2016 Q2 法說會逐字稿

Welcome to the second quarter 2016 Harmonic earnings conference call. My name is Anna, and I will be your operator for today's call. (Operator Instructions). Please note that this conference is being recorded. I will now turn the call over to Blair King, Director of Investor Relations. Please go ahead.

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

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

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

We refer you to documents that Harmonic files with the SEC, including our most recent 10-Q and 10-K reports and the forward-looking statements section of today's preliminary results press release. These documents identify important risk factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements.

Please note that, unless otherwise indicated, the financial metrics we provide you on this call are determined on a non-GAAP basis. These items, together with corresponding GAAP numbers and reconciliation to GAAP, are contained in today's press release, which we posted on our Website and filed with the SEC on Form 8-K.

We will also discuss historical, financial, and other statistical information regarding our business and operations. And some of this information is included in the press release, and the remainder of the information will be available in a recorded version of this call on our Website.

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

All right. Thanks, Blair, and thank you, all, for joining us today. Turning to slide 3, we executed well in Q2, reporting a quarter characterized by improved demand trends for our video products and services, solid integration work with Thomson Video Networks, and significant progress on our transformational product initiatives.

Revenue of $110 million was up 33% sequentially, reflecting both our first full quarter of Thomson Video Networks contribution and improved video products demand worldwide.

Bookings were a healthy $117 million, up 7% sequentially an 18% year over year. This was a third consecutive quarter of book-to-bill greater than one. And consequently, our backlog and deferred revenue has grown to a record $190 million.

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

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

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

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

The second key message about our video business is that the integration of Thomson Video Networks is going well. Customers are responding positively to our enhanced global presence, scale, and strategic focus on high-quality video.

Our revenue goals for Thomson remain in line with our pre-acquisition estimates. Our sales teams and product roadmaps are aligned. And we're seeing good signs of cross-selling across our customer base. And our global synergy and 12-month accretion plans are on track, with positive financial impact increasing for the back half of this year and into 2017.

The third key video segment message is that we're seeing growing success transitioning our business to being more software centric. And specifically, our first-generation VOS platform sold both as software bundled on commercial off-the-shelf servers and as pure virtual machine software, exceeded a record 75% of our video encoding and transcoding sales in the second quarter.

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

So, leveraging our growing software momentum and capabilities, during the quarter, we introduced our second-generation VOS platform, a Cloud native application suite for deployment in public and/or private Cloud environments.

We also announced a software-as-a-service offering based on this advancement, new business model designed to expand our addressable market and open the door to new recurring revenue streams.

So, we're in the midst of several key trials of this technology with both new Cloud partners and several tier-one pay TV operators. We're finding this new VOS 2.0 Cloud platform to be more robust, simple, and scalable than competitive solutions. And we expect it to become an increasingly important differentiator for Harmonic going forward.

With our newly expanded R&D capability via Thomson Video Networks and continuing close customer collaboration, we're driving more innovations and opportunity in the Cloud.

And so, in summary here, our video business is healthy. And our full-year segment growth and profitability plans are firmly on track.

So, let's now turn to our Cable Edge business on slide 5. As a reminder, our Cable Edge strategy is to become a leading player in the $2 billion-plus CCAP market by delivering truly innovative new DOCSIS technology that we call CableOS.

Since our last update, we've continued to make material progress. And our confidence in our CableOS program has continued to grow. So, why are we increasingly confident about driving transformative growth through this initiative? Well, first, during the quarter, we successfully expanded the number of active customer engagements while also passing several more key performance and scalability milestones, bringing us closer to volume deployment readiness.

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

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

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

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

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

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

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

And so, with that, Hal, let me turn the call over to you.

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

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

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

As Patrick indicated, during the quarter, we signed an engineering collaboration agreement with one of our customers. This agreement is focused on development initiatives that have been underway and extend into 2017.

The agreement provides Harmonic with funding from our customer up to $10 million to offset associated engineering expenses upon achievement of agreed-upon milestones. Payments will occur when these milestones are achieved in $2 million increments. We received our first payment in July 2016.

