My E. Chung - President and CEO Dale E. Messick - CFO Cameron Donahue - Hayden IR.

Gregory Greenberg - Wells Fargo Advisors.

Good day, ladies and gentlemen, and welcome to the Third Quarter 2014 Luna Innovations Incorporated Earnings Conference Call. My name is Sarah, and I'll be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions).

As a reminder, this conference is being recorded for replay. I would now like to turn the conference over to your host for today, Mr. Cameron Donahue of Hayden IR. Please proceed, sir..

Thank you. Welcome to Luna Innovations Incorporated 2014 third quarter financial results conference call. The call today will be hosted by My Chung, President and Chief Executive Officer; and Dale Messick, Chief Financial Officer. Following this discussion, there will be a formal Q&A session opened to participants on the call.

We appreciate to have an opportunity to review the 2014 third quarter and year-to-date financial results.

Before we proceed with the presentation today, let me remind each of you that statements made in this conference call as well as the company’s public filings, releases and Web sites, 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 future financial and operating performance.

We caution investors that any forward-looking statements made by the company are management's beliefs based on the currently available information and should not be taken as a guarantee of future results or performance.

Actual results may differ materially as a result of a variety of factors discussed in our earnings release and our latest Forms 10-K and 10-Q filed with the Securities and Exchange Commission.

The company disclaims 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 development.

There is more complete information regarding forward-looking statements, risks and uncertainties in the company's filings with the SEC available on the company’s Web site. With that out of the way, I'd like to turn it over to My Chung, President and CEO of Luna Innovations..

Thank you, Cameron. I am pleased to share with you all the continued improvements we have made in our operations and performance against our strategic growth initiative of being a leader in the distributed strain and temperature of data acquisition market.

As noted on our previous calls, we have successfully restructured Luna with a strong balance sheet and competitively positioned ourselves towards and exciting growth opportunity. Following my remarks, Dale will go through the financial results for the third quarter and then we’ll be happy to take any questions you might have.

For those joining us today for the first time, I’d like to briefly recap the value proposition offered by ODiSI sensing platform. As the aerospace and automotive manufacturers strive for lower weight and better fuel economy, there are increasingly transitioning from aluminum and steel to carbon fiber composite materials.

This transition has opened up a need for a better, more thorough and more cost-effective testing solution than the traditional strain gage and thermocouples being used today.

Luna is uniquely positioned to take advantage of this trend, as our ODiSI data acquisition system with the single fiber optic cable is the equivalent of 100s to 1,000s sensing points with better resolution than the incumbent electrical strain gage point solutions.

The primary driver for this need is the fact that carbon fiber composites are non-uniform in a structure, requiring test engineers to try to cover as much of the surface area as possible, thus significantly increasing the requirement on the number of testing points on strain gages and data acquisition channels than previously required.

Our patent portfolio surrounding our optical technology provides us with a strong competitive advantage and we believe a barrier to entry from existing legacy competitors. Throughout 2014, we have achieved year-over-year top line growth. In the most recent quarter, our product revenues increased 47% over the same period last year.

The uplift we did to our sales force have resulted in a record number of Odyssey systems booked, providing us confidence in our strategic goal. We are working closely with a number of aerospace and automotive companies and validating that the measurements we made correlate well with their traditional methods.

As our Odyssey system provides a significant number of data points, it’s been sometimes overwhelming for customers to grasp.

To help address this, the latest firmware upgrade released by our focused engineering team includes the ability to display this wealth of data, color coated directly onto a 2-dimensional drawing of the customers’ test article so that they can now immediately identify problem areas.

Also, within our products and licensing business, we continue to realize growth in our telecom test and measurement products with sales of our OVA and OBR instruments increasing as well year-over-year. In the technology development side of the business, we had a very good quarter in terms of new government research program awards.

As a result, our backlog for work to be performed in future periods increased to $15.6 million at the end of the quarter compared to $9.3 million at September 30 of last year, and up $3.5 million sequentially from $12.1 million in the second quarter leaving us well funded for development activities into next year.

Across our entire organization, we have instituted well-defined operational targets and provide specific action items to accomplish this goal, which has been champion by our entire team from the bottoms up.

While we understand we are at the forefront of our transition to a high growth, profitable company and still have significant work in front of us, we are excited by the results and execution our team has achieved to-date. With that, I’ll turn the call over to Dale..

Thanks, My.

Before I begin, let me remind you that our results for the third quarter and first nine months of 2013 have been restated to now reflect the revenues and expenses associated with our prior medical shape sensing operations within discontinued operations rather than operating revenue and costs as they were when we reported our results last year.

With that reclassification, our 2014 revenues and costs are comparative to the 2013 results as shown. For the third quarter of 2014, our overall revenues were $5.4 million representing a 14% increase over the third quarter of 2013 and a 3% increase over the second quarter of this year.

