Welcome to the Q3 2016 Harmonic’s Earnings Conference Call. My name is Candace and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to Blair King, Harmonic’s Director of Investor Relations. Blair King, you may begin.

Thank you, Candace. Hello, everyone and thank you for joining us today for Harmonic's third quarter 2016 earnings conference call. Again, my name is Blair King. With me here at our headquarters in San Jose, California are Patrick Harshman, our CEO; and Hal Covert, our CFO. First, I’d like to just point out that in addition to the audio portion of this call, we have also provided slides for the webcast, which you can see by going to the Investor Relations Page on harmonicinc.com and clicking on the third quarter 2016 preliminary results call button. Now turning to our slide 2, during this call, we will provide projections and other forward-looking statements regarding future events or the future financial performance of the company. We caution you that such statements are only current expectations and actual events or results may differ materially. We refer you to documents that Harmonic files with the SEC, including our most recent 10-Q and 10-K reports and the forward-looking statement section of today's preliminary results press release. These documents identify important risk factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. Please note that unless otherwise indicated, the financial metrics we provide during this call are determined on a non-GAAP basis. These items, together with corresponding GAAP numbers and a reconciliation to GAAP, are contained in today's press release, which we have posted on our website and filed with the SEC on Form 8-K. We will also discuss historical, financial and other statistical information regarding our business and operations. 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 that, I'll now turn the call over to our CEO, Patrick Harshman. Patrick?

Thanks, Blair, and thank you everyone for joining the call today. 2016 has been a year of transformation for Harmonic, and for the video and cable industries we serve. With that in mind, I'll begin by briefly reviewing our headline third quarter results and then delve into the underlying business transformations we are seeing and driving in the marketplace. So with that, turning to our slide 3, the third quarter revenue was $102 million, down 8% sequentially, but up 22% year-over-year. Underneath this headline, our video business grew modestly from last quarter and was up 28% year-over-year, an encouraging result. On the other hand, our Cable Edge business was down 47% sequentially and 12% year-over-year as customer focus pivoted faster than we anticipated to our soon to be released CableOS software based CCAP and consequently demand for our legacy Cable Edge products softened significantly during the quarter. Similar revenue, bookings were $97 million, down 17% from the second quarter, but up 30% from a year ago. The sequential decline was expected due to seasonality trends, while the year-over-year growth was again driven by encouraging global demand for video products and services. As a result of a nearly one-to-one book-to-bill ratio, backlog and deferred revenue remains at a near record level of $181 million, over up 60% from a year ago. And a footnote here, bookings backlog and deferred revenue results do not include new video software as a service purchase orders signed during the quarter, and an upside development will have more to say about in a couple of minutes. Gross margin in the quarter was 52.5%, down 0.5 point from the second quarter and the end result was a $0.01 EPS loss comprised of positive contribution from our increasingly profitable video segment, but a loss from our Cable Edge…

Thank you, Patrick. We want to thank you everyone for joining our call today. During my discussion, I will cover three topics: First, our financial results for Q3 2016; next, our financial goals for Q4 2016; and then our financial performance aspirations for 2017. Before discussing our Q3 financial results, we would like to start with some opening comments. We were disappointed with our financial results. The primary issues we faced during the quarter from a revenue standpoint were steeper than anticipated drop in Cable Edge bookings and related revenue. Cable Edge segment revenue declined $10 million for Q 32016 compared to $19 million in Q2 and $16.8 million in Q1. Our goal for Q3 revenue was $14 million. In addition, although our video bookings for Q3 were in line with our goal, they reflected a higher level of project oriented software products and services than expected and less book and ship business. As a result, we converted less bookings to revenue than planned during the quarter. Our non-GAAP video segment revenue of $91.7 million for Q3 was below our goal for the quarter of $95 million but was sequentially higher than the $91.3 million reported in Q2. Going forward, our backlog remains at a near record level and by leveraging our backlog and with projected Q4 video bookings, we are targeting a high single digit sequential increase in segment revenue for the quarter. This expectation as well as the progress that we have achieved in our transition from building custom hardware to providing software running on commercial off-the-shelf servers, private clouds and public clouds are meaningful milestone markers that indicate our video operating segment is on a positive path. We like to point out that TVN is in line with our expectations for revenue and gross margin. In addition,…

