(Editors' Note: This article covers a stock trading at less than $1 per share and/or has less than a $100 million market cap. Please be aware of the risks associated with these stocks.)
While glancing through my watchlist a few weeks ago, a small obscure company, Luna Innovations (LUNA), caught my eye with an impressive triple-digit gain. To be honest, I had to go back and look at my notes as to why I even put this company on my screen to begin with. In short, my notes read: Interesting technology, partnership with Intuitive Surgical (ISRG), good cash position, watch for news.
Well, news came. Naturally, it was the type of news that didn't do me any good: Intuitive decided to purchase Luna's shape sensing technology for up to $30 million. Not bad for a company with a $20 million market cap. Luna got halted, gapped up, and ran from a previous close of $1.32 to over $3.
Now, in aviation there is a saying that I think relates pretty well to the stock market: "There are old pilots and bold pilots, but no old, bold pilots." Throughout my years of investing, I have learned (albeit sometimes the hard way) to not chase stocks after a huge run. I would rather miss out on potential gains than lose money. Simply due to the math of percentages, a 50% loss takes a 100% gain to get you back to baseline. So to state the obvious, I wasn't interested in buying Luna at $3 a share.
It's funny how the market works though. Luna is right back to where it started, at about $1.40 a share. Why such a stunning reversal you may ask? I have my theories that I'll go into more detail later, but they do not explain the absolute retracement. As such, this is one of the most attractive risk/reward scenarios I have come across.
As a short overview, Luna Innovations engages in the development, manufacture, and marketing of fiber-optic test and measurement, sensing, and instrumentation products to measure, monitor, protect, and enhance the processes in the telecommunications, medical, composite, and defense industries worldwide. The company operates in three main areas: Fiber-optic testing, strain and temperature sensing, and fiber-optic shape sensing.
On January 22nd, Luna announced the sale of its shape sensing technology for medical applications to Intuitive Surgical. The terms of the deal include Luna receiving $12 million upfront in two tranches and up to an additional $18 million upon certain technical milestones and commercial measures. Intuitive will acquire Luna's fiber-optic shape-sensing and localization technology, including related patents, and hire a number of engineering employees formerly used in Luna's medical shape-sensing business.
The sale will allow Luna to focus on the growth potential of its fiber-optic sensing business while significantly strengthening the company's balance sheet. The sale contains provisions that maintain Luna's ability to service its existing agreements and for the continued use and exploration of opportunities outside the medical industry.
With the stock now back to where it was before this deal was announced, it appears the asymmetry of this investment is extremely attractive. Consider: Luna has a current market capitalization of roughly $14.5 million, net of cash. They are guaranteed $12 million from the sale to Intuitive (say $10 million after M&A fees). So as it sits, the company is trading for about a $4.5 million market cap...with another $18 million in potential earn-outs and royalties. Not to mention they can sell the technology Intuitive just purchased to other industries besides healthcare. Additionally, they have two other viable and growing business segments that generate revenue. I think you can see where I'm going with this. Even if they never see a penny of the $18 million in incentives, the stock is still cheap.
So why is the stock back at $1.40? I think it relates to artificial selling pressure by the original founder divesting his shares. On Luna's conference call after the acquisition was announced, executive management indicated the company's founder, Kent A. Murphy, would be resigning from the Board and intended to sell his shares in order to use the capital for a new company he had started. This may have spooked the market, but it was really nothing new to anyone who had paid attention. The company filed an S-3 back in October 2013 indicating Mr. Murphy was offering his shares to the public. On January 27th a Form 4 was filed indicating Mr. Murphy had sold roughly 1.5 million shares and had another 1.3 million shares remaining. The sale of 1.5 million shares brought him below 10% ownership and he was no longer an insider, so he was not required to file Form 4s for the sale of the remaining 1.3 million shares, but it is reasonable to assume he sold the entire position. Obviously, on a low float stock like Luna, this can create substantial weakness.
I've always felt downside risk is mitigated when companies have large cash positions, but that does not mean risk is eliminated entirely. Leaving a significant amount of cash with management can often lead to problems. Maybe management wastes it on acquisitions or doesn't make the best use of it in order to maximize returns for shareholders. These agency problems can lead to a floundering stock price. It remains to be seen if that becomes the case for Luna, but it's a risk I'm willing to take at the current share price.
Luna was too much of a gamble at $3 a share, but at current levels, the asymmetry of this stock is too attractive to pass up. I think the market is also underestimating the potential of its shape sensing technology being used in other industries besides healthcare. The fact Intuitive laid down the coin to buy it tells you it works. If it's good enough to go into surgical robots, I'm sure it could be made of use in less critical areas like automotive, aerospace, or defense. In fact, this shape sensing technology was originally developed for NASA to use on Rovers.
The market bidding the stock to over $3 after the deal was announced may not be far off the mark if Luna is able to collect a majority of the $18 million in future payments or if there are positive developments in other areas of the business. Having a chance to buy this stock for basically where it was prior to the acquisition announcement is a gift in my opinion. Within the next 6 months, I only see limited downside in the 10-15% range with upside in the 50-100% range. A stock that's only trading for a $14.5 million market cap, net of cash, with a guaranteed $10 million payment, incentives for another $18 million, and a technology that works is a bet I'll take every time.
Additional disclosure: I am not a financial advisor. You should consult your own financial advisor before acting on recommendations to consider its suitability for your investment circumstances.