Shares of Coherent and Lumentum are Deutsche Bank's 'highest conviction' picks among hardware companies in the era of AI

Hardware companies in the business of optical networking are shaping up to be the big winners in the era of artificial intelligence.

Several companies involved in manufacturing networking components and in running the networks themselves - basically, companies that "make and move light" - are set to benefit the most at a time of growing demand for hardware in the data-center buildout, according to Deutsche Bank analyst Gianmarco Conti.

"The first wave of the [artificial-intelligence] buildout was a compute story, the next wave is a connectivity story," he wrote, referring to the growing demand - and short supply - of compute and, recently, networking components.

With that new wave in mind, Conti initiated coverage of eight hardware stocks on Monday. He placed buy ratings on Lumentum Holdings (LITE), Coherent (COHR), Arista Networks (ANET), Cisco Systems (CSCO) and Hewlett Packard Enterprise (HPE), and set hold ratings on Dell Technologies (DELL), Ingram Micro Holding (INGM) and A10 Networks (ATEN).

Lumentum and Coherent, which make optical components and lasers for connecting data centers, are Conti's "highest conviction" picks.

"[E]very AI architecture, pluggable or [co-packaged optics] needs their lasers," Conti wrote, referring to types of optical architectures. He added that both companies "are supply constrained, sold out and raising prices."

He also pointed out that Nvidia (NVDA) has invested $2 billion in each company to support their research, and to secure purchase commitments for their hardware.

Lumentum is the "purest expression" of his investment thesis for the networking industry, Conti said. The company "wins under every architecture," and its III-V laser is the "one component that every path requires," he added, referring to different ways to package optical components and chips in data-center networks.

What differentiates Coherent, which manufactures lasers and transceivers, is that the company is vertically integrated, from the raw-materials layer to lasers and the modules that house them.

Shares of Lumentum have climbed 553% over the past year, and shares of Coherent have gained 204%, as investors have piled into the networking trade.

Cisco is another play that Conti notes is the "only large cap networker" that touches all three layers of the hardware stack, given it has its custom silicon, Silicon One; its optical components; and its systems, or the routers and switches that house the components. That gives it a competitive advantage compared with other networking companies, which typically buy components and chips from separate vendors, he explained.

Kevin Wollenweber, general manager of data-center and internet infrastructure at Cisco, told MarketWatch that networking is one of the biggest problems to solve in artificial intelligence.

"You've got compute, you've got storage, you've got all the [graphics processing units] and everything you need to connect to," Wollenweber said. "But everything has to operate as a single system, and so the connectivity between those becomes a critical bottleneck."

As for HPE, Conti said that networking is the "earnings engine," given its ownership of networking subsidiaries Juniper Networks and Aruba Networks under the umbrella of HPE Networking. He expects that arm to contribute a "disproportionate share" of operating profits.

He also said that the company's highly efficient liquid-cooling technology, which is needed for data centers, helps set it apart.

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-Hannah Pedone