Okay, thanks, Hal. Turning to Slide 10, we want to conclude by describing the world as we see it entering 2017 comparing it with the world we saw entering 2016 and putting our strategic priorities and progress into this context. The Video side of our business, the ongoing transition is the conversion of the market to software-based over-the-top solutions. And in this context, we are increasing the value of our core business by delivering solid bookings revenue in earnings growth. And we are growing beyond the core, expanding our addressable market with new cloud-based Software-as-a-Service offerings and by leading the charge in ultrahigh definition and high dynamic range video. With a solid top line as Hal just explained, strong year-over-year bookings growth, record video backlog and on target integration synergies, we remain on track to exit the year and drive 2017 with double-digit operating income. On a standalone basis, this is a solid business with compelling upside. On the Cable Edge side of our business, the year is turning out to be even more transformational. Entering the year we knew that the traditional EdgeQAM market was in decline. Instead of deciding to go home, we decided to go big. And today we are bringing to the market disruptive new software technology that we believe is going to lead the next generation of innovation in the cable network and position Harmonic to become the leader in the $2 billion plus CCAP market. A warrant agreement with Comcast highlights both our credibility as a real player in this space and our opportunity to seize the market leading position. Growing customer engagements, ongoing field trial success and the commencement of revenue shipments this quarter, all give us further confidence that we are well on our way to delivering compelling results in a business area where many observers have not foreseen much Harmonic opportunity or value. Well, financially, 2016 has offered a number of chances. I want to emphasize that as we wrap up the yea and enter 2017, we are looking at major product transition developments largely in the rearview mirror and we’re seeing tangible new momentum in results as we shared with you here today. Our entire organization is incredibly excited and laser focused on the continued execution of the strategic Video and Cable Edge initiatives and on driving a new phase of profitable growth and shareholder value creation. So with that, let's now open up the call to your questions.

Thank you. [Operator Instructions] And our first question comes from George Notter of Jefferies. Your line is now open.

Hi, guys. Can you hear me?

Yes.

Great. Super. So, I guess, I had a couple of questions. First, I was curious on gross margins. So for this quarter, I think, you said that over half of the gross margin decline came from the Cable Edge side of the business and I guess I was trying to better understand that. Obviously, the revenue is quite a bit lower than you thought. I guess I would imagine that a lower mix of revenue from Cable Edge would actually be a positive influence in gross margin. So I was hoping you can explain that. And then I also wanted to ask about the Cable Edge outlook for 2017. I think you are including $100 million revenue of run rate if I heard you correctly in the second half and that's for the CableOS platform, but help me understand kind of the milestone as you see them that’s kind of attracted generating that kind of revenue in the second half of next year.

Okay. George, let me start and then Patrick can chime in. First of all, if you look at our margin for the past quarter, Cable Edge was the primary contributor to the down tick that we had. It was because we had lower margin on the business that we shipped and it had a higher level of service in there, so the combination of those two just put pressure on the overall margin. And then our Video margin was off again less than half of the overall total primarily because of mix. We had a very good mix of software revenue on Q2, we have no – we no longer have any VSOE issues that we talked about in Q1. We had a little bit less software orient revenue in Q3 and we expect that to tick back up in Q4. So we believe that our overall gross margin is going to be higher sequentially in Q4. And then heading into next year with the backlog that we have right now and the mix of that backlog, we think our gross margin for our Video business is going to be pretty consistent. The second part of your question, as we indicated in our prepared remarks, it's a little bit early to predict our revenue for our Cable Edge business segment. But if you take the run rate for our legacy products in the service level and assume that we run along at the current level, somewhere between $10 million to $15 million, keeping in mind, that's a lumpy business for us. We have a very few customers and that was part of the bouncing around that we had in 2016 to date. So we are assuming that it’s going to stay somewhere around the $10 million to $15 million range in the first half of the year and then with the shipments of our CableOS starting in Q4, we expect to ramp as we go with a low ramp in the first half of the year with a pretty aggressive ramp in the back half of the year. The combination of those two things gets us to the $100 million run rate that we talked about again in the prepared remarks as well as putting us in a position where we believe that our Cable Edge business won't be a drag on our non-GAAP EPS for the full year, which, as you know for 2016, it was a meaningful drag. So that – I don’t know Patrick if you want to add anything to the CableOS piece of that?

