Edgar Filing: HARMONIC INC

e10vq

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 29, 2006


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

Commission File No. 0-25826

HARMONIC INC.

(Exact name of Registrant as specified in its charter)


Delaware		77-0201147

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

549 Baltic Way
Sunnyvale, CA 94089
(408) 542-2500

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

Securities registered pursuant to section 12(b) of the Act:
None

Securities registered pursuant to section 12(g) of the Act:
Common Stock, par value $.001 per share
Preferred Share Purchase Rights

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

Yes þ No o

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

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

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

Yes o No þ

The number of shares outstanding of the Registrant’s Common Stock, $.001 par value, was 74,681,986 on October 27, 2006.

TABLE OF CONTENTS


PART I
Item 1.	CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)	3
Item 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	20
Item 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	31
Item 4.	CONTROLS AND PROCEDURES	32

PART II
Item 1.	LEGAL PROCEEDINGS	32
Item 1A.	RISK FACTORS	34
Item 2.	UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	51
Item 3.	DEFAULTS UPON SENIOR SECURITIES	51
Item 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS	51
Item 5.	OTHER INFORMATION	51
Item 6.	EXHIBITS	51
SIGNATURES		52
EXHIBIT INDEX		53
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

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 29, 2006			December 31, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	50,404		$	37,818
Short-term investments		60,320			73,010
Accounts receivable, net of allowances of $4,015 and $3,230		52,423			43,433
Inventories		35,635			38,552
Prepaid expenses and other current assets		16,104			8,335

Total current assets		214,886			201,148
Property and equipment, net		14,943			17,040
Intangibles and other assets		7,238			8,109

Total assets	$	237,067		$	226,297

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt	$	596		$	812
Accounts payable		22,864			19,378
Income taxes payable		6,952			6,480
Deferred revenue		23,019			18,932
Accrued liabilities		40,990			37,438

Total current liabilities		94,421			83,040
Long-term debt, less current portion		61			460
Accrued excess facilities costs, long-term		17,889			18,357
Other non-current liabilities		7,020			11,458

Total liabilities		119,391			113,315

Commitments and contingencies (Notes 15 and 16)
Stockholders’ equity:
Preferred stock, $0.001 par value, 5,000 shares authorized; no shares issued or outstanding		—			—
Common stock, $0.001 par value, 150,000 shares authorized; 74,645 and 73,636 shares issued and outstanding		75			74
Capital in excess of par value		2,056,519			2,048,090
Accumulated deficit		(1,938,750	)		(1,934,715	)
Accumulated other comprehensive loss		(168	)		(467	)

Total stockholders’ equity		117,676			112,982

Total liabilities and stockholders’ equity	$	237,067		$	226,297

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

HARMONIC INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)


	Three Months Ended					Nine Months Ended
	September 29,		September 30,			September 29,			September 30,
(In thousands, except per share amounts)	2006		2005			2006			2005
Net sales	$	62,856	$	60,960		$	172,346		$	193,638
Cost of sales		33,059		39,564			101,064			121,797

Gross profit		29,797		21,396			71,282			71,841

Operating expenses:
Research and development		10,021		9,403			29,554			28,381
Selling, general and administrative		16,931		15,166			48,623			47,102
Amortization of intangibles		45		110			179			1,233

Total operating expenses		26,997		24,679			78,356			76,716

Income (loss) from operations		2,800		(3,283	)		(7,074	)		(4,875	)
Interest income, net		1,182		669			3,349			1,828
Other income (expense), net		137		(288	)		173			(643	)

Income (loss) before income taxes		4,119		(2,902	)		(3,552	)		(3,690	)
Provision for (benefit from) income taxes		103		(11	)		482			25

Net income (loss)	$	4,016	$	(2,891	)	$	(4,034	)	$	(3,715	)

Net income (loss) per share — basic	$	0.05	$	(0.04	)	$	(0.05	)	$	(0.05	)

Net income (loss) per share — diluted	$	0.05	$	(0.04	)	$	(0.05	)	$	(0.05	)

Weighted average shares — basic		74,588		73,554			74,286			73,168

Weighted average shares — diluted		75,050		73,554			74,286			73,168

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

HARMONIC INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)


	Nine Months Ended
(In thousands)	September 29, 2006			September 30, 2005
Cash flows from operating activities:
Net loss	$	(4,034	)	$	(3,715	)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
Amortization of intangibles		672			2,311
Depreciation		5,719			6,278
Stock-based compensation		4,376			9
Loss on disposal of fixed assets		55			15
Deferred income taxes		—			(282	)
Changes in assets and liabilities, net of effect of acquisition:
Accounts receivable		(9,314	)		16,774
Inventories		2,877			22
Prepaid expenses and other assets		(8,133	)		2,275
Accounts payable		3,486			(2,727	)
Deferred revenue		2,474			4,774
Income taxes payable		366			(706	)
Accrued excess facilities costs		683			(3,530	)
Accrued and other liabilities		764			(12,475	)

Net cash provided by (used in) operating activities		(9	)		9,023

Cash flows from investing activities:
Purchases of investments		(58,061	)		(47,202	)
Proceeds from sales of investments		71,030			49,053
Acquisition of property and equipment		(3,677	)		(4,232	)
Acquisition of BTL, net of cash received		—			(5,955	)

Net cash provided by (used in) investing activities		9,292			(8,336	)

Cash flows from financing activities:
Proceeds from issuance of common stock		4,017			6,281
Repayments under bank line and term loan		(615	)		(829	)
Repayments of capital lease obligations		(61	)		(72	)

Net cash provided by financing activities		3,341			5,380

Effect of exchange rate changes on cash and cash equivalents		(38	)		134

Net increase in cash and cash equivalents		12,586			6,201
Cash and cash equivalents at beginning of period		37,818			26,603

Cash and cash equivalents at end of period	$	50,404		$	32,804

Supplemental disclosure of cash flow information:
Income tax payments, net	$	177		$	118
Interest paid during the period	$	94		$	269
Non-cash investing and financing activities:
Issuance of restricted common stock for BTL acquisition	$	—		$	1,831

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

HARMONIC INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Note 1: Basis of Presentation

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

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

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

Use of Estimates

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

Note 2: Recent Accounting Pronouncements

In March 2006, the Emerging Issues Task Force reached a consensus on Issue No. 06-03, “How Taxes Collected from Customers and Remitted to Government Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation)” (EITF No. 06-03). The Company is required to adopt the provisions of EITF No. 06-03 beginning in fiscal year 2007. The Company does not expect the provisions of EITF No. 06-03 to have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

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

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108`). SAB 108 provides guidance on how prior year misstatements should be taken into consideration when quantifying misstatements in current year financial statements for purposes of determining whether the current year’s financial statements are materially misstated. SAB 108 becomes effective during our 2007 fiscal year. We do not expect the adoption of SAB 108 to have a material impact on our financial statements.

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 will have on our results of operations or financial position.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 106, and 132(R)” (SFAS No. 158). SFAS No. 158 requires companies to recognize a net liability or asset and an offsetting adjustment to accumulated other comprehensive income to report the funded status of defined benefit pension and other postretirement benefit plans. SFAS No. 158 requires prospective application, and the recognition and disclosure requirements are effective for the Company’s fiscal year ending December 31, 2007. Additionally, SFAS No. 158 requires companies to measure plan assets and obligations at their year-end balance sheet date. This requirement is effective for fiscal years ending after December 15, 2008. We do not expect the adoption of SFAS No. 158 to have a material impact on our financial statements.

Note 3: Stock-based Compensation

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

The Company adopted SFAS 123(R) using the modified-prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Condensed Consolidated Financial Statements as of and for the three and nine months ended September 29, 2006 reflect the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s Condensed Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the three and nine months ended September 29, 2006 was $1.2 million and $4.4 million, respectively, which consisted of stock-based compensation expense related to employee equity awards and employee stock purchases. There was no stock-based compensation expense related to employee equity awards and employee stock purchases recognized during the three and nine months ended September 30, 2005.

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

Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Company’s Condensed Consolidated Statement of Operations for the three and nine months ended September 29, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). In conjunction with the adoption of SFAS 123(R), the Company changed its method of attributing the value of stock-based compensation costs to expense from the accelerated multiple-option method to the straight-line single-option method. Compensation expense for all share-based payment awards granted on or prior to December 31, 2005 will

continue to be recognized using the accelerated approach while compensation expense for all share-based payment awards related to stock options and employee stock purchase rights granted subsequent to December 31, 2005 are recognized using the straight-line method.

As stock-based compensation expense recognized in our results for the three and nine months ended September 29, 2006 is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to fiscal year 2006, we accounted for forfeitures as they occurred for the purposes of pro forma information under SFAS 123, as disclosed in our Notes to Consolidated Financial Statements for the related periods.

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

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

Also see Note 10 for further discussion of stock-based compensation.

Note 4: BTL Acquisition

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

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


Cash acquired	$	149
Other tangible assets acquired		2,508
Amortizable intangible assets:
Existing technology		2,050
Customer relationships		540
Tradenames/trademarks		320
Order backlog		60
Goodwill		3,745

Total assets acquired		9,372
Liabilities assumed		(568	)
Deferred tax liability for acquired intangibles		(891	)

Net assets acquired	$	7,913

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

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

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

Note 5: Cash, Cash Equivalents and Investments

At September 29, 2006 and December 31, 2005, cash, cash equivalents and short-term investments are summarized as follows (in thousands):


	September 29,		December 31,
	2006		2005
Cash and cash equivalents	$	50,404	$	37,818

Short-term investments:
Less than one year		57,326		56,605
Due in 1-2 years		2,994		16,405

Total short-term investments		60,320		73,010

Total cash, cash equivalents and short-term investments	$	110,724	$	110,828

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


			Gross Unrealized		Gross Unrealized			Estimated Fair
	Amortized Cost		Gains		Losses			Value
September 29, 2006
U.S. government debt securities	$	21,992	$	20	$	(65	)	$	21,947
Corporate debt securities		36,826		26		(54	)		36,798
Other debt securities		1,575		—		—			1,575

Total	$	60,393	$	46	$	(119	)	$	60,320

December 31, 2005
U.S. government debt securities	$	20,264	$	—	$	(146	)	$	20,118
Corporate debt securities		46,873		3		(209	)		46,667
Other debt securities		6,225		—		—			6,225

Total	$	73,362	$	3	$	(355	)	$	73,010

Impairment of Investments

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

In accordance with FASB Staff Position Nos. 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP FAS 115-1”), the following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of September 29, 2006 (in thousands):


	Less than 12 months					Greater than 12 months					Total
			Gross					Gross					Gross
			Unrealized					Unrealized					Unrealized
	Fair Value		Losses			Fair Value		Losses			Fair Value		Losses
U.S. Government debt securities	$	8,206	$	(43	)	$	8,260	$	(22	)	$	16,466	$	(65	)
Corporate debt securities		8,293		(33	)		14,010		(20	)		22,303		(53	)

Total	$	16,499	$	(76	)	$	22,270	$	(42	)	$	38,769	$	(118	)

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

Note 6: Inventories


(In thousands)	September 29, 2006		December 31, 2005
Raw materials	$	11,690	$	14,392
Work-in-process		2,881		4,131
Finished goods		21,064		20,029

	$	35,635	$	38,552

Note 7: Goodwill and Identified Intangibles

The following is a summary of goodwill and intangible assets as of September 29, 2006 and December 31, 2005 (in thousands):


	September 29, 2006							December 31, 2005
	Gross					Net		Gross					Net
	Carrying		Accumulated			Carrying		Carrying		Accumulated			Carrying
	Amount *		Amortization			Amount		Amount *		Amortization			Amount
Identified intangibles:
Developed core technology	$	29,839	$	(28,875	)	$	964	$	29,663	$	(28,315	)	$	1,348
Customer base		31,909		(31,909	)		—		31,904		(31,904	)		—
Trademark and tradename		4,218		(4,218	)		—		4,190		(4,142	)		48
Supply agreement		3,510		(3,256	)		254		3,464		(3,109	)		355

Subtotal of identified intangibles		69,476		(68,258	)		1,218		69,221		(67,470	)		1,751
Goodwill		4,614		—			4,614		4,896		—			4,896

Total goodwill and other intangibles	$	74,090	$	(68,258	)	$	5,832	$	74,117	$	(67,470	)	$	6,647


*		Foreign currency translation adjustments, reflecting movement in the currencies of the underlying entities, totaled approximately $0.1 and $0.3 million for intangible assets and approximately $0.3 and $0.3 million for goodwill as of September 29, 2006 and December 31, 2005, respectively.

The changes in the carrying amount of goodwill for the nine months ended September 29, 2006 are as follows (in thousands):


	Goodwill
Balance as of January 1, 2006	$	4,896
Purchase price adjustments*		(531	)
Foreign currency translation adjustments		249

Balance as of September 29, 2006	$	4,614


*		Purchase price adjustments that affect existing goodwill were due to deferred taxes.

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. For the three and nine months ended September 30, 2005, the Company recorded a total of $0.3 and $2.3 million of amortization expense for identified intangibles, of which $0.2 million and $1.1 million was included in cost of sales, respectively. The estimated future amortization expense of purchased intangible assets with definite lives for the next three years is as follows (in thousands):


Years Ending December 31,	Amounts
2006 (remaining 3 months)	$	215
2007		860
2008		143

Total	$	1,218

Note 8: Restructuring and Excess Facilities

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

As of September 29, 2006, accrued excess facilities cost totaled $24.3 million of which $6.4 million was included in current accrued liabilities and $17.9 million in other non-current liabilities. The Company incurred cash outlays of $3.5 million during the first nine months of 2006 principally for lease payments, property taxes, insurance and other maintenance fees related to vacated facilities. Harmonic expects to pay approximately $1.7 million of excess facility lease costs, net of estimated sublease income, for the remainder of 2006 and to pay the remaining $22.6 million, net of estimated sublease income, over the remaining lease terms through September 2010.

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

During the fourth quarter of 2005, in response to the consolidation of the Company’s two operating segments into a single segment as of January 1, 2006, the Company implemented workforce reductions of approximately 40 full-time employees across all functions and primarily in our U.S. operations and recorded severance and other costs of approximately $1.1 million. No liability remains as of September 29, 2006.

During the second quarter of 2006, the Company streamlined its senior management team primarily in the U.S. operations and recorded severance and other costs of approximately $1.0 million. We expect the remaining payments related to these actions to be paid by the end of the second quarter of 2007.

During the third quarter of 2006, the Company recorded a net charge in selling, general and administrative expenses for excess facilities of $2.1 million. The Company recorded a charge of $3.8 million, net of estimated sublease income, in accordance with the provisions of FAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” for two buildings which were vacated during the third quarter in connection with a plan to make more efficient use of our Sunnyvale campus. The $5.9 million accrued excess facility costs for these buildings also includes the reclassification of a deferred rent liability of $2.1 million. In addition, during the third quarter of 2006, the Company recorded a benefit of $1.7 million as a result of a revision to estimates of projected sublease income on entering into sublease agreements for certain buildings previously exited under EITF 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This benefit partially offsets the charge recorded by the Company in the third quarter of 2006 from the consolidation of its Sunnyvale campus.

The following table summarizes restructuring activities (in thousands):


	Workforce			Management			Excess			Campus
	Reduction			Reduction			Facilities			Consolidation		Total
Balance at December 31, 2005	$	635		$	—		$	23,576		$	—	$	24,211
Provisions/(recoveries)		(25	)		962			(1,743	)		5,947		5,141
Cash payments, net of sublease income		(610	)		(451	)		(3,521	)		—		(4,582	)

Balance at September 29, 2006	$	—		$	511		$	18,312		$	5,947	$	24,770

Note 9: Credit Facilities and Long-Term Debt

Harmonic has a bank line of credit facility with Silicon Valley Bank, which provides for borrowings of up to $23.7 million, including $3.7 million for equipment under a secured term loan. This facility, which was amended and restated in December 2005, expires in December 2006, and contains financial and other covenants including the requirement for Harmonic to maintain cash, cash equivalents and short-term investments, net of credit extensions, of not less than $30.0 million. If Harmonic is unable to maintain this cash, cash equivalents and short-term investments balance or satisfy the additional affirmative covenant requirements, Harmonic would be in noncompliance with the facility. In the event of noncompliance by Harmonic with the covenants under the facility, Silicon Valley Bank would be entitled to exercise its remedies under the facility which include declaring all obligations immediately due and payable and disposing of the collateral if obligations were not repaid. At September 29, 2006, Harmonic was in compliance with the covenants under this line of credit facility. The December 2005 amendment resulted in the company paying a fee of approximately $33,000 and requiring payment of approximately $43,000 of additional fees if the company does not maintain an unrestricted deposit of $20.0 million with the bank. Future borrowings pursuant to the line bear interest at the bank’s prime rate (8.25% at September 29, 2006) or prime plus 0.5% for equipment borrowings. Borrowings are payable monthly and are collateralized by all of Harmonic’s assets except intellectual property. As of September 29, 2006, $0.7 million was outstanding under the equipment term loan portion of this facility and there were no additional borrowings in 2005 or 2006. The term loan is repayable monthly, including principal and interest at 8.75% per annum on outstanding borrowings as of September 29, 2006 and matures at various dates through December 2007. Other than standby letters of credit and guarantees (Note 15), there were no other outstanding borrowings or commitments under the line of credit facility as of September 29, 2006.

Note 10: Benefit Plans

Stock Option Plans. Harmonic has reserved 12,329,000 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 of such grant 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 have a term of seven years. Certain option awards provide for accelerated vesting if there is a change in control.

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

The following table summarizes activities under the Plans:


	Shares Available			Stock Options			Weighted Average
	for Grant			Outstanding			Exercise Price
	(In thousands except exercise price)
Balance at December 31, 2005		3,984			9,064		$	13.05
Shares authorized		300			—			—
Options granted		(1,947	)		1,947			5.64
Options exercised		—			(197	)		3.73
Options canceled		1,462			(1,462	)		11.41
Options expired		—			(94	)		43.99

Balance at September 29, 2006		3,799			9,258			11.64

Options vested and exercisable as of September 29, 2006					6,297			11.90

Options vested and expected-to-vest as of September 29, 2006					8,859		$	14.27

The weighted-average fair value of options granted for the nine months ended September 29, 2006 was $3.62.

The following table summarizes information regarding stock options outstanding at September 29, 2006:


			Stock Options Outstanding						Stock Options Exercisable
					Weighted-
					Average
			Number		Remaining				Number
Range of Exercise			Outstanding at		Contractual Life		Weighted-Average		Exercisable at		Weighted Average
Prices			September 29, 2006		(Years)		Exercise Price		September 29, 2006		Exercise Price
					(In thousands, except exercise price and life)
$ 1.75	—	5.56		1,403		6.3	$	3.90		866	$	3.50
5.62	—	5.87		2,317		7.2		5.86		367		5.84
5.88	—	8.93		1,450		5.9		8.02		1,122		7.99
9.00	—	9.29		1,156		5.2		9.17		1,039		9.16
9.53	—	13.82		1,262		4.7		10.64		1,233		10.64
14.50	—	25.17		988		3.6		22.96		988		22.96
25.50	—	121.68		682		3.1		44.57		682		44.57

				9,258		5.6	$	11.64		6,297	$	14.27

The weighted-average remaining contractual life for all exercisable stock options at September 29, 2006 was 4.9 years. The weighted-average remaining contractual life of all vested and expected-to-vest stock options at September 29, 2006 was 5.5 years.

Aggregate pre-tax intrinsic value of options outstanding and exercisable at September 29, 2006 was $8.8 million and $4.2 million, respectively. The aggregate intrinsic value of stock options vested and expected-to-vest net of estimated forfeitures was $8.2 million at September 29, 2006. Aggregate pre-tax intrinsic value represents the difference between our closing price on the last trading day of the fiscal period, which was $7.36 as of September 29, 2006, and the exercise price multiplied by the applicable number of options. The intrinsic value of exercised stock options is calculated based on the difference between the exercise price and the quoted market price of our common stock as of the close of the exercise date. The aggregate intrinsic value of exercised stock options was $0.1million and $0.3 million during the three and nine months ended September 29, 2006, respectively.

Employee Stock Purchase Plan.

In May 2002, Harmonic’s stockholders approved the 2002 Employee Stock Purchase Plan (the “2002 Purchase Plan”) replacing the 1995 Employee Stock Purchase Plan effective for the offering period beginning on July 1, 2002. In May 2004, Harmonic’s stockholders approved an amendment to the 2002 Purchase Plan and increased the maximum number of shares of common stock authorized for issuance over the term of the 2002 Purchase Plan by an additional 2,000,000 shares. In June 2006, Harmonic’s stockholders approved an amendment to the 2002 Purchase Plan to increase the maximum number of shares of common stock available for issuance under the 2002 Purchase Plan by an additional 2,000,000 shares to 5,500,000 shares and reduce the term of future offering periods to six months. The 2002 Purchase Plan enables employees to purchase shares at 85% of the fair market value of the

Common Stock at the beginning of the offering period or end of the purchase period, whichever is lower. Prior to the approval of the June 2006 amendment, each offering period had a maximum duration of two years and consisted of four six-month purchase periods. Offering periods and purchase periods generally began on the first trading day on or after January 1 and July 1 of each year. The 2002 Purchase Plan is intended to qualify as an “employee stock purchase plan” under Section 423 of the Internal Revenue Code. During the first nine months of 2006 and the years 2005 and 2004, the number of shares of stock issued under the purchase plans were 811,565; 705,171 and 774,683 shares at weighted average prices of $4.04, $5.05 and $2.32, respectively. The weighted-average fair value of each right to purchase shares of common stock granted under the purchase plans were $1.44, $1.82 and $2.68 for the first nine months of 2006 and the years 2005 and 2004, respectively. At September 29, 2006, there were 2,483,495 shares reserved for future issuances under the 2002 Purchase Plan.

Retirement/Savings Plan. Harmonic has a retirement/savings plan which qualifies as a thrift plan under Section 401(k) of the Internal Revenue Code. This plan allows participants to contribute up to 20% of total compensation, subject to applicable Internal Revenue Service limitations. Harmonic makes discretionary contributions to the plan of 25% of the first 4% contributed by eligible participants up to a maximum contribution per participant of $750 per year. This amount has been increased to $1,000 effective January 1, 2006. Such amounts totaled $0.1 million and $0.3 million in the third quarter and first nine months of 2006, respectively.

Stock-based Compensation

The following table summarizes the impact of options from SFAS 123(R) on stock-based compensation costs for employees on our Condensed Consolidated Statements of Operations for the three and nine months ended September 29, 2006 and September 30, 2005:


	Three Months		Nine Months
	Ended		Ended
(In thousands)	September 29, 2006		September 29, 2006
Employee stock-based compensation in:
Cost of sales	$	184	$	727


Research and development expense		331		1,304
Sales, general and administrative expense		729		2,342

Total employee stock-based compensation in operating expense		1,060		3,646

Total employee stock-based compensation		1,244		4,373

Amount capitalized in inventory		38		38
Total other stock-based compensation (1)		—		2

Total stock-based compensation	$	1,282	$	4,413


(1)		Other stock-based compensation represents charges related to non-employee stock options.

As of September 29, 2006, total unamortized stock-based compensation cost related to unvested stock options was $6.9 million, with the weighted average recognition period of 1.4 years.

The table below reflects net loss and net loss per share, and pro forma information for the three and nine months ended September 30, 2005 (in thousands, except per share amounts):


	Three Months Ended			Nine Months Ended
	September 30,			September 30,
	2005			2005
	(pro forma)			(pro forma)
Net loss, before stock-based compensation for employees, prior period	$	(2,891	)	$	(3,715	)
Less: Stock-based compensation expense previously determined under fair value based method, net of related tax effects		(2,594	)		(6,740	)

Net loss, after effect of stock-based compensation for employees	$	(5,485	)	$	(10,455	)

Net loss per share:
Basic — as reported for prior period	$	(0.04	)	$	(0.05	)

Basic — after effect of stock-based compensation for employees	$	(0.07	)	$	(0.14	)

Diluted — as reported for prior period	$	(0.04	)	$	(0.05	)

Diluted — after effect of stock-based compensation for employees	$	(0.07	)	$	(0.14	)

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


	Employee Stock Options
	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Expected life (years)		4.75			3.2			4.75			3.7
Volatility		69	%		91	%		76	%		96	%
Risk-free interest rate		4.9	%		3.8	%		4.6	%		3.8	%
Dividend yield		0.0	%		0.0	%		0.0	%		0.0	%


	Employee Stock Purchase Plan
	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Expected life (years)		0.5			0.8			0.5			0.8
Volatility		56	%		61	%		56	%		69	%
Risk-free interest rate		5.07	%		3.7	%		5.07	%		3.7	%
Dividend yield		0.0	%		0.0	%		0.0	%		0.0	%

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

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

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

Note 11: Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing the net income (loss) attributable to common stockholders for the period by the weighted average number of the common shares outstanding during the period. Diluted net income per share is computed by dividing the net income (loss) for the period by the weighted average number of common shares and potential common shares outstanding during the period if their effect is dilutive. 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. During the three and nine months ended September 29, 2006, 8.9 million and 11.0 million, respectively, of potentially dilutive shares, consisting of options, were excluded from the net income (loss) per share computations, because their effect was antidilutive. During the three and nine months ended September 30, 2005, 9.7 million and 10.3 million, respectively, of potentially dilutive shares, consisting of options, were excluded from the net income (loss) per share computations, because their effect was antidilutive.

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


	Three Months Ended					Nine Months Ended
	September 29,		September 30,			September 29,			September 30,
	2006		2005			2006			2005
Net income (loss) (numerator)	$	4,016	$	(2,891	)	$	(4,034	)	$	(3,715	)

Shares calculation (denominator):
Weighted average shares outstanding — basic		74,588		73,554			74,286			73,168
Effect of dilutive securities:
Potential common stock relating to stock options		462		—			—			—

Average shares outstanding — diluted		75,050		73,554			74,286			73,168

Net income (loss) per share — basic	$	0.05	$	(0.04	)	$	(0.05	)	$	(0.05	)

Net income (loss) per share — diluted	$	0.05	$	(0.04	)	$	(0.05	)	$	(0.05	)

Note 12: Comprehensive Income (Loss)

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


	Three Months Ended					Nine Months Ended
	September 29,		September 30,			September 29,			September 30,
	2006		2005			2006			2005
Net income (loss)	$	4,016	$	(2,891	)	$	(4,034	)	$	(3,715	)
Change in unrealized gain (loss) on investments, net		83		(35	)		173			(46	)
Foreign currency translation		19		(286	)		125			(164	)

Total comprehensive income (loss)	$	4,118	$	(3,212	)	$	(3,736	)	$	(3,925	)

Note 13: Segment Information

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

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

Geographic Information (in thousands):


	Three Months Ended				Nine Months Ended
	September 29,		September 30,		September 29,		September 30,
	2006		2005		2006		2005
Net sales:
United States	$	29,265	$	33,954	$	81,968	$	115,526
Canada		7,408		2,591		12,216		6,515
International		26,183		24,415		78,162		71,597

Total	$	62,856	$	60,960	$	172,346	$	193,638

In the third quarter of 2006, sales to Cox Communications and Comcast accounted for 13% and 10% of net sales, respectively, and in the third quarter of 2005, sales to a reseller for a major telco accounted for 13% of net sales. In the first nine months of 2006, no customer had sales that accounted for more than 10% of net sales, and in the first nine months of 2005, sales to Comcast accounted for 21% of net sales.

Note 14: Related Party

A director of Harmonic is also a director of Terayon Communications, from which the Company purchases products for resale. Product purchases from Terayon were approximately $1.3 million and $2.8 million, for the three and nine months ended September 29, 2006, respectively. Product purchases from Terayon were approximately $1.9 million and $18.9 million, for the three and nine months ended September 30, 2005, respectively. As of September 29, 2006 and December 31, 2005, Harmonic had liabilities to Terayon of approximately $0.9 million and $0.7 million, respectively, for inventory purchases.

Note 15: Guarantees

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Balance at beginning of the period	$	6,018		$	5,425		$	6,166		$	5,429
Accrual for warranties		1,383			1,517			3,404			4,042
Warranty costs incurred		(985	)		(1,128	)		(3,154	)		(3,678	)
BTL acquisition		—			—			—			21

Balance at end of the period	$	6,416		$	5,814		$	6,416		$	5,814

Standby Letters of Credit. As of September 29, 2006 the Company’s financial guarantees consisted of standby letters of credit outstanding, which were principally related to customs bond requirements, performance bonds and state requirements imposed on employers. The maximum amount of potential future payments under these arrangements was $0.8 million.

Indemnification Obligations. Harmonic is obligated to indemnify its officers and the members of its Board of Directors pursuant to its bylaws and contractual indemnity agreements. Harmonic also indemnifies some of its suppliers and customers for specified intellectual property matters pursuant to certain contractual arrangements, subject to certain limitations. The scope of these indemnities varies, but in some instances, includes indemnification for damages and expenses (including reasonable attorneys’ fees). There have been no claims against us for indemnification pursuant to any of these arrangements and, accordingly, no amounts have been accrued in respect of the indemnifications provisions through September 29, 2006.

Guarantees. As of September 29, 2006, Harmonic had no other guarantees outstanding.

Note 16: Legal Proceedings

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

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

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

On November 8, 2005, the Ninth Circuit panel affirmed in part, reversed in part, and remanded for further proceedings the decision of the District Court. The Ninth Circuit affirmed the District Court’s dismissal of the plaintiffs’ fraud claims under Sections 10(b), 14(a), and 20(a) of the Exchange Act with prejudice, finding that the plaintiffs failed to adequately plead their allegations of fraud. The Ninth Circuit reversed the District Court’s dismissal of the plaintiffs’ claims under Sections 11 and 12(a)(2) of the Securities Act, however, finding that those claims did not allege fraud and therefore were subject to only minimal pleading standards. Regarding the secondary liability claim under Section 15 of the Securities Act, the Ninth Circuit reversed the dismissal of that claim against Anthony J. Ley, Harmonic’s Chairman and Chief Executive Officer, and affirmed the dismissal of that claim against Harmonic, while granting leave to amend. The Ninth Circuit remanded the surviving claims to the District Court for further proceedings.

On November 22, 2005, both the Harmonic defendants and the plaintiffs petitioned the Ninth Circuit for a rehearing of the appeal. On February 16, 2006 the Ninth Circuit denied both petitions. On May 17, 2006 the plaintiffs filed an amended complaint on the issues remanded for further proceedings by the Ninth Circuit, to which the Harmonic defendants responded on with a Motion to Dismiss. Briefing on the motion was completed in August 2006. There will be no hearing unless the Court requests one.

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

A second derivative action purporting to be on behalf of Harmonic was filed in the Superior Court for the County of Santa Clara on May 15, 2003. It alleged facts similar to those previously alleged in the securities class action and the federal derivative action. The complaint named as defendants former and current Harmonic officers and directors, along with former officers and directors of C-Cube Microsystems, Inc., who were named in the securities class action. The complaint also named Harmonic as a nominal defendant. The complaint alleged claims for abuse of control, gross mismanagement, and waste of corporate assets against the Harmonic defendants, and claims for breach of fiduciary duty, unjust enrichment, and negligent misrepresentation against all defendants. On July 22, 2003, the Court approved the parties’ stipulation to stay the case pending resolution of the appeal in the securities class action. Following the decision of the Ninth Circuit discussed above, on May 9, 2006, defendants filed demurrers to this complaint. The plaintiffs then filed an amended complaint on July 10, 2006, which names only the Harmonic defendants. The defendants filed demurrers to the amended complaint, and a case management conference and hearing are scheduled for December 19, 2006.

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

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

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

Note 17: Entone Acquisition

In the third quarter of 2006, Harmonic entered into a definitive agreement to acquire the video networking software business of Entone Technologies, Inc., a privately-held company based in San Mateo, Ca, with research and development facilities in Hong Kong. The Entone software solutions—encompassing content ingest, distributed content management and video streaming—facilitate the provisioning of personalized video services including video-on-demand (VOD), network personal video recording (nPVR), time-shifted television and targeted advertisement insertion. By combining Harmonic’s industry-leading video headend, edge and access network solutions with Entone’s on-demand software, Harmonic expects to be able to provide cable, satellite and telco/IPTV service providers an advanced and uniquely integrated delivery system for the next generation of both broadcast and personalized IP-delivered video services.

The agreed upon purchase price is comprised of $26 million in cash and the value of 3.54 million shares of Harmonic common stock (with an approximate market value of $19.0 million at August 21, 2006), as determined in accordance with the terms of the definitive agreement. In addition, Harmonic will assume certain liabilities of $1.5 million and invest $2.5 million in the form of a convertible note in Entone’s consumer premise equipment (CPE) business, which will be spun out to Entone’s existing stockholders immediately prior to the closing of the acquisition. The Company currently expects the acquisition of Entone will be completed in the fourth quarter of 2006.

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

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

Overview

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

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

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

In the third quarter of 2006, Harmonic’s net sales increased 3% compared to the third quarter of 2005, although net sales in the first nine months of 2006 decreased by 11% compared to the first nine months of 2005. We believe that the increase in sales in the third quarter of 2006 compared to the same period in 2005 was due to increased shipments of a broad range of new video delivery solutions to domestic cable customers and new international telco and satellite customers. The decrease in net sales in the first nine months of 2006 compared to the first nine months of 2005 was attributable to weaker spending by domestic cable customers in the first half of 2006, the significant

amount of third party products sold to our end customers in the first nine months of 2005, as well as supply chain constraints and delays in the completion of projects for our international telco customers during the first nine months of 2006. Our quarterly and annual results may fluctuate significantly due to spending by our customers, our revenue recognition policies and the timing of the receipt of orders, as well as other factors, including those set forth in the section entitled “Risk Factors” in this Quarterly Report on Form 10-Q.

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

Historically, a majority of our net sales have been to relatively few customers, and due in part to the consolidation of ownership of cable television and direct broadcast satellite systems, we expect this customer concentration to continue for the foreseeable future. In the third quarter of 2006, sales to Cox Communications and Comcast accounted for 13% and 10% of net sales, respectively, and in the third quarter of 2005, sales to a reseller for a major telco accounted for 13% of net sales. In the first nine months of 2006, no customer had sales that accounted for more than 10% of net sales, and in the first nine months of 2005, sales to Comcast accounted for 21% of net sales.

Sales to customers outside of the U.S. in the third quarter and first nine months of 2006 represented 53% and 52% of net sales, respectively, compared to 44% and 40% for the comparable periods in 2005. A significant portion of international sales are made to distributors and system integrators, which are generally responsible for importing the products and providing installation and technical support and service to customers within their territory. Sales denominated in foreign currencies were approximately 9% of net sales in the first nine months of 2006 compared to 7% for the comparable period of 2005. We expect international sales to continue to account for a significant portion of our net sales for the foreseeable future.

In the third quarter of 2006, the Company completed its facilities rationalization plan resulting in more efficient use of our Sunnyvale campus and vacated several buildings, some of which were subsequently subleased. The Company also revisited its estimates of excess facilities reserves for buildings previously vacated due to entering into sublease agreements during the quarter. This resulted in a net charge for excess facilities of $2.1 million in the third quarter of 2006.

In May 2006, the Company’s Board of Directors appointed Patrick J. Harshman as President and Chief Executive Officer, replacing Anthony Ley, who retired after 18 years with the Company. Mr. Ley carries on as a consultant to the Company and as chairman of its Board of Directors. Following Dr. Harshman’s appointment, the Company announced a reorganization of its senior management, resulting in a charge of approximately $1 million in severance costs in the second quarter of 2006.

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

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

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

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

Critical Accounting Policies, Judgments and Estimates

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

Our significant accounting policies are described in Note 1 to the annual consolidated financial statements as of and for the year ended December 31, 2005, included in our Annual Report on Form 10-K filed with the SEC on March 14, 2006 and notes to condensed consolidated financial statements as of and for the three and nine month periods ended September 29, 2006, included herein. Our most critical accounting policies include the following:

–		revenue recognition;

–		allowances for doubtful accounts, returns and discounts;

–		valuation of inventories;

–		impairment of long-lived assets;

–		restructuring costs and accruals for excess facilities;

–		assessment of the probability of the outcome of current litigation;

–		accounting for income taxes; and

–		stock-based compensation.

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

Stock-Based Compensation

The Company adopted SFAS 123(R) using the modified-prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Condensed Consolidated Financial Statements as of and for the three and nine months ended September 29, 2006 reflects the impact of SFAS 123(R). In accordance with the modified prospective transition method, the Company’s Condensed Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Stock-based compensation expense recognized under SFAS 123(R) for the three and nine months ended September 29, 2006 was $1.2 million and $4.4 million, respectively, which consisted of stock-based compensation expense related to employee equity awards and employee stock purchases. There was no stock-based compensation expense related to employee equity awards and employee stock purchases recognized during the three and nine months ended September 30, 2005.

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

an option-pricing model is affected by the Company’s stock price as well as the assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the term of the awards, and actual and projected employee stock option exercise behaviors.

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

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

Results of Operations

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Net sales		100	%		100	%		100	%		100	%
Cost of sales		53			65			59			63

Gross profit		47			35			41			37
Operating expenses:
Research and development		16			15			17			15
Selling, general and administrative		27			25			28			24
Amortization of intangibles		—			—			—			1

Total operating expenses		43			40			45			40
Income (loss) from operations		4			(5	)		(4	)		(3	)
Interest income, net		2			1			2			1
Other income (expense), net		—			(1	)		—			—

Income (loss) before income taxes		6			(5	)		(2	)		(2	)
Provision for (benefit from) income taxes		—			—			—			—

Net income (loss)		6	%		(5	)%		(2	)%		(2	)%

Net Sales — Consolidated

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


	Three Months Ended					Nine Months Ended
	September 29,			September 30,		September 29,			September 30,
Product Sales Data:	2006			2005		2006			2005
Video Processing	$	26,116		$	24,668	$	66,363		$	99,077
Edge and Access		25,143			27,412		77,029			68,947
Software, Support and Other		11,597			8,880		28,954			25,614

Net sales	$	62,856		$	60,960	$	172,346		$	193,638

Video Processing increase (decrease)	$	1,448				$	(32,714	)
Edge and Access increase (decrease)		(2,269	)				8,082
Software, Support and Other increase		2,717					3,340

Total increase (decrease)	$	1,896				$	(21,292	)

Video Processing percent change		5.9	%				(33.0	)%
Edge and Access percent change		(8.3	)%				11.7	%
Software, Support and Other percent change		30.6	%				13.0	%
Total percent change		3.1	%				(11.0	)%

Net sales increased in the third quarter of 2006 compared to the same period of 2005 due to increased shipments to domestic cable customers and shipments to new international telco and satellite customers. In the video processing product lines, revenue increased primarily due to shipments of encoder and stream processing products to domestic cable customers, partially offset by a decrease in the sale of third party products. The edge and access products line experienced a decrease in sales in the third quarter of 2006 compared to the third quarter of 2005 as sales to a major domestic telco decreased significantly, which were partially offset by an increase in sales to international telco customers, primarily in Europe. Software revenue increased in the third quarter of 2006 compared to the prior year primarily due to the introduction of new products. Third party product sales decreased by approximately $2.1 million in the third quarter of 2006, compared to the corresponding period in 2005.

Net sales decreased in the first nine months of 2006 compared to the same period of 2005 principally due to the decrease in the sale of third party products to our end customers, supply chain constraints resulting in product shortages, delays in the completion of certain projects for international telco customers and decreased spending by domestic cable customers for major digital headend projects. In the video processing product line, sales of encoder and stream processing products decreased by approximately $18.2 million in the first nine months of 2006 compared to the same period in the prior year due to lower spending for major digital headend projects by domestic cable companies. Delays in the completion of certain projects underway with our international telco customers resulted in less revenue being recognized. In addition, sales of third party products to end customers decreased by approximately $14.6 million in the first nine months of 2006 compared to the same period in 2005. The edge and access products line, which includes certain VOD products, experienced a significant increase in revenue in the first nine months of 2006 compared to the first nine months of 2005 as telcos and other broadband operators continued to introduce and expand video and other services, primarily in the U.S. and European markets.

Net Sales — Geographic

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


	Three Months Ended					Nine Months Ended
	September 29,			September 30,		September 29,			September 30,
Geographic Sales Data:	2006			2005		2006			2005
U.S	$	29,265		$	33,954	$	81,968		$	115,526
International		33,591			27,006		90,378			78,112

Net sales	$	62,856		$	60,960	$	172,346		$	193,638

U.S. decrease	$	(4,689	)			$	(33,558	)
International increase		6,585					12,266

Total increase (decrease)	$	1,896				$	(21,292	)

U.S. percent change		(13.8	)%				(29.0	)%
International percent change		24.4	%				15.7	%
Total percent change		3.1	%				(11.0	)%

The decreased U.S. sales in the third quarter and the first nine months of 2006 compared to the corresponding periods in 2005 was principally due to fewer sales of third party products to end customers and lower spending by a major domestic telco.

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

Gross Profit

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Gross profit	$	29,797		$	21,396		$	71,282		$	71,841
As a % of net sales		47.4	%		35.1	%		41.4	%		37.1	%

Increase (decrease)	$	8,401					$	(559	)
Percent change		39.3	%					(0.8	)%

The increase in gross profit in the third quarter of 2006 as compared to the corresponding period of 2005 was primarily due to higher sales, an increase in gross margin percentage, lower amortization of intangibles and a one-time benefit arising from successful progress on a European telco project. The gross margin percentage in the third quarter and first nine months of 2006 compared to the corresponding periods of 2005 was higher primarily due to a higher proportion of digital video and service revenue, which carry higher gross margins than the average gross margins for our products, lower sales of third party products to our end customers in the third quarter and first nine months of 2006 compared to the corresponding periods of 2005, sales of which products have significantly lower gross margins than the average gross margin on sales of our products and the benefit for successful progress on a European telco project.

In the first nine months of 2006, $0.5 million of amortization of intangibles was included in cost of sales compared to $1.1 million in the first nine months of 2005. The lower amortization in the first nine months of 2006 was due to certain intangibles arising from the BTL acquisition being fully amortized in the third quarter of 2006. We expect to record approximately $0.2 million in amortization of intangibles in cost of sales in the remaining three months of 2006 due to the acquisition of BTL in February 2005.

Research and Development

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Research and development expense	$	10,021		$	9,403		$	29,554		$	28,381
As a % of net sales		15.9	%		15.4	%		17.1	%		14.7	%

Increase	$	618					$	1,173
Percent change		6.6	%					4.1	%

The increase in research and development expense in the third quarter of 2006 as compared to the same period in 2005 was primarily the result of increased use of outside consulting services associated with the development of new products of $0.3 million and stock-based compensation expense of $0.3 million. The increase in research and development expense in the first nine months of 2006 as compared to the same period in 2005 was primarily the result of increased use of outside consulting services associated with the development of new products of $1.3 million and stock-based compensation expense of $1.3 million, which was partially offset by lower compensation expense of $0.9 million from reductions in headcount and incentive compensation and lower prototype materials expense of $0.4 million.

Selling, General and Administrative

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Selling, general and administrative expense	$	16,931		$	15,166		$	48,623		$	47,102
As a % of net sales		26.9	%		24.9	%		28.2	%		24.3	%

Increase	$	1,765					$	1,521
Percent change		11.6	%					3.2	%

The increase in selling, general and administrative expense in the third quarter of 2006 compared to the same period in 2005 was primarily the result of the net excess facilities charge of $2.1 million in the third quarter of 2006 for the campus consolidation and stock-based compensation expense of $0.7 million, partially offset by lower facilities overhead expenses of $0.4 million, lower compensation expenses of $0.2 million and lower trade show expenses of $0.1 million. The increase in selling, general and administrative expense in the first nine months of 2006 compared to the same period in 2005 was primarily a result of the net excess facilities charge of $2.1 million for the campus consolidation, stock-based compensation expense of $2.3 million, which were partially offset by lower compensation expenses of $1.0 million, lower facilities overhead expenses of $1.0 million, lower trade show expenses of $0.3 million and lower corporate governance costs of $0.4 million.

Amortization of Intangibles

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Amortization of intangibles	$	45		$	110		$	179		$	1,233
As a % of net sales		0.1	%		0.2	%		0.1	%		0.6	%

Decrease	$	(65	)				$	(1,054	)
Percent change		(59.1	)%					(85.5	)%

The decrease in the amortization of intangibles in the third quarter of 2006 compared to the same period in 2005 was primarily due to the completion of amortization of certain items acquired in connection with the BTL transaction during the third quarter of 2006. The decrease in the amortization of intangibles in the first nine months of 2006 compared to the same period in 2005 was primarily due to the completion of amortization of the DiviCom intangible assets during the first nine months of 2005. Harmonic expects to record a total of approximately $45,000 in amortization of intangibles in operating expenses in the remaining three months of 2006 due to the intangible assets resulting from the acquisition of BTL in February 2005.

Interest Income, Net

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Interest income, net	$	1,182		$	669		$	3,349		$	1,828
As a % of net sales		1.9	%		1.1	%		1.9	%		0.9	%

Increase	$	513					$	1,521
Percent change		76.7	%					83.2	%

The increase in interest income, net, in third quarter and the first nine months of 2006 compared to the corresponding periods of 2005 was due primarily to higher interest rates on the cash and short-term investments portfolio and lower interest expense due to a lower debt balance in the third quarter and the first nine months of 2006 as compared to the corresponding periods in 2005.

Other Income (Expense), Net

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


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Other income (expense)	$	137		$	(288	)	$	173		$	(643	)
As a % of net sales		0.2	%		(0.5	)%		0.1	%		(0.3	)%

Increase	$	425					$	816
Percent change		147.6	%					126.9	%

The increase in other income (expense), net, in the third quarter and first nine months of 2006 compared to the corresponding periods of 2005 was primarily due to lower foreign exchange losses in 2006.

Income Taxes

Harmonic’s provision for income taxes, and provision for income taxes as a percentage of consolidated net sales in the third quarter and first nine months of 2006, as compared with the corresponding periods of 2005, are presented in the tables below. Also presented is the related dollar and percentage increase in income taxes in the third quarter and first nine months of 2006 as compared with the corresponding periods of 2005 (in thousands, except percentages).


	Three Months Ended						Nine Months Ended
	September 29,			September 30,			September 29,			September 30,
	2006			2005			2006			2005
Provision for (benefit from) income taxes	$	103		$	(11	)	$	482		$	25
As a % of net sales		0.2	%		0.0	%		0.3	%		0.0	%

Increase	$	114					$	457
Percent change		1,036.4	%					1,828.0	%

The increase in the provision for income taxes in the third quarter and the first nine months of 2006 compared to the corresponding periods in 2005 was due to higher foreign income taxes.

Liquidity and Capital Resources


	Nine Months Ended
	September 29,			September 30,
(In thousands)	2006			2005
Cash, cash equivalents and short-term investments	$	110,724		$	104,883
Net cash provided by (used in) operating activities	$	(9	)	$	9,023
Net cash used provided by (used in) investing activities	$	9,292		$	(8,336	)
Net cash provided by financing activities	$	3,341		$	5,380

As of September 29, 2006, cash, cash equivalents and short-term investments totaled $110.7 million, compared to $110.8 million as of December 31, 2005. Cash used in operations was $9,000 in the first nine months of 2006, compared to cash provided by operations of $9.0 million in the first nine months of 2005. The increased use of cash in operating activities in the first nine months of 2006 was primarily due to higher accounts receivable and prepaid expenses, which was partially offset by higher accounts payable and deferred revenue. The higher accounts receivable was due to increased revenue in the third quarter of 2006 compared to the third quarter of 2005 and the timing of shipments during the quarter. The higher prepaid expenses were primarily due to the increase in deferred costs on projects. The higher accounts payable was due to increase in inventory purchases and the timing of payments. The higher deferred revenue was due to new projects and delays in the progress and completion of

specific projects due to product shortages resulting in higher deferred costs in prepaid expenses and higher deferred revenue.

Additions to property, plant and equipment were $3.7 million during the first nine months of 2006 compared to $4.2 million in the first nine months of 2005. The decrease in the first nine months of 2006 from the comparable period in 2005 was primarily due to a decrease in the acquisition of test equipment. Harmonic currently expects capital expenditures to be approximately $5 million to $6 million during 2006.

In the third quarter of 2006, Harmonic entered into a definitive agreement to acquire the video networking software business of Entone Technologies, Inc., a privately-held company based in San Mateo, Ca, with research and development facilities in Hong Kong. The agreed upon purchase price is comprised of $26 million in cash and the value of 3.54 million shares of Harmonic common stock (with an approximate market value of $19.0 million at August 21, 2006), as determined in accordance with the terms of the definitive agreement. In addition, Harmonic will assume certain liabilities of $1.5 million and invest $2.5 million in the form of a convertible note in Entone’s consumer premise equipment (CPE) business, which will be spun out to Entone’s existing stockholders immediately prior to the closing of the acquisition.

On November 3, 2003, Harmonic completed a public offering of 9.0 million shares of its common stock at a price of $7.40 per share. The net proceeds were approximately $62.0 million, which is net of underwriters’ fees of $3.7 million, and related legal, accounting, printing and other expenses totaling approximately $0.9 million. In connection with this offering, the underwriters exercised their option to purchase 1.35 million additional shares of common stock at $7.40 per share on November 12, 2003 to cover over-allotments which resulted in additional net proceeds of approximately $9.4 million. The net proceeds from the offering are being used for general corporate purposes, including payment of existing liabilities, research and development, the development or acquisition of new products or technologies, equipment acquisitions, strategic acquisitions of businesses, general working capital and operating expenses.

Under the terms of the merger agreement with C-Cube, Harmonic is generally liable for C-Cube’s pre-merger tax liabilities. Approximately $10.0 million of pre-merger tax liabilities remained outstanding at September 29, 2006 and are included in accrued liabilities. These liabilities represent estimates of C-Cube’s pre-merger tax obligations to various tax authorities in 11 countries. We are working with LSI Logic, which acquired the spun-off semiconductor business in June 2001 and assumed its obligations, to settle these obligations, a process which has been underway since the merger in 2000. Although we expect to make payments within the next 12 months for these tax liabilities, Harmonic is unable to predict when the remaining obligations will be paid, or in what amount. The full amount of the estimated obligation has been classified as a current liability. To the extent that these obligations are finally settled for less than the amounts provided, Harmonic is required, under the terms of the tax-sharing agreement, to refund the difference to LSI Logic. Conversely, if the settlements are more than the $10.0 million pre-merger tax liability, LSI is obligated to reimburse Harmonic.

Harmonic has a bank line of credit facility with Silicon Valley Bank, which provides for borrowings of up to $23.7 million, including $3.7 million for equipment under a secured term loan. This facility, which was amended and restated in December 2005, expires in December 2006 and contains financial and other covenants including the requirement for Harmonic to maintain cash, cash equivalents and short-term investments, net of credit extensions, of not less than $30.0 million. If Harmonic is unable to maintain this cash, cash equivalents and short-term investments balance or satisfy the additional affirmative covenant requirements, Harmonic would be in noncompliance with the facility. In the event of noncompliance by Harmonic with the covenants under the facility, Silicon Valley Bank would be entitled to exercise its remedies under the facility which include declaring all obligations immediately due and payable and disposing of the collateral if obligations were not repaid. At September 29, 2006, Harmonic was in compliance with the covenants under this line of credit facility. The December 2005 amendment resulted in the company paying a fee of approximately $33,000 and requiring payment of approximately $43,000 of additional fees if the Company does not maintain an unrestricted deposit of $20.0 million with the bank. Future borrowings pursuant to the line bear interest at the bank’s prime rate (8.25% at September 29, 2006) or prime plus 0.5% for equipment borrowings. Borrowings are repayable monthly and are collateralized by all of Harmonic’s assets except intellectual property. As of September 29, 2006, $0.7 million was outstanding under the equipment term loan portion of this facility and there were no additional borrowings in 2005 or 2006. The term loan is payable monthly, including principal and interest at 8.75% per annum on outstanding borrowings as of September 29, 2006 and

matures at various dates through December 2007. Other than standby letters of credit and guarantees (Note 15), there were no other outstanding borrowings or commitments under the line of credit facility as of September 29, 2006.

Harmonic’s cash and investment balances at September 29, 2006 were $110.7 million. We currently believe that our existing liquidity sources, including our bank line of credit facility, will satisfy our requirements for at least the next twelve months, including the acquisition of Entone Technologies, which includes cash payments of $26 million for the acquisition and a $2.5 million investment in Entone’s CPE business, and final settlement and payment of C-Cube’s pre-merger tax liabilities. However, we may need to raise additional funds if our expectations or estimates change or prove inaccurate, or to take advantage of unanticipated opportunities or to strengthen our financial position. The completed stock offering in the fourth quarter of 2003 was part of a registration statement on Form S-3 declared effective by the SEC in April 2002. In April 2005, we filed another registration statement on Form S-3 with the SEC. Pursuant to these registration statements on Form S-3, which have been declared effective by the SEC, we are able to issue various types of registered securities, including common stock, preferred stock, debt securities, and warrants to purchase common stock from time to time, up to an aggregate of approximately $200 million, subject to market conditions and our capital needs.

In addition, we actively review potential acquisitions that would complement our existing product offerings, enhance our technical capabilities or expand our marketing and sales presence. Any future transaction of this nature could require potentially significant amounts of capital or could require us to issue our stock and dilute existing stockholders. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities, to develop new products or to otherwise respond to competitive pressures.

Our ability to raise funds may be adversely affected by a number of factors relating to Harmonic, as well as factors beyond our control, including increased market uncertainty surrounding the ongoing U.S. war on terrorism, as well as conditions in capital markets and the cable and satellite industries. There can be no assurance that any financing will be available on terms acceptable to us, if at all.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk represents the risk of loss that may impact the operating results, financial position, or liquidity of Harmonic due to adverse changes in market prices and rates. Harmonic is exposed to market risk because of changes in interest rates and foreign currency exchange rates as measured against the U.S. Dollar and currencies of Harmonic’s subsidiaries.

Foreign Currency Exchange Risk

Harmonic has a number of international subsidiaries each of whose sales are generally denominated in U.S. dollars. Sales denominated in foreign currencies were approximately 9% and 7% of net sales in the first nine months of 2006 and the full year of 2005, respectively. In addition, the Company has various international branch offices that provide sales support and systems integration services. Periodically, Harmonic enters into foreign currency forward exchange contracts, or forward contracts, to manage exposure related to accounts receivable denominated in foreign currencies. Harmonic does not enter into derivative financial instruments for trading purposes. At September 29, 2006, we had a forward contract to sell Euros totaling $4.1 million that matures during the fourth quarter of 2006. While Harmonic does not anticipate that near-term changes in exchange rates will have a material impact on Harmonic’s operating results, financial position and liquidity, Harmonic cannot assure you that a sudden and significant change in the value of local currencies would not harm Harmonic’s operating results, financial position and liquidity.

Interest Rate Risk

Exposure to market risk for changes in interest rates relate primarily to Harmonic’s investment portfolio of marketable debt securities of various issuers, types and maturities and to Harmonic’s borrowings under its bank line of credit facility. Harmonic does not use derivative instruments in its investment portfolio, and its investment portfolio only includes highly liquid instruments with an original maturity of less than two years. These investments are classified as available for sale and are carried at estimated fair value, with material unrealized gains and losses

reported in other comprehensive income. There is risk that losses could be incurred if Harmonic were to sell any of its securities prior to stated maturity. A 10% change in interest rates would not have had a material impact on financial conditions, results of operations or cash flows.

Item 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures.

Our management, with the participation of our chief executive officer and our chief financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Quarterly Report on Form 10-Q.

A control system, no matter how well conceived and operated, can provide only reasonable assurance that the objectives of the control system are met. Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all errors and fraud. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues within the company have been detected. These inherent limitations include the reality that judgments in decision-making can be incorrect, and that breakdowns can occur because of simple errors or mistakes. The design of any control system is also based, in part, upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and not be detected.

Based upon their evaluation of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this quarterly report on Form 10-Q, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures are effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.

Changes in internal controls.

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II

OTHER INFORMATION

Item 1. LEGAL PROCEEDINGS

Shareholder Litigation

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

defendants violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”). The complaint also alleged that certain defendants violated section 14(a) of the Exchange Act and sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”) by filing a false or misleading registration statement, prospectus, and joint proxy in connection with the C-Cube acquisition.

Other Litigation

Item 1A. RISK FACTORS

We Depend On Cable, Satellite And Telecom Industry Capital Spending For A Substantial Portion Of Our Revenue And Any Decrease Or Delay In Capital Spending In These Industries Would Negatively Impact Our Resources, Operating Results And Financial Condition And Cash Flows.

A significant portion of Harmonic’s sales have been derived from sales to cable television, satellite and telecommunications operators, and we expect these sales to constitute a significant portion of net sales for the foreseeable future. Demand for our products will depend on the magnitude and timing of capital spending by cable television operators, satellite operators, telephone companies and broadcasters for constructing and upgrading their systems.

These capital spending patterns are dependent on a variety of factors, including:

–		access to financing;

–		annual budget cycles;

–		the impact of industry consolidation;

–		the status of federal, local and foreign government regulation of telecommunications and television broadcasting;

–		overall demand for communication services and the acceptance of new video, voice and data services;

–		evolving industry standards and network architectures;

–		competitive pressures, including pricing pressures;

–		discretionary customer spending patterns; and

–		general economic conditions.

In the past, specific factors contributing to reduced capital spending have included:

–		uncertainty related to development of digital video industry standards;

–		delays associated with the evaluation of new services, new standards, and system architectures by many operators;

–		emphasis on generating revenue from existing customers by operators instead of new construction or network upgrades;

–		a reduction in the amount of capital available to finance projects of our customers and potential customers;

–		proposed and completed business combinations and divestitures by our customers and regulatory review thereof;

–		economic and financial conditions in domestic and international markets; and

–		bankruptcies and financial restructuring of major customers.

The financial difficulties of certain of our customers and changes in our customers’ deployment plans adversely affected our business in recent years. An economic downturn or other factors could also cause additional financial difficulties among our customers, and customers whose financial condition has stabilized may not purchase new equipment at levels we have seen in the past. Continued financial difficulties among our customers would adversely affect our operating results and financial condition. In addition, industry consolidation has, in the past and may in the future, constrain capital spending among our customers. In this regard, we believe that the bankruptcy of Adelphia Communications has led to capital spending delays and we cannot currently predict the impact of the sale of Adelphia Communications’ cable systems to Comcast and Time-Warner Cable on our future sales. As a result, we cannot assure you that we will maintain or increase our net sales in the future.

Major U.S. cable operators have indicated that the substantial completion of major network upgrades, which involved significant labor and construction costs, will lead to lower capital expenditures in the future. If our product portfolio and product development plans do not position us well to capture an increased portion of the capital spending of U.S. cable operators, our revenue may decline and our operating results would be adversely affected.

Our Customer Base Is Concentrated And The Loss Of One Or More Of Our Key Customers, Or a Failure to Diversify Our Customer Base, Could Harm Our Business.

Historically, a majority of our 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 in the foreseeable future. Sales to our ten largest customers in the first nine months of 2006 and the years 2005 and 2004 accounted for approximately 48%, 54% and 55% of net sales, respectively. Although we are attempting to broaden our customer base by penetrating new markets such as the telecommunications and broadcast markets and expand internationally, we expect to see continuing industry consolidation and customer concentration due in part to the significant capital costs of constructing broadband networks. For example, Comcast acquired AT&T Broadband in November 2002, thereby creating the largest U.S. cable operator, reaching approximately 22 million subscribers. In the DBS market, The News Corporation Ltd. acquired an indirect controlling interest in Hughes Electronics, the parent company of DIRECTV in 2003. NTL and Telewest, the two largest cable operators in the UK have recently completed their announced merger. In the telco market, AT&T has announced an agreement to acquire Bell South and has recently received approval from the Department of Justice for the merger. The sale of Adelphia Communications has led to further industry consolidation. In addition, rumors have circulated recently about the potential merger of DirecTV and Echostar, the two largest DBS operators in the U.S. In the third quarter of 2006 and the years 2005 and 2004, sales to Comcast accounted for 10%, 18% and 17%, respectively, of net sales. The loss of Comcast or any other significant customer or any reduction in orders by Comcast or any significant customer, or our failure to qualify our products with a significant customer could adversely affect our business, operating results and liquidity. In this regard, sales to Comcast declined in 2004 compared to 2003, both in absolute

dollars and as a percentage of revenues. Furthermore, in the third and fourth quarters of 2005, sales for a major telco accounted for 13% of net sales. However, we do not expect to make continuing significant shipments for this telco after the second quarter of 2006, and we did not make any significant shipments for this telco in the third quarter of 2006. The loss of, or any reduction in orders from, a significant customer would harm our business.

In addition, historically we have been dependent upon capital spending in the cable and satellite industry. We are attempting to diversify our customer base beyond cable and satellite customers, principally into the telco market. Major telcos have begun to implement plans to rebuild or upgrade their networks to offer bundled video, voice and data services. While we have recently increased our revenue from telco customers, we are relatively new to this market. In order to be successful in this market, we may need to build alliances with telco equipment manufacturers, adapt our products for telco applications, take orders at prices resulting in lower margins, and build internal expertise to handle the particular contractual and technical demands of the telco industry. In addition, telco video deployments are subject to delays in completion, as video processing technologies and video business models are new to most telcos and many of their largest suppliers. Implementation issues with our products or those of other vendors have caused, and may continue to cause delays in project completion for our customers and delay the recognition of revenue by Harmonic. As a result of these and other factors, we cannot assure you that we will be able to increase our revenues from the telco market, or that we can do so profitably, and any failure to increase revenues and profits from telco customers could adversely affect our business.

Our Operating Results Are Likely To Fluctuate Significantly And May Fail To Meet Or Exceed The Expectations Of Securities Analysts Or Investors, Causing Our Stock Price To Decline.

Our operating results have fluctuated in the past and are likely to continue to fluctuate in the future, on an annual and a quarterly basis, as a result of several factors, many of which are outside of our control. Some of the factors that may cause these fluctuations include:

–		the level and timing of capital spending of our customers, both in the U.S. and in foreign markets;

–		changes in market demand;

–		the timing and amount of orders, especially from significant customers;

–		the timing of revenue recognition from solution contracts which may span several quarters;

–		the timing of revenue recognition on sales arrangements, which may include multiple deliverables;

–		the timing of completion of projects;

–		the need to replace revenue from shipments to a distributor for a major telco, which we do not expect to continue at the same level of revenue in 2006 as in 2005;

–		competitive market conditions, including pricing actions by our competitors;

–		seasonality, with fewer construction and upgrade projects typically occurring in winter months and otherwise being affected by inclement weather;

–		our unpredictable sales cycles;

–		the amount and timing of sales to telcos, which are particularly difficult to predict;

–		new product introductions by our competitors or by us;

–		changes in domestic and international regulatory environments;

–		market acceptance of new or existing products;

–		the cost and availability of components, subassemblies and modules;

–		the mix of our customer base and sales channels;

–		the mix of our products sold;

–		changes in our operating expenses and extraordinary expenses;

–		the impact of SFAS 123(R), a recently adopted accounting standard which requires us to expense stock options;

–		our development of custom products and software;

–		the quantity of third-party products we sell, which products carry lower gross margins, compared to our own products;

–		the level of international sales; and

–		economic and financial conditions specific to the cable, satellite and telco industries, and general economic conditions.

The timing of deployment of our equipment can be subject to a number of other risks, including the availability of skilled engineering and technical personnel, the availability of other equipment such as compatible set top boxes, and our customers’ need for local franchise and licensing approvals.

For example, during the first and second quarters of 2006, our net sales declined sequentially due in part to a reduction in sales to Verizon, one of our major customers, and in comparison to the comparable period in 2005, due to a decrease in the volume of third party products we sold.

In addition, we often recognize a substantial portion of our revenues in the last month of the quarter. We establish our 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. As a result of all these factors, our operating results in one or more future periods may fail to meet or exceed the expectations of securities analysts or investors. In that event, the trading price of our common stock would likely decline. In this regard, due to lower than expected sales during the first quarter of 2003, the third quarter of 2004, a decrease in gross profit percentage in 2005, and lower than expected sales during the first and second quarters of 2006, we failed to meet our internal expectations, as well as the expectations of securities analysts and investors, and the price of our common stock declined, in some cases significantly.

Our Future Growth Depends on Market Acceptance of Several Emerging Broadband Services, on the Adoption of New Broadband Technologies and on Several Other Broadband Industry Trends.

Future demand for our products will depend significantly on the growing market acceptance of several emerging broadband services, including digital video; VOD; HDTV; very high-speed data services and voice-over-IP (VoIP) telephony.

The effective delivery of these services will depend, in part, on a variety of new network architectures and standards, such as:

–		new video compression standards such as MPEG-4/H.264 and Microsoft’s Windows Media 9 broadcast profile (VC-1), for both standard definition and high definition services;

–		FTTP and DSL networks designed to facilitate the delivery of video services by telcos;

–		the greater use of protocols such as IP; and

–

the introduction of new consumer devices, such as advanced set-top boxes and personal video recorders (PVRs).

If adoption of these emerging services and/or technologies is not as widespread or as rapid as we expect, or if we are unable to develop new products based on these technologies on a timely basis, our net sales growth will be materially and adversely affected.

Furthermore, other technological, industry and regulatory trends will affect the growth of our business. These trends include the following:

–		convergence, or the desire of certain network operators to deliver a package of video, voice and data services to consumers, also known as the “triple play”;

–		the use of digital video by businesses, governments and educators;

–		the entry of telcos into the video business to allow them to offer the “triple play”;

–		growth in HDTV, on-demand services and mobile video;

–		efforts by regulators and governments in the U.S. and abroad to encourage the adoption of broadband and digital technologies; and

–		the extent and nature of regulatory attitudes towards such issues as competition between operators, access by third parties to networks of other operators, local franchising requirements for telcos to offer video, and new services such as VoIP.

If, for instance, operators do not pursue the “triple play” as aggressively as we expect, our net sales growth would be materially and adversely affected. Similarly, if our expectations regarding these and other trends are not met, our net sales may be materially and adversely affected.

We Need To Develop And Introduce New And Enhanced Products In A Timely Manner To Remain Competitive.

Broadband communications markets are characterized by continuing technological advancement, changes in customer requirements and evolving industry standards. To compete successfully, we must design, develop, manufacture and sell new or enhanced products that provide increasingly higher levels of performance and reliability. However, we may not be able to successfully develop or introduce these products if our products:

–		are not cost effective;

–		are not brought to market in a timely manner;

–		are not in accordance with evolving industry standards and architectures;

–		fail to achieve market acceptance; or

–		are ahead of the market.

We are currently developing and marketing products based on new video compression standards. Encoding products based on the MPEG-2 compression standards have represented a significant portion of the Company’s sales since the acquisition of DiviCom in 2000. New standards, such as MPEG-4/H.264 and Microsoft’s Windows Media 9 broadcast profile (VC-1), have been adopted which provide significantly greater compression efficiency, thereby making more bandwidth available to operators. The availability of more bandwidth is particularly important to those DBS and telco operators seeking to launch, or expand, HDTV services. One of our competitors has already announced significant orders for MPEG-4 HD encoders from a major DBS operator. Harmonic has developed and

launched products, including HD encoders, based on these new standards in order to remain competitive and is devoting considerable resources to this effort. There can be no assurance that these efforts will be successful in the near future, or at all, or that competitors will not take significant market share in HD encoding.

We are also currently marketing products for FTTP networks which certain telcos have begun to build. We believe that a number of our existing products can be deployed successfully in these networks and we have devoted considerable resources to obtaining orders, qualifying our products and hiring knowledgeable personnel. Shipments of products for a major telco’s FTTP projects represented 13% of sales in our third and fourth quarters of 2005. However, we do not expect to make significant shipments for this telco after the second quarter of 2006, and did not make significant shipments for this telco in the third quarter of 2006, and we have reduced the amount of resources devoted to these products. While we expect to continue to market these products to other customers, there can be no assurance that these efforts will be successful in the near future, or at all.

Also, to successfully develop and market certain of our planned products for digital applications, we may be required to enter into technology development or licensing agreements with third parties. We cannot assure you that we will be able to enter into any necessary technology development or licensing agreement on terms acceptable to us, or at all. The failure to enter into technology development or licensing agreements when necessary could limit our ability to develop and market new products and, accordingly, could materially and adversely affect our business and operating results.

Broadband Communications Markets Are Characterized By Rapid Technological Change.

Broadband communications markets are relatively immature, making it difficult to accurately predict the markets’ future growth rates, sizes or technological directions. In view of the evolving nature of these markets, it is possible that cable television operators, telephone companies or other suppliers of broadband wireless and satellite services will decide to adopt alternative architectures or technologies that are incompatible with our current or future products. Also, decisions by customers to adopt new technologies or products are often delayed by extensive evaluation and qualification processes and can result in delays in sales of current products. If we are unable to design, develop, manufacture and sell products that incorporate or are compatible with these new architectures or technologies, our business will suffer.

The Markets In Which We Operate Are Intensely Competitive And Many Of Our Competitors Are Larger And More Established.

The markets for fiber optics systems and digital video systems are extremely competitive and have been characterized by rapid technological change and declining average selling prices. Pressure on average selling prices was particularly severe during the most recent economic downturn as equipment suppliers competed aggressively for customers’ reduced capital spending. Harmonic’s competitors for fiber optic products include corporations such as Motorola, Cisco Systems and C-Cor. In our digital and video broadcasting products, we compete broadly with products from vertically integrated system suppliers including Motorola, Cisco Systems, Tandberg Television and Thomson Multimedia, and in certain product lines with a number of smaller companies.

Many of our competitors are substantially larger and have greater financial, technical, marketing and other resources than Harmonic. Many of these large organizations are in a better position to withstand any significant reduction in capital spending by customers in these markets. They often have broader product lines and market focus and may not be as susceptible to downturns in a particular market. In addition, many of our competitors have been in operation longer than we have and therefore have more long-standing and established relationships with domestic and foreign customers. We may not be able to compete successfully in the future, which may harm our business.

If any of our competitors’ products or technologies were to become the industry standard, our business could be seriously harmed. For example, new standards for video compression are being introduced and products based on these standards are being developed by Harmonic and certain competitors. If our competitors are successful in bringing these products to market earlier, or if these products are more technologically capable than ours, then our sales could be materially and adversely affected. In addition, companies that have historically not had a large presence in the broadband communications equipment market have begun recently to expand their market share through mergers and acquisitions. The continued consolidation of our competitors could have a significant negative

impact on us. Further, our competitors, particularly competitors of our digital and video broadcasting systems business, may bundle their products or incorporate functionality into existing products in a manner that discourages users from purchasing our products or which may require us to lower our selling prices resulting in lower gross margins.

If Sales Forecasted For A Particular Period Are Not Realized In That Period Due To The Unpredictable Sales Cycles Of Our Products, Our Operating Results For That Period Will Be Harmed.

The sales cycles of many of our products, particularly our newer products and products sold internationally, are typically unpredictable and usually involve:

–		a significant technical evaluation;

–		a commitment of capital and other resources by cable, satellite, and other network operators;

–		time required to engineer the deployment of new technologies or new broadband services;

–		testing and acceptance of new technologies that affect key operations; and

–		test marketing of new services with subscribers.

For these and other reasons, our sales cycles generally last three to nine months, but can last up to 12 months. If orders forecasted for a specific customer for a particular quarter do not occur in that quarter, our operating results for that quarter could be substantially lower than anticipated. In this regard, our sales cycles with our current and potential satellite and telco customers are particularly unpredictable. Additionally, orders may include multiple elements, the timing of delivery of which may impact the timing of revenue recognition. Quarterly and annual results may fluctuate significantly due to revenue recognition policies and the timing of the receipt of orders. For example, revenue from two significant customer orders in the third quarter of 2004 was delayed due to these factors until the fourth quarter of 2004, and delays in the completion of certain projects underway with our international telco customers in the second quarter of 2006 resulted in lower revenue.

In addition, a significant portion of our revenue is derived from solution sales that principally consist of and include the system design, manufacture, test, installation and integration of equipment to the specifications of Harmonic’s customers, including equipment acquired from third parties to be integrated with Harmonic’s products. Revenue forecasts for solution contracts are based on the estimated timing of the system design, installation and integration of projects. Because the solution contracts generally span several quarters and revenue recognition is based on progress under the contract, the timing of revenue is difficult to predict and could result in lower than expected revenue in any particular quarter.

We Face Risks Associated With Having Important Facilities And Resources Located In Israel.

Harmonic maintains a facility in Caesarea in the State of Israel with a total of 70 employees as of September 29, 2006, or approximately 12% of our workforce. The employees at this facility consist principally of research and development personnel involved in development of certain digital video products. In addition, we have pilot production capabilities at this facility consisting of procurement of subassemblies and modules from Israeli subcontractors and final assembly and test operations. Accordingly, we are directly influenced by the political, economic and military conditions affecting Israel. Any recurrence of the recent conflict in Israel and Lebanon could have a direct effect on our business or that of our Israeli subcontractors, in the form of physical damage or injury, reluctance to travel within or to Israel by our Israeli and foreign employees, or the loss of employees to active military duty. Most of our employees in Israel are currently obligated to perform annual reserve duty in the Israel Defense Forces and several have been called for active military duty recently. In the event that more employees are called to active duty, certain of our research and development activities may be adversely affected and significantly delayed. In addition, the interruption or curtailment of trade between Israel and its trading partners could significantly harm our business. Terrorist attacks and hostilities within Israel, the hostilities between Israel and Hezbollah and the election of Hamas representatives to a majority of the seats in the Palestinian Legislative Council have also heightened these risks. We cannot assure you that current tensions in the Middle East will not adversely

affect our business and results of operations, and we cannot predict the effect of events in Israel on Harmonic in the future.

We Depend On Our International Sales And Are Subject To The Risks Associated With International Operations, Which May Negatively Affect Our Operating Results.

Sales to customers outside of the U.S. in the first nine months of 2006 and the years 2005 and 2004 represented 52%, 40% and 42% of net sales, respectively, and we expect that international sales will continue to represent a meaningful portion of our net sales for the foreseeable future. Furthermore, a substantial portion of our contract manufacturing occurs overseas. Our international operations, the international operations of our contract manufacturers, and our efforts to increase sales in international markets, are subject to a number of risks, including:

–		changes in foreign government regulations and telecommunications standards;

–		import and export license requirements, tariffs, taxes and other trade barriers;

–		fluctuations in currency exchange rates;

–		difficulty in collecting accounts receivable;

–		the burden of complying with a wide variety of foreign laws, treaties and technical standards;

–		difficulty in staffing and managing foreign operations;

–		political and economic instability; and

–		changes in economic policies by foreign governments.

Certain of our international customers have accumulated significant levels of debt and have announced during the past three years reorganizations and financial restructurings, including bankruptcy filings. Even if these restructurings are completed, we cannot assure you that these customers will be in a position to purchase new equipment at levels we have seen in the past.

While our international sales and operating expenses have typically been denominated in U.S. dollars, fluctuations in currency exchange rates could cause our products to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country.

Following implementation of the Euro in January 2002, a higher portion of our European business is denominated in Euros, which may subject us to increased foreign currency risk. Gains and losses on the conversion to U.S. dollars of accounts receivable, accounts payable and other monetary assets and liabilities arising from international operations may contribute to fluctuations in operating results. Furthermore, payment cycles for international customers are typically longer than those for customers in the U.S. Unpredictable sales cycles could cause us to fail to meet or exceed the expectations of security analysts and investors for any given period. In addition, foreign markets may not develop in the future. Any or all of these factors could adversely impact our business and results of operations and we cannot predict the effect of events in Israel on Harmonic in the future.

Pending Business Combinations And Other Financial And Regulatory Issues Among Our Customers Could Adversely Affect Our Business.

Many of our domestic and international customers accumulated significant levels of debt and announced reorganizations and financial restructurings during the past three years, including bankruptcy filings. In particular, Adelphia Communications, a major domestic cable operator, declared bankruptcy in June 2002. The stock prices of other domestic cable companies came under pressure following the Adelphia bankruptcy due to concerns about debt levels and capital expenditure requirements for new and expanded services, thereby making the raising of capital more difficult and expensive.

While the capital market concerns about the domestic cable industry have eased, market conditions remain difficult and capital spending plans are generally constrained. It is likely that further industry restructuring will take place via mergers or spin-offs, such as the Comcast/AT&T Broadband transaction in 2002 and the acquisition by The News Corporation Ltd. in December 2003 of an indirect controlling interest in Hughes Electronics, the parent company of DIRECTV. This transaction followed regulatory opposition to the proposed acquisition of DIRECTV by EchoStar. We believe that uncertainty during 2002 regarding the proposed DIRECTV and EchoStar merger adversely affected capital spending by both of these parties as well as other customers. Rumors have again surfaced recently concerning a possible combination of these customers. More recently, restructuring of the industry has continued with the privatization of Cox Communications, the sale of Adelphia Communications out of bankruptcy to Comcast and Time-Warner, the sale of Cablevision’s VOOM! satellite assets to Echostar and the recently completed merger of UK cable operators NTL and Telewest. In addition, further business combinations may occur in our industry, and these further combinations could adversely affect our business. Regulatory issues, financial concerns and business combinations among our customers are likely to significantly affect the industry, its capital spending plans, and our levels of business for the foreseeable future.

Changes in Telecommunications Legislation and Regulations Could Harm Our Prospects And Future Sales.

Changes in telecommunications legislation and regulations in the U.S. and other countries could affect the sales of our products. In particular, regulations dealing with access by competitors to the networks of incumbent operators could slow or stop additional construction or expansion by these operators. Local franchising and licensing requirements may slow the entry of telcos into the video business. Increased regulation of our customers’ pricing or service offerings could limit their investments and consequently the sales of our products. Changes in regulations could have a material adverse effect on our business, operating results, and financial condition.

Competition For Qualified Personnel, Particularly Management Personnel, Can Be Intense. In Order To Manage Our Growth, We Must Be Successful In Addressing Management Succession Issues And Attracting And Retaining Qualified Personnel.

Our future success will depend, to a significant extent, on the ability of our management to operate effectively, both individually and as a group. We must successfully manage transition and replacement issues that may result from the departure or retirement of members of our senior management. For example, on May 4, 2006 we announced that our Chairman, President and Chief Executive Officer, Anthony J. Ley, was retiring from his position as President and Chief Executive Officer effective immediately, and that he was being succeeded by our current Executive Vice President, Patrick J. Harshman. In addition, on November 6, 2006, we announced that our Senior Vice President of Operations and Quality, Israel Levi, was retiring from his position effective immediately, and that he was being succeeded by Charles Bonasera as Vice President of Operations. We cannot assure you that transitions of management personnel will not cause disruption to our operations or customer relationships, or a decline in our financial results.

In addition, we are dependent on our ability to retain and motivate high caliber personnel, in addition to attracting new personnel. Competition for qualified management, technical and other personnel can be intense, and we may not be successful in attracting and retaining such personnel. Competitors and others have in the past and may in the future attempt to recruit our employees. While our employees are required to sign standard agreements concerning confidentiality and ownership of inventions, we generally do not have employment contracts or non-competition agreements with any of our personnel. The loss of the services of any of our key personnel, the inability to attract or retain qualified personnel in the future or delays in hiring required personnel, particularly senior management and engineers and other technical personnel, could negatively affect our business.

Recent And Proposed Regulations Related To Equity Compensation Could Adversely Affect Earnings, Affect Our Ability To Raise Capital And Affect Our Ability To Attract And Retain Key Personnel.

Since our inception, we have used stock options as a fundamental component of our employee compensation packages. We believe that our stock option plans are an essential tool to link the long-term interests of stockholders and employees, especially executive management, and serve to motivate management to make decisions that will, in the long run, give the best returns to stockholders. The Financial Accounting Standards Board (FASB) has issued

FAS 123(R) that requires us to record a charge to earnings for employee stock option grants and employee stock purchase plan rights for all future periods beginning on January 1, 2006. This standard has negatively impacted and will continue to negatively impact our earnings and may affect our ability to raise capital on acceptable terms. For the three and nine months ended September 29, 2006, stock-based compensation expense recognized under SFAS 123(R) was $1.2 million and $4.4 million, respectively, which consisted of stock-based compensation expense related to employee equity awards and employee stock purchases.

In addition, regulations implemented by Nasdaq requiring stockholder approval for all stock option plans could make it more difficult for us to grant options to employees in the future. To the extent that new accounting standards make it more difficult or expensive to grant options to employees, we may incur increased compensation costs, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, each of which could materially and adversely affect our business.

We Are Exposed To Additional Costs And Risks Associated With Complying With Increasing And New Regulation Of Corporate Governance And Disclosure Standards.

We are spending an increased amount of management time and external resources to comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, SEC regulations and Nasdaq rules. Particularly, Section 404 of the Sarbanes-Oxley Act requires management’s annual review and evaluation of our internal control over financial reporting, and attestation of the effectiveness of our internal control over financial reporting by management and the Company’s independent registered public accounting firm in connection with the filing of the annual report on Form 10-K for each fiscal year. We have documented and tested our internal control systems and procedures and have made improvements in order for us to comply with the requirements of Section 404. This process required us to hire additional personnel and outside advisory services and has resulted in significant additional expenses. While our assessment of our internal control over financial reporting resulted in our conclusion that as of December 31, 2005, our internal control over financial reporting was effective, we cannot predict the outcome of our testing in future periods. If we conclude in future periods that our internal control over financial reporting is not effective or if our independent registered public accounting firm is unable to provide an unqualified opinion as of future year-ends, investors may lose confidence in our financial statements, and the price of our stock may suffer.

We May Need Additional Capital In The Future And May Not Be Able To Secure Adequate Funds On Terms Acceptable To Us.

We have generated substantial operating losses since we began operations in June 1988. We have been engaged in the design, manufacture and sale of a variety of broadband products since inception, which has required, and will continue to require, significant research and development expenditures. As of September 29, 2006 we had an accumulated deficit of $1.9 billion. These losses, among other things, have had and may have an adverse effect on our stockholders’ equity and working capital.

We believe that the proceeds of the stock offering we completed in November 2003, together with our existing liquidity sources, will satisfy our cash requirements for at least the next twelve months, including the acquisition of Entone Technologies, which includes cash payments of $26 million for the acquisition and a $2.5 million investment in Entone’s CPE business, and final settlement and payment of C-Cube’s pre-merger tax liabilities. However, we may need to raise additional funds if our expectations are incorrect, to fund our operations, to take advantage of unanticipated strategic opportunities or to strengthen our financial position. The stock offering we completed in November 2003 related to a registration statement on Form S-3 declared effective by the SEC in April 2002. In April 2005, we filed another registration statement on Form S-3 with the SEC. Pursuant to these registration statements on Form S-3, which have been declared effective by the SEC, we will continue to be able to issue registered common stock, preferred stock, debt securities and warrants to purchase common stock from time to time, up to an aggregate of approximately $200 million, subject to market conditions and our capital needs. Our ability to raise funds may be adversely affected by a number of factors relating to Harmonic, as well as factors beyond our control, including conditions in capital markets and the cable, telecom and satellite industries. There can be no assurance that such financing will be available on terms acceptable to us, if at all.

could require potentially significant amounts of capital to finance the acquisition and related expenses as well as to integrate operations following a transaction, and could require us to issue our stock and dilute existing stockholders. If adequate funds are not available, or are not available on acceptable terms, we may not be able to take advantage of market opportunities, to develop new products or to otherwise respond to competitive pressures.

We may raise additional financing through public or private equity offerings, debt financings or additional corporate collaboration and licensing arrangements. To the extent we raise additional capital by issuing equity securities, our stockholders may experience dilution. To the extent that we raise additional funds through collaboration and licensing arrangements, it may be necessary to relinquish some rights to our technologies or products, or grant licenses on terms that are not favorable to us. If adequate funds are not available, we will not be able to continue developing our products.

If Demand For Our Products Increases More Quickly Than We Expect, We May Be Unable To Meet Our Customers’ Requirements.

If demand for our products increases, the difficulty of accurately forecasting our customers’ requirements and meeting these requirements will increase. For example, we had insufficient quantities of certain products to meet customer demand late in the second quarter of 2006 and, as a result, our revenues were lower than internal and external expectations. These product shortages are expected to have some continuing impact on our business until the end of this year. Forecasting to meet customers’ needs and effectively managing our supply chain is particularly difficult in connection with newer products. Our ability to meet customer demand depends significantly on the availability of components and other materials as well as the ability of our contract manufacturers to scale their production. Furthermore, we purchase several key components, subassemblies and modules used in the manufacture or integration of our products from sole or limited sources. Our ability to meet customer requirements depends in part on our ability to obtain sufficient volumes of these materials in a timely fashion. Also, in recent years, in response to lower net sales and the prolonged economic recession, we significantly reduced our headcount and other expenses. As a result, we may be unable to respond to customer demand that increases more quickly than we expect. If we fail to meet customers’ supply expectations, our net sales would be adversely affected and we may lose business.

We Must Be Able To Manage Expenses And Inventory Risks Associated With Meeting The Demand Of Our Customers.

If actual orders are materially lower than the indications we receive from our customers, our ability to manage inventory and expenses may be affected. If we enter into purchase commitments to acquire materials, or expend resources to manufacture products, and such products are not purchased by our customers, our business and operating results could suffer. In this regard, our gross margins and operating results have been in the past adversely affected by significant charges for excess and obsolete inventories.

In addition, the Company must carefully manage the introduction of next generation products in order to balance potential inventory risks associated with excess quantities of older product lines and forecasts of customer demand for new products. For example, in 2005, we wrote down approximately $8.4 million for obsolete and excess inventory, with a major portion of the write-down being the result of product transitions in certain product lines. There can be no assurance that the Company will be able to manage these product transitions in the future without incurring write-downs for excess inventory or having inadequate supplies of new products to meet customer expectations.

We Purchase Several Key Components, Subassemblies And Modules Used In The Manufacture Or Integration Of Our Products From Sole Or Limited Sources, And We Are Increasingly Dependent On Contract Manufacturers.

Many components, subassemblies and modules necessary for the manufacture or integration of our products are obtained from a sole supplier or a limited group of suppliers. For example, we depend on LSI Logic and a small privately held company for certain video encoding chips. Our reliance on sole or limited suppliers, particularly foreign suppliers, and our increased reliance on subcontractors since the merger with C-Cube involves several risks, including a potential inability to obtain an adequate supply of required components, subassemblies or modules and reduced control over pricing, quality and timely delivery of components, subassemblies or modules. In particular,

certain optical components have in the past been in short supply and are available only from a small number of suppliers, including sole source suppliers. While we expend resources to qualify additional optical component sources, consolidation of suppliers in the industry and the small number of viable alternatives have limited the results of these efforts. We do not generally maintain long-term agreements with any of our suppliers. Managing our supplier and contractor relationships is particularly difficult during time periods in which we introduce new products and during time periods in which demand for our products is increasing, especially if demand increases more quickly than we expect. Furthermore, from time to time we assess our relationship with our contract manufacturers. In late 2003, we entered into a three-year agreement with Plexus Services Corp. as our primary contract manufacturer. This agreement has automatic annual renewals unless prior notice is given.

Difficulties in managing relationships with current contract manufacturers, could impede our ability to meet our customers’ requirements and adversely affect our operating results. An inability to obtain adequate deliveries or any other circumstance that would require us to seek alternative sources of supply could negatively affect our ability to ship our products on a timely basis, which could damage relationships with current and prospective customers and harm our business. We attempt to limit this risk by maintaining safety stocks of certain components, subassemblies and modules. As a result of this investment in inventories, we have in the past and in the future may be subject to risk of excess and obsolete inventories, which could harm our business, operating results, financial position and liquidity. In this regard, our gross margins and operating results in the past were adversely affected by significant excess and obsolete inventory charges.

We Need To Effectively Manage Our Operations And The Cyclical Nature Of Our Business.

The cyclical nature of our business has placed, and is expected to continue to place, a significant strain on our personnel, management and other resources. We reduced our work force by approximately 44% between December 31, 2000 and December 31, 2003 due to reduced industry spending and demand for our products. If demand for products increases significantly, we may need to increase our headcount, as we did during 2004, adding 33 employees. In the first quarter of 2005, we added 42 employees in connection with our acquisition of BTL, and in connection with the consolidation of our two operating divisions in December 2005, we reduced our workforce by approximately 40 employees. Our ability to manage our business effectively in the future, including any future growth, will require us to train, motivate and manage our employees successfully, to attract and integrate new employees into our overall operations, to retain key employees and to continue to improve our operational, financial and management systems.

We May Be Materially Affected By The WEEE And RoHS Directives.

The European Parliament and the Council of the European Union have finalized the Waste Electrical and Electronic Equipment (WEEE) directive, which became effective in August 2005, which regulates the collection, recovery, and recycling of waste from electrical and electronic products, and the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment (RoHS) directive, which became effective in July 2006, which bans the use of certain hazardous materials including lead, mercury, cadmium, hexavalent chromium, and polybrominated biphenyls (PBBs), and polybrominated diphenyl ethers (PBDEs) that exceed certain specified levels. Under WEEE, we are responsible for financing operations for the collection, treatment, disposal, and recycling of past and future covered products that we produce. In addition, we may not have saleable inventory located within the EU that can be sold to customers due to import restrictions which could result in unfulfilled sales orders. We cannot assure you that compliance with WEEE and RoHS will not have a material adverse effect on our financial condition or results of operations.

We Are Liable For C-Cube’s Pre-Merger Tax Liabilities, Including Tax Liabilities Resulting From The Spin-Off Of Its Semiconductor Business.

