Thursday, October 5, 2006

Harmonic Hits a High Note

News Analysis
October 5, 2006

Business Week Online

Harmonic Hits a High Note

The networking and video systems maker's stock led the S&P 1500 index in the third quarter. But is the picture as bright as investors think?

Harmonic's (HLIT ) stock has been making some sweet music in recent months. During the third quarter, the Sunnyvale (Calif.) tech outfit's stock outpaced the rest of the Standard & Poor's 1500 index, surging 64%. While investors may be singing the stock's praises, some analysts remain hesitant to join the chorus.

On Sept. 27, Harmonic shares hit a 52-week high of $7.75, a gain of more than 100% since the stock bottomed in mid-June. The share price has slipped modestly since then, finishing at $7.50 on Oct. 5. The stock's rebound has come over a period when small-cap issues have lagged as the blue-chip Dow Jones industrial average hits record levels (see, 10/2/06, "Small Caps: Out in the Cold").

An improved earnings outlook, a key product launch, and a potentially lucrative acquisition have helped Harmonic's stock price hit its recent high notes. Still, analysts question whether Harmonic's good news is already priced into its shares. It might not be time yet for shareholders to take profits, but potential investors shouldn't count on Harmonic to keep up its hot streak indefinitely.

A BETTER QUARTER.  The year has been an eventful one for the company, which supplies broadband networking and digital video systems to satellite, cable, telecommunications, and broadcast companies. On May 4, Harmonic named Patrick Harshman, previously an executive vice-president, as its new president and chief executive. Harshman succeeded retiring CEO Anthony Ley, who has stayed on as nonexecutive chairman.

The company was coming off lackluster first-quarter results, with some analysts lowering their second-quarter forecasts (see, 5/16/06, "More Losses for Harmonic").

Then, on July 26, Harmonic reported that its second-quarter loss narrowed to $200,000, from $2.2 million a year earlier, on sales of $53.3 million. While the revenue number came in below Harmonic's target, the company projected sales of $135 million for the second half of the year, topping Street estimates. Harmonic also detailed ongoing cost-cutting measures.

UPTURN POTENTIAL.  One source of additional revenue should be Harmonic's new compression technology for high-definition (HD) video. The company unveiled its Electra 7000 HD MPEG-4 encoder on July 26, in a move that could help it make up ground against MPEG-4 HD video compression leader Tandberg, based in Norway.

Along with Harmonic's Internet Protocol TV (IPTV) business, the new offering may lift shares further in the months ahead, some analysts say. "We continue to see potential for an upturn over the next few quarters," says CIBC World Markets analyst Ittai Kidron, who has a sector performer rating on the stock, in an Aug. 22 note. (CIBC makes a market in Harmonic's securities.)

Shares got another boost following Harmonic's $45 million purchase of privately held Entone Technologies' video networking software business on Aug. 22. The deal comes as bigger players such as Cisco (CSCO ) and Motorola (MOT ) have been buying similar video-on-demand tech players. The Entone unit could add $15 million to $20 million to Harmonic's 2007 top line, according to UBS analyst Nikos Theodosopoulos, who has a neutral rating on the shares. (UBS has an investment banking relationship with Harmonic and makes a market in its securities.)

GROWING APPETITES.  In addition, the company is likely to announce new business from satellite operator DirecTV (DTV) "in the near future," according to Friedman Billings Ramsey research analyst Brian Coyne, who has a market perform rating on Harmonic. (FBR makes a market in Harmonic's securities.) A Harmonic spokeswoman declined to comment on DirecTV.

Going forward, constraints on cable bandwidth could provide Harmonic with an opportunity, as consumers' appetite for high-definition video and video-on-demand services increases, says Merriman Curhan Ford analyst Tim Savageaux, who has a buy rating on the shares. "We believe cable operators will increase spending on network infrastructure over the next few years after several years of declines," Savageaux wrote in a July 27 note.

He's not the only analyst bullish on Harmonic. On Sept. 15, Thomas Weisel analyst Jason Ader raised his recommendation on Harmonic shares from peer perform to outperform. Shares finished the trading session up 2.8%. A Weisel spokeswoman declined to provide Ader's research, citing company policy, while Ader was unavailable to comment.

Nevertheless, others continue to see some hurdles ahead for Harmonic. Operating expenses would still have to fall significantly for the company to achieve "meaningful profitability," Cowen analyst John Anthony says in a July 27 report. Anthony has a neutral rating on the shares. He adds that the "timing and magnitude of potential benefits from new products still remain uncertain." (Cowen makes a market in Harmonic securities and seeks to do business with the companies it covers.)

TEMPERED OPTIMISM.  The real question is what Harmonic will do from here, according to FBR's Coyne. He says the company's business is by nature inconsistent, with two or three strong quarters typically followed by two or three weak quarters. He also points to growing competition in the video compression space from companies like Atlanta's privately held EGT.

Coyne expects Harmonic's performance to revert to the mean, as it has done in the past. "They've gotten back on their feet and they're executing again, but I'm very hesitant to say that they're on a whole new track here," he says.

In a July 26 conference call, Harmonic head Harshman said the company's growth strategy would address the big trends in on-demand video, HD programming, and multiplatform video delivery. "With our deep customer relationships, outstanding technologies, a strong balance sheet, and a proven financial performance, we believe Harmonic is an increasingly strong strategic position to capitalize on the emerging opportunities ahead," Harshman said.

The burgeoning on-demand video market stands likely to become a profitable opportunity for the right tech outfits (see, 11/21/05, "The End of TV (As You Know It)"). Wall Street will be watching to see whether Harmonic can improve its bottom line as it tries to stave off the competition.

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