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LUNA Luna Innovations

Participants
Allison Woody Director-Administration
Scott Graeff President and Chief Executive Officer
Dale Messick Chief Financial Officer
Brian Soller Senior Vice President and General Manager-Lightwave Division
Jim Marrone Singular Research
Dave Kang B. Riley FBR
Call transcript
Operator

Good day, ladies and gentlemen, and welcome to the First Quarter 2019 Luna Innovations Earnings Conference 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] As a reminder, this call will be recorded. I would now like to introduce your host for today’s conference, Ms. Allison Woody, Director of Administration at Luna.

You may begin.

Allison Woody

Thank you. Good morning and thank you for joining us today. This afternoon we issued our first quarter fiscal 2019 earnings press release.

In addition, we posted to the Investor Relations section of our website a presentation with supplemental information for the quarter.

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

We will also 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. These adjusted numbers exclude the effect of certain non-cash expenses and other items. The adjusted results are a supplement to the GAAP financial statements. Luna believes the presentation and 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, maybe 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. Actual results may differ materially as a result of a variety of factors. More complete information regarding forward-looking statements, risks and uncertainties is available in the company’s SEC filings, which can be found on the SEC website and our website. We disclaim any obligation to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments except as required by law. After our prepared remarks, Scott Graeff, our President and Chief Executive Officer; Dale Messick, our Chief Financial Officer; and Brian Soller, Senior Vice President and 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.

Scott Graeff

Good afternoon, everyone, and thanks for joining our call.

As Alison mentioned, we issued our first quarter fiscal 2019 press release at market close. Since it is our first quarter and a relatively straight forward one, we will keep our prepared remarks brief before we move into Q&A.

Although we were together on our last conference call only two short months ago, we have made some great progress and continued to build on the momentum we created in 2018.

As always, I must start by thanking the Luna team who stayed laser-focused on delivering our goals and who continue to serve our customers with excellence. I am very proud of our work this quarter and I’m encouraged by the strength of our deep management bench.

Even as we juggle the due diligence process for General Photonics, one of the largest acquisitions we’ve ever done, we asked our leaders to continue to sell, build and deliver product to customers and they really rose to the occasion and delivering an exceptionally strong first quarter performance.

In addition to the strong performance, Luna just received the 2019 Innovator of the Year award by the Roanoke-Blacksburg Technology Council. This award is given to “a company that sets the standards for thought leadership and innovation in their respective field. They are doing something new or different and they’re doing it well. And their innovation represents a significant technological breakthrough or addresses a great market opportunity.” The whole Luna team was very honored by this recognition of the work we are doing.

Let me now start with an overview of the quarter and then I’ll cover some of the detail of our operations and progress on acquisition integration.

The first quarter of 2019 marks the sixth consecutive quarter of double-digit year-over-year growth in our revenues from continuing operations. Digging into more details on the financial performance, we grew revenue 69% in the quarter versus a comparable year-ago period, and gross profit margins grew from 44% to 46%. Revenues from our Products and Licensing segment grew at a robust 98%, while revenue from our Technology Development segment grew a very strong 43%.

Before I move on to discuss some of the progress we’ve made in our various business divisions, I want to cover one last financial metric, adjusted EBITDA. We improved from slightly negative adjusted EBITDA in the first quarter of 2018 to $1 million of positive in the first quarter of 2019. This is an important metric because it shows two things; first, the robust growth of our existing businesses; and second, the accretion from both the Micron Optics acquisition in October of 2018 and the General Photonics acquisition in March. Recall that when I announced those acquisitions, I committed to both being accretive immediately.

Now moving onto our Lightwave business. We made significant progress within our Sensing segment, growing sales of our ODiSI product, a robust 91% over the same quarter last year.

