Dale Messick - Chief Financial Officer Scott Graeff - President and Chief Executive Officer Brian Soller - Vice President and General Manager, Lightwave.

Tim Savageaux - Northland Capital Randy Knudson - Private Investor Charles Noll - Private Investor.

Good day, ladies and gentlemen and welcome to the Luna Innovations Incorporated Fourth Quarter 2017 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] And as a reminder, this conference maybe recorded.

I would now like to turn the conference over to Mr. Dale Messick, Chief Financial Officer for Luna Innovations. Sir, you may begin..

Thank you, Sabrina. Good afternoon everyone and thank you for joining us today as we review our operations and results for the fourth quarter and full year of 2017. 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 changes at anytime 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 except as required by law.

There is more complete information regarding forward-looking statements, risk and uncertainties in the company’s filings with the SEC available on the SEC website and our website. At this time, I would like to turn the call over to Scott Graeff, President and CEO of Luna Innovations..

Thank you, Dale and thank you all for joining us today. Today, we issued our operating results for both the fourth quarter of 2017 and for the full year. I am extremely pleased and excited about our continued progress both on the strategic and a financial basis.

2017 saw some significant changes in our company and I couldn’t be more proud of the way our teams executed this past year continuing to innovate to provide the best products and solutions possible for our customers. Let me first give an overview of the financial results and Dale will certainly follow-up with more detail.

In the fourth quarter, we reported net income from continuing operations of over $200,000. It’s worth noting though that the NOI would have been over $700,000 had it not been for a one-time payout owed to My Chung under his employment agreement upon his departure from the company.

This second consecutive quarter of positive income is a huge step forward for Luna on a continuing profitability front. For the full year 2017, we delivered approximately $500,000 of positive net income from operations normalized for the one-time charge in the fourth quarter. Even with this charge, we were near breakeven for the year.

Adjusted EBITDA is in line as well with over $1.2 million in the fourth quarter and over $2.5 million for the entire year of 2017, a number that is $2.6 million better than all of 2016.

This strong profitability performance was certainly driven in part by the double-digit growth in the top line of 12% in the fourth quarter as compared to the same quarter in 2016 and over 10% for the full year compared to the same period in 2016.

I want to thank the whole Luna team of whom I am incredibly proud and whose sharp focus allowed us to deliver these results. Now, let me provide some detail on the progress and status of the various business divisions at Luna.

As you may know, we have two business segments, a product segment consisting of our lightweight division, our optical components and subsystems business and our terahertz business and our technology development segment for contract research.

As we discussed in our previous call, Luna sold its high speed optical receiver business in the third quarter of 2017 to MACOM for $33.5 million in cash. $29.5 million of that cash was received at closing and $4 million remains in escrow until December of this year. These assets were part of the Picometrix division located in Ann Arbor, Michigan.

Luna retained the terahertz assets that were also located in Michigan. The sale helped Luna to have the strongest balance sheet in its history with nearly $37 million in cash at December 31 and over $44 million in working capital. So what’s the plan for leveraging this strong balance sheet, I will cover that in a little bit.

But first, let me give you an update on our Lightwave Division. The Lightwave Division is the team that sells the telecom test instruments and the ODiSI strain measurement platform.

As before, I have asked Brian Soller, the Vice President and General Manger of the Lightwave Division to join us on this call, so if there any questions at the end, we can gladly address them all at all levels.

Within the Lightweight Division, the fiber optic test and measurement segment ended the year on a strong note with orders for new products growing 32% for the full year in 2017 versus 2016. Performance in Q4 was also strong with 58% growth in new orders versus Q4 of 2016.

As a reminder sales of our fiber optic test and measurement products breakdown broadly into two main markets, one is communications test which deals with measurement of high speed fiber optic communication devices and the second is structural test where our ODiSI product line is used to measure stress, strain and temperature for composite and other materials for a variety of industrial applications.

In Q4 sales of our communications test products were again primarily driven by the need for accurate characterization of a new generation of high speed optical devices based on silicon or silicon photonics.

Integration of optical communication devices within silicon provides many of the same advantages that silicon brings to electronics industry, namely, higher bandwidth in a much smaller and less power hungry footprint.

As a result many major device manufacturers are developing new products based on silicon photonics and using our OVA and OBR products to accelerate their design cycles and ensure the performance of their products.

