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 29, 2007

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 organization)		(I.R.S. Employer Identification Number)

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).

The number of shares outstanding of the Registrant’s Common Stock, $.001 par value, was 79,765,014 on July 27, 2007.

 

 

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 29, 2007				December 31, 2006
ASSETS
Current assets:
Cash and cash equivalents		$	21,421			$	33,454
Short-term investments			60,798				58,917
Accounts receivable, net of allowances of $4,791 and $4,471			62,476				64,674
Inventories			42,508				42,116
Prepaid expenses and other current assets			16,387				12,807
Total current assets			203,590				211,968
Property and equipment, net			14,011				14,816
Goodwill			37,204				37,141
Intangibles, net			14,483				16,634
Other assets			1,415				1,403
Total assets		$	270,703			$	281,962
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt		$	—			$	460
Accounts payable			16,716				33,863
Income taxes payable			480				7,098
Deferred revenue			28,844				29,052
Accrued liabilities			37,756				44,097
Total current liabilities			83,796				114,570
Accrued excess facilities costs, long-term			13,403				16,434
Income taxes payable, long-term			8,040				—
Other non-current liabilities			7,045				5,824
Total liabilities			112,284				136,828
Commitments and contingencies (Notes 15,16 and 17)
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; 79,410 and 78,386 shares issued and outstanding			79				78
Capital in excess of par value			2,086,992				2,078,863
Accumulated deficit			(1,928,442	)			(1,933,708	)
Accumulated other comprehensive loss			(210	)			(99	)
Total stockholders’ equity			158,419				145,134
Total liabilities and stockholders’ equity		$	270,703			$	281,962

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

HARMONIC INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

(In thousands, except per share amounts)		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Product sales		$	64,066			$	46,662			$	130,022			$	98,446
Service revenue			7,216				6,608				11,497				11,045
Net sales			71,282				53,270				141,519				109,491
Product cost of sales			37,501				29,061				78,417				63,242
Service cost of sales			3,216				2,603				5,385				4,763
Total cost of sales			40,717				31,664				83,802				68,005
Gross profit			30,565				21,606				57,717				41,486
Operating expenses:
Research and development			9,605				9,585				20,597				19,533
Selling, general and administrative			15,771				15,979				31,446				31,692
Amortization of intangibles			111				43				222				135
Total operating expenses			25,487				25,607				52,265				51,360
Income (loss) from operations			5,078				(4,001	)			5,452				(9,874	)
Interest income, net			990				1,175				1,986				2,167
Other expense, net			7				128				(16	)			36
Income (loss) before income taxes			6,075				(2,698	)			7,422				(7,671	)
Provision for (benefit from) income taxes			(174	)			205				57				380
Net income (loss)		$	6,249			$	(2,903	)		$	7,365			$	(8,051	)
Net income (loss) per share
Basic		$	0.08			$	(0.04	)		$	0.09			$	(0.11	)
Diluted		$	0.08			$	(0.04	)		$	0.09			$	(0.11	)
Weighted average shares
Basic			79,361				74,167				79,164				74,134
Diluted			80,480				74,167				80,304				74,134

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

HARMONIC INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

(In thousands)		Six Months Ended
		June 29,				June 30,
		2007				2006
Cash flows from operating activities:
Net income (loss)		$	7,365			$	(8,051	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Amortization of intangibles			2,151				458
Depreciation			3,347				3,993
Stock-based compensation			2,786				3,130
Net loss (gain) on disposal and impairment of fixed assets			(60	)			20
Changes in assets and liabilities, net of effect of acquisition:
Accounts receivable, net			2,172				7,630
Inventories			(383	)			7,564
Prepaid expenses and other assets			(3,706	)			(3,731	)
Accounts payable			(16,913	)			(3,129	)
Deferred revenue			1,622				(3,248	)
Income taxes payable			(664	)			319
Accrued excess facilities costs			(2,646	)			(2,335	)
Accrued and other liabilities			(5,054	)			698
Net cash provided by (used in) operating activities			(9,983	)			3,318
Cash flows from investing activities:
Purchases of investments			(53,843	)			(39,431	)
Proceeds from sales of investments			51,928				49,024
Acquisition of property and equipment			(2,482	)			(2,404	)
Acquisition costs related to the merger of Entone Technologies, Inc.			(2,466	)			—
Net cash provided by (used in) investing activities			(6,863	)			7,189
Cash flows from financing activities:
Proceeds from issuance of common stock, net			5,329				2,145
Repayments under bank line and term loan			(460	)			(418	)
Repayments of capital lease obligations			(43	)			(41	)
Net cash provided by financing activities			4,826				1,686
Effect of exchange rate changes on cash and cash equivalents			(13	)			(41	)
Net increase (decrease) in cash and cash equivalents			(12,033	)			12,152
Cash and cash equivalents at beginning of period			33,454				37,818
Cash and cash equivalents at end of period		$	21,421			$	49,970
Supplemental disclosure of cash flow information:
Income tax payments, net		$	768			$	138
Interest paid during the period		$	66			$	59

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

Basis of Presentation. The accompanying unaudited condensed consolidated financial statements include all adjustments (consisting only of normal recurring adjustments) which Harmonic Inc. (“Harmonic,” the “Company” or “we”) considers necessary for a fair presentation 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, which was filed with the Securities and Exchange Commission on March 15, 2007. 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, 2007, 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.