While the main drivers behind the adoption of ODiSI technology continued to be the use of new lighter weight materials in industries such as automotive and aerospace, sales in Q1 were to a well diversified customer group. This includes our first sale to a major air frame manufacturer in the U.S. as well as sales related to industrial process monitoring and large civil structure monitoring. The adoption of ODiSI across multiple industries and applications is a positive indicator of the continued growth we expect in the future. Last week we announced a significant order for the Phoenix 1000 Tunable Laser. The order from an industry leading robotics company was valued at more than $6 million and will be delivered over four years.

We expect to begin deliveries this summer.

While robotics are an excellent example of the capability we can deliver to precise applications, laser-based fiber optic sensing systems are now widely deployed across many industries. This ability is due to the benefits of optical fiber over traditional techniques in terms of precision and scalability. Luna’s collaboration with an industry leading robotics company demonstrates how far our optical sensing technology has advanced. From a commercialization standpoint, an order of this magnitude allows us to achieve greater economies of scale on existing and future products. In our Communications Test segment, the integration of General Photonics has progressed well, with sales and operations teams already working together to identify and execute on efficiencies and cross-selling opportunities. Also in comms testing, we introduced our newest product, the 6415. The Luna 6415 Lightwave Analyzer supports measurements for deployment and manufacturing of high – of modern high speed optical components and networks.

So what does that all mean? It means we have a critical product that enables the next generation high speed networks from data centers to the cloud to 5G mobile, all of which require an ultra fast economical optical network.

Our Terahertz business is focused on process control applications, where there is growing demand for thinner buried lay layer measurements. The control and testing requirements are increasing at a continuous rate, driving demand for accurate process control with high repeatability and the ability to reproduce easily. The main drivers for Terahertz adoption continue to be effective thickness control, lower manufacturing costs, minimalization of waste and the optimization of product quality.

As an example, our Terahertz division is currently capitalizing on our unique ability to measure thin buried layers in plastic for food packaging such as a yogurt cup.

While the end user is deploying our technology for examining the final package, they are also requiring their suppliers to incorporate Terahertz into the production of the package. In our Technology Development business, we delivered a strong quarter of double-digit top line growth. Growth is being driven by our continued quality performance in Phase 1 and Phase 2 contract wins as well as success in winning contracts that fund later-stage product development and demonstration projects. I want to provide a few product examples to give you a sense for the work we’re doing in this segment.

First, we’re working on an air force qualification project to transition one of our codings for flight testing. In Q1 we coded full scale prototype F16 canopies for validation testing. Also, we began a navy project to qualify our corrosion sensors to meet the requirements for the navy’s new heavy lift helicopter from Sikorsky.

Importantly, both of these efforts are fully externally funded. This allows us to build expertise and intellectual property to strengthen and diversify Luna’s technology portfolio and set us up for future growth. Overall, I am very pleased with a strong performance from our Technology Development team this quarter.

Now I’d like to provide an update on the integration progress for our two recent acquisitions, both of which are being combined into our Lightwave Division.

First, I want to provide an overview, as we anticipated, integration has progressed very rapidly and in many cases we’re no longer distinguishing between legacy Luna and the two new companies.

We have moved quickly to merge complimentary products into integrated customer solutions and migrate sales teams to common compensation systems. And in many other ways, we are working as a single integrated company.

As a reminder, these two companies fits squarely into our vision for long-term growth. Lightwave is home to our fiber optic-based test and measurement products. Historically, we’ve described our two main target verticals for Lightwave products, as being either sensing, structural test or in the communications test. The Sensing segment focuses on the integration of optical fiber sensors in and on advanced materials and structures for the measurement of physical quantities such as train, temperature and acceleration.

Our optical fiber sensors are combined with our instruments and used in the lab to assess the integrity, quality and reliability of new materials.

As an example, I’m talking about materials used in modern aerospace design, our products can also be used in field applications for long-term health monitoring of civil structures, such as bridges and dams or to enhance the security of a perimeter. This quote, sensing vertical includes our primary products of Odyssey, Hyperion and associated sensors. Target markets include aerospace, automotive, security and energy, all with strong macro drivers for our fiber optic-based sensing technology and products. Because the products of Micron Optics were so complimentary, we are experiencing a smooth integration with our existing product lines. And we now have the ability to provide our customers with a broader range of capabilities, including higher speeds and sensing over longer ranges.

