Scott Graeff - President and Chief Executive Officer Dale Messick - Chief Financial 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 Q1 2018 Luna Innovations Incorporated Earnings Conference Call. At this time all participants on 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 conference call is being recorded.

I would now like to turn the conference over to Mr. Dale Messick, Chief Financial Officer of Luna Innovations. Sir, the podium is yours..

Thank you, Brian. Good afternoon and thank you for joining us today as we review our operations and results for the first quarter of 2018. A recording of this conference call will subsequently be posted on our Web site.

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 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 our expectations regarding future operating results or the ongoing prospects of the company.

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

Actual results may differ materially as a result 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's more complete information regarding forward-looking statements risk and uncertainties in the company's filings with the SEC available on the SEC Web site and our Web site. At this time, I'd 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. I'm extremely pleased with the progress that we have made in the execution of our strategic initiatives and in the financial performance we've been able to achieve as a result.

Our first quarter 2018 earnings marks the fourth consecutive quarter of positive earnings going back to Q2 of 2017 and a positive Q1 earnings from continuing operations a first in our history as a public company.

As you will see, we have capitalized on growth opportunities particularly in the advancement of Optical Technologies and we are well positioned to continue to benefit from trends such as demand for higher bandwidth and data communications and data centers as well as the growing use of composites and other advanced materials.

I'll briefly review our Q1 financial results and Dave will follow with more detail. As you may recall, the first quarter of each calendar year is typically the most challenging quarter from a revenue perspective.

As many of our products sell for price ranging from $50,000 to $150,000 because investment in our products often represent significant capital expenditures for our customers their ability to obtain capital equipment spending approval sometimes takes longer particularly if it's the beginning of their fiscal year as well.

This seasonality in our business makes the start of any year particularly challenging, but given the momentum that we carried into 2018 and the healthy backlog we were able to overcome the obstacles that historically contributed to Luna recognizing operating losses for the first quarter in prior years.

With more than 20% growth in revenues over the last year and continued focus on controlling our expenses, we have now reported nearly $149,000 of income from continuing operations in Q1 of 2018 compared to a loss from continuing operations of $865,000 and an overall net loss of $1.4 million just a year ago.

First quarter revenues increased 21% or $2.1 million year-over-year and contributed more than $1 million to our bottom line. Revenues from our products and license segment grew 29%. Within this segment, sales from our Lightwave division grew 74%. As a reminder, Lightwave includes our instruments for testing optical components and networks.

These target the growing demand for bandwidth fueling the development of silicon photonics and the building of more and more data centers. It also includes the sales of our Odyssey instruments for measuring structural health and integrity.

As I've mentioned previously, we've identified these as key strategic growth opportunities and as you can see that growth is materializing. Dale will provide more financial detail in a moment, but first I'd like to highlight the progress and status of the various business divisions at Luna.

As I've done in the past, I've asked Brian Soller, the Vice President and General Manager of Lightwave division to join us on this call. So if there are any questions at the end, we can gladly address them at all levels.

For the Lightwave division, I've already mentioned the significant revenue growth for Q1 on a year-over-year base of nearly 70% with 74% growth in products. In the fourth quarter of last year, we launched our new multi-channel version of The Odyssey product for measuring strain and temperature in composites and other advanced materials.

In the first quarter of this year, I'm very pleased to say that we shipped 8 of those new multi-channel systems with an average sales price of approximately $100,000 each as well as receiving seven additional orders for that system primarily in applications related to aerospace and large civil structures.

We are very pleased with the growth that we've seen in Lightwave and the progress it is making at penetrating the markets. During the first quarter, we launched a new component analyzer at ODiSI, which we have called the LCA 500.

Specifically targeting the measurement of most critical parameters for characterizing the performance of silicon photonic devices.

The LCA 500 provides measurement of insertion loss, return loss and polarization dependent loss in a single scan, its high resolution and has fast scan times allowing our customers to have higher test throughput in their operations.

On the Terahertz side, I discussed last quarter, our new leadership in that group and the traction taking place across the Terahertz organization whether in sales, engineering or manufacturing. The group continues to gain momentum and recognized a 29% increase in revenues in Q1 compared to a year ago.

We are increasing our marketing presence for the Terahertz platform with much greater tradeshow presence. We plan to participate in 10 shows this year with four shows already completed in 2018. For comparison, we only completed four shows in all of 2017.

Additionally, we are gaining efficiency in our operations, for instance since January 1, w have reduced our time to build a system by 27% taking 67% of the engineering hours out of the build and lowered overall cost of goods sold by nearly 10%.

