Imperatives for photonics companies in the next wave of growth

Being in the right vertical segments and deftly using M&A will help photonics companies to succeed in the future.

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 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.

Sizing 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).

Photonics-enabled systems continue strong growth across end markets.
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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).

Components have a smaller base but are experiencing faster growth.
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Megatrends’ effect on microverticals

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:

  • Surging demand for data transfer speed. The need for computing power is rising as more and more data are created by digitalization and by the Internet of Things (IoT). Cloud computing further increases the demand for fast data transfers. This is a sizable opportunity for component manufacturers that have a position in optical communication products.
  • Growth in remote vision and sensing applications. Augmented reality, autonomous driving, process automation, and unmanned reconnaissance are no longer futuristic concepts; they’re already in use in consumer, commercial, and government settings. For these tools to have the required level of sophistication and performance, new components will be needed.
  • The rise of digital and additive manufacturing. Today, 3-D printers are being used to make everything from semiconductors to automobile parts and prototypes. Photonics components are crucial in increasing the performance of this equipment and in reducing its cost.
  • Rapid expansion in the noninvasive life sciences. Treatment of a wide range of conditions (including cancer and diabetes) has gotten a boost from noninvasive technologies. Such technologies may also help healthcare become more efficient and accessible. Many of the lasers that enable these procedures rely on photonic materials.
  • Transition to sustainable energy sources. 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. This should give a boost to companies that make photovoltaic components.
  • An increase in geopolitical uncertainty. Instability in the geopolitical sphere means governments will be looking to innovate in defense and surveillance, strengthen their supply chains, and automatically enforce tariffs or prohibit trade of certain products. Photonics components will be needed to make some aspects of this possible.

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).

Megatrends show only part of the picture; a microvertical lens can help identify pockets of attractive growth.
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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.

Role of M&A in the industry

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.

Deal momentum in the past seven years has been meaningful.
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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.

Imperatives for photonics component companies in the next three years

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:

  • Establishing a position in a top microvertical. With the component industry’s likely 10 percent overall annual growth and the expanding number of applications requiring some level of photonics integration, the next few years are going to be interesting. Demand for components will increase in many microverticals and will be particularly robust in areas such as silicon photonics, ultrafast lasers, VCSELs, sapphire glass, and NLO crystals. Component companies that have a “play” in the fastest-growing areas—or that are able to obtain one—will have a good chance of outperforming their peers.
  • Using M&A to increase value. The trend toward vertical integration is already altering the competitive dynamics of the global photonics market, and there are good reasons to expect the trend to continue. Given the effect that vertical integration will have on profit pools in the industry, companies should already be scanning for possible deals. They should also know their starting points: Are they operating in a commodity part of photonics or a specialized segment? Should they be looking to integrate up (into a systems play) or down (into a component play)? M&A will be an important tool for value creation in the industry; it should be in every company’s arsenal.
  • Ensuring strong financial management. This last imperative is, in some ways, merely a fundamental business discipline. It’s a given that every company should limit its operating and capital expenses to maintain cost competitiveness, but these disciplines are not always followed in emerging areas of technology. R&D efficiency, footprint consolidation, and capital productivity are going to be increasingly important in photonics as consolidation gains momentum and the industry matures.

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.

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