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Luna Innovations Incorporated (NASDAQ:LUNA)

Q4 2011 Earnings Conference Call

March 8, 2012 5:00 PM ET

Executives

My Chung – President and Chief Executive Officer

Dale Messick – Chief Financial Officer

Analysts

Greg Greenberg – Wells Fargo Advisors

Mark Dalton [ph]

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2011 Luna Innovations Incorporated Earnings Conference Call. My name is Larry and I will be your operator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. (Operator instructions)

I would now like to turn the conference over to your host for today, Mr. Dale Messick, Chief Financial Officer of Luna Innovations. Please proceed.

Dale Messick

Thank you, Larry. Good afternoon, everyone and thank you for joining us today as we review Luna's results for the fourth quarter and full year 2011.

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, may be forward-looking statements that involve risks and uncertainties and are subject to change at any time, including, but not limited to, statements about future financial and operating performance.

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 earnings release and our latest Forms 10-K and 10-Q filed with the Securities and Exchange Commission.

We disclaim any obligation to update any such factors or to announce publicly the result of any revisions to any of the forward-looking statements to reflect future events or developments. There is more complete information regarding forward-looking statements, risks, and uncertainties in the company's filings with the SEC available on our website.

At this time, I'd like to turn the call over to My Chung, President and CEO of Luna Innovations.

My Chung

Thank you, Dale. Today, I would like to give you an update on the strategic initiatives that we laid out on our last call, as well as our plans for future interaction with you, our investors, our customers, and the public overall. Following my comments, I will turn the call back over to Dale for a discussion of our operating results for the quarter and the year. And then I will be happy to take any questions you might have.

Overall, I am pleased with the progress we have made in Luna since my arrival nearly a year ago. I remain very optimistic about the company's future as we pursue our growth initiatives. I'll begin our initiative in fiber optic shape sensing for minimally invasive medical procedures.

Here, we are talking specifically about our current relationships with Intuitive Surgical and Hansen Medical for shape sensing technologies that have the potential to improve robotic medical procedures. For the past few years, we have been working to enhance the technology to meet various technical specifications for our customers. Over the next several months, we will be focusing our efforts on the stability, repeatability, and reliability of each of the platforms.

With incredible progress having been made in our capability for shape sensing and localization with these important customers, our teams are now focused on moving from technology to commercialization.

In the Secure Computing group, during 2011, we were awarded a $12 million follow-on contract to continue the advancement of the unique technology capability created by this group. As part of our strategic initiative for growth in this area, our initial activities are centered around introducing our capabilities to key government agencies and the large government prime contractors. We have begun these introductions and are receiving favorable reception to our offerings. These marketing efforts will continue to be the focus for the next several quarters.

With regard to the use of fiber optics to measure strain and temperature, we have begun to receive orders from early adopters for our ODiSI product, which we introduced last year.

As I mentioned on our last call, our initial rollout of this product identified improvements that we should make in some of the technical specifications in order to really penetrate the market opportunity in sensing for composite materials. We have since put together a high-performance development team, dedicated solely to that objective. I have been impressed with the focus, energy, and the dedication from this team. They are on track to deliver some incredible results in record time.

Of course, a large portion of our revenues continue to be earned through our telecom test products and contract research with our government customers. I am happy to say we saw a return to growth in our contract research outside of Secure Computing in 2011 after two years of decline.

In order to maintain momentum in this area, our groups will be focused on increasing their win rates in the follow-on Phase II proposal opportunities, as well as more aggressively seeking new opportunities outside of the SBIR program, as our Secure Computing group has successfully done. In the telecom market, we will continue to introduce enhancements to our products to maintain our technology leadership.

Let me now touch briefly on additional marketing related activities. When I joined Luna, it was clear to me that within the company, marketing had never been given the priority that was needed, whether in terms of clearly understanding the drivers in our target markets, developing a concise message to describe our company and goals, or even to keep up-to-date with a consistent presence and image to the public.

One of my objectives has been to hire a seasoned marketing professional to help address these issues. And I am pleased that Geoff McCarty recently joined the company in the role of VP of Marketing. Geoff brings to – more than 20 years of professional marketing experience, including recent experience with a Fortune 500 company.

As a result of Geoff's efforts, over the next quarter you can expect to see improvements in our public presence, do enhancements to our website, increase news flow, and consistent messaging.

With that, I will now turn the call over to Dale to review the financial highlights.

Dale Messick

Thank you, My. This afternoon, I'll start with an overview of our fourth quarter results and then briefly touch on our full year 2011 results as well.

Our revenue for the fourth quarter of 2011 were $8.1 million compared to $9.1 million for the last quarter of 2010, with technology development revenues declining $464,000, while product and license revenues declined by $456,000. The decrease in technology development revenue was driven by lower revenues in our Secure Computing group and nanotechnology areas, which other areas of our technology development organization increased.