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 September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (SFAS No. 157). This statement clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We have not determined the effect, if any, the adoption of this statement in the first quarter of 2008 will have on our results of operations or financial position.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159 expands the use of fair value accounting but does not affect existing standards which require assets or liabilities to be carried at fair value. Under SFAS 159, a company may elect to use fair value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities, equity method investments, accounts payable, guarantees and issued debt. Other eligible items include firm commitments for financial instruments that otherwise would not be recognized at inception and non-cash warranty obligations where a warrantor is permitted to pay a third party to provide the warranty goods or services. If the use of fair value is elected, any upfront costs and fees related to the item must be recognized in earnings and cannot be deferred, e.g., debt issue costs. The fair value election is irrevocable and generally made on an instrument-by-instrument basis, even if a company has similar instruments that it elects not to measure based on fair value. At the adoption date, unrealized gains and losses on existing items for which fair value has been elected are reported as a cumulative adjustment to beginning retained earnings. Subsequent to the adoption of SFAS 159, changes in fair value are recognized in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by Harmonic in the first quarter of fiscal 2008. Harmonic currently is determining whether fair value accounting is appropriate for any of its eligible items and cannot estimate the impact, if any, which SFAS 159 will have on its consolidated results of operations and financial condition.

The Company adopted Financial Standards Accounting Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (FIN 48) on January 1, 2007. FIN 48 clarifies the

accounting and reporting for uncertainties in income tax law. FIN 48 prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. See Note 10 for additional information, including the effects of adoption on the Company’s condensed consolidated financial statements.

Note 3: Entone Acquisition

On December 8, 2006, Harmonic acquired Entone Technologies, Inc., or Entone, pursuant to the terms of an Agreement and Plan of Merger (the “Merger Agreement”) dated August 21, 2006. Under the terms of the merger agreement, Entone spun off its consumer premise equipment business, or CPE business, to Entone’s existing stockholders prior to closing. Entone then merged into Harmonic, and Harmonic acquired Entone’s VOD business, which includes the development, sale and support of head-end equipment (software and hardware) and associated services for the creation, distribution and delivery of on-demand television programming to operators who offer such programming to businesses and consumers. Harmonic believes Entone’s software solution, which facilitates the provisioning of personalized video services including video-on-demand, network personal video recording, time-shifted television and targeted advertisement insertion, will enable Harmonic to expand the scope of solutions we can offer to cable, satellite and telco/IPTV service providers in order to provide an advanced and uniquely integrated delivery system for the next generation of both broadcast and personalized IP-delivered video services. These opportunities, along with the established Asia-based software development workforce, were significant factors to the establishment of the purchase price, which exceeded the fair value of Entone’s net tangible and intangible assets acquired resulting in the amount of goodwill we have recorded with this transaction. Management has made a preliminary allocation of the estimated purchase price to the tangible and intangible assets acquired and liabilities assumed based on various preliminary estimates. The allocation of the estimated purchase price is preliminary pending finalization of various estimates and analyses.

The purchase price of $49.0 million included $26.2 million in cash, $20.1 million of stock issued, consisting of 3,579,715 shares of Harmonic common stock, $0.2 million in stock options assumed, and $2.5 million of transaction costs. Stock options to purchase Harmonic common stock totaling 175,342 shares were issued to reflect the conversion of all outstanding Entone options for continuing employees. The fair value of Harmonic’s stock options issued to Entone employees were valued at $925,000 using the Black-Scholes options pricing model of which $697,000 represented unearned stock-based compensation, which is being recorded as compensation expense as services are provided by optionholders, and $228,000 was recorded as purchase consideration. As part of the terms of the Merger Agreement, Harmonic was obligated to purchase a convertible note with a face amount of $2.5 million in the new spun off private company subject to closing of an initial round of equity financing in which at least $4 million is invested by third parties. This note was funded in July 2007.

The Entone acquisition was accounted for under SFAS No. 141 and certain specified provisions of SFAS No. 142. The results of operations of Entone are included in Harmonic’s Consolidated Statements of Operations from December 8, 2006, the date of acquisition. The following table summarizes the preliminary 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		$	—
Accounts receivable			297
Inventory			184
Fixed assets			313
Other tangible assets acquired			22
Amortizable intangible assets:
Existing technology			11,600
Core technology			2,800
Customer relationships			1,700
Tradenames/trademarks			800
Goodwill			32,412
Total assets acquired			50,128
Accounts payable			(855	)
Deferred revenue			(166	)
Other accrued liabilities			(146	)
Net assets acquired		$	48,961

The purchase price was allocated as set forth in the table above. The “Income Approach” which includes an analysis of the markets, cash flows and risks associated with achieving such cash flows, was the primary method used in valuing the identified intangibles acquired. The Discounted Cash Flow method was used to estimate the fair value of the acquired existing technology and customer relationships. The Royalty Savings Method was used to estimate the fair value of the acquired core technology and trademarks/trade names. In the Royalty Savings Method, the value of an asset is estimated by capitalizing the royalties saved because the Company owns the asset. Expected cash flows were discounted at the Company’s weighted average cost of capital of 18%. Identified intangible assets, including existing technology and core technology are being amortized over their useful lives of three to four years; tradename/trademarks are being amortized over their useful lives of five years; and customer relationships are being amortized over its useful life of six years.

The residual purchase price of $32.4 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 Entone is not being amortized and will be tested for impairment annually or whenever events indicate that an impairment may have occurred.

The following unaudited pro forma financial information presented below summarizes the combined results of operations as if the merger had been completed as of the beginning of January 1, 2006. The unaudited pro forma financial information for the three and six months ended June 30, 2006 combines the results for Harmonic for the three and six months ended June 30, 2006, and the historical results of Entone’s VOD business for the three and six months ended June 30, 2006. The pro forma financial information is presented for informational purposes only and does not purport to be indicative of what would have occurred had the merger actually been completed on such date or of results which may occur in the future.

