Harmonic (HLIT) Project Hunt Report
I. Overview
Two-way, broadband interactive applications like cable internet (i.e., @Home, RoadRunner),
interactive television (ITV), video-conferencing, and video-on-demand are killer applications.
HLIT provides the hardware and software that makes these killer apps possible. Harmonic
provides optical networking gear which lowers the cost of bandwidth, which in turn results in
new industries becoming viable, such as worldwide distribution of digital content, movies over
the internet, and e-commerce.
II. Market Description
Worldwide, cable television and other broadband services are undergoing dramatic growth as
the demand for communication increases. Hybrid fiber coax (HFC) systems have become
recognized as the delivery platform of choice for broadband services. In 1997, there were
100,000 households in the U.S. with cable modems. This number had increased to 500,000 by
1998, to over 1 million by 1999, and is projected to be over 5 million by 2001. Some project
that over 20% of US households will have broadband cable internet access by 2005.
Cable systems, however, were traditionally designed to deliver a relatively limited set of analog
data in one direction - from the cable headend to the home. Broadband applications, like
internet, telephony, and video-on-demand, require both greater bandwidth, the ability to
add/drop signals to conserve bandwidth, and two-way capabilities. Multiple system operators
(MSOs) like AT&T (T) - which recently purchased TCI and is in the process of purchasing
MediaOne - and Time-Warner (TWX) - which was just recently purchased by AOL - have
been upgrading their legacy systems to provide these new applications. Other companies, like
RCN (RCNC) and some Regional Bell Operating Companies (RBOCs), are building entire new,
cost-effective fiber networks from scratch to deliver these services. In the U.S., much of this
recent activity has been spurred by the Telecommunications Act of 1996, the purpose of which
was to increase competition in the local communications market and investments in broadband
networks. In addition, in the United States, MSOs are under a FCC mandate to deliver digital
(i.e., HDTV) programming by 2006 and are upgrading their networks in response.
Broadband connections provide internet content roughly fifty times faster than dial-up (56k)
modems for roughly twice the cost ($40/month vs. $20/month). Despite these compelling
numbers, broadband services are still not universally available and, where available, the market
penetration rate remains under five percent.
A. The Company
Harmonic (HLIT) designs, manufactures and markets digital and fiber optic hardware and
software for delivering video, voice and data over cable, satellite and wireless networks. These
advanced solutions enable cable television and other network operators to provide a range of
broadcast and interactive broadband services that include high-speed Internet access, telephony,
and video-on-demand.
The company was founded in 1988, had its IPO in May 1995, and a secondary public offering
in April 1999. The company is headquartered in Sunnyvale, CA, with a wholly-owned
subsidiary (Harmonic Data Systems) headquartered in Tel Aviv, Israel. There are currently
about 450 employees. The company recently entered into an agreement with C-Cube (CUBE)
to purchase C-Cube's DiviCom division for 1.7 billion in HLIT stock.
The company's product offerings include flexible hardware and proprietary software which can
be grouped into two major categories: (1) Fiber-optic primarily for cable; and (2) Digital
products (including TRANsend digital transmitters and CyberStream, and end-to-end system
including uplink gateways at the operator end to PC receiver cards and routers for LAN markets
at the customer end) for all three major platforms: cable, wireless (LMDS and MMDS), and
satellite.
The company's domestic customers include AT&T (which purchased TCI, and is in the midst
of purchasing MediaOne), Time Warner (which was just purchased by AOL), RCN, Charter
Communications, Cox, Comcast, and Teleglobe. International customers include Rogers,
Telewest, Europe Online, Tele Danmark, and Eutelsat.
The broadband market is characterized by rapid technological innovation with long lead times
and short product life cycles. Although HLIT holds several patents, patents are not as valuable
in this industry as innovation (requiring extensive R&D), direct relationships with customers,
and the ability to interactively solve problems. Each customer has a different architecture
customized to their own needs. The architecture of the network, and the specifications of the
components that comprise the network, are developed jointly by HLIT and their customers.
