Luna Innovations Inc (LUNA) 2006 Q4 法說會逐字稿

Good afternoon, ladies and gentlemen, and welcome to the Luna Innovations Fourth Quarter and Full Year 2006 Earnings Call. My name is Eric, and I'll be your coordinator for today.

[OPERATOR INSTRUCTIONS]

At this time, I would like to turn the call over to Mr. Dale Messick, Chief Financial Officer for Luna Innovations.

Thank you, Eric. Before we proceed further with our presentation, I would like to remind each of you that statements by Luna's executives during this presentation include information that constitutes forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, including without limitation statements about Luna's plans, objectives and strategies and management's expectations and beliefs about business results in the future.

Forward-looking statements are subject to many assumptions, risks and uncertainties that may cause future results to differ materially from those anticipated, including the risks and other factors included in Luna's filings with the Securities and Exchange Commission. Such filings include Luna's registration statement of Form S-1, dated June 2, 2006, in its quarterly reports on Form 10-Q and its annual report on Form 10-K.

All forward-looking statements are based on information available to Luna as of today's date. Luna undertakes no obligations to update any forward-looking statements as a result of any new information, future events, changed expectations or otherwise.

And now, I'd like to turn the call over to Kent Murphy, Chairman, President and Chief Executive Officer of Luna Innovations.

Thank you Dale, and welcome to those of you who are listening. A year ago at this time, Luna was still a private company and involved in the early stages of the IPO process. Today, we are conducting our third conference call for shareholders. As in our previous calls, I want to use this opportunity to put our results in the context of where we are in the execution of our growth strategy. You will hear from Dale, our CFO, who will review our results in more quantitative terms. And then, we'll welcome any questions that you may have.

The Luna story is straightforward. Our business model is a process of introducing disruptive products through the commercialization of innovative technologies and then building shareholder value by either growing or selling these businesses we create from this process. We are at a relatively early stage of this process. We're just beginning to see our initial products and services emerge and succeed in the marketplace. I think I can speak for all of us at Luna and say with great confidence that we are encouraged at how our strategy is playing out and by what we see on the horizon.

The engine behind that process of innovation is the intellectual property we build by entering into research contracts with government agencies, research labs or commercial enterprises that share out strong interest in selected technologies. In 2006, the revenues we generated from those contracts grew by 22% from $15.4 million in 2005, to $18.8 million in 2006. In the final quarter of the year, we realized a 36% growth in these revenues over the previous year from $4.3 million to $5.8 million.

Our process culminates in the sale of our products that uniquely fill a market need. As I said earlier, we are just beginning to see the emergence of growth in these revenues. The growth is rapid, and the impact that growth is having on our operating margins is substantial. Revenues from products sales and licensing more than doubled between the fourth quarter of 2005 to the fourth quarter of 2006 from $1.1 million to $2.2 million.

The growth in product sales is having a strong and positive impact on our operating results, due to the fact that the revenues from products sales have significantly higher margins than revenues from research contracts. So, we obtain a growing improvement in our operating margin as product sales increase as a percent of total revenues. These improvements are reflected in our financial results.

Between the fourth quarter of 2005 when product sales accounted for 20% of our total revenues, to the fourth quarter of 2006 when they accounted for 28% of our total revenues our gross margins improved from 17% to 30%. We can see the same trend from the last time we reported to you at the end of the third quarter last year when product sales represented 19% of total revenues and gross margin of 22%. If we are successful in continuing to increase product sales as a proportion of our total revenues, we expect to continue to see gross margins expand.

In total, excluding one-time license transactions in our early years, our fourth quarter revenues of $8 million was the highest for any quarter in our history, reflecting a 51% increase over the same quarter last year and a 33% increase over the immediately preceding third quarter. For the full year, total revenues increased by 43% to $23.5 million from $16.5 million.