		Three Months				Six Months
		Ended				Ended
(in thousands, except per share data)		June 30, 2006				June 30, 2006
Net sales		$	55,019			$	111,574
Net loss		$	(4,544	)		$	(12,329	)
Net loss per share – basic		$	(0.06	)		$	(0.17	)
Net loss per share – diluted		$	(0.06	)		$	(0.17	)

Note 4: Cash, Cash Equivalents and Investments

At June 29, 2007 and December 31, 2006, cash, cash equivalents and short-term investments are summarized as follows (in thousands):

		June 29, 2007				December 31, 2006
Cash and cash equivalents		$	21,421			$	33,454
Short-term investments:
Less than one year			44,380				54,724
Due in 1-2 years			16,418				4,193
Total short-term investments			60,798				58,917
Total cash, cash equivalents and short-term investments		$	82,219			$	92,371

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

						Gross				Gross
		Amortized				Unrealized				Unrealized				Estimated
		Cost				Gains				Losses				Fair Value
June 29, 2007
U.S. government debt securities		$	19,257			$	8			$	(31	)		$	19,234
Corporate debt securities			35,047				8				(41	)			35,014
Other debt securities			6,550				¾				¾				6,550
Total		$	60,854			$	16			$	(72	)		$	60,798
December 31, 2006
U.S. government debt securities		$	17,187			$	¾			$	(36	)		$	17,151
Corporate debt securities			38,678				38				(25	)			38,691
Other debt securities			3,075				¾				¾				3,075
Total		$	58,940			$	38			$	(61	)		$	58,917

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 our 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 29, 2007 (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		$	12,583			$	(23	)		$	3,492			$	(8	)		$	16,075			$	(31	)
Corporate debt securities			19,414				(41	)			749				¾				20,163				(41	)
Total		$	31,997			$	(64	)		$	4,241			$	(8	)		$	36,238			$	(72	)

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 5: Inventories

		June 29,				December 31,
(In thousands)		2007				2006
Raw materials		$	11,166			$	12,845
Work-in-process			4,306				3,759
Finished goods			27,036				25,512
		$	42,508			$	42,116

Note 6: Goodwill and Identified Intangibles

The following is a summary of goodwill and intangible assets as of June 29, 2007 and December 31, 2006 (in thousands):

		June 29, 2007												December 31, 2006
										Net												Net
		Gross Carrying				Accumulated				Carrying				Gross Carrying				Accumulated				Carrying
		Amount *				Amortization				Amount				Amount				Amortization				Amount
Identified intangibles:
Developed core technology		$	44,367			$	(32,135	)		$	12,232			$	44,322			$	(30,160	)		$	14,162
Customer relationships			33,613				(32,072	)			1,541				33,611				(31,929	)			1,682
Trademark and tradename			5,038				(4,328	)			710				5,031				(4,241	)			790
Supply agreement			3,544				(3,544	)			—				3,532				(3,532	)			—
Subtotal of identified intangibles			86,562				(72,079	)			14,483				86,496				(69,862	)			16,634
Goodwill			37,204				—				37,204				37,141				—				37,141
Total goodwill and other intangibles		$	123,766			$	(72,079	)		$	51,687			$	123,637			$	(69,862	)		$	53,775

The changes in the carrying amount of goodwill for the six months ended June 29, 2007 are as follows (in thousands):

		Goodwill
Balance as of January 1, 2007		$	37,141
Purchase price adjustments			—
Foreign currency translation adjustments			63
Balance as of June 29, 2007		$	37,204

For the three and six months ended June 29, 2007, the Company recorded a total of $1.1 million and $2.2 million of amortization expense for identified intangibles, of which $1.0 million and $2.0 million was included in cost of sales, respectively. 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. The estimated future amortization expense of purchased intangible assets with definite lives for the next five years is as follows (in thousands):

Years Ending December 31,		Amounts
2007 (remaining 6 months)		$	2,151
2008			4,302
2009			4,237
2010			3,094
2011			433
2012			266
Total		$	14,483

Note 7: Restructuring and Excess Facilities

In 2001 and 2002 excess facilities charges totaling $44.3 million were recorded due to the Company’s reduced headcount, difficult business conditions and a weak local commercial real estate market.

As of June 29, 2007, accrued excess facilities cost totaled $20.1 million, of which $6.7 million was included in current accrued liabilities and $13.4 million in other non-current liabilities. The Company incurred cash outlays of $3.2 million during the first six months of 2007 principally for lease payments, property taxes, insurance and other maintenance fees related to vacated facilities. Harmonic expects to pay approximately $3.5 million of excess facility lease costs, net of estimated sublease income, for the remainder of 2007 and to pay the remaining $16.6 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 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 2007.

During the third quarter of 2006, the Company recorded a charge in selling, general and administrative expenses for excess facilities of $3.9 million. This charge relates to two buildings which were vacated during the third quarter in connection with a plan to make more efficient use of our Sunnyvale campus in accordance with applicable provisions of FAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities.” In addition, during the third quarter of 2006 the Company revised its estimate of expected sublease income with respect to previously vacated facilities and recorded a credit of $1.7 million in accordance with applicable provisions of EITF 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).”

During the first quarter of 2007, the Company recorded a charge in selling, general and administrative expenses for excess facilities of $0.4 million. This charge primarily relates to two buildings in the UK which were vacated during the first quarter of 2007 in connection with the closure of the manufacturing and research and development activities of Broadcast Technology Limited, or BTL, in accordance with applicable provisions of FAS No. 146. The Company expects to record an additional charge in the third quarter of 2007 for an additional building in the UK in connection with the closure of BTL.