These important measurements are critical to the growth that we expect and a true testament to the outstanding work being done in our facility. Our Technology Development segment, which for the most part represents funded research under U.S. government contracts, grew 9% year-over-year.

This was largely driven by our diverse team and their ability to win Phase 1 feasibility projects and extend them into larger development programs at a higher conversion rate. I'm extremely pleased with the performance of that segment thus far and the breadth and depth of the IP portfolio that has developed in this area.

There are solid synergies from having this division as it relates to our ability to innovate quickly and efficiently.

And finally, a little bit about our growth strategy, as I mentioned on our last earnings call we are very excited about the growth we have seen so far in 2018 and remain focused on capturing the expanding opportunities that our products target in the test and measurement market.

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

Since our last earnings call, we've continued exploring opportunities that would utilize some of the cash on our balance sheet to grow Luna through an acquisition. I would still characterize those efforts as early stage at this point although the team has devoted substantial time over the past several months towards this objective.

As I've stated before, we will be very disciplined in the deployment of any capital and therefore we are taking a very targeted and deliberate approach toward any potential strategic transaction. I will keep everyone apprised of the progress we make on all of these fronts.

I would like to thank our employees for their hard work and achievement this quarter. I know that our employees remain committed and focused on driving results. With that, I will turn the call over to Dale to review the first quarter 2018 financial results in more detail.

Dale?.

Thank you, Scott. Our revenues for the quarter ended March 31, 2018 were $12.2 million compared to revenues of $10.1 million for the same period of the prior year representing a 21% year-over-year increase.

The increase in revenues year-over-year was comprised of a 29% increase in our product and licensing segment along with a 9% increase in the Technology Development segment.

The growth in revenues recognized in the products and licensing segment realized primarily in the fiber optic test products of our Lightwave division which grew 74% year-over-year as Scott mentioned.

While growth in technology development segment continues to be related mostly to government funded research into advancing optical and biomedical technologies. Effective January 1, 2018, we adopted ASC 606, the new standard for revenue recognition under generally accepted accounting principles.

The adoption of ASC 606 resulted in the recognition of approximately $125,000 more revenue in the first quarter of 2018 than we would have recognized under the previous accounting standards.

Our gross profit realized on those revenues increased to $5 million for the first quarter of 2018 compared to $3.9 million for the first quarter of last year representing a gross margin of 41% in Q1 of 2018 compared to 38% in Q1 of 2017.

Operating expenses increased to $4.1 million or 40% of revenue for the three months ended March 21, 2018 compared to $4.7 million or 46% of revenue for the three months ended March 31, 2017. SG&A expenses were essentially flat year-over-year while R&D expenses increased less than $200,000, year-over-year.

With the year-over-year increase in revenues and gross profit and closed management of our operating expenses, we recognized income from continuing operations of $149,000 for the first quarter of 2018 compared to a loss from continuing operations of $865,000 for the first quarter of 2017.

We did not recognize any income or loss related to discontinued operations in the first quarter of 2018 amount shown as discontinued operations for the first quarter of 2017 in our release today reflect the operations of the HSOR group that we sold in August of last year.

Our net income attributable to common stockholders was approximately $84,000 or breakeven on a fully diluted share basis for the three months ended March 31, 2018 and compared to a loss of $1.4 million or $0.05 cents per diluted share for the three months ended March 31, 2017. Turning to a couple of highlights on the balance sheet.

We ended the quarter with cash of $33.4 million; the remaining balance on our outstanding bank debt has declined to approximately $2 million.

During the quarter, we used $0.3 million of cash under our stock purchase plan announced last year to purchase 132,000 shares of our common stock during the first quarter with our cumulative purchases of treasury stock now accumulating to 1.2 million shares or more than 4% of our issued common stock. With that, I'll turn the call back over to Scott..

Thank you, Dale. At this time, I'd like to open up 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 is available to address any questions as well.

Brian?.

Thank you. [Operator Instructions] Our first question comes from the line of Tim Savageaux from Northland Capital. Your line is now open..

HI, there. Good afternoon. And congrats on the strong results. I guess my question was on fiber optic tests, I think you mentioned growth year-over-year above 70%. And it looks like I guess that might have grown pretty nicely on a sequential basis as well. I wonder if you could sort of speak to that.

And also maybe comment on kind of your view of the sort of stage we are in that certain your particular growth cycle and whether that type of growth is sustainable or what sort of growth rates that you do think might be sustainable driven -- I would guess continued to be driven by cloud operators, silicon photonics and those type of drivers. Thanks..

