Scott Graeff - President, CEO & Director Dale Messick - CFO Brian Soller - VP & GM, Lightwave Division.

Barry Sine - Dawson James Securities Chris Sakai - Singular Research.

Good day, ladies and gentlemen, and welcome to the Third Quarter 2018 Luna Innovations Incorporated 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 be given at that time. [Operator Instructions]. As a reminder, this call is being recorded.

I would now like to turn the call over to the Luna team..

Good morning, and thank you for joining us today. This morning we issued our third quarter earnings press release. In addition, we posted to the Investor Relations section of our website a presentation with supplemental information on our third quarter fiscal 2018 results.

If you do not have a copy of the release or the supplemental materials, please check our website at lunainc.com. We will also post a replay of this call to our website. Some of our comments and discussions today are based on non-GAAP measures, specifically adjusted EBITDA.

Our non-GAAP or adjusted numbers exclude the effect of certain non-cash expenses and items. The non-GAAP results are a supplement to the GAAP financial statement. Luna believes this non-GAAP presentation and the exclusion of these items is useful in order to focus on what we deem to be a more reliable indicator of ongoing operating performance.

Before we proceed with our presentation today, let us remind you that statements made on this conference call as well as in our public filings, releases and websites, which are not historical facts, may be forward-looking statements that involve risk and uncertainties and are subject to changes at any time, including, but not limited to, statements about our expectations regarding future operating results or the ongoing prospects of the company.

Actual results may differ materially as a result of a variety of factors. 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.

We disclaim any obligation to update any such factors or to announce publicly the results of any revisions to any of these forward-looking statements to reflect future events or developments except as required by law.

After our prepared remarks this morning, Scott Graeff, our CEO; Dale Messick, our Chief Financial Officer; and Brian Soller, General Manager of our Lightwave Division, will be available to take your questions. And at this time, I'd like to turn the call over to Scott Graeff, President and CEO of Luna Innovations..

Good morning, everyone. Thanks for joining our call this morning. We have a few things discussed today including very strong results for the third quarter and a further discussion of the acquisition of Micron Optics that we announced several weeks ago.

Also, because we're close to the end of our fiscal year and we've had several recent transactions, we'd like to cover briefly some of our expectations for the duration of 2018. With all of this to discuss, our call maybe a bit longer this morning.

As I review the specifics, I hope you will see that we continue to accelerate the progress of executing our strategy to drive robust growth through a focus on our core fiber optic-based capabilities.

The third quarter of 2018 marks the fourth consecutive quarter of double-digit growth in our revenues from continuing operations and the sixth quarter of very strong revenue growth. In the quarter, we achieved growth of 29% in revenue and over 40% in gross profit versus the same quarter last year.

I'm am very proud of all the members of the Luna team, who worked to deliver these terrific results. And I'm excited about our progress as we see this performance as a validation that our strategy is working and that our target markets are rich with opportunity for continued growth. We've capitalized on the advancement of optical-based technologies.

And as I've mentioned before, our products and capabilities fit squarely into the sweet spot of this growth.

We feel we are well positioned to continue to benefit from trends, such as higher demand for higher bandwidth in data communications and data centers, and the growing use of composites and other advanced materials in the automotive and aerospace sectors.

We maintain a strong balance sheet with financial flexibility and still have good liquidity following the acquisition of Micron Optics, which we paid cash.

We are continuing to invest internally, both in the R&D necessary to advance our technologies offerings and in the sales and marketing resources necessary to create exposure for and awareness of our capabilities and products.

I'm pleased to say that the existing businesses continue to perform well with strong top line growth evidence that we're getting a return from some of these internal investments we've already made.

In addition, we will continue to be interested in further M&A investments that fits squarely within our strategy and which we believe would accelerate our performance in our two important market verticals, communications test and structural test based on optical sensing.

We drove revenue growth of 29% in the quarter and 27% for the first three quarters of 2018 versus the comparable year-ago periods. Gross profit margin grew from 40% to 44% in both the third quarter and the first nine months of fiscal 2018.

Revenues from our Technology Development segment grew 16% in the quarter and revenues from our Products and Licensing segment, which includes Lightwave and Odyssey grew a robust 45%. As a reminder, in addition to Odyssey, Lightwave includes our instruments for testing fiber optic components and networks used for high speed communications.

These products target the growing demand for bandwidth, fueling the development of silicon photonics and the building of more and more data centers. Our Odyssey instruments measure structural health and integrity of components and structures.

Before handing over to Dale, I'd like to highlight the progress and status of the various business divisions at Luna, as well as review the acquisition we announced last month. Starting with Lightwave, here are some of the highlights for the quarter. Total Lightwave revenues were up 22% year-over-year.

