Dale Messick - Chief Financial Officer My Chung - President and Chief Executive Officer.

Jim Kennedy - Marathon Capital Management Tim Savageaux - Northland Capital Markets.

Good day ladies and gentlemen and welcome to the Luna Innovations Incorporated Fourth Quarter 2016Earnings Conference Call. [Operator Instructions] I would now like to turn the conference over to your host Mr. Dale Messick, Chief Financial Officer. Sir, you may begin..

Thank you, Chelsie. Good afternoon and thank you for joining us today as we review our operations and results for the fourth quarter and the full year of 2016. A recording of this conference call will subsequently be posted on our website.

Before we proceed with our presentation today, let me remind each of you that statements made in this conference call, as well as in our public filings, releases and websites, which are not historical facts, maybe forward-looking statements that involve risk and uncertainties and are subject to change 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 results 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 the forward-looking statements to reflect future events or developments expect 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. And at this time, I'd like to turn the call over to My Chung, President and CEO of Luna Innovations..

Thank you, Dale, and thank you all for joining us today. We are very pleased to update you on our fourth quarter results. You have heard me speak for several quarters about continued improvement and our bottom line with the focus towards achieving profitability.

Today, we're happy to share with you that for the fourth quarter of 2016 we achieved this critical milestone. I'm very proud of the team we here and the commitment that has been demonstrated throughout the company in achieving this goal.

Our focus on executing on our key strategic growth initiatives while closely managing our expenses has paid off in the results you see today, an operating profit, $427,000 for the fourth quarter of 2016 versus an operating loss of 815,000 in the fourth quarter of 2015. We continued to advance our two key strategic initiatives during the quarter.

I've described on previous calls, the benefits of our ODiSI platform and that it provides the testing of strain and fatigue instructions made with composite materials in terms of our measurement resolution. The number of sensors for fiber, the cost of the system and the ease of installation compared to the legacy technology of strain gauges.

I've also provided a clearly update on our progress within the aerospace and automotive industries. Today, we're happy to report that we have received positive thumbs up endorsement of our product by one of the world's leading aircraft manufacturers.

They have formerly specified our ODiSI system for the upcoming testing of strain and fatigue of a new composite wing structure for one of their commercial aircrafts. Getting formerly specked into this test was an important milestone for us, as it validates our customers' need for an improved test methodology.

Their satisfaction with the test results they were able to achieve from the systems we previously sold to them and the overall value proposition the ODiSI system provides in terms of measurement accuracy, resolution, ease of installation and cost savings.

Our team has done an exceptional job in working with the customer and getting our product approved.

We expect the successful outcome of this upcoming test, along with our future product enhancements such as the introduction of the multichannel system to help us grow this relationship and start to replace their strain gauge data acquisition systems with our solution. Our ODiSI mainframe sales increased over 40% in 2016 versus 2015.

For our second key strategic initiative namely growth in the deployment of our high-speed optical receiver, we recently announced that at the end of Q4 we signed a vendor managed inventory or VMI agreement with our largest customer in China.

Under this agreement, we will work more closely with their component sourcing and manufacturing operations to provide receivers on just in time basis. We'll accomplish this by maintaining a dedicated inventory of our receivers in Hong Kong, from which our customers' to draw as needed for their manufacturing schedule.

This VMI agreement is the typical arrangement required by this customer for all their strategic slides, as it ensures them of the availability of critical parts at all times. This was a major step for us in order to continue to grow our business with this key account.

As we move to this new VMI process, there will be some early financial impact resulting from the change in how we will manage shipments for future orders.

As the objective is to have the VMI sufficiently filled to satisfy their quarterly production requirements, yet we'll not be able to recognize revenue until the customer actually pulls it from our VMI. High-speed optical receivers remain an exciting opportunity for us, having grown over 50% in 2016, compared to 2015.

With continued strong demand expected from the Asian markets in 2017, as they begin to build out their metro and provisional networks. Our Q4 was a strong finish to a successful 2016.