The aforementioned funding will flow through the R&D expense line in our income statement as a reduction in R&D expense in sync with related expenditures. In Q2 2016, we recorded approximately $1.6 million of such expenses along with an offsetting reduction. Overall, payments and expenditures related to our engineering collaboration agreement are expected to offset each other and therefore will not increase our R&D expense run rate.

Our financial results for bookings, revenue, and operating profit for Q2 were ahead of or in line with our plan. From a revenue standpoint, approximately $4 million of revenue that we originally anticipated recognizing in Q1 2016 was recorded in Q2. And we achieved expectations for Harmonic and TVN revenue, even if we exclude the $4 million.

Our goal is to record the remaining $1 million of rollover revenue from Q1 2016 in the second half of the year. This revenue is related to the establishment of fair market value for software elements.

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

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

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

These legacy products would require additional R&D resources and focused effort to continue selling. Given our planned launch of our new CableOS products in Q4 2016, we did not deem the use of our resources for these products to be in our best interests.

In conjunction with this decision, we recorded a $4.5 million charge related to inventory. This charge is included in our GAAP financial results for Q2, but not in our non-GAAP financial results, due to its infrequent nature. As you will hear when we discuss our financial goals for 2016, our Cable Edge revenue is expected to be higher than our original financial goals, including the impact of this decision.

Turning to our Q2 2016 financial results, during our call today and in our Q2 2016 SEC filings, Harmonic's financial results will include TVN on a fully consolidated basis. We will provide selected pro forma financial information for TVN as a note to our financial statements in our SEC filings, as required by GAAP.

Please note that our financial results and guidance discussed during this call are based on non-GAAP measurements. These non-GAAP measurements reflect Harmonic's traditional approach for reporting such information as well as taking certain TVN purchase price accounting adjustments into consideration. A table reconciling GAAP and non-GAAP measurements is included in our Q2 2016 earnings press release.

Bookings for Q2 2016 were $117.3 million compared to $109.6 million in Q1 2016 and $99.3 million in Q2 2015. Our bookings for the quarter were in line with our expectations on a geographic and product basis.

Non-GAAP revenue for Q2 2016 was $109.5 million versus $82.5 million in Q1 2016 and $103.1 million in Q2 2015. As noted earlier, Q2 2016 revenue included approximately $4 million of rollover revenue from Q1 2016.

In Q2 2016, we had good sequential revenue growth in both our video and Cable Edge segments. In particular, with a full quarter of TVN revenue of approximately $18 million, our video revenue increased sequentially by $24.8 million. In Q2 2016, we did not have any 10% customers.

Our year-over-year revenue increase was related to TVN. For Q2 2016, non-GAAP video revenue was $90.5 million compared to $65.7 million in Q1 2016 and $78.2 million in Q2 2015. We expect our video revenue to continue to grow sequentially in Q3 and Q4 2016.

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

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

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

Our non-GAAP operating profit for Q2 2016 was $0.9 million compared to a loss of $8.4 million in Q1 2016 and profit of $5.3 million in Q2 2015. Higher sequential revenue and gross margin more than offset our increase in operating expenses for the quarter. The year-over-year decline in operating profit is related to higher operating expenses. Upon achievement of our synergy goals, we will reduce operating expenses as a percent of revenue in both Q3 and Q4 2016.

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

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

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

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

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

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

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

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

Now, turning to our financial goals for the second half of 2016, first, we would like to point out some highlights: one, achieve sequential revenue growth in Q3 and Q4 of 2016 and year-over-year revenue growth for our video business; two, achieve double-digit non-GAAP operating profit in Q4 2016; three, exit 2016 with annualized synergy savings of approximately $20 million to $22 million as a result of the Harmonic plus TVN combination; four, contain our estimated 2016 restructuring and integration charge for the Harmonic plus TVN combination within the range of $22 million to $24 million, which includes approximately $2 million to $3 million for depreciation and the write-off of fixed assets and the related cash charge within the $20 million to $22 million range; five, exit 2016 with $65 million to $70 million in cash on hand.

By achieving this goal, it essentially means that we would have funded the majority of the projected restructuring and integration charge related to TVN from cash flow from operations; six, continue to achieve planned milestones related to the development and deployment of our new CableOS products and services; and finally, seven, position the Company to generate double-digit non-GAAP operating profit in 2017.

