Saturday, December 3, 2022

Harmonic Activist Investor Looks Forward to Realising Harmonic’s Full Potential

Harmonic recently announced a cooperation agreement with Scopia Capital Management, a New York based hedge fund with over $1 billion of assets under management. The agreement was made on April 9th, announced three days later, and gives Scopia the right to appoint two directors to Harmonic’s board. In return, Scopia has agreed to a series of standstill provisions, including a refrain from acquiring a larger equity position in Harmonic.

Based on a February 26, 2021 filing, Scopia has amassed an ownership position of 9,692,935 shares or 9.6 percent of the outstanding shares of Harmonic. At this past Friday’s closing price, this position has a market value of more than $82 million.

For those interested in the trading habits of large hedge fund investors, Scopia’s filing associated with Harmonic cites the trading pattern employed by Scopia in the 60 days leading up to March 8th, 2021.

What is the purpose of trading $8 million of notional market cap to increase a share position by 82,703 (market value of around $600,000)? Unclear, though illustrative of a fundamentally different capability for navigating capital markets possessed by Scopia.

As part of the press release, Jerome Lande, Partner and Head of Special Situations for Scopia, offered the only public background on Scopia’s interest in Harmonic. “We are great admirers of the innovative solutions that Harmonic is bringing to market and look forward to collaborating with management and the board on realising Harmonic’s full potential.”

The emphasis on “realising Harmonic’s full potential” is ours. Scopia may admire away; admiration does not a return on investment make. Financial parties have financial ends.

What then is a reasonable expectation of full potential? And how might Harmonic now achieve full potential? Indulge us in a review of the past to frame expectations for the future.

Harmonic held an initial public offering in late May 1995 and would close its first day of trading at a split adjusted price of $7.28. This past Friday, a month prior to the 26th anniversary of its IPO, Harmonic’s stock closed at a price of $8.49. The cumulative 18 percent appreciation over almost 26 years compares to the NASDAQ-100 increase of 2,700 percent. Set as an investment, $1 invested in Harmonic at its IPO has turned into $1.18 whereas $1 invested in the NASDAQ-100 index has become $28 over the same time span.

Perhaps a better comparison is inflation, which has risen by 73 percent over the same period. Or perhaps a more intuitive positioning is the cost of a McDonald’s Big Mac, which has increased by a factor of 2.5x since 1995. Assuming you had a means of preserving a Big Mac for 26 years, it would have yielded a better return.

Page 3 of Harmonic’s investor presentation cites the Cisco VNI index, which predicts IP traffic growth of 25 percent CAGR from 2019-2022 with video accounting for more than 80 percent of the traffic.

Since its inception Cisco’s VNI index has tracked the tremendous growth of video traffic across the broader internet and has forecasted continued exponential growth. It is often cited by industry suppliers because it has ‘Video’ in the name (the V) and it predicts fantastic, up-and-to-the-right growth.

Dulling the impact of the citation in 2021 is the decade-plus inventory of Cisco VNI reports, and the apparent lack of relationship to the media technology market and individual vendor performance. Speaking to all Cisco VNI apostles in the sector, if there was no relationship in the past to your historical business performance, why would the next few years buck this trend?

The 2009 vintage of the Cisco VNI index anticipated 35 percent CAGR for the same figure thru 2014. How did that higher growth level translate into Harmonic’s market opportunity growing?

The above is intended to set up a serious discussion. Citing the Cisco VNI index in the context of an investment thesis for Harmonic is not a serious discussion.

Here is the plot of Harmonic’s stock return versus the NASDAQ-100 over the past decade.

The historical returns for Harmonic are simply unacceptable to a large institutional investor. Let us next annotate the last 10 years of Harmonic stock trading with several major events:

  • Acquisition of Omneon: Harmonic announced its acquisition of Omneon on May 6th, 2010 (it closed in September). The consideration was $274 million or 2.6x Omneon’s 2009 revenue. In the associated press release, Patrick Harshman CEO of Harmonic offered the following, “This proposed combination will position Harmonic to become a global leader in video infrastructure for the digital media industry.”
  • $250+ million Stock Repurchase: In April 2012, Harmonic’s Board approved a stock repurchase program with an approval level subsequently increased to $300 million in May 2014. Under this program Harmonic would repurchase more than 30 percent of its outstanding shares thru the 2015 calendar year for a total cash outlay of $254 million. Average share prices for the purchases varied from $6.25 to $6.70, with all purchases concluded during the 2015 calendar year. On the 23rd of October 2015, Harmonic’s stock closed trading at $6.02. It would not close a trading session above $6.0 a share again until November 2018. They bought high.
  • Divestiture of legacy Cable Access Assets to Aurora Networks: On February 19, 2013, Harmonic announced its intention to divest its Cable Access (optical transmitters, amplifiers, receivers and nodes) business to Aurora Networks. The deal closed in March 2013. It provided cash proceeds of $46 million to Harmonic. The divested business generated $52.9 million in revenue during the 2012 fiscal year. The notable excerpt from the press release reads “The strategic decision to divest the Cable Access business reflects Harmonic’s commitment to the Video Production and Playout, Video Processing, and Cable Edge product areas, where it currently holds market share leadership. In contrast, Harmonic is not the market leader in the Cable Access product area, and there is limited strategic synergy between Cable Access and the Company’s other higher growth product lines.” As you read the remainder of the post, keep the underlined phrase in mind.
  • Acquisition of Thomson Video Networks: Harmonic announced its acquisition of Thomson Video Networks on December 7, 2015 and the deal would close the following February. Thomson Video Networks had an annual revenue profile of approximately $95 million USD and Harmonic paid approximately $90 million to acquire the business ($75 million upfront).
  • Comcast Warrant Agreement: In September 2016 Harmonic announced a warrant agreement with Comcast providing Comcast with warrants to acquire Harmonic shares in return for meeting certain purchasing levels of Harmonic’s CableOS product and related services. This was described in Harmonic’s Annual report as a further incentive for Comcast to purchase Harmonic’s products. (As an aside, what term describes the circumstance where a supplier provides an offering of monetary value to a customer, separate to the intended purchase, with the express purpose of persuading the customer to move forward with the purchase?) Comcast was 20 percent of Harmonic’s revenue in 2020 and 23 percent in 2019.
  • SaaS Transition: Beginning in early 2017 Harmonic’s Management communicated a transition in its product mix toward Software-as-a-Service (SaaS) pricing models. During its Q3 2017 conference call management disclosed 8 percent of Q2 bookings were SaaS-based. This represented a significant headwind to revenue growth. Quoting Harmonic’s CFO Sanjay Kalra from the same call, “As a general rule of thumb, on an annual basis, each $1 million shipped from our traditional CapEx purchase to SaaS will reduce total company revenue by $600,000.”
  • US C-Band Re-Pack: This past January the FCC completed an auction of 300 MHz of C-Band satellite spectrum for terrestrial 5G broadband. The US government is paying (by way of auction proceeds) to repack the incumbent users of those frequencies. Those incumbent users are by in large traditional media companies. For example, Comcast indicated in ex-parte filing with the FCC that 84 percent of the primary signals for its cable channels are received by way of this C-band spectrum. During its Q2 2020 Harmonic’s management estimated the associated reclamation would represent a new several hundred-million-dollar opportunity, with revenue commencing in Q4 2020.

The resulting chart of Harmonic’s stock is below.

There is no need to overthink the cause of the lack of stock price appreciation. A revenue time-series will suffice. Consider the below quarterly revenue plot of Harmonic over the past 10 years, again with the callouts for major corporate events.

Harmonic is smaller than it was at the start of last decade. Repeating for effect: despite an up-and-to-the-right Cisco VNI Index and an explosion in OTT viewership, Harmonic is smaller than it was at the start of the last decade. In revenue terms 2020 was 10 percent below 2010 levels. Versus the high-water revenue mark in 2011 (reached after the Omneon acquisition), Harmonic is now 30 percent smaller. Harmonic’s operating income post-2011 was positive once (in 2019).

The quarterly breakdown amplifies the analysis. There are 44 quarters of financial performance captured from 2010 to 2020. Operating income was negative 30 times, positive 14 times. 12 of the 44 quarters are influenced from M&A events. Removing those 12 quarters, organic revenue growth occurred in 11 quarters (on a year-over-year basis) versus revenue declines in 21 of the quarters (almost 2 to 1 decline to growth).