Overall revenues at $59.2 million for the full year 2016, represents a 12% growth compared to 2015 on pro forma basis as our merger with API happened at the beginning of 2015. Similarly, our full year loss from continuing operations improved to 2.3 million in 2016, compared to a pro forma 2015 loss of 4.6 million.

We made great progress as a company in 2016, while had the slight startup transition in Q1, we're setting up the DMI as I've mentioned, but we're focused on another successful year. With this I will turn the call back over to Dale to cover more detail our financial results..

Thank you, My. Revenues for the fourth quarter of 2016 were $16 million, compared to $15.5 million for the fourth quarter of 2015.

The increased revenues year-over-year were driven primarily by growth in technology development segment with higher contract win rates both in phase 1 contracts and phase 2 follow-on contracts that resulted in realized growth in this segment throughout 2016.

Our gross profit increased to $6.1million of 38% of revenues for the fourth quarter of 2016 versus $5 million or 33% of revenues for the fourth quarter of 2015. Margins improved in each segment of the business year-over-year.

Our operating expenses decreased slightly to $5.7 million for the fourth quarter of 2016, compared to $5.9 million for the fourth quarter of 2015.

Within operating expenses, R&D cost decreased approximately $300,000, primarily due to greater utilization of engineering in the manufacturing process and therefore those costs are included up in cost of sales. Our G&A expenses increased less than $150,000.

With these higher revenues, better margins and reduced expenses, we realized an operating profit of $427,000 for the fourth quarter of 2016, compared to an operating loss of $815,000 for the fourth quarter of 2105, a year-over-year improvement of $1.2 million for the fourth quarter.

Our net income attributable to common stockholders was $276,000 in the fourth quarter of 2016, compared to net income attributable to common stockholders of $7.9 million for the fourth quarter of 2015.

In the fourth quarter of 2015, we recognized a non-operating gain related to the final $9 million received from the sale of our medical shape sensing business driving that year-over-year decline in net income.

Adjusted EBITDA improved to $1.6 million for the fourth quarter of 2016 compared to adjusted EBITDA of $421,000 for the fourth quarter of 2015. For the year, our total revenues were $59.2 million versus $44 million in 2015.

As a reminder, our reported 2015 results only include the operation of Advanced Photonix, from the time of our merger in May 2015 through the end of the year.

If we were to look at pro forma revenues for the full year 2015, we would have revenues of $52.9 million, compared to our 2016 full year revenues of $59.2 million, representing growth of $6.3 million or 12% year-over-year. Gross margins were 37% of revenue for the full year 2016, compared to 38% for 2015.

The slight decrease in gross margin percentage reflects the impact of the full year inclusion of the API operations in 2016.

The margins on product sales for the API operations tend to be lower than the margins of the test and measurement equipment historically sold by Luna and therefore the shift in overall product mix year-over-year drives the one point decline in the gross margin percentage.

Operating expenses increased less than $1 million in 2016 to $23.7 million, compared to $22.8 million in 2015. Operating expenses in 2015 included $3.7 million of transaction related expenses associated with the API merger.

The savings associated with not having those expenses recur in 2016 was offset by the full year impact of including the operating expenses of API for the full year in 2016, which added an incremental $2.6 million to our SG&A cost and $1.2 million to our R&D cost for a total incremental $3.8 million for the year.

Our operating loss for the full year 2016 improved to $1.9 million, compared to an operating loss of $6.2 million for 2015. We had a net loss attributable to common stockholders of $2.5 million for the full year 2016, compared to a net income attributable to common stockholders of $2.2 million for 2015.

As I noted previously, our 2015 result included a onetime gain or approximately $9 million related to the sale of our medical shape sensing business. Adjusted EBITDA improved to $2.6 million for the full year 2016, compared to $1 million for 2015.

Turning to the balance sheet, we ended 2016 with $12.8 million of cash compared to $17.5 million at the end of 2015.