Moving to our communications test vertical, remember that this is the business focused on the ever growing need for more bandwidth in communications networks. Optical fiber is a key enabler to high speed communications, this ability runs the gamut from core telecommunications networks to data centric networks found in data centers to enabling cloud computing and mobile networking.

Our products feed the need for speed and include the OVA, the Optical Vector Analyzer and the OBR, the Optical Backscatter Reflectometer. OVA and OBR measure the performance of optical components in short-haul networks to ensure top speed and provide pinpoint diagnostics when networks aren’t performing as they should. The acquisition of general photonics brings strong opportunities for deeper penetration into our existing customer base with complimentary capabilities at differing price points. The combination also allows Luna to continue to bring more value to customers in critical applications, such as precise measurement in high speed communications networks and data centers. It also adds to our capability to deliver products that precisely control light in photonic applications.

For example, these products drive faster networks and higher performance devices at a lower cost. Precision assemblies using guided weapons deployed in our country’s security systems and precise measurements used to make better LiDAR systems, which are key to autonomous vehicles. With both acquisitions, the teams are working very well together to combine sales efforts, integrate product offerings and messaging and find operational efficiencies across our engineering and manufacturing organizations. Significant progress has been made in branding, messaging and marketing, as well as in sales. And the integration of many of our back office functions are proceeding right on target. Both Micron and General Photonics have proven to be a strong cultural fit with Luna. Collaboration across our team has been terrific and managers are really stepping up their leadership. We’ve acquired excellent talent through these two transactions.

Before I turn things over to Dale, I’d like to remind you of the outlook we provided on our last call. Full year revenues to be in the range of $60 million to $65 million, with full year 2019 adjusted EBITDA to be in the range of $6 million to $6.5 million. And we are still very comfortable with that range. Overall, this is a great start to the fiscal year and I’m proud and pleased that our team continues to deliver our momentum that we gained in fiscal 2018. The integration of the two recent acquisitions is progressing rapidly. And the teams are executing at a pace that is delivering well against our initial expectations.

We continue to focus on delivering high quality products with a commitment to customer excellence and some of our recent orders underscore our progress in that area. With that, I’ll turn the call over to Dale to review our first quarter results in more detail. Dale?

Dale Messick

Thank you, Scott. I’d like to start by covering four components of this quarter results.

First, as a reminder with the sale of our optoelectronic components business in July of 2018, the operating results of that business for the first quarter of 2018 have been reclassified the discontinued operations in our income statement.

Second, the income statement for the first quarter of 2019 includes a full quarter of Micron Optics, but only one month of General Photonics.

Third, this quarter includes a few non-recurring items, the largest of which are a one-time tax benefit of $1.9 million, which I’ll discuss in more detail in a moment and $0.9 million of transaction costs which are associated with the General Photonics acquisition and which show up in our SG&A line.

Finally, also on SG&A, there’s about a $0.5 million in recurring non-cash expenses, which are also associated with two acquisitions, it include the amortization of the new intangible assets and an increase in share-based compensation.

So remember that this quarter only includes one month of these costs for General Photonics.

Our revenues for the quarter ended March 31st, 2019 were $14. 8 million, compared to revenues of $8.8 million for the same period of the prior year, representing a 69% year-over-year increase. The increase in revenues year-over-year was comprised of a 98% increase in our Product and Licensing segment, along with a 43% increase in our Technology Development segment, continuing the strong revenue growth performance delivered as we exited 2018.

Within the Product and Licensing segment, the year-over-year growth was driven by a growth in Odyssey sales, in addition to the revenues associated with our recent acquisitions.

