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Executives

Dr. Ken Murphy – Chief Executive Officer

Dale Messick – Chief Financial Officer

Analysts

[Collin Bullock – Bank Equity]

Luna Innovations Incorporated (LUNA) Q1 2009 Earnings Call May 13, 2009 11:00 AM ET

Operator

Good morning. My name is Landon Barretto and I'll be the moderator for today's presentation which is being recorded and will accessible following this call for 30 days on the Luna Innovations website at www.lunainnovations.com. Please go to the webcasts and presentations portion of the website.

Thank you for your interest in Luna Innovations. With me today are Dr. Kent Murphy, the CEO of the company, Dale Messick, the Chief Financial Officer and Scott Graeff, Chief Operating Officer. Dr. Murphy, Mr. Messick and Mr. Graeff are going to discuss the company's financial results for the first quarter ended March 31, 2009. At the conclusion of the prepared remarks, we'll open the conference for questions.

In compliance with SEC requirements, I must read the following statement. Except for historical information, the matters discussed in the conference call are forward-looking statements that are subject to certain risks and uncertainties that could cause actual results to differ materially from those set forth in the forward-looking statements.

The factors that could cause results to differ materially are included in the company's filings with the Securities and Exchange Commission. Forward-looking statements made during today's call are only made as of the date of this conference call and the company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

Gentlemen, please proceed.

Dr. Ken Murphy

Thanks to all of you for joining us today for a review of our first quarter 2009. As on our previous calls, I will use this opportunity to put our results in the context of where we are in the execution of our growth strategy, and I will also talk about a recent development surrounding our litigation.

Dale will review our results in more quantitative terms after which we'll welcome any questions you may have.

To begin, I first need to update you as to where we are with our legal proceedings in the Hansen case. Results from the trial had a very significant impact on our financial statements for the quarter as you have probably seen by now, and Dale will walk through that in just a moment.

We are highly disappointed with the decision of the jury, and now we are directing all efforts towards opportunities to reduce the loss exposure while continuing to move the company forward.

To give you a brief background on the matter, a law suite with Hansen was filed against Luna approximately two years ago related to an $84,000 feasibility study we did with Hansen in 2006 and early 2007. In June 2007, we announced that we had entered into an intellectual property licensing development and supply agreement with Intuitive Surgical, the global technology leader in robotic assistant minimally invasive surgery.

Under the terms of the multi-year agreement, Luna was to develop and supply its fiber optic shape sensing and position tracking system for integration into Intuitive Surgical products. About a week later, Hansen sued Luna, alleging breach of contract and misappropriation of trade secrets and fraud.

The trial which occurred in the Supreme Court of the State of California County of Santa Clara was long and technically complicated. After four weeks worth of testimony from both parties, the jury found in favor of Hansen, alleging we breached our contract by not providing Hansen the right of first opportunity to our technology and that we had misappropriated trade secrets belonging to Hansen.

The jury award is approximately $36 million in damages to Hansen. That includes $26 million of lost profits based on Hansen's estimates of additional sales they would have realized in a deal with us. It also includes $10 million in unjust enrichment to Luna which represents our potential profits from our agreement with Intuitive.

In our industry, confidential, technical information is our lifeblood and we strive to preserve the integrity of that information whether it's ours or someone else's. Over the years we've worked with highly confidential information for military, government, industrial and university clients.

I do not believe that there is anything in our work related to Hansen that we learned and then applied to other work we are doing for intuitive or any other partner, and I believe that we did offer Hansen the first opportunity in accordance with our 2006 contract.

However, as you know, the jury decided otherwise. The verdict and recovery of damages is subject to customary post trial motions and potential appeals and Hansen will likely seek further equitable relief. We will continue to pursue the avenues available to us to reduce damages awarded.

The damages amount as it stands is obviously significant to Luna. We are working aggressively on post trial motions and the potential to appeal the verdict so we can reach a resolution that allows us to continue to do the great work we've been doing.

The next steps in this process are, in the immediate future there will be several motions filed by both Hansen and Luna. Hansen is seeking to increase the award and Luna is seeking to decrease it. Depending upon how these motions pay out and depending upon the ultimate verdict that is entered by the judge, we may decide to appeal the courts decision.

Again, Hansen may seek further equitable relief. The motions of both parties are expected to be decided over the coming weeks. If we are to appeal, it could be 18 months before that is decided.

Luna as a company is committed to continuing operating our ordinary course of business as the various legal activities take their path. In the last earnings call we talked about our expectation to be adjusted EBITDA positive in the second half of this year and cash flow positive by the fourth quarter.

These statements were predicated by the litigation being behind us. Now, with these next steps we must take in the legal process, those goals may not be attainable in the second half of this year and we anticipate pushing these milestones to 2010.

With that update on the legal front, I will turn to more of the business update. In sensing instrumentation, we continue to produce world class products. In March we participated in the premier U.S. conference for optical fiber solutions, the Optical Fiber Communications Conference and Exposition and the National Fiber Optics Engineering Conference just held in San Diego.

