Marvell Is Betting $115 Billion on 1 of AI's Biggest Bottlenecks

There are a ton of supply constraints in the artificial intelligence industry. As large language models grow bigger and more complex and the number of people using them grows, a handful of companies are working to supply as much compute capacity as possible.

There are a few bottlenecks limiting their ability to scale, though. Many people know about the memory chip shortage, which has led to booming profits for the chipmakers supplying that key component. But optical networking components may be an even bigger bottleneck. Lumentum (NASDAQ: LITE) CEO Michael Hurlston said at a conference that the shortage the key material for developing its lasers "will become even more acute than what we see from the memory guys."

That shortage has already shown up in its financial statement with booming revenue and profit margins. Marvell Technology (NASDAQ: MRVL), which expects its optical interconnect chips to remain its biggest business for the foreseeable future despite a rapidly growing custom XPU business, seems to agree with Hurlston.

Access to its lasers could be key for Marvell's continued growth. In fact, the chipmaker just offered $115 billion to absorb Lumentum entirely. Let's see what this could all mean for investors.

Image source: The Motley Fool.

The next-generation of AI connectivity

Marvell's bid for Lumentum gives it an enterprise value of $115 billion at the time of the offer. However, the deal is an all-stock offer, with Lumentum shareholders receiving 4.5 shares of Marvell stock per share of Lumentum stock. As a result, the closing value will depend on where Marvell trades.

So far, the market is not optimistic about the deal, sending shares of Marvell lower on the news. To be sure, Marvell is paying a significant premium for Lumentum, and shareholders will see considerable dilution, owning just 67% of the combined company after the deal goes through.

But the acquisition could bolster one of the most important parts of Marvell's business. Marvell sees connectivity remaining its biggest business, with the total addressable market growing at a 65% compound annual growth rate between 2026 and 2031. Optical interconnect chips turn electrical signals into light, which moves much faster. Lumentum makes the lasers and transmission modules for producing that light.

Lumentum and its chief rival, Coherent, are the two largest producers of the indium phosphide lasers that power today's fiber networks. The supply shortage has led to phenomenal financial results for both companies. Lumentum saw sales climb 109% in the fourth quarter, with gross margin expanding 14.1 percentage points and operating margin expanding 29.5 percentage points. The result was adjusted earnings growth of more than 400%.

Management expects the supply constraints to lead to further margin expansion this quarter. What's more, Hurlston says the supply constraints could last through 2028 with Lumentum's capacity sold out into 2029. It takes years to build out new capacity, and Lumentum is booking take-or-pay deals with its customers to ensure it maximizes the utility of new facilities that won't start producing new components for several years.

Marvell is securing its competitive position

Lumentum fills in some significant gaps in Marvell's interconnect business. Specifically, as it looks to "scale-in" with co-packaged optics (CPO) bringing the optical chips closer to the core processing units in AI data centers, the need for some of its chips is eliminated. Lumentum's lasers, however, are necessary for optical transmission, so they'll remain a key component of interconnect chips in all forms.

The combined company would have a complete portfolio of optical chips and packages, rivaling Broadcom. The ability to design CPO architecture and supply all of the components provides a hedge against disruption to its digital signal processing (DSP) chips.

Marvell's management says the combined company unlocks new opportunities for the business, expanding its total addressable market. Management's outlook calls for a $550 billion TAM by 2030 for the combined company, adding $60 billion to previous forecasts.

Investors should be wary of the risks, however. Perhaps the biggest risk is acquiring a company amid a booming earnings cycle. If the supply shortage isn't as severe as Lumentum's management believes or if demand slows faster than expected in later years, Marvell could be paying a very high premium for the company. Premium pricing for Lumentum's components could fall considerably once new production capacity comes online.

Investors should pay close attention to Lumentum's commentary over the next year, as the deal isn't expected to close until 2028. If the supply shortage is narrowing more quickly than expected, it could indicate that Marvell could have trouble charging the premium prices to end customers it needs to achieve its forecasts laid out in its presentation announcing the deal.

Adam Levy has positions in Broadcom. The Motley Fool has positions in and recommends Broadcom, Coherent, Lumentum, and Marvell Technology. The Motley Fool has a disclosure policy.