Luna attended the industry leading conference OFC in San Diego last week and saw more booth traffic and excitement that has been seen in nearly 20 years. In a speech at the executive forum one of the large service providers stated there are more than a million videos uploaded every second.

Given the broader trends we are seeing in the industry related to this need for more bandwidth in smaller more energy efficient packaging, we at Luna believe we are well positioned to continue to grow our sales within this segment. The structural test segment also finished the year strong.

Orders for the new ODiSI system in Q4 grew 31% over Q4 of 2016. As I mentioned on our last call in Q4, we launched a completely overhauled and enhanced version of our ODiSI product, the ODiSI 6100.

The ODiSI 6100 platform employs next generation fiber optic technology for distributed multipoint ultrahigh definition profile in the strain and temperature. ODiSI fiber optic sensors are small, lightweight and economical, greatly reducing the cost of sensor installation and the ability to embed sensors directly with their materials and structures.

The enhancements included with the ODiSI 6100 strain and temperature measurement platform include minimized per sensor cost, increased multi-channel capability, increased sensor length, increase speed of output and real-time 3D data visualization software for computer model calibration.

I am glad to report that sales of the ODiSI 6100 were off to a good start. Since its introduction in December, we have booked 11 new orders with multiple large orders on that horizon.

Our challenging going forward continues to be expanding our presence throughout our target customer base to create a new standard of test, so that we can turn single unit sales into recurring multiple unit opportunities.

The optical components and subsystem business based in California that sells custom photo-detectors and sensors into industrial, military and medical applications grew 15% in the fourth quarter over the prior year. Because they are custom products, the business relationships tend to be long-term and new business tends to require long lead times.

You may recall we telling you that we typically have good insights into the next couple of quarters and thus expect to see a dependable solid contribution to the bottom line from this division. Our technology development segment’s quarterly revenue, which consists primarily of third-party contract research, grew 14% year-over-year.

The growth has been driven primarily by the success in the government contracting space. Our backlog of contract funding is up over 20% from year end 2016. This segment also earns commercialization revenue for early-stage products that are licensed or sold into new markets.

While the revenue is not a huge portion of the total, it does allow us to interact directly with customers, improve the products and build the value of the technology. We had nearly $900,000 in product sales and licensing revenue in 2017.

And as of March 1 this year, we have hired a Business Development Manager in this segment who will be focused on getting some of the more mature technologies into the market through partnerships with bigger corporations. The momentum that we are carrying into this year excites us for the growth opportunities we have for 2018 and beyond.

Within our terahertz business as you probably saw in our previous press release, we started 2018 with the hiring of a new General Manager for that operation. Margaret Murdock is keenly focused on our objectives of reducing the cost of the product, improving its manufacturability and penetrating new customers for industrial process control.

She has in her short tenure already made good progress in the cost and manufacturing objectives. We have previously noted tier manufacturing as a significant market opportunity for the terahertz product. And we have recently completed our first deployment in that application and we recently engaged two additional value-added resellers.

The market overall will also be seeing more of our product capabilities as we have expanded the tradeshow participation to 10 events in 2018 compared to just 4 in 2017.

So back to the question of what’s next? We began 2018 in a strategy session with our business unit leaders along with Dale and me and some key members of our Board of Directors to bring the finest thinking to how we leverage our distinct opportunity to best grow the business organically.

As I discussed with you on our last call, we have an aggressive go-forward plan to leverage off of our 2017 momentum generated in key accounts and the market momentum that will fuel our growth in financial results.

Our plan includes and we have already executed on the hiring of four more experienced sales and marketing professionals in the Lightwave division, an expanded sales and marketing force will be critical for the growth expectations for our Comtest and structural strain markets.

While we are excited about and focused on delivering on that plan, we know that within our two market verticals, we still have some interesting opportunities we can capture to improve and grow the profile of that business.

Therefore, we are currently in the early stages of exploring opportunities that would utilize some of the cash on our balance sheet to grow LUNA through an acquisition. As I have stated before, we will be very disciplined in the deployment of any capital and we use a very targeted and deliberate approach toward a new strategic transaction.

I will keep everyone apprised as to the progress we make on all of these fronts. I continue to have strong confidence in the team that we have assembled here at LUNA, including world class engineers, leaders and an industry experienced sales people and I wholeheartedly believe that we can execute on our initiatives and our vision.

With that, I will turn the call over to Dale to review the Q4 and full financial results..