Perhaps just on the milestone – on the non-financial milestones, George, part of your question, we have a couple of design wins, as I mentioned, we are in the field, we actually have the live customers and active cable networks receiving their cable modem service through our technology, which is a big deal, after doing scale – a number of scale trials in labs for a while. So the milestones are to drive continued success of these field trials and we see greater volume over the next three to since months to scale with the existing customers and at the same time to score a couple of additional design wins. And that’s really the big focus for us over the next quarter or two and, as Hal said, putting us in a place to really start to ramp the business and volume beginning, let’s say, the middle of the year.

Got it. Okay. And just as a follow-up, just to be clear if I do the math of Cable Edge segment correctly, I think what you are saying is you would be running at something like $10 million to $15 million per quarter in revenue for the CableOS products within that Cable Edge segment?

No, for our Cable Edge business, which includes the CableOS products in the first half of the year, we think the numbers will be somewhere between $10 million to $15 million. We have not completed our 2017 operating plan yet and we will give you more detail on the call. And then as we head into the back half of the year, again, for our Cable Edge and CableOS products we think we will get to an annualized run rate of up to $100 million that we were talking about.

I guess I was netting the two sides against each other and that's how I got to that $10 million to $15 million assumption on…

Yeah, yeah, it’s kind of a combination.

Okay.

The other point that I would like to add is that we believe as I indicated again in my prepared comments that the back half of the year revenue is we think is going to have a higher element of software because of the architecture of our new CableOS products and we think that’s going to help improve the overall Cable Edge – Cable Edge in the sense of the Cable Edge segment gross margin.

Thank you.

Thank you.

Thank you. And our next question comes from Greg Mesniaeff with Drexel Hamilton. Your line is now open.

Yes, thank you. When you guys gave guidance on the current quarter, on the second quarter conference call, I guess it’s fair to assume you had a different set of expectations regarding spending by the MSOs on Cable Edge second half of this year. What has changed in the interim? Have you gotten feedback from customers that there's a delay in the OS cycle? Or is it some other factors?

So let’s kind of break it into two pieces. First of all on the Video side, we were a little bit low our target revenue, roughly around $94 million, $95 million and that really related more to mix than anything else and it’s basically sitting in our backlogging, again, not due to any accounting related issues like VOS or anything that we talked about in Q1, it’s just simply there is features and functions that we have to deliver as part of the project we are working on that’s why again we talked about backlog changing in terms of projects and service. So on the Video side, it’s in the backlog, it will come out in its natural course. On the Cable Edge side, we had $19 million of Cable Edge revenue in Q2, we thought that would drop somewhere to around $14 million in Q3 and because of fundamentally few customers that we are dealing with, all large customers, any kind of movement from those customers could cause a big impact on the revenue side. So even though we talked about $10 million to $15 million run rate in Q1 for both our Cable Edge and CableOS revenue combined, that could bounce around on us with a potential uptick because we could get some large orders for old Cable Edge products in the first half of the year. We simply don't know because of the size of the customers that we are dealing with and the kind of the volatility, there's a large install base out there and they may need some replacements for that. So, again, it’s hard to predict.

So, is it fair to say that the visibility you had a quarter ago became more cloudy or is this just a shifting time line?

