Shares of Applied Optoelectronics (NASDAQ:AAOI) started sinking after the company issued a preliminary third-quarter report on Oct. 12. Final results reported on Nov. 7 are sending the stock up today, giving the stock a roughly 80% gain year to date, but investors who bought over the summer months are feeling the pain as the stock has a ways to go to get back to levels from July and early August.

AAOI Chart

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What happened in Q3 2017

Third-quarter results were a big disappointment compared to original guidance. Revenue tallied up to $88.9 million, well short of original guidance of $107 million to $115 million. Management had set the stage for investors on Oct. 12, predicting quarterly revenue of $88 million to $89 million.

Non-GAAP earnings per share, which exclude stock-based compensation and other one-time items, were $1.08, compared with original guidance of $1.30 to $1.43 a share. On Oct. 12, management had forecast non-GAAP EPS of $1.04 to $1.09, so the company came in near the high end.

CEO Thompson Lin had this to say about the quarter:

While our third quarter results were negatively impacted by lower demand from a large customer, we continued to experience solid demand from our other large data center customers, especially for our 100G CWDM transceivers, and revenue for our CATV products reached a new record.

We remain confident in our leadership position in advanced optics. We are working diligently to diversify our customer base and are encouraged with the customer response so far, which led to nine design wins in the quarter, including three for our 100G products. We also continue to make progress on developing new innovative products and expanding our vertical integration to further extend the gap between AOI and the competition.

That big data center customer, likely Amazon (NASDAQ: AMZN) based on the company's 2016 annual report, has been largely responsible for AAOI's big run-up and is now the main reason for the big declines. In fact, three-fourths of its data center business came from just two customers in the previous quarter, adding some color to the current situation as management explains what went wrong. It's a tough gig relying on a small handful of customers for revenue, and AAOI's recent reversal is proof of such.

However, management said during the conference call with analysts that it continues to talk with its large customer and thinks related inventory issues will be back on track in the first half of the year.

An AOI fiber-optic transceiver, an essential part used in the construction of internet data centers.

An AOI fiber-optic transceiver used in the construction of data centers. Image source: Applied Optoelectronics.

A pipeline for future growth

All of the negativity aside, this company's growth is nonetheless impressive in the last year. The $88.9 million in revenue was up 27% from the year-ago quarter. Revenue through the first nine months of the year came in at $302 million, a 72% increase over the same period in 2016.

What tailwind is pushing sales higher? AOI makes laser chips and other equipment for high-speed fiber-optic networks. Primary end markets are the aforementioned data center business, broadband cable TV, fiber to the home, and telecom.

All of those industries are experiencing increased demand for bandwidth, especially the internet data center with cloud-based computing and video streaming on the rise. That increased consumer demand in turn is increasing the need for higher-speed server connections to data centers. That's where AOI comes in with its next-gen products that enable progressively faster speeds.

If a progressively more connected world continues to be the trend, that should provide plenty more growth for AOI in the future. The trend as of late has been a slowing of revenue, but the company could see a resurgence in sales as new clients are added in the years ahead.

Food for thought

The good news is that AOI's retreating stock price has made the company look like a bargain. The trailing-12-month price-to-earnings ratio is at 10.0, and the one-year forward ratio is only 9.1. Those numbers illustrate how sour the investor mood has gotten.

More interesting to me is the company's free cash flow situation, which measures money left over after basic operations are paid for. The company's operations are now solidly in the black, and price-to-free-cash-flow is also beginning to indicate the stock is approaching bargain territory.

AAOI Free Cash Flow (TTM) Chart

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Of course, any of the above numbers could change if AOI can't get sales growth reignited, and share prices could fall further if management disappoints again on guidance fourth quarter guidance of $81 to $90 million. If you think demand for high-speed fiber-optic based connections will continue to grow, though, it might be time to start paying attention to AOI shares.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Nicholas Rossolillo has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.