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 September 28, 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 80,973,812 on October 26, 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)		September 28, 2007				December 31, 2006
ASSETS
Current assets:
Cash and cash equivalents		$	40,993			$	33,454
Short-term investments			58,038				58,917
Accounts receivable, net of allowances of $7,192 and $4,471			69,339				64,674
Inventories			36,341				42,116
Prepaid expenses and other current assets			11,911				12,807
Total current assets			216,622				211,968
Property and equipment, net			14,084				14,816
Goodwill			46,222				37,141
Intangibles, net			19,522				16,634
Other assets			3,903				1,403
Total assets		$	300,353			$	281,962
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt		$	—			$	460
Accounts payable			15,583				33,863
Income taxes payable			726				7,098
Deferred revenue			30,794				29,052
Accrued liabilities			43,904				44,097
Total current liabilities			91,007				114,570
Accrued excess facilities costs, non-current			11,126				16,434
Income taxes payable, non-current			8,243				—
Other non-current liabilities			8,968				5,824
Total liabilities			119,344				136,828
Commitments and contingencies (Notes 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; 80,798 and 78,386 shares issued and outstanding			81				78
Capital in excess of par value			2,100,059				2,078,863
Accumulated deficit			(1,919,025	)			(1,933,708	)
Accumulated other comprehensive loss			(106	)			(99	)
Total stockholders’ equity			181,009				145,134
Total liabilities and stockholders’ equity		$	300,353			$	281,962

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

HARMONIC INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
(In thousands, except per share amounts)		2007				2006				2007				2006
Product sales		$	74,995			$	56,815			$	205,017			$	155,260
Service revenue			7,300				6,041				18,797				17,086
Net sales			82,295				62,856				223,814				172,346
Product cost of sales			43,131				30,866				121,547				94,109
Service cost of sales			3,521				2,193				8,907				6,955
Total cost of sales			46,652				33,059				130,454				101,064
Gross profit			35,643				29,797				93,360				71,282
Operating expenses:
Research and development			11,018				10,021				31,615				29,554
Selling, general and administrative			14,911				16,931				46,357				48,623
Write-off of acquired in-process technology			700				—				700				—
Amortization of intangibles			143				45				365				179
Total operating expenses			26,772				26,997				79,037				78,356
Income (loss) from operations			8,871				2,800				14,323				(7,074	)
Interest income, net			1,238				1,182				3,224				3,349
Other income, net			58				137				42				173
Income (loss) before income taxes			10,167				4,119				17,589				(3,552	)
Provision for income taxes			750				103				807				482
Net income (loss)		$	9,417			$	4,016			$	16,782			$	(4,034	)
Net income (loss) per share
Basic		$	0.12			$	0.05			$	0.21			$	(0.05	)
Diluted		$	0.12			$	0.05			$	0.21			$	(0.05	)
Weighted average shares
Basic			80,371				74,588				79,570				74,286
Diluted			81,642				75,050				80,743				74,286

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

HARMONIC INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

		Nine Months Ended
		September 28,				September 29,
(In thousands)		2007				2006
Cash flows from operating activities:
Net income (loss)		$	16,782			$	(4,034	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Amortization of intangibles			3,661				672
Write-off of acquired in-process technology			700				—
Depreciation			5,089				5,719
Stock-based compensation			4,475				4,376
Net loss (gain) on disposal and impairment of fixed assets			(31	)			55
Changes in assets and liabilities, net of effect of acquisitions:
Accounts receivable, net			(4,234	)			(9,314	)
Inventories			5,777				2,877
Prepaid expenses and other assets			799				(8,133	)
Accounts payable			(18,217	)			3,486
Deferred revenue			3,714				2,474
Income taxes payable			(271	)			366
Accrued excess facilities costs			(5,661	)			683
Accrued and other liabilities			(3,242	)			764
Net cash provided by (used in) operating activities			9,341				(9	)
Cash flows from investing activities:
Purchases of investments			(70,584	)			(58,061	)
Proceeds from sales of investments			71,578				71,030
Acquisition of property and equipment			(4,193	)			(3,677	)
Acquisition of Rhozet Corporation, net of cash received			(1,370	)			—
Purchase of Entone, Inc. convertible note			(2,500	)			—
Acquisition costs related to the merger of Entone Technologies, Inc.			(2,466	)			—
Net cash provided by (used in) investing activities			(9,535	)			9,292
Cash flows from financing activities:
Proceeds from issuance of common stock			8,292				4,017
Repayments under bank line and term loan			(460	)			(615	)
Repayments of capital lease obligations			(65	)			(61	)
Net cash provided by financing activities			7,767				3,341
Effect of exchange rate changes on cash and cash equivalents			(34	)			(38	)
Net increase in cash and cash equivalents			7,539				12,586
Cash and cash equivalents at beginning of period			33,454				37,818
Cash and cash equivalents at end of period		$	40,993			$	50,404
Supplemental disclosure of cash flow information:
Income tax payments, net		$	1,132			$	177
Interest paid during the period		$	66			$	94
Non-cash investing and financing activities
Issuance of restricted common stock for Rhozet acquisition		$	8,424			$	—
Liability for future issuance of common stock for Rhozet acquisition		$	1,870			$	—

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 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, 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 fiscal 2008 will have on our consolidated results of operations or financial condition.

