Apple, Inc. Is Making a Massive -- and Brilliant -- Bet on 3D Sensing

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When Apple (NASDAQ: AAPL) decides to bet on a technology, it bets big.

The Mac maker has just announced that it is awarding Finisar (NASDAQ: FNSR) a $390 million investment out of its $1 billion Advanced Manufacturing Fund. It's the second award out of the fund, which was set up in May, following a $200 million investment in glass supplier Corning.

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Finisar, which is one of several suppliers for vertical-cavity surface-emitting lasers (VCSELs) that enable 3D sensing, surprised investors earlier this month when it disclosed it had acquired a new manufacturing facility in Sherman, Texas, for $20 million. Now we know that Apple is involved in that expansion project, as the investment will help fund the facility, which is expected to commence volume production in the second half of 2018.

The "VCSEL capital of the US"

Once the 700,000-square-foot facility is up and running, Apple says Sherman will become the "high-tech VCSEL capital of the US." The company also notes that all of the VCSELs that it plans on purchasing from Finisar will be made in Texas, and the project will create over 500 high-skill jobs.

While the facility itself only cost $20 million, Finisar's payroll expenses for its Northern Texas workforce will be about $65 million, and that's before including other costs like capital expenditures and infrastructure upgrades that will be necessary.

Mysteries solved

When discussing the Sherman plant on the earnings call earlier this month, there were a few mysteries surrounding the project. Management said the Sherman plant would ramp to production capacity that would translate into about $100 million in quarterly revenue, which would require significant capital investments in infrastructure, but also clarified that the $50 million in capital expenditures in the third quarter did not include costs associated with Sherman.

"As Jerry talked about, we've ordered a lot of the long lead time items. So we're still finalizing what the exact equipment set is going to be and how many wafers we're going to be able to add to capacity," CFO Kurt Adzema said about the new building. "Obviously, capacity is only part of the equation. You have to have capacity and then obviously, you have to have a customer."

Analysts were slightly puzzled by how confident Finisar was. After all, you don't invest this kind of money unless you know the demand is there. Here's Adzema again:

Finisar finished the third quarter with $1.2 billion in cash, cash equivalents, and short-term investments, so the Sherman investments would represent a decent chunk of the company's total cash position.

Apple's involvement solves all of these mysteries: it is helping cover the costs, and will be a big buyer of the plant's VCSEL output.

Locking down VCSEL supply

The VCSEL and 3D-sensing market are expected to explode in the years ahead, thanks in part to Apple's aggressive adoption of the technology. The VCSEL market was valued at around $775 million in 2015, and may reach as high as $4.7 billion by 2024 (a compound annual growth rate of 22%), according to estimates from Transparency Market Research from late 2016.

Apple says in Q4 2017 that it will "purchase 10 times more VCSEL wafers than were previously manufactured worldwide over a similar time period." In other words, Apple is going to play a huge role in expanding the market for VCSELs and 3D-sensing components, and to the extent that it can lock down VCSEL supply, it can preclude Android original equipment manufacturers from meaningfully catching up in 3D sensing. Apple has reportedly already locked down much of the industry's current supply through exclusive supply agreements.

While granular details regarding the Finisar investment were not disclosed and whether or not there are supply agreements involved, there should be little doubt that supply agreements are part of Apple's strategy here.

Supply agreements were absolutely involved in a similar deal from a few years back with GT Advanced Technologies to acquire copious amounts of sapphire. While Apple did not require absolute exclusivity from the expected sapphire output, the agreements did include provisions that GT Advanced could only sell sapphire to Apple in the context of consumer electronics (i.e., GT Advanced could not sell sapphire to other companies producing consumer gadgets). That deal (which had some key differences) ultimately fell through, with GT Advanced declaring bankruptcy to dissolve the partnership (it subsequently emerged from bankruptcy last year).

Investors can't help but wonder if Apple has similar types of agreements with Finisar. VCSELs are used in a wide range of legacy as well as emerging applications, including in automotive. It's feasible (but entirely speculative) that Apple has similar terms, where Finisar can only supply VCSELs to Apple for consumer electronics, which would block direct rivals while still allowing Finisar to address growing demand in other markets with its newfound capacity.

The future of 3D sensing

Most of the time when Apple picks a new technology, it likes to adopt that technology throughout its product portfolio. In the case of 3D sensing, VCSELs are used to enable Face ID, and Apple has begun the process of transitioning away from Touch ID. Ironically, Apple had just started bringing Touch ID to the Mac a year prior, and now the fingerprint recognition technology's fate is unclear.

Beyond facial recognition, 3D sensing has incredible potential to supercharge augmented reality (AR) technologies, tools, and experiences, particularly when you consider high-power VCSELs that can even be used to create 3D environmental maps. Alphabet subsidiary Google has an experimental Project Tango that does precisely this with mobile devices that are covered in VCSEL sensors. iPhone X only has a front-facing TrueDepth camera, but you can bet Apple wants to add rear-facing TrueDepth camera systems (probably with improved specs) in future iPhone models that will raise the bar in terms of AR capabilities.

VCSELs are also used in AirPods, so there are other applications for Apple's growing wearables business as well.

Face ID and TrueDepth will likely make it to the iPad Pros next, which could then similarly be followed by rear-facing TrueDepth cameras on iPads at some point. The iPhone X notch that houses TrueDepth would fit very easily in Macs eventually too, bringing Face ID biometric security to Apple's computer lineup. All of this will require a lot more VCSEL supply than currently exists.

In one fell swoop, Apple is helping fund the VCSEL capacity ramp while likely hogging much of the resulting output for itself, all while earning political points for supporting domestic job creation. Well played, Tim Cook.

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