Well, Tim. This is Scott. I'll start and I'm going to let Brian jump in there. He certainly lives this day in and day out. But I mentioned on the Q4 call, I think it might have been with you, I don't remember. But, on the comp test side, we're looking at kind of 15% to 20% range in those products that are serving the silicon photonics initiative.

On the structural test side, I believe I mentioned before is a larger growth percentage because it's starting with a smaller number, but we see substantial larger growth than the contest side on that and we look forward that to continue with the rolling out and gaining traction of the 6100 is getting with the multi -- multi-channel has got a lot of traction and we are continuing to see a lot of energy in this silicon photonics initiative.

So I'll let Brian, if you want to add to that..

Yes. Tim, this is Brian.

That answers your question or can I give you more color on that?.

Well, I mean I guess I'll just go for that. I think last quarter you talked you may have given an order metric as well with regard. And may we can kind of define our terms sort of segment wise and we're talking about fiber optic tests. But I think you talked about revenue growth there kind of in the 27% range.

This looks like to be acceleration, I'm just wondering interested to know if I am looking at it on an apples-to-apples basis when we talk about comp test versus fiber optic test and whether you have any commentary on the order bookings as well..

Yes. Okay. So on a year-over-year basis, the 74% broke down that's the fiber optic test.

So the whole product portfolio which includes comm test and our Odyssey product revenues both of those segments as we sort of break them down into those two buckets communications test driven primarily by silicon photonics and structural test and Odyssey revenues driven by new material types.

Both of those buckets show pretty healthy growth on a year-over-year basis. And the larger number going forward, we believe is going to be in the structural Test side and Odyssey revenues but that's got a smaller basis.

For the numbers in Q1, the communication test side actually grew a little bit more healthy and that reflects the same thing we saw in Q4. So we're in a bit of an accelerated timeframe here for those revenues.

I don't believe those rates will be sustainable, but I believe Scott mentioned on the last call that we do think 15% to 20% range is reasonable and that's what we've been basing our plan on..

Yes. And Tim, when we say comm test and I said this before, and I worry about repeating myself kind of in the script this year. But, on the comp test, we really look at it, two primary products is the OVA, the optical vector analyzer that test kind of inside the component and our Optical Backscatter Reflectometer that's testing across the network.

So that's really how we look at that. We talk about silicon photonics as being the growth vehicle that's driving increased sales in those two products. But those two products and any hybrid thereof we call comm test kind of your telco if you will.

And then, when we talk about structural test is where we get into different versions of the Odyssey itself measuring the strain and the temperature across the -- say the composites..

Okay. Fair enough. I'm just at least the way given you're right the Odyssey numbers and I think the commentary you made about the eight system shipping at 100 KSP and the seven new orders that was obviously correct..

Specifically Odyssey 6100, the unit that we released in December..

All right. Well, but even looking at that overall performance off a relatively small base, it does seem like the comm test part of the business is growing substantially ahead of kind of your sort of baseline growth estimate. I'm wondering if there is a reason to believe that that should slow heading forward.

Is there some conservatism here or how are you looking at kind of the Q1 growth rate you've seen their relative to your kind of normalized growth estimate?.

Yes. Right now we are seeing more aggressive than what we were giving. We gave -- we talked about 15% to 20% on an annual basis and we're seeing a lot more activity than that.

Whether that continues, I mean we are out in front of a lot of folks seeing a lot of traction, but I don’t know if we are ready to change off the 15% to 20% annually that we've got to. But what we are seeing a lot more activity..

Great. And then, let me follow up on gross margins which came in at least a little better than I was expecting. I wonder if you could talk about whether there were mixed factors at work there or what were there kind of moving parts that are driving gross margins solidly above 40%..

Yes. Some of that is mixed in because as we look at how much of the growth was driven by the instrument sales now those are our highest margin business. And so I think that that product mix created a little bit of a shift for us..

Okay. Thanks very much..

Thank you..

And our next question comes from the line of [indiscernible]. Your line is open..

Yes. Good afternoon. We've taken a position of stock since the first of the year and got pretty substantial, but I like what you're doing. I think you've turned this around completely. You did mention in your release that you might do some pull down acquisitions.

It does look from listening to your previous calls and looking to your previous filings that you are willing to horse trade. In other words, you might sell one division and buy something and it falls in better. All those things make sense.

But, and correct me if I'm wrong on any of that, but what I have learned over the years is that the one business that you know best is, your business and with the amount of cash on the balance sheet returning some cash to shareholders by buying back more stock who would seem to be a very good use for some of the cash because if we want a money market fund we can put money in the money market fund.