The growth in revenue for the quarter was driven by our product and licensing segment, which increased 47% to $2.3 million in the third quarter of 2014 compared to $1.6 million in the third quarter of last year.

While we continued to see strong performance in the sales of our OVA and OBR products, a high percentage of the growth we saw in the product side of the business came from the increase in sales of our ODiSI products going into the third quarter.

Revenues from our technology development segment were essentially flat at $3.1 million for the third quarter both 2014 and 2013.

As My mentioned a moment ago, we had a very good quarter for acceptances of new research proposals, and as a result ended the quarter with a contract research backlog of $15.6 million compared to $9.3 million a year ago and $12.1 million at the end of Q2 of this year.

With our revenue growth, our gross profit improved to $2.1 million for the third quarter of 2014 compared to $1.7 million for the comparable period last year.

With more of our revenues coming from the product segment of the business, our overall gross margin for the quarter improved to 39% compared to a 36% gross margin in the third quarter last year.

As a result of the cost reductions we took following the sale of the medical shape sensing business earlier in the year, we continued to see lower operating expenses. Operating expenses were $2.8 million in the most recent quarter compared to $3 million in the third quarter of last year, an improvement of 6%.

As a result of these lower costs along with our revenue growth, our pre-tax loss from continuing operations of $720,000 is an improvement of $582,000 compared to the third quarter of last year.

After considering the impact of income taxes and discontinued operations, which for the third quarter of last year included approximately income of $650,000 from our shape sensing development activities, we reported a net loss to common shareholders for the third quarter of this year of $771,000 compared to a net loss of $640,000 for the third quarter of last year.

Year-to-date, we’ve realized revenues of $15.1 million reflecting 11% growth over the first nine months of last year. This improvement has been driven by our products and licensing segment, which has grown 20% compared to the first nine months of last year.

Revenues from our technology development segment have increased 5% compared to the first nine months of last year as well. With the higher percentage of products and licensing in our overall revenue mix, gross margins improved to 37% of revenue for the first three quarters of 2014 compared to 34% in the first nine months of last year.

With the growth in revenues, our gross profit increased by $1 million to $5.6 million for the first nine months of this year compared to $4.6 million for the first three quarters of 2013.

Operating expenses decreased to $9.3 million for the nine months of 2014 compared to $9.9 million for the first nine months of 2013, reflecting primarily the operating expense reductions undertaken in the second quarter following the sale of our medical shape sensing business.

Our resulting pre-tax loss from continuing operations was $3.6 million for the first three quarters of 2014 compared to a loss of $5.2 million for the first three quarters of last year, an improvement of $1.6 million in operations.

After considering income taxes and discontinued operations, we achieved a net income to common stockholders of $6.8 million or $0.40 per fully diluted common share for the first nine months of 2014 compared to a net income of $1.1 million or $0.07 per fully diluted share for the first nine months of 2013.

As a reminder, discontinued operations includes the sale of the medical shape sensing business to Intuitive Surgical in 2014 and discontinued operations for the first nine months of last year includes the sale of our secure computing group in 2013 as well as the operating results of our shape sensing business in 2013.

Turning to the balance sheet, I’ll just highlight that we did receive the second installment from Intuitive during the second quarter of last year, and cash balances continued to improve. So we ended the third quarter with $14.4 million in cash compared to $14.7 million at the end of the second quarter.

Also, our outstanding bank debt has continued to amortize with the balance declining to just $1 million outstanding as of the end of the third quarter. With that, I’ll turn the call back to My..

Sarah, we would like to now take any questions from the participants on today’s call..

Certainly. (Operator Instructions). We do have a question here. It’s coming from Greg Greenberg. Go ahead, Greg..

Hi, gentlemen. Good afternoon..

Hi, Greg..

Congratulations. It looks like everything is definitely moving in the right direction. A couple of questions. First one has to do with – My, I think you mentioned expanding the sales presence and sales force.

Can you kind of give us an update of how many more people are hitting the streets?.

We actually today, probably in my opinion, have one of the strongest sales teams around. We put in place a Vice President of Sales who previously worked with Luna and came back, very experienced in our technology as well as in the industry. Working for him, we currently have one, two, three directors of sales.

We’re in the process of adding a fourth one in the United States as well as another one in Europe. Again, fairly seasoned experienced sales people with the ability not only to penetrate new markets but to go high within every organization. So, we’re really pleased.

Our third quarter results demonstrate that indeed they bring to us different capabilities than we previously had..

Okay.

And then when I think about maybe a sales cycle or a customer, any sort of service agreement? And then kind of a follow up is when you’re getting into some of these customers, you mentioned automotive and aerospace, are you kind of in the situation where you’re sort of proving it out and there could be many more orders should that value proposition be accepted by the customer?.

Yes. For the most part, we are in various stages of proving out the technology with different automotive companies as well as aerospace. So a number of them have purchased at least one system. They’re running it (indiscernible).