Our gross profit increased to $6.8 million for the quarter, compared to $3.8 million for the same quarter of last year, representing a gross margin of 46% in Q1 of 2019, compared to 44% in Q1 of 2018. The gross margin improvement reflects the changing mix of our revenues with 55% of revenues coming from the Product and Licensing segment in the first quarter of this year, compared to 47% in the first quarter of last year. Operating expenses were $7.7 million or 52% of revenue for the three months ended March 31st, 2019, compared to $4.2 million or 48% of revenue for the three months ended March 31st, 2018. The increase in SG&A expenses was due in part to the approximately $900,000 of transaction related costs, associated with the acquisition of General Photonics that I mentioned earlier. Naturally, we also incurred ongoing incremental operating expenses associated with the additional revenues generated by the operations of both Micron Optics and General Photonics following those acquisitions.

Moving into income taxes, you’ll note that we had a one-time non-cash income tax benefit from the release of valuation allowance of $1.9 million, this benefit is a non-recurring items. After recognizing the deferred tax attributes associated with the General Photonics acquisition, we needed to reduce the valuation allowance that we had previously maintained for our historical deferred tax asset. That reduction in the valuation allowance represents the current period tax benefit.

In terms of income related to discontinued operations, as I mentioned the amount shown is discontinued operations for the first quarter of 2018, reflects the operations of the divested optoelectronic business during that period.

Our net income attributable to common stockholders for the three months ended March 31st, 2019 was $1 million, compared to breakeven for the three months ended March 31st, 2018.

As a reminder, all the one-time and recurring items that I’ve already discussed, impacted the net income line. We ended the quarter with $24.6 million of cash down from $42.5 million at the end of 2018, that decline was due to the acquisition of General Photonics.

Our principal debt outstanding on the balance sheet was $0.3 million, which is scheduled to be paid off this week, leaving us debt free.

Our working capital decreased to $38 million at March 31st, down from $56 million at the end of last year. The decline again was due to the acquisition of General Photonics in the first quarter of this year for which we paid cash. One additional note for the balance sheet, effective January 1st we did adopt the new accounting standard related to leases which resulted in us adding right-of-use assets and liabilities of approximately $3 million to our balance sheet principally related to the operating leases of our facilities. The adoption of the new standard did not have any significant impact to our income statement. I want to conclude by saying I’m very pleased with the performance our teams delivered to start this fiscal year.

We continue to take a strategic and deliberate approach to investment, managing expenses prudently and ensuring that we maintain good financial flexibility.

As for last quarter, I want to add to Scott’s discussion of our outlook by reminding you about Luna’s typical seasonality.

As you consider our annual guidance and update your models, remember that Q4 is typically our strongest quarter and Q1 is usually our slowest. That said, we have entered 2019 with good momentum and we feel comfortable with our fiscal 2019 outlook. 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 Senior Vice President and General Manager of Lightwave is with Dale and me at this time and he is also available to address any of your questions.

Operator

Thank you. [Operator Instructions] And our first question comes from Jim Marrone with Singular Research.

Your line is open.

Jim Marrone

Yes. Good afternoon. A nice to the year, John Tuman.

Scott Graeff

Thank you.

Jim Marrone

Yes, my question is just in regards to the guidance.

So just based on first corridor teams like it’s going to fall a little bit short on – if it continues on the same trajectory. And just one clarification, is it because it doesn’t include the full quarter of Micron and General Photonics. And maybe if you can just provide some color on that. And also in regards to the first quarter in relationship to the next three quarters, were this business experience any seasonality with the first quarter compared to the other quarters?

Scott Graeff

Yes. Jim, I think that you’ve touched on part of it, we did only have one month of General Photonics in the first quarter. But even notwithstanding that, our business typically does grow throughout the year, as I’ve mentioned in my remarks, the first quarter of the year is typically our lowest quarter, and then it does improve each quarter throughout the year.

So we would expect to still be within that guidance range on the adjusted EBITDA.