So, I don't want you to just buy something because you want to put the cash to work. Why not concentrate on buying back some of the shares at these prices because you certainly know your business best..

Yes. Well, I certainly agree that cash in the bank is non-accretive. So we are looking at opportunities -- we took a very deliberate approach for this. We sat back and said from an organic standpoint what do we need to do.

We looked at Lightwave and we set up a very lean forward budget for 2018 in deploying some of that in some investments that internally that we just needed to do and in the way of more marketing sales, some more engineering specifically at Lightwave, we saw some opportunities to invest some money at our Terahertz division and we've done that.

And only until then could we step back and look at the where the holes were, what could we add through acquisition to have this company grow faster and we are looking at those.

And we are just doing it in a very deliberate state, but I can tell you we are very active in looking at getting things that fit under what we're calling the test and measurement umbrella. We have these two verticals and we're looking at things that fit within those two verticals to really make the story very clean and grow faster..

No. I fully understand and I would encourage you to do some of that and the test and measurement section certainly has a nice high profit margins and certainly would fit in with your current platform. So I don't reject any of that but you have $30 million, so if you invest in and invest in a little bit in buying back stock, I think you're own shares.

I think that makes sense. All shareholders benefit..

Yes. I think we're going through a process right now of looking at things and I think everything's on the table. But I mean we are going through a process and the first process was get the house in order with -- from an organic perspective and I think you're seeing that.

And we're also then looking at it from an inorganic position of how do we -- how do we grow this faster. We're just trying to increase the value to shareholders. Like I believe we've done over the last kind of six months in what we've done for shareholders and want to continue driving that forward. And we'll look at all options.

So I certainly understand where you're coming from Lenny and I can tell you that we are looking at all options..

Okay. Well I'm not telling you not to do the other things and I'm certainly would not want to do anything other than being very deliberate about the acquisition. And so I have not opposed any of that. But as you know, so that you can do different things, you have an awful a lot of cash. So….

Yes. Thank you..

And our next question comes from the line of Randy Knudson, Private Investor. Your line is now open..

Good afternoon. On the last conference call you talked about Odyssey coming or you're hopeful that it might be recognized as the industry standard for composites or in composite testing and maybe I misunderstood that. So has there been any -- how do you achieve that.

I guess is the first question, are you and where are we in terms of being recognized as the industry standard for testing composite products..

Yes. I'm going to let Brian answer that. I know I will say that it is top of our priority list. We believe it is important and we are going down that path and doing everything we can. I will say you're dealing with some bureaucratic organizations and there is a process involved in going through that.

I'll let Brian who is very involved in this talk a little bit more..

Yes, sure. Hi, Randy. I thin there are standard bodies that deliver essentially confirmed documentation with regards to what would be considered a standard and test for materials -- all different types of materials.

And we've identified two standards bodies that we believe the most relevant to our Odyssey products and using fiber optics to measure composite materials. And we have over the last year engaged with those committees -- at the committee level with those bodies.

And we are now members of at the committee level teams that are working on new standards and the partnership between the standards body and other corporate entities in Luna to develop standards over the course of time that would include our technology.

You have to be careful with this, as Scott mentioned that they are fairly bureaucratic organizations, so it can take some time. But over the last year we have gotten engaged with what we believe to be the right folks in the right standard bodies and over the next 18 months or so I think we'll see some real progress..

Let me ask a follow up question if I could.

In terms of competition without naming competition, is there significant competition in this market, are you the only -- are we the only people that's really doing this kind of testing?.

That’s a good question. The competition that we have in this market is really other types of measurement technology..

Okay..

So whether these electrical strain gauges or thermocouples or stand offs temperature detection using a flare type instrument. So there's competition -- a lot of competition from other technologies.

We bring some very specific benefits to these types of measurements and there's not a lot of direct head-to-head competition with the way we make these measurements using fiber optics. There certainly are other fiber optics techniques on the market. They'll have different benefits they bring.

Ours is pretty unique though in terms of the combination of resolution and accuracy that we can achieve. So I hope that answers the question..

No. It did.

And one of the technologies that I've seen and in fact I think in Ann Arbor, aren’t they using Terahertz to evaluate airplane -- various parts of airplane holes or in various modalities, isn't Terahertz being used?.

Yes. Our Terahertz technologies used to measure layered thickness and quality of coatings for different types of aerospace and many other applications actually. It's not an apples-to-apples to exactly what we're measuring with fiber optics but you can think of them as complimentary..