At the same time, we grew total revenues as we expected. The cost of the growth itself also increased, primarily from personnel costs as we have grown from a total employment of 136 at the end of 2005 to 211 at the end of the 2006. Dale will explain other components of our total increase of expenses from $6 million in 2005 to $17.1 million in 2006, or on a quarter-to-quarter basis from $3.1 million to $5.3 million.

Because the increase in cost to execute our growth strategy has risen faster than the growth in gross margin, we incurred a loss for the fourth quarter of $2.7 million and of $9.4 million for the full year. Our loss for the year is consistent with the guidance we issued in September. The path to success and profitability centers around growing total revenues while achieving higher margins, so that the growth of our gross profit will outpace and then out-distance the increase the cost of that growth.

I'd like to take a moment to give you some insight into how we are doing that and what it should mean for out future. Let's start by taking a look at recent trends in technology development contracts. In the fourth quarter, we booked more than $4 million in new technology development contracts, bringing our total new contract awards to more than $22 million for the year.

Continuing to grow the technology development segment of our business provides us with the funding to enhance our current product pipeline at a faster pace than we would accomplish if funded internally. Examples include our development of EDAC and EN-TACT medical devices, our hand-held optical test equipment and other products where much of the underlying technology was funded by partners through Technology Development Division.

To keep pace with the flow of our contract work, we hired ten new technology development employees in the fourth quarter, primarily scientists and engineers. In 2006, we hired a total of 48 new technology development people, mostly in the third and fourth quarter, which was a 70% increase over 2005 and translates directly to our growing backlog.

On the healthcare products side of our business, we continue to sell our Emboli Detection and Classification or EDAC product to research institutions and are currently working through a third-party, accredited reviewer to obtain FDA clearance to sell the product for clinical use.

We originally submitted our application to the third-party reviewer back in December and have just completed amending the application, based upon feedback from their reviews. Historically, working through a third-part reviewer has reduced the total time necessary for companies to obtain the FDA clearance for their products.

We have also completed preliminary animal testing for our EN-TACT product for the diagnosis of compartment syndrome with positive results. Also, we expect to begin preliminary testing for applicability to be able to nonevasively measure intracranial pressure by quarter's end.

Also in the medical device area, we have demonstrated a fiber optic sensing product platform that gives enhanced positioning information for use in multiple medical devices. This system can potentially provide medical personnel the ability to pinpoint the location and shape of invasive diagnostic and surgical instruments with great precision than currently possible.

Related to pharmaceutical development, on our call last quarter, I talked through -- I talked about breakthroughs we achieved in the production of TRIMETASPHERE molecules providing the quantity of material that we need to progress in the efforts to develop a safer and more effective MRI contrast agent. Recent developments in the marketplace have confirmed that there are significant risks associated with today's commercially available gadolinium-based MRI contrast agents for patients with impaired kidney function.

In fact, the FDA has released two warnings to the radiology community regarding the danger -- the dangers of gadolinium-based contrast agent to people with impaired kidney function, noting that there have been at least 90 fatal outcomes within two days to 18 months after they have received an injection of today's most common contrast agent. Our TRIMETASPHERE nanomaterials have a completely new approach to preventing the toxicity currently associated with gadolinium -based contrast agents. And we have recently achieved important milestones in the development of this technology towards filling this urgent medical need.

Also during our work with these carbon-based nanomaterials, we have made important discoveries that could provide us new insights in the potential opportunity to develop therapeutics for a number of incurable diseases.

Now for instrumentation and test and measurement products, the fourth quarter was an extremely strong one for Luna Technologies, both from a financial and an operational perspective. The demand for bandwidth in the increasing deployment of fiber for communications infrastructure continues to drive market need for products like the Optical Vector Analyzer and the Optical Backscatter Reflectometer, products delivered by Luna Technologies.

The fourth quarter of 2006 was marked by record bookings and record revenues of $2 million and $1.8 million respectively. Luna Technologies signed contracts with 12 new customers, and we also signed agreements with eight repeat customers. Much of the growth that we have experienced in this area was in the manufacturing sector, where our products will be used to test optical components as they come off the production lines.