The following table summarizes restructuring activities (in thousands):

		Management				Excess				Campus				BTL
		Reduction				Facilities				Consolidation				Closure				Total
Balance at December 31, 2006		$	394			$	17,184			$	5,514			$	—			$	23,092
Provisions/(recoveries)			(18	)			—				232				336				550
Cash payments, net of sublease income			(298	)			(2,184	)			(1,015	)			(15	)			(3,512	)
Balance at June 29, 2007		$	78			$	15,000			$	4,731			$	321			$	20,130

Note 8: 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 $20.0 million that matures on March 5, 2008. In March 2007, Harmonic paid in full the outstanding balance of its secured term loans for equipment and canceled this term loan feature as part of the renewal process for the bank line of credit. As of June 29, 2007, other than standby letters of credit and guarantees (Note 15), there were no amounts outstanding under the line of credit facility and there were no borrowings in 2006 or 2007. This facility, which was amended and restated in March 2007, 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 29, 2007, Harmonic was in compliance with the covenants under this line of credit facility. The March 2007 amendment resulted in the Company paying a fee of $10,000 and requiring payment of approximately $20,000 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 29, 2007). Borrowings are payable monthly and are collateralized by all of Harmonic’s assets except intellectual property.

Note 9: Benefit Plans

Stock Option Plans. Harmonic has reserved 11,533,000 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. Certain option awards provide for accelerated vesting if there is a change in control. Certain option awards granted to former Entone employees in 2006 had a term of ten years from the original Entone date of grant and are fully exercisable at the date of grant and, to the extent not vested, become restricted shares subject to repurchase. At June 29, 2007 there were no restricted shares outstanding.

Director Option Plans. In May 2002, Harmonic’s stockholders approved the 2002 Director Option Plan (the “Plan”), replacing the 1995 Director Option 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 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. 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 option granted under the Plan to seven years. Harmonic has a total of 714,000 shares

of Common Stock reserved for issuance under the Plan.

The following table summarizes activities under the Plans:

		Shares Available				Stock Options				Weighted Average
		for Grant				Outstanding				Exercise Price
		(In thousands except exercise price)
Balance at December 31, 2006			3,632				9,249			$	11.50
Options granted			(2,060	)			2,060				8.32
Options exercised			—				(623	)			6.04
Options canceled			550				(550	)			12.37
Options expired			—				(11	)			31.53
Balance at June 29, 2007			2,122				10,125				11.12
Options vested and exercisable as of June 29, 2007							6,267			$	13.53
Options vested and expected-to-vest as of June 29, 2007							9,433			$	11.42

The weighted-average fair value of options granted for the six months ended June 29, 2007 was $4.46.

The following table summarizes information regarding stock options outstanding at June 29, 2007:

		Stock Options Outstanding								Stock Options Exercisable
						Weighted-
						Average
		Number				Remaining								Number				Weighted
Range of Exercise		Outstanding at				Contractual Life				Weighted-Average				Exercisable at				Average
Prices		June 29, 2007				(Years)				Exercise Price				June 29, 2007				Exercise Price
(In thousands, except exercise price and life)
$ 0.19 -    5.66			1,271				5.7			$	3.74				921			$	3.60
5.67 –     5.87			1,923				6.3				5.86				772				5.86
5.88 –     8.20			2,326				6.1				7.91				484				7.08
8.21 –     9.29			2,013				5.1				9.00				1,554				9.05
9.44 –   14.50			1,127				4.0				10.71				1,071				10.74
15.00 –   25.50			1,026				2.6				23.64				1,026				23.64
25.81 – 121.68			439				2.3				54.02				439				54.02
			10,125				5.1			$	11.12				6,267			$	13.53

The weighted-average remaining contractual life for all exercisable stock options at June 29, 2007 was 4.3 years. The weighted-average remaining contractual life of all vested and expected-to-vest stock options at June 29, 2007 was 5.0 years.

Aggregate pre-tax intrinsic value of options outstanding and exercisable at June 29, 2007 was $8.1 million. The aggregate intrinsic value of stock options vested and expected-to-vest net of estimated forfeitures was $13.4 million at June 29, 2007. Aggregate pre-tax intrinsic value represents the difference between our closing price on the last trading day of the fiscal period, which was $8.87 as of June 29, 2007, and the exercise price multiplied by the number of options outstanding or exercisable. The intrinsic value of exercised stock options is calculated based on the difference between the exercise price and the current market value at the time of exercise. The aggregate intrinsic value of exercised stock options was $0.4 million and $2.3 million during the three and six months ended June 29, 2007, respectively.

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. 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 to 5,500,000 shares and reduce the term of future offering periods to six months, which became effective for the offering period beginning January 1, 2007. 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. Offering periods and purchase periods generally begin 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 2007 and 2006, the number of shares of stock issued under the purchase plans were 401,061 and 411,324 shares at weighted average prices of $3.90 and $4.18, respectively. The weighted-average fair value of each right to purchase shares of common stock granted under the purchase plans were $2.14 and $1.70 for the first six months of 2007 and 2006, respectively. At June 29, 2007, 2,082,434 shares were 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 $1,000 per year. Such amounts totaled $0.1 million and $0.2 million in the three and six months periods ended June 29, 2007.

Stock-based Compensation

The following table summarizes stock-based compensation costs on our Condensed Consolidated Statements of Operations for the three and six months ended June 29, 2007 and June 30, 2006:

(In thousands)		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Employee stock-based compensation in:
Cost of sales		$	256			$	268			$	464			$	542
Research and development expense			485				451				875				973
Sales, general and administrative expense			696				783				1,157				1,613
Total employee stock-based compensation in operating expense			1,181				1,234				2,032				2,586
Total employee stock-based compensation			1,437				1,502				2,496				3,128
Amount capitalized as inventory			(2	)			38				14				38
Total other stock-based compensation(1)			141				1				290				2
Total stock-based compensation		$	1,576			$	1,541			$	2,800			$	3,168

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

		Employee Stock Options
		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Expected life (years)			4.75				4.75				4.75				4.75
Volatility			59	%			72	%			59	%			76	%
Risk-free interest rate			4.8	%			4.9	%			4.7	%			4.6	%
Dividend yield			0.0	%			0.0	%			0.0	%			0.0	%