No, I think on the Video side, our visibility is very good. It’s reflected in the bookings that we recorded as well as the backlog. And again on the Cable Edge side, it's simply the customer base that we are dealing with, the size of the customers and when they decide to make a move more than anything else. Nothing fundamental on our Video side has changed and nothing fundamental on our Cable Edge side has changed.

Got it. Just one quick follow up. Now that the TVN integration is pretty much done, which of their products if any are you cross-selling in the domestic U.S. market and how – what kind of traction is that getting?

The strategic combination with TVN is going quite well, Greg. We are selling a number of the products. So for broadcasters, we are using an encoder for high-density direct terrestrial transmission and we are using other products with cable operators who are – who are doing work with broadcasters to deliver broadcast channels over cable networks in a high quality way. So there is a fair amount of cross selling going on, in fact the three largest video deals that we did in the quarter involved mixes of legacy TVN and Harmonic video products. So on a worldwide basis, the synergy is pretty positive. All that being said, what’s really the most important thing for us is the longer term engineering synergy. As I described, we see a lot of the market pivoting to cloud-based architectures. And frankly, one of the things that we’ve struggled a little bit with is simply being spread too thin as Harmonic, keeping the legacy business going while also driving the cloud stuff as fast and as hard as we can. With a combined integrated R&D team, that is clearly strongest in the industry now, we are actually able to pick up the pace there and drive legacy business hard in a way that's – at least competitive differentiation and at the same time drive the cloud stuff that I spoke about as hard as we want as well. And it's a great place to be. We are seeing real competitive difference in the marketplace. I spoke to not only traditional business but some very significant strategic new cloud wins that we scored during the quarter, and those are certainly – by having an even stronger joint R&D machine pushing us forward.

Thank you.

Thanks, Greg.

Thank you. And our next question comes from Simon Leopold of Raymond James. Your line is now open.

Great, thanks for taking my questions. You may have mentioned this in the prepared remarks, I want to go back and thank you first of all for giving us gross margin by segment in the guidance because it is very helpful. Did you give us or can you give us the gross margin by segment for the September quarter?

Yes, Simon. This is Hal. I think we actually did give you the gross margin by segment, for the quarter in the prepared remarks.

Could you repeat that?

Yes. Our gross margin for our video was right around 54% and it was right around 38% for the Cable Edge. Overall gross margin was 52.5% for the quarter.

Thank you.

Simon, while I have this opportunity, when we are talking about gross margin, one of the things we are going to do as we head into 2017 is to really come up with a better nomenclature for what we are calling our Cable Edge segment today so that we don't get confused between our old Cable Edge products and our CableOS products. So we’re going to work on that and make sure we’re pretty clear on that, but those were the gross margins that I think I commented on during my prepared remarks.

Okay. Yes, I thought – I think I jotted down one of those two numbers and missed the other one, so I appreciate you going back to that. So as we look at the way that business unit is transforming, and we think about the point in time where what we call Cable Edge is at $25 million per quarter or $100 million run rate, and the new product contributions being much more software oriented, how do you – what's the gross margin you would expect for that business unit when you reach that $100 million annual run rate in revenue?

So, I don't want to get too far ahead of myself on this, but let me just give you what we are thinking about today and we will give you more direction on our earnings call in the first quarter. The gross margin in our video business is really kind of software driven with our architecture and more off-the-shelve oriented hardware and so forth. Our CableOS products are fundamentally going down the same track. We will have the old Cable Edge products mixed in with that as part of that operating segment, but I would think of it going from our historical patterns of somewhere between 40% to 45% on our old Cable Edge business, approaching 50% initially, and then we will see what happens from there.

Great, that's very helpful.

That's a combined margin, the overall combined margin.

Okay. And when we think about the competitive landscape for CCAP, and in general, with any sales to large operators of any equipment, incumbency tends to count for a lot. So you are going to need to displace incumbents in terms of a new architecture, in terms of new technology, can you speak a little bit to your competitive positioning and how you would be able to disrupt incumbents in the CCAP or distributed CCAP market.