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

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

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

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

Our Cable Edge gross margin as a percent of revenue is approximately 5 percentage points below our initial plan as a result of shipping product with a higher content of hardware revenue than anticipated. We believe that associated license revenue will follow in 2017.

Our initial gross margin goal as a percent of revenue was approximately 55% with 55% to 57% for video and 45% to 47% for Cable Edge.

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

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

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

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

In closing, we realize that our financial goals for 2016 includes strong sequential performance in the fourth quarter of the year. With that in mind, as I indicated in my opening remarks, we are making good progress in enhancing our business processes as our revenue generation profile continues to transition to more software content.

Most important, with our record backlog and deferred revenue, we are heading into the second half of 2016 with momentum. Our projected 2016 revenue for our Cable Edge segment is higher than our initial financial guidance ranges. And although gross margin as a percent of revenue is lower, due to the hardware mix, we expect related license revenue to follow in 2017.

Our projected video segment financial performance for 2016 is in line with our initial financial guidance ranges and reflects double-digit year-over-year increases for both revenue and gross margin dollars.

I will now turn the call back over to Patrick.

Okay. Thanks, Hal. So, let's turn to slide 12, where I want to conclude by emphasizing that we remain very focused on executing the strategic priorities we've previously outlined.

Our video business us the market share leader in video encoding and related systems for the world's leading pay TV and media companies. We're increasing the value of this business by leading the industry transformation to software-based video infrastructure and the next generation of high-quality over-the-top services.

For acquisition of Thomson Video Networks, we're accelerating the execution of this strategy, combining innovation software approaches from Thomson and Harmonic into compelling customer offerings, expanding our global footprint, and driving greater profitability. The stronger customer demand and competitive wins we've seen through the first half of the year validate that we're on track here.

We're also investing in our Cable Edge business that is poised for significant growth with the release of our new CableOS platform. While most of 2016 will be spent bringing this CableOS product to market, positive customer engagement and a pending cable architectural shift give us confidence in the growth potential of this business.

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

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

(Operator Instructions). George Notter, Jefferies.

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

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

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

Can you at least -- ?

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

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

We can't answer it explicitly, George. I'm sorry. But, I would tell you we wouldn't do any deal that didn't make good sense for the business.

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

Yes, no, I'll tell you what it boiled down, quite simple, was, as I indicated in my comments, our revenue for Cable Edge was actually higher by our initial guidance by roughly $5 million. So, we had some products that didn't have much activity. And to sell those products in today's environment, we would've had to put more R&D and sales effort than we thought was justified, given the opportunity that we have with CableOS.

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

All right. Sounds like we may have missed -- lost George there. So, why don't we move on?

Greg Mesniaeff, Drexel Hamilton.

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

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

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

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

Got it. Any greater than 10% customer?

Not this quarter, no.

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

Matthew Galinko, Sidoti & Co.

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

It's a good question. I want to at the outset clarify that it's one of several drivers that we see of the stronger video demand on top of aggressive competition between traditional service providers, investment in over the top, and indeed, we're starting to see -- slower than we had at one time expected -- but nonetheless a steady increase in 4K or UltraHD activity.

And we've had a couple of interesting press releases speaking about what we're doing there, including a couple months back with a content producer called Sneaky TV. You'll probably also see in some of the advertising some of the large service providers talking about one or two channels or bits of programming available in UltraHD.

And indeed, what we're seeing is really right across the globe. We're seeing large service providers looking to add a couple of UltraHD channels to their packages or their portfolios. So, on one hand, it's the service providers. On the other hand, people like the broadcast and media companies we've mentioned in a couple of press releases starting to produce more of the content.

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

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

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

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

Okay. Well, let me first clarify that, for us, what we've developed is software. And what we did was we offered it packaged however the customer likes. We can do a deal where we put that software onto a commercial off-the-shelf server and ship it as a box. But, to be clear, we didn't do a lick of hardware engineering there. We just packaged the software with the box.

And then some customers are saying: You know what? I've got my own blade servers. Just ship me the software. And I'll take that, and I'll install it myself.