(Go to harmonicinc.com and click on Systems and Architectures for an illustration
of a typical network architecture.) The key components in the traditional system include
headend, hubs, and nodes, along with software to manage the system. HLIT's MetroLink
DWDM (Dense Wavelength-Division Multiplexing) system represents a significant step forward
in network design. HLIT was the first to market with a metro DWDM system. DWDM uses
the different colors (or wavelengths) of light to send many signals over the same length of
optical fiber. DWDM significantly increases the capacity of the existing fiber network and
enables the delivery of narrowcast services directly from the headend to the node (bypassing the
hubs, which saves MSOs real estate and maintenance costs, thereby making the investment in
the network upgrade more cost-effective). At the company's website, click on Library for an
article on HLIT's DWDM architecture.
In addition to the MetroLink DWDM system, T and HLIT engineers have teamed up to create
an even more advanced architecture known as LightWire. LightWire pushes fiber even closer to
the customer, reduces the need for active components such as amplifiers, and adds tremendous
two-way capacity at the node. In a traditional architecture, each node was designed to serve
500-2000 homes, depending upon the level of usage. Since bandwidth is not dedicated to a
single customer, but is shared amongst those sharing a node, performance can become sluggish
as customer usage increases. This was experienced by some @Home customers several years
ago. The LightWire architecture is intended to eliminate this bottleneck and provide additional
capacity by (1) subdividing nodes to serve approximately 50-100 homes, and (2) providing
DWDM technology at the node (which was previously not possible due to the extreme
environmental conditions that nodes are exposed to). Many experts believe interactive television
(ITV), with user control of start time, pause, rewind and fast-forward (and no trips to the video
store), becomes feasible at this nodal density. (Go to
zdnet.com for a recent article on T's
LightWire trial in Salt Lake City.) T is currently the only customer using the LightWire
architecture. In HLIT's recent conference call, the company's CEO stated that he expects T to
deploy LightWire in other cities. In addition, as other MSO's encounter capacity limitations due
to the number of homes served per node, or wish to offer a greater number of interactive
services, these other customers may consider migrating to the LightWire architecture. An
important factor for HLIT is that the MetroLink DWDM network is a necessary first step to
deploying the LightWire system. LightWire is essentially overlaid on top of the MetroLink
system.
HLIT has recently begun a video-on-demand (VOD) field trial using open standards to 300,000
households for Telewest in the U.K. HLIT CEO Tony Ley stated in the 4Q conference call that
revenues from VOD applications would be recorded on a per-stream basis. This represents a
promising approach to deriving revenue that is distinctly different from past practices. Assuming
VOD is successful, recording revenue on a per-stream basis creates the potential for HLIT to
increase revenues and gross margins. VOD has been slow to take off in the U.S. in part due to
confusion over which standards will be used. HLIT favors open standards, while competitors
GIC and SFA have been promoting proprietary standards. VOD is unlikely to tornado in the
U.S. until this issue with regard to standards is resolved.
HLIT's recent acquisition DiviCom's expertise is in digital head-end equipment for cable,
satellite, and wireless applications and video compression using MPEG-2 standards. MPEG-2 is
an open, internationally acknowledged standard intended to promote compatibility among
systems. DiviCom has proprietary algorithms used to compress data that are recognized to be
among the best in the industry.
The strength of the combined HLIT/Divicom is in developing better architectures for optical
networking, recognizing three key industry trends: (1) the need for bandwidth is nearly
insatiable; (2) there is a need to move toward more simple networks with fewer active
components, more passive and steady state components, and which make more efficient use of
fiber; and (3) there is a need to "expand" bandwidth by reducing the amount of space data
consumes within the network through software applications, data compression, and signal
processing technology. Executing this business plan allows existing and new network operators
to channel video, data, and voice streams to and from the consumer at much lower costs,
enabling broadband access to more and more users.
