Coherent's AI Growth Engine: Evaluating Margin Expansion as a Scalability Driver

The investment case for Coherent hinges on capturing a massive, scalable opportunity in AI data center optics. The total addressable market here is not just large-it is accelerating. The Communications end-market, where Coherent's AI transceivers are sold, is projected to grow 50% to $3.4 billion in 2025. This isn't a niche play; it's the core infrastructure upgrade required as hyperscalers race to handle AI-driven workloads, creating a powerful secular tailwind.

Segment-level traction confirms the engine is firing. In the first quarter of fiscal 2026, Data Center and Communications revenue grew 26% year-over-year, with 800G transceivers cited as the primary growth driver. The company is also pushing into the next generation, with accelerating 1.6 Terabit per second (T) transceiver adoption and generating its first revenues from these products in the prior quarter. This mix shift toward higher-speed, higher-margin modules is a key indicator of market leadership and pricing power.

What makes this growth potentially sustainable is Coherent's vertically integrated manufacturing model. This isn't just a cost advantage; it's a competitive moat that alleviates supply chain uncertainty for customers. As the company rapidly converts to six-inch indium phosphide (InP) wafers, it unlocks significant cost and yield benefits, directly supporting the 200 basis point year-over-year gross margin expansion seen last quarter. This vertical integration allows Coherent to scale production capacity in tandem with explosive demand, turning a massive TAM into captured market share.

Margin Expansion: Result or Driver of Scalability?

The recent jump in profitability is a clear result of the company's operational turnaround, but it's also becoming a powerful driver of future scalability. Last quarter, non-GAAP gross margin expanded to 38.7%, a 200 basis point year-over-year improvement. This wasn't a one-off accounting shift; it was driven by tangible manufacturing gains from the rapid conversion to six-inch indium phosphide wafers and a favorable product mix as 800G and 1.6T transceivers ramped. The full-year 2025 picture is even more telling, with non-GAAP gross margin up 358 basis points to 37.9%, demonstrating the durability of these cost and yield benefits.

What's more interesting for a growth investor is how this margin expansion is funding the very growth it supports. The company's R&D intensity of 10% of sales is significantly higher than the industry average of 7.2%. This aggressive reinvestment is the engine behind the technological leadership that commands premium pricing for next-generation optics. The result is a virtuous cycle: higher margins from current products provide the capital to push the innovation frontier, which in turn drives future revenue and profit growth. This is evident in the full-year results, where record revenue of $5.81 billion and a non-GAAP EPS of $3.53 reflect a successful operational turnaround that has built a stronger financial foundation.

The bottom line is that margin expansion here is a two-way street. It's a direct outcome of the scalability achieved through vertical integration and product mix. At the same time, the cash flow generated from these improved margins is being plowed back into R&D, ensuring the company can maintain its technological edge as it scales production to meet the surging AI demand. This creates a self-reinforcing loop where growth begets profitability, and profitability funds the next phase of growth.

Scalability and the Path to Sustained Growth

The path from current momentum to sustained dominance hinges on execution at scale. Coherent's planned expansion of its six-inch indium phosphide capacity is the critical catalyst here. This isn't just about making more chips; it's about locking in the cost and yield advantages that have already driven a 200 basis point year-over-year gross margin expansion. By rapidly converting to this larger wafer size, the company is building a manufacturing moat that directly supports the explosive growth in optical transceivers. This vertical integration ensures Coherent can meet the multi-year order backlog extending from its record bookings, turning a massive TAM into reliable, scalable revenue.

Market share will be determined by how effectively this capacity ramp aligns with the AI infrastructure build-out. The Communications end-market is projected to grow 50% to $3.4 billion in 2025, with the Networking division leading the charge. Coherent's ability to capture a growing slice of that pie depends on its product mix and technological lead. The acceleration of 1.6 Terabit per second transceivers and early traction in optical circuit switching broaden the opportunity beyond standard pluggables, potentially allowing the company to command premium pricing and deepen customer relationships. The key will be maintaining this innovation pipeline while scaling production.

Competitive dynamics are shifting, but the company faces headwinds outside its core growth engine. The Materials segment, which includes consumer electronics, is forecast to decline 6.2% in 2025. While this is a smaller drop than last year's steep contraction, it underscores that weakness in that market continues to weigh on overall performance. This divergence means Coherent's growth story is becoming more concentrated in AI data centers, which is a double-edged sword: it focuses capital and R&D on a high-growth area but also increases reliance on a single, albeit massive, market.

For investors, the near-term gauge is clear. Watch for sequential growth in Data Center and Communications revenue to confirm the capacity expansion is translating to sales. Equally important is management's guidance for operating expenses. The company is reinvesting heavily, with R&D intensity of 10% of sales, to fund the next generation of products. If operating leverage holds as revenue scales, it will validate the model's sustainability. The bottom line is that Coherent has built a powerful engine for growth, but its ability to dominate the AI optics market will be proven by its capacity to execute flawlessly on the production line and the balance sheet.