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 or 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.

In June 2007, the FASB also ratified Emerging Issues Task Force (“EITF”) Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities (“EITF No. 07-3”). EITF No. 07-3 requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and capitalized and recognized as an expense as the goods are delivered or the related services are performed. EITF No. 07-3 is effective, on a prospective basis, for fiscal years beginning after December 15, 2007. We are currently evaluating the effect that the adoption of EITF No. 07-3 will have on our consolidated results of operations and financial condition.

Note 3: Acquisitions

Rhozet Corporation

On July 31, 2007, Harmonic completed its acquisition of Rhozet Corporation, a privately held company based in Santa Clara, California. Rhozet develops and markets software-based transcoding solutions that facilitate the creation of multi-format video for internet, mobile and broadcast applications. With Rhozet’s products, and sometimes in conjunction with other Harmonic products, Harmonic’s existing broadcast, cable, satellite and telco customers can deliver traditional video programming over the Internet and to mobile devices, as well as expand the types of content delivered via their traditional networks to encompass web-based and user-generated content. The acquisition also opens up new customer opportunities for Harmonic with Rhozet’s customer base of broadcast content creators and online video service providers and is complementary to Harmonic’s video-on demand networking software business acquired in December 2006 from Entone Technologies. These opportunities were significant factors to the establishment of the purchase price, which exceeded the fair value of Rhozet’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.

Under the terms of the merger agreement, Harmonic paid or will pay an aggregate of approximately $15.5 million in total merger consideration, comprised of approximately $2.5 million in cash, approximately $10.3 million of common stock issued and to be issued, consisting of approximately 1.1 million shares of Harmonic’s common stock, in exchange for all of the outstanding shares of capital stock of Rhozet, approximately $2.8 million of cash which will be paid, at such time as provided in the merger agreement, to the holders of outstanding options to acquire Rhozet common stock plus approximately $0.7 million in transaction costs. Pursuant to the merger agreement, approximately $2.3 million of the total merger consideration, consisting of cash and shares of Harmonic common stock, are being held back by Harmonic for at least 18 months following the closing of the acquisition to satisfy certain indemnification obligations of Rhozet’s shareholders. As of September 28, 2007, $ 3.9 million in merger costs, cash consideration payable to Rhozet shareholders and cash consideration payable to holders of Rhozet stock options remains unpaid and has been recorded in either accounts payable or current liabilities. In addition, as of September 28, 2007, approximately $1.9 million of purchase consideration, which based on the terms of the merger agreement will be settled through the issuance of approximately 0.2 million shares of Harmonic’s common stock, has been recorded as a non-current liability.

The Rhozet acquisition was accounted for under SFAS No. 141 and certain specified provisions of SFAS No. 142. The results of operations of Rhozet are included in Harmonic’s Consolidated Statements of Operations from July 31, 2007, 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		$	657
Accounts receivable			457
Fixed assets			133
Other tangible assets acquired			59
Intangible assets:
IP technology			169
Software license			80
Existing technology			4,000
In-process technology			700
Core technology			1,100
Customer contracts			300
Maintenance agreements			600
Tradenames/trademarks			300
Goodwill			8,989
Total assets acquired			17,544
Deferred revenue			(174	)
Other accrued liabilities			(1,165	)
Net assets acquired		$	16,205

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, in-process technology, maintenance agreements and customer contracts. 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 four years; trade name/trademarks are being amortized over their useful lives of five years; customer contracts are being amortized over its useful life of six years and maintenance agreements are being amortized over its useful life of eight years. In-process technology was written off due to the risk that the developments will not be completed or competitive with comparable products. Existing technology is being amortized using the double declining method which reflects the future projected cash flows. The core technology, customer contracts, maintenance agreements and trade name/trademarks are being amortized using the straight-line method.

The residual purchase price of $9.0 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 Rhozet is not being amortized and will be tested for impairment annually or whenever events indicate that an impairment may have occurred.

Entone Technologies, Inc.

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. See Note 15.

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 acquisitions of Rhozet and Entone had been completed as of the beginning of the fiscal years presented. The unaudited pro forma financial information for the three and nine months ended September 29, 2006 combines the results for Harmonic for the three and nine months ended September 29, 2006, and the historical results of Rhozet and Entone for the three and nine months ended September 29, 2006. The unaudited pro forma financial information for the three and nine months ended September 28, 2007 combines the results of Harmonic for the three and nine months ended September 28, 2007 with the results of Rhozet for the respective periods through July 31, 2007, the acquisition date. 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 mergers actually been completed on such date or of results which may occur in the future.

