Global Leap in Optical Modules

In the rapidly evolving landscape of the global optical module market, China has firmly established itself as a dominant playerOf the top ten optical module manufacturers worldwide, seven are Chinese companies, collectively commanding over 50% market shareNoteworthy among these is InnoLight Technology, which has recently outpaced Coherent to become the leading entity in shipments within the industryDespite this remarkable growth, challenges remain, particularly in reliance on imported core components, such as optical chips, signaling that the quest for greater domestic production remains critical.

The year 2023 has been unprecedented for NVIDIA, driven by the explosive rise in demand for AI hardware following the breakout success of ChatGPTThis surge has put NVIDIA’s high-performance GPUs in the spotlight, with substantial orders flowing in continuously

A crucial aspect to note is the strong coupling between optical modules and GPUs; they must work in tandem to achieve optimal performanceAs a result, the ascendency of NVIDIA has not only benefited its status but has also fostered a burgeoning niche market for upstream optical module suppliers, including both domestic firms like Tianfu Communication and international players such as Fabrinet and Coherent.

Since March 2023, revenue from NVIDIA's optical module suppliers has witnessed a marked increaseHowever, as time has progressed, overseas manufacturers have begun to lag, experiencing declining revenues, while their Chinese counterparts have reported continued growth, capturing market share that was previously dominated by foreign companies through cost advantages.

An essential detail in understanding this market is the production structure of domestic manufacturers

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Most Chinese suppliers primarily operate at the manufacturing stage of optical modules, while their upstream counterparts involve optical chips, electrical chips, and optical devicesOptical chips and electrical chips are the core components of optical modules, with optical chips typically constituting 40% to 60% of the module cost, while electrical chips account for 10% to 30%. Currently, domestic production has achieved basic substitution for products below 10GB/s; however, the domestic rate for products exceeding 25GB/s lingers at a mere 10%, indicating a pressing need for further enhancement of localization.

The rise of domestic manufacturers has been propelled by the advent of AI, particularly with the launch of large language models like ChatGPT, significantly increasing demands for computing powerMajor tech firms such as Amazon, Google, Apple, Microsoft, and Meta have engaged in a fierce contest for market share in computing power

In the fourth quarter of 2023, the combined capital expenditure among these five leading cloud computing giants reached an impressive $45.4 billion, marking a 4.7% year-over-year growthFurthermore, they all indicated a commitment to increasing investments in AI for 2024.

Research from an investment firm highlighted that in the first quarter of 2024, capital expenditure for these cloud leaders continued to climb, amounting to approximately $46.3 billion, representing a year-over-year increase of 25.7%. Chinese cloud computing firms also reported significant growth, with Tencent’s capital investment soaring to RMB 14.36 billion (approximately $2.2 billion), showing an astonishing year-over-year rise of 225.5%. Alibaba and Baidu followed suit with similar increases in their capital spending.

Given the synergistic relationship between GPUs and optical modules, it would be reasonable to expect that the major international cloud computing firms would naturally benefit from this latest wave of AI computing power

However, the situation has developed differently than anticipatedAccording to recent data, Coherent, which previously shared the top market spot with InnoLight, reported a revenue drop of 2.53%, alongside a significant loss in profit marginLumentum also saw a decline, while Fabrinet managed to generate positive growth amidst the downturn.

The stark contrast in performance between foreign and domestic firms is evident; while the latter group has experienced substantial growth, heavily outperforming their international counterpartsThe preliminary earnings forecasts for the first half of 2024 reflect this trend: InnoLight anticipates net profits between RMB 2.1 billion and 2.45 billion, representing a year-over-year increase ranging from 260% to 320%. Similarly, NewEase's net profit expectations range from RMB 810 million to 950 million, while Tianfu Communication targets a profit between RMB 617 million and 664 million.

The discrepancy in performance indicates a significant shift in market dynamics, with domestic optical module manufacturers clearly gaining competitive ground as performance metrics for overseas companies falter

With the demand for optical modules growing and the international competition declining, it is apparent that Chinese firms are solidifying their presence and expanding their market share.

According to research records, by the end of 2023, Chinese manufacturers made up seven of the top ten optical module producers globallyInnoLight has taken the lead, with Huawei, LightSpeed Technology, Hisense, NewEase, Huagong Zhengyuan, and Solsight Photonics following closelyThese statistics reveal that Chinese optical companies are commanding more than half of the overall market share.

Heading into 2024, the performance metrics of the leading manufacturers indicate a strengthening trend towards Chinese dominance in the global optical module market.

However, despite the high market share held by domestic optical module manufacturers, their position within the production chain still appears vulnerable

Specifically, the upstream sections of the optical module industry chain encompass the production of optical chips and optical device suppliersThe midstream includes the manufacturing of optical modules as well as suppliers of optical communication equipment, responsible for assembling the optical chips and devices into fully functional modules, in addition to developing corresponding drive circuits and control systemsLastly, the downstream sector primarily consists of the data communication market and telecommunications market, which includes end users such as internet and cloud computing firms, and telecom operators.

This positioning places domestic manufacturers in the midstream sector, which is characterized by a relatively lower technological barrier involving assembly, packaging, and testing.

Insights from an investment report clarify that domestic manufacturers have been preferentially benefitting over their foreign counterparts due to two main factors: Firstly, overseas firms initiated operations earlier, and beginning in 2018, manufacturers from the U.S

and Japan began divesting their low-margin optical module businesses, subsequently shifting their focus to the R&D of core optical chip products.

Secondly, by leveraging advantages such as lower labor costs, a vast domestic market, and support from telecom equipment manufacturers, domestic optical module companies have rapidly seized market share that overseas firms vacated, gradually gaining an edge over foreign competitors.

Moreover, an important takeaway from recent studies is the acknowledgement that the optical and electrical chips, which serve as key components of optical modules, collectively account for substantial portions of the overall module costsMultiple reports indicate that while foreign chip manufacturers possess established technology and higher barriers to market entry, domestic manufacturers are presently only capable of mass-producing lower-speed optical chips, predominantly relying on imports for higher-speed components.

Similar situations apply to the field of electrical chips, where current domestic capabilities lag behind, with only a limited number of suppliers involved in 25G/s products while most have to import chips for higher speeds

This depicts a concerning reality for domestic manufacturers striving for progress in optical module localization.

However, a positive observation is the strategic moves made by domestic firms like SourceJet Technology and LightSpeed, which are seeking to strategically develop optical chips while successfully achieving domestic substitution at lower speeds, concurrently intensifying research efforts targeting high-speed optical chips.

Amidst these developments, many Chinese optical module firms attempt to leap ahead through the adoption of silicon photonic solutionsReports suggest that these newer solutions, in comparison to traditional optical modules, not only enhance integration but also exhibit superior performance concerning peak speed, energy consumption, and costThis positions silicon photonic technology as a significant future trend in the optical module sector.

Despite challenges related to yield rates and loss, the overall advantages of silicon photonic solutions may not reach full visibility yet

However, for short-distance scenarios exceeding 400G, the low-cost benefits of silicon modules could make them a preferred choice for data center networks, particularly as the optical module speeds continue to rise.

Forecasts from industry experts highlight an impending turning point for the optical communications industry regarding the application of silicon photonic technology, projecting significant market share increases from 2021 to 2026. By the end of this period, the global silicon photonic module market is anticipated to approach $8 billion, likely capturing nearly half of the market share.

In a recent investor relations activity report, InnoLight confirmed the commencement of mass shipments of their silicon photonic modules for certain models operating at 400G and 800G speedsAdditionally, they are sending more products for testing, anticipating enhanced deployment ratios for silicon photonic modules in 2024.

Simultaneously, firms like NewEase and LightSpeed are actively conducting R&D on silicon photonic solutions, with several products already transitioning to the testing phase