We also acquired the rights to a -- to manufacture and sell a line of swept tunable lasers. Our new laser is a miniaturized, external cavity laser offering high performance in a compact footprint designed with systems integration in mind, and applicable to a range of optical fiber test and measurement instrumentation and sensing applications.

We anticipate the technology will allow us to compete more effectively in our current fiber optic test and measurement markets by providing our customers with fast, flexible and cost effective test and measurement products. This laser technology will also allow us to aggressively pursue business opportunities in new markets such as industrial and medical sensing.

We introduced new distributed sensing technique that will greatly reduce the expense associated with deploying fiber optics and sensing systems. This product is based upon our Optical Backscatter Reflectometer or OBR system that we launched last year. Among the things that are currently out -- standing out that's especially promising is the successful fourth quarter transition of our distributed sensing system from technology development to the LUNA Technologies Division. The underlying DSS technology has the potential to translate to a number of new commercial opportunities including medical robotics and perimeter sensing.

International markets are becoming an increasing important component of our business, and in the fourth quarter, we hired a Director of Sales for Europe, the Middle East and Africa to be based in the UK. I would like to review some of the great accomplishments we achieved in 2006.

We raised over $17 million in support of our commercialization strategy, and we are already experiencing the fruits of that strategy with growing revenues and profit margins. We saw a major breakthrough in our nanomaterials process, and now can manage TRIMETASPHEREs in the quantities necessary for product development, including MRI contrast agents. We also achieved breakthroughs in the ability to modify carbon-based nanomaterials to demonstrate their pharmaceutical applications.

We launched our Advanced Systems Division and announced the launch of the EDAC and EN-TACT medical devices. We signed a joint development agreement with JDSU for a field-deployable test instrument. Our products received recognition at the highest levels including awards from Test and Measurement World for our OBR product and Frost & Sullivan award for EDAC. We hired almost 100 new employees, and we are seeing the results in a strong and growing backlog.

We anticipate continued growth in our technology development line of business. We anticipate FDA clearance for the sale of EDAC in clinical settings. In nanomaterials, we are targeting partnerships with diagnostic and therapeutic companies for our MRI contrast agents and therapeutics.

In Luna Technologies, we will be ramping up two new sales hires for western US and Europe, launching the next generation of mainframe crossover, getting our new lasers into active production, and the next generation of fact-scanning OBA and DSS products. We also hope to identify and have on board, a Director of Asia-Pacific Sales by the end of the year. We believe all these accomplishments are a prelude for the future. We expect this year to be even more exciting and successful.

Now, Dale will review the 2006 financial results.

Thanks, Kent. For the fourth quarter of 2006, Luna earned revenue of $8 million, representing a $2.7 million or 51% increase over the fourth quarter 2005 revenues of $5.3 million. Technology Development revenues of $5.8 million grew $1.5 million or 36% compared to the fourth quarter of 2005, while product and license revenues increased 111% to $2.3 million in the fourth quarter of '06 from $1.1 million in the fourth quarter of '05.

The growth in product and license revenues came largely from sales of Optical Test and Measurement equipment, where revenues grew approximately $700,000 compared to the fourth quarter of the 2005. Sales of the EDAC product contributed $100,000 of revenue growth, and various other activities in the company's Advanced Systems group contributed the remaining $300,000 of revenue growth for the quarter.

Overall, cost of sales for the fourth quarter of 2006 increased $1.2 million or 27% compared to the fourth quarter of 2005. Technology Development cost of sales increased $0.6 million or 15.4% versus the fourth quarter of 2005. The increase in cost of sales was primarily attributable to increased headcount, which delivered a growth of 50% in billable hours compared to the same quarter of the prior year.

Gross margins for Technology Development improved from 6% in the fourth quarter of 2005 to 20% for the fourth quarter of 2006. Cost of sales related to product and license activities increased [$2.6] million, compared to the fourth quarter of 2005. This increase was primarily related to the incremental sales volume I mentioned a moment ago. Gross margins for the product and license segment were 56% for the quarter compared to 62% a year ago with the year-over-year decrease being attributable to product mix.

