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LUNA Luna Innovations

Participants
Jane Bomba Investor Relations
Scott Graeff President and Chief Executive Officer
Dale Messick Chief Financial Officer
Brian Soller General Manager-Lightwave Division
Tim Savageaux Northland Capital Markets
Lenny Dunn Mutual Trust of America
Randy Knudson Private Investor
Call transcript
Operator

Good day ladies and gentlemen and welcome to the Second Quarter 2018 Luna Innovations Incorporated Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. I would now like to turn the conference over to the Luna team.

You may begin.

Jane Bomba

Thank you, Shelby. Good afternoon and thank you for joining us today. We issued two press releases earlier this morning.

Our Q2 earnings release as well as the release announcing the divestiture of our Optoelectronic Solutions business through a cash payout to a leader in this space, OSI Optoelectronics. We posted to the Investor Relations section of our website a presentation with supplemental information on the divestiture as well as information on our second quarter fiscal 2018 results.

If you do not have a copy of the releases or the supplemental materials, please check our website at lunainc.com.

We will post a replay of this call to our website.

Some of our comments and discussions today are based on non-GAAP measures specifically adjusted EBITDA.

Our non-GAAP or adjusted numbers exclude the effect of certain non-cash expenses and items. The non-GAAP result or supplement to the GAAP financial segment Luna believes this non-GAAP presentation and the exclusion of these items is useful in order to focus on what we deem to be a more reliable indicator of ongoing operating performance.

Before we proceed with our presentation today, let us remind you that statements made on this conference call as well as in our public filings, releases and websites, which are not historical facts may be forward-looking statements that involve risks and uncertainties, and are subject to changes at any time including but not limited to statements about our expectations regarding future operating results or the ongoing prospects of the company. We caution investors that any forward-looking statements made by us are management’s beliefs based on currently available information and should not be taken as a guarantee of future result or performance. Actual results may differ materially as a result of a variety of factors discussed in our latest forms filed with the Securities and Exchange Commission. We disclaim any obligation to update any such factors or to announce publicly the results of any revisions to any of these forward-looking statements to reflect future events or developments except as required by law. There is more complete information regarding forward-looking statements, risks and uncertainties in the company’s filings with the SEC available on the SEC website and our website. After our prepared remarks this morning, Scott Graeff, our CEO; Dale Messick, our Chief Financial Officer; and Brian Soller, General Manager of our Lightwave division will be available to take your questions. And at this time, I’d like to turn the call over to Scott Graeff, President and CEO of Luna Innovations.

Scott Graeff

Good morning, everyone. it’s great to be with all of you today and thanks for accommodating the change in our quarterly conference call to this early time slot. We felt that this timeframe better suited our ability to interact with customers, investors, employees and suppliers during the course of the day. I am excited to share with you our very strong results for both the second quarter and the first quarter of 2018, and also to discuss the particulars of the divestiture we announced this morning. Both of which are covered in more detail in the supplemental deck that we posted to our website.

As I review the specifics of both, you will see that we have accelerated the progress of executing our strategy to drive robust growth through a focus on our core fiber optic-based capabilities.

The second quarter of 2018 marks the fifth consecutive quarter of year-over-year top-line growth and positive earnings for Luna. In the quarter, we achieved growth of roughly 22% in revenue and close to 30% in gross profit versus the same quarter last year. I’m very proud of all the members of the Luna team, who have focused hard to deliver these results. And I’m excited about our progress as we see this performance as a validation of our strategy is working and that our target markets are rich with opportunity for continued growth. We’ve capitalized on the advancement of optical-based technologies and as I’ve mentioned before, we are squarely in the sweet spot of this growth. We feel we are well positioned to continue to benefit from trends such as demand for higher bandwidth in data communications and data centers, and the growing use of composites and other advanced materials. Dale and I will spend more time on earnings in a moment. But first, let me cover the divesture we announced today. Hopefully, you’ve had a chance to review the release.

As I’ve mentioned in the past, we will look for opportunities to focus on our core strengths, while being prudent about how we manage our cash position with a strong focus on long-term sustainable growth. We announced this morning that we’ve closed on the sale of our Optoelectronic Solutions business to OSI Optoelectronics, a subsidiary of OSI Systems with a cash sale price of up to $18.5 million. Of this, we received $17.5 million at closing and have the opportunity to earn an additional $1 million based upon an 18-month post-close revenue target. We feel that the revenue target subject to be earn-out are reasonable based on the current trajectory of the OPTO business.

You may remember that this business became part of the Luna through the merger with API in 2015 and had operations both in Camarillo, California and Montreal, Quebec. OPTO is a strong business with talented employees, but it is outside of our core business, which is what drove the decision to divest.

In addition, we believe that OSI is the optimal home for this asset and will provide business continuity to our customers and a great place to work for the OPTO employees. This divestiture is another important step towards the streamlining of our product portfolio and our businesses, and is highly consistent with the long-term strategic vision that we’ve shared previously.

We are focusing investment on our core strengths and competitive advantages in the fiber-optic test and measurement business. I believe that we have immense opportunity in the rapidly expanding markets we serve, and I also believe there is opportunity for us to drive growth both organically and through acquisition. We maintain a strong balance sheet with financial flexibility and the liquidity this divesture provides will be used to grow in scale Luna with a focus on our optical technology expertise.

We continue to focus on driving long-term sustainable growth through a combination of internal R&D investment necessary to advance our technology offerings and investing in sales and marketing resources as well as looking for external investments that have a strong, strategic and financial fit.

We’re beginning to see the payoff in some of the internal investments as evidenced by our strong top-line growth. And I’m pleased to say that the existing businesses continue to perform well, any additional investments in M&A would just accelerate our performance in our two important market verticals.

As we discussed last quarter, we would be very disciplined in the deployment of any capital and therefore, are taking a targeted and deliberate approach towards any potential strategic transaction. and certainly, our focus is on transactions that we expect to be accretive within a reasonable timeframe. To wrap up on the sale, we are extremely pleased with the progress in streamlining our company and creating additional liquidity to invest in our core business.

Okay, let’s switch gears now to the second quarter, which I’ll briefly review and then we’ll turn the call over to Dale who will review the financials.

As we discussed in Q1, we came into 2018 with momentum and a healthy backlog, which allowed us to overcome the obstacles that historically contributed to a slow start to the year. We drove revenue growth of 22% in the quarter and 21% in the first half of 2018 versus the comparable year-ago periods with gross profit margins growing from 39% to 41% in both the second quarter and the first half. Revenues from our products and licensing segment, which includes Lightwave and ODiSI grew 24%.

As a reminder, Lightwave includes our instruments for testing optical components and networks. These products target the growing demand for bandwidth fueling the development of silicon photonics in the building of more and more data centers.

Our ODiSI instruments measure structural health and integrity of components.

Before handing over to Dale, I’d like to highlight the progress and status of the various business divisions at Luna. Starting with our Lightwave segment. Total Lightwave products were up 12% over the same quarter last year; certainly, some of the strongest performance we saw was in our sensing equipment, which was up 146%. And from our ODiSI sensing product in particular, which delivered 123% year-over-year increase for the quarter. Sales of the newest version of our ODiSI product, which we launched in late 2017, continue to grow with a total of 14 systems shipped in Q2 versus eight in Q1.

As we’ve discussed, there are some very positive trends that are driving the strong performance in the sensing segment. Lightwave materials like composites in aerospace and automotive designs continue to be a main driver behind the growth in our sensing segment. Included in the new orders in Q2 for our ODiSI sensing system, we’re multiple units to major OEMs and research institutes in the automotive industry and an order from one of the largest military aerospace companies in the market. In the Communications Test segment, we had a significant win as we penetrated the verification test side of one of the largest computer chip manufacturers in the world. Previously, all of our sales have been in R&D. We’ve mentioned the silicon photonics space on many previous calls and this win is evidence of our continued progress in penetrating a rapidly growing space.

As a result of a strong Q2 2017 with several multiple unit orders along with certain orders in the Asia being delayed in 2018, revenues in our Communications Test segment were down 24% on a year-over-year basis.

We have a strong pipeline going into Q3 and Q4, and expect the performance in this segment will continue to grow.

Our Terahertz division is continuing the strong momentum built in Q1 and while a smaller part of our business, the division experienced a more than doubling of product revenue year-over-year.

We continued with our strategy of enhancing market presence and sales channel expansion with the increased visibility resulting in new opportunities and customers that are more educated.

We also are adding distributors and value-added resellers.

As an example, we are transitioning the aerospace market from direct sales to distribution in order to expand defense and commercial opportunities, which we expect to improve our reach into these larger customers. In the second quarter, we continued our targeted product development while maintaining operating efficiencies. We successfully developed a higher performing sensor that will enable new market opportunities in coated customer products, pipe coatings and plastics. I’m extremely proud of this high level of performance, which is a result of both efficiencies within the Terahertz team and strong collaboration within Luna.

Our technology development segment, which for the most part represents funded research under U.S. government contracts, grew 19% for the quarter on a year-over-year basis. Approaching contract research with a product mindset has been important in our ability to increase the program funding that we get on these research contracts.

As an example to some of the work we’re doing, Luna sent three different material samples to the International Space Station to test their durability in space. We’ve discussed previously that there are solid synergies from having this division and the demonstration of our ability to innovate quickly and efficiently and I’m pleased with the progress, and the breadth and depth of the IP portfolio that has developed in this area.

Going forward at Luna, I continue to be excited about the growth we’ve seen so far in 2018 and we remain focused on capturing the expanding opportunities that our products target in the test and measurement market.

We continue to believe that within our two market verticals, comp test and structural test for sensing, we still have some interesting outside opportunities, we could capture to improve and grow the profile of that business.

As I’ve stated before, we will be very disciplined in the deployment of any capital and therefore, we’re taking a very targeted and deliberate approach towards any potential strategic transaction as always we’ll keep everyone apprised of the progress we made.

Finally, but importantly, I would like to thank our employees for their hard work and achievements delivered this quarter. I know that they remain committed and focused on driving future results. And with that, I will turn the call over to Dale.

Dale Messick

Thank you, Scott.

Let me first cover the performance for the second quarter, and then I’ll talk about our results for the first half.

Our revenues for the quarter ended June 30, 2018 were $13.8 million, compared to revenues of $11.3 million for the same period of the prior year, representing a 22% year-over-year increase. The increase in revenues year-over-year was comprised of a 24% increase in our Product and Licensing segment along with a 19% increase in our Technology Development segment continuing the strong revenue growth performance from the first quarter.

As Scott mentioned, sales of our ODiSI and Lightwave products drove the Product and Licensing segment revenue improvement with year-over-year increases of 123% and 12% respectively.

Continued growth in government research targeted at advancing optical and biomedical technologies and our success in winning these research contracts, helped to drive the year-over-year increase in the Technology Development segment.

Our gross profit realized on those revenues increased to $5.7 million for the quarter, compared to $4.4 million for the same quarter last year representing a gross margin of 41% in Q2 of 2018, compared to 39% in Q2 of 2017. Operating expenses were $4.8 million or 34% of revenue for the three months ended June 30, 2018, compared to $4.2 million or 37% of revenue for the three months ended June 30, 2017. The increase in SG&A and in R&D expenses were due primarily to investing in additional sale professionals as well as engineers in our Lightwave division. These are some of the incremental investments we’ve discussed making in our business in order to capture some of the growing opportunities in our end markets.

As evidenced by the top-line growth this quarter, we’re seeing the positive impact these investments can make.

With the year-over-year increase in revenues and gross profit and close management of our operating expenses, we recognized income from continuing operations of over $1 million for the second quarter of 2018, compared to just over $77,000 for the second quarter of 2017. We did not recognize any income or loss related to discontinued operations in the second quarter of 2018 amount shown as discontinued operations for the second quarter of 2017 in our release today reflect the operations of the HSOR group that we sold in August of last year.

However, be aware that given the sale of OPTO on July 31, 2018, our September quarter will reflect one month of OPTO financial results and third quarter year-to-date results will reflect seven months of OPTO, both of which will be displayed on the discontinued operations slide.

Our net income attributable to common stockholders with approximately $1 million or $0.03 per diluted share for the three months ended June 30, 2018 and compared to a loss of $251,000 or $0.01 per diluted share for the free months ended June 30, 2017.

Our revenues for the first half of 2018 were $26 million compared to revenues of $21.4 million for the same period of the prior year representing a 21% year-over-year increase. We drove more of that revenue to gross profit delivering $10.7 million or 41% of revenues in the period. Further with continued focus on expenses, we improved operating income to $1 million in the first half of 2018 from a loss of $600,000 in the first half of last year, despite the increased, but very necessary investment in sales, marketing and engineering resources. And finally, we improved income per diluted share to $0.04 in the first half of 2018 from a loss of $0.06 per share in the first half of 2017. We ended the quarter with $33.3 million of cash essentially flat to where we finished Q1.

We have less than a year remaining term on our outstanding debt with the principal balance now down to $1.5 million.

Our working capital increased $1.6 million to $45.6 million at June 30, compared to $43.9 million at the end of Q1 and $44 million at the end of last year. One housekeeping item of which I’d like to make you aware although we’ve included pro forma figures in the supplemental deck on pages six and 16, we’ll be filing an 8-K with more pro formas in the next couple of days. In summary, I’m really pleased with the first half performance and we look forward to reporting to you on our continued progress. And with that, I’ll turn the call back over to Scott.

Scott Graeff

Thank you, Dale. At this time, I would like to open the call for questions. Brian Soller, our Vice President and General Manager of our Lightwave Division, which is the fiber optic test and measurement business is with Dale and me at this time and also available to address your questions. Shelby?

Operator

Thank you. [Operator Instructions]. And we do have a question from Tim Savageaux from Northland Capital Markets.

Your line is now open.

Tim Savageaux

Hi, good morning, and congratulations on both the strong results and the asset sale, and I guess that I want to focus there to start with obviously, you come out of this with a pretty strong balance sheet I guess cash getting up toward, your $50 million level, I wonder if you could update us on focus on potentials, M&A coming out of this transaction, you’ve kind of maintained a pretty deliberate approach to-date, as it’s fair to infer that post the OPTO sale, maybe you’ll be kind of increasing the focus on M&A heading forward and perhaps, talk about potential areas of focus there. Thanks.

Scott Graeff

Well, Tim, we have been, as we talked about, very focused in staying disciplined on what we believe that. We talk about the – our fiber optic-based test and measurement and we have our two verticals inside of that and related to the communications test, and the structural test and sensing. And I believe we are going to continue to stay focused on that, stay disciplined on that. Like I said before, we are looking at several things, but we wanted to fit really within those two market verticals. And looking at something that is really accretive out of the gate is our focus and we are spending a good amount of time on that as well as the organic side of investing and we feel that the investments that we’ve made in Q4 and Q1 are a direct resolved of some of the revenue increases that we’ve seen here in 2018.

Tim Savageaux

Okay.

Sorry about that. If I could follow-up, I mean, I’m just getting a chance to look at the pro forma financials here and obviously, there’s some profits associated with OptoSolutions. Coming out of the model, I wonder at this point, if you’d be able to estimate as you look at growth potential across both composite and communications, fiber optic tests, I guess, there’s a our timeframe over which you think you can recoup the profitability coming out of the model with OptoSolutions and you mentioned kind of heading forward to the potential for some increases or improvement in the second half on the communications test side. I wonder if you could talk with any more specifics about kind of dynamics there.

Scott Graeff

Yes. I mean I think when you look at that last quarter on a pro forma basis, I think somewhere around $10 million or so of top-line revenue with the existing – with the remaining businesses and right at break-even a little bit above that going forward.

We continue to invest organically in Lightwave and believe that like we’ve talked about before some of the growth percentages that we expect to see on the – in the Lightwave segment in a kind of mid teens is what we believe you’ll continue to see going forward.

So that that’s kind of how we look at it going forward we are continuing to invest organically.

As far as inorganic timing, I don’t have a good feel for that. I can only say that we are working on things and as we progress and close on something, we’ll obviously, let you guys know. but I don’t want – we’re being very specific as to what fits and will help grow this business, because we know that there are strong opportunities within those two market verticals that we know investing organically, will accelerate that that growth.

So anything that we add we want to make sure it is in line with that growth.

Tim Savageaux

Okay. Thanks very much.

Scott Graeff

Thanks, Tim.

Operator

Thank you. And our next question comes from Lenny Dunn from Mutual Trust of America.

Your line is now open.

Lenny Dunn

Good morning and very pleased with the results in the trade that you did. Are there any other parts of the company that you’re considering divesting or do you think that this is you pretty much to have it the way you want and will probably just be bolting on things.

Scott Graeff

Yes.

I think when you look at what we have now and again, looking at that that umbrella that we cast with the fiber optic-based test and measurement in the two verticals.

I think the remaining businesses fit within that of course, we have our contract research, our technology development division that continues to be what we’d like to refer to internally as our kind of engine to innovation with the focus that they have on delivering products, and a very targeted approach to the contract research, we think that is very complimentary to what we do.

So, I would say that we feel very good about the focus that we have at Luna right now and continuing to grow on that, is probably a fair statement.

Lenny Dunn

Okay, good.

So, it’s just easier to look at things going forward, if this is the last large investors.

So, I appreciate that fact and don’t want to see too much horse trading…

Scott Graeff

Yes.

For sure.

Lenny Dunn

And I assume that you’re continually reviewing potential acquisitions, but everything has to be at the right price and additive to earnings.

So I am no – it does not really preface on my part, right.

Scott Graeff

No, I think – I think you’re dead on. I mean we are looking at things that are additive, they’re complimentary and certainly accretive. And I can tell you that things are varying in size from the size of revenue of the targets that we’re looking at.

Lenny Dunn

Okay. And last, but not least, I think it’s probably time a little of what you’re doing to Wall Street, because I think the story is pretty compelling going forward.

Scott Graeff

Yes.

Now we agree, and I’m spending, Dale and I are spending more time in front of investors in – at some different events to try to get that across that is certainly a focus within Luna to improve our communications and our investor relations strategy.

Lenny Dunn

Okay. Well, that’s all my questions and thank you. Good quarter and I think a pretty good price for the divestiture too.

Scott Graeff

Yes.

Now, I believe so too. Thanks, Lenny.

Operator

Thank you. [Operator Instructions]. And our next question comes from Randy Knudson, a Private Investor.

Your line is now open.

Randy Knudson

Good morning. Wow, a great job in selling the OptoSolutions here in Camarillo, I think that’s just tremendous.

Scott Graeff

Thank you.

Randy Knudson

And I’ve applied you on that. Can you add any more color to the synergies you see between the Lightwave division and the Terahertz division?

Scott Graeff

Yes. I mean, Brian is here and he can talk a little bit about that and as you know, Randy, we added some key folks to the team out in Ann Arbor, Margaret Murdock has been outstanding in the leadership, she has provided out there. And when you look at the synergies that we have and certainly, the type of sensing that Terahertz is doing, is very complimentary to the other sensing that we do from a customer perspective. In interesting, we just last week, spent the day in Dallas, with a large defense contractor and inside of there, they took us around and we saw the OBR in deployment on the line that is under Lightwave, we saw the ODiSI, they then took us back into the final test in pain area, and showed us the Terahertz system being used.

So, while they’re spending a day inside of a very large defense contractor, we saw across all of – all of our divisions, different products that were inside there.

So, we look at working even closer to really hone the story and leverage off of the synergies that we have internally.

Randy Knudson

Well, great. It’s really exciting what you’re doing there. And once again, I think the sale in Camarillo and I guess in Canada, API Canada that’s just tremendous, and thank you.

Scott Graeff

Thanks, Randy.

Operator

Thank you. [Operator Instructions]. And I’m showing no further questions. I would like to turn the call back over to Randy [ph] for any further remarks.

Scott Graeff

Yes. Thanks everyone for joining us today.

As you’ve heard in the call, we feel very good about the strong first half results that our employees delivered, and believe we will carry that momentum for growth throughout 2018. This completes today’s call. Please feel free to reach out us with any questions that you have relating to the financial results or the divestiture that we just did.

Operator

Ladies and gentlemen, thank you for your participating in today’s conference. This concludes today’s program.

You may all disconnect. Everyone, have a great day.