		Three Months				Three Months				Nine Months				Nine Months
		Ended				Ended				Ended				Ended
		September 28,				September 29,				September 28,				September 29,
(in thousands, except per share data)		2007				2006				2007				2006
Net sales		$	82,553			$	63,473			$	226,550			$	175,255
Net income (loss)		$	8,981			$	309			$	12,397			$	(13,823	)
Net income (loss) per share — basic		$	0.11			$	0.00			$	0.15			$	(0.18	)
Net income (loss) per share — diluted		$	0.11			$	0.00			$	0.15			$	(0.18	)

Note 4: Cash, Cash Equivalents and Investments

At September 28, 2007 and December 31, 2006, cash, cash equivalents and short-term investments are summarized as follows:

		September 28,				December 31,
(in thousands)		2007				2006
Cash and cash equivalents		$	40,993			$	33,454
Short-term investments:
Less than one year			48,376				54,724
Due in 1-2 years			9,662				4,193
Total short-term investments			58,038				58,917
Total cash, cash equivalents and short-term investments		$	99,031			$	92,371

The following is a summary of available-for-sale securities:

						Gross				Gross
		Amortized				Unrealized				Unrealized				Estimated
(in thousands)		Cost				Gains				Losses				Fair Value
September 28, 2007
U.S. government debt securities		$	17,056			$	48			$	—			$	17,104
Corporate debt securities			37,420				74				(30	)			37,464
Other debt securities			3,470				—				—				3,470
Total		$	57,946			$	122			$	(30	)		$	58,038
December 31, 2006
U.S. government debt securities		$	17,187			$	—			$	(36	)		$	17,151
Corporate debt securities			38,678				38				(25	)			38,691
Other debt securities			3,075				—				—				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 September 28, 2007:

		Less than 12 months								Greater than 12 months								Total
						Gross								Gross								Gross
						Unrealized								Unrealized								Unrealized
(in thousands)		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
Corporate debt securities			11,557				(30	)			—				—				11,557				(30	)
Total		$	11,557			$	(30	)		$	—			$	—			$	11,557			$	(30	)

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

		September 28,				December 31,
(in thousands)		2007				2006
Raw materials		$	10,475			$	12,845
Work-in-process			2,923				3,759
Finished goods			22,943				25,512
		$	36,341			$	42,116

Note 6: Goodwill and Identified Intangibles

     The following is a summary of goodwill and intangible assets as of September 28, 2007 and December 31, 2006:

		September 28, 2007												December 31, 2006
										Net												Net
		Gross Carrying				Accumulated				Carrying				Gross Carrying				Accumulated				Carrying
(in thousands)		Amount				Amortization				Amount				Amount				Amortization				Amount
Identified intangibles:
Developed core technology		$	49,489			$	(33,493	)		$	15,996			$	44,322			$	(30,160	)		$	14,162
Customer relationships/contracts			33,913				(32,152	)			1,761				33,611				(31,929	)			1,682
Trademark and tradename			5,341				(4,381	)			960				5,031				(4,241	)			790
Supply agreement			3,549				(3,549	)			—				3,532				(3,532	)			—
Maintenance agreements			600				(14	)			586				—				—				—
Software license and intellectual property			249				(30	)			219				—				—				—
Subtotal of identified intangibles			93,141				(73,619	)			19,522				86,496				(69,862	)			16,634
Goodwill			46,222				—				46,222				37,141				—				37,141
Total goodwill and other intangibles		$	139,363			$	(73,619	)		$	65,744			$	123,637			$	(69,862	)		$	53,775

The changes in the carrying amount of goodwill and intangibles for the nine months ended September 28, 2007 are as follows:

(in thousands)		Goodwill				Intangibles, net
Balance as of January 1, 2007		$	37,141			$	16,634
Acquisition of Rhozet Corporation			8,989				6,549
Purchase price adjustments			—				—
Intangible amortization			—				(3,661	)
Foreign currency translation adjustments			92				—
Balance as of September 28, 2007		$	46,222			$	19,522

For the three and nine months ended September 28, 2007, the Company recorded a total of $1.5 million and $3.7 million of amortization expense for identified intangibles, of which $1.3 million and $3.3 million was included in cost of sales, respectively. For the three and nine months ended September 29, 2006, the Company recorded a total of $0.2 million and $0.7 million of amortization expense for identified intangibles, of which $0.2 million and $0.5 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 3 months)		$	1,678
2008			6,191
2009			5,821
2010			4,441
2011			790
2012			436
2013			115
2014			50
Total		$	19,522

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 September 28, 2007, accrued excess facilities cost totaled $17.0 million, of which $5.9 million was included in current accrued liabilities and $11.1 million in other non-current liabilities. The Company incurred cash outlays of $4.9 million during the first nine months of 2007 principally for lease payments, property taxes, insurance and other maintenance fees related to vacated facilities. Harmonic expects to pay approximately $1.6 million of excess facility lease costs, net of estimated sublease income, for the remainder of 2007 and to pay the remaining $15.4 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 fourth 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 fourth quarter of 2007 for an additional building in the UK which will be vacated in connection with the closure of BTL.

