China Galaxy Securities has released a research report stating that indium phosphide (InP) production capacity is severely constrained. Global demand for related devices is projected to reach 2 million units by 2025, with the actual supply-demand gap exceeding 50%. Capital expenditure guidance indicates that future growth expectations remain high. Factors such as component price increases, computing power shortages, and sustained demand expansion are driving a capital expenditure race that is far from its peak. The firm believes AI investment has formally entered a return phase. The realization of expectations is boosting overall confidence across the industrial chain, but substantial capital expenditures are simultaneously placing significant pressure on cash flow. Downstream capital expenditures are expected to structurally reshape the optical components industry. It is recommended to focus on leading companies in related fields, particularly those involved in optical modules and optical communications. The key views of China Galaxy Securities are as follows:
AI computing power growth is driving demand for optical components, and the supply-demand gap for indium phosphide chips is ushering in industry changes. With the rapid adoption of cloud computing workloads, AI training clusters, and 5G backhaul infrastructure, network operators and hyperscale cloud service providers are accelerating the deployment of optical interconnect solutions. Concurrently, data traffic is growing exponentially at double-digit annual rates, and data rates for optical modules are accelerating towards 400G, 800G, and even 1.6T. Furthermore, globally implemented national broadband expansion plans are generating new demand for coherent optical modules in metropolitan and long-haul transmission networks. The global optical module market is forecast to reach $39.6 billion by 2034, representing a ten-year CAGR of 11.5%. Currently, indium phosphide production capacity is severely limited. By 2025, global device demand is expected to hit 2 million units, with the actual supply-demand gap surpassing 50%.
Supply shortages are fueling high prosperity in the optical components sector, with greater resilience upstream in the value chain. According to the latest financial reports, the combined upper limit of capital expenditure guidance from the four major U.S. Cloud Service Providers (CSPs)—Google, Amazon, Microsoft, and Meta—approaches $725 billion, an increase of approximately 165% from about $245 billion in 2024. Future growth expectations remain elevated, as component price hikes, computing power scarcity, and continuous demand expansion suggest the capital expenditure competition is nowhere near its peak. The firm's analysis indicates: 1) AI investment has officially entered a payback period, with the four major CSPs reporting high-speed growth in cloud services and AI-related revenue, signaling stable conversion of AI investment into profits. 2) The realization of expectations is bolstering overall confidence across the industrial chain. Continuously rising capital expenditure forecasts have completely dispelled concerns that AI-related spending would peak and decline. However, these substantial expenditures are concurrently exerting significant pressure on cash flow. 3) Downstream capital expenditures will structurally reshape the optical components industry. On the demand side, the rigid need for high-bandwidth, low-power interconnects in AI clusters is accelerating the technological shift from traditional pluggable optical modules towards more integrated solutions like Co-Packaged Optics (CPO) and Optical Circuit Switches (OCS). This directly drives demand for indium phosphide (InP) chips, silicon photonics, and advanced packaging technologies. On the supply side, the scale and persistence of capital expenditures require upstream suppliers to possess large-scale, high-consistency delivery capabilities. Industry differentiation is expected to intensify, with leading vertically integrated manufacturers likely securing more Long-Term Agreement (LTA) orders, while small and medium-sized specialized design firms may face foundry capacity constraints or be compelled to seek mergers and acquisitions. 4) CSPs are becoming key drivers of the technology ecosystem. As end-users, CSPs are deeply involved in standard-setting, promoting interface openness and decoupling, which may reshape value distribution within the supply chain, further amplifying the value share of core chips and advanced packaging. 5) In the short term, the supply-demand gap may support device prices and enhance the bargaining power of leading manufacturers. Global capacity for key materials like indium phosphide is already tight. The capital expenditure race will likely trigger a new round of capacity expansion competition, though expansion cycles are long and technological barriers are high. Overall, the optical components sector is transitioning towards a competitive landscape driven by high prosperity from AI infrastructure investment, with technological leadership and ecosystem synergy as core differentiators.
An analysis of a typical company, Lumentum, reveals it as a leading photonics IDM with full-stack vertical integration capabilities spanning chip design, InP wafer manufacturing, chip packaging and testing, optical module packaging, OCS optical switches, and system solutions. The company has secured orders worth hundreds of millions of dollars for its 400mW/800mW Ultra-High Power/Super High Power (UHP/SHP) lasers for CPO, with deliveries expected in the first half of 2027. Its OCS products based on MEMS technology have an order backlog exceeding $400 million, with sales projected to surpass $1 billion by 2027. Concurrently, the synergistic advancement of 1.6T/3.2T optical modules and CPO technology forms a clear future growth trajectory.
Investment Recommendation: It is advised to focus on relevant leading companies in the optical modules/optical communications sector, such as Lumentum (LITE), Coherent (COHR), Fabrinet (FN), Corning Inc. (GLW), and Applied Optoelectronics (AAOI), monitoring the trend of simultaneous improvement in profitability and valuation.
Risk Warnings: 1. Risk of demand volatility due to downstream capital expenditures falling short of expectations. 2. Risk that indium phosphide capacity expansion progresses slower than anticipated. 3. Risk of slow yield improvement in the mass production of CPO technology. 4. Risk associated with high customer concentration and changes in orders from single clients.
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