At that show, we launched a third product in our Phoenix web tunable laser family. The new PHOENIX 1200 model with picometer accuracy has the industries first integrated wave meter. This last provides precision and accuracy required for the most challenging applications such as fiber optic test systems, inertial navigation systems, laser ranging, spectroscopy and distributed sensing for the stress and strain measurement.

We also demonstrated fiber optics skew measurement capability with our optical Backscatter Reflectometer combined with our scalable optical switch and software with enables our customers to reduce manufacturing costs and increase performance.

Our shape sensing platform development continues to improve accuracy, speed and precision while lowering costs, thereby increasing the potential markets where we may be able to deploy this unique capability in markets such as non robotic medical, energy production, defense and aviation.

Revenues and bookings for the products division were down just slightly from the same quarter in 2008 with bookings at $5.6 million, revenue at $6.9 million.

In nanomedicines and pharmaceuticals, efforts we demonstrated in Vitro our Trimetasphere based contrast agent, can possibly be used to target arterial plaque which could lead to improved diagnosis and treatment of coronary artery and other diseases.

We continue our verification of nanomaterials based contrast candidates by third parties and on the therapeutics front, we had several conference presentations including one from our partners at Virginia Commonwealth University at the annual meeting of the American Association of Immunologists which we showed data revealing that our compound block and also prevent airway constriction.

Next month we are an invited speaker at the Congress of the European Academy of Allergology and Clinical Immunology in Warsaw, Poland.

In our technology development division, revenues grew by 4% compared to the first quarter of 2008 and our contract backlog remains strong at $26.4 million. The growth within this segment of our company reflects continued strong success in obtaining research contracts and increasing in the size of certain awards, and the addition of direct contract personnel.

Achievements this quarter include the demonstration of a new approach of enhancing organic photovoltaic device performance using our exclusive carbon atom materials called Trimetaspheres.

Our carbon nanomaterials are independently verified at the U.S. Department of Energy's National Renewable Energy lab. This research has been recognized in public in prestigious journals, nature materials. We are now collaborating with multiple solar cell manufacturers for testing and evaluation of our proprietary nanomaterial technology.

Now I'll turn the call over to Dale who will discuss our finances.

Dale Messick

As you've heard, our financial results for the first quarter of 2009 were primarily driven by the charges we took with respect to the jury verdict in our litigation with Hansen Medical. I'll take a few minutes to step through the various impacts on the financial statements and then go back and provide an overview of the normal operating results other than the jury verdict for the quarter.

Of course the largest single impact on the income statement was to accrue the amount of the jury verdict itself which you will see separated out on the income statement in the amount of $36.3 million. This amount has the potential to be adjusted up or down by the court when the verdict is ultimately entered following the post trial motions, but the amount awarded by the jury is the best estimate we have today as a basis for accrual.

It shows up in our operating expenses on the income statement and current liabilities on our balance sheet. Should the courts alter the amount up or down, those changes would flow through our income statement as well in future periods.

With an expense of this magnitude being recorded, we needed to then also consider the possibility of impairment of the goodwill and other intangible assets within the product and license segment of our business.

We performed the analysis required by FAS 142 and 144 and concluded that those assets are impaired based upon the effect of the jury verdict on our expected future cash flows, and accordingly took an impairment charge in the amount of $1.3 million to write off the carrying value of those assets.

Lastly, the company had previously maintained a net deferred tax asset of $600,000 relating to our estimated ability to utilize our net operating loss carried forwards in future years. As a result of the litigation and potential impact on our operating results, we concluded that it was no longer more likely than not that we would realize the value of the deferred tax asset in the near future, and therefore recorded an additional valuation allowance reserve which is reflected as income tax expense in the first quarter results. Both the impairment of intangible assets and the income tax expense are non cash charges.

So just to summarize the impact on the income statement, we recorded a total of $38.2 million resulting from the Hansen litigation consisting of $36.3 million related to the jury verdict, $1.3 million related to impairment of intangibles and $0.6 million related to the deferred tax asset.

Before I go through the remainder of the income statement, there's one more impact to discuss and that's over on the balance sheet. With an accrual of this magnitude now on our current liabilities, we fall out of compliance with some of the covenants on our debt facility with Silicon Valley Bank.

While they have not yet done so, the bank does have the ability to call some or all of the outstanding debt currently and therefore we have characterized the outstanding balance of $4.6 million under that facility as a current liability.

Those are the various impacts related to the Hansen litigation on this quarter's financials. Circling back to the income statement, now I'll touch on some of the highlights of the normal business activities.

Revenues of $8.5 million in the first quarter of this year were down nearly 5% compared to the first quarter of last year. Technology development revenues increased year over year by 4% while product and license revenues declined year over year.

We had expected to see that decline based upon the slowdown in the economy at the end of last year and its impact on the backlog of product sales that we carried into 2009 versus what we carried into 2008.

As we said on the last earnings call, during the first quarter of this year, actual new bookings levels at that time were on par with the levels we had in 2008 and the quarter did finish up that way as well with total new orders in this segment just slightly ahead of the orders we received in the first quarter of 2008. Thus far in Q2, the new orders are not trending as close to last year, but do appear to be trending toward an increase in this segment over Q1.

