Luna Innovations Incorporated

Good day and thank you for standing by. Welcome to the Q3 2021 Luna Innovations Incorporated Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question and answer session. To ask a question during the session, you will need to press star 1 on your telephone. If you require any further assistance, please press star 0. I would now like to hand the conference over to Allison Rudy, Director of Administration. Please go ahead.

Good afternoon and thank you for joining us today. This afternoon we issued our third quarter 2021 earnings press release. In addition, we posted to the investor relations section of our website a presentation with supplemental information for the quarter. 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. These adjusted numbers exclude the effect of certain non-cash expenses and other items. The adjusted results are a supplement to the GAAP financial statements. Luna believes the presentation and 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. More complete information regarding forward-looking statements, risks, and uncertainties is available in the company's SEC filings, which can be found 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 the forward-looking statements to reflect future events or developments, except as required by law. After our prepared remarks, Scott Graves, our President and Chief Executive Officer, Gene Nestro, our Chief Financial Officer, and Brian Soler, our Chief Operating Officer, will be available to take your questions. And at this time, I'd like to turn the call over to Scott.

Good afternoon, everyone, and thanks for taking the time to join our call. I'm happy to be with you today as we announce an extremely important step in executing on our strategy to enable the future with fiber. Since early 2018, we've spoken about focusing our strategy and leveraging our unique capabilities to capture the vast opportunities in fiber. Since we established that strategy and began that work, the applications for our fiber optic-based technologies have only grown. For those of you who have been with us for several years, you'll remember that there was a lot of foundational work to be done. And since then, you've seen us simplify our portfolio by divesting non-core assets and putting our capital to work in acquiring extremely complementary technologies that have allowed us to drive strong growth. As a major pivotal step in focusing our portfolio on fiber, we have decided to divest Luna Labs. So you will note that our Luna Labs segment is now classified in discontinued operations, reflecting this intent. We are proud of what has been accomplished in the Luna Labs business by a really talented and committed group of employees, and we believe that the business continues to have tremendous potential. As we've discussed through the past several years, This business, however, does not fit with our strategy of capturing the opportunities from our capabilities in fiber. Just as a reminder, Luna Labs was the business where we leveraged third-party contract research to build a portfolio of technologies. These technologies... which are commercialized through direct sales, distributors, or licensing agreements have been outside our core strategic fiber optic offerings as we have shared with you consistently over the past several years. To the Luna Labs employees, I'm proud of what you've accomplished. Your work is critical and I know you'll continue to stay focused on driving innovation and value for our customers. In terms of the timing of this divestiture, As we completed the acquisition of OptiSense and continue to consider and evaluate the pipeline of additional acquisition opportunities, we decided that this was the right time to take this step. We are considering a number of opportunities related to this divestiture and would hope to announce something in the near term. It is important to mention that we will continue to be an acquisitive company, sharply focused on building our capability and expertise in fiber. As always, we will only do those deals that make sense from both a financial and cultural perspective, as one of our key priorities will always be the prudent and thoughtful deployment of capital. As many of you know, we have streamlined and simplified the Luna portfolio through targeted divestitures while simultaneously adding value-creating assets through acquisitions. In addition, we have continued a steady cadence of making important investments in our people, processes, and platforms in areas like engineering, marketing, and sales, setting us up for incremental growth well into the future. Our capital deployment strategy has not changed. To wrap up on Luna Labs, I just want to say again what a pivotal moment this is and how proud I am of the work that the team has done. We believe strongly in the potential and opportunities for fiber optic-based technologies, and that conviction has only grown since we established our strategy several years ago. As we move forward, LightWave is now the totality of Luna. Any discussion of Luna will be a discussion of the assets that we formerly categorized as the LightWave division. As I mentioned last quarter, Luna products and capabilities have a tremendous positive impact on our customers and society. Whether it's enabling the next generation of a global network of smart infrastructure, or making data centers faster and more reliable, or securing the perimeters and borders of critical assets around the