B. Competitors
HLIT's competitors in the fiber optic market include ADC Telecommunications (ADCT),
General Instrument (GIC), Antec (ANTC), Philips, Scientific-Atlanta (SFA), Ortel (ORTL), and
C-Cor.net (CCBL). HLIT was recently reported to hold 45% of this market share. Competitors
in the satellite and wireless market include Broadlogic, Echostar, Hybrid Networks, SAGEM,
and Philips.
III. Financial Information
Harmonic (HLIT) 12/31/98 3/31/99 6/30/99 9/30/99 12/31/99
Net Rev $27,097 $30,263 $37,902 $52,624 $63,286
Cost of Sales $16,728 $17,852 $21,946 $29,528 $34,144
Gross Profit $10,369 $12,411 $15,956 $23,096 $29,142
Op. Expense $9,786 $10,644 $11,527 $13,771 $15,646
Op. Income $583 $1,767 $4,429 $9,325 $13,496
Other Income $45 $32 $711 $931 $882
Income before Taxes $628 $1,799 $5,140 $10,256 $14,378
Income Tax $0 $450 $1,285 $2,564 $3,594
Net Income $628 $1,349 $3,855 $7,692 $10,784
Outstanding Shares 25,250 26,692 31,396 32,836 33,074
EPS (diluted) $0.02 $0.05 $0.12 $0.23 $0.33
Gross Margin 38.3% 41.0% 42.1% 43.9% 46.0%
Net Margin 2.3% 4.5% 10.2% 14.6% 17.0%
YOY Revenue Growth 99.5% 119.5%
QOQ Rev. Growth 56.2% 86.8% 108.6% 135.1% 133.6%
IV. Stock Information
Shares Outstanding: 33 M
Float: 20.6 M
% owned by insiders 32%
% owned by institutions: 85%
52 week hi/lo: $124 - $9
Market Capitalization: $3.1 billion (after DiviCom acquisition, the market cap will be
approximately $5 billion
V. G/K Characteristics
A. Is there a discontinuous innovation or a proprietary open architecture?
Yes, converting legacy networks of one-way, analog pipes into (and building from scratch new)
two-way communication channels that facilitate interactive services, such as video-on-demand
(VOD) and video conferencing, represents a discontinuous innovation. MSOs are literally
replacing existing, outdated networks with new 2-way capable systems that provide interactive
services. Many broadband modem users report many existing servers are not yet fast enough to
take advantage of the available bandwidth. In addition, many interactive services (i.e. VOD) are
not yet available.
No, there is not a proprietary open architecture. Most of the intellectual property in use is in the
public domain (i.e., DWDM), is jointly developed and is shared (LightWire), or is quickly
superceded by the rapid innovation that characterizes the industry. In addition, Multimedia
Cable Network System's (MCNS), a consortium of North American MSOs and CableLabs)
have developed a specification known as DOCSIS (Data Over Cable Service Interface
Specification) for transmitting data over a cable network. Vendors in this space are expected to
conform to DOCSIS protocals. In addition to DOCSIS, there are other consortium-controlled
standards to which vendors are expected to conform, including: Moving Pictures Expert Group
(MPEG-2), Digital Video Broadcasting (DVB), and Digital Audio Visual Council (DAVIC).
HLIT has pursued an acquisition strategy as one way to incorporate innovative technology and
intellectual property into their portfolio of products. In January 1998, HLIT purchased New
Media Communications (now known as Harmonic Data Systems). In late 1999, HLIT
announced the acquisition of C-Cube's DiviCom division for $1.7 billion.
B. Does it have the potential to grow into a mass market phenomenon, become a standard?
Yes. The expectation of the Telecommunications Act of 1996 was to deregulate
telecommunications markets in order to spur increased competition and investment, particularly
in the arena of broadband communications. I think the ultimate vision is not just to have
broadband access available to U.S. households, but to have multiple forms of broadband access
available from a variety of carriers.