		Employee Stock Purchase Plan
		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Expected life (years)			0.5				0.8				0.5				0.8
Volatility			52	%			69	%			52	%			69	%
Risk-free interest rate			4.9	%			3.7	%			4.9	%			3.7	%
Dividend yield			0.0	%			0.0	%			0.0	%			0.0	%

The expected term for 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 for stock options and historical data for the ESPP. 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 10: Income Taxes

We adopted the provisions of Financial Standards Accounting Board Interpretation No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”) an interpretation of FASB Statement No. 109 (“SFAS 109”) on January 1, 2007. The effect of this pronouncement on the Company’s retained earnings as of January 1, 2007 was a decrease in retained earnings of $2.1 million for interest and penalties. At the date of adoption of January 1, 2007, we had $7.1 million of unrecognized tax benefits which included $0.7 million of unrecognized tax benefits that were fully offset by a valuation allowance. The amount of interest and penalties at the adoption date was approximately $2.1 million. The Company historically had a $6.4 million balance in current taxes payable. As a result of the adoption of FIN 48, the FIN 48 liability of $6.4 million was reclassified to long-term taxes payable.

For the six months ended June 29, 2007, the Company has accrued $0.3 million of interest and reversed $0.8 million of FIN 48 liability upon the expiration of the statute of limitation in foreign jurisdictions. The Company does not anticipate a significant change in unrecognized tax benefits within the next twelve months.

We anticipate the unrecognized tax benefit may increase during the year for items that arise in the ordinary course of business. Such amounts will be reflected as an increase in the amount of unrecognized tax benefits and an increase to the current period tax expense. These increases will be considered in the determination of the Company’s annual effective tax rate. The amount of the unrecognized tax benefit classified as a long-term tax payable, if recognized, would reduce the annual income provision.

As of June 29, 2007, we have accrued $0.3 million of interest related to uncertain tax positions. The cumulative balance as of June 29, 2007 of interest and penalties related to uncertain tax positions is approximately $2.4 million.

The tax years 2001-2006 remain open to examination by the major taxing jurisdictions to which we are subject.

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 29, 2007 because

potential common shares, such as common shares issuable upon the exercise of stock options, are only considered when their effect would be dilutive.

The following table shows the potentially dilutive shares, consisting of options, for the periods presented that were excluded from the net income (loss) computations because their effect was antidilutive (in thousands):

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Potentially dilutive options outstanding			6,561				6,521				9,944				10,797

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 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Net income (loss) (numerator)		$	6,249			$	(2,903	)		$	7,365			$	(8,051	)
Shares calculation (denominator):
Weighted average shares outstanding — basic			79,361				74,167				79,164				74,134
Effect of dilutive securities:
Potential common stock relating to stock options			1,119				—				1,140				—
Average shares outstanding — diluted			80,480				74,167				80,304				74,134
Net income (loss) per share — basic		$	0.08			$	(0.04	)		$	0.09			$	(0.11	)
Net income (loss) per share — diluted		$	0.08			$	(0.04	)		$	0.09			$	(0.11	)

Note 12: Comprehensive Income (Loss)

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

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Net income (loss)		$	6,249			$	(2,903	)		$	7,365			$	(8,051	)
Change in unrealized gain (loss) on investments, net			(26	)			44				(20	)			91
Foreign currency translation			(95	)			81				(90	)			106
Total comprehensive income (loss)		$	6,128			$	(2,778	)		$	7,255			$	(7,854	)

Note 13: Segment Information

We operate our business in one reportable segment, which is the design, manufacture and sales of products and systems that enable network operators to efficiently deliver broadcast and on-demand video services that include digital audio, video-on-demand and high definition television as well as high-speed internet access and telephony. 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 in deciding how to allocate resources and assessing performance. Our chief operating decision maker is our Chief Executive Officer.

Our revenue by geographic region, based on the location at which each sales originates, is summarized as follows:

Geographic Information (in thousands):

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Net sales:
United States		$	38,705			$	26,949			$	81,027			$	52,602
International			32,577				26,321				60,492				56,889
Total		$	71,282			$	53,270			$	141,519			$	109,491

Note 14: Related Party

A director of Harmonic was also a director of Terayon Communication Systems Inc., until Terayon’s merger with Motorola in July 2007, and the Company purchases products for resale from Terayon. Product purchases from Terayon were approximately $0.1 million and $1.0 million for the three and six months ended June 29, 2007, respectively. Product purchases from Terayon were approximately $0.9 million and $1.6 million, for the three and six months ended June 30, 2006, respectively. As of June 29, 2007 and December 31, 2006, Harmonic had liabilities to Terayon of approximately $0.2 million and $1.0 million, respectively, for inventory purchases.

A recently appointed director of Harmonic is also a director of JDS Uniphase Corporation, from whom the Company purchases products used in the manufacture of our products. Product purchases from JDS Uniphase were approximately $0.1 million and $0.4 million for the three and six months ended June 29, 2007, respectively. As of June 29, 2007, Harmonic had liabilities to JDS Uniphase of approximately $0.1 million.

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 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Balance at beginning of the period		$	5,869			$	6,058			$	6,061			$	6,166
Accrual for warranties			871				979				1,580				2,021
Adjustments for pre-existing warranties			422				—				422				—
Warranty costs incurred			(1,106	)			(1,019	)			(2,007	)			(2,169	)
Balance at end of the period		$	6,056			$	6,018			$	6,056			$	6,018

Standby Letters of Credit. As of June 29, 2007, the Company’s financial guarantees consisted of standby letters of credit outstanding, which were principally related to customs bond requirements and state requirements imposed on employers. The maximum amount of potential future payments under these arrangements was $0.7 million.

Indemnification. 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 indemnification provisions through June 29, 2007.

Guarantees. As of June 29, 2007, Harmonic had no other guarantees outstanding.