Randy, if you were ever out in the Ann Arbor area, it's a very disruptive technology. I'd welcome you to come in and meet the folks out there and see it firsthand..

I appreciate that.

And what's the thoughts in terms of when -- how long are they going to stay in the current facility or are the plans to move outer?.

Yes. Our lease -- like I talked before our lease is through the end of this year. It is not ideal space. We're within -- we're kind of where we were mixed in with the [Maycomb] [ph] facility as well. So we're evaluating that right now looking at where we go from here. But that is a kind of a mid-year decision point as far as where we're going..

Yes. Great.

In terms of Terahertz, are there any new value added resellers, I was really been impressed with some of the press releases where we can see, I think five significant value added resellers selling in different aspects of using Terahertz in various whether it's plastic paper, whatever but are there other --are there new value added resellers on the horizon.

Are there new markets in that area?.

Well, we are active in that and the guys out there and the folks out there have done a nice job, Margaret and Earl and John and Steve in signing up some additional VARs and some additional distributors and some reps. So I don't have them the names of them at my fingertips right now.

But that is an active approach and you're dead on with when you get into a specific market many times it requires a specific VAR or a specific rep that knows that business it’s not just saying. Let me just broad stroke Terahertz technology out here. It's where we're going after and who has those contacts.

So we are active in that and I can follow up with you with the names. I just don't know right now..

Well, I appreciate that and overall just really impressed with what you gentlemen have done and so thank you for answering my questions..

Thanks Randy..

Our next question comes from the line of Charles Noll, Private Investor. Your line is now open..

Thank you. On this Odyssey's assist to mid-term, as I understand it measures cumulative stress on the composite. And the Terahertz, when I was talking to them, when I was up there they said they could detect delamination in the middle of composites not just applications of the thickness to begin with an added coat.

So it seems like they would be complimentary. First of all, thanks for the last six months. Keep it up. It's great. I don't understand everything you're doing and that's fine. Hope to be there next week.

One other things that I remember talking to [indiscernible] about several years ago was that they -- somehow Luna was involved in something in Israel where they laid a fiber optic and maybe with the Terahertz pulse but they were able to detect the tunnels -- the subterranean tunnels in the Gaza Strip.

And if that's true is anything being done toward our wall with this technology..

Yes.

I don't believe that we are doing anything -- you are talking about the Trump Wall?.

Yes, yes. That's where the money is going to be..

Yes, yes. Exactly. Well, we certainly could benefit and offer them benefits to that as well. But I'm not aware that we are contracted with them right now..

Okay. Is that something that we should be looking at, I know some people on..

Yes. We should look at everything and if you want to have a separate call, we can include Steve or Margaret or Earl and John and we include anyone that we want to on that call to think about that. That makes sense..

Okay, great. All right. That sounds like you answered it. Thanks..

Thanks Charles..

[Operator Instructions] Our next question comes from the line of Tim Savageaux from Northland Capital. Your line is now open..

Hi, there.

I wanted to follow up and see if you had any commentary on trends going kind of the [outward] [ph] solutions or custom optical side, it looks that might have been down a little bit on a year-over-year basis, I’m wondering if you're seeing seasonality there, if you can talk to whether you continue to expect to see kind of relative stability out of that group? Thanks..

Yes. They continue to deliver internally what we've set them for goals. It is a smaller piece of the overall pie and that's something that we've talked a lot about, but they have a tremendous backlog so they know their business going forward.

I think they were probably flat year-over-year somewhere a little bit down maybe, but it was -- they continue to chug along out there. And it's a very nice business that we just didn't talk about a lot, but they will continue I think they'll probably do for this year somewhere in the 5% to 10% growth – 7% to 10% growth year-over-year.

So it's a continuing business. It's not a large piece of our business but they do nice work out there..

Great. Thank you very much..

Thanks Tim..

[Operator Instructions] And I'm showing no further questions. I would now like to turn the call back to Scott Graeff, Chief Executive Officer of Luna Innovations for any further remarks..

Yes. Thanks Brian. Thank you everyone for joining us today. As you've heard on the call, we had a strong start to the year in our Q1 results and we believe we will carry this momentum for growth throughout 2018.

I would like to remind everyone that we'll be holding our annual stockholders meeting in Roanoke next Tuesday, May 15 at the Hotel Roanoke with breakfast starting around 8:30 and the meeting kicking off at 9:00. I invite you all to join me an expanded executive team and the Board Directors in person. This completes today's call..

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