The primary uses of cash during the year were $1.9 million in paying down our bank debt, $1.5 million of fixed asset acquisitions primarily related to the build out of microfab for Avalanche Photodiodes in our Ann Arbor location and $333,000 in treasury stock repurchases.

We had outstanding bank debt of $4.3 million at December 31, 2016 for a net cash minus debt of $8.5 million. With that I'll now turn the call back over to My..

Thank you, Dale. And at this time we will be happy to take any questions that you might have..

[Operator Instructions].Your first question comes from the line of Jim Kennedy with Marathon Capital Management. Your line is now open..

Hi, My. Hi, Dale..

Hi, Jim..

I wanted to drill down a little bit on two areas and perhaps you could educate both me and the listeners.

The first is in the Avalanche Photodiode business, can you talk a little bit about why that business maybe picking up, what's driving that and what are those key factors for 2017, as we move forward that would indicate increasing demand?.

Yeah, the opportunities that we're working on currently Jim, is again in the Asia market, both China as well as in South Korea and some in Japan. It's really the build out of the fiber-to-the-home network.

The major shifts that China made in 2016 was to really start ramping up the higher speed network, the 10 gigabit, which is the one that we're pursuing heavily. We've got a number of contracts in the works, but that's what's driving the 10 gigabit Avalanche Photodiode business..

And would that go through your normal partners or how do you go to market with that?.

It's going through the partner that we currently have in China. We have a distributor called Melotech that we work with. They're basically our channel that covers the China market. In the South Korea market, we go direct..

Okay, so you go direct to the end customer?.

Correct..

And how many are there in South Korea in terms of customers?.

Right now, there's one significant one that we're working on. We're meeting with him - he actually wants to increase the capacity that we're delivering to them today, so that's a positive news..

What has been the - and I don't know if you break this out or not, but what has been the level of revenue coming out of this area to date?.

On the average our diodes is probably - yeah, we really don't break it out, but it's still probably below 5 million..

Okay and then - so going forward you would be looking for some pretty substantial growth in this area over the next year or two given what you just described?.

Yes, we are, but the bigger growth would continue to still be on the 100 gig..

Okay and then secondary really relates back to your fiber optic sensing technology and what you're doing on that side of the business with composites.

Could you just take a moment and just kind of brings up the speed, where you're there in terms of either customers or trials and then remind us exactly how you're positioned and why you're positioned in that way?.

Okay, it's the example that I discussed on the overview, why we actually are in a very strong position with a major aerospace manufacturer here in North America. They've been working with us over the last couple of years trying to get our technology to the point where it meets what they're expecting. They gave us the thumbs-up recently.

They've run our system through multiple tests. They actually purchased four systems from us early in the year to test different scenarios to see if indeed we can identify the problems that they were unable to find new traditional strain gauges. They passed our system with flying colors.

It had now, as we said, given us the thumbs-up to be certified within their company and they are in the process of buying additional systems to test the wing of an aircraft that they're building..

So, my - in terms of exactly what you're selling and how they're utilizing it, is that a one-time sale into a lab? Is there a recurring revenue piece? What is kind of the business model in this area?.

Probably the best way to help you visualize the opportunity that this presents to us is that every lab that's evaluating a new material, this is within the same corporation now and they have in fact at least 50 labs throughout the United States looking at different materials.

They would buy a minimum of one system per engineer for the most part, okay. So, that's your starting point at the, what they call, the coupon level. The big investment will happen and this is where the multi-channel system that will be introducing this year will come into play.

All right, today to test a new aircraft like the Boeing Dreamliner, they had to install over 5000 individual strain gauges, that data acquisition system alone runs anywhere from $1 million to $1.5 million. That's with the individual strain gauges.

Now, you take our technology, which provides the equivalent from a lot more sensors per that 20-meter fiber that you connect to an ODiSI, right, in the ODiSI, the sales price, the average sales prices probably was about $50,000.

It gives them a lot more data points per fiber, right, than they get laid down individually in terms of strain gauges and get a lot more measurements, a lot better resolution than they could put strain gauges side by side, right. And that's key, because again they're trying to cover as much of the surface area as they possibly can, right.