We're ready to go either way. And that's the great and the exciting news. As it turns out, and I'll tell you, frankly, a little surprising to us, still the majority of customers are asking for us to package it with an off-the-shelf server. And I think our gross margin trend is indicative of the fact that you see that hardware box we're passing through being part of the revenue, basically neutral from a gross margin dollar perspective.

But, I'd tell you, a couple of our largest customers are starting to tip towards just taking the software to run on their own hardware. They've got volume purchasing on blade servers, and they've also got the operational know-how.

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

Fair enough.

Does that answer your question?

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

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

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

So, I'd say that that overall architecture is a secondary benefit. But, first and foremost is just the great compression and the other functionality that we're including in these offerings. So, this is the highest-performing platform, regardless of what the underlying hardware chipset is in the industry that we're delivering. And the fact that we can do it on these commercially available Intel chips is all the more amazing and I think all the more powerful in the marketplace.

Excellent. Thank you.

Thank you.

Tim Savageaux, Northland Capital.

Okay. I think that's me. Good afternoon. And some questions on the service provider front, if we can -- and pardon me if I missed some of this. I'm hopping on the call late. But, if you could talk to sort of organic trends on the cable spending side in particular across both your Edge and video businesses.

You've seen pretty strong indications really through the first half here of kind of a pretty robust spending environment amongst North American cable operators. I wonder if kind of that's what you're seeing and if you have any outlook there.

I ask because it's obviously tough to get kind of organic -- an organic sense of what's happening with your service provider business as you fold in Thomson. And I guess I'd ask the same question about kind of US satellite providers. Thanks.

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

That being said, cable operators are embarking on a big architectural transition. And frankly, where possible, they're looking ahead with their investments to this next-generation CCAP. And in our particular case, as we get closer and closer to general availability of our new CableOS platform, naturally, we see customers pulling back a little bit and waiting -- looking ahead to that platform. So, that's what's behind the commentary about softening Cable Edge demand in the second half of the year as we transition from legacy EdgeQAM to our new CableOS launch.

And on the other side of the equation, things have been going well for us on the digital video front with cable operators. And frankly, there was a real slowdown last year. But, a combination of the UltraHD we were just talking about and some real significant advancements that we've made around compressing high-definition content and some of the interesting things we're doing around over the top, we've got good momentum with cable operators on the video front worldwide.

And of course, the subscription numbers that you've seen for cable as well as the broader pay TV space are not bad. I think it's clear that the -- well, over the -- while the cord cutting is a threat, I think it's not one that is turning out on the short term to be that damaging to our service provider businesses, customers' businesses. And they're responding to the threat.

So, we've seen a resurgence actually in spending not only in cable, but also in satellite direct to home as well as telecom. And while our largest customers are notoriously reticent to allow publicity, I think you can go to some of the press releases we've made over the past couple of months, Claro in Chile, [America Mobile] operation, Airtel in India, in Finland a very significant over-the-top project, etc. So, we see satellite direct to home as well as telecom operators following suit with cable and making investments and expanding and upgrading their video infrastructure.

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

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

Thanks.

Okay. Thank you.

Simon Leopold, Raymond James.

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

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

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

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

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

Okay. And there's no impacts to revenue from the discontinuation of the products that you spoke about?

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

Okay. Okay. Thank you.

Greg Mesniaeff, Drexel Hamilton.

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

Well, I think there's a couple different ways to look at it, Greg. The first one is that, as we exit Q4, we believe that will have a lower level in OpEx than we had in Q2 and in Q3. So, we're going to have a lower level in Q4 as we exit the year, first point.

The second point, as a percent of revenue, our OpEx in Q3 and Q4 will be lower. And particularly, in Q4, it will be at the -- probably I think the lowest point that Harmonic has had for OpEx as a percent of revenue in a number of years.

And I think the most important point is, with the operating expense run rate that we expect to have, we will be in a position to generate double-digit operating profit in 2017 without a significant increase in revenue. So, I think the expenses are about where we targeted them to be. And again, with the exit rate that we're planning for the year, we're going to be in great shape from a percent of revenue standpoint as well as generating double-digit operating profit heading into 2017.

Got it. Thank you.

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

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