SAN FRANCISCO--()--Voce Capital Management LLC (“Voce”) sent a letter today to the Board of Directors of Harmonic Inc. (“Harmonic”) (Nasdaq:HLIT) calling for immediate action to address the Company’s inefficient capital structure and flawed capital allocation processes. Voce also criticized the composition of Harmonic’s Board and its attentiveness to shareholder interests.
“[t]he Board’s recent decisions – such as tip-toeing on returning capital when much bolder steps are required – only underscore that shareholder-focused and market-sensitive viewpoints are not adequately represented in Harmonic’s current Board deliberations.”
Voce has had a series of meetings with management and the Board of Harmonic in recent months to present these concerns, and has offered constructive suggestions to address them. Unfortunately, Voce’s efforts have so far proven fruitless. Voce’s letter to the Harmonic Board states:
[A]s we have expressed in these previous meetings, we have significant concerns that we believe the Company does not fully appreciate nor is it moving rapidly enough to address. These include the most urgent issue, its bloated balance sheet and inefficient capital structure. In truth, however, the capital structure is but an example of a larger set of chronic capital allocation issues that have dogged Harmonic for years, including unwise acquisitions and a runaway share count, to name but a couple. These missteps have destroyed shareholder value and led investors to question whether the Board is properly attuned to, and aligned with, the interests of Harmonic shareholders.
Voce’s letter points out that since the appointment of current management on May 4, 2006, Harmonic has significantly underperformed its peers and all relevant indices. During this time Harmonic undertook a series of progressively larger acquisitions, which the market currently values at far less than the $385 million Harmonic spent on its buying binge. Voce’s letter notes that Harmonic has floated the idea of additional acquisitions recently and urges the Company to focus exclusively on its organic growth opportunities.
Voce’s letter also observes that Harmonic’s shares outstanding have exploded by approximately 60% since 2006. Voce argues that Harmonic should deploy at least half of its current cash balance, which exceeds $200 million, to repurchase immediately a significant number of shares outstanding through a tender offer, in addition to maintaining the Company’s recently announced open market repurchase plan. The Company’s existing plan, similar to its predecessor open market plan, will have only a modest impact on shares outstanding and a negligible effect on the Company’s cash balance. The existing plan also fails to capture the opportunity to retire a substantial number of shares prior to the growth ramp the Company has predicted in late 2013 and 2014. A tender offer, however, will unlock significant value for shareholders by retiring the largest possible number of shares today while signaling Harmonic’s confidence in its prospects.
Finally, Voce’s letter argues that “[t]he Board’s recent decisions – such as tip-toeing on returning capital when much bolder steps are required – only underscore that shareholder-focused and market-sensitive viewpoints are not adequately represented in Harmonic’s current Board deliberations.” The independent directors collectively own less than 1% of Harmonic’s stock, and most of that is concentrated with one member. Six of the eight directors (including all of its leaders: the Board Chair and every committee head) have served since at least 2007 (many much longer), when all of the issues arose.
J. Daniel Plants, Voce’s Managing Partner, said upon sending the letter: “Harmonic suffers from three significant and interrelated problems: an inefficient capital structure, including excessive cash and an overextended share count; a history of acquisitions that failed to earn an acceptable return on capital; and an honest but ineffective Board, with little skin in the game, that has not undergone more than a cosmetic overhaul in years. In this context, it is hard to fathom why Harmonic resists our suggestions to enhance shareholder value, which would address all three issues simultaneously and can be accomplished immediately with tools at the Board’s ready disposal.”
Voce’s letter concludes that it is considering nominating directors at the upcoming annual meeting of Harmonic shareholders.
About Voce Capital Management
Voce Capital Management LLC is an employee-owned investment manager and the adviser to Voce Catalyst Partners LP, a private investment partnership.
The full text of Voce’s letter follows.
February 13, 2013
Members of the Board of Directors
4300 North First Street
San Jose, CA 95134
Ladies and Gentlemen:
Voce Capital Management LLC (“VCM”) is the investment advisor to Voce Catalyst Partners LP (“VCP” and, together with VCM, “Voce”). Beginning in April 2012, we have met with management and members of the Board several times, including both before and after becoming a shareholder of Harmonic. We would describe the relationship as cordial and sincerely hope this continues, the necessity of sending this letter notwithstanding.
However, as we have expressed in these previous meetings, we have significant concerns that we believe the Company does not fully appreciate nor is it moving rapidly enough to address. These include the most urgent issue, its bloated balance sheet and inefficient capital structure. In truth, however, the capital structure is but one example of a larger set of chronic capital allocation issues that have dogged Harmonic for years, including unwise acquisitions and a runaway share count. These missteps have destroyed shareholder value and led investors to question whether the Board is properly attuned to, and aligned with, the interests of Harmonic shareholders. We believe these shortcomings are ultimately the Board’s responsibility and that the resolution of these issues, and the prevention of similar ones in the future, can only be accomplished through changes to the Company’s Board of Directors.
As we detail more fully herein, we call upon the Harmonic Board to:
- Immediately return a substantial amount of capital to shareholders – a minimum of $100 million – through a tender offer that significantly reduces shares outstanding, in addition to maintaining the ongoing open market repurchase plan;
- Eschew further acquisitions and focus all of the Company’s resources on capturing its organic growth opportunities; and
- Tighten the Board’s alignment with shareholders, and deepen its appreciation of investor concerns and market expectations, through the addition of shareholder representation to the Board.
Each of these steps will decisively enhance shareholder value and, importantly, all can be undertaken by Harmonic without further delay. We have until now pressed our views on these matters in private communications, but the lack of action to date is unacceptable to us. Should we continue to be unable to achieve progress we will consider nominating candidates for the Board of Directors at Harmonic’s 2013 annual meeting of shareholders to replace you.
* * *
There is no escaping the fact that Harmonic has been an underperformer for many years. On May 4, 2006 – when current management was appointed – Harmonic’s stock closed at $5.46. Nearly seven years later, it trades essentially in the same place. During this span, Harmonic has significantly lagged its closest remaining public competitors, Arris and Seachange, as well as all relevant benchmarks1:
In addition, throughout this period the industry has consolidated around Harmonic, often at extremely high valuations. Serial acquirors like Arris, Cisco, Ericsson and Motorola repeatedly paid rich prices for Harmonic’s peers. Yet Harmonic consistently chose to forego a potential strategic premium for its shareholders. By our analysis, Harmonic would have created significant excess value for shareholders at any point during 2006-2012 by simply selling the Company for no better than the average M&A multiple in a given year when compared to the value Harmonic ultimately delivered to them by remaining independent. Instead, during this time Harmonic embarked upon a series of progressively larger acquisitions of its own.
* * *
Twinned with Harmonic’s long-term underperformance has been its poor capital stewardship. Harmonic currently has $201 million of cash on its balance sheet – an enormous sum for a company this size – constituting approximately 1/3 of its market valuation. Such a capital structure is indefensible. In addition to its rank inefficiency, Harmonic’s hulking cash balance is an ongoing temptation for management to pursue additional acquisitions – a complete non-starter, as discussed below.
We recognize that the Company instituted a small share repurchase program last year, which it recently completed. But Harmonic has even more cash on hand now than it did prior to the commencement of that plan. On January 29, 2013 the Company announced a $75 million “expansion” of the share repurchase program, once again to be pursued via open market repurchases. But like its predecessor, if consummated this open market plan will not even dent the existing cash pile. Indeed, given the Company’s prodigious cash flow, at the end of the new program we estimate Harmonic will still be sporting nearly the same $200 million in cash it currently wields.
The new plan is also inadequate when measured against a paramount objective: reducing shares outstanding, which currently stand at almost 116 million. Through a combination of acquisitions and generous compensation policies, Harmonic’s share count has exploded by almost 60% since 2006. This “silent killer” of shareholder value must aggressively be reversed, or it will strangle any earnings leverage when Harmonic finally returns to growth. By our calculations the Company’s announced open market repurchase program will, after dilution from the ongoing issuance of stock compensation, likely result in a net reduction of only about 6% of Harmonic’s shares outstanding. This is unsatisfactory for a firm that has nearly 33% of its current value in cash and is, by our estimates, likely to generate cash exceeding an additional 12% of its current value over the term of the buyback.
But there’s an even larger opportunity to create shareholder value the Board has failed to seize, despite our repeated helpful hints. The Company’s cautious short-term guidance on the recent Q4 earnings call, and the admission that its visibility had dimmed, were obviously concerning. Yet while management acknowledged that growth in 2013 will be more muted (and back-half loaded at that), they also stated repeatedly that 2014 was expected to be a strong growth year, propelled by technology cycles and commercialization of new products; management has reiterated this view in subsequent investor presentations. If so, then Harmonic should be buying every share it can get its hands on now in advance of that growth ramp. Harmonic can create real value for shareholders (especially those that do not sell) by retiring the largest possible number of shares today at prices significantly below the level at which they are expected to trade 12-18 months hence.
The announced open market repurchases simply cannot capture that value on their own, given that they are limited by trading volume and will trudge along relatively slowly over the next few quarters. On the other hand, a large tender offer would unlock tremendous shareholder value given the current stock price relative to expected future results. As a result, the value creation potential of an immediate tender dwarfs the costs to execute it, even including a likely premium. A large tender also signals real confidence to the market, which will support the stock and lend credence to management’s stated opinions about the Company’s future growth potential. Best of all, Harmonic can have it both ways: The Company can (and should) maintain the open market repurchase plan to return excess cash as it is generated over the next 18 months while accomplishing the aforementioned objectives via an immediate tender offer that deploys the existing surplus.
* * *
As emphatic as we are that Harmonic must rapidly deploy its cash to undo years of profligate share issuance, we are equally adamant this cash must not be used to underwrite further acquisitions. We had trusted that the Company had finally sworn off of trying to grow through M&A rather than organic performance. However, the Company has begun to float the idea of another acquisition, deeply disquieting from our perspective. Some history is again instructive.
As the video processing and delivery sectors underwent the massive consolidation described earlier, Harmonic chose not to sell, despite the potentially large value creation opportunity it bypassed in doing so. But Harmonic didn’t exactly decide to go it alone, either; instead it went on a buying spree of its own: Entone (2006, $45 million), Rhozet (2007, $16 million), Scopus (2008, $51 million) and then Omneon (2010, $273 million) – four acquisitions in five years. The Omneon acquisition in particular remains controversial, given its size, price, timing, integration missteps and subsequent performance. It thrust the Company into an adjacent but unfamiliar space, with new customers and channels, and greatly increased its European exposure at the worst possible time. Omneon’s revenue has shriveled since the acquisition and we believe it has still not been fully integrated even after nearly three years.
Looking beyond the individual transactions, in aggregate Harmonic spent $385 million on these four acquisitions. Yet the Company’s revenue grew by only $280 million from 2006 through the end of 2012. Analyzed another way, with Harmonic’s current enterprise value of approximately $428 million, either the market is ascribing no value to Harmonic’s original businesses (unlikely), or it is valuing the acquisitions at substantially less than what Harmonic paid for them (much more likely). Harmonic’s acquisitions have thus not only failed to earn an acceptable rate of return, they have affirmatively destroyed value for shareholders. These results certainly have not earned Harmonic the right to allocate further capital to such endeavors.
We cannot overstate this point: Another acquisition attempt by Harmonic would be dead-on-arrival with investors. Harmonic must focus exclusively on its organic growth opportunities rather than attempting further acquisitions.
* * *
We do not question the integrity of Harmonic’s Board members, nor doubt the sincerity of their desire to act in shareholders’ best interests; but this does not immunize them from responsibility for the Company’s track record. The long-term underperformance; questionable acquisitions, especially Omneon; proliferation of shares outstanding; gluttonous cash balance – these all happened on this Board’s watch, with six of the current eight directors (including all of its leaders: the Board Chair and every committee head) serving since at least 2007 (many much longer), when this transpired.
It’s easy to see why shareholders do not feel that their interests are properly represented by the current Board. In aggregate, the independent directors own less than 1% of Harmonic’s shares outstanding. Only one independent director, Mr. Kvamme, has any meaningful share ownership (he alone owns more than all other independent directors combined). Moreover, and again other than Mr. Kvamme, we see no evidence that any independent director has purchased a single share of Harmonic stock in the open market within the last ten years – meaning that 100% of their “ownership” is stock that they have awarded to themselves as Board members. Shareholders, all of whom have purchased shares with their own capital, rightfully question whether the Board’s interests are truly aligned with theirs when directors play only with the “house’s money.”
The Board’s recent decisions – such as tip-toeing on returning capital when much bolder steps are required – only underscore that shareholder-focused and market-sensitive viewpoints are not adequately represented in Harmonic’s current Board deliberations. Apparently responding to proposals we presented last year, the Company took the unusual step of congratulating itself on its most recent earnings call for the appointment of two Board members … in 2012. “We’ve added … two new industry leaders with deep and relevant business experience in media, software and telecommunications . . . [to] our Board of Directors.” A deeper understanding of shareholder concerns and market expectations for the Company are at least as important as those skill sets and also deserves a place on the Harmonic Board.
The Company has explained its rejection of our proposals for Board change only with the assertion that these 2012 vintage directors – all two of them – are the maximum change the Harmonic Board can manage at one time. We find it hard to comprehend that a Board of eight cannot welcome any new members because it absorbed a pair of new directors last year. Moreover, even with the addition of last year’s bumper crop of two, the average tenure of a Harmonic director is still almost eight years and the average age is 63. Several directors are past retirement age and/or have logged more than ten years of service on the Board. The addition of fresh outside perspective, and the inclusion of missing skill sets, will lead to better decisions and help rebuild credibility with the investment community.
* * *
As management reminds us on every earnings call, Harmonic cannot direct the rate of capital spending by its customers; alter the pace of adoption of new technology; nor tame the business cycle. But there is much within its power to control, and after years of underperformance it’s time that Harmonic manages that which it can. Harmonic has amassed a gigantic, unproductive pile of cash that is creating negative value for shareholders at the same time they suffer under the weight of the Company’s incontinent issue of shares. It has failed to earn acceptable returns on its previous acquisition forays, yet it’s now tempted anew by the siren call of another acquisition. The Board has not undergone more than cosmetic changes in years, and runs a credibility deficit with investors – yet resists the addition of shareholder representation and financial expertise to its ranks.
Three significant issues – yet all could be solved at once, and with tools at the Board’s ready disposal. What’s more they are not distinct phenomena, but closely interrelated, making them all the more tractable. We therefore reiterate our call for the Harmonic Board to address each of these needs with immediate action: A tender offer of substantial size, and at least $100 million; an acquisitions embargo and a renewed laser-focus on organic growth; and Board reform that better aligns its membership and competencies with the interests of shareholders. If you cannot embrace these shareholder value enhancing steps then we will not hesitate to replace you by nominating directors who will.
VOCE CAPITAL MANAGEMENT LLC
By:/s/ J. Daniel Plants
J. Daniel Plants
1 Prices as of February 8, 2013. Benchmark returns are illustrated with ETFs for the S&P 600, Russell 2000, S&P 500, Dow Jones Industrials and Nasdaq 100.