Note 16: Commitments

Convertible Note. As part of the terms of the Agreement and Plan of Merger with Entone Technologies, Inc., Harmonic was obligated to purchase a convertible note with a face amount of $2.5 million in the new spun off private company subject to its closing of an initial round of equity financing in which at least $4 million is invested by third parties. This note was funded in July 2007.

Note 17: 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 former 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 with a motion to dismiss certain claims and to strike certain allegations. On December 11, 2006, the Court granted the motion to dismiss with respect to the Section 12(a)(2) claim against the individual Harmonic defendants and granted the motion to strike, but denied the motion to dismiss the Section 15 claim. A case management conference was held on January 25, 2007, at which the Court set a trial date in August 2008, with discovery to close in February 2008. The Court also ordered the parties to attend a settlement conference with a

magistrate judge or a private mediation before June 30, 2007. A mediation session was held on May 24, 2007 at which the parties were unable to reach a settlement.

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. The defendants filed demurrers to the amended complaint and reply briefs are due September 13, 2007. A case management conference and hearing are scheduled for October 5, 2007.

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. 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.

Note 18: Subsequent Event

On July 25, 2007, Harmonic announced that it had entered into a definitive agreement to acquire Rhozet Corporation, a privately held company based in Santa Clara, California. Harmonic completed the acquisition of Rhozet on July 31, 2007. Rhozet offers software-based universal transcoding solutions that facilitate the creation of multi-format video for Internet, mobile and broadcast applications. The purchase consideration of approximately $15.5 million was comprised of approximately $5.3 million in cash and the issuance of approximately 1.1 million shares of Harmonic common stock with a value of $10.2 million, as set forth in the definitive agreement.

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, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements related to our expectation that the acquisition of Entone will enable us to expand the scope of solutions we offer to cable, satellite and IPTV providers; our expectation that the majority of our net sales will be to relatively few customers 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 the completion of the closure of the facilities we occupied in the UK as a result of the BTL acquisition will result in an additional charge to excess facilities in the third quarter of 2007; our expectation that we will record approximately $2.0 million in amortization of intangibles in cost of sales in the remaining six months of 2007 due to the acquisition of Entone; our expectation that we will record a total of approximately $0.2 million in amortization of intangibles in operating expenses in the remaining six months of 2007 due to the acquisition of Entone; our expectation that capital expenditures will be in the range of $5 million to $6 million during 2007; our belief that our existing liquidity sources, including our bank line of credit facility, will satisfy our requirements for at least the next twelve months; our belief that near-term changes in exchange rates will not have a material impact on our operating results, financial position and liquidity; our belief that a 10% change in interest rates would not have a material impact on our financial conditions, results of operations or cash flows; our expectation that sales to cable television, satellite and telecommunications operators will constitute a significant portion of net sales for the foreseeable future; our expectation that SFAS 123(R) will continue to negatively impact our earnings and may affect our ability to raise capital on acceptable terms; our expectation that our operations will be affected by new environmental laws and regulations on an ongoing basis; 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; 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 and systems that enable network operators to efficiently deliver broadcast and on-demand video services that include digital video, video-on-demand (VOD) and high definition television (HDTV) as well as high-speed Internet access and telephony. Historically, the majority of our sales have been derived from sales of video processing solutions and edge and access systems to cable television operators. We also provide our video processing solutions to direct broadcast satellite (DBS) operators and to telephone companies, or telcos, that offer video services to their customers.

In the second quarter and first six months of 2007, Harmonic’s net sales increased 34% and 29% compared to the second quarter and first six months of 2006, respectively. The increase in sales in the second quarter and the first six months of 2007 compared to the corresponding periods in 2006 were primarily due to stronger demand from our domestic cable customers for products and solutions related to video-on-demand (VOD) deployments as well as continuing bandwidth and network expansion, and sales of our recently introduced products. Gross margins increased in the second quarter and the first six months of 2007 compared to the corresponding periods in 2006 due to favorable margins from the sale of new products and lower average product costs due to increased manufacturing volumes.

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 2007, sales to Comcast accounted for 16% of net sales, and in the second quarter of 2006, sales to Cox Communications accounted for 13% of net sales. In the first six months of 2007, sales to Comcast accounted for 19% of net sales, and in the first six months of 2006 no customer had sales that accounted for more that 10% of sales.

Sales to customers outside of the U.S. in the second quarter and the first six months of 2007 represented 46% and 43% of net sales, respectively, compared to 49% and 52% for the comparable periods in 2006. 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 6% in the first six months of 2007 compared to 5% for the comparable period of 2006. We expect international sales to continue to account for a significant portion of our net sales for the foreseeable future.

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. 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. 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.

In 2001 and 2002 excess facilities and fixed asset impairment charges totaling $52.6 million were recorded due to the Company’s reduced headcount, difficult business conditions and a weak local commercial real estate market. 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. In the third quarter of 2006, we completed our facilities rationalization plan resulting in more efficient use of our Sunnyvale campus and vacated several buildings, some of which were subsequently subleased. This resulted in a net charge for excess facilities of $2.1 million in the third quarter of 2006. Although we entered into new subleases for approximately 60,000 square feet of space in 2004, 30,000 square feet of space in 2005 and approximately 60,000 square feet of space in 2006, 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.

In the fourth quarter of 2006, we discontinued a decoder product line and announced the closing of our manufacturing operations in the UK. In the first quarter of 2007 we decided to shut down our UK research and development operations and to abandon the facility in which such operations were conducted which resulted in an excess facility charge of $0.3 million for two buildings. We expect to complete the closure of the facility in the third quarter of 2007 which we expect will result in an additional charge to excess facilities.