Dale Messick

Yes, I think we would come out and not support the guidance we gave Jim, if we thought so. But four is typically better than three, better than two, better than one, certainly.

Jim Marrone

Okay, great. That provides a little bit of color, thank you. And maybe just as a follow-up in terms of what you see going forward and particularly in the aerospace, do you see any headwinds in that industry, just given the recent troubles of Boeing and the cutback in production on their end?

Brian Soller

Yes. Hey there, this is Brian Soller, so we’re tied into a pretty long-term development cycle with our honesty product and now with our Hyperion product out of Atlanta, with our acquisition of micro and optics.

So we’re looking at kind of next generation composite designed aircraft and – so we’re not tied to the current issues that for instance Boeing is having in terms of their planting grounded.

So it’s something we’re certainly keeping a very close eye on, but that issue doesn’t create any specific headwinds for us. And in general, when we look at that space, aerospace is continuing to move pretty aggressively towards composite materials and their new designs.

So our outlook there is positive.

Jim Marrone

Okay. Great. Thank you, gentlemen.

Scott Graeff

Thank you, Jim.

Dale Messick

Thank you.

Brian Soller

Thanks.

Operator

Thank you. And our next question comes from Dave Kang with B. Riley FBR.

Your line is open.

Dave Kang

Thank you, good afternoon. On General Photonics, can you disclose how much they contributed in one month or you’re not going to break it out?

Scott Graeff

Yes, we really didn’t break it out, like I talked about Dave this because of the – we integrated so quickly, these products have really rolled into Lightwave and we’re kind of managing it as the Lightwave division, we are not really kind of breaking it out because of how it rolls into an existing division.

Dave Kang

Fair enough. And then on the optical calm or contest, can you just talk about the demand picture from some of the datacom or data center customers because there seems to be some headwind, especially at 100 gig. But then you talked about 6415, four high-speed I assuming that’s for like 400 gig and above.

Brian Soller

Yes. Hey, Dave, this is Brian.

Dave Kang

Hi Brian.

Brian Soller

Yes, so it’s definitely driven by the 400 g side of the equation, when you look at in particular data, that’s the half of it. And the other half, I think as we’ve discussed before is the – we’re seeing the impending kind of switch to 5G or the new 5G kind of hitting the market maybe later this year. And that’s causing lot of them, the major component and system players to be upgrading their core networks in terms of component capability. And with our new product, the 6415 that we mentioned – that Scott mentioned is aimed right at that space, it’s more of a high speed measurement system for development and manufacturing of the high speed components that go into both of those macro drivers, 400 g, which has a better outlook this year than it did last year. And core systems, which also are looking better this year than they did last year based on some of the 5G activities.

So what we’ve seen from our customers in particular has been, it’s early in the year, but I will say it’s been positive. And in general, I think 2019 is supposed to be better than 2018 in that market.

Dave Kang

Got it. And then, can you just provide more color on this $6 million order for – from a robotics customer? Is this sort of a one-time deal or can this become something more meaningful? And can you just talk about shipment linearity, whether it’s going to be like $6 million divided by 4 in terms of shipments.

Brian Soller

Yes, it’s fairly linear. It’s loaded more towards the backend than the front end.

So it’s definitely going to have impact more in years, two, three and four than year one. And this is kind of an OEM sale of our Tunable Laser, the Phoenix Tunable Laser that we manufacture, Luna manufacturers this laser through a partnership with a contract manufacturer. And we use it in our products, it’s kind of the heart for the key to the – several of our products, both in the sensing and comms test side, it’s the source, it’s the laser source for us and, but it does have applications as a standalone. It tends to be, in markets outside of the ones that we’re focusing on, but from time to time we do have these OEM type arrangements and we do have sales of the product as a standalone and as you can see from this particular OEM deal, it’s fairly sizable.

So this is a nice order for us. It will help smooth out and linearize our production. It helps drive the cost side of the equation. And it certainly is possible that there are other deals maybe not of that magnitude in the near future, but for that product as a standalone, but it’s not something that we put a lot of effort into marketing.