world, Luna's products help make the world a better and safer place. We are extremely well positioned to take advantage of the growing needs across multiple industries for solutions built on the benefits of fiber sensing technology. We are the market leader with thousands of systems already deployed and operating in the field today. And as far as this third quarter is concerned, we saw record-breaking demand for our products as we recorded historic levels of bookings and backlogs. However, as I mentioned in my comment on the earnings release, we have also experienced increasing pressure from COVID-related delays, including supply chain challenges. When we were together in August, I had mentioned that we were beginning to see some trends from the ongoing pandemic that we had not previously seen. But I had also shared that, at that time, our ability to deliver product to customers on a timely basis had not been materially affected, even though we were getting indications that some parts, which we would normally receive in a number of days, were taking longer. And as always, I committed to share with you what I was seeing when I saw it. As we got to the end of the summer, it started to become clear that timing of deliveries for some critical electronic components were not reverting back to a more typical delivery pattern. Recently, it has gotten worse. and our capacity to manufacture on time to meet customer demand is being challenged. In addition, our OptiSense business often involves traveling to customer locations to install or perform services. I had shared with you previously that we had been experiencing some slippage from one quarter to the next due to the fact that our team was experiencing restrictions on travel to customer locations. As the Delta variant became more prevalent, so did some of those trends, thereby pushing our backlog to historic levels and delaying revenue recognition. You will notice this when I talk about our update to guidance to adjust for the reclassification of Luna Labs to discontinued operations and to reflect the pandemic-related impact to revenue. But let me first talk about some of the high-level financial results for the quarter. Remember, now that Luna Labs has been moved to discontinue operations, when I talk about the results for Luna, LightWave is now Luna, Luna is LightWave. For the third quarter of 2021, total revenues were up 32% to $20.3 million compared to the prior year's quarter. For the first nine months, revenues were up 59% versus the first nine months of last year. Both increases were largely driven by the acquisition last year of OptiSense. I do want to point out that we delivered gross margin of 62%, which compares to our historic gross margin performance in the low 50% range, which included Luna Labs. Clearly, the legacy lightweight business operated at a higher gross margin than did the Luna Labs business. Therefore, we would expect to maintain higher levels of gross margin as we move forward. We reported an operating loss of $10,000 for Q3 2021 versus operating income of $1.2 million for Q3 2020. The largest driver of the year-over-year decrease in operating income was the increase in expenses due to our recent acquisitions, as well as the pressure on revenue as a result of the ongoing pandemic that I just described. Reflecting the same dynamic for adjusted EBITDA, we delivered $2.1 million in Q3, compared to $3.1 million in the prior year period. This resulted in adjusted earnings per share figure of 3 cents for Q3 2021 compared with 11 cents for Q3 in the prior year period. Before I move on to a deeper dive on our operations, I do want to talk about guidance. Given the reclassification of the Luna Labs business to discontinued operations, we are modifying the guidance we've given previously that included both business units. In addition, as I've already said, although we had some of the strongest customer demand to date, the effects of COVID on supply chain and on travel have delayed recognition of revenue. The new guidance for 2021, excluding Luna Labs and taking into account the pandemic, is total revenues of 85 to 88 million and adjusted EBITDA of 6 to 8 million. We are continuing to do everything in our power to work on our supply chain, looking for alternative sources for our key components and trying to order certain inputs earlier than we normally would. As we move into the beginning of 2022, we will also be focused trying to work down our significant backlog, pulling all of those orders into revenue. Now, let me discuss what drove our results in more detail. Remember that our solutions focus on two areas, sensing and communications testing. For the third quarter 2021, the revenue growth I just mentioned was driven by both the incremental revenues due to the acquisition of OptiSense and also by strong commercial sales in the comms testing business. Let's dig a little deeper into the sensing segment, which you may recall is the segment where we use the fiber as the physical sensor to create smart materials and structures. Revenues grew by 27% compared to Q3 last year. largely driven by the acquisition of the OptiSense product lines that are included in this segment. As a reminder, we added the OptiSense distributed acoustic sensing, or DAS, technology to gain access to fully distributed measurement capabilities over long-range applications to augment our already industry-leading line of fiber optic sensing products. Staying with our sensing vertical, we made important