Within Secure Computing, during 2011, we were awarded a $12 million multi-year follow-on contract to a similar program that reached its schedule end date earlier in the year. The new contract was of a lower value than the preceding one. However, the difference was largely in pass-through type costs, but the internal resources dedicated to the current project are similar. Within our product and license segment, the revenue decline was attributed to continuing softer sales of our telecom products.

With the decline in revenues for the quarter, gross profit decreased to $2.7 million for the fourth quarter of 2011 versus $3.4 million for the same quarter in 2010. Our overall gross margin was 34% in the most recent quarter compared to 37% in the fourth quarter of 2010, with the change being driven by a decline in lower margins realized in our product development contracts.

Lower operating expenses largely offset the decline in gross margin. Operating expense improved 14% to $3.2 million for the last quarter of 2011 versus $3.7 million in the fourth – in the final quarter of 2010.

SG&A expenses decreased nearly $800,000 to $2.4 million in Q4 of 2011 versus $3.2 million in the last quarter of 2010. This decrease was driven by a $0.4 million decrease in share-based compensation expenses, with the remaining improvement coming mostly from lower labor and consulting costs. Partially offsetting that decrease in SG&A costs, R&D costs increased approximately $273,000. The increased R&D costs reflect principally additional labor in the engineering of our fiber optic products under our Luna Technologies brand.

Accordingly, we incurred an operating loss of $437,000 in the fourth quarter of 2011 compared to an operating loss of $344,000 in the fourth quarter of 2010, and a net loss attributable to common shareholders of $386,000 for the most recent quarter compared to a net loss attributable to common shareholders of $475,000 in the fourth quarter of 2010.

We realized positive cash flow from operations of $2.4 million for the quarter. You may recall, we had negative cash flow in the third quarter of 2011 and I told you on our last call that it was driven by the tack of sales in Q3 such that much of the Q3 revenues were still on accounts receivable at September 30th and not yet due for payment from our customers. I am pleased to tell you that that was in fact the case, as we did return to positive cash flow in the fourth quarter with $2.4 million of cash provided by operations and a $2.1 million overall increase in cash for the quarter.

Looking at the full year results, revenues grew by $1.1 million or 3% to $35.6 million in 2011 compared to $34.5 million for the full year 2010. Technology development revenues were unchanged at $22.4 million in each of the years. Within this segment, our contract research, excluding the Secure Computing group, grew 9% overall.

Product and license revenues increased nearly 9% to $13.2 million for the year compared to $12.1 million last year. Growth in this segment for the year included the $600,000 growth in product sales, principally fiber optic test and measurement equipment, along with a growth of $400,000 in contracted product development revenue.

Our gross profit increased to $13.2 million for 2011 compared to $12.9 million in 2010, with margins holding steady at 37% in each year.

Operating expenses decreased approximately $700,000 or 5% to $14.5 million in 2011 compared to $15.2 million in 2010. Operating expenses represented 41% of revenues for the year 2011 and 44% of revenues in 2010. The decrease in operating expenses included $1.5 million or 11% decrease in SG&A costs, which was largely driven by a $1.3 million decline in share-based compensation expense. Operating expenses in 2010 also included approximately $174,000 of costs associated with the wrap-up of our reorganization, which of course were non-recurring for 2011.

These savings in operating expenses were partially offset by a $1 million increase in research, development and engineering costs for the year. Of the $1 million increase in research and development costs, $0.6 million related to higher costs, primarily labor related in our engineering for fiber optic products, and $0.4 million related to internal R&D costs incurred within our Secure Computing and Communications group during the time that they were between contracts.

Our operating loss also improved by $1 million to $1.2 million for the full year 2011 compared to $2.2 million loss for the full year 2010. Our net loss attributable to common shareholders was $1.5 million or $0.11 per share for the year 2011 versus a net loss attributable to common shareholders of nearly $3 million or $0.23 per share in 2010.

We achieved positive cash flow from operations of $3 million during 2011 compared to cash used by operating activities of nearly $100,000 in 2010. Overall, our net cash position improved by $1.7 million during the year 2011. We ended the year with $8.9 million of cash compared to $7.2 million at the prior year-end.

Looking ahead now, for 2012, we currently expect our revenues for the first quarter of 2012 to also come in the $8 million to $8.2 million range, with a net loss of $0.2 million to $0.6 million. For the full year, we currently expect revenues to be within a range of $32.5 million to $37 million, with a corresponding net loss of $0.2 million to $1.2 million.

And with that, I would like to turn the call back over to My.

My Chung

Thank you, Dale. I am excited by the improvements we have made during 2011, especially in driving bottom line improvement and cash flow in times of economic uncertainty.

We continue to grow the product development work we are doing in fiber optic shape sensing for minimally invasive surgeries. We launched our new ODiSI product, opening up new market opportunities for us using optical fiber to measure structural strain, and we continue to expand our capabilities and government relationships within our Secure Computing group.

We will continue to focus in 2012 on enhancing the bottom line as we push forward on our strategic growth plan and move toward profitability.

At this point, I would like to open up the line for any questions that you might have.