On December 8, 2006, Harmonic completed its acquisition of the video networking software business of Entone for a total purchase price of $49.0 million. The purchase price consisted of a payment of $26.2 million, the issuance of 3,579,715 shares of Harmonic common stock with a value of $20.1 million, the issuance of 175,342 options to purchase Harmonic common stock with a value of $0.2 million, and $2.5 million of transaction costs. Prior to the closing of the acquisition, Entone spun off its consumer premises equipment, or CPE, business into a separate private company. As part of the terms of the acquisition agreement pursuant to which Harmonic acquired the video networking software business of Entone, Harmonic was obligated to purchase a convertible note with a face amount of $2.5 million in the new spun off private company subject to its closing of an initial round of equity financing in which at least $4 million is invested by third parties. This note was funded in July 2007.

On July 31, 2007, Harmonic announced that it had entered into a definitive agreement to acquire Rhozet Corporation, a privately held company based in Santa Clara, California. Harmonic completed the acquisition of Rhozet on July 31, 2007. Rhozet offers software-based universal transcoding solutions that facilitate the creation of multi-format video for Internet, mobile and broadcast applications. The purchase consideration of approximately $15.5 million was comprised of approximately $5.3 million in cash and the issuance of approximately 1.1 million shares of Harmonic common stock with a value of $10.2 million, as set forth in the definitive agreement.

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, 2006, included in our Annual Report on Form 10-K filed with the SEC on March 15, 2007 and notes to condensed consolidated financial statements as of and for the three and six month periods ended June 29, 2007, included herein. Our most critical accounting policies have not changed since December 31, 2006 and 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.

Our accounting policy for income taxes was recently modified due to the adoption of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”, or FIN 48, see Note 10 to the Condensed Consolidated Financial Statements on Income Taxes.

Results of Operations

Harmonic’s historical consolidated statements of operations data for the second quarter and first six months of 2007 and the second quarter and first six months of 2006 as a percentage of net sales, are as follows:

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Products sales			90	%			88	%			92	%			90	%
Service revenue			10				12				8				10
Net sales			100				100				100				100
Product cost of sales			53				55				55				58
Service cost of sales			4				4				4				4
Cost of sales			57				59				59				62
Gross profit			43				41				41				38
Operating expenses:
Research and development			14				18				15				18
Selling, general and administrative			22				30				22				29
Amortization of intangibles			¾				¾				¾				¾
Total operating expenses			36				48				37				47
Income (loss) from operations			7				(7	)			4				(9	)
Interest income, net			2				2				1				2
Other income (expense), net			¾				¾				¾				¾
Income (loss) before income taxes			9				(5	)			5				(7	)
Provision for (benefit from) income taxes			¾				¾				¾				¾
Net income (loss)			9	%			(5	)%			5	%			(7	)%

Net Sales — Consolidated

Harmonic’s consolidated net sales in the second quarter and first six months of 2007 compared with the corresponding periods in 2006 are presented in the table below. Also presented are the related dollar and percentage increase in consolidated net sales in the second quarter and first six months of 2007 compared with the corresponding periods in 2006 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
Sales Data:		2007				2006				2007				2006
Video Processing		$	28,216			$	20,563			$	54,166			$	40,248
Edge and Access			31,117				23,434				66,736				51,886
Software and Other			4,733				2,665				9,120				6,312
Service and Support			7,216				6,608				11,497				11,045
Net sales		$	71,282			$	53,270			$	141,519			$	109,491
Video Processing increase		$	7,653							$	13,918
Edge and Access increase			7,683								14,850
Software and Other increase			2,068								2,808
Service and Support increase			608								452
Total increase		$	18,012							$	32,028
Video Processing percent change			37.2	%							34.6	%
Edge and Access percent change			32.8	%							28.6	%
Software and Other percent change			77.6	%							44.5	%
Service and Support percent change			9.2	%							4.1	%
Total percent change			33.8	%							29.3	%

Net sales increased in the second quarter of 2007 compared to the same period of 2006 principally due to stronger demand from our domestic cable customers for products and solutions related to video-on-demand (VOD) deployments as well as continuing bandwidth and network expansion, and sales of our recently introduced products. In the video processing product line, encoder sales increased by approximately $6.4 million in the second quarter of 2007 compared to the same period in the prior year due to higher spending by all types of customers. The edge and access products line experienced an increase in net sales of $7.7 million in the second quarter of 2007 compared to the same period in 2006 due to an increase in VOD deployments from domestic cable operators in the second quarter of 2007 compared to the second quarter of 2006. Software and other revenue increased in the second quarter of 2007 compared to the same period of 2006 primarily due to continued network expansion and upgrades, and sales of recently introduced products. Service and support revenue, primarily consisting of maintenance agreements, system integration and customer repairs, increased in the second quarter of 2007 compared to the same period of 2006 principally due to an increased customer base.

Net sales increased in the first six months of 2007 compared to the same period of 2006 principally due to stronger demand from our domestic cable customers for products and solutions related to video-on-demand (VOD) deployments as well as continuing bandwidth and network expansion, and sales of our newly introduced products. In the video processing product line, encoder sales were higher by approximately $10.4 million and stream processing products sales were higher by approximately $6.0 million in the first six months of 2007 compared to the same period in the prior year due to higher spending across all types of customers except telco. The edge and access products line experienced an increase in net sales of $15.7 million in the first six months of 2007 compared to the same period in 2006 due to an increase in VOD deployments from domestic cable operators in the first six months of 2007. Software and other revenue increased in the first six months of 2007 compared to the same period of 2006 primarily due to continued network expansion and upgrades, and sales of recently introduced products. Service and support revenue, consisting of maintenance agreements, system integration and customer repairs, increased in the first six months of 2007 compared to the same period of 2006 principally due to an increased customer base.