Thank you, Scott. Before I go through the numbers, I would like to remind everyone that with the sale of the HSOR business in August 2017, the historical operating results associated with the HSOR business are now reflected as discontinued operations in our income statement for both 2017 and 2016.

So, as you look at the income statement now for all of the periods presented, the revenues and expenses in the top part of the statement reflect our ongoing business activities and towards the bottom of the statement, you will see captioned as discontinued operations, the operating results of the HSOR business activities and the gain we recognized on the sale of HSOR.

So, to start with continuing operations, revenues for the quarter ended December 31, 2017 were $13.2 million compared to revenues of $11.8 million for the same period in the prior year representing a 12% year-over-year increase.

The increase in revenues year-over-year was comprised of an 11% increase in our products and licensing segment, along with a 14% increase in our technology development segment.

The growth in revenue is recognized in the products and licensing segment was realized primarily in our fiber optic test products which grew 27% year-over-year, while growth in the technology development segment related mostly to government funded research in advancing optical and biomedical technologies.

Our gross profit realized on those revenues increased to $5.3 million from the fourth quarter of 2017 compared to $4.7 million for the fourth quarter of last year representing a gross margin of 41% in Q4 of 2017 compared to 40% in Q4 of 2016.

Operating expenses increased to $5.3 million or 40% of revenue for the three months ended December 31, 2017 compared to $4.2 million or 46% of revenue for the three months ended December 31, 2016.

As Scott mentioned earlier in his comments, My Chung retired as our CEO in October 2017 and the costs associated with that including cash payments owed to him in addition to the acceleration of stock vesting added $0.7 million as a one-time charge to our operating expenses in the fourth quarter of 2017.

Excluding that non-recurring charge operating expenses for the fourth quarter of 2017 would have been 35% of revenues.

With the year-over-year increase in revenues and gross profit offset by the impact of this $0.7 million of one-time charge to our OpEx, we were essentially breakeven with respect to pretax income from continuing operations for the three months ended December 31, 2017 compared to pretax income from continuing operations of $0.4 million for the three months ended December 31, 2016.

We have recognized an income tax benefit of $0.2 million for the fourth quarter of 2017 making our net income from continuing operations $0.2 million for the three months ended December 31, 2017 versus $0.3 million for the three months ended December 31, 2016.

We have recognized income from discontinued operations of $0.2 million for the three months ended December 31, 2017 compared to a slight loss of less than $0.1 million from discounts for the fourth quarter of 2016.

The income recognized on discontinued operations in the fourth quarter of 2017 primarily related to accounting for the inter-period allocation of income taxes between continuing and discontinued operations.

Including both continuing and discontinued operations our net income attributable to common stockholders was $0.4 million or $0.01 per diluted share for the three months ended December 31, 2017 and $0.3 million were also $0.01 per diluted share for the three months ended December 31, 2016.

For the full year revenues increased 10% to $46.2 million compared to $41.9 million for 2016. The year-over-year increase in revenues includes a 14% growth in technology development revenues and the 8% growth in parts and licensing revenues.

Within the Products and Licensing segment, our sales related to our Lightwave Division’s fiber optic test and measurement products increased 16% year-over-year. Gross profit improved to $18.1 million or a 39% of revenue for the full year of 2017 compared to $15.8 million or 38% of revenue for 2016.

Operating expenses declined slightly to $18.2 million or 39% of revenue for the year 2017 compared to $18.3 million or 44% of revenue for the year 2016.

After tax we essentially broke even with respect to continuing operations for the year ended December 31, 2017 compared to a loss from continuing operations of $2.7 million or $0.10 per share for the year ended December 31, 2016.

We have recognized after tax income from discontinued operations of $14.6 million for the year ended December 31, 2017 compared to $0.3 million for 2016.

Our resulting net income attributable to common stockholders was $14.5 million or $0.52 per share for the year ended December 31, 2017 compared to a net loss attributable to common stockholders of $2.5 million or $0.09 per share for the full year of 2016.

Turning to our balance sheet, I will start by pointing out here that the value of assets and liabilities associated with HSOR business that was sold in August are reflected separately in the December 31, 2016 column under the caption of assets or liabilities held for sale.

We ended the year with cash of $37 million representing an increase of $24.2 million in cash year-over-year. This increase resulted primarily from $28 million of net proceeds received in the sale of the HSOR business partially offset by debt payments of $1.8 million and an additional $1.1 million in purchases of treasury stock.