During the third quarter of 2007, the Company recorded a net credit in selling, general and administrative expenses for excess facilities of $1.4 million for its Sunnyvale campus. The Company revised its estimate of expected sublease income due to the extension of a sublease of a building to the lease expiration and recorded a credit of $1.8 million. This was partially offset by a charge of $0.4 million on a reduction in estimated sublease income for another building that is vacant and available for sublease.

The following table summarizes restructuring activities:

		Management				Excess				Campus				BTL
(in thousands)		Reduction				Facilities				Consolidation				Closure				Total
Balance at December 31, 2006		$	394			$	17,184			$	5,514			$	—			$	23,092
Provision/(recoveries)			(18	)			(1,792	)			637				353				(820	)
Cash payments, net of sublease income			(298	)			(3,274	)			(1,533	)			(52	)			(5,157	)
Balance at September 28, 2007		$	78			$	12,118			$	4,618			$	301			$	17,115

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 loan for equipment and canceled its term loan facility as part of the renewal process for the bank line of credit. As of September 28, 2007, other than standby letters of credit and guarantees (Note 16), 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 September 28, 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 (7.75% at September 28, 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 11,324,000 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 September 28, 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 678,000 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			(2,335	)			2,335				8.42
Options exercised			—				(837	)			6.05
Options canceled			820				(820	)			12.21
Options expired			—				(34	)			35.64
Balance at September 28, 2007			2,117				9,893				11.09
Options vested and exercisable as of September 28, 2007							6,062				13.43
Options vested and expected-to-vest as of September 28, 2007							9,186				11.39

The weighted-average fair value of options granted for the nine months ended September 28, 2007 was $4.50.

The following table summarizes information regarding stock options outstanding at September 28, 2007:

		Stock Options Outstanding								Stock Options Exercisable
						Weighted-Average
		Number Outstanding				Remaining								Number
Range of Exercise		at September 28,				Contractual Life				Weighted-Average				Exercisable at				Weighted Average
Prices		2007				(Years)				Exercise Price				September 28, 2007				Exercise Price
(In thousands, except exercise price and life)
$     0.19 — 5.66			1,210				5.5			$	3.79				909			$	3.67
5.67 — 5.87			1,830				6.2				5.86				820				5.86
5.88 — 8.20			2,281				5.9				7.91				486				7.07
8.21 — 9.29			2,061				5.2				8.96				1,509				9.06
9.44 — 14.50			1,077				4.7				10.59				904				10.67
15.00 — 25.50			1,037				2.4				23.41				1,037				23.41
25.81 — 121.68			397				2.3				56.08				397				56.08
			9,893				5.1			$	11.09				6,062			$	13.43

The weighted-average remaining contractual life for all exercisable stock options at September 28, 2007 was 4.3 years. The weighted-average remaining contractual life of all vested and expected-to-vest stock options at September 28, 2007 was 5.0 years.

Aggregate pre-tax intrinsic value of options outstanding and exercisable at September 28, 2007 was $14.4 million. The aggregate intrinsic value of stock options vested and expected-to-vest net of estimated forfeitures was $24.4 million at September 28, 2007. Aggregate pre-tax intrinsic value represents the difference between our closing price on the last trading day of the fiscal period, which was $10.61 as of September 28, 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 $0.7 million and $3.0 million during the three and nine months ended September 28, 2007, respectively.

Employee Stock Purchase Plan. 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 nine months of 2007 and 2006, the number of shares of stock issued under the purchase plans were 669,871 and 811,565 shares at weighted average prices of $4.82 and $4.04, respectively. The weighted-average fair value of each right to purchase shares of common stock granted under the purchase plans were $2.38 and $1.44 for the first nine months of 2007 and 2006, respectively. At September 28, 2007, 1,813,624 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 $0.3 million in the three and nine months periods ended September 28, 2007.