From a gross profit perspective, we realized $2.7 million in the first quarter of 2009 compared to $3.3 million in the first quarter of 2008. Of course the lower revenue was a major component of that decrease year over year and in addition, an increase in the overhead allocate able to our technology development contracts resulted in a lower margin for the quarter.

SG&A expenses declined 6% year over year due to the various cost savings initiatives we implemented in the fourth quarter of last year as well as Q1 of this year. Within our SG&A expenses of $4.2 million was approximately $900,000 recognized in legal fees related to the litigation.

R&D costs increased primarily in the areas related to engineering of enhancements to our fiber optics platform and we've already talked about the other two operating expense items; namely the litigation reserve and the impairment charge.

With those revenues and expenses, we incurred a net loss of $40.9 million or $3.66 per share. Again, with approximately $38.2 million of that coming from the charges we recorded driven by the litigation.

With respect to our balance sheet and cash flow, we ended the quarter with $13.2 million in cash, a decrease of $2.3 million from year end. This rate of usage is considerably larger than the $1 million or less net usage that we had been running in previous quarters and it is primarily a timing difference.

You may recall that in the fourth quarter of 2008, we actually had a small net cash increase. However at year end, we had accumulated a significant amount of outstanding payables related to our legal fees and caught up on those payments prior to going into trial. That timing difference resulted in approximately $900,000 of additional cash usage in the first quarter of this year.

Our other current asset balances remain fairly consistent at quarter end compared to last year end. In our long term assets, we have a decline in the carrying value of intangible assets due to the impairment charge I spoke of earlier and the reduction of net deferred tax asset that I also mentioned.

Looking at the current liabilities which increased from $11.1 million at year end to $50.6 million at March 31, we have the full $4.6 million outstanding balance of our term loan reflected here as well as a $35.5 million increase in accrued liabilities driven of course by the litigation reserve added in the amount of $33.6 million.

Our long term debt decreased due to the reclassification of the Silicon Valley term debt. With recognition of a $40.9 million loss, our stockholders equity has turned to a net deficit of $25.8 million.

Looking forward to Q2, we currently believe our revenues will grow to a range of $9 million to $9.5 million, but because of the uncertainly in our ongoing operating expenses related to the various litigation matters, we'll not be providing guidance at this time with respect to our expected net results.

And with that, I'll turn the call back over to Kent.

Kent Murphy

As we continue to evaluate the situation at hand with our legal team, we're filing post trial motions. We expect more legal activity on both sides of the issue before the judge makes the final determination. We do believe there exists several valid legal basis for challenging the amount of the damages awarded.

As we work through our legal options, it is important to reiterate that Luna is a widely diversified company, working in many areas unrelated to this case. We have an excellent record for award winning technology, support and service with government, industrial and university partners.

For almost two decades, Luna has been inventing and developing fiber optic sensing technologies with a focus on moving them to commercialization. This proven track record has been established by building trusting business relationships with industrial, academic and government entities leading to numerous joint development partnerships, licensing agreements and our Luna branded product development in many different industries.

We're a company that others have been seeking out for technology innovation. In the past, a significant and growing portion of our business has been product development in partnership with industry leaders. The company continues to make progress towards new opportunities for partnering in solar and wind energy generation, non robotic medical devices, pharmaceuticals and defense solutions.

What we currently have is a complicated case and though we have not been down this road previously, we are prepared to address it. We believe in the strength of our employees and the technology assets that we have. I'm pleased with the accomplishments we have made over the years.

One other accomplishment that I would like to point out to you, one that has been overshadowed by the litigation impacts on us, is the improvements we've made in reducing our operating costs, increasing efficiencies while continuing to grow our business.

Our current level of operating expenses excluding the charges Dale spoke about as a result of the litigation verdict, were approximately $5.2 million, the same as they were two years ago in the first quarter of 2007. If we take out the $900,000 that we expenses for legal fees last quarter, that weren't incurred two years ago, our real base line of expenses decreased to approximately $4.3 million, about a 17% reduction from 2007 while our revenues continue to grow.

We're now prepared to answer any questions that you have and we'll do our best to answer them to the best of our ability in the current legal situation and the unknowns related to this case.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [Collin Bullock – Bankequity]

[Collin Bullock – Bankequity]

I wondered if you could elaborate on any kind of strategic options that you're evaluating with regard to Hansen and maybe how we should view the relationship going forward.

Kent Murphy

I'm not sure we can answer that question in light of the activities that are going on right now.

[Collin Bullock – Bankequity]

With regard to progress in the nanotech areas, could you walk us through some milestones that investors could look to during the second half of the year, i.e. hair growth and solar cells?

Kent Murphy

We are currently testing the hair growth compounds in two different mouse models. We've proven it in two past mouse models and we're working on two different ones from those two. Those results will most likely be in sometime in the middle to later part of this year, and on the contract agents, we're continuing to make progress on targeted agents and hopefully we'll continue to move that forward with possible outside partnerships we're discussing now.

Operator

There are no other questions at this time. I would like to hand the call to Kent Murphy for closing remarks.

Kent Murphy

Thank you all for your participation. We look forward to talking with you on our next earnings call.

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