We also have on the balance sheet a short-term receivable of $4 million reflecting the funds held in escrow from the HSOR sale transaction. The escrow receivable was subject to future indemnification claims by the buyer and is scheduled to be released in December of 2018. Our remaining balance of our bank debt is now $2.4 million.

And with that, I will turn the call back over to Scott..

Thank you, Dale. At this time, I would like to open the call for questions. As I mentioned in my comments, Brian Soller, our Vice President and General Manager of our Lightwave division, which is the fiber optics test and measurement business is with Dale and me at this time and is available to address your questions.

Sabrina, if you have anyone in the queue, let’s open it up..

Thank you. [Operator Instructions] And the first question will come from the line of Tim Savageaux with Northland Capital. Your line is now open..

Hi good afternoon..

Hi, Tim..

Hi, there. I wanted to follow-up in a couple of questions.

First on what sounded like some very strong orders on the fiber optic test side, I just want to make sure I heard that right whether you are talking about just overall orders in the segment or orders for new products or any kind of subset, but looking at 30% growth for the year, nearly 60% for the quarter, I wonder if you could sort of characterize that in terms of maybe expectations for growth in 2018 or what sort of overall growth expectations do you think we should have for the communications part of the fiber optic test business given the silicon photonics drivers and I will follow-up from there?.

Yes, I mean, again, like I said we have put together a pretty aggressive go-forward plan and we have the two verticals.

So, we have the Comtest side and I think that that will continue to see expansion we have added some like I said additional sales folks that will drive that, I think that certainly will be in the kind of 15% to 20% type range of that business and then the other vertical on the test and measurement on the strain side.

You are dealing with a smaller number there. So you will see much larger growth in that segment, because you are starting with a smaller number. So, I think you will see similar growth if not more in 2018 on that sensing side of the market. The folks – two of the salespeople that we added are sensing specific here in North America.

We believe there is opportunity here in North America that we are just not seeing do feet on the street and that was a part of that plan. So you will see a more robust growth in 2018 in that segment like I said primarily remember you are starting with a smaller number on that..

Understood. But I know I might be mixing up segments a little bit here, but it seems like you talked about order growth from at least on the comp side over 30% in revenue growth about half of that and I think that’s the whole Lightwave business, but again understanding Odyssey is a small part.

There I assume in that case that you are building a fair bit of backlog on the one hand, I wonder if that’s the number you sort of disclosed on an annual basis? And on the other, I wonder over on the comm side or really on both sides of the Lightwave business whether there are any major customers we should be focused on in terms of concentration or significant growth drivers heading forward or is this sort of a pretty diversified broad-based strength you are seeing?.

Yes, I will let Brian weigh in on that if he wants to. On the sensing side, we are focused in the automotive and aerospace markets and I think on the Comtest side, you do see the silicon photonics in kind of the AIM initiatives. So, I will let Brian weigh in on if there is specific customer..

Yes, sure. On the telecommunication test side, it’s fairly broad across developers of high-speed optoelectronic devices. And very specifically if you wanted to look more into that, customers of ours are developing components based on silicon photonics as we mentioned on this call and previous calls.

So in that subset of customers, we have a pretty good base and we are fairly well concentrated. So someone sense on the telecom test side in particular, we are fairly well concentrated within the types of customers that are developing high speed components in silicon photonics.

Historically, that would have been telecommunications device manufacturers and that’s been broadly and recently to include data communications device manufacturers and providers.

So we have pretty strict confidentiality agreements with our customers, so I can’t and are not at liberty to give specifics in terms of names, but that subset of customers can be sort of viewed as is where the concentration is for that side of the business.

And in sensing for ODiSI products, that’s a little bit more broadly distributed amongst major OEMs in aerospace and you can imagine the kind of customers in that side of the big OEMs and also in automotive. So I would say that segment is a little bit more about broadly based..

Great.

And the final follow-up for me I mean yes, I would have imagined given most of the silicon photonics focus is on shorter reach applications that you would be more focused on the datacom device providers and I guess you have said there that you have got some of the big cloud guys directly as customers, is that right?.

Yes, that’s correct, yes. In fact, of course they have the supply chain that they go into, that we fell into. But I would say probably without exception all of the major folks in the cloud side of datacom are investing in their own products and R&D efforts towards developing high speed components of silicon photonics..

