UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

HARMONIC INC.

Delaware				77-0201147
(State or other jurisdiction of incorporation or				(I.R.S. Employer Identification Number)
organization)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ                      No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” (as defined in Rule 12b-2 of the Exchange Act). (Check one):

Large accelerated filer o            Accelerated filer þ            Non-accelerated filer o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o                      No þ

The number of shares outstanding of the Registrant’s Common Stock, $.001 par value, was 74,583,450 on July 28, 2006.

 

 

PART I

FINANCIAL INFORMATION

Item 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

HARMONIC INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

(In thousands, except par value amounts)		June 30, 2006				December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents		$	49,970			$	37,818
Short-term investments			63,564				73,010
Accounts receivable, net of allowances of $3,491 and $3,230			35,493				43,433
Inventories			30,961				38,552
Prepaid expenses and other current assets			11,932				8,335
Total current assets			191,920				201,148
Property and equipment, net			15,431				17,040
Intangibles and other assets			7,322				8,109
Total assets		$	214,673			$	226,297
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt		$	693			$	812
Accounts payable			16,249				19,378
Income taxes payable			6,856				6,480
Deferred revenue			16,518				18,932
Accrued liabilities			37,281				37,438
Total current liabilities			77,597				83,040
Long-term debt, less current portion			161				460
Accrued excess facilities costs, long-term			16,536				18,357
Other non-current liabilities			9,937				11,458
Total liabilities			104,231				113,315
Commitments and contingencies (Notes 15 and 16)
Stockholders’ equity:
Preferred stock, $0.001 par value, 5,000 shares authorized; no shares issued or outstanding			—				—
Common stock, $0.001 par value, 150,000 shares authorized; 74,171 and 73,636 shares issued and outstanding			74				74
Capital in excess of par value			2,053,404				2,048,090
Accumulated deficit			(1,942,766	)			(1,934,715	)
Accumulated other comprehensive loss			(270	)			(467	)
Total stockholders’ equity			110,442				112,982
Total liabilities and stockholders’ equity		$	214,673			$	226,297

The accompanying notes are an integral part of these consolidated financial statements.

HARMONIC INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

		Three Months Ended								Six Months Ended
(In thousands, except per share amounts)		June 30, 2006				July 1, 2005				June 30, 2006				July 1, 2005
Net sales		$	53,270			$	59,762			$	109,491			$	132,678
Cost of sales			31,664				36,365				68,005				82,233
Gross profit			21,606				23,397				41,486				50,445
Operating expenses:
Research and development			9,585				9,519				19,533				18,977
Selling, general and administrative			15,979				16,611				31,692				31,937
Amortization of intangibles			43				165				135				1,123
Total operating expenses			25,607				26,295				51,360				52,037
Loss from operations			(4,001	)			(2,898	)			(9,874	)			(1,592	)
Interest income, net			1,175				636				2,167				1,157
Other expense, net			128				(304	)			36				(353	)
Loss before income taxes			(2,698	)			(2,566	)			(7,671	)			(788	)
Provision for (benefit from) income taxes			205				(36	)			380				36
Net loss		$	(2,903	)		$	(2,530	)		$	(8,051	)		$	(824	)
Net loss per share basic and diluted		$	(0.04	)		$	(0.03	)		$	(0.11	)		$	(0.01	)
Weighted average shares basic and diluted			74,167				73,112				74,134				72,976

The accompanying notes are an integral part of these consolidated financial statements.

HARMONIC INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

		Six Months Ended
(In thousands)		June 30, 2006				July 1, 2005
Cash flows from operating activities:
Net loss		$	(8,051	)		$	(824	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Amortization of intangibles			458				2,065
Depreciation			3,993				4,033
Stock-based compensation			3,130				8
Loss on disposal of fixed assets			20				13
Deferred income taxes			—				(136	)
Changes in assets and liabilities, net of effect of acquisition:
Accounts receivable			7,630				16,875
Inventories			7,564				514
Prepaid expenses and other assets			(3,731	)			1,705
Accounts payable			(3,129	)			(9,139	)
Deferred revenue			(3,248	)			4,144
Income taxes payable			319				(583	)
Accrued excess facilities costs			(2,335	)			(2,372	)
Accrued and other liabilities			698				(15,516	)
Net cash provided by operating activities			3,318				787
Cash flows provided by (used in) investing activities:
Purchases of investments			(39,431	)			(30,388	)
Proceeds from sales of investments			49,024				27,950
Acquisition of property and equipment			(2,404	)			(2,929	)
Acquisition of BTL, net of cash received			—				(5,955	)
Net cash provided by (used in) investing activities			7,189				(11,322	)
Cash flows from financing activities:
Proceeds from issuance of common stock			2,145				6,106
Repayments under bank line and term loan			(418	)			(662	)
Repayments of capital lease obligations			(41	)			(50	)
Net cash provided by financing activities			1,686				5,394
Effect of exchange rate changes on cash and cash equivalents			(41	)			277
Net increase (decrease) in cash and cash equivalents			12,152				(4,864	)
Cash and cash equivalents at beginning of period			37,818				26,603
Cash and cash equivalents at end of period		$	49,970			$	21,739
Supplemental disclosure of cash flow information:
Income tax payments, net		$	138			$	90
Interest paid during the period		$	59			$	186
Non-cash investing and financing activities:
Issuance of restricted common stock for BTL acquisition		$	—			$	1,831

The accompanying notes are an integral part of these consolidated financial statements.

HARMONIC INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1: Basis of Presentation

The accompanying unaudited condensed consolidated financial statements include all adjustments (consisting only of normal recurring adjustments) which Harmonic Inc. (the “Company”) considers necessary for a fair statement of the results of operations for the interim periods covered and the consolidated financial condition of the Company at the date of the balance sheets. This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s audited consolidated financial statements contained in the Company’s Annual Report on Form 10-K and Form 10-K/A, which were filed with the Securities and Exchange Commission on March 14, 2006 and April 26, 2006, respectively. The interim results presented herein are not necessarily indicative of the results of operations that may be expected for the full fiscal year ending December 31, 2006, or any other future period. The Company’s fiscal quarters end on the Friday nearest the calendar quarter end, except for the fourth quarter which ends on December 31.

The condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

Certain amounts in the prior year’s financial statements and related notes have been reclassified to conform to the 2006 presentation. These reclassifications have no material impact on previously reported net loss or cash flows.

Use of Estimates

The preparation of the consolidated financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Note 2: Recent Accounting Pronouncements

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present, and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return. FIN 48 will be effective for fiscal years beginning after December 15, 2006. We are currently in the process of evaluating the effect, if any, FIN 48 will have on our consolidated financial statements.

Note 3: Stock-based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options and employee stock purchases related to our Employee Stock Purchase Plan (“ESPP”) based upon the grant-date fair value of those awards. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations, and provided the required pro forma disclosures prescribed by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”) as amended. In addition, we have applied the provisions of Staff Accounting Bulletin No. 107 (“SAB 107”), issued by the Securities and Exchange Commission, in our adoption of SFAS No. 123(R).

The Company adopted SFAS 123(R) using the modified-prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Condensed Consolidated Financial Statements as of and for the three and six months ended June 30, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s Condensed Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the three and six months ended June 30, 2006 was $1.5 million and $3.1 million, respectively, which consisted of stock-based compensation expense related to employee equity awards and employee stock purchases. There was no stock-based compensation expense related to employee equity awards and employee stock purchases recognized during the three and six months ended July 1, 2005.

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in the Company’s Condensed Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for employee equity awards and employee stock purchases using the intrinsic value method in accordance with APB 25 as allowed under SFAS 123. Under the intrinsic value method, no stock-based compensation expense had been recognized in the Company’s Condensed Consolidated Statement of Operations because the exercise price of the Company’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s Condensed Consolidated Statement of Operations for the three and six months ended June 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). In conjunction with the adoption of SFAS 123(R), the Company changed its method of attributing the value of stock-based compensation costs to expense from the accelerated multiple-option method to the straight-line single-option method. Compensation expense for all share-based payment awards granted on or prior to December 31, 2005 will continue to be recognized using the accelerated approach while compensation expense for all share-based payment awards related to stock options and employee stock purchase rights granted subsequent to December 31, 2005 are recognized using the straight-line method.