Revenues in the sensing part of Lightwave were up 18% year-over-year with 12 Odyssey units shipped during the quarter. Revenues in the communications test part of our business were up 26% year-over-year. We continue to make progress in our two key growth verticals.

In our sensing vertical, lightweighting and electrification of vehicles remains a strong driver for the technology in the aerospace and automotive markets.

In order to further penetrate these markets, we have continued to invest in the Odyssey platform and in Q3, we introduced multiple new features that improve its overall performance and ease of use, which has been well received by our customer base.

This allows us to infiltrate core markets and this quarter we delivered multiple units to Top tier automotive manufacturers and research institutions for design validation of next-generation designs.

In our communications test vertical, development of optical functionality in silicon continues to be a primary growth driver to sales of our OVA and OVR products. In Q3, this trend continued with multiple sales into our silicon photonics applications. Growth was also enhanced by strengthening sales into other applications as well.

Reversing the decline we saw last quarter, in Q3, we experienced strong sales of our comps test products in North America to our base of government funded laboratories such as Lawrence Livermore, Los Alamos National Lab and Sandia Natural Lab.

New sales of our OVR product to these entities were strong in Q3 based on common applications requiring very precise measurement of the length of optical fiber links used in high energy physics research. Our OVR products provide very precise length measurements of fiber links with capability far beyond that of any other product on the market.

Our Terahertz division is continuing the strong momentum built in Q1 and Q2 with a 55% increase in products revenue in Q3 year-over-year. We continued with our strategy of enhancing market presence and sales channel expansion with the addition of two new value-added resellers.

These additions accelerated our sales and marketing efforts to deliver innovative Terahertz products into new process control market opportunities in Korea and Taiwan. In the third quarter, we successfully deployed the higher performing Terahertz gauge developed in Q2 into new process control and non-destructive testing applications.

This new gauge will meet the demand for measurement of thinner and buried layers. These more demanding process control and non-destructive testing applications are driving demand for accurate process control with high repeatability at a continuously growing rate.

Additionally, we continue to improve our operating efficiencies to effectively balance the daily deliverables and growth opportunities our expanded sales channels demand. As a reminder, our Technology Development segment complements the business drivers in our Product and Licensing segment.

Here we create and develop new technologies and products that can generate future revenue growth. The work is funded by government contracts, which support not only the research, but the full operations, including management and business development. This segment grew 16% for the quarter on a year-over-year basis.

And as we've discussed, we approached the work in this segment with an eye not just on contracts, but towards commercialization. A great example of this is in the third quarter.

Luna shipped over 150 aircraft corrosion sensors, amounting to over $600,000 to complete a deployment at 10 air force bases around the world to study the effect of corrosion and maintenance cycles. Although this revenue is reflected in our product line, the development of these sensors began with two Phase 1 SBIR projects.

And we see many other similar opportunities in the future. In summary, we made great progress in the first three quarters of 2018. And I continue to be excited about the expanding opportunities that our products target in the test and measurement market.

We believe we have the right strategy in place and certainly we are seeing the results of that performance. More importantly, I'd like to thank our employees for their hard work and achievements delivering this record third quarter. I know that they remain committed and focused on driving future results. Now let's switch gears.

I'd like to quickly review some of the highlights of the acquisition of Micron Optics announced a couple weeks ago. You might remember that Luna acquired Micron for $5 million in cash and Micron had 2017 sales of $8 million. This 30-year old company with a corporate culture very similar to Luna's is based in Atlanta, Georgia.

The company sells products and sensing solutions, filters and lasers with a significant piece of the revenue driven by sales of its fiber optic sensing instrumentation, which is very complementary to our Odyssey product and fits right into our structural test vertical. Like Luna, Micron sells into Aerospace and Defense, Industrial and Medical.

But the acquisition also brings exposure to the oil and gas and civil engineering [Technical Difficulty] giving Luna the opportunity to cross-sell quickly into markets in which it previously did not have a significant exposure. Both companies offer product suites that combine an instrument and fiber optic sensor for measurement.

And both companies are also driven by the continuing trends driving demand for higher bandwidth. The engineering teams at Micron in Lightwave Division of Luna already have a strong understanding of one another's existing products and programs, allowing for speedy integration.

The combined products and capabilities will allow us to offer solutions containing a full suite of products to measure structures and processes on both a continuous basis and the point-basis depending on the application.

There are some applications where Micron's products maybe more cost-effective or easier to install, making our solutions better for a wider range of customers.

The combination will also open up new markets for both Luna and Micron products, including a greater exposure to Europe and Asia and will provide robust opportunities for cross-sell and up-sell.