And what they’re trying to validate is first of all that the measurements that we make correlate with the strain gage measurements or thermocouple measurements that they’ve made in the past. And I’ll probably just say that the results that they’re seeing are dead-on.

The next stage of the process that we envision happening is that they’ll take an element of a design that they’re working on, fully test it with our technology to get a feel for how to use our instrument actually making a fatigue test. So it’s the cycle we’re in.

The positive that we see is that customers keenly understand the need for our technology because they’ve experienced issues with the traditional method, and they’ve also I believe have come to a realization that the way that we make the measurement with the Odyssey system is rather unique, because we don’t use any grading on our fiber.

The resolution that we can provide them are significantly better than other techniques available. And again, when we look at composite materials and the need to cover as much surface area as possible, our technology stands out strongly..

But there aren’t too many automakers – I mean I obviously can’t say what their demand would be, but if they wanted to replace what they’re doing in general, I mean how many systems could someone at an automaker want or use?.

The only data point that we have is that there is a Frost & Sullivan report put out a couple of years ago defining the size of strain gage data acquisition systems. And they valued the market back then and which I believe was with 2008 at over $1 billion. So it’s fairly huge. That’s why we’re excited about it.

There is a cycle that you have to go through to get to the point where your standardize was in a company, but we do believe over time that the number of systems that they will need is comparable to the number of systems that they have today..

And then just following up on one of my questions as far as revenue potential from a client.

At this point is the model just selling the main piece of hardware? In other words, is there a service contracted? What would be an upgrade cycle that you would think, or is that too far out to comment on?.

We currently offer the customer the ability to key their own fiber optic sensor, because we weren’t able to perhaps provide it in the timeframe that they wanted. There are customers that have this need to get it sooner, and so they purchase the ability to key their own fiber. But one of our business models is to get into the consumable side.

So our intentions are to package the fiber sensor and make them available so that when customers need them at different lanes, we’ve got it available on the shelf and we can see it.

We’re not quite there yet, but if you envision our business model going forward it’d be one-third instruments, one-third consumables and one-third really on the support side..

Okay. And that consumable news is new to me….

The fiber sensor..

Yes. As far as balance sheet goes and relative to the size of the company, significant cash not including the potential milestone announced from Intuitive Surgical.

Any update on what that may do since you’re getting closer to breakeven?.

We continue to monitor the progress that they make. They have – because they are now a dedicated team working on it have made a lot of progress towards achievement of the milestone. Are they there yet? Not quite. How soon can they get there is really difficult to tell, but we’re still optimistic. Sometime soon, we should see it..

Okay.

And then as far as cash on the balance sheet, have you thought of returning that, using it and if you guys are actually going to do what you are doing stock buyback at these low prices?.

Not at this time. But as you saw in the announcement, we use very little of that cash this past quarter..

Right, 300,000..

Right. Ideally, as I think I’ve mentioned previously, as we progress with the Odyssey initiative, I would believe that there is some point that we can accelerate the growth even more by doing some meaningful bolt-on acquisition.

But I haven’t given that a lot of thought, it’s just – when I think about where we are and how big we could get and with cash on hand, that’d be one means with which we could achieve top line growth faster than even on the rate at which we’re growing today..

And what kind of color can you give us – what would be the qualities of a bolt-on acquisition? Somebody that’s already got relationships with the customers you’re going after or in the same field.

Obviously, you’re doing a very small amount of revenue per se, so it would be kind of hard to imagine there’s much smaller companies in this field for you to bolt-on.

Can you give me any color on what kind of…?.

I think it’s too early to say. Again, we haven’t spend a lot of time thinking about that. But my past history – if you look at my past history, done a lot of acquisitions, so it’s something I’m very familiar with but as I said, our focus short-term is right now on executing on our strategy.

And probably ask me the same question a year from now, I’ll have a better answer for you..

Okay. Thank you very much..

I didn’t want to get ahead of ourselves..

All right. Thank you..

Thank you. (Operator Instructions). Cameron, do you have any comments to make while we wait..

Just one quick announcement. The company will be presenting at the upcoming LD Micro investor conference that’s going to held in LA from December 3 through 5 and we’ll put out a formal announcement with additional details on presentation times and as well as the webcast information for that call. So that will be upcoming as well..

All right, great. It looks like there are no further questions, so I’ll turn the call back to My for closing remarks..

Thank you. Thank you, everyone, for joining us today. As I think you can see, we are very pleased with the results that we’ve delivered in Q3 and indeed it gives us confidence that we are headed in the right direction.

As Cameron said, we will be at the LD Micro conference in early December, so if you get a chance and you’re attending it, by all means we’ll be having one-on-ones then. With that, again, thank you for joining us today..

Ladies and gentlemen, that concludes today’s conference. Thanks for your participation. You can disconnect. Have a great day..