I think there is two things to that, Simon. Particularly in cable, Harmonics planned and reputation and actually presence in the network is actually – because the larger shadow on the wall than actually the size of the company as you know. If you talk to most leading cable operators, they will tell you that Harmonic is one of their top let’s say 3 to 5 technology partners. So we start off with a – not a start up situation. We have to build the relationship with a very strong reputation of technology and excellence in the space. But then the other thing is, really it is disrupt product. I think if we were coming in with a product that was 10% better or 10% faster or cheaper, frankly I wouldn't give as much chance of being successful. But that's not what is going on here. We are coming in with a product that is 4x faster probably from an economical perspective 4x more attractive for the operators. We aren't just throwing around the term disruptive. It's really important and compelling stuff. In the context of the cable industry or market, which for the very same reasons are legacy edge product is declining, it is because video is moving from traditional video traffic to being all over IP. You’re going to see the cable network bandwidth go from about 20% IP traffic to 100% IP traffic. It's a major disruption of service for the cable operators and they need corresponding disruptive technology to make that feasible from a space perspective, from a power perspective, and from an economical perspective. So we are there with we think uniquely technology that can get the job done, and from a company that they know and trust. So in that context, we are – we like our chance is very much. Does it mean will it’s going to be a walk in the park? No. But – but we think we are extremely well positioned. Simon?

Great, thank you for taking my questions.

Well, thank you.

Thank you. Our next question comes from Matthew Galinko of Sidoti. Your line is now open.

Good afternoon guys. I guess my question is what you are seeing competitively for the SaaS video processing deals that you are starting to bring in, how competitively are they contested?

It's relatively new for us, Matthew. There's – it's a little bit of a fragmented space. Some of our large customers particularly in the over-the-top area are trying to do some of it themselves. But in general, at the quality and with the compression efficiency and the other knowhow that we have, particularly for high quality services delivered to the big screen, we actually right now is a somewhat more benign competitive environment than the historical box business if you will that we’ve had. I think time will tell and we’ll continue to report back to you, but so far we like what we see.

Got it, and just – I guess how deep customization work do you have to do to – I realize it is relatively new for you, but to win those deals, are they more or less off the shelf for you doing a fair amount of work to get them to the finish line?

Actually, so far, Matthew, one of the interesting things is so far we have seen is actually relatively less customization than the traditional business. These media, these head ends – these video head end is on sight, it is just different customers they have drown up over years and there's a lot of idiosyncrasies or unique aspects of an non-premises legacy video deployment. That's kind of been built and added on to over the last decade or so. You come with a fresh brand new video cloud offing and our customer is interested in results, now not necessarily how that fits in with a legacy environment. And that’s allowed us to come with us a little bit more of just out of the box as we’ve designed it offering. So it is still early days but one of the things that we are modestly encouraged about so far is the potential frankly of this being a way of delivering our technology with a lower level of the spoke development, and a little bit more volume. And I think that's part of the promise of the cloud and cloud related services more generally. Everybody gets to take advantage of the scale and the efficiency of shared infrastructure. And that is certainly something that we are looking to leverage for the benefit of our customers and frankly for our bottom line.

Got it, thank you.

All right. Thank you.

Thank you. And I am showing no further questions at this time. I would like to turn the conference back over to Mr. Harshman for any further remarks.

Okay, well, thanks very much for joining us again, and let me simply close by emphasizing that we are very encouraged with the growth and profitability trajectory that we are seeing in our video business. And we are executing well to expand the addressable market and as we have laid out here, we see a pretty clear path to a strong top and bottom line business in the video space in 2017. And we are also enthusiastic about entering the CCAP space with a truly innovative new platform and here too we are executing well. With both of these businesses emerging from major transitions, we believe we're uniquely positioned relative to our recent history to drive growth, to expand margins and to create new shareholder value as we head into 2017. And with that, we appreciate your support and we look forward to speaking with you all again soon. Thanks very much everyone, and good day.

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