With solid product management and greater resources, this acquisition will enable Luna's Lightwave Division to penetrate worldwide markets more quickly and therefore expedite the scaling towards which the division has been working.

And as we discussed during the announcement, we believe Micron is a perfect strategic acquisition with a profile that will allow a seamless and quick integration and which will be fully accretive in 2019 and adjusted EBITDA accretive in Q4 of 2018.

As I've mentioned before, we're very excited about this acquisition and confident this is the right deployment of capital for the right asset. One last item I'll cover, is an outlook for the remainder of the year. As you know, we do not typically give financial guidance.

But because of the proximity to year-end and the various transactions we've done this year, we'd like to provide an outlook range. We are not committing to providing guidance in the future, but we will continue to regularly evaluate which disclosures makes the most sense.

We expect fourth quarter 2018 revenues to be in the range of $12 million to $12.5 million. We expect full-year 2018 revenues to be in the range of $41.5 million to $42 million. This would give us EPS in a range of breakeven to $0.01 per diluted share for the fourth quarter of fiscal 2018.

And for the full fiscal 2018, we would expect EPS in a range of $0.31 to $0.32 per diluted share. With that I will turn the call over to Dale to review the third quarter and year-to-date 2018 financial results in more detail.

Dale?.

Thank you, Scott. Let me first cover the performance for the third quarter and then I'll talk about our year-to-date results.

As a reminder, with the sale of our optoelectronic components business in July of this year, the operating results of that business for both the current year and the comparable period of last year have been reclassified to discontinued operations in our income statement.

Our revenues for the quarter ended September 30, 2018 were $10.7 million compared to revenues of $8.3 million for the same period of the prior year, representing a 29% year-over-year increase.

The increase in revenues year-over-year was comprised of a 45% increase in our Product and Licensing segment along with a 16% increase in our Technology Development segment, continuing the strong revenue growth performance from the first half of the year.

Within the Product and Licensing segment, revenues in our Lightwave Division grew 22% versus the third quarter of last year and Terahertz revenue grew 55%.

Our gross profit realized on those revenues increased to $4.7 million for the quarter compared to $3.3 million for the same quarter of last year, representing a gross margin of 44% in Q3 of 2018, compared to 40% in Q3 of 2017.

The gross margin improvement reflects the changing mix of our revenues with more than 50% of our revenues coming from the Products and Licensing segment in the third quarter of this year compared to 45% in the third quarter of last year, in addition to smaller margin improvements within both of our operating segments.

Operating expenses were $4.1 million or 38% of revenue for the three months ended September 30, 2018, compared to $3.5 million or 42% of revenue for the three months ended September 30, 2017.

The increase in SG&A expenses was due primarily to investing in additional sales professionals and other selling expenses associated with our revenue growth in the Lightwave Division. R&D expenses also grew with investment and development of new products in the Lightwave Division.

These are some of the incremental investments we've discussed making in our business in order to capture some of the growing opportunities in our end markets. As evidenced by the continued top line growth, we are seeing the positive impact these investments can make.

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 $1.3 million for the third quarter of 2018, compared to $0.2 million for the third quarter of 2017.

In terms of income or loss related to discontinued operations, for the third quarter of 2018, we recognized one month of financial results from our divested Opto business.

Amount shown as discontinued operations for the third quarter of 2017 reflect the operations of the Opto business in addition to the operations of the High Speed Optical Receivers Group that we sold in August of last year.

Net income attributable to common stockholders for the three months ended September 30, 2018 was $8.8 million compared to net income of $15.7 million for the three months ended September 30, 2017.

The decline in net income attributable to the common stockholders was primarily due to the gain of $15.1 million recognized on the sale of our High Speed Optical Receivers business during the third quarter of 2017 compared to the gain of $7.6 million recognized on the sale of our optoelectronic business during the third quarter of 2018.

Our revenues for the first nine months of 2018 were $29.4 million compared to revenues of $23.2 million for the same period of the prior year, representing a 27% year-over-year increase. We drove more of that revenue to gross profit, delivering $12.9 million or 44% of revenues in the period, compared to $9.2 million or 40% of revenues in 2017.

Further with our continued focus on expenses, we improved operating income to $454,000 in the first nine months of 2018 from a loss of $1.8 million in the first nine months of last year, despite the increased but very necessary investment in sales, marketing and engineering resources about which we've been talking.

And finally, we improved our income per diluted share from continuing operations to $0.04 in the first nine months of 2018 from a loss of $0.05 per diluted share during the first nine months of 2017. Turning to the balance sheet, we ended the quarter with $47.1 million of cash, up from $33.3 million versus the end of Q2.