Question-and-Answer Session

Operator

(Operator instructions). And our first question comes from the line of Greg Greenberg of Wells Fargo Advisors. Please proceed.

Greg Greenberg – Wells Fargo Advisors

Hi, during the quarter, it looks like the SBIR/STTR programs were extended for six years and possibly the funding looked like it was increased as well. So, wondering if you could comment, are there any changes to those programs that either positively or negatively affects you guys.

My Chung

I'd say, overall, we are positive. I think the continuation of that program was good news to us in light of the – all the discussions going on about government cutbacks. The only thing that might concern us is that they have opened up to VC-funded entities to also bid for some of those proposals.

Greg Greenberg – Wells Fargo Advisors

I did notice that. Okay. And as far as from those programs where I assume that that's where some of the decline was this year as far as grants received in 2011 versus 2010. Is that accurate?

Dale Messick

Yes. As far as the revenue goes, Greg, my comments were that in the contract research area, when you exclude our Secure Computing group, revenues actually grew by 9% year-over-year. And the Secure Computing group is one that actually works primarily outside the SBIR program. So from a revenue standpoint, we actually had a favorable year in the SBIR/STTR kind of work that we do.

Greg Greenberg – Wells Fargo Advisors

Okay. A question about Intuitive Surgical. I know last year, it wasn't until March 31 that you announced the extension of the agreement for the work in 2011. Certainly your comments so far indicate that the relationship is ongoing. Is there any update as far as an extension for 2012?

My Chung

No.

Greg Greenberg – Wells Fargo Advisors

No, was that a no comment?

My Chung

Yes, it was a no comment. I have my Internal Counsel saying – shaking his head, no comment.

Greg Greenberg – Wells Fargo Advisors

Okay. And then just as far as the future for Hansen and Intuitive Surgical, I understand the sensing systems should they be put in place, as you guys have said in press releases would be – it would consist of software, instrumentation, and then disposable optical sensing fiber. Do you have any color on what the economics of the disposable might be?

My Chung

We are hoping that the economics will be similar to the system, but chances are the margins would indeed end up being lower.

Greg Greenberg – Wells Fargo Advisors

On the disposable?

My Chung

Correct.

Greg Greenberg – Wells Fargo Advisors

Okay. And then lastly, just as far as the Secure Computing group, you mentioned that $12 million multi-year contract. Are there other contracts that that group is actively bidding on or is that the main one that it's set up to go after?

Dale Messick

Well, the group is – the group does bid on numerous contracts throughout the year as the various government grants are opened up. Certainly that one that I referred to is the largest one that they work on; they do have others that they work on as well.

Greg Greenberg – Wells Fargo Advisors

Okay. Thank you for answering my questions.

Dale Messick

Thank you.

Operator

Our next question comes from the line of Mark Dalton [ph]. Please proceed.

Mark Dalton

Good evening. A couple of questions. A little disappointed. So, listening to your call, your guys – and correct me if I'm wrong, you earlier – back last of 2011, didn't you actually anticipate by the end of 2012 you would be profitable per se or am I incorrect on that?

Dale Messick

No, I – Mark, I don't believe that we ever said that we would be profitable for 2011, early –

Mark Dalton

I'm sorry, 2012.

Dale Messick

Okay. No, I don't believe that we said that in any of our guidance. We didn't give 2012 guidance on the –

Mark Dalton

I thought – I'm not – I thought it was said you guys hoped last quarter of '12 to show profitability. I may be in error, but another question. For a tiny microcap company, you guys have got a fairly diverse business plan and a lot of different segments of your company.

Any consideration to possibly – and I know this is probably the wrong place, probably the wrong etiquette to ask a question like this on a conference call, but any consideration to discontinue some of – you might lose segments of your business that have yet to show any realistic promise of net profits? (inaudible), but you got certain segments that you – it seems like you sort of struggle with ever actually making a net profit. Any thought of cutting back on some of those parts of your business?

My Chung

If managed correctly, the government research side of our business should be somewhat profitable, all right, the way that the proposals are generated. I think a way towards profitability and really ensuring the future of the company is again focusing our initiatives in the right areas. And so, the three that we've laid out, we believe will help transform the company from where it is today to something that's highly focused, as well as profitability.

Mark Dalton

And I don't think I misunderstood you on this point. There was a mention in your last call about possibly getting some sort of investor presentations together to increase interest in the stock (inaudible). Anything has been done on that front at all other than hiring a marketing expert?

My Chung

We are making progress; we are probably not as far along as we'd like to be. We've been working with an investment relations firm in Manhattan and we're hoping to make some progress over the next couple of quarters.

Dale Messick

Thank you, Mark.

Operator

(Operator instructions) With no further questions, I would like to turn the call over to Dale for closing remarks.

Dale Messick

Thank you, Larry. So that does conclude our presentation for today. I appreciate everyone's participation on the call, and we certainly look forward to speaking with you again when we release our Q1 2012 results.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may disconnect at this time. Have a great day.

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