C. Are there high barriers to entry and high switching costs?
No, there are low barriers to entry and to switching between firms that provide the necessary
hardware and software. To a large extent, barriers are largely the relationships HLIT has
established with customers as problem-solvers who are willing and able to tinker with their
products to meet the individual needs of customers. There are extremely high switching costs to
MSOs to swap out one system for another. This is one of the reasons why many MSOs have
tread slowly into the waters of converting their systems to make them 2-way capable and why
they are concerned with ensuring open standards are retained. They are also concerned with
committing to a particular architecture that will quickly become obsolete due to the rapid
innovation in the industry.
Moderate switching costs could be generated for HLIT to the extent the LightWire architecture
becomes adopted as a standard. This is because LightWire is overlaid on top of the MetroLink
DWDM system. While HLIT is not the sole supplier of either of these systems, in many
respects, they were the first-mover in terms of developing, integrating, and installing these
networks.
D. Have value chains developed?
Yes. According to the manual, a value chain is a cooperative enterprise whereby numerous
entities link up to fulfill a specific value proposition to a target customer (p. 44). The cable
broadband market has formed an extensive value chain to deliver broadband access to
households. The broadband value chain includes component makers like JDSU, those who
manufacture network hardware and software, like HLIT and ADCT, those who manufacture
cable modems, like Motorola, Terayon, and COM-21, and those who provide broadband
content and related services, like Excite@Home. The value chain has coalesced around
interoperable industry standards, including DOCSIS, MPEG-2, and others. The value chain for
the wireless and satellite markets are less extensive, especially in the U.S.
Harmonic is a supporter of open standards. Harmonic has established the Harmonic Cable
Modem Partnership which supports the DOCSIS standards. Cable modem manufacturers such
as Thompson Consumer Electronics, Daewoo Electronics and Panasonic Video
Communications Company are members of this partnership. In addition, Harmonic has
established a partnership with Seachange (SEAC) and nCUBE to support open standards for
VOD applications.
E. Have they crossed the chasm?
Yes, HLIT has crossed the chasm and is in the bowling alley. Identifiable niche markets include:
1. Head pin: Cable MSOs with established HFC networks (i.e., T and TWX);
2. Cable MSOs constructing new 2-way HFC networks (i.e., RCN and Charter)
3. Satellite broadband (i.e., Teleglobe, Europe Online)
4. Wireless broadband (i.e., IMAGE Wireless Communications, Shenzhen Broadcast
Transmission Center.
5. RBOCs (i.e., Bellsouth)
6. Media companies with streaming data feeds (i.e., CNN Newsource, Video Networks)
7. Long-distance learning (Miralite Communications).
There are three indications HLIT is succeeding in the bowling alley. First is the rate of adoption
of the MetroLink DWDM architecture by MSOs. Three quarters ago, T was the only reported
customer. Two quarters ago, the number of customers had increased to 12, and this latest
quarter the number of customers had increased to 17. Second is the increase in the construction
of new 2-way HFC networks. Although T remains their largest customer (40% of revenues),
RCN and Charter were listed as their second and third largest customers in the last quarter. And
third is the increase in revenues from the companies' digital product line (marketed primarily to
niche markets 3-7 listed above). This last quarter, digital revenues were reported to be
approximately $2.5 million, which is up from approximately $1 million three quarters ago. This
represents an increase of 150% over a six month period.
Although the company is succeeding in the bowling alley, it is possible this is a "bowling alley
forever" market. This is because the company competes in a market where there are relatively
few customers who are constantly tinkering and upgrading their networks, but have not adopted
a single architecture en masse. For example, a recent article included the following quote: "I
think we're entering a pretty intense phase where manufacturers will be offering many different
approaches to satisfying bandwidth needs," Harmonic Inc. CEO Tony Ley said. "It will
probably require a lot of experimentation by MSOs before the industry decides which ones are
best."
F. Existance of hypergrowth?
Harmonic's YOY revenue growth over the past year has been 119 percent, and in recent
quarters QOQ revenue growth has been in the 135 percent range. In addition, HLIT has not
achieved YOY revenue growth in excess of 100 percent since 1995. Although revenue growth
has accelerated in recent quarters, it is not quite up to hypergrowth standards.