Combining the two financial factors of quarterly revenue growth and operating margin is similarly stark. The sum of quarterly revenue growth and quarterly operating margin has a median value of -5 percent over the past 10 years.

To put a finer point on it, Harmonic’s financial profile has been in continuous decline for a decade.

Harmonic Business Segment Review

Harmonic operates two business segments (both definitions are excerpts from Hamonic’s annual report):

  • Video Business

The Video business provides video processing and production and playout solutions and services worldwide to cable operators and satellite and telco Pay-TV service providers, and to broadcast and media companies, including streaming media companies.

  • Cable Access Business

The Cable Access business provides cable access solutions and related services, including Harmonic’s CableOS software-based cable access solution, primarily to cable operators globally.

The overlap in the profile of those two business segments is the common cable customer base, Harmonic’s traditional customer base. Here is a comparison of the financial profile of both business segments over the 2020 financial year.

While Video was almost twice as large in 2020, just about every other comparison of interest to a shareholder favours Cable Access. Most acute is a comparison of growth prospects. Harmonic’s investor presentation provides third-party market sizing for Cable Access of approximately $200 million in 2020, growing to $900 million in 2024. No similar figures are quoted for the Video segment – and for good reason.

Harmonic announced the acquisition of Thomson Video Networks on December 7th, 2015. “The combination of Harmonic and TVN will, if completed, set the bar for video innovation globally,” stated Harshman. For the trailing twelve months prior to the announcement Harmonic’s Video Segment had revenue of $306 million. During the acquisition announcement, Management offered annual revenue guidance of Thomson (based on 2014 actual) of $95 million. Taken together the acquisition would – in addition to ‘setting the bar for video innovation globally’ – create a more than $400 million annual revenue basis. 2020 Video segment revenue was below $250 million. A 40 percent revenue decline in four fiscal years.

Harmonic began disclosing revenue results for its Video segment in 2014. We then have 24 quarters of revenue growth available to discern a trend. In that span, there were 16 quarters of revenue decline. Of the eight quarters of revenue growth, 4 are attributable to the impact of the Thomson Video acquisition, and the most recent quarter driven by the C-band repack.

The below chart plots of the quarterly revenue series of the Video segment and Cable Access business, with the major events noted.

Innovation notwithstanding, in terms of revenue profile, the Video segment has been a snowball in the sun, melting away. A reflection of the market reality for compression-based products and to a lesser extent the challenge of transitioning to the economic profile of SaaS revenue and cloud deployments. The latter impact is captured by the below illustration based on a disclosure in Harmonic’s 2019 10K filing.

The rule of thumb noted by Harmonic’s CFO suggested the capex to SaaS transition reduced current revenue by 60 percent. The trade of appliance to SaaS described above is a reduction of 95 percent. Other factors are responsible.

At the 2018 Devoncroft Executive Summit, I posited aggregate revenues for compression products would never, ever grow again. I have observed nothing to cause me to revisit that statement.

However, there is (finally) near-term cause for optimism for the Video segment. Much of the initial pain of the SaaS transition has occurred. SaaS revenue was upwards of 40 percent of Harmonic’s total revenue during the first half of 2020. Also, as already mentioned, the C-Band reclamation is happening, and Harmonic is well-positioned to capture a meaningful share of the business. SES, one of the primary conduits for the repack, represented 19 percent of Harmonic’s Q4 revenue or nearly $25 million. To put that figure in the context, consider the Q4 2020 Video segment revenue figure was about $7 million higher than Q4 2019.

The mid-point of management’s guidance for 2021 is $267.5 million in revenue for the Video segment, representing 10 percent growth over 2020. It is a forecast based on record backlog and deferred revenue. There is then a broader, strategic opportunity for Harmonic based on anticipated performance of the Video Segment in 2021.

Video and Cable Access are different businesses in many respects and only set to distance themselves further. As a purely financial matter, a third-party could reasonably argue for harvesting the value in a mature business division to better fund another division with a greater growth profile. Or to recast a phrase from Harmonic’s past as a question: “What is the level of strategic synergy between Cable Access and the Company’s other product lines?” Such speculation is already occurring.

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