Margins in our Advanced Systems group, which was not in place during 2005 and produced approximately $400,000 of revenue in the fourth quarter 2006 were below the levels typically experienced in our Optical Test and Measurement sales. Gross margins related to sales of Optical Test and Measurement instruments remained above 60%.

Overall, gross margins improved to 30% in the fourth quarter 2006 from 17% in the fourth quarter 2005, demonstrating the importance of our ongoing commercialization strategy. Growth in the product and license segment of our business provides an opportunity for significant margin expansion. Product and license sales accounted for 27% of our revenue in the most recent quarter.

Operating expenses were $5.3 million for the quarter, an increase of $2.3 million compared to the fourth quarter 2005. As we've discussed the past two quarters, operating expenses have been higher throughout 2006 due to increased R&D spending, as well as the additional required infrastructure and costs associated with being a public company. Operating expenses in the most recent quarter were also higher than the rate of approximately $4.3 million experienced in the earlier quarters of 2006.

Increased product sales drove higher commissions to our internal sales force and our third-party resellers. Higher operating expenses were realized due to our facilities expansions and additional resource devoted to the preparation of bids and proposals for our new technology development opportunities. We incurred approximately $0.2 million in engineering and other start-up costs during the quarter in connection with our recent acquisition of new product lines. And we had approximately $300,000 in non-recurring costs for legal and related expenses associated with the successful resolution of a contractual dispute.

Accordingly, we incurred a net loss for the fourth quarter of $2.7 million or $0.27 per share on a fully diluted basis, compared to $1.7 million or $0.33 per fully diluted share in the fourth quarter of 2005. Overall, revenue increased $2.7 million, driving additional gross margin of $1.5 million, offset by $2.3 million increase in operating expenses.

For the year ended December 31, 2006, revenues were $23.5 million, compared to $16.5 million for 2005, and exceeded our most recent guidance of $21 million to $22 million for the year. Technology Development revenue increased $3.4 million or 22.2% year-over-year, while product and license revenue grew by $3.7 million. The growth in Technology Development was driven by the additional headcount brought into the company throughout 2006 to fulfill our continued growth in research contracts awarded.

Product and license revenue increased to $4.8 million for the year, compared to $1.1 million in 2005. The growth in product and license revenue reflects the full-year impact of the acquisition of Luna Technologies in September 2005, a strong fourth quarter of 2006 for sales of Optical Test and Measurement equipment and the addition of revenues from sales of EDAC and other products within our Advanced Systems group.

Sales of our Optical Test and Measurement equipment have historically seen significant seasonal fluctuations. Revenues recognized in this product line during 2006 were $3.9 million, of which $1.8 million was earned in the fourth quarter. Orders received in the fourth quarter of 2006 were approximately $2 million. In the fourth quarter 2005, revenues recognized for the same product line were $1.1 million.

Cost of sales were $16.4 million in 2006, compared to approximately $13 million in 2005, an increase of $3.4 million in cost of sales compared to the increased revenue year-over-year of $7 million. Overall, gross margin percentages improved from 21% in 2005 to 30% for the year 2006, reflecting both the higher margin impact from increasing product sales and an improvement in the gross margin performance of the Technology Development business segment.

Gross margins on Technology Development improved from 18% in 2005 to 24% in 2006. Product and license gross margins decreased from 62% in 2005 to 51% in 2006. Within the product and license segment, margins on Optical Test and Measurement equipment remained strong at 57% for the year. Gross margins on other product-related sales were 22% due to the absorption of fixed manufacturing overhead on a smaller volume of products. As sales volume in this area increase, gross margins are expected to improve.

Operating expenses for the year were $17.1 million in 2006, compared to $6 million in 2005. As we've discussed in prior quarters, this growth in expense is attributable primarily to the company's investment in new products and technologies, the addition of Luna Technologies, which was acquired in September 2005 to the company's expense base, the inclