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Jan 10, 2024

Imperatives for photonics companies

Semiconductor lasers that enable data transfers at two terabits per second;

Semiconductor lasers that enable data transfers at two terabits per second; cell phones that incorporate 3-D sensors to deliver more-interactive games and commercials; light-based technologies that make needle jabs and scalpels a thing of the past for certain medical procedures; and laser-enabled directed-energy weapons that deter foreign threats and ensure a nation's security: these are just a handful of the applications that may soon be possible because of photonics,1"The next wave of innovation in photonics," McKinsey, June 28, 2021. the branch of technology connected to light. Photonics-enabled systems are already widely used by consumers, businesses, and government organizations every day in products that amount to a $1.4 trillion global market. By 2025, the market for photonics-enabled systems should grow to almost $2 trillion.

This growth is enabled by a foundation of raw materials, along with lasers, sensors, optics, and other photonics components. Though small today, the market for photonics components is poised for rapid expansion thanks to several megatrends, including increased automation and the explosion in digitalization and cloud computing. With the market headed for a sustained period of double-digit growth, the next few years will be pivotal for large component players.

Though small today, the market for photonics components is poised for rapid expansion thanks to several megatrends.

This article provides an analysis by McKinsey of the size and estimated growth of two markets: photonics components and photonics-enabled products. Our article also discusses the megatrends that are starting to benefit photonics component suppliers and how those suppliers can capture the opportunities that are fast arriving in the global photonics market.

Photonics components are everywhere: They enable military night vision systems and the smartphones that consumers use; the streetlights in many major cities have photonics components, as do the photovoltaic cells in the cities’ solar-heated buildings; state-of-the-art manufacturing plants use photonic lasers for marking and cutting; and automobile manufacturers take advantage of photonics in their advanced driver assistance systems (ADAS).

Consumer applications account for the largest share of photonics-enabled systems, followed by defense and display applications, according to our analysis. The average compound annual growth rate across ten end markets is projected to reach 6 percent between now and 2025. Solar, automotive, and LED revenues will increase at a rate considerably above that, with semiconductor revenues seeing the slowest growth (Exhibit 1).

At $120 billion, component revenues are only about one-twelfth of photonics-enabled systems. But component revenues are growing at a faster compound rate than system revenues—10 percent versus 6 percent—as photonics content continues to increase in overall system shares across many verticals. Discrete optics is the biggest subsegment today, with more than $35 billion in revenue; lasers, at about $10 billion, is the smallest subsegment (Exhibit 2).

As part of our analysis, we looked at the growth prospects and likely profitability of 30 microverticals within photonics components. Some microverticals, particularly in the sensor area, are likely to have quite low levels of profitability and growth over the next five years. For instance, complementary metal-oxide semiconductor (CMOS) and charge-coupled device (CCD) sensors—both mature, commoditizing technologies—will be below average on both financial metrics. Other microverticals, such as silicon photonics and ultrafast lasers, are headed for much higher growth and profitability. Better-positioned microverticals will be helped by six megatrends:

The pressure to reduce harmful emissions and pollutants is going to intensify, which will increase demand for renewable sources of energy all over the world.

Which microverticals will benefit the most from these trends? From among the 30 microverticals that McKinsey analyzed, five stand out as particularly promising (Exhibit 3).

Silicon photonics for data center transceivers. This embryonic area of photonics components, with only about $500 million in revenue today, is poised for explosive growth. By combining silicon integrated circuits and semiconductor lasers, silicon photonics offers a significant improvement over traditional electronics components in the speed at which it can transfer data over long distances. Data center transceivers will be the biggest market.

Ultrafast lasers. These components emit sub-nanosecond pulses, which gives them advantages in "cold" material processing. They are accurate to within ten microns. Demand for ultrafast lasers is limited today but will grow because of technology disruptions including electric cars, 5G, and the miniaturization of medical devices.

Vertical-cavity surface-emitting lasers (VCSELs). With VCSELs, the light or optical beam is emitted from the top surface of a laser diode. This technology is beginning to see applications in computer mice, 3-D imaging and sensing, and industrial heating, and it could become more common in areas such as virtual reality and heads-up displays.

Sapphire glass and windows. Sapphire, which is second only to diamond in material hardness, is long-lasting, scratch-resistant, and transparent. It has the potential to play a large role in industrial lasers, in underwater cameras and marine spectrometers, and in military displays that need to be protected from harsh environments.

Nonlinear optical (NLO) crystals. These components can generate a nonlinear optical effect on properties such as frequency, polarization, phase, or path of incident light (for example, second-harmonic generation, sum-frequency generation, or optical rectification). They have some initial use in noninvasive medical procedures—including ophthalmologic, orthopedic, and dermatologic procedures—and those applications are expanding.

Globally, there are about 30 photonics component companies with revenues greater than $1 billion. The global photonics market also includes hundreds of other component companies with revenues of less than $10 million and fewer than 50 employees. Such a long tail of small companies is a sign of an industry that is still in a relatively early stage.

Consolidation is inevitable. Indeed, the consolidation has already begun, with hundreds of deals occurring in the past seven years. Although the number of deals has declined somewhat since peaking at 66 in 2018 (Exhibit 4), two big transactions in 2021—Teledyne's purchase of FLIR for $8.2 billion and II-VI's $6.9 billion acquisition of Coherent—helped push total deal value above $20 billion. That was more than twice the amount seen in any prior year.

About half of recent transactions have been aimed at achieving top-down vertical integration as companies look to control more of the value chain and unlock system-level innovation. One example of a vertical-integration deal was the 2020 acquisition by a lithography systems supplier of a precision-optics company with experience in the areas of extreme-ultraviolet and deep-ultraviolet products.

The next biggest piece of M&A spending is essentially a mirror of the top-down strategy. The acquirers in this second group—bottom-up vertical-integration acquirers—view M&A as helping them get into higher-value areas of the photonics component space and as expanding their available markets. Such a deal happened in 2019 when a major materials company bought a laser and optical-communications company to gain a foothold in the red-hot VCSEL space.

There have also been deals done for the purpose of horizontal expansion, with the goal of moving into adjacent end markets. One example is when a major diversified laser company acquired a fiber laser company to expand its product portfolio in 2016.

According to our analysis, these will continue to be the three dominant deal categories as the wave of consolidation in photonics continues.

There is no single "right" value creation strategy for all photonics component companies. But there are three things that all companies currently in—or that are considering investing in—the space should consider:

The growing use of light-based technology in a wide range of product areas is further expanding the opportunity for photonics companies. The companies that perform the best will be those that position themselves in the highest-growth product areas. Photonics companies may also find themselves on one end of an M&A discussion. Success will come to those who deftly play the hand they’re holding.

Ryan Fletcher and Abhijit Mahindroo are partners in McKinsey's Southern California office, and Jwalit Patel is an associate partner in the New York office.