NeoPhotonics' (NPTN) CEO Tim Jenks on Q2 2016 Results - Earnings Call Transcript

NeoPhotonics Corporation (NYSE:NPTN)

Q2 2016 Earnings Conference Call

August 8, 2016 4:30 PM ET

Executives

Erica Mannion - IR, President of Sapphire IR

Tim Jenks - Chairman, President, CEO

Ray Wallin - CFO, SVP

Analysts

Alex Henderson - Needham & Company

Simon Leopold - Raymond James

Tim Savageaux - Northland Capital

Austin - Piper Jaffray

Richard Shannon - Craig-Hallum Capital Group

Operator

Welcome to the NeoPhotonics 2016 Second Quarter Conference Call. This call is being webcast live on the NeoPhotonics event calendar webpage at www.neophotonics.com. This call is the property of NeoPhotonics and any recording, reproduction or transmission of this call without the express written consent of NeoPhotonics is prohibited. You may listen to a webcast replay of this call by visiting the event calendar page of the NeoPhotonics website. I would now like to turn the call over to Erica Mannion at Sapphire Investor Relations, Investor Relations for NeoPhotonics.

Erica Mannion

Good afternoon. Thank you for joining us to discuss NeoPhotonics operating results for the second quarter of 2016 as well as the company’s outlook for the third quarter of 2016. With me today are Tim Jenks, Chairman and CEO, and Ray Wallin, Chief Financial Officer.

Tim will begin with a review of the second quarter results. Ray will provide a financial update including results for the second quarter and the outlook for the third quarter and then Tim will summarize before opening the call up for questions.

Material contained in the webcast is the sole property and copyright of NeoPhotonics, with all rights reserved. Certain statements in this conference call, which are not historical facts, may be considered forward-looking statements that involve risks and uncertainties, and include statements regarding future business results, levels of sales and profitability, subsequent events, product and technology development, customer demand, inventory levels and economic and industry projections. Various factors could cause actual results to differ materially. Some of these risk factors have been set forth in our press release dated August 8, 2016 and are described in our SEC filings, including our Annual Report on Form 10-K for the year ended December 31, 2015, which was filed on March 15, 2016 and our Quarterly Reports on Form 10-Q for quarter ended March 31, 2016, which was filed on May 10, 2016.

Listeners may obtain a copy of the company’s press release by visiting the Company’s web site.

Now, I will turn the call over to CEO, Tim Jenks.

Tim Jenks

Thank you for joining us today. In our second quarter NeoPhotonics delivered solid results with revenue of $99.1 million and non-GAAP earnings per share of $0.15. High Speed 100G and above products again increased to a record 66% of revenue. We are experiencing an unprecedented level of demand for our 100G products which we are seeing as a major and sustaining mid-term trend, in China as well as in the west. Now, consistent with our outlook, our revenue was flat reflecting continuing increases in 100G volumes but offset by significant softness in our fiber-to-the-home, or PON, market in China. These two points mark some key transitions in our business and in the industry. We have been increasing our 100G production capacities throughout the year, to a large extent to support the transition to pluggable modules, notably to DCO coherent pluggable modules in China. This will continue, and accelerate, as I will explain further in a moment.

At the same time, the PON market softness resulted in an approximate $4 million decrease in our PON revenue from Q1 to Q2. This decrease had not been factored into our outlook. So without this impact our revenue would have been above the high end of our range. At this point we anticipate an equivalent further decrease in PON for Q3, which is now factored into our Q3 outlook.

We had previously said that our revenue for the year will grow 20% to 25%. At this point we are raising and narrowing this range to 22% to 25% growth, now inclusive of the soft PON impact. Which is to say that our 100G product volume growth is extremely strong, and as our capacity continues to expand, we will accelerate our top line growth continuously through the next year. In fact in the second quarter, nine of our top 10 customers were sequentially up, reflecting continued strength for 100G products. Huawei, at 45% of revenue, was down from Q1 in which we saw a strong surge in 100G products and a resulting depletion in our inventories. Hence all of our Q2 revenue was from same period production while absorbing ASP changes and PON declines.