Net Sales — Geographic

Harmonic’s domestic and international net sales in the second quarter and first six months of 2007 compared with the corresponding periods in 2006 are presented in the table below. Also presented are the related dollar and percentage increase in domestic and international net sales in the second quarter and first six months of 2007 compared with the corresponding periods in 2006 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
Geographic Sales Data:		2007				2006				2007				2006
U.S.		$	38,705			$	26,949			$	81,027			$	52,602
International			32,577				26,321				60,492				56,889
Net sales		$	71,282			$	53,270			$	141,519			$	109,491
U.S. increase		$	11,756							$	28,425
International increase			6,256								3,603
Total increase		$	18,012							$	32,028
U.S. percent change			43.6	%							54.0	%
International percent change			23.8	%							6.3	%
Total percent change			33.8	%							29.3	%

The increased U.S. sales in the second quarter and first six months of 2007 compared to the corresponding periods in 2006 was principally due to stronger demand from our domestic satellite and cable customers for products and solutions related to VOD deployments as well as continued bandwidth and network expansion, and sales of recently introduced products. For example, sales to Comcast increased by $8.8 million and $16.8 million in the second quarter and first six months of 2007 compared to the corresponding periods of 2006, respectively.

International sales in the second quarter and the first six months of 2007 increased compared to the corresponding periods in 2006 primarily due to stronger demand from satellite and cable customers for network expansion, primarily in the South American and Asian markets. 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 2007 as compared with the corresponding periods of 2006 are presented in the tables below. Also presented are the related dollar and percentage increases in gross profit in the second quarter and first six months of

2007 as compared with the corresponding periods of 2006 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Gross profit		$	30,565			$	21,606			$	57,717			$	41,486
As a % of net sales			42.9	%			40.6	%			40.8	%			37.9	%
Increase		$	8,959							$	16,231
Percent change			41.5	%							39.1	%

The increase in gross profit in the second quarter of 2007 as compared to the corresponding period of 2006 was primarily due to increased sales, partially offset by increased expense of $0.8 million from amortization of intangibles. The gross margin percentage of 42.9% in the second quarter of 2007 compared to 40.6% in the second quarter of 2006 was higher primarily due to higher gross margin on recently introduced products, partially offset by increased expense from amortization of intangibles.

The increase in gross profit in the first six months of 2007 as compared to the first six months of 2006 was primarily due to increased sales, partially offset by increased expense of $1.7 million from amortization of intangibles. The gross margin percentage of 40.8% in the first six months of 2007 compared to 37.9% in the first six months of 2006 was higher primarily due to higher gross margin on recently introduced products, which was partially offset by increased expense from amortization of intangibles.

In the first six months of 2007, $2.0 million of amortization of intangibles was included in cost of sales compared to $0.3 million in the first six months of 2006. The higher amortization in the first six months of 2007 was due to the amortization of intangibles arising from the Entone acquisition which was completed in the fourth quarter of 2006. We expect to record approximately $2.0 million in amortization of intangibles in cost of sales in the remaining six months of 2007 due to the acquisition of Entone. Additional amortization of intangibles is expected to be recorded in the remaining six months of 2007 when the acquisition of Rhozet Corporation is completed.

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 2007, as compared with the corresponding periods of 2006, are presented in the table below. Also presented are the related dollar and percentage increases in research and development expense in the second quarter and first six months of 2007 as compared with the corresponding periods of 2006 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Research and development expense		$	9,605			$	9,585			$	20,597			$	19,533
As a % of net sales			13.5	%			18.0	%			14.6	%			17.8	%
Increase		$	20							$	1,064
Percent change			0.2	%							5.4	%

Research and development expense was flat in the second quarter of 2007 as compared to the same period in 2006, although there were lower facility and overhead expenses of $0.6 million and lower consulting expenses of $0.2 million, which were substantially offset by increased compensation costs of $0.7 million. The increased compensation costs in the second quarter of 2007 were related to the increased headcount associated with the acquisition of Entone in December 2006 and higher incentive compensation expenses.

The increase in research and development expense in the first six months of 2007 as compared to the first six months of 2006 was primarily the result of increased compensation costs of $2.1 million, which was partially offset by lower facility and overhead expenses of $0.9 million and decreased use of prototype materials of $0.3 million associated with the development of new products. The increased compensation costs in the first six months of 2007

were related to the increased headcount associated with the acquisition of Entone in December 2006 and higher incentive compensation expenses.

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 2007, as compared with the corresponding periods of 2006, are presented in the table below. Also presented are the related dollar and percentage decreases in selling, general and administrative expense in the second quarter and first six months of 2007 as compared with the corresponding periods of 2006 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Selling, general and administrative expense		$	15,771			$	15,979			$	31,446			$	31,692
As a % of net sales			22.1	%			30.0	%			22.2	%			28.9	%
Decrease		$	(208	)						$	(246	)
Percent change			(1.3	)%							(0.8	)%

The decrease in selling, general and administrative expense in the second quarter of 2007 compared to the same period in 2006 was primarily a result of lower overhead and facilities expenses of $0.4 million and lower third party commissions of $0.3 million, partially offset by higher legal expenses of $0.3 million resulting from acquisition and personnel expenses and increased travel expenses of $0.1 million associated with selling activities.

The decrease in selling, general and administrative expense in the first six months of 2007 compared to the first six months of 2006 was primarily a result of lower ongoing overhead and facilities expenses of $0.6 million and lower third party commissions of $0.3 million, partially offset by the excess facilities charge of $0.4 million related to the closure of the BTL facility in the UK and higher legal expenses of $0.3 million resulting from acquisition and personnel expenses.

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 2007 as compared with the corresponding periods of 2006 are presented in the table below. Also presented are the related dollar and percentage increases in amortization of intangible assets in the second quarter and first six months of 2007 as compared with the corresponding periods of 2006 (in thousands, except percentages).

		Three Months Ended								Six Months Ended
		June 29,				June 30,				June 29,				June 30,
		2007				2006				2007				2006
Amortization of intangibles		$	111			$	43			$	222			$	135
As a % of net sales			0.2	%			0.1	%			0.2	%			0.1	%
Increase		$	68							$	87
Percent change			158.1	%							64.4	%