We have less than a year remaining term on our outstanding debt with principal balance now down to $1.1 million. Following the sale of the opto business, our working capital increased $11.9 million to $57.5 million at September 30, compared to $45.6 million at the end of the second quarter and $44 million at the end of last year.

So in summary, I'm really pleased that we've consistently driven strong performance through the first three quarters of this year and we look forward to finishing 2018 strongly. And with that, I'll turn the call back over to Scott..

Thank you, Dale. As you can tell, we are very excited about the progress we're making. And at this time, I'd like to open up the call for questions.

Brian Soller, our Vice President and General Manager of our Lightwave Division, which is the fiber optic test and measurement business is with Dale and me at this time and is also available to address your questions..

[Operator Instructions]. Our first question comes from Barry Sine of Dawson James..

First question I want to ask about is on the technology development, obviously very, very strong year-over-year revenue growth, roughly flat on a sequential basis.

Could you remind us and just explain the normal contract process, I know those are mainly Federal government contracts, when do they come in, is that tied to the fiscal year and what should we look at in terms of a seasonality standpoint on that part of the business?.

Yeah, thanks Barry. This is Scott. We have submission periods throughout the year and the process is, you bid on those and when awarded you negotiate a contract, and it starts with the Phase I SBIR if it is an SBIR, and then going on to Phase II and then follow on funding from there.

But they spread throughout the year and at any given time, we have well over -- I guess over 100 contracts that we're working on. So it will spread throughout the year. There's not a lot of seasonality related to that contract..

And then focusing in on the gross margin, very strong improvement this quarter. I'm wondering what the overall potential is, you really growing organically, you're going to be adding the Micron revenue stream in when you report fourth quarter.

What is the potential to expand the gross margin as you amortize your fixed cost over a larger revenue base?.

Well, I think you're seeing the increase in in margin due to more -- more business is coming out of the Lightwave Division. We continue to have strong performance in our Product and Licensing segment. With that now approaching half of the business and half of it being on the contract side, you see that that gross margin to continue to increase.

So the more that we can grow the instrumentation side of our business, which includes Micron and certainly includes Lightwave, you will see that continue to creep..

And speaking of Micron, in the script, you talked about how the engineers on both sides have a thorough understanding now of each other's products.

Could you talk about sales team integration, give us an update what's the combined headcount and are the respective sales teams fully cross-trained or is that still a work in progress on each other's products?.

Hey, Barry, this is Brian. As it relates to the sales and marketing team integration, that process is in full swing right now. It will take some more time.

But the core technologies are so similar and the end uses on market applications are similar enough that we don't expect that the process will take -- really take much longer than the next say quarter or so to get the teams integrated and sort of fully up to speed on both sides of the historical Luna products and the new products that are coming from the line.

So we will expect to start to see the benefit of that here relatively soon, but that process is in full swing and the teams on both sides are really excited about the opportunities that we will have here going into next year..

Yes, Barry, that is ongoing, we want to finish the year strong, we have a Micron team up in our Blacksburg facility. This week, Brian and I will be with the sales team in Europe. Next week, we have a fully integrated kind of all sales global meeting. We want to finish strong in 2018 here [Technical Difficulty] but the integration is well underway..

And Brian, I think you have some experience with that Micron sales and marketing team. So that gives you a head start as well..

Yes, that's right..

Next question, I guess my last question is, if I look at the balance sheet, obviously still a significant amount of cash on the balance sheet even after you adjust for the Micron acquisition, could you update us on your view just for the Micron acquisition, could you update us on your -- the current corporate expense on M&A? Assume you're still looking, update us on what you're looking for from a product standpoint and from a financial standpoint? And then last question on also the uses of cash, any thoughts of things like a buyback or dividend, things like that as uses of cash beyond M&A?.

I mean, I think as I've been saying over sale, we have a very disciplined approach and -- but in finding the right fit. We truly believe in these two market verticals that we have under our test and measurement umbrella and continue to look at that, we certainly like the instrumentation side of the business.

We like the margins that associate with that. So I think we are -- I would say we're continuing to be actively engaged in conversations regarding the M&A business. We also believe that investing organically, what we've put to work so far has certainly we've seen results from. So we'll continue to do that in 2019.

But like I said, actively engaged, sticking with that discipline that we've had in the instrumentation type of market, specifically in the -- either the structural test vertical or the comps test vertical. We continue to talk about stock buyback. We obviously have a plan out there, we're above it.

But we continue to talk about whether that's the right use of the capital as well. So I don't have anything to announce right now, but we continue to talk about it. I'm sorry, Barry, that plan did expire. I thought it was still in place with a bogey that was below where the stock price, but that plan did expire. So we'll continue to talk about that.

