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You have to love the internet. I found this post on the SI Board (and a cross link to the HLIT board here). This has to be the best analysis I've seen of a company, especially Gorilla/King analysis. I would love to hear the opinions of the Board on HLIT's opportunities in the future. It appears clear that HLIT is in a royalty game, but it also seems they have technology that could propel them into a Gorilla game should it be adopted as industry standard (if that's possible for the broadband hardware industry).

Take you time and read this carefully. ---Maverick

Harmonic (HLIT) Project Hunt Report (from Mr. Miller at SI)
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 http://www.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 http://www.zdnet.com/intweek/stories/news/0,4164,2405436,00.html 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: http://www.harmonicinc.com/
Harmonic Data Systems: http://www.harmonicdata.com/
DiviCom: http://www.divi.com/

Real Audio Replay of 4Q1999 Conference Call (the Tony and Robin show)
Go to http://www.harmonicinc.com/ and click on Investor Relations and then Financial Reports

10-K (for FY 1998) from SEC Edgar
http://www.sec.gov/Archives/edgar/data/851310/0000891618-99-000989.txt

10-Q (for 3Q 1999) from SEC Edgar
http://www.sec.gov/Archives/edgar/data/851310/0000891618-99-005176.txt

Harmonic Announces Record Fourth Quarter and Year-end Results
http://biz.yahoo.com/bw/000119/ca_harmoni_2.html

Telewest Selects Harmonic to Deliver Broadband Access Solutions for VOD Services
http://biz.yahoo.com/bw/000119/ca_harmoni_1.html

Video-on-demand now in sight
http://www.forbes.com/tool/html/00/Jan/0119/mu3.htm

Harmonic to buy digital video unit
http://cbs.marketwatch.com/archive/19991027/news/current/hli...

Lightwire Pushes into Phase 3
http://www.multichannel.com/b3.shtml

AT&T Claims Quick Success with LightWire
http://www.zdnet.com/intweek/stories/news/0,4164,2405436,00.html

Cable Operators Begin to Seize the Light
http://www.zdnet.com/intweek/stories/news/0,4164,2308379,00.html

Teleglobe Saddles Harmonic Box
http://www.zdnet.com/intweek/stories/news/0,4164,2332314,00.html

Harmonic's Convergence
http://www.forbes.com/tool/html/99/jun/0623/feat.htm

Miracle Grow: The Bloomberg 100
http://www.bloomberg.com/personal/feature_new99.html

DiviCom Wins Head-End Deployment for First Digital MMDS Television System in China
http://biz.yahoo.com/bw/991221/ca_divicom_1.html

DiviCom Wins Digital Channel Expansion of Time Warner Cable System in New York
http://biz.yahoo.com/bw/991217/ca_c_cube__1.html

DiviCom Wins Head-End Deployment for Colombian Satellite Television System
http://biz.yahoo.com/bw/991202/ca_c_cube__1.html

DiviCom Wins at DIRECTV Colorado Broadcast Center
http://biz.yahoo.com/bw/991101/ca_c_cube__1.html






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