As stock-based compensation expense recognized in our results for the three and six months ended June 30, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to fiscal year 2006, we accounted for forfeitures as they occurred for the purposes of pro forma information under SFAS 123, as disclosed in our Notes to Consolidated Financial Statements for the related periods.

The fair value of share-based payment awards is estimated at grant date using a Black-Scholes-Merton option pricing model. The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as the assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.

Harmonic currently does not expect to receive any tax benefits in fiscal 2006 for any expense deductions resulting from expensing of stock options or shares issued under its ESPP plan. On November 10, 2005 the FASB issued FASB Staff Position No. FSP FAS 123(R)-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. Harmonic currently provides a valuation allowance for most of its deferred tax assets, and a valuation allowance has also been provided for deferred tax assets related to nonqualified stock options.

Note 4: BTL Acquisition

On February 25, 2005, Harmonic purchased all of the issued and outstanding shares of Broadcast Technology Limited, or BTL, a private UK company, for a purchase consideration of £4.0 million, or approximately $7.6 million. The purchase consideration consisted of a payment of £3.0 million in cash and the issuance of 169,112 shares of Harmonic common stock. In addition, Harmonic paid approximately $0.3 million in transaction costs for a total transaction price of approximately $7.9 million. The addition of BTL has expanded Harmonic’s product line to include professional video/audio receivers and decoders. This enabled us to expand the scope of solutions we provide for existing and emerging cable, satellite, terrestrial broadcast and telecom applications. These factors contributed to a purchase price exceeding the fair value of BTL’s net tangible and intangible assets acquired; as a result, we have recorded goodwill in connection with this transaction.

The BTL acquisition was accounted for under SFAS No. 141 and certain specified provisions of SFAS No. 142. The results of operations of BTL are included in Harmonic’s Condensed Consolidated Statements of Operations from February 25, 2005, the date of acquisition. The following table summarizes the allocation of the purchase price based on the estimated fair value of the tangible assets acquired and the liabilities assumed at the date of acquisition (in thousands):

Cash acquired		$	149
Other tangible assets acquired			2,508
Amortizable intangible assets:
Existing technology			2,050
Customer relationships			540
Tradenames/trademarks			320
Order backlog			60
Goodwill			3,745
Total assets acquired			9,372
Liabilities assumed			(568	)
Deferred tax liability for acquired intangibles			(891	)
Net assets acquired		$	7,913

Identified intangible assets, including existing technology and customer relationships are being amortized over their useful lives of three years; tradename/trademarks are being amortized over their useful lives of two years; and order backlog is being amortized over its useful life of three months.

The residual purchase price of $3.7 million has been recorded as goodwill. The goodwill as a result of this acquisition is not expected to be deductible for tax purposes. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill relating to the acquisition of BTL is not being amortized and will be tested for impairment annually or whenever events indicate that an impairment may have occurred.

Supplemental pro forma information is not provided because the acquisition of BTL was not material to the Company’s financial statements for all periods presented.

Note 5: Cash, Cash Equivalents and Investments

At June 30, 2006 and December 31, 2005, cash, cash equivalents and short-term investments are summarized as follows (in thousands):

		June 30, 2006				December 31, 2005
Cash and cash equivalents		$	49,970			$	37,818
Short-term investments:
Less than one year			62,831				56,605
Due in 1-2 years			733				16,405
Total short-term investments			63,564				73,010
Total cash, cash equivalents and short-term investments		$	113,534			$	110,828

The following is a summary of available-for-sale securities (in thousands).

						Gross				Gross
		Amortized				Unrealized				Unrealized				Estimated Fair
		Cost				Gains				Losses				Value
June 30, 2006
U.S. government debt securities		$	25,951			$	1			$	(145	)		$	25,807
Corporate debt securities			34,243				86				(147	)			34,182
Other debt securities			3,575				¾				¾				3,575
Total		$	63,769			$	87			$	(292	)		$	63,564
December 31, 2005
U.S. government debt securities		$	20,264			$	¾			$	(146	)		$	20,118
Corporate debt securities			46,873				3				(209	)			46,667
Other debt securities			6,225				¾				¾				6,225
Total		$	73,362			$	3			$	(355	)		$	73,010

Impairment of Investments

We monitor our investment portfolio for impairment on a periodic basis. In the event that the carrying value of an investment exceeds its fair value and the decline in value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis for the investment is established. In order to determine whether a decline in value is other-than-temporary, we evaluate, among other factors: the duration and extent to which the fair value has been less than the carrying value; our financial condition and business outlook, including key operational and cash flow metrics, current market conditions and future trends in the company’s industry; our relative competitive position within the industry; and our intent and ability to retain the investment for a period of time sufficient to allow any anticipated recovery in fair value.

In accordance with FASB Staff Position Nos. 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP FAS 115-1”), the following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of June 30, 2006 (in thousands):

		Less than 12 months								Greater than 12 months								Total
						Gross								Gross								Gross
						Unrealized								Unrealized								Unrealized
		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
U.S. Government debt securities		$	11,985			$	(103	)		$	8,998			$	(42	)		$	20,983			$	(145	)
Corporate debt securities			22,052				(107	)			5,929				(40	)			27,981				(147	)
Total		$	34,037			$	(210	)		$	14,927			$	(82	)		$	48,964			$	(292	)

The decline in the estimated fair value of these investments relative to amortized cost is primarily related to changes in interest rates and is considered to be temporary in nature.

Note 6: Inventories

(In thousands)		June 30, 2006				December 31, 2005
Raw materials		$	9,369			$	14,392
Work-in-process			1,928				4,131
Finished goods			19,664				20,029
		$	30,961			$	38,552

Note 7: Goodwill and Identified Intangibles

The following is a summary of goodwill and intangible assets as of June 30, 2006 and December 31, 2005 (in thousands):

		June 30, 2006												December 31, 2005
		Gross												Gross								Net
		Carrying				Accumulated				Net Carrying				Carrying				Accumulated				Carrying
		Amount *				Amortization				Amount				Amount *				Amortization				Amount
Identified intangibles:
Developed core technology		$	29,767			$	(28,673	)		$	1,094			$	29,663			$	(28,315	)		$	1,348
Customer base			31,907				(31,907	)			—				31,904				(31,904	)			—
Trademark and tradename			4,207				(4,207	)			—				4,190				(4,142	)			48
Supply agreement			3,491				(3,203	)			288				3,464				(3,109	)			355
Subtotal of identified intangibles			69,372				(67,990	)			1,382				69,221				(67,470	)			1,751
Goodwill			4,514				—				4,514				4,896				—				4,896
Total goodwill and other intangibles		$	73,886			$	(67,990	)		$	5,896			$	74,117			$	(67,470	)		$	6,647

The acquisition of BTL resulted in an increase in goodwill and intangible assets of $3.5 million and $2.7 million, respectively, during 2005. In addition, intangible assets decreased by $3.0 million in 2005 from the reversal of a reserve for a DiviCom pre-acquisition uncertain tax provision.

The changes in the carrying amount of goodwill for the six months ended June 30, 2006 are as follows (in thousands):

		Goodwill
Balance as of January 1, 2006		$	4,896
Purchase price adjustments*			(531	)
Foreign currency translation adjustments			149
Balance as of June 30, 2006		$	4,514

For the three and six months ended June 30, 2006, the Company recorded a total of $0.2 million and $0.5 million, of

amortization expense for identified intangibles, of which $0.2 million and $0.3 million, was included in cost of sales, respectively. For the three and six months ended July 1, 2005, the Company recorded a total of $0.3 and $2.1 million of amortization expense for identified intangibles, of which $0.2 million and $0.9 million was included in cost of sales, respectively. The estimated future amortization expense of purchased intangible assets with definite lives for the next three years is as follows (in thousands):

Years Ending December 31,		Amounts
2006 (remaining 6 months)		$	415
2007			829
2008			138
Total		$	1,382

Note 8: Restructuring and Excess Facilities

During 2001, Harmonic recorded a charge for excess facilities costs of $21.8 million. As a result of uncertain market conditions and lower sales during the second half of 2002, the Company changed its estimates related to accrued excess facilities with regard to the expected timing and amount of sublease income due to the substantial surplus of vacant commercial space in the San Francisco Bay Area. In connection with these actions, Harmonic recorded an additional excess facilities charge of $22.5 million, net of sublease income, to selling, general and administrative expenses during the second half of 2002.

