Description

Investment Thesis

Harmonic (“HLIT” or the “Company”) is a supplier of cable and broadcast equipment to Cable MSOs globally (i.e.- Comcast, Charter, Liberty Global, Cox, etc.) and is positioned to capture significant share of Cable MSOs future network transition to a virtualized architecture as it is the only vendor with a commercially-viable virtualized solution (CableOS) today and a 18-24 month lead on competitors. We believe there is ~50% upside to the current share price over the next 12-months with intermediate-term upside to $15+, while the recent Comcast agreement removes primary downside risk and provides a reasonable floor for the equity.

*This write-up will focus on the CableOS segment as it represents the vast majority of current and future equity value

Industry Overview

Cable MSOs globally are in the early stages of transitioning their cable infrastructure networks from a hardware-centric solution (CCAP) to a software-defined, virtualized solution (vCCAP).  The go-forward architecture spearheaded by a joint effort by Comcast and Harmonic takes advantage of the scale and cost advantages of the x86 hardware ecosystem, investment to drive fiber deeper into the cable network, and scalable centralized software.   

Historically, the industry has been highly concentrated with three primary vendors (Arris, Cisco and Casa) representing >95% of the market and each offering a hardware-centric solution.  Real estate and power consumption cost headwinds at cable head-ends / bunkers have driven Comcast and other leading MSOs to look for a cheaper alternative to keep up with robust broadband demand growth, which is unlikely to abate.

HLIT is at the leading edge of this transition, having developed hand-in-hand with Comcast a containerized software solution that we believe over time will be the core of all of Comcast’s ~60m homes passed.  Harmonic will also have a very good chance of winning share at other MSOs as they recently did at a meaningful European customer announced last quarter. It is also widely believed that Liberty Global has been in fairly extensive trials with CableOS and received purchase orders in 2018 that signal deployment starting late this year.  Also an arrangement with Comcast gives CMCSA incentives (purchase credits) to resell this vCCAP solution to other MSOs (similarly to what they did with their X1 set top business), which would driver further high margin software sales at Harmonic.   

Benefits of a vCCAP architecture for a cable MSO include:

• Significantly lower total cost of ownership (we spoke to an operator who had deployed CableOS who expected go-forward capex and opex savings of up to 75%!  (Primarily driven by reductions in field engineer, truck rolls, and network hardware)

• Reduced reliability on incumbent vendors

• Increased scalability

• Increased flexibility in future network infrastructure decisions

The vCCAP market is expected to grow meaningfully over the next 5 years to a ~$400M mostly software market, potentially representing >30% of the total market, from <2% currently. Additionally, inclusive of the hardware nodes that would accompany CableOS, the opportunity for HLIT is $800M-$1,000M by 2022.  Also worth noting that the software world has much more frequently been “winner take all” than the hardware universe.

Recent Events

On July 9 HLIT disclosed an enterprise license pricing agreement with Comcast (effective July 1) which detailed $175M of software license fees (100% gross margin) over the next 4 years – providing a floor for CableOS sales over this period. Additionally, the announcement indicated that all warrant shares of previous Comcast warrant agreement were fully vested and exercisable as all remaining milestones and thresholds required were deemed satisfied. HLIT was up ~25% the following day and a cumulative ~33% over the next three weeks until 2Q19 earnings on July 29.

HLIT reported in line 2Q19 earnings, narrowed FY2019 CableOs revenue guidance, increased EBIT guidance and provided additional details on the Comcast agreement as well as expectations around other CableOS opportunities including an incremental $55M contract agreed to in early July. The stock traded up after-hours and opened higher the following day before ending the day down ~8%.  Since 2Q19 earnings the stock is now down an additional ~9% for total sell-off of ~17% with no fundamental change to the underlying thesis.

Valuation

• We believe HLIT will meaningfully grow revenue and EBITDA next few years as the CMCSA business ramps as well as the other European contract announced, as well as likely deployments from Liberty Global and other MSOs

• As the company shifts to a higher mix of software revenue, this should improve ROIC and margins (typically followed by multiple expansion)

• The EBITDA multiples below on CableOS imply revenue multiples between 3-4x sales, in line with industry peers with robust growth prospects (and well below that of software industry comps)

• Longer-term opportunity suggests mid-teens stock

o    Given HLIT’s technology lead in vCCAP and other Cable MSOs tendency to follow Comcast’s lead (other than Charter), we believe HLIT can be the #1 player in the vCCAP market, similar to ARRS in the cycle we are now beginning to exit

o    If HLIT were to garner global market share similar to ARRS (~45%), industry research would imply the following financial position by 2023

§R&D and SG&A are also likely to show more leverage in a scenario where HLIT gets to ~$550m CableOS revenue

o    We also acknowledge that we may be conservative with our 45% share assumption given “winner take all” nature of software universe and believe the ultimate share opportunity for HLIT could be materially higher than our current estimate

Conclusion

Harmonic’s agreement with Comcast and the acceptance of the remaining warrants is very strong validation of the HLIT technology and its current position as market leader for the next cable capex cycle. Despite timing for other Tier 1’s contracts remaining uncertain, we believe the majority of other Tier 1 and Tier 2/3 Cable MSOs will accelerate their adoption of the CableOS solution as the industry aligns on standards and they see the benefits accruing to Comcast, resulting in significant uptick in CableOS revenue in 2020/2021.

Risks

• Cable MSOs delay shift to vCCAP architecture

• Incumbent players (Arris, Cisco, Casa) develop competing vCCAP solutions and maintain their dominant market share in cable infrastructure

• Data consumption growth decelerates materially resulting in less need to increase bandwidth across cable networks

Catalyst

• New CableOS customer win announcements

• Estimate revisions by buy/sellside as Comcast business scales and CableOS brings on new customers

• Potential acquisition by Cisco / CommScope

• Potential sale of Video segment