Margins were impacted as a result, and reflected PON under-recoveries, and additional ramp up costs and reserves, as Ray will detail. These issues are reflected in our Q2 results with gross margin at 29.3%, which is below the mid-point of our outlook range. And we achieved non-GAAP earnings per share of $0.15, which is at the high end of our outlook range, reflecting focused expense control.

While we’ve been adding capacity, we have been volume constrained by supply bottlenecks as we ramp our supply chain to support increasing volumes. This situation is now being resolved, so with solid bookings and forecasts through the end of the year and into 2017, we believe demand will continue to strengthen and this industry expansion will be directly reflected in our revenue growth as 100G deployments globally for both Telecom and Datacenter applications are expanding, and are in sync.

In China, our 100G product demand in the second quarter was up substantially year over year, and we expect it to increase markedly over the next few quarters in support of the China deployment strength. This will happen as Chinese carriers continue to build out backbone network capacity, continuing their nationwide network deployments, but also in anticipation of moving from 4G/LTE eventually to 5G wireless rollouts expected in a few years. This is a major trend and a driver for the medium term. Nearer term, we anticipate awards for approximately another 30,000 100G ports for the second half of the year and into 2017.

I would like to comment on an additional and important industry trend that is driving our business and our capacity plans. Pluggable DCO modules have rapidly emerged in China as the preferred approach for 100G coherent deployments. We expect DCO modules to dominate in the China market and to be considerably higher in volume there than ACO modules for the foreseeable future. NeoPhotonics is seeing a significant benefit from this ascending industry trend as our compact ultra-narrow line-width tunable laser and our micro coherent receiver are specially designed for use in CFP and CFP2 modules, and we are designed in with several of the leading volume module vendors. By the end of this year, we will have essentially tripled our capacity for these module component products versus the second half of last year, and we expect that about half of our added capacity will be devoted to supplying into CFP-DCO applications, and eventually to CFP2-DCO modules.

As 100G Coherent transmission is the technology of choice for long haul, metro and DCI connections, the use of contentionless switching architectures in coherent networks is expanding, and is critical for Software Defined Networks for Content Providers’ Datacenters, which is driving increases in our switching products. Our Multi-cast Switch product expands NeoPhotonics’ product line in the 100G metro ROADM market and shipments into the North American market continue to accelerate. Moreover, contentionless architectures are being trialed in several cities in China that could drive rapid volume increases in 2017 and beyond.

I would also like to further comment on plans for our PON products. Given our focus on high speed solutions, we have announced the end-of-life of our PON products, which will be done within the next year. For reference, our PON revenues for the last four quarters were $43.9 million and had gross margins in the range of 15% to 20%. As a result of this change we will provide both Total Revenue and Revenue less PON so that models can be built on the continuing business. For Q1, Revenue less PON was $87.2 million and for Q2 it was $91.3 million. For our second half, we expect PON revenues to be less than $10 million with gross margins in the range of 10-15%.

This concludes my initial comments and I will now turn the call over to Ray Wallin, our Chief Financial Officer.

Ray Wallin

Good afternoon and thank you for joining us today. I will start with the second quarter financial results and close with the outlook for the upcoming quarter.

As Tim mentioned, in Q2 we delivered solid non-GAAP results that were in line with our financial outlook, with revenue of $99.1 million, non-GAAP gross margin of 29.3% and adjusted EBITDA of $12.0 million or 12% of revenue, and non-GAAP earnings of $0.15 per share, which was at the top end of our outlook range. We delivered strong free cash flow of $8 million in the quarter. This was achieved through our efforts on managing operating expenses and working capital efficiencies, including strong collections and inventory management.

Now, let’s walk through our second quarter ending June 30, 2016 financial results in more detail. I will focus most of the discussion around non-GAAP results which exclude stock-based compensation expense of $2.2 million, amortization of acquisition related intangibles of $1.3 million and transaction related expenses of $0.8 million. We have posted a full GAAP to non-GAAP reconciliation at our website at www.neophotonics.com and in our press release which may be useful when comparing GAAP to non-GAAP results.

Revenue of $99.1 million was in the midpoint of our outlook range, up 16% from the year ago period, and flat with our prior quarter, driven by robust demand for 100G products and offset by the $4 million decrease in PON product revenue, which Tim discussed.

Geographically, our revenue mix for Q2 was 20% in the Americas, as in the prior quarter. China was 60% of revenue, down two percentage points from the prior quarter. Japan was 5% of total revenue, which was unchanged, and the rest of the world was 15%, up 2 percentage points from Q1.

We had two 10% or greater customers in Q2, with Ciena at 16% of our total revenue, as in Q1, and Huawei Technologies including Huawei affiliate Hi-Silicon Technologies at 45%, down nine percentage points from the Q1 surge, but in line with our 2015 full year total, at 44%.

On a non-GAAP basis, gross margins were 29.3% in the June quarter, which was at the lower end of our guidance range of 29% to 31%, as it reflected an approximately one percentage point reduction from our taking additional reserves on certain end-of-life laser products.

Non-GAAP operating expenses were 22% of sales, slightly below the lower end of our guidance range due to lower than anticipated expenses for development materials and higher recognition of NRE which benefited R&D expenses. In Q3, we expect to see our typical R&D spending levels relative to revenue. Non-GAAP operating income and net income were each approximately 7% of revenue, resulting in earnings of $0.15 per share, based on a fully diluted share count of 45.4 million shares.

In Q2, the non-GAAP tax rate was 10% and the GAAP tax rate was 19%. We expect our longer-term forward looking non-GAAP effective tax rate to be between 15% and 20%. Our Non-GAAP net income benefited from a foreign exchange gain of $0.4 million, principally from strengthening of the Japanese Yen but offset by weakness in the Chinese RMB against the US dollar. As noted last quarter, we implemented a foreign exchange hedging program which is now moderating foreign exchange fluctuations in our Non-GAAP earnings.

On a GAAP basis, Q2 gross margin was 28% down from 31% in the prior year period and from 31% in the first quarter of 2016. GAAP operating expenses were $24.7 million, or 25% of revenue.

On a GAAP basis in the June quarter, we generated positive earnings, recording net income of $2.7 million, or $0.6 per fully diluted share.

Turning to the balance sheet, we had $113.5 million in cash, a $9.7 million sequential increase, in cash equivalents, short-term investments and restricted cash. Our total debt was $45.4 million. Accounts receivable decreased by $0.3 million in Q2, ending at $86.9 million, with day’s sales outstanding remaining at 79 days. Net inventory decreased $1.0 million in Q2 to $61.5 million, with days of inventory on hand decreasing to 77 days from 83 days in the prior quarter reflecting strong demand for our products.

Now let me turn to our outlook for the third quarter. We commented on last quarter’s call that Q2 revenue would be generally in line with Q1 revenue as we worked through our capacity expansion plans and we absorbed deferred ASP declines. Based on the accelerating demand for our 100G products we are seeing, we have increased our capital expenditures to support the growth of our production capabilities. We added approximately $13 million in capital equipment in the June quarter and we now expect about $30 to $35 million of capital spending in the second half of 2016 aggregating to 12% to 13% of revenue for the full year of 2016.

Tim noted that our volumes are increasing as supply chain bottlenecks are resolved, such that in Q3 our investments in production, assembly and test operations are resulting in continued volume growth. With increasing demand for 100G components and modules, muted by further declines in the PON business, we are raising and narrowing our full year 2016 outlook range to growth of 22% to 25%, from 20% to 25%, but now inclusive of the lower PON forecast. Note that our gross margin forecast includes ongoing ramping costs as well as under-recovery due to PON revenue declines.

Reflecting these comments regarding our markets and capital expansion plans, we expect to achieve the following financial results for the September quarter.