Measuring hypergrowth by the number of cable modem subscribers indicates higher growth
rates. @Home has reported the following number of broadband subscribers over the past five
quarters: 331,000, 460,000, 620,000, 840,000, and 1,115,000. These numbers represent
sequential growth rates of 39%, 35%, 36%, and 37% over this period, and a YOY increase of
247%. This clearly meets tornado standards. In addition, the number of U.S. households with
cable modems is projected to increase from about 1 million in 1999 to about 5 million by 2001.
This is a projected increase of 400 percent over a two-year period, which is within tornado
proportions. Also, cable modems are expected to be available in retail outlets by the middle of
2000. Widespread availability of cable modems, combined with increased competition (and
lower costs) in the broadband space, may keep the winds of the tornado blowing for a number
of years.
VI. Summary and Analysis
The market in which Harmonic competes is applications hardware for the implementation of
broadband networks. Because there is no proprietary, open architecture, HLIT is not in a gorilla
game. The broadband market is in the midst of a tornado as measured by adoption rate of
broadband subscribers, although HLIT's revenues are not currently meeting hypergrowth
standards. It is possible HLIT is in a "bowling alley forever" market as MSOs continue to tinker
with and gradually upgrade their network architectures which prevents the widespread adoption
of a single network configuration.
According to the manual, a king is the "market leader, properly with two-times lead or better
over its closest competitor. The market will allow a little leeway here, but if the lead shrinks too
far, the king becomes a prince?and we have a kingless market" (p. 59). A prince is a "market
challenger, or potentially a co-leader of a market that has no definable king. Typically this
company has around 10% to 15% market share" (p. 60).
HLIT is reported to have a 45% market share in the metro DWDM market that has
approximately six other main competitors. It is unclear exactly how the remainder of the market
is divided between these other competitors. It is possible, but not probable, that HLIT has twice
the market share of its closest competitor. Therefore, I have to conclude at this time it is a
kingless market, and HLIT is a prince. However, a 45% market share exceeds the typical
10-15% market share of a prince by a considerable margin, so it is possible HLIT is a strong
prince that may be able to parlay this market share advantage in the metro DWDM market into
a similar leadership position in other niche markets. Harmonic has several promising application
hardware technologies which are in the bowling alley and are good places to watch for future
tornadoes. To this end, it will be important to: (1) watch for adoption of the LightWire platform
by MSOs; (2) monitor the broadband strategy adopted by combined AOL-Time Warner; and
(3) monitor progress in the satellite and wireless broadband markets.
VII. References
Company Webpages
Harmonic: harmonicinc.com
Harmonic Data Systems: harmonicdata.com
DiviCom: divi.com
Real Audio Replay of 4Q1999 Conference Call (the Tony and Robin show)
Go to harmonicinc.com and click on Investor Relations and then Financial Reports
10-K (for FY 1998) from SEC Edgar
sec.gov
10-Q (for 3Q 1999) from SEC Edgar
sec.gov
Harmonic Announces Record Fourth Quarter and Year-end Results
biz.yahoo.com
Telewest Selects Harmonic to Deliver Broadband Access Solutions for VOD Services
biz.yahoo.com
Video-on-demand now in sight
forbes.com
Harmonic to buy digital video unit
cbs.marketwatch.com.
Lightwire Pushes into Phase 3
multichannel.com
AT&T Claims Quick Success with LightWire
zdnet.com
Cable Operators Begin to Seize the Light
zdnet.com
Teleglobe Saddles Harmonic Box
zdnet.com
Harmonic's Convergence
forbes.com
Miracle Grow: The Bloomberg 100
bloomberg.com
DiviCom Wins Head-End Deployment for First Digital MMDS Television System in China
biz.yahoo.com
DiviCom Wins Digital Channel Expansion of Time Warner Cable System in New York
biz.yahoo.com
DiviCom Wins Head-End Deployment for Colombian Satellite Television System
biz.yahoo.com
DiviCom Wins at DIRECTV Colorado Broadcast Center
biz.yahoo.com |