And the other key advantage that we offer because we use the fiber optic as the sensor is that they can test around the bend far easier than they can ever put strain gauges around it..

If I deploy your technology, do I necessarily need to use strain gauge anymore?.

No, no, that's where we're moving towards. Ideally, we're looking for these aerospace and automotive companies to come to the realization that what we offer is something that gives them a lot better visibility on composites than they could ever get. It's going to be far less expensive for them to install.

Today just the installation costs of putting this that number of strain gauges on an aircraft is over $1 million. Go ahead..

So, the idea would be that your fiber is manufactured into that composite material?.

No, it's actually laid down. It's glued on to the surface to measure strain. Remember this is done more in the engineering side than in production. Now with that said, where everybody wants to go, automobiles as well as airplanes, is actually embed fiber into the composite itself, right.

It's very difficult to embed strain gauges into the structure far easier as the nature of composites to embed multiple fibers.

So, the expectation is once the plane comes in for service or you bring your car in for service, they'll connect an ODiSI to that fiber to determine if there was any structural damage between the time that it left the shop to when it's coming back in..

I'm sorry. Go ahead, My..

It's a critical requirement that people are looking for..

So, coming back to the business model, so you would sell an ODiSI or your system to a lab, to an engineer for his or her use there, it sounds like there might be multiple systems per lab depending on the number of engineers.

And is that a one-time sale or is there some recurring maintenance and recurring revenue?.

It's typically the number of systems that get purchased a year as a function of the number of programs that they have going. You think about it like in a stethoscope, right, they become a critical piece of test equipment that anyone designing a new composite part would need one.

Of course, they get always shared, but you will typically find that there will be multiple systems as they start up new programs. Again, our expectation in terms of the total market size of our opportunities is anywhere from mid-$300 million to over $500 million..

Got you and that encompasses both airframe, as well as automotive?.

Correct..

Okay. And then, so we've talked about the U.S. manufacturer.

Obviously, there are manufactures around the globe, any progress outside of the U.S.?.

Sure. So, coincidentally, yes, we are working with one of the major aerospace companies. We are also working with the other one and there's a lot of, I'm sure, collaboration that goes on, because coincidentally when we got the thumbs-up from one, the other one was right around the corner, right.

We are also heavily involved in aerospace companies outside of the North America and Europe. Okay, so there is, of course, activity going on in Asia. Same with automotive, automotive, we've got a number of opportunities going on with Detroit, as well as our largest install base of automotive test systems for composites actually in Japan..

Got you, okay.

And remind me again, obviously you've got a fairly disruptive technology here and that is well protected through IP and patents?.

That is correct..

Okay, very good. I will hop out of the queue and let someone else have some questions. Thank you very much..

Thank you..

And our next question comes from the line of Tim Savageaux with Northland Capital Markets. Your line is now open..

Hey, Tim..

Hey good afternoon, and congratulations on a strong Q4. I'm going to start with customer concentration. I wonder if you can, I am going to assume that your, the VMI customer that you were discussing before is going to end up being a significant customer for '16.

I wonder if you can give us kind of an order of magnitude estimate of concentration assuming that's the only 10% customer if they are more than the other metrics around customer concentration, you might be able to provide for 2016..

Yeah. That's our - that's in the U.S. government, of course, are the only ones that are over 10% and this particular one is in the line of 15% or so of our total revenues..

Right and I guess that makes sense. And sort of continuing on from there, you mentioned some pretty nice growth rates for both the high speed optical receiver business. I think that was up 50%. I assume that's a pro forma number..

That is pro forma number, correct..

Okay. And also the ODiSI business, what I would like to try and do is get a better sense of the size of those businesses relative to your overall product business, which I think you mentioned was in, based on my memory, the pro forma number was down for the year.

So, I am going to assume that those two growth businesses are kind of at least half of the product business if not solidly more, but I would be interested in any color you might have on that front?.

I'm sorry, Tim. I missed the first part of your question.