Revenue between $100 million to $106 million, or up between 1% and 7% sequentially; Non-GAAP gross margin between 29% and 31%; with a non-GAAP share count of 45.8 million shares, earnings per share in a range of $0.09 to $0.17 per share. Revenue less PON will be $96 million to $102 million, up from $91 million in Q2, or up between 6% and 11% sequentially.

With the capacity we have added and as we accelerate 100G shipments, we anticipate gross margins will expand by two to three percentage points in Q4.

I would note that our revenue growth is limited by our supply chain ramping with us, and we look forward to discussing more about our business at our Analyst Day on September 8th in New York.

Finally, I want to remind everyone to refer to our public filings with the SEC and our Safe Harbor statement included in our press release that discuss the risks and uncertainties that could affect future performance causing actual results to differ materially from our forward-looking statements. We do not plan to update, nor do we take on any obligation to update this outlook in the future.

Now I will turn the call back over to Tim.

Tim Jenks

Thank you, Ray. This concludes our formal comments. I'd now like to ask the operator to open the line up for questions. Thank you very much. Andrew?

Question-and-Answer Session

Operator

[Operator Instructions]

Your first question comes from the line of Alex Henderson with Needham & Company. Your line is open.

Alex Henderson

Thanks. So given your $4 million shy in the June quarter relative to your PON estimate. And you are expecting a sequential decline in the September quarter of $4 million which put you I think $8 million below in the September, that's $12 million combined and you are talking about another probably $4 million to $8 million in the December quarter. That's essentially an offset to the numbers on the top line yet you've raised guide. Does that imply your up $15 million -$18 million in your estimated growth rate for the 100G product line?

Tim Jenks

Yes. That's pretty close. We would probably say we have a comparable decline in the fourth quarter but we said that we expect $10 million of PON in the second half. So the third and fourth quarter will be pretty similar in the PON space. So and with that minor adjustment your arithmetic and your assumptions are spot on.

Alex Henderson

Okay. So to the extent that the PON business is 15% type gross margins or less, generally that would mean you are having an extremely robust acceleration in your higher margin product which should cause significant expansion in your gross margins. I guess I am not understanding why your gross margins wouldn't be 35 or better in that context?

Tim Jenks

Yes. So two things. The situation with PON, PON is declined faster than we predicted as we talked about. And so we do have under recovery because essentially as the volume goes down we have to cost out commensurate with that. So we are under recovering and we have that cost to deal with. Also our volumes on 100G are going up quite markedly but it's worth noting that product mix also changes. So far example the metro market products generally are lower ASPs than things that we are done over a longer period of time for transport so essentially there is very rapid volume increase but revenue doesn't ramp quite with it. So essentially we've got some ramping cost, we've got PON declines and we got under recovery but therefore as Ray pointed out we would expect over the course of the next two quarters to see by the fourth quarter 2% to 3% percentage point increases in the margin. But those are the reasons why it doesn't expand faster than that.

Ray Wallin

Yes. So, Alex, if you do the math and you add two to three points to our range of 29 to 31, at the midpoint it would be 32 to 33 at the high end, it would be 33 to 34.

Alex Henderson

All right. So if did the math on that it looks like your fall out of the cost associated with the -- or the impact for the ramp up of the 100G would result in a very, very strong EPS for the fourth quarter relative to the third quarter guide, if I take kind of the midpoint of the guide of $0.14 - $0.15, it would imply more like an almost $0.30 type fourth quarter. I know you don't want to forecast the fourth quarter but is there anything that's falling out of that that we should be aware of?

Ray Wallin

Well, we’ve given you couple of data points but I don't think we would be uncomfortable with how you model is currently constructed for the year.

Operator

Your next question comes from the line of Simon Leopold with Raymond James. Your line is open.

Simon Leopold

Great, thanks a lot. Tim I think it would be helpful to folks if you could just remind us what kind of products are remaining in the sort of the non 100G and above? So the network product segment and I don't think you gave specific numbers for the split in the product segment. If you could review what's in there and give us a split please.

Tim Jenks

Yes, sure. So at present the high speed products are actually about 66% of our revenue and network products and solutions are about 34%. And we have to adjust that now for the PON products. In network products and solutions the kinds of things that without PON are in there, we have essentially all of our client side transceivers that are not 100G so essentially 10G and below, it includes things like BiDi's Compact SFP, SFP and SFP plus transceivers, it also includes all of our passive products. So these are things like planar lightwave circuits ADBG, drop module, VMAX products, VOAs, tap monitors things of that sort. So this makes up network products and solutions I think the big buckets to refer to it would be low speed transceivers for the client side and passives. Is that help?

Simon Leopold

It does. And what do you look at sort of the long-term growth rate for that group of products now that you got the PON kind of shaking out of it? What's sort of other than seasonal trending or longer term trending?

Tim Jenks

So this is a pretty stable product group. In the last we've seen it, as a group we've seen a decline very slightly. But that's offsetting pretty significant decline in PON. So the rest of the business is very slightly up. It's slow but real grower and then the high speed products obviously have been the faster grower.

Simon Leopold

Great. And then let's just shift back to the high speed. You talked about some developing opportunities for 100G DCO and I wanted to make sure I heard this correctly that the first phase of deployments will be CFP not CFP2 and what would you expect for the timeframe for a transition for those products to either go CFP2 ACO or CFP2 DCO?

Tim Jenks

Well, so I am referring in particular here, Simon, to China. And in China there are network for backbone between cities and there is also provincial deployments. And there is a desire essentially in China to have a pluggable solution that is generally served by the DCO market. And so we expect that really for the next two years. It will be primarily DCO and eventually it will transition from CFP form factor to CFP2. But we expect that also to be primarily in China DCO. Now this is actually -- this is different than for example the carriers in the west that ramping with ACO. So you've got ramp in ACO in the west and you got ramp in DCO in China. And this is the result of the architecture and primarily the biggest volume suppliers of DCOs into the China are essentially component customers for us.

Simon Leopold

Okay. And just to review this fourth quarter implication, you are going to strongly defy your typical seasonality. So normally with the exception of last year you tended to suffer some decline in both gross margin and sales in the fourth calendar quarter. And what you are suggesting is roughly 10% sequential growth with gross margin expansion. I just wanted to make sure on banging myself for the head to get this right.

Tim Jenks

That is what we said. You are correct.

Operator

Your next question comes from the line of Tim Savageaux with Northland Capital. Your line is open.

Tim Savageaux

Hi, good afternoon. Question on kind of customer make up in the quarter. Obviously, you saw some pretty sizable declines with Huawei and its double edged sword lower concentration is I think better to some degree. And kind of flat quarter with Ciena so implying considerable strength elsewhere. I wondered if you might be able to provide any color geography application or customer as to where you saw that strength.

Tim Jenks

Sure. Well, let's see in the prepared remarks I did comment on nine out of our top 10 customers for the quarter were sequentially up and Huawei down from a very, very strong first quarter. Now while Huawei was down I also pointed out that our -- I think Ray said our average for all of 2015 for Huawei was about 45% of revenue and we were 44% of revenue. And for the second quarter we were 45% of revenue. So it really I would describe the second quarter with Huawei as normalized. It was just at the first quarter was kind of out of the park high. Now among the customers that are growing rapidly we do have strong growth for other Chinese customers for example. We have strong growth for other module customers so folks who are doing both DCO and ACO modules and then we also have strong strength of people who are buying components for client side modules notably LR4 CFP2 products. So the underlying product strength for us on the coherent side would be narrow line-width tunable laser and receivers and on the client side would be EML lasers and drivers as well as the modules associated with both of those product groups.

Tim Savageaux

Got it. Well thanks for that and maybe one more question and I'll pass it on for now. That really is around operating expenses which I think were down sequentially maybe a little lower than expected. I wondered if you could talk to kind of what sort of profile you expect there for the balance of the year from an OpEx perspective.

Tim Jenks

Yes. Let me -- I'll defer to Ray for the balance of the year but couple of the comments where as we do our R&D activities through the course of the year, we do plan out how we spend on materials and I think in Ray's comments he pointed out the fact that we had slightly low expenditures on development materials during the second quarter and we had higher than expected NRE payments for certain development that we are doing and so those are both favorable to R&D. But there are also frankly Tim there are also very short lived. So we would expect it to be back to the normal level in the third quarter. So you should see slightly higher R&D spending for the backend of the year which is more in a normalized model.

Ray Wallin

Yes. Tim I want to put -- we actually gave our range in our table this time for operating expenses in the press release. We gave some numbers there. So you use those and you'll see, it's going to be -- as we said Q3 is going to be return it is kind of more of a normal level. And then we don't see really much growth in Q4 from operating expenses.

Tim Savageaux

Right. Well, okay maybe I'll pass it on and go back reading the rest of the release so I don't ask any more stupid questions.

Operator

Your next question comes from the line of Troy Jensen with Piper Jaffray. Your line is open.

Austin

Thanks for taking my question. This is Austin on behalf of Troy. My first question for Tim is going back to ACO could you maybe just give an update on where are you in the qualification stage and when you guys expect to start shipping volume?

Tim Jenks

Yes. We have -- we did say that we've moved from -- we moved to initial shipments. So we've been in the sampling stage and we've made our first shipments in the quarter. So we are still small volumes admittedly so I'd expect to be in 2017 before they are significant volumes for us for ACOs.

Austin

Okay. And then for one Ray and just a simple one. Did you say that the tax rate for Q3 is expected to be 15% to 20% or is that for the full year?

Ray Wallin

Yes. That's our kind of go forward tax rate for the rest of the year here

Austin

For the second half

Ray Wallin

Non-GAAP, yes

Operator

Your next question comes from the line of Richard Shannon with Craig-Hallum. Your line is open.

Richard Shannon

Hi, Tim and Ray. Thank you for taking my questions. I apologize I got in the call little bit late so I may have missed some detail and a couple of questions I had here but Ray if I could just ask you to repeat the CapEx forward numbers you had mention I think you mentioned. And I have a quick follow up on that topic.

Ray Wallin

Yes. So CapEx numbers here we added $13 million in capital equipment in the June quarter. And we expect to be about $30 million to $35 million of CapEx spending in the second half of 2016. And we expect that the total of revenue would be about 12% to 13% of revenue through the full year of 2016.

Richard Shannon

Okay, perfect. And then Ray what is that take to depreciation level to from what you just reported in the second quarter to I don't know say the fourth quarter or some other period in next four quarter. Where do you expect depreciation to go?

Ray Wallin

Hold on, let me just look this up. So I think we are looking at depreciation here so I think we reported $4.1 million of depreciation in Q1. There is about $4.4 million in Q2, it goes to the $4.5 million in Q3 and it goes up little bit in Q4. Most of these equipments coming online currently and then so the depreciation would be increasing in 2017 but this year will be fairly insignificant.

Richard Shannon

Okay, got it, that's helpful. How far it falls with the efforts on some gross margin falls on those as I can make those calculations. Following up on your response to an earlier question I think you had mention about the mix shift as it relates to pricing into some effect on gross margins on products that are metro oriented versus long haul. I guess kind of big picture there Tim can you give us a sense of where is the split look like in your 100G and plus business between those two and where can we expect that to trend over say the next two to four quarters?

Tim Jenks

Well, let's see to an earlier question I did respond that about two thirds of our business is in high speed domain. So 100G and above. It's also the case that we are seeing fairly rapid growth in the products that goes specifically into metro types of equipment. So the products that are we are shipping in metro and in a number of cases are different than the products that we ship in the long haul transport. And the volumes are increasing more rapidly for those metro types of products. So essentially we have talked about the amount of volume increases that we are seeing essentially in some cases 3x over the same period last year notably for narrow line-width tunable laser but that's not to say that the revenue scales at the same rate as volume because as products become metro instead of transport, if you will, there are some different design that are if you will lower ASPs. All of that said it's also the case even on -- without -- on revenue less PON basis; there is still a difference in the overall margin. I can't really tell you the difference in the margin between metro and long haul but rather to stay that even on a post PON basis the high speed products will still have probably a 10 margin point advantage. They are at or above our corporate target model whereas the network products and solutions are a bit below our current margin. So there is even as we go to metro which is a bit lower ASP and higher volume, that doesn’t mean that as a group it necessarily goes down much in margin rather they are still that is the higher margin product area for NeoPhotonics. Those products are lower ASP but frankly they are also designed to be lower cost to manufacture.

Richard Shannon

Okay. That is helpful. And I guess just a one last question for me on the topic of DCO. I think I may have missed some of the introductory comments along those lines. But I guess the case is known as the early leader in that market. Do you expect to be kind of a second source then in most accounts or could it be a primary source in obtaining -- Tim, just give your thoughts on and where you are going to sit in DCO and I guess specifically in China.

Tim Jenks

Well, so specifically I was commenting on the fact that the DCO form factor in China is -- it's really rapidly emerged as the lead form factor but for us it's a component market. So we sell components to the leading suppliers of DCO modules and so we enjoy that growth. So I hope that addresses your question.

Richard Shannon

Yes. It does. And thank you for that. I think that's all my questions for now. I'll jump out of line I guess. Thank you very much.

Operator

Your next question comes from the line of Alex Henderson with Needham. Your line is open.

Alex Henderson

Thanks. So second bite at the apple here. I was hoping to go back to the under absorbed cost associated with PON. So how long does it take for that under absorption to play out before you are able to essentially not have to cope with that anchor on your gross margins? And I mean what is the dollar value or the margin percentage value of that. I mean how much of temporary cost that we are looking around here.

Tim Jenks

Well, let's there are -- there was a desire for precision here which is difficult to say. What happens in the situation is we've announced to our leading customers that these products will go into end of life situation which means they then have a period of time to place orders on us which will fulfill. So we will continue to manufacture these products well into 2017 before winding them up. That said the actual end of production time will probably in the second half of 2017. But specifically within about two quarter we would expect to be able to adjust fully the operations overheads in line with the new volume level, the new lower volume level so about two quarters. And the amount of money that we are talking about here is generally about $1 million a quarter.

Ray Wallin

Yes. And Alex, Ray here. So I'd like to add to the PON comment that we mentioned in our script. We are also as we ramp up and add capital equipment and ramp up volumes, we did have ramp up cost. And those ramps up cost also probably analyzing gross margin maybe about a point.

Alex Henderson

So if I were to take look at the trajectory and I know you guys don't want to go this far out but just bear with me for a second. And goes from the fourth quarter end of the first half of next year, these two costs are essentially going to fall out of the numbers by the time we get into the first half of 2017. So we are talking about a couple hundred basis points of margin falling to the bottom line as we get into the first half. And obviously you got to go through the offsets to associate with annual price reductions and all other lot of the stuff but all other things being equal it should help. What would have been the trajectory by roughly two points?

Tim Jenks

I think we've had actually done that arithmetic and come up with 1.5 so we agree generally with your notion.

Alex Henderson

A million dollar is point the ramp cost you said was a point.

Ray Wallin

Yes. That's about two points.

Alex Henderson

One and one. So is it reasonable to think that two point benefits to the first half of 2017 is really what I am driving at here?

Tim Jenks

It's difficult to say that only because we don't know what's going to happen in the first quarter of 2017 from pricing negotiations which are yet to begin.

Alex Henderson

All other things being equal and normal in a price condition. I mean you got to deal with a normal seasonal price adjustment; these two pieces fall out against that backdrop.

Tim Jenks

Yes.

Alex Henderson

So the bearing the weight-bearing timeframe is two quarters and then it falls out is the key point. And so going back to the margin equation if the high margin -- if the 100G products the high speed products are above corporate average and these two pieces fall out would we start to see that corporate average start to move up I mean we be thinking about maybe a higher range of gross margins over time as you become more of a 100G product company.

Tim Jenks

Yes. If you think about the high speed products as I said have the margin advantage over network products and solutions. So with that percentage continues to go up the margin moves up and it moves more toward our target model. And this is actually accelerated by the PON products which for starters are essentially half the margin of the corporate target. And so as the costs are move with that it too benefits in the overall margin model.

Alex Henderson

So just to clarify I think the last question that came out on the call was about the DCO side. You don't sell DCO, you sell parts that are going into DCO and you are not a competitor to a DCO company, you are probably more of a supplier to a DCO company.

Tim Jenks

Yes. We are supplier to multiple DCO companies and ACO companies.

Alex Henderson

Right. And then the third thing I was hoping to get a handle on was the Multi-cast Switch piece, could you give us some sense of where you think that will be by the end of the year and where it might be by the end of say 2017. What's kind of the trajectory of that business if things go well with it?

Tim Jenks

Well, I think last quarter we said that we thought it might get to the range of $10 million for this year. That's not per quarter, that's for the year $10 million. So we are -- we started from zero and it is ramping. Four quarter is probably 2x the third quarter. And the third quarter is 2x to the second quarter. And it is ramping up. So we will do in the range of $10 million maybe a little less this year. And we can expect to double it in 2017 but doubling it is without any impact from China adopting CDC architecture. So I noted that there are some build trust going on right now with CDC colorless directionless contentionless architectures they are going on in the current and next quarter in China. If those led to adoption of CDC architecture then I would be understating the potential for this. But right now we expect to at least double it.

Operator

[Operator Instructions] Your next question comes from the line of Tim Savageaux with Northland Capital. Your line is open.

Tim Savageaux

Yes. I want to follow up on kind of step back to an overall view of the growth that you have been seeing in China in particular and what sort of visibility you have to the sort of continuation to that growth. It sounds like you have indicated that at least most recent round of 100G backbone activity looks to stretch out into 2017 and it also sounds like you got some, and given you got a pretty nice ramp build in for Q4 ex PON some pretty good order visibility there or at least I would assume so. But can you speak to kind of you termed it a mid term trends maybe I can try and get you to find out little bit better and how long we expect to see this growth surge in China and then maybe I can follow up with one after that.

Tim Jenks

Sure. There are couple of national programs that are drivers here, there is in the big picture. There is so called China Broadband 2020 initiative which was launched in 2013. And that is covered in the current five years plan in China that actually has very strong investment into broadband architectures and in the initial position they were working to provide service to a large amount of residences and now increasing the data rates to those residences. There are also going back and forth between wireless and wire line so essentially deploying 4G LTE and then subsequently strengthening the backbone with 100G. Information we have from carriers is that right now out of about 30 provincial centers in China, they've only gotten the initial 100G to about 20 of them so they still have to fill out all of those provinces and they are still a third of the provincial areas that aren't really touched yet. So all of this is part of the broadband 2020 initiative and it is also part of their desire to invest in winning technologies and winning industries which has to do with the overall IT infrastructure. So while the current activity is seeing significant growth in 100G and wire line as well as wireless what we see near term I mentioned the expectation for another 30,000 ports, the total for next year is looking more like 60,000 ports and essentially we will see a lot of this get filled by the DCO pluggable that I talked about. And then as the -- our China location is actually Shenzhen, well we have three locations in China but Shenzhen is our principal one. In this past month actually the city of Shenzhen announced that they would be -- they expected to be the first 5G city in China. And so there are actually national and regional plans to have the infrastructure in place. So that by 2020 they would be able to do -- begin the 5G rollout. So these are all things that in the medium term give us a strong level of confidence toward continuing strength of the market in China beyond the normal tender to tender harmony ports. I hope that answers your question, Tim.

Operator

There are no further questions at this time. I'll turn the call back over to management.

Tim Jenks

Very good. Well, thank you very much Andrew. I appreciate everyone's joining our call today. In closing, I'd like to thank our global employees for their diligent efforts enabling our results and our continued volume ramping up. I'd like to thank all of you for taking the time to join our call. And remind our listeners that we will be hosting an Investor Day on September 8 in New York City. Thank you. And have a good evening.

Operator

This concludes today's conference call. You may now disconnect.

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