Great. I will pass it on. Thanks..

Thank you. [Operator Instructions] And the next question will come from the line of Randy Knudson with Private Investor. Your line is now open..

Good afternoon.

I wanted to just follow-up on your terahertz division there in Ann Arbor and ask first of all at the last conference call you had indicated that you, Steve and the gang were going to be trying to move towards the smaller and less expensive T-gauge 5000s I assume, what’s the progress there?.

Yes. I think I have stated earlier, Margaret got in there, we laid out our plan that she is working on and she is making good progress in manufacturing – getting the manufacturability of this system down and she is doing a great job there as well as the cost.

I mean, we believe there is opportunities as you get the cost down in the system and she is making strides in that. So, we believe getting the cost down enables us to get that the larger multi-unit order and we have several of those in the pipeline. We just need to make sure that we have the proper margins in place as well, so good progress there..

So, got it.

I want to give you kudos on your blog in terms of just getting out more information, especially in regard to your terahertz division, we have never seen that before, so we do appreciate that and any other blog post give us private investors some ability to figure out – we are trying to figure out what’s going on with the company, so thank you in that regard..

No, certainly, I appreciate. We are trying to be – we are trying to be more transparent in all of the segments and trying to be out in front talking to investors as well in between these calls, but trying to be more transparent in all of the segments to give you guys..

And then last question for me in regard to the terahertz division, you are currently housed or you were in housed in what used to be the Picometrix facility, are you getting new space, are you going to stay there for the foreseeable future, what’s the plan there?.

Yes. We have a sublease for MACOM through the end of this year, 12/31/18 and we are evaluating that right now starting to look at what happens at 12/31/18. I think I am not sensing that that MACOM is anxious to get more – get the entire space, but it’s not a perfect environment. We are kind of under that one roof.

So, we will evaluate that and try to firm that up in the middle of the year so that’s from that please..

Thank you very much..

Yes, thank you..

Thank you. And we do have a follow-up from Tim Savageaux with Northland Capital Markets. Your line is now open..

Okay.

I do want to follow-up on the strategic commentary as well and just want to make sure I understand what you are trying to say there in terms of being is it a specific opportunity I guess that you are describing being in the early stages of evaluating or with a specific target or is it more you are in the early stages of kind of the strategic process in developing potential targets, just so we can set our expectations.

Just a comment on the timing you might expect as well?.

Yes. So like I said, we really focus on these two verticals ComTest and kind of the strain and tempt side and we look at those and we put together an organic plan like I said and certainly there were some holes at that that could fill those verticals and help us grow in a more aggressive basis.

And so when you look at those two markets there are opportunities within our verticals that sell if we are at one end of that vertical, there is folks that provide product in other areas of that vertical.

And we are identifying them and beginning to have conversations in both of those verticals with some different folks, how long that will take, I don’t really have a timeline for you, there, Tim, but I can tell you while trying to deliver on the plan that we have put in place we are moving contemporaneously with those conversations.

So, those are going on currently and we will see where they will go many of them that we have identified are private, so they wouldn’t be the longer end of a typical transaction so..

Right. Although, it sounds relatively early on and also obviously….

Yes, I mean, with some of these private companies you need, QV and things like that, so there is some things that need to go on, but yes, it’s relatively low..

Okay, thanks..

Yes..

Thank you. [Operator Instructions] And the next question comes from the line of Charles Noll, Private Investor. Your line is now open..

Hello.

I have seen a lot of increase in the institutional holdings I just wonder what you attributed that to mainly?.

Well, I think once we have the earnings call last time and a lot of the news of the transactions hit the market, we were pretty active with going out and meeting and having conversations with folks. So, we have been trying to drive that internally and I think that transaction coming out and hitting the financials was helpful as well..

Okay, it sounds like it’s looking good. Thanks..

Thank you..

I am showing no further questions at this time. I would like to turn the conference back over to Mr. Scott Graeff, President and CEO for closing remarks..

Okay. Well, thanks everyone for joining us today. And as you have heard on the call, we had a strong finish to 2017 and believe we are carrying that momentum for growth into 2018. I’d like to remind everyone that we are holding our Annual Stockholders Meeting in Roanoke, Virginia on May 15 at the Hotel Roanoke at 9 AM Eastern.

And I invite you all to join us and have an opportunity to meet in person and meet the entire Luna team. That completes today’s call..

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