Stock-based Compensation

The following table summarizes stock-based compensation costs on our Condensed Consolidated Statements of Operations for the three and nine months ended September 28, 2007 and September 29, 2006:

		Three Months Ended								Nine Months Ended
(In thousands)		September 28, 2007				September 29, 2006				September 28, 2007				September 29, 2006
Employee stock-based compensation in:
Cost of sales		$	255			$	184			$	719			$	727
Research and development expense			563				331				1,438				1,304
Sales, general and administrative expense			822				729				1,979				2,342
Total employee stock-based compensation in operating expense			1,385				1,060				3,417				3,646
Total employee stock-based compensation			1,640				1,244				4,136				4,373
Amount capitalized as inventory			(5	)			38				9				38
Total other stock-based compensation(1)			48				—				339				2
Total stock-based compensation		$	1,683			$	1,282			$	4,484			$	4,413

As of September 28, 2007, total unamortized stock-based compensation cost was $12.3 million, with the weighted average recognition period of 2.8 years.

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								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
		2007				2006				2007				2006
Expected life (years)			4.75				4.75				4.75				4.75
Volatility			56	%			69	%			59	%			76	%
Risk-free interest rate			4.6	%			4.9	%			4.7	%			4.6	%
Dividend yield			0.0	%			0.0	%			0.0	%			0.0	%

		Employee Stock Purchase Plan
		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
		2007				2006				2007				2006
Expected life (years)			0.5				0.5				0.5				0.5
Volatility			50	%			56	%			51	%			56	%
Risk-free interest rate			4.9	%			5.1	%			4.9	%			5.1	%
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. 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 - an interpretation of FASB Statement No. 109” (“FIN 48”) 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 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 Company historically had a $6.4 million balance in current taxes payable. As a result of the adoption of FIN 48, the liability of $6.4 million was reclassified to long-term taxes payable.

For the nine months ended September 28, 2007, the Company has accrued $0.5 million of interest and reversed $0.8 million of FIN 48 liability due to the expiration of the statute of limitation in two foreign jurisdictions. The cumulative balance as of September 28, 2007 of interest and penalties related to uncertain tax positions is approximately $2.5 million. The Company does not anticipate a significant change in unrecognized tax benefits within the next twelve months.

We anticipate the unrecognized tax benefits 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.

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

As of September 28, 2007, we maintained a full valuation allowance against our net deferred tax assets because we expect that it is more likely than not that all deferred tax assets will not be realized in the foreseeable future. We continuously monitor the circumstances impacting the expected realization of our deferred tax assets for each jurisdiction. We consider all available evidence, both positive and negative, including historical levels of income in each jurisdiction, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. If we determine it is more likely than not that some or all of our deferred tax assets will be realized in the foreseeable future, we will adjust our valuation allowance accordingly. A change in our assessment regarding the realization of our deferred tax assets will impact our effective tax rate in the period we revise our assessment and in subsequent periods. As of December 31, 2006 our valuation allowance totaled $120.0 million. As of December 31, 2006, the Company had $184.0 million of federal and $60.4 million of state net operating loss carryforwards available to reduce future taxable income which will begin to expire in 2021 and 2012 for federal tax purposes and for state tax purposes, respectively. As of December 31, 2006 the Company had foreign net operating loss carryforwards of $23.7 million which do not expire.

Our effective tax rate for the three and nine months ended September 28, 2007 differs from the U.S. statutory rate primarily due to utilization of unbenefited net operating loss carryforwards.

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 nine months ended September 29, 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.

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:

		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
(in thousands)		2007				2006				2007				2006
Potentially dilutive options outstanding			5,464				8,929				7,196				11,008

Following is a reconciliation of the numerators and denominators of the basic and diluted net loss per share computations:

		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
(in thousands, except per share data)		2007				2006				2007				2006
Net income (loss) (numerator)		$	9,417			$	4,016			$	16,782			$	(4,034	)
Shares calculation (denominator):
Weighted average shares outstanding — basic			80,371				74,588				79,570				74,286
Effect of dilutive securities:
Potential common stock relating to stock options			1,139				462				1,129				—
Potential common stock relating to Rhozet acquisition			132				—				44				—
Average shares outstanding — diluted			81,642				75,050				80,743				74,286
Net income (loss) per share — basic		$	0.12			$	0.05			$	0.21			$	(0.05	)
Net income (loss) per share — diluted		$	0.12			$	0.05			$	0.21			$	(0.05	)

Note 12: Comprehensive Income (Loss)

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

		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
(in thousands)		2007				2006				2007				2006
Net income (loss)		$	9,417			$	4,016			$	16,782			$	(4,034	)
Change in unrealized gain (loss) on investments, net			92				83				71				173
Foreign currency translation			(11	)			19				(78	)			125
Total comprehensive income (loss)		$	9,498			$	4,118			$	16,775			$	(3,736	)

Note 13: Segment Information

We operate in one reportable segment, which is the design, manufacture and sale of versatile and high performance video products and system solutions that enable service providers to efficiently deliver the next generation of broadcast and on-demand services, including high-definition television, or HDTV, video-on-demand, or VOD, networked personal video recording and time-shifted TV. Historically, the majority of our sales have been derived from sales of video processing solutions and edge and access systems to cable television operators and from sales of video processing solutions to direct-to-home satellite operators. We also provide our video processing solutions to telecommunications companies, broadcasters and Internet companies that offer video services to their customers. 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 sale originates, is summarized as follows:

Geographic Information:

		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
(in thousands)		2007				2006				2007				2006
Net sales:
United States		$	44,638			$	29,265			$	125,447			$	81,968
Canada			6,953				7,408				11,002				12,216
International			30,704				26,183				87,365				78,162
Total		$	82,295			$	62,856			$	223,814			$	172,346

In the third quarter of 2007, sales to Comcast and Echostar accounted for 16% and 15% of net sales, respectively. In the third quarter of 2006, sales of the Cox Communications accounted for 13% of net sales. In the first nine months of 2007, sales of Comcast accounted for 18% of net sales, and in the first nine months of 2006, no customer had sales that accounted for more than 10% of sales. As of September 28, 2007, one customer had a balance of 17% of our net accounts receivable.

The Company’s assets are primarily located within the United States of America.

Note 14: Related Party

A 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 $0.3 million and $0.7 million for the three and nine months ended September 28, 2007, respectively. As of September 28, 2007, Harmonic had liabilities to JDS Uniphase of approximately $0.1 million.

Note 15: Convertible Note Receivable

On July 5, 2007, Harmonic purchased an unsecured convertible promissory note from Entone, Inc. with a face amount of $2.5 million. Interest accrues on the note at the rate of 4.95% per annum and will be due with principal at the earlier of August 21, 2011 or upon a “Change of Control Transaction” of Entone, Inc, unless the note is otherwise converted. The principal amount of $2.5 million and all accrued interest will automatically convert into preferred stock of Entone when it closes its next preferred stock equity financing of at least $8.0 million prior to the due date of the note. Upon the next preferred stock equity financing, Harmonic will be entitled to receive shares of such series of preferred stock equal to the principal amount of the note and all accrued interest up to the date of conversion divided by the greater of (i) 80% of the per share purchase price of the such preferred stock or (ii) the original purchase price of Entone’s Series A preferred stock. Upon a Change of Control Transaction, Harmonic will be entitled to receive Series A preferred stock equal to the $2.5 million principal amount of the note and all accrued interest up to the date of conversion divided by the greater of (a) 80% of the amount received by a holder for a share of Series A preferred stock in connection with such Change of Control Transaction, assuming conversion of the note, or (b) the original purchase price of the Series A Preferred Stock.

As of September 28, 2007 the Company had accrued $29,000 of interest and all accrued interest is deferred. The Convertible Note will be tested for impairment quarterly or whenever events indicate that impairment may have occurred. The note is included in Other Assets on the Balance Sheet as of September 28, 2007.

Note 16: 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:

		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
(in thousands)		2007				2006				2007				2006
Balance at beginning of the period		$	6,056			$	6,018			$	6,061			$	6,166
Accrual for current period warranties			1,120				1,383				2,700				3,404
Adjustments for preexisting warranties			(148	)			—				274				—
Warranty costs incurred			(1,208	)			(985	)			(3,215	)			(3,154	)
Balance at end of the period		$	5,820			$	6,416			$	5,820			$	6,416

Standby Letters of Credit. As of September 28, 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 September 28, 2007.

Guarantees. As of September 28, 2007, Harmonic had no other guarantees outstanding.

Note 17: Legal Proceedings

Between June 28, 2000 and August 25, 2000, several actions alleging violations of the federal securities laws by us and certain of our officers and directors (some of whom are no longer with us) were filed in or removed to the United States 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 our publicly traded securities between January 19, 2000 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, 2000 and May 3, 2000. In addition to us and certain of our 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 our prospects and customers and our acquisition of C-Cube, certain defendants violated Sections 10(b) and 20(a) of the Securities 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 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 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 because those claims did not allege fraud, they met the applicable pleading requirements. 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, our Chairman and former Chief Executive Officer, and affirmed the dismissal of that claim against us, 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 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 defendants affiliated with Harmonic 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 director and officer defendants affiliated with Harmonic 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 our behalf was filed against its then-current directors in the Superior Court for the County of Santa Clara on September 5, 2000. We were also 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 us 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 our behalf 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 our former and current 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 us as a nominal defendant. The complaint alleges claims for abuse of control, gross mismanagement, and waste of corporate assets against the defendants affiliated with Harmonic, 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 defendants affiliated with Harmonic. The defendants filed demurrers to the amended complaint and the parties have stipulated to several continuances of the hearing on the demurrers, which currently is set for December 14, 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 require that we pay substantial damages. In addition we may decide to settle the litigation, which could cause us to incur significant costs. A settlement or an unfavorable outcome in these shareholder actions 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 our products infringe U.S.

Patent No. 4859016. This patent expired in September 2003. The complaint sought injunctive relief, royalties and damages. On August 6, 2007, the District Court granted our motion to dismiss. The plaintiffs have appealed this motion.

An unfavorable outcome of any of these litigation matters could require that we pay substantial damages, or, in connection with any intellectual property infringement claims, could require that we pay ongoing royalty payments or could prevent us from selling certain of our products. In addition, we may decide to settle any litigation, which could cause us to incur significant costs. A settlement or an unfavorable outcome of these litigation matters could have a material adverse effect on our business, 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, 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 regarding a potential reversal of all or part of the valuation allowance we hold against our deferred tax assets; our expectation that the closure of the facilities we occupied in the UK will be complete in the fourth quarter of 2007; our expectation that we will record approximately $1.5 million in amortization of intangibles in cost of sales in the remaining three months of 2007 due to the acquisitions of Rhozet and Entone; our expectation that we will record a total of approximately $0.2 million in amortization of intangibles in operating expenses in the remaining three months of 2007 due to the acquisitions of Rhozet and 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 condition and liquidity; our belief that a 10% change in interest rates would not have a material impact on our financial condition, 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 expectation that the effective tax rate may fluctuate in future periods; our belief that any ultimate liability of Harmonic with respect to certain litigation arising in the normal course of business would 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 versatile and high performance video products and system solutions that enable service providers to efficiently deliver the next generation of broadcast and on-demand services, including high-definition television, or HDTV, video-on-demand, or VOD, networked personal video recording and time-shifted TV. Historically, the majority of our sales have been derived from sales of video processing solutions and edge and access systems to cable television operators and from sales of video processing solutions to direct-to-home satellite operators. We also provide our video processing solutions to telecommunications companies, broadcasters and Internet companies that offer video services to their customers.

In the third quarter and first nine months of 2007, Harmonic’s net sales increased 31% and 30% compared to the third quarter and first nine months of 2006, respectively. The increases in sales in the third quarter and the first nine months of 2007 compared to the corresponding periods in 2006 were primarily due to stronger demand from our domestic and international satellite customers for products and solutions related to HDTV, stronger demand from our domestic cable customers for HDTV and VOD deployment, and sales of our new products and software. Gross margins increased in the third quarter and first nine months of 2007 compared to the corresponding periods in 2006 due to favorable margins from the higher proportion of sales of higher margin video processing

solutions and software and services partially offset by an increase in expense for excess and obsolete inventories.

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 third quarter of 2007, sales to Comcast and Echostar accounted for 16% and 15% of net sales, respectively. In the third quarter of 2006, sales to Cox Communications accounted for 13% of net sales. In the first nine months of 2007, sales to Comcast accounted for 18% of net sales, and in the first nine months of 2006, no customer had sales that accounted for more than 10% of sales.

Sales to customers outside of the U.S. in the third quarter and the first nine months of 2007 represented 46% and 44% of net sales, respectively, compared to 53% 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 7% in the first nine months of 2007 compared to 9% 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 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. 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. In the third quarter of 2007, we recorded a net credit of $1.4 million resulting from a revision to expected sublease income. 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 fourth quarter of 2007 which we expect will result in an additional charge to excess facilities, which is estimated to be approximately $0.2 million.

As of December 31, 2006, we maintained a full valuation allowance against our net deferred tax assets because we expect that it is more likely than not that all deferred tax assets will not be realized in the foreseeable future. Each reporting period we evaluate both positive and negative evidence and, as of September 28, 2007, we considered our history of losses and volatility of earnings to represent sufficient negative evidence to require us to maintain a full valuation allowance against our net deferred tax assets. We expect to maintain a valuation allowance on future tax benefits until an appropriate level of profitability, primarily in the U.S., is sustained and we are able to develop tax planning strategies that enable us to conclude that it is more likely than not that our deferred tax assets would be realizable. However, if our income projections for future periods are realized, it is reasonably possible that these earnings could provide sufficient positive evidence to require release of all, or a portion, of these valuation allowances in the future. In the quarter that we release all or part of the valuation allowance, it will have a material impact on our effective tax rate. As of December 31, 2006, our valuation allowance was $120.0 million. In periods following the release of our valuation allowance we anticipate that our effective tax rate will increase.

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 completed its acquisition of Rhozet Corporation, a privately held company based in Santa Clara, California. Under the terms of the merger agreement, Harmonic paid or will pay an aggregate of approximately $15.5 million in total merger consideration, comprised of approximately $2.5 million in cash, approximately 1.1 million shares of Harmonic’s common stock in exchange for all of the outstanding shares of capital stock of Rhozet, approximately $2.8 million of cash which will be paid, at such time as provided in the merger agreement, to the holders of outstanding options to acquire Rhozet common stock plus approximately $0.7 million in transaction costs. Pursuant to the merger agreement, approximately $2.3 million of the total merger consideration, consisting of cash and shares of Harmonic common stock, are being held back by Harmonic for at least 18 months following the closing of the acquisition to satisfy certain indemnification obligations of Rhozet’s shareholders.

