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Harmonic: In Tune with Cable's Expansion

By Ari Bensinger Standard & Poor's believes that video-equipment provider Harmonic (HLIT

, recent price, $9.56), is well positioned to benefit from the increasing competition between cable and satellite-TV operators. In addition, we believe the company is making inroads in the promising telecom video-equipment market. Given our view of improving fundamentals, significant earnings growth, and compelling valuation, we have a 5 STARS (strong buy) recommendation on the shares.

We regard Harmonic's portfolio of video compression offerings as best in class, and think it is well positioned to offer bandwidth-enhancement products and services. Furthermore, by leveraging its strong position in the cable and satellite markets, we think the company will garner solid market share in the emerging telecom video-equipment market.

Cable and satellite operators are both seeking to increase bandwidth capacity in order to launch additional high definition television (HDTV) and local channels. Cable companies are launching video-on-demand (VOD) and cable telephony in an effort to differentiate themselves from the satellite operators. Telecom operators are also beginning to deploy video services through fiber- and digital-service lines.

UPGRADE BENEFIT. From a network capacity standpoint, we see the widespread proliferation of enhanced video services creating extra demand for the company's video distribution and transport equipment. Specifically, we think the industry transition toward HDTV plays directly into Harmonic's strengths in encoding. We believe the company's core encoding market is set for an upgrade cycle from the MPEG-2 standard to MPEG-4, which lowers bandwidth requirements.

From a valuation perspective, the stock trades at a discount to its communications-equipment peers on a p-e basis, despite our forecast for higher-than-industry average earnings growth. However, we expect the valuation multiple to expand, as Harmonic successfully takes advantage of the significant market opportunity we anticipate.

Harmonic develops digital-video systems and fiber-optic systems that enable network operators to provide a range of interactive and advanced digital services. The majority of sales are derived from cable and satellite operators, although telecom operators are fast becoming an increasing part of the revenue mix. Products are organized in two principal groups: Convergent Systems and Broadband Access Networks. Harmonic also provides technical-support services to its customers worldwide.

BROAD AND NARROW. The Convergent Systems division's standards-based offerings enable operators to increase the capacity of their broadband networks. Digital encoders -- compression devices that produce high-quality video and audio at low data rates -- account for the lion's share of divisional revenue. We view the company's encoding capabilities as outstanding, with product price efficiency and video quality among the best in the industry.

The division's other primary product is the Narrowcast Services Gateway, or NSG, which interfaces with the output from a video server and integrates routing, multiplexing, and modulation into a single package for the delivery of VOD services to subscribers over cable networks. The NSG business slowed down considerably during the latter part of 2004, due, we think, to operators pausing to digest excess capacity after significant infrastructure investment in the first half of the year. We expect cable operators to increase VOD deployments since those services reduce subscriber churn.

Harmonic's Broadband Access Networks division manufactures optics and electronics that enhance network reliability and allow broadband service providers to deliver advanced services. The company offers transmitters, optical amplifiers, and dense wave multiplexing systems for a wide range of optical transmission requirements. While cable network upgrades have been largely completed, operators will continue to upgrade network equipment for the maintenance and support of new services. Also included in this division are products sold to the telecom customer base, which is beginning to deploy fiber to the home (FTTH).

THE HD HORIZON. While overall cable capital expenditures are weakening with the recent completion of large network upgrades, we believe operators are materially shifting spending priorities toward enhanced services such as HDTV, VOD, and cable telephony. Meanwhile, satellite operators are compressing video streams in an effort to enhance bandwidth capacity for the aggressive launch of additional HDTV and local channels. Lastly, telecom operators have begun to offer video services through the deployment of FTTH and digital-service lines. We believe these industry developments play directly into Harmonic's strength in supplying video distribution and transport equipment.

As the bandwidth requirement for an HDTV channel is about four times that for a standard digital channel, cable operators will need to expand their bandwidth capabilities in the distribution part of the network. Some operators are utilizing digital simulcasting, a method that duplicates analog channels in a digital format. On average, each analog channel recaptured can support about 10 digital channels. Digital simulcasting should fuel a strong ramp-up in Harmonic HDTV encoders, in our opinion. We think these encoders will help improve the product mix, since they cost two to three times more than their standard encoder equivalent.

We think a large cycle upgrade toward next-generation compression technology should provide the company with a strong underlying growth driver for the next several years. Despite its significant compression improvements over the past couple of years, we believe that the current standard of MPEG-2 has essentially reached its performance limit. Accordingly, we expect customers, beginning with the satellite operators, to migrate toward MPEG-4, which is designed to eventually lower the channel bit rate by nearly 50% compared to MPEG-2. Harmonics' new encoder products are configured to support all the next-generation encoding technologies.

STOCK TRACK. In our view, Harmonic is successfully gaining traction in the telecom market, as carriers begin to offer video services through fiber and digital service lines. During 2004, the company made its first volume shipments of fiber optic products for FTTH applications. We estimate that the telecom market represents about 15% of total sales. We view the telecom segment as an important growth driver for the company. We note, however, that the telecom business is still relatively new and is likely to be spotty throughout 2005, in our opinion.

Our 2005 Standard & Poor's Core Earnings estimate of 37 per share for Harmonic reflects projected stock option expense of 16 cents. While noteworthy, the absolute per share amount has steadily declined over the past three years. Given our forecast for a material ramp-up in Harmonic's earnings, we expect the variation between our S&P Core and operating EPS estimates to narrow substantially in future years.

The stock recently traded at 18 times our 2005 EPS estimate of 53 cents, for a p-e-to-growth (PEG) ratio of 1.2 times our long-term EPS growth rate expectation of 15%, well below the industry average. On a price-to-sales basis, the stock is trading at a slight premium to the industry average. We believe that this premium is justified by Harmonic's strong gross margin, currently around 40%, well above the peer mean. The stock trades at an above-industry average six times its book value per share of $1.50.


discounted cash-flow (DCF) model indicates a fair value of about $12. Based on a blend of our intrinsic value, as determined by our DCF model, and our relative analysis, largely derived from the group average PEG ratio, we arrive at our 12-month target price of $12.

Below we comment on the company's board of directors, executive compensation, and composition of shareholders, based on information from the company's schedule 14A proxy statement filed in early 2004. The company's governance guidelines have not been publicly disclosed.

The board of directors consists of six people, who, in our opinion, bring experience and diversity to the company. The corporate structure permits Anthony Ley, the CEO, to simultaneously serve as chairman of the board of directors, which may present a potential conflict of interest.

POTENTIAL DOWNSIDES. We think the company's executive compensation philosophy appropriately balances its business environment with the need to effectively attract and retain a high-caliber management team. During 2003, the CEO's salary, bonus, and all other compensations, excluding long-term compensation awards that vest, in part, after 2003, totaled slightly under $500,000.

No shareholder owns more than 10% of the outstanding shares. Three shareholders -- Fidelity Management & Research, Barclays Global Investors, and State of Wisconsin Investment Board -- own 10%, 7.3%, and 5.6% of the shares outstanding, respectively. Company directors and executive officers own an aggregate of 3% of the shares outstanding.

In addition to general market and macroeconomic risks to our recommendation and 12-month target price, Harmonic's shares, in our view, could be negatively affected by the following: lower capital spending by cable and satellite operators, delays in the widespread deployment of HDTV and VOD technologies, the potential loss of a major customer, and a loss of market share as the industry migrates toward next-generation encoding technologies. Analyst Bensinger follows shares of communications equipment companies for Standard & Poor's Equity Research Services

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