It's an agenda item at our Board meetings to talk about whether that's a good use for our capital..

[Operator Instructions]. And next question comes from Chris Sakai of Singular Research..

Just wondering about -- can you shed light on your pipeline for 2019 and beyond?.

Pipeline in the product side of the business?.

Revenues -- yes, products, revenues, do you give guidance there?.

No, we have not put out any guidance for 2019.

I think, as Scott mentioned in his prepared remarks, we have not historically been giving even quarterly guidance and we felt that because of the couple of transactions we've done here recently that it was especially helpful for us to do a little bit here at the end of the year for giving some ideas on how those transactions will impact our baseline.

But we're not yet ready to go out with anything beyond the fourth quarter of this year..

I just was looking at -- I see that you've got in the fourth quarter net income of breakeven to $0.01 per share.

Can you -- what sort of costs are attributable to that as far as what, the lower EPS in Q3?.

Yes, so we'll have in Q4, we did the Micron acquisition and we'll certainly have expenses come through in Q4 associated with completing that transaction in terms of things like professional fees and advisors that we engaged throughout that process..

Yes, so pretty accurate, so you can imagine what comes through when you do an acquisition as it relates to the accounting fees associated with doing an audit of Micron, the banker fees, legal fees, there's a lot of things that will come through that affect that EPS in Q4.

We will certainly provide an adjusted EBITDA number at that time to compensate for that, that's why we called the Micron transaction is certainly adjusted EBITDA accretive in Q4, but we do from a GAAP net income perspective have to recognize all those costs that come through related to those things..

Looks like a good a good quarter and you guys are on the right track..

While not providing guidance in 2019, we continue to see strength in the business. And the Lightwave Division is doing very well and continue to see that in 2019..

Jim, if your telephone is muted please unmute..

Congratulations on a nice quarter. I just want to -- had two questions. Number one, you mentioned the additional process control business coming out of the Terahertz division.

Could you elaborate just a little bit on when you talk about process control, what is it that your customer is actually doing? And then what is that taking the place of, what were they doing before and is there a definitive cost benefit ratio to them?.

The Terahertz system in getting the new gauge out there, it's measuring thickness several layers deep, that's why I talked about embedded layers or several layers down in measuring. Typically, historically ultrasound or using some kind of radioactive technology and we are replacing that with more efficiency and effectiveness.

So but you can imagine anything, whether it be tires or any material that has relevant several layers to it, us being able to measure a layer that is several layers down below the surface is critical for a lot of our customers..

These are multiple material opportunities?.

Yes..

Think about blowing film, plastic packaging kind of applications and how widespread that is and that's a target environment that we're currently pursuing in and getting some success with..

So the last part of that question was the cost benefit analysis ratio, obviously these people have put it through the paces and determined that they want to deploy it, what is the payback to them? Is there such thing as ROI in this area?.

Yes, I think I what they look at is, as you can imagine, if you're, whether it be water bottles, shampoo bottles, a lot of those things they don't want it any thicker than it needs to be, but it needs to be thick enough such to not have leaks and things like that.

So their benefit is to get a precise measurement to have that bottle or that substance specifically thick enough and not too thick. So there is a major return from a customer..

And that would be globally, there's nothing specific about Japan or regulators deployed?.

Yes, remember, this is in real time on a line, so it's embedded into someone's manufacturing line to give real time feedback on that thickness of that specific product..

And then Dale, quick question, ex the payment for the acquisition, would you state again what is the working capital at this point?.

Yes, so the working capital that's we've got right now is as far as $57.5 million -- $57.5 million at September 30. So it's $47.1 million of cash and $69 million of total current assets..

Is that $57 million include the payment to Micron?.

No this was as of September 30..

And so that's, so let's call it a net $52 million after the payment to Micron?.

Yes, right, the pro forma, like $5 million, yeah..

And then remind us on how many shares are outstanding at September 30..

Just under 28 million..

Just under 28 million. So I can't do the math, I don't have a calculator in front of me.

If you have done the math as to how much working capital is represented in the share price?.

Well, it's just below two, right?.

Yes, 1.9..

$1.90 in working capital, okay..

[Operator Instructions]. There are no further questions. I'd like to turn the call back over to Scott Graeff, for any closing remarks..

Okay. Well, thanks everyone for joining us today. As you've heard on the call. We feel very good about the strong year-to-date results our employees delivered. And we believe we will carry that momentum for growth as we close out fiscal 2018.

This completes today's call, please feel free to reach out to us, myself at any time with any questions that you have. Thank you..

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..