Can you redo it for me?.

Sure. Thanks. I am basically looking for - you mentioned two growth businesses in one high-speed optical receiver, the other, the ODiSI composite test platform and growth rates in those businesses are 50% and 40% respectively.

What I am trying to get a better of is if you look at those two businesses together, how significant are they as a percentage of your overall outside of technology development revenue? So, we'll just call it product revenue and there is licensing in there too.

With my overall thought that it's likely at least half of that business, but I was looking for any color you might be able to provide there?.

So, the ODiSI business is lesser than that. So, well, we had a very good growth rate there. It's not driving the overall product growth business. And so you are right.

You look at those growth revenues that we did - growth that we did have on the key strategic initiatives and then we were kind of flat in our traditional telco test and measurement kind of business and also in our other optical component subsystem kind of business that we do out of California.

So, those kept our overall growth rates from being a significant as what you saw in the discussion of the HSOR and the ODiSI..

Well, yeah, let me just go back and make sure I got that right because if I am looking on a pro forma, we obviously saw some pretty good growth in technology development revenue.

Am I right in saying that was the overall product revenue or product licensing down for the year on a pro forma basis, which to me would imply something came down pretty significantly, given the growth -.

The product side wasn't down on a pro forma, not on a consolidated basis..

Right, we had an overall $6 million increase pro-forma, a little over $6 million increase in the revenue pro-forma. The technology development revenue is not really impacted by that. So, the $6 million growth was really all in the product side..

Okay. I will go back to the drawing board a little bit there. Okay. Okay, if I get that right, then I do get kind of a flat profile even with my current assumptions here. Okay. Well, let me move on from there.

There has been a lot of focus of late across the 100 gig optical sector about various concerns around inventory demand levels, what have you, especially coming out of China, this does sound like you're seeing any of that outside of this kind of one-off VMI issue, which is typical I guess when you see that initially instituted.

Given the date, here we are in the last two weeks of March, I wonder if you could give us any indication of assuming that has a fairly solid negative impact on first quarter revenue, any chance we can sort of bracket that impact in terms of the effect on product revenue and whether that solely VMI impact or whether you're seeing anything else notable from a demand - there have been recently mentioned delays and letting up plans for incremental builds in China in '17 or if you can discuss that overall demand environment given that you - for the year I think you expect continued growth?.

Yes. So, growth is definitely in the forecast and from everything that we've heard in terms of the investments that will happen in China, it confirms that. I think what we're seeing is the same as what the other vendors are seeing is that there is a transitional period here going on, as they move to the next phase.

The thing that gates part of our softness is also we're moving from a Gen 100 gig receiver to a Gen 2. The Gen 2, which requires for the build out of the metro network, because it's half the size of Gen 1. We currently have samples out for evaluation and certification now.

If that goes well, which is our expectation and that will start ramping in the second quarter. The speed with which we ramp that determines how strong Q2 will be.

I would definitely - as they build out the metro network, they are very much focused on the smaller module as opposed to the current one and the metro build out, as everybody is anticipating, is going to be bigger than the long haul.

So, that's really in terms of the HSOR business where we're seeing, I remember we're only a subset of the applications that the other major players are playing in..

Okay, great. I'll pass it on for now. Thanks..

Thanks, Tim..

Thanks, Tim..

Thank you. And I'm not showing any further questions at this time. I would now like to turn the call back to Mr. My Chung for closing remarks..

Well, thank you everyone for joining us. For those that will be attending the upcoming OFC show in Ana, not in Ana, but in Los Angeles this coming week, we'll be having a booth there. So, by all means, start by. I'll be there on Monday and Tuesday. We'll also be sponsoring the executive forum on Monday and the big topic there is silicon photonics.

That's something that we benefited from in our telecom test side. We've actually been very involved in the development of that technology with key labs, as well as working with the manufacturing sites. So, by all means, if you are in town on Monday and can attend that executive forum, we'll be glad to see you.

Other than that, I appreciate everybody joining us today. And with that, I'll sign off..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day..