progress on several strategic growth areas, I shared last quarter that we had delivered a number of major contracts to South American customers for infrastructure monitoring, which further positioned Luna as a trusted supplier and recognized world leader within these markets. In Q3, we continued to build on that momentum by delivering a large order for our mining application in South America. This validates our strategy of penetrating the infrastructure monitoring space with our new quantitative OptiSense DAS solution. We signed a significant deal for a perimeter monitoring system in Indonesia, further expanding our geographic reach. We validated our technology for real-time traffic monitoring systems with a large win for this technology with the Department of Transportation in the western United States. Our Hyperion strain monitoring solution for offshore oil and gas showed continued order strength in the quarter, which has continued into Q4. We won another competitive bid from the Department of Transportation for real-time monitoring of a bridge. This win was significant because I believe that this is the first of what should be multiple, similar, large infrastructure installations over the coming year utilizing our Hyperion products and associated sensors. And finally, we have driven continued successful penetration of the industrial process control market with our Terahertz products. recognizing record bookings in Q3. Now, switching to the communications test vertical. These product lines grew strongly again this quarter, 39% in Q3 this year versus the prior year period. For some additional clarity, remember that the Rio laser business acquired through the acquisition of OptiSense is included in the comms test results. Without OptiSense, our legacy Luna comms test business grew 8% in Q3 2021 versus last year. With the sales of our high-speed communications test equipment, the OVA and OVR growing a robust 31% versus last year. As a reminder, this business is 50% test and measurement for communication devices and 50% optical components and laser modules for a variety of photonic applications such as medical devices, sensing systems, and LIDAR. Our core products, the OVA and OBR, continue to grow strongly on a year-over-year basis, driven by a continuation of the strong commercial environment we've been seeing, as well as the continuation of deliveries of our newest product in this category, the OBR6200. You'll remember that last year, we announced our partnership with Lockheed Martin and their order for over 100 units in Q4 2020. Throughout this year, our deliveries to Lockheed proceeded without interruption, allowing us to complete the order. We had expected to expand on this order in the second half of 2021, but due to COVID-related program delays, we won't start delivering on the expansion until 2022. That said, we are fully approved and a very good line of sight to the growing opportunity for this product in 2022 and the years to come. In general, comms testing drove significant overall improvement in commercial sales over last year with multiple system sales to large corporate customers, reinforcing the point I made earlier. We have seen tremendous and growing levels of customer demand for Luna products. Before I turn the call over to Gene for a deeper dive into the Q3 results, I want to build on some comments I made earlier about the continuing effect of the global pandemic. I think we are all keenly aware that earlier predictions of easing of the supply chain issues have not come to fruition and have actually grown more pronounced. Let me give you an example to illustrate the extent of this issue beyond what you've seen in the press around electronic components. Luna has consistently used a type of epoxy in many of our products. Like toilet paper in the consumer segment, there is no particular reason that this product should be difficult to get. Yet, during the quarter, we were unable to order from anywhere the supplies we needed to produce certain products. In addition to supply challenges, we are also experiencing requested delivery delays from our customers for a variety of delay reasons on their end. One example of this is a customer in Asia with whom we have a firm order and we're able to produce the product and prepare to ship. The customer is experiencing their own supply chain challenges, delaying their readiness. They have asked us to hold on shipping the finished product due to security issues at the customer location. So we have the order and the product but won't recognize revenue until we ship. I could give you a dozen more examples like this. Demand for our products is at historic levels, but recognizing revenue is being delayed by supply chain challenges and customer delays. At this point in time, I would have to say that we expect some of these dynamics to carry into the first part of 2022. In summary, we are continuing to do the fundamental blocking and tackling that allows us to build our company for the long term. When I think about some of the strategic moves we've executed over the last several years, the plan to divest Luna Labs certainly ranks up there as one of the most important. As always, I'm incredibly grateful to the Luna team for their continued focus and work, especially as we have newly experienced some of the pandemic-related challenges that we've been hearing about for the past 18-plus months. I'll now hand the call over to Gene for more of the financial details in the quarter. Gene?