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 month period ended September 28, 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 third quarter and first nine months of 2007 and the third quarter and first nine months of 2006 as a percentage of net sales, are as follows:

		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
		2007				2006				2007				2006
Product sales			91	%			90	%			92	%			90	%
Service revenue			9				10				8				10
Net sales			100				100				100				100
Product cost of sales			52				49				54				55
Service cost of sales			5				4				4				4
Cost of sales			57				53				58				59
Gross profit			43				47				42				41
Operating expenses:
Research and development			13				16				14				17
Selling, general and administrative			18				27				21				28
Write-off of acquired in-process technology			1				—				—				—
Amortization of intangibles			—				—				—				—
Total operating expenses			32				43				35				45
Income (loss) from operations			11				4				7				(4	)
Interest income, net			1				2				1				2
Other income, net			—				—				—				—
Income (loss) before income taxes			12				6				8				(2	)
Provision for income taxes			1				—				—				—
Net income (loss)			11	%			6	%			8	%			(2	)%

Net Sales — Consolidated

Harmonic’s consolidated net sales in the third quarter and first nine months of 2007 compared with the corresponding periods in 2006 are presented in the table below. Also presented are the related dollar and percentage

changes in consolidated net sales in the third quarter and first nine months of 2007 compared with the corresponding periods in 2006.

(in thousands, except percentages)		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
Sales Data:		2007				2006				2007				2006
Video Processing		$	38,623			$	26,116			$	92,790			$	66,363
Edge and Access			29,156				25,143				95,891				77,029
Software and Other			7,216				5,556				16,336				11,868
Service and Support			7,300				6,041				18,797				17,086
Net sales		$	82,295			$	62,856			$	223,814			$	172,346
Video Processing increase		$	12,507							$	26,427
Edge and Access increase			4,013								18,862
Software and Other increase			1,660								4,468
Service and Support increase			1,259								1,711
Total increase		$	19,439							$	51,468
Video Processing percent change			47.9	%							39.8	%
Edge and Access percent change			16.0	%							24.5	%
Software and Other change			29.9	%							37.6	%
Service and Support change			20.8	%							10.0	%
Total percent change			30.9	%							29.9	%

Net sales increased in the third quarter of 2007 compared to the same period of 2006 principally due to stronger demand from our domestic and international satellite operators, and sales of our recently introduced products. In the video processing product line, the sales increase in the third quarter of 2007 compared to the same period in the prior year was primarily due to higher spending by domestic and international satellite operators. The edge and access product line experienced an increase in net sales in the third quarter of 2007 compared to the same period in 2006 due to continuing sales of VOD and video transmission products for deployments from cable operators. Software and other revenue increased in the third quarter of 2007 compared to the same period of 2006 primarily due to sales of recently introduced software products, including products from the recent acquisitions of Entone and Rhozet, partially offset by a reduction in other revenue. Service and support revenue, primarily consisting of maintenance agreements, system integration and customer repairs, increased in the third quarter of 2007 compared to the same period of 2006 principally due to an increased customer base.

Net sales increased in the first nine months of 2007 compared to the same period of 2006 principally due to stronger demand from our domestic and international satellite operators and our domestic cable operators, and sales of our recently introduced products. In the video processing product line, the sales increase in the first nine months of 2007 compared to the same period in the prior year was primarily due to higher spending across all types of customers except telco. The increase in the edge and access product lines was principally attributable to an increase of approximately $27.7 million in sales of VOD and video transmission products for deployments for domestic and international cable operators, offset by a decrease in sales of lower margin FTTP products of $9.6 million. Software and other revenue increased in the first nine months of 2007 compared to the same period of 2006 primarily due to sales of recently introduced software products, including products from the recent acquisitions of Entone and Rhozet. Service and support revenue, consisting of maintenance agreements, system integration and customer repairs, increased in the first nine 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 third quarter and first nine months of 2007 compared with the corresponding periods in 2006 are presented in the table below. Also presented are the related dollar and percentage changes in domestic and international net sales in the third quarter and first nine months of 2007 compared with the corresponding periods in 2006.

(in thousands, except percentages)		Three Months Ended								Nine Months Ended
		September 28,				September 29,				September 28,				September 29,
Geographic Sales Data:		2007				2006				2007				2006
U.S.		$	44,638			$	29,265			$	125,447			$	81,968
International			37,657				33,591				98,367				90,378
Net sales		$	82,295			$	62,856			$	223,814			$	172,346
U.S. increase		$	15,373							$	43,479
International increase			4,066								7,989
Total increase		$	19,439							$	51,468
U.S. percent change			52.5	%							53.0	%
International percent change			12.1	%							8.8	%
Total percent change			30.9	%							29.9	%