The rapid expansion of artificial intelligence (AI) is driving a significant and costly shift in data center infrastructure. Traditional copper connectivity cables are reaching their limits as advanced AI models demand the transmission of increasing amounts of information across vast clusters of thousands of chips. This development is forcing a massive upgrade to optical technology, a change that is proving non-negotiable for the future of AI.
This transition from copper to optical solutions is creating a new investment frontier beyond the well-known semiconductor companies. Analysts are now highlighting the 'AI connectivity trade' as a critical, yet often overlooked, segment of the AI boom. This shift is not only about faster data transfer but also about enabling AI at the edge, where devices like wearables and autonomous vehicles process data locally.
Key Takeaways
- AI demands are pushing data centers to replace copper with optical connectivity.
- Optical networking stocks are seen as a high-growth, high-risk investment area.
- Experts predict over 50% year-over-year growth for the optical-component market in 2025.
- Companies involved in optical components, modules, and assembly are poised to benefit.
- The industry faces volatility due to customer concentration and rapid technological changes.
The Imperative for Faster Pipes
The core challenge stems from the sheer volume and speed of data that modern AI models require. When thousands of AI chips need to communicate instantly, the latency and bandwidth limitations of copper cables become a bottleneck. Optical technology, which uses light signals transmitted over fiber optics, offers a solution by providing significantly faster and more efficient data transfer.
Brad Gastwirth, global head of research and market intelligence at Circular Technology, emphasizes the critical need for this upgrade.
“Data centers need low latency and high-density bandwidth density,” Gastwirth stated, referring to fiber-optic technology’s ability to transmit data faster and in greater quantities. “You just need faster pipes.”
Optical Advantage
Light travels faster and more efficiently than electricity over copper wires. This fundamental physical advantage makes optical fiber essential for the high-speed data demands of AI.
This technological evolution is not just about current AI models. Future innovations, particularly in 'AI at the edge,' will further intensify the demand for robust connectivity. Edge AI refers to devices such as wearables, cars, and robots that must process data and make intelligent decisions locally, without constant reliance on central data centers. This requires a distributed, high-speed network that optical solutions are uniquely positioned to provide.
Emerging Investment Landscape
While semiconductor giants like Nvidia have captured significant investor attention, the underlying infrastructure supporting AI's growth is attracting new focus. Mizuho trading-desk analyst Jordan Klein noted that optical-networking stocks are “the least understood and probably least owned by retail investors” compared to more visible memory, power, and semiconductor names.
Klein identified several companies well-positioned to capitalize on the surging need for connectivity. These companies span various critical functions within the optical ecosystem. Some produce semiconductors that enable high-speed data transmission over fiber optics, while others build the optical modules that create and receive light signals.
Understanding Optical Networking
Optical networking involves converting electrical data signals into light pulses, sending them through fiber optic cables, and then converting them back into electrical signals at the destination. This process allows for much higher bandwidth and longer transmission distances compared to traditional copper wiring, which is crucial for modern data centers.
The projected growth for this sector is substantial. Consensus estimates among analysts polled by LSEG indicate strong compound annual growth rates (CAGR) for revenue from 2025 through 2027 for these companies. While these stocks often come with high forward price-to-earnings and price-to-sales ratios relative to the S&P 500, their recent performance has been notable. Most have outperformed the S&P 500, which saw a 17.2% return (with dividends reinvested) during the same period.
Key Players in the Optical Ecosystem
The optical networking space involves a diverse set of companies, each playing a vital role in the data transmission chain. These players address different aspects of creating, transmitting, and managing light signals for AI data.
- Semiconductor Providers: Companies like Astera Labs, Credo, Macom, and Semtech develop the specialized chips that facilitate high-speed data transmission over fiber optics. These chips are fundamental to converting electrical signals into light and vice versa.
- Optical Module Manufacturers: Firms such as Lumentum and Coherent build optical modules. These modules are the components responsible for generating and receiving the light signals that travel through fiber-optic communication systems. They are the heart of optical data transfer.
- Assembly and Packaging: Fabrinet specializes in assembling and packaging these optical components. This ensures they can be properly installed into high-performance routing and switching equipment.
- Network Equipment Providers: Companies like Arista and Ciena design and manufacture the routing and switching equipment that manages data transfers and traffic across networks. These systems integrate the optical components to create a seamless data flow.
- Specialty Cable Manufacturers: Amphenol produces the specialty cables that carry light signals from switch to switch when an AI server needs to send data from a graphics processing unit (GPU). These cables are designed for optimal light signal integrity.
Inside the switches, optical modules transform light pulses into electrical signals, which chips then boost for strength and quality. The electrical signal is then converted back into light to continue its journey to another switch, ensuring continuous high-speed data flow.
Market Volatility and Future Outlook
Despite the high growth potential, the optical networking industry is not without its challenges. Gastwirth points out that the sector experiences volatility due to the boom-bust nature of the overall industry. This is characterized by factors such as significant customer concentration, constant technological updates, and dynamic shifts in supply and demand. Maintaining sustainably high margins can be difficult for companies operating in this environment.
However, Gastwirth remains optimistic, anticipating that connectivity solutions will remain undersupplied in the near future. This undersupply could provide a sustained boost for these companies.
“I don’t think we’re anywhere near an overproduction,” Gastwirth affirmed.
Projected Market Growth
The optical-component market is predicted to grow more than 50% year over year in 2025, with continued momentum into 2026, according to Brad Gastwirth.
Other analysts share this positive outlook. Needham analyst N. Quinn Bolton, for instance, has become more optimistic about shares of Credo and Semtech. Bolton highlighted Credo’s next-generation chips for their significant power advantages over competitors. He also noted Semtech’s strong position for the initial ramp-up of Google parent Alphabet Inc.’s AI infrastructure. This suggests a broad consensus on the critical role these companies will play in the expanding AI landscape.
The combination of high valuation ratios and strong recent performance underscores the importance of thorough research and a long-term investment approach. As AI continues to evolve, the demand for high-speed, reliable connectivity will only intensify, positioning optical networking as a foundational element of this technological revolution.