Under the terms of the merger agreement with C-Cube, Harmonic is generally liable for C-Cube’s pre-merger tax liabilities. As of September 29, 2006, approximately $10.0 million of pre-merger tax liabilities remained outstanding and are included in accrued liabilities. We are working with LSI Logic, which acquired C-Cube’s spun-off semiconductor business in June 2001 and assumed its obligations, to develop an approach to settle these obligations, a process which has been underway since the merger in 2000. These liabilities represent estimates of C-Cube’s pre-merger tax obligations to various tax authorities in 11 countries. Harmonic paid $5.8 million of these tax obligations

in February 2005, but is unable to predict when the remaining tax obligations will be paid, or in what amount. The full amount of the estimated obligation has been classified as a current liability. To the extent that these obligations are finally settled for less than the amounts provided, Harmonic is required, under the terms of the merger agreement, to refund the difference to LSI Logic. Conversely, if the settlements are more than the $10.0 million pre-merger tax liability after the February 2005 payments, LSI Logic is obligated to reimburse Harmonic.

The merger agreement stipulates that Harmonic will be indemnified by the spun-off semiconductor business if the cash reserves are not sufficient to satisfy all of C-Cube’s tax liabilities for periods prior to the merger. If for any reason, the spun-off semiconductor business does not have sufficient cash to pay such taxes, or if there are additional taxes due with respect to the non-semiconductor business and Harmonic cannot be indemnified by LSI Logic, Harmonic generally will remain liable, and such liability could have a material adverse effect on our financial condition, results of operations or cash flows.

We May Be Subject To Risks Associated With Acquisitions.

We have made, continue to consider making and may make investments in complementary companies, products or technologies. For example, on February 25, 2005, we acquired all of the issued and outstanding shares of Broadcast Technology Ltd., a private U.K. company. In connection with this and other acquisition transactions, such as the Entone acquisition currently in process, we could have difficulty assimilating or retaining the acquired companies’ key personnel and operations, integrating the acquired technology or products into ours or complying with internal control requirements of the Sarbanes-Oxley Act as a result of an acquisition. We also may face challenges in achieving the strategic objectives, cost savings or other benefits from these acquisitions and difficulties in expanding our management information systems to accommodate the acquired business. These difficulties could disrupt our ongoing business, distract our management and employees and significantly increase our expenses. Moreover, our operating results may suffer because of acquisition-related expenses, amortization of intangible assets and impairment of acquired goodwill or intangible assets. Furthermore, we may have to incur debt or issue equity securities to pay for any future acquisitions, or to provide for additional working capital requirements, the issuance of which could be dilutive to our existing shareholders. If we are unable to successfully address any of these risks, our business, financial condition or operating results could be harmed.

Cessation Of The Development And Production Of Video Encoding Chips By C-Cube’s Spun-off Semiconductor Business May Adversely Impact Us.

The DiviCom business and C-Cube semiconductor business (acquired by LSI Logic in June 2001) collaborated on the production and development of two video encoding microelectronic chips prior to the merger. In connection with the merger, Harmonic and the spun-off semiconductor business entered into a contractual relationship under which Harmonic has access to certain of the spun-off semiconductor business technologies and products on which the DiviCom business previously depended for its product and service offerings. The current term of this agreement is through October 2006, with automatic annual renewal unless terminated by either party in accordance with the agreement provisions. The spun-off semiconductor business is the sole supplier of these chips to Harmonic. Several of these products continue to be important to our business, and we have incorporated these chips into additional products that we have developed. If the spun-off semiconductor business is not able to or does not sustain its development and production efforts in this area our business, financial condition, results of operations and cash flow could be harmed.

Our Failure To Adequately Protect Our Proprietary Rights May Adversely Affect Us.

We currently hold 38 issued U.S. patents and 19 issued foreign patents, and have a number of patent applications pending. Although we attempt to protect our intellectual property rights through patents, trademarks, copyrights, licensing arrangements, maintaining certain technology as trade secrets and other measures, we cannot assure you that any patent, trademark, copyright or other intellectual property rights owned by us will not be invalidated, circumvented or challenged, that such intellectual property rights will provide competitive advantages to us or that any of our pending or future patent applications will be issued with the scope of the claims sought by us, if at all. We cannot assure you that others will not develop technologies that are similar or superior to our technology, duplicate our technology or design around the patents that we own. In addition, effective patent, copyright and trade secret

protection may be unavailable or limited in certain foreign countries in which we do business or may do business in the future.

We believe that patents and patent applications are not currently significant to our business, and investors therefore should not rely on our patent portfolio to give us a competitive advantage over others in our industry. We believe that the future success of our business will depend on our ability to translate the technological expertise and innovation of our personnel into new and enhanced products. We generally enter into confidentiality or license agreements with our employees, consultants, vendors and customers as needed, and generally limit access to and distribution of our proprietary information. Nevertheless, we cannot assure you that the steps taken by us will prevent misappropriation of our technology. In addition, we have taken in the past, and may take in the future, legal action to enforce our patents and other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of resources and could negatively affect our business, operating results, financial position or cash flows.

In order to successfully develop and market certain of our planned products for digital applications, we may be required to enter into technology development or licensing agreements with third parties. Although many companies are often willing to enter into technology development or licensing agreements, we cannot assure you that such agreements will be negotiated on terms acceptable to us, or at all. The failure to enter into technology development or licensing agreements, when necessary, could limit our ability to develop and market new products and could cause our business to suffer.

We Or Our Customers May Face Intellectual Property Infringement Claims From Third Parties.

Harmonic’s industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and other intellectual property rights. In particular, leading companies in the telecommunications industry have extensive patent portfolios. From time to time, third parties, including these leading companies, have asserted and may assert exclusive patent, copyright, trademark and other intellectual property rights against us or our customers. Indeed, a number of third parties, including leading companies, have asserted patent rights to technologies that are important to us.

Our suppliers and customers may receive similar claims. We have agreed to indemnify some of our suppliers and customers for alleged patent infringement. The scope of this indemnity varies, but, in some instances, includes indemnification for damages and expenses (including reasonable attorney’s fees).

We Are The Subject Of Securities Class Action Claims And Other Litigation Which, If Adversely Determined, Could Harm Our Business And Operating Results.

3, 2000. In addition to Harmonic and certain of its officers and directors, the complaint also named C-Cube Microsystems Inc. and several of its officers and directors as defendants. The complaint alleged that, by making false or misleading statements regarding Harmonic’s prospects and customers and its acquisition of C-Cube, certain defendants violated sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”). The complaint also alleged that certain defendants violated section 14(a) of the Exchange Act and sections 11, 12(a)(2), and 15 of the Securities Act of 1933 (the “Securities Act”) by filing a false or misleading registration statement, prospectus, and joint proxy in connection with the C-Cube acquisition.

Harmonic defendants. The defendants filed demurrers to the amended complaint, and a case management conference and hearing are scheduled for December 19, 2006.

No estimate can be made of the possible range of loss associated with the resolution of each of these claims, and, accordingly, Harmonic has not recorded a liability. An unfavorable outcome of any of these litigation matters could have a material adverse effect on Harmonic’s business, operating results, financial position or cash flows.

The Terrorist Attacks Of 2001 And The Ongoing Threat Of Terrorism Have Created Great Uncertainty And May Continue To Harm Our Business.

Current conditions in the U.S. and global economies are uncertain. The terrorist attacks in the U.S. in 2001 and subsequent terrorist attacks in other parts of the world have created many economic and political uncertainties that have severely impacted the global economy, and have adversely affected our business. For example, following the 2001 terrorist attacks in the U.S., we experienced a further decline in demand for our products after the attacks. The long-term effects of the attacks, the situation in Iraq and the ongoing war on terrorism on our business and on the global economy remain unknown. Moreover, the potential for future terrorist attacks has created additional uncertainty and makes it difficult to estimate the stability and strength of the U.S. and other economies and the impact of economic conditions on our business.

We Rely On A Continuous Power Supply To Conduct Our Operations, And Any Electrical And Natural Gas Crisis Could Disrupt Our Operations And Increase Our Expenses.

We rely on a continuous power supply for manufacturing and to conduct our business operations. Interruptions in electrical power supplies in California in the early part of 2001 could recur in the future. For example, extremely hot weather in recent weeks has pushed power capacity close to its limits. In addition, the cost of electricity and natural gas has risen significantly. Power outages could disrupt our manufacturing and business operations and those of many of our suppliers, and could cause us to fail to meet production schedules and commitments to customers and other third parties. Any disruption to our operations or those of our suppliers could result in damage to our current and prospective business relationships and could result in lost revenue and additional expenses, thereby harming our business and operating results.

The Markets In Which We, Our Customers And Suppliers Operate Are Subject To The Risk Of Earthquakes And Other Natural Disasters.

Our headquarters and the majority of our operations are located in California, which is prone to earthquakes, and some of the other locations in which we, our customers and suppliers conduct business are prone to natural disasters. In the event that any of our business centers are affected by any such disasters, we may sustain damage to our operations and properties and suffer significant financial losses. Furthermore, we rely on third party manufacturers for the production of many of our products, and any disruption in the business or operations of such manufacturers could adversely impact our business. In addition, if there is a major earthquake or other natural disaster in any of the locations in which our significant customers are located, we face the risk that our customers may incur losses, or sustained business interruption and/or loss which may materially impair their ability to continue their purchase of products from us. A major earthquake or other natural disaster in the markets in which we, our customers or

suppliers operate could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Our Stock Price May Be Volatile.

The market price of our common stock has fluctuated significantly in the past, and is likely to fluctuate in the future. In addition, the securities markets have experienced significant price and volume fluctuations and the market prices of the securities of technology companies have been especially volatile. Investors may be unable to resell their shares of our common stock at or above their purchase price. In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation.

Some Anti-Takeover Provisions Contained In Our Certificate Of Incorporation, Bylaws And Stockholder Rights Plan, As Well As Provisions Of Delaware Law, Could Impair A Takeover Attempt.

Harmonic has provisions in its certificate of incorporation and bylaws, each of which could have the effect of rendering more difficult or discouraging an acquisition deemed undesirable by the Harmonic Board of Directors. These include provisions:

–		authorizing blank check preferred stock, which could be issued with voting, liquidation, dividend and other rights superior to Harmonic common stock;

–		limiting the liability of, and providing indemnification to, directors and officers;

–		limiting the ability of Harmonic stockholders to call and bring business before special meetings;

–		requiring advance notice of stockholder proposals for business to be conducted at meetings of Harmonic stockholders and for nominations of candidates for election to the Harmonic Board of Directors;

–		controlling the procedures for conduct and scheduling of Board and stockholder meetings; and

–		providing the board of directors with the express power to postpone previously scheduled annual meetings and to cancel previously scheduled special meetings.

These provisions, alone or together, could delay hostile takeovers and changes in control or management of Harmonic.

In addition, Harmonic has adopted a stockholder rights plan. The rights are not intended to prevent a takeover of Harmonic, and we believe these rights will help Harmonic’s negotiations with any potential acquirers. However, if the Board of Directors believes that a particular acquisition is undesirable, the rights may have the effect of rendering more difficult or discouraging that acquisition. The rights would cause substantial dilution to a person or group that attempts to acquire Harmonic on terms or in a manner not approved by the Harmonic Board of Directors, except pursuant to an offer conditioned upon redemption of the rights.

As a Delaware corporation, Harmonic also is subject to provisions of Delaware law, including Section 203 of the Delaware General Corporation law, which prevents some stockholders holding more than 15% of our outstanding common stock from engaging in certain business combinations without approval of the holders of substantially all of our outstanding common stock.

Any provision of our certificate of incorporation or bylaws, our stockholder rights plan or Delaware law that has the effect of delaying or deterring a change in control could limit the opportunity for Harmonic stockholders to receive a premium for their shares of Harmonic common stock, and could also affect the price that some investors are willing to pay for Harmonic common stock.

Item 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None.

Item 3. DEFAULTS UPON SENIOR SECURITIES

None.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

Item 5. OTHER INFORMATION

None.

Item 6. EXHIBITS

Exhibits.


Exhibit Number		Exhibit
31.1		Section 302 Certification of Principal Executive Officer
31.2		Section 302 Certification of Principal Financial Officer
32.1		Section 906 Certification of Principal Executive Officer
32.2		Section 906 Certification of Principal Financial Officer

SIGNATURES

Pursuant to the requirements of Section 13 or 15 (d) of the Securities Act of 1934, the Registrant, Harmonic Inc., a Delaware corporation, has duly caused this Quarterly Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Sunnyvale, State of California, on November 8, 2006.


	HARMONIC INC.
	By:	/s/ Robin N. Dickson
		Robin N. Dickson
		Chief Financial Officer (Principal Financial and Accounting Office

EXHIBIT INDEX


Exhibit Number		Exhibit Index
31.1		Section 302 Certification of Principal Executive Officer
31.2		Section 302 Certification of Principal Financial Officer
32.1		Section 906 Certification of Principal Executive Officer
32.2		Section 906 Certification of Principal Financial Officer