What Is Acacia Communications' Competitive Advantage?

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Acacia Communications (NASDAQ: ACIA) is a high-performing growth stock that trades like a value play. Part of that could be due to quality issues sourced to a contract manufacturer. Those errors took a toll on Q2 revenue and earnings. A bigger reason may be that investors don't fully understand or appreciate the source of Acacia's competitive advantage, and why it matters so much. Here's what you need to know.

Lighting up optical networks -- with silicon

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As a rule, optical networks push and pull data at the speed of light. To do that, you need fiber optic cabling and freaking laser beams, and then you need networking equipment such as routers and switches that can capture data as it comes in and transmit digitally at high speeds. You need optical interconnect cards to do this.

Think of them as bridges between systems. Infinera (NASDAQ: INFN) is a popular maker of these sorts of interconnects, and it's a stock many of us here at Fool.com and our premium services like. The problem with Infinera is that it's made a straight bet on optical interconnects -- lasers linking up with lasers. OK, it's a lot more complicated than that, but bear with me. The point is when you stick with straight optic-to-optic connections, you're sometimes asking the network operators and data-center operators that most need optical technology to substantially replace big chunks of equipment to get the upgrade. Customers aren't always willing to pay the freight, and in Q2, Infinera investors experienced this truth firsthand.

Acacia operates differently. Instead of selling some optical componentry and mixing in some silicon for good measure, the company is betting essentially everything on three types of silicon-based products: photonic integrated circuits (PICs) and digital signal processors (DSPs) for transmitting optical signals, and entire subsystems that feature both PICs and DSPs to unite network equipment inside a data center or across a telecom network. It's a bold all-in bet on siliconization that others have been unwilling to make.

Why it matters

The important point here is that Acacia simplifies high-speed networks by using silicon to replace the traditionally difficult and multi-step process of connecting optical networking gear. Just as the CPU consolidated once-distinct processing functions of a computer, Acacia is consolidating the components for connecting optical equipment with silicon, making data centers and telecom networks faster and putting more of the world's laid fiber to use. And doing it at a lower cost with less power consumption, the company claims.

Is the company right? That's a question for customers. For now, all we can do is consult the financials, and there are definitive differences. Acacia outperforms every single peer in its core market in terms of gross margin, EBITDA margin, and net margin. And even with the quality problems, it's growing revenue faster than all but two of all of its 10 peers, as defined by S&P Global Market Intelligence. That includes Infinera.

So while the silicon photonics market is still in the early stages and Infinera is still an excellent business, there's ample evidence that Acacia Communications' all-silicon strategy is forming the basis of what could become a highly lucrative niche.

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Tim Beyers has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Infinera. The Motley Fool has a disclosure policy.