As of June 30, 2006, accrued excess facilities cost totaled $21.2 million of which $4.7 million was included in current accrued liabilities and $16.5 million in other non-current liabilities. The Company incurred cash outlays of $2.3 million during the first six months of 2006 principally for lease payments, property taxes, insurance and other maintenance fees related to vacated facilities. Harmonic expects to pay approximately $2.3 million of excess facility lease costs, net of estimated sublease income, for the remainder of 2006 and to pay the remaining $18.9 million, net of estimated sublease income, over the remaining lease terms through September 2010.

Harmonic reassesses this liability quarterly and adjusts as necessary based on changes in the timing and amounts of expected sublease rental income. In the fourth quarter of 2005 the excess facilities liability was decreased by $1.1 million due to subleasing a portion of an unoccupied building for the remainder of the lease.

During the fourth quarter of 2005, in response to the consolidation of the Company’s two operating segments into a single segment as of January 1, 2006, the Company implemented workforce reductions of approximately 40 full-time employees across all functions and primarily in our U.S. operations and recorded severance and other costs of approximately $1.1 million. No liability remains as of June 30, 2006.

During the second quarter of 2006, the Company streamlined its senior management team primarily in the U.S. operations and recorded severance and other costs of approximately $1.0 million. We expect the remaining payments related to these actions to be paid by the end of the third quarter of 2006.

The following table summarizes restructuring activities (in thousands):

		Workforce				Management				Excess
		Reduction				Reduction				Facilities				Total
Balance at December 31, 2005		$	635			$	—			$	23,576			$	24,211
Provisions/(recoveries)			(25	)			962				—				937
Cash payments, net of sublease income			(610	)			(172	)			(2,337	)			(3,119	)
Balance at June 30, 2006		$	—			$	790			$	21,239			$	22,029

Note 9: Credit Facilities and Long-Term Debt

Harmonic has a bank line of credit facility with Silicon Valley Bank, which provides for borrowings of up to $23.7 million, including $3.7 million for equipment under a secured term loan. This facility, which was amended and restated in December 2005, expires in December 2006, and contains financial and other covenants including the requirement for Harmonic to maintain cash, cash equivalents and short-term investments, net of credit extensions, of

not less than $30.0 million. If Harmonic is unable to maintain this cash, cash equivalents and short-term investments balance or satisfy the additional affirmative covenant requirements, Harmonic would be in noncompliance with the facility. In the event of noncompliance by Harmonic with the covenants under the facility, Silicon Valley Bank would be entitled to exercise its remedies under the facility which include declaring all obligations immediately due and payable and disposing of the collateral if obligations were not repaid. At June 30, 2006, Harmonic was in compliance with the covenants under this line of credit facility. The December 2005 amendment resulted in the company paying a fee of approximately $33,000 and requiring payment of approximately $43,000 of additional fees if the company does not maintain an unrestricted deposit of $20.0 million with the bank. Future borrowings pursuant to the line bear interest at the bank’s prime rate (8.25% at June 30, 2006) or prime plus 0.5% for equipment borrowings. Borrowings are payable monthly and are collateralized by all of Harmonic’s assets except intellectual property. As of June 30, 2006, $0.9 million was outstanding under the equipment term loan portion of this facility and there were no borrowings in 2005 or 2006. The term loan is repayable monthly, including principal and interest at 8.75% per annum on outstanding borrowings as of June 30, 2006 and matures at various dates through December 2007. Other than standby letters of credit and guarantees (Note 15), there were no other outstanding borrowings or commitments under the line of credit facility as of June 30, 2006.

Note 10: Benefit Plans

Stock Option Plans. Harmonic has reserved 12,450,000 shares of Common Stock for issuance under various employee stock option plans. The options are granted for periods not exceeding ten years and generally vest 25% at one year from date of grant, and an additional 1/48 per month thereafter. Stock options are granted at the fair market value of the stock at the date of grant. Beginning on February 27, 2006, option grants had a term of seven years.

Director Option Plans. In May 2002, Harmonic’s stockholders approved the 2002 Director Option Plan (the “Plan”), replacing the 1995 Director Option Plan. In June 2006, Harmonic’s stockholders approved an amendment to the Plan and increased the maximum number of shares of common stock authorized for issuance over the term of the Plan by an additional 300,000 shares to 700,000 shares and reduced the term of future options granted under the Plan to seven years. Harmonic has a total of 728,000 shares of Common Stock reserved for issuance under the Plan. The Plan provides for the grant of non-statutory stock options to certain non-employee directors of Harmonic pursuant to an automatic, non-discretionary grant mechanism. Options are granted at the fair market value of the stock at the date of grant for periods not exceeding ten years. Initial grants generally vest monthly over three years, and subsequent grants generally vest monthly over one year.

The following table summarizes activities under the Plans:

		Shares Available for				Stock Options				Weighted Average
		Grant				Outstanding				Exercise Price
		(In thousands except exercise price)
Balance at December 31, 2005			3,984				9,064			$	13.05
Shares authorized			300				—				—
Options granted			(1,735	)			1,735				5.72
Options exercised			—				(123	)			3.46
Options canceled			917				(917	)			11.46
Options expired			—				(50	)			34.79
Balance at June 30, 2006			3,466				9,709				11.90
Options vested and exercisable as of June 30, 2006							6,572			$	12.20
Options expected-to-vest as of June 30, 2006							9,240			$	14.65

The weighted-average fair value of options granted for the six months ended June 30, 2006 was $3.64.

The following table summarizes information regarding stock options outstanding at June 30, 2006:

		Stock Options Outstanding								Stock Options Exercisable
						Weighted-
						Average
		Number				Remaining								Number
Range of Exercise		Outstanding at				Contractual Life				Weighted-Average				Exercisable				Weighted Average
Prices		June 30, 2006				(Years)				Exercise Price				at June 30, 2006				Exercise Price
		(In thousands, except exercise price and life)
$    1.75  —      5.82			1,444				6.6			$	3.97				914			$	3.64
5.84  —      5.87			2,322				7.6				5.87				264				5.86
5.88  —      8.93			1,543				6.1				8.05				1,168				7.96
9.00  —      9.29			1,221				5.4				9.17				1,083				9.16
9.37  —    11.50			1,241				5.0				10.45				1,214				10.45
11.53  —    24.73			1,190				3.9				21.98				1,181				22.05
25.16  —  121.68			748				3.3				44.76				748				44.76
			9,709				5.8			$	11.90				6,572			$	14.65

The weighted-average remaining contractual life for all exercisable stock options at June 30, 2006 was 5.0 years. The weighted-average remaining contractual life of all vested and expected-to-vest stock options at June 30, 2006 was 5.7 years.

Aggregate pre-tax intrinsic value of options outstanding and exercisable at June 30, 2006 was $1.1 million and $0.9 million, respectively. The aggregate intrinsic value of stock options vested and expected-to-vest net of estimated forfeitures was $1.0 million at June 30, 2006. Aggregate pre-tax intrinsic value represents the difference between our closing price on the last trading day of the fiscal period, which was $4.48 as of June 30, 2006, and the exercise price multiplied by the number of options outstanding or exercisable. Total pre-tax intrinsic value of options exercised was de minimis for the three and six months periods ended June 30, 2006.

Employee Stock Purchase Plan. In May 2002, Harmonic’s stockholders approved the 2002 Employee Stock Purchase Plan (the “2002 Purchase Plan”) replacing the 1995 Employee Stock Purchase Plan effective for the offering period beginning on July 1, 2002. In May 2004, Harmonic’s stockholders approved an amendment to the 2002 Purchase Plan and increased the maximum number of shares of common stock authorized for issuance over the term of the 2002 Purchase Plan by an additional 2,000,000 shares to 3,500,000 shares. In June 2006, Harmonic’s stockholders approved an amendment to the 2002 Purchase Plan to increase the maximum number of shares of common stock available for issuance under the 2002 Purchase Plan by an additional 2,000,000 shares and reduce the term of future offering periods to six months. The 2002 Purchase Plan enables employees to purchase shares at 85% of the fair market value of the Common Stock at the beginning of the offering period or end of the purchase period, whichever is lower. Prior to the approval of the June 2006 amendment, each offering period had a maximum duration of two years and consisted of four six-month purchase periods. Offering periods and purchase periods generally began on the first trading day on or after January 1 and July 1 of each year. The 2002 Purchase Plan is intended to qualify as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code. During the first six months of 2006 and the years 2005 and 2004, the number of shares of stock issued under the purchase plans were 411,324, 705,171 and 774,683 shares at weighted average prices of $4.18, $5.05 and $2.32, respectively. The weighted-average fair value of each right to purchase shares of common stock granted under the purchase plans were $1.70, $1.82 and $2.68 for the first six months of 2006 and the years 2005 and 2004, respectively. At June 30, 2006, there were 2,884,017 shares reserved for future issuances under the 2002 Purchase Plan.

Retirement/Savings Plan. Harmonic has a retirement/savings plan which qualifies as a thrift plan under Section 401(k) of the Internal Revenue Code. This plan allows participants to contribute up to 20% of total compensation, subject to applicable Internal Revenue Service limitations. Harmonic makes discretionary contributions to the plan of 25% of the first 4% contributed by eligible participants up to a maximum contribution per participant of $750 per year. This amount has been increased to $1,000 effective January 1, 2006. Such amounts totaled $0.1 million and $0.2 million in the first three and six months of 2006, respectively.

Stock-based Compensation

The following table summarizes the impact of options from SFAS 123(R) on stock-based compensation costs for employees on our Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2006 and July 1, 2005:

		Three Months Ended				Six Months Ended
(In thousands)		June 30, 2006				June 30, 2006
Employee stock-based compensation in:
Cost of sales		$	268			$	542
Research and development expense			451				973
Sales, general and administrative expense			783				1,613
Total employee stock-based compensation in operating expense			1,234				2,586
Total employee stock-based compensation			1,502				3,128
Amount capitalized in inventory			38				38
Total other stock-based compensation (1)			1				2
Total stock-based compensation		$	1,541			$	3,168

As of June 30, 2006, total unamortized stock-based compensation cost related to unvested stock options was $7.6 million, with the weighted average recognition period of 1.5 years.

The table below reflects net income (loss) and net income (loss) per share for the three and six months ended June 30, 2006, compared with pro forma information for the three and six months ended July 1, 2005 (in thousands, except per share amounts):

		Three Months Ended								Six Months Ended
		June 30, 2006				July 1, 2005				June 30, 2006				July 1, 2005
						(pro forma)								(pro forma)
Net income (loss), before stock-based compensation for employees, prior period			N/A			$	(2,530	)			N/A			$	(824	)
Less: Stock-based compensation expense previously determined under fair value based method, net of related tax effects		$	(1,502	)			(1,964	)		$	(3,128	)			(4,146	)
Net loss, after effect of stock-based compensation for employees		$	(2,903	)		$	(4,494	)		$	(8,051	)		$	(4,970	)
Net income (loss) per share:
Basic – as reported for prior period			N/A			$	(0.03	)			N/A			$	(0.01	)
Basic – after effect of stock-based compensation for employees		$	(0.04	)		$	(0.06	)		$	(0.11	)		$	(0.07	)
Diluted – as reported for prior period			N/A			$	(0.03	)			N/A			$	(0.01	)
Diluted – after effect of stock-based compensation for employees		$	(0.04	)		$	(0.06	)		$	(0.11	)		$	(0.07	)

The fair value of each option grant is estimated on the date of grant using the Black-Scholes-Merton multiple option pricing model with the following weighted average assumptions:

		Employee Stock Options
		Three Months Ended								Six Months Ended
		June 30, 2006				July 1, 2005				June 30, 2006				July 1, 2005
Expected life (years)			4.75				3.7				4.75				3.7
Volatility			72	%			96	%			76	%			96	%
Risk-free interest rate			4.9	%			3.8	%			4.6	%			3.8	%
Dividend yield			0.0	%			0.0	%			0.0	%			0.0	%

		Employee Stock Purchase Plan
		Three Months Ended								Six Months Ended
		June 30, 2006				July 1, 2005				June 30, 2006				July 1, 2005
Expected life (years)			0.8				0.8				0.8				0.8
Volatility			69	%			69	%			69	%			69	%
Risk-free interest rate			3.7	%			3.7	%			3.7	%			3.7	%
Dividend yield			0.0	%			0.0	%			0.0	%			0.0	%

The expected term for employee stock options and the ESPP represents the weighted-average period that the stock options are expected to remain outstanding. We derived the expected term using the SAB 107 simplified method. As alternative sources of data become available in order to determine the expected term we will incorporate these data into our assumption.

We use the historical volatility over the expected term of the options and the ESPP offering period to estimate the expected volatility. We believe that the historical volatility, at this time, represents fairly the future volatility of its common stock. We will continue to monitor relevant information to measure expected volatility for future option grants and ESPP offering periods.

The risk-free interest rate assumption is based upon observed interest rates appropriate for the term of our employee stock options. The dividend yield assumption is based on our history and expectation of dividend payouts.

Note 11: Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders for the period by the weighted average number of the common shares outstanding during the period. The diluted net loss per share is the same as basic net loss per share for the three and six months ended June 30, 2006 because potential common shares, such as common shares issuable upon the exercise of stock options, are only considered when their effect would be dilutive. During the three and six months ended June 30, 2006, 9.9 million and 10.8 million, respectively, of potentially dilutive shares, consisting of options, were excluded from the net income (loss) per share computations, because their effect was antidilutive. During the three and six months ended July 1, 2005, 9.8 million and 10.3 million, respectively, of potentially dilutive shares, consisting of options, were excluded from the net income (loss) per share computations, because their effect was antidilutive.

Following is a reconciliation of the numerators and denominators of the basic and diluted net loss per share computations (in thousands, except per share data):

		Three Months Ended								Six Months Ended
		June 30, 2006				July 1, 2005				June 30, 2006				July 1, 2005
Net income (loss) (numerator)		$	(2,903	)		$	(2,530	)		$	(8,051	)		$	(824	)
Shares calculation (denominator):
Weighted average shares outstanding — basic			74,167				73,112				74,134				72,976
Effect of dilutive securities:
Potential common stock relating to stock options			—				—				—				—
Average shares outstanding — diluted			74,167				73,112				74,134				72,976
Net income (loss) per share — basic		$	(0.04	)		$	(0.03	)		$	(0.11	)		$	(0.01	)
Net income (loss) per share — diluted		$	(0.04	)		$	(0.03	)		$	(0.11	)		$	(0.01	)

Note 12: Comprehensive Income (Loss)

The Company’s total comprehensive income (loss) was as follows (in thousands):

		Three Months Ended								Six Months Ended
		June 30, 2006				July 1, 2005				June 30, 2006				July 1, 2005
Net income (loss)		$	(2,903	)		$	(2,530	)		$	(8,051	)		$	(824	)
Change in unrealized gain (loss) on investments, net			44				83				91				(11	)
Foreign currency translation			81				104				106				123
Total comprehensive income (loss)		$	(2,778	)		$	(2,343	)		$	(7,854	)		$	(712	)

Note 13: Segment Information

Operating segments are defined as components of an enterprise that engage in business activities for which separate financial information is available and evaluated by the chief operating decision maker. Previously, the Company was organized into two operating segments: BAN, for fiber optic systems, and CS, for digital headend systems. Each segment had its own management team directing its product development, marketing strategies and its customer service requirements. A separate sales force generally supported both segments with appropriate product and market specialization as required.

The Company restructured its CS and BAN segments into one consolidated group in the fourth quarter of 2005 and effective as of January 1, 2006 no longer has two operating segments. The restructuring involved merging the manufacturing operations, research and development, and marketing departments into one segment.

Geographic Information (in thousands):

		Three Months Ended								Six Months Ended
		June 30, 2006				July 1, 2005				June 30, 2006				July 1, 2005
Net sales:
United States		$	26,949			$	35,196			$	52,602			$	81,570
International			26,321				24,566				56,889				51,108
Total		$	53,270			$	59,762			$	109,491			$	132,678

Note 14: Related Party

A director of Harmonic is also a director of Terayon Communications, with whom the Company purchases products for resale. Product purchases from Terayon were approximately $0.9 million and $1.6 million, for the three and six months ended June 30, 2006, respectively. Product purchases from Terayon were approximately $7.2 million and $17.0 million, for the three and six months ended July 1, 2005, respectively. As of June 30, 2006 and December 31, 2005, Harmonic had liabilities to Terayon of approximately $0.4 million and $0.7 million, respectively, for inventory purchases.

Note 15: Guarantees

Warranties. The Company accrues for estimated warranty costs at the time of product shipment. Management periodically reviews the estimated fair value of its warranty liability and adjusts based on the terms of warranties provided to customers, historical and anticipated warranty claims experience, and estimates of the timing and cost of specified warranty claims. Activity for the Company’s warranty accrual, which is included in accrued liabilities is summarized below (in thousands):

		Three Months Ended								Six Months Ended
		June 30, 2006				July 1, 2005				June 30, 2006				July 1, 2005
Balance at beginning of the period		$	6,058			$	5,608			$	6,166			$	5,429
Accrual for warranties			979				1,125				2,021				2,525
Warranty costs incurred			(1,019	)			(1,308	)			(2,169	)			(2,550	)
BTL acquisition			—				—				—				21
Balance at end of the period		$	6,018			$	5,425			$	6,018			$	5,425

Standby Letters of Credit. As of June 30, 2006 the Company’s financial guarantees consisted of standby letters of credit outstanding, which were principally related to customs bond requirements, performance bonds and state requirements imposed on employers. The maximum amount of potential future payments under these arrangements was $1.0 million.

Indemnification Obligations. Harmonic is obligated to indemnify its officers and the members of its Board of Directors pursuant to its bylaws and contractual indemnity agreements. Harmonic also indemnifies some of its suppliers and customers for specified intellectual property matters pursuant to certain contractual arrangements, subject to certain limitations. The scope of these indemnities varies, but in some instances, includes indemnification for damages and expenses (including reasonable attorneys’ fees). There have been no claims against us for indemnification pursuant to any of these arrangements and, accordingly, no amounts have been accrued in respect of the indemnifications provisions through June 30, 2006.

Guarantees. As of June 30, 2006, Harmonic had no other guarantees outstanding.

Note 16: Legal Proceedings

Between June 28 and August 25, 2000, several actions alleging violations of the federal securities laws by Harmonic and certain of its officers and directors (some of whom are no longer with Harmonic) were filed in or removed to the United States District Court (the “District Court”) for the Northern District of California. The actions subsequently were consolidated.

A consolidated complaint, filed on December 7, 2000, was brought on behalf of a purported class of persons who purchased Harmonic’s publicly traded securities between January 19 and June 26, 2000. The complaint also alleged claims on behalf of a purported subclass of persons who purchased C-Cube securities between January 19 and May 3, 2000. In addition to Harmonic and certain of its officers and directors, the complaint also named C-Cube Microsystems Inc. and several of its officers and directors as defendants. The complaint alleged that, by making false or misleading statements regarding Harmonic’s prospects and customers and its acquisition of C-Cube, certain defendants violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”). The complaint also alleged that certain defendants violated section 14(a) of the Exchange Act and sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”) by filing a false or misleading registration statement, prospectus, and joint proxy in connection with the C-Cube acquisition.

On July 3, 2001, the District Court dismissed the consolidated complaint with leave to amend. An amended complaint alleging the same claims against the same defendants was filed on August 13, 2001. Defendants moved to dismiss the amended complaint on September 24, 2001. On November 13, 2002, the District Court issued an opinion granting the motions to dismiss the amended complaint without leave to amend. Judgment for defendants was entered on December 2, 2002. On December 12, 2002, plaintiffs filed a motion to amend the judgment and for leave to file an amended complaint pursuant to Rules 59(e) and 15(a) of the Federal Rules of Civil Procedure. On June 6, 2003, the District Court denied plaintiffs’ motion to amend the judgment and for leave to file an amended complaint. Plaintiffs filed a notice of appeal on July 1, 2003. The appeal was heard by a panel of three judges of the United States Court of Appeals for the Ninth Circuit (the “Ninth Circuit”) on February 17, 2005.

On November 8, 2005, the Ninth Circuit panel affirmed in part, reversed in part, and remanded for further proceedings the decision of the District Court. The Ninth Circuit affirmed the District Court’s dismissal of the

plaintiffs’ fraud claims under Sections 10(b), 14(a), and 20(a) of the Exchange Act with prejudice, finding that the plaintiffs failed to adequately plead their allegations of fraud. The Ninth Circuit reversed the District Court’s dismissal of the plaintiffs’ claims under Sections 11 and 12(a)(2) of the Securities Act, however, finding that those claims did not allege fraud and therefore were subject to only minimal pleading standards. Regarding the secondary liability claim under Section 15 of the Securities Act, the Ninth Circuit reversed the dismissal of that claim against Anthony J. Ley, Harmonic’s Chairman and Chief Executive Officer, and affirmed the dismissal of that claim against Harmonic, while granting leave to amend. The Ninth Circuit remanded the surviving claims to the District Court for further proceedings.

On November 22, 2005, both the Harmonic defendants and the plaintiffs petitioned the Ninth Circuit for a rehearing of the appeal. On February 16, 2006 the Ninth Circuit denied both petitions. On May 17, 2006 the plaintiffs filed an amended complaint on the issues remanded for further proceedings by the Ninth Circuit, to which the Harmonic defendants responded on June 23, 2006 with a Motion to Dismiss. The plaintiffs’ opposition was filed on July 24, 2006, and the defendants are due to reply by August 11, 2006. There will be no hearing unless the Court requests one.

A derivative action purporting to be on behalf of Harmonic was filed against its then-current directors in the Superior Court for the County of Santa Clara on September 5, 2000. Harmonic also was named as a nominal defendant. The complaint is based on allegations similar to those found in the securities class action and claims that the defendants breached their fiduciary duties by, among other things, causing Harmonic to violate federal securities laws. The derivative action was removed to the United States District Court for the Northern District of California on September 20, 2000. All deadlines in this action were stayed pending resolution of the motions to dismiss the securities class action. On July 29, 2003, the Court approved the parties’ stipulation to dismiss this derivative action without prejudice and to toll the applicable limitations period pending the Ninth Circuit’s decision in the securities action. Pursuant to the stipulation, defendants have provided plaintiff with a copy of the mandate issued by the Ninth Circuit in the securities action.

A second derivative action purporting to be on behalf of Harmonic was filed in the Superior Court for the County of Santa Clara on May 15, 2003. It alleges facts similar to those previously alleged in the securities class action and the federal derivative action. The complaint names as defendants former and current Harmonic officers and directors, along with former officers and directors of C-Cube Microsystems, Inc., who were named in the securities class action. The complaint also names Harmonic as a nominal defendant. The complaint alleges claims for abuse of control, gross mismanagement, and waste of corporate assets against the Harmonic defendants, and claims for breach of fiduciary duty, unjust enrichment, and negligent misrepresentation against all defendants. On July 22, 2003, the Court approved the parties’ stipulation to stay the case pending resolution of the appeal in the securities class action. Following the decision of the Ninth Circuit discussed above, on May 9, 2006, defendants filed demurrers to this complaint. The plaintiffs then filed an amended complaint on July 10, 2006, which names only the Harmonic defendants. A schedule for briefing and a hearing on the amended complaint has been established through November 2006. On July 11, 2006, the plaintiffs served requests for discovery, to which the defendants’ responses are due by August 15, 2006.

Based on its review of the surviving claims in the securities class actions, Harmonic believes that it has meritorious defenses and intends to defend itself vigorously. There can be no assurance, however, that Harmonic will prevail. No estimate can be made of the possible range of loss associated with the resolution of this contingency, and accordingly, Harmonic has not recorded a liability. An unfavorable outcome of this litigation could have a material adverse effect on Harmonic’s business, operating results, financial position or cash flows.

On July 3, 2003, Stanford University and Litton Systems filed a complaint in U.S. District Court for the Central District of California alleging that optical fiber amplifiers incorporated into certain of Harmonic’s products infringe U.S. Patent No. 4859016. This patent expired in September 2003. The complaint seeks injunctive relief, royalties and damages. Harmonic has not been served in the case. At this time, we are unable to determine whether we will be able to settle this litigation on reasonable terms or at all, nor can we predict the impact of an adverse outcome of this litigation if we elect to defend against it. No estimate can be made of the possible range of loss associated with the resolution of this contingency and accordingly, we have not recorded a liability associated with the outcome of a negotiated settlement or an unfavorable verdict in litigation. An unfavorable outcome of this matter could have a material adverse effect on Harmonic’s business, operating results, financial position or cash flows.

Harmonic is involved in other litigation and may be subject to claims arising in the normal course of business. In the opinion of management the amount of ultimate liability with respect to these matters in the aggregate will not have a material adverse effect on the Company or its operating results, financial position or cash flows.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations of continued customer concentration; our expectations regarding future sales for a major telecommunications operator; our expectations that sales to cable television, satellite and telecommunications operators will constitute a significant portion of net sales for the foreseeable future; our expectation that international sales will continue to account for a significant portion of our net sales for the foreseeable future; our expectation that our facilities rationalization plan will result in a significant charge for excess facilities in the third quarter of 2006; our expectations regarding our capital expenditures during the remainder of 2006; our expectation that we will not receive any tax benefits in fiscal 2006 for any expense deductions resulting from expensing of stock options or shares issued under our ESPP; our expectations regarding the amount of amortization expense we will incur during the remainder of 2006; our expectation that near-term changes in foreign exchange rates will not have a material impact on our operating results, financial position and liquidity; our belief that any ultimate liability of Harmonic with respect to certain litigation arising in the normal course of business will not, in the aggregate, have a material adverse effect on us or our operating results, financial position or cash flows; our belief that our existing liquidity sources will satisfy our cash requirement for at least the next 12 months; and our expectation that operating results are likely to fluctuate in the future. These statements involve risks and uncertainties as well as assumptions that, if they were to never materialize or prove incorrect, could cause actual results to differ materially from those projected, expressed or implied in the forward-looking statements. These risks and uncertainties include those set forth under “Risk Factors” below and elsewhere in this Quarterly Report on Form 10-Q and that are otherwise described from time to time in Harmonic’s filings with the Securities and Exchange Commission.

Overview

Harmonic designs, manufactures and sells products for video processing and edge and access applications. In addition, we provide network management software and have recently introduced new application software products. Harmonic also provides technical support services to its customers worldwide. Our video processing products provide broadband operators with the ability to accept a variety of signals from different sources, in different protocols, and to organize, manage and distribute this content to maximize use of the available bandwidth. Our edge products enable operators to deliver customized broadcast or narrowcast on-demand services to their subscribers, and our access products, which consist mainly of optical transmission products, node platforms and return path products, allow operators to deliver video, data and voice services over their physical networks.

These products and services enable network operators to provide a range of interactive and advanced digital services that include digital video, video-on-demand (VOD), high-definition television (HDTV), high-speed Internet access and telephony. They enable our customers to process video for distribution over cable, satellite, telephone and wireless networks. We also provide fiber optic transmission systems to cable television operators and to certain telephone companies that offer video services to their customers.

The sequential increases in net sales in 2005 and 2004 that Harmonic experienced reflected an improved industry capital spending environment worldwide which favorably impacted us. We believe that this improvement in the industry capital spending environment was, in part, a result of the intensifying competition between cable and satellite operators to offer more channels of digital video and new services, such as VOD and HDTV, and in part the result of the entry of telephone companies into the business of delivering video services to their subscribers. We also believe that the improvement was due to more favorable conditions in industry capital markets and the completion or resolution of certain major business combinations, financial restructurings and regulatory issues.

In the second quarter and first six months of 2006, Harmonic’s net sales decreased 11% and 17% compared to the second quarter and first six months of 2005, respectively. We believe that the decrease in sales in the second quarter

of 2006 compared to 2005 was primarily due to supply chain constraints on certain product lines and the timing of completion of certain projects for our international telco customers. The decrease in net sales in the first six months of 2006 compared to the first six months of 2005 was also attributable to weaker spending by domestic cable customers, the significant amount of third party products sold to our end customers in the first six months of 2005, as well as the supply chain constraints and delays in the completion of projects for our international telco customers. Our quarterly and annual results may fluctuate significantly due to spending by our customers, our revenue recognition policies and the timing of the receipt of orders, as well as other factors, including those set forth in the section entitled “Risk Factors” in this Quarterly Report on Form 10-Q.

Harmonic often recognizes a significant portion, or the majority, of its revenues in the last month of the quarter. Harmonic establishes its expenditure levels for product development and other operating expenses based on projected sales levels, and expenses are relatively fixed in the short term. Accordingly, variations in timing of sales can cause significant fluctuations in operating results. In addition, because a significant portion of Harmonic’s business is derived from orders placed by a limited number of large customers, the timing of such orders can also cause significant fluctuations in our operating results. Harmonic’s expenses for any given quarter are typically based on expected sales and if sales are below expectations, our operating results may be adversely impacted by our inability to adjust spending to compensate for the shortfall.

Historically, a majority of our net sales have been to relatively few customers, and due in part to the consolidation of ownership of cable television and direct broadcast satellite systems, we expect this customer concentration to continue for the foreseeable future. In the second quarter of 2006, sales to Cox Communications accounted for 13% of net sales and in the second quarter of 2005, sales to Comcast accounted for 19% of net sales. In the first six months of 2006, no customer had sales that accounted for more than 10% of net sales, and in the first six months of 2005, sales to Comcast and Charter Communications accounted for 28% and 10% of net sales, respectively.

Sales to customers outside of the U.S. in the second quarter and first six months of 2006 represented 49% and 52% of net sales, respectively, compared to 41% and 39% for the comparable periods in 2005. A significant portion of international sales are made to distributors and system integrators, which are generally responsible for importing the products and providing installation and technical support and service to customers within their territory. Sales denominated in foreign currencies were approximately 5% of net sales in the first six months of 2006 compared to 6% for the comparable period of 2005. We expect international sales to continue to account for a significant portion of our net sales for the foreseeable future.

In May 2006, the Company’s Board of Directors appointed Patrick J. Harshman as President and Chief Executive Officer, replacing Anthony Ley, who retired after 18 years. Mr. Ley carries on as a consultant to the Company and as chairman of its Board of Directors. Following Dr. Harshman’s appointment, the Company announced a reorganization of its senior management, resulting in a charge of approximately $1 million in severance costs in the second quarter of 2006. In addition to our management reorganization plan, in the third quarter of 2006, the Company is executing on a facilities rationalization plan to make more efficient use of our Sunnyvale campus and expects to vacate additional space. We expect that this will result in a significant charge for excess facilities in the third quarter of 2006.

In the fourth quarter of 2005, Harmonic announced a restructuring that combined our product development, marketing and manufacturing operations and resulted in the BAN and CS operating segments being combined into a single segment, effective January 1, 2006. In connection with this restructuring, Harmonic reduced its workforce by approximately 40 employees and recorded an expense of $1.1 million for severance costs related to the restructuring.

In the fourth quarter of 2005, the excess facilities liability was decreased by $1.1 million due to subleasing a portion of the unoccupied portion of one building for the remainder of the lease. Although we entered into new subleases for approximately 60,000 square feet of space in 2004 and approximately 30,000 square feet of space in 2005, in the event we are unable to achieve expected levels of sublease rental income, we will need to revise our estimate of the liability, which could materially impact our financial position, liquidity, cash flows and results of operations.

On February 25, 2005, Harmonic purchased all of the issued and outstanding shares of Broadcast Technology Ltd., a private UK company, for a total purchase consideration of £4.0 million, or approximately $7.6 million. The purchase

consideration consisted of a payment of £3.0 million in cash and the issuance of 169,112 shares of Harmonic common stock. Broadcast Technology Ltd. develops, manufactures and distributes professional video/ audio receivers and decoders and had 42 employees at the time of the acquisition.

Critical Accounting Policies, Judgments and Estimates

The preparation of financial statements and related disclosures requires Harmonic to make judgments, assumptions and estimates that affect the reported amounts of assets and liabilities, the disclosure of contingencies and the reported amounts of revenue and expenses in the financial statements and accompanying notes. Material differences may result in the amount and timing of revenue and expenses if different judgments or different estimates were made.

Our significant accounting policies are described in Note 1 to the annual consolidated financial statements as of and for the year ended December 31, 2005, included in our Annual Report on Form 10-K filed with the SEC on March 14, 2006 and notes to condensed consolidated financial statements as of and for the three and six month period ended June 30, 2006, included herein. Our most critical accounting policies include the following:

§		Revenue recognition;
§		Allowances for doubtful accounts, returns and discounts;
§		Valuation of inventories;
§		Impairment of long-lived assets;
§		Restructuring costs and accruals for excess facilities;
§		Assessment of the probability of the outcome of current litigation;
§		Accounting for income taxes; and
§		Stock-based compensation.

Since January 1, 2006, our accounting policy for stock-based compensation for employee stock-based awards was modified due to the adoption of SFAS 123(R) and is described below.

Stock-Based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment,” (“SFAS 123(R)”) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options and employee stock purchases related to our Employee Stock Purchase Plan (“ESPP”) based upon the grant-date fair value of those awards. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations, and provided the required pro forma disclosures prescribed by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS 123”) as amended. In addition, we have applied the provisions of Staff Accounting Bulletin No. 107 (“SAB 107”), issued by the Securities and Exchange Commission, in our adoption of SFAS No. 123(R).

The Company adopted SFAS 123(R) using the modified-prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Condensed Consolidated Financial Statements as of and for the three and six months ended June 30, 2006 reflects the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s Condensed Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the three and six months ended June 30, 2006 was $1.5 million and $3.1 million, respectively, which consisted of stock-

based compensation expense related to employee equity awards and employee stock purchases. There was no stock-based compensation expense related to employee equity awards and employee stock purchases recognized during the three and six months ended July 1, 2005.

SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period in the Company’s Condensed Consolidated Statement of Operations. Prior to the adoption of SFAS 123(R), the Company accounted for employee equity awards and employee stock purchases using the intrinsic value method in accordance with APB 25 as allowed under SFAS 123. Under the intrinsic value method, no stock-based compensation expense had been recognized in the Company’s Condensed Consolidated Statement of Operations because the exercise price of the Company’s stock options granted to employees and directors equaled the fair market value of the underlying stock at the date of grant.

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s Condensed Consolidated Statement of Operations for the three and six months ended June 30, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). In conjunction with the adoption of SFAS 123(R), the Company changed its method of attributing the value of stock-based compensation costs to expense from the accelerated multiple-option method to the straight-line single-option method. Compensation expense for all share-based payment awards granted on or prior to December 31, 2005 will continue to be recognized using the accelerated approach while compensation expense for all share-based payment awards related to stock options and employee stock purchase rights granted subsequent to December 31, 2005 are recognized using the straight-line method.

As stock-based compensation expense recognized in our results for the second quarter and the first six months of fiscal year 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to fiscal year 2006, we accounted for forfeitures as they occurred for the purposes of pro forma information under SFAS 123, as disclosed in our Notes to Consolidated Financial Statements for the related periods.

The fair value of share-based payment awards is estimated at grant date using a Black-Scholes-Merton option pricing model. The Company’s determination of fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price as well as the assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.

Harmonic currently does not expect to receive any tax benefits in fiscal 2006 for any expense deductions resulting from expensing of stock options or shares issued under its ESPP. On November 10, 2005 the FASB issued FASB Staff Position No. FSP FAS 123(R)-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. Harmonic currently provides a valuation allowance for most of its deferred tax assets, and a valuation allowance has also been provided for deferred tax assets related to nonqualified stock options.

Also see Note 10 to the Condensed Consolidated Financial Statements on Stock-Based Compensation.

Results of Operations

Harmonic’s historical consolidated statements of operations data for the second quarter and first six months of 2006 and 2005 as a percentage of net sales, are as follows:

		Three Months Ended								Six Months Ended
		June 30,				July 1,				June 30,				July 1,
		2006				2005				2006				2005
Net sales			100	%			100	%			100	%			100	%
Cost of sales			59				61				62				62
Gross profit			41				39				38				38
Operating expenses:
Research and development			18				16				18				14
Selling, general and administrative			30				28				29				24
Amortization of intangibles			—				—				—				1
Total operating expenses			48				44				47				39
Loss from operations			(7	)			(5	)			(9	)			(1	)
Interest income, net			2				1				2				1
Other income (expense), net			—				—				—				—
Loss before income taxes			(5	)			(4	)			(7	)			(1	)
Provision for (benefit from) income taxes			—				—				—				—
Net loss			(5	)%			(4	)%			(7	)%			(1	)%

Net Sales — Consolidated

Harmonic’s consolidated net sales in the second quarter and first six months of 2006 compared with the corresponding periods in 2005 are presented by product line in the table below. Also presented is the related dollar and percentage increase (decrease) in consolidated net sales in the second quarter and first six months of 2006 compared with the corresponding periods in 2005 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 30,				July 1,				June 30,				July 1,
Product Sales Data:		2006				2005				2006				2005
Video Processing		$	20,563			$	30,678			$	40,248			$	74,409
Edge and Access			23,434				20,295				51,886				41,535
Software, Support and Other			9,273				8,789				17,357				16,734
Net sales		$	53,270			$	59,762			$	109,491			$	132,678
Video Processing decrease		$	(10,115	)						$	(34,161	)
Edge and Access increase			3,139								10,351
Software, Support and Other increase			484								623
Total decrease		$	(6,492	)						$	(23,187	)
Video Processing percent change			(33.0	)%							(45.9	)%
Edge and Access percent change			15.5	%							24.9	%
Software, Support and Other percent change			5.5	%							3.7	%
Total percent change			(10.9	)%							(17.5	)%

Net sales decreased in the second quarter of 2006 compared to the same period of 2005 principally due to supply chain constraints, which resulted in product shortages, and delays in the completion of certain international telco customer projects. In the video processing product lines, delays in the completion of certain projects underway for our international telco customers resulted in less revenue being recognized along with product shortages. The edge and access products line experienced an increase in revenue in the second quarter of 2006 compared to the second quarter of 2005 as telcos and a major North American multiple system operator continued to introduce and expand video and other services, primarily in the U.S. and European markets. Third party product sales decreased by approximately $2.7 million in the second quarter of 2006, compared to the corresponding period in 2005.

Net sales decreased in the first six months of 2006 compared to the same period of 2005 principally due to weaker spending by domestic cable customers for major digital headend projects, supply chain constraints resulting in product shortages, delays in the completion of certain projects for international telco customers and the decrease in

the sale of third party products to our end customers. In the video processing product line, encoder and stream processing sales decreased by approximately $22.3 million in the first six months of 2006 compared to the same period in the prior year due to lower spending for major digital headend projects by domestic cable companies. Delays in the completion of certain projects underway with our international telco customers resulted in less revenue being recognized. In addition, sales of third party products to end customers decreased by approximately $12.5 million in the first six months of 2006 compared to the same period in 2005. The edge and access products line, which includes VOD products, experienced a significant increase in revenue in the first six months of 2006 compared to the first six months of 2005 as telcos and other broadband operators continued to introduce and expand video and other services, primarily in the U.S. and European markets.

Net Sales — Geographic

Harmonic’s domestic and international net sales in the second quarter and first six months of 2006 compared with the corresponding periods in 2005 are presented in the table below. Also presented is the related dollar and percentage increase (decrease) in domestic and international net sales in the second quarter and first six months of 2006 compared with the corresponding periods in 2005 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 30,				July 1,				June 30,				July 1,
Geographic Sales Data:		2006				2005				2006				2005
U.S		$	26,949			$	35,197			$	52,602			$	81,571
International			26,321				24,565				56,889				51,107
Net sales		$	53,270			$	59,762			$	109,491			$	132,678
U.S. decrease		$	(8,248	)						$	(28,969	)
International increase			1,756								5,782
Total decrease		$	(6,492	)						$	(23,187	)
U.S. percent change			(23.4	)%							(35.5	)%
International percent change			7.1	%							11.3	%
Total percent change			(10.9	)%							(17.5	)%

The decreased U.S. sales in the second quarter and the first six months of 2006 compared to the corresponding periods in 2005 was principally due to supply chain constraints, which resulted in product shortages, fewer sales of third party products to end customers and weaker spending by domestic cable customers for major digital headend projects.

International sales in the second quarter and the first six months of 2006 increased significantly compared to the corresponding periods in 2005 primarily due to sales to telcos in the European market. The increased international sales in the second quarter of 2006 as compared to the same period of 2005, was also due to increased international capital spending by customers primarily in Europe and Asia. As a result of these factors, we expect that international sales will continue to account for a significant portion of our net sales for the foreseeable future.

Gross Profit

Harmonic’s gross profit and gross profit as a percentage of consolidated net sales in the second quarter and first six months of 2006 as compared with the corresponding prior year periods of 2005 are presented in the tables below. Also presented is the related dollar and percentage decrease in gross profit in the second quarter and first six months of 2006 as compared with the corresponding periods of 2005 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 30,				July 1,				June 30,				July 1,
		2006				2005				2006				2005
Gross profit		$	21,606			$	23,397			$	41,486			$	50,445
As a % of net sales			40.6	%			39.2	%			37.9	%			38.0	%
Decrease		$	(1,791	)						$	(8,959	)
Percent change			(7.7	)%							(17.8	)%

The decrease in gross profit in the second quarter and the first six months of 2006 as compared to the corresponding periods of 2005 was primarily due to lower sales and the recording of stock-based compensation expense. The gross margin percentage of 40.6% in the second quarter of 2006 compared to 39.2% in the second quarter of 2005 was higher primarily due to a higher proportion of digital video and service revenue, which carry higher gross margins than the average gross margins for our products, and lower sales of third party products to our end customers compared to the second quarter of 2005, sales of which products have significantly lower gross margins than the average gross margin in sales of our products.

In the first six months of 2006, $0.3 million of amortization of intangibles was included in cost of sales compared to $0.9 million in the first six months of 2005. The lower amortization in the first six months of 2006 was due to certain intangibles arising from the BTL acquisition being fully amortized in the second quarter of 2006. We expect to record approximately $0.3 million in amortization of intangibles in cost of sales in the remaining six months of 2006 due to the acquisition of BTL in February 2005.

Research and Development

Harmonic’s research and development expense and the expense as a percentage of consolidated net sales in the second quarter and first six months of 2006, as compared with the corresponding periods of 2005, are presented in the table below. Also presented is the related dollar and percentage increase in research and development expense in the second quarter and first six months of 2006 as compared with the corresponding periods of 2005 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 30,				July 1,				June 30,				July 1,
		2006				2005				2006				2005
Research and development expense		$	9,585			$	9,519			$	19,533			$	18,977
As a % of net sales			18.0	%			15.9	%			17.8	%			14.3	%
Increase		$	66							$	556
Percent change			0.7	%							2.9	%

The increase in research and development expense in the second quarter of 2006 as compared to the same period in 2005 was primarily the result of increased use of outside consulting services of $0.4 million associated with the development of new products and stock-based compensation expense of $0.5 million, which was partially offset by lower prototype materials expense of $0.4 million and lower compensation expense of $0.3 million from reductions in headcount and incentive compensation. The increase in research and development expense in the first six months of 2006 as compared to the same period in 2005 was primarily the result of increased use of outside consulting services of $0.9 million associated with the development of new products and stock-based compensation expense of $1.0 million, which was partially offset by lower prototype materials expense of $0.3 million and lower compensation expense of $1.0 million from reductions in headcount and incentive compensation.

Selling, General and Administrative

Harmonic’s selling, general and administrative expense and the expense as a percentage of consolidated net sales in the second quarter and first six months of 2006, as compared with the corresponding periods of 2005, are presented in the table below. Also presented is the related dollar and percentage decrease in selling, general and administrative expense in the second quarter and first six months of 2006 as compared with the corresponding periods of 2005 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 30,				July 1,				June 30,				July 1,
		2006				2005				2006				2005
Selling, general and administrative expense		$	15,979			$	16,611			$	31,692			$	31,937
As a % of net sales			30.0	%			27.8	%			28.9	%			24.1	%
Decrease		$	(632	)						$	(245	)
Percent change			(3.8	)%							(0.8	)%

The decrease in selling, general and administrative expense in the second quarter of 2006 compared to the same period in 2005 was primarily the result of lower compensation expenses of $0.5 million, lower trade show expenses of $0.4 million and lower travel expenses of $0.2 million, which was partially offset by stock-based compensation expense of $0.8 million. The decrease in selling, general and administrative expense in the first six months of 2006 compared to the same period in 2005 was primarily a result of lower compensation expenses of $0.8 million, lower trade show expenses of $0.5 million and lower corporate governance costs of $0.4 million, which were substantially offset by higher stock-based compensation expense of $1.6 million.

Amortization of Intangibles

Harmonic’s amortization of intangible assets and the expense as a percentage of consolidated net sales in the second quarter and first six months of 2006 as compared with the corresponding periods of 2005 are presented in the table below. Also presented is the related dollar and percentage decrease in amortization of intangible assets in the second quarter and first six months of 2006 as compared with the corresponding periods of 2005 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 30,				July 1,				June 30,				July 1,
		2006				2005				2006				2005
Amortization of intangibles		$	43			$	165			$	135			$	1,123
As a % of net sales			0.1	%			0.3	%			0.1	%			0.8	%
Decrease		$	(122	)						$	(988	)
Percent change			(73.9	)%							(88.0	)%

The decrease in the amortization of intangibles in the second quarter of 2006 compared to the same period in 2005 was primarily due to the completion of amortization of certain items acquired in connection with the BTL transaction during the second quarter of 2006. The decrease in the amortization of intangibles in the first six months of 2006 compared to the same period in 2005 was primarily due to the completion of amortization of the DiviCom intangible assets during the first six months of 2005. Harmonic expects to record a total of approximately $0.1 million in amortization of intangibles in operating expenses in the remaining six months of 2006 due to the intangible assets resulting from the acquisition of BTL in February 2005.

Interest Income, Net

Harmonic’s interest income, net, and interest income, net, as a percentage of consolidated net sales in the second quarter and first six months of 2006 as compared with the corresponding periods of 2005, are presented in the table below. Also presented is the related dollar and percentage increase in interest income, net, in the second quarter and first six months of 2006 as compared with the corresponding periods of 2005 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 30,				July 1,				June 30,				July 1,
		2006				2005				2006				2005
Interest income, net		$	1,175			$	636			$	2,167			$	1,157
As a % of net sales			2.2	%			1.1	%			2.0	%			0.9	%
Increase		$	539							$	1,010
Percent change			84.7	%							87.3	%