Scott Graeff

Yes. We’ve been collaborative with this company for a while and knew that this order was coming.

So it was something that we feel good about; delivering this order as a sole source to these folks, and getting our costs down for existing products that we have.

Dave Kang

Got it. And then, Dale, just a couple of financial questions.

First of all, I think you’ve talked about regarding OpEx, you talked about it like $0.5 million and then like $0.9 million non-recurring or some kind of like an acquisition-related charges.

Just can you run it by one more time?

Dale Messick

Yes.

So there was the $0.5 million was going to be a recurring non-cash expense for the amortization of intangible assets. And the increased share-based compensation we have after those acquisitions, it will increase slightly in the next couple of quarters as the part that relates to the General Photonics acquisition. We only had one month of it in this quarter, so we’ll have three full months of it in the following quarters. We had $900,000 of transaction cost related to doing the acquisition itself. And then most, but not all of the remaining growth in the OpEx came from really just having the incremental R&D and selling expenses of those facilities and operations that we added in Atlanta and California.

Dave Kang

Got it. My last question is on the tax rate.

You had some tax benefits in the first quarter. How should we think about the tax rate going forward?

Dale Messick

Yes, I think that that’ll certainly normalize out. We do still have a little bit of NOL carryforward that we’ll utilize, but we’ll start to see more of a normal mid-20%s kind of tax rate as we go later into the year.

Dave Kang

20%. Got it. Thank you.

Dale Messick

Thanks Dave.

Scott Graeff

I appreciate it.

Operator

Thank you. [Operator Instructions] And we have a question from [indiscernible].

Your line is open.

Unidentified Analyst

Good afternoon.

First, I want to make sure you’re not planning on retiring anytime soon.

Scott Graeff

Nope.

Unidentified Analyst

Okay. And where did this spacecraft coding come from? What – how did you all come up with that? And is it on the outside of the spacecraft or is it on the inside just protecting instruments inside? Or am I completely out to lunch on this?

Scott Graeff

Yes, it was the outside coating, the canopy. Yes.

Unidentified Analyst

And how did you all come up with this? That’s amazing.

Scott Graeff

Yes. Working with the air force and they made some introductions to us.

We’re constantly out talking to a lot of these folks and I wish you had a chance to see it because it is pretty amazing stuff.

Unidentified Analyst

Yes. And can you say anything about it? I mean, it’s like, I guess not.

Okay.

Scott Graeff

Yes, a lot of it is pretty confidential and we’re pretty locked down and don’t want to get out ahead of ourselves with the government on that kind of stuff. But again, if we have the opportunity to get together to some things that we can show that that I think you’d be very impressed with that.

Unidentified Analyst

Do you have enough leftover that I can cover my assessment 152?

Scott Graeff

We can always make more.

Dale Messick

Certainly

Unidentified Analyst

Keep up the great work. Talk to you next time. Bye.

Scott Graeff

Yes, thanks, Charles.

Operator

[Operator Instructions] I’m showing no further questions at this time. I’d like to turn the call back to Scott Graeff for any closing remarks.

Scott Graeff

Well, thank you everyone for joining us today.

As I hope, you will take away from our call. I am incredibly proud of the strong starts of fiscal 2019 and the performance delivered by our employees and I continue to feel comfortable with our fiscal 2019. One thing I learned in Q1 was the deep bench strength that we had across the organization. There was a lot of leadership in delivering sales and filling funnel, while doing the due diligence that we did on acquiring General Photonics. I want to remind everyone that we will be holding our annual stockholders meeting in Roanoke next Tuesday, May 14 at the Hotel Roanoke with breakfast starting at 8:00 AM and the meeting kicking off at 9:00 AM Eastern. I invite you to join me along with the Luna executive team and our Board of Directors. This completes today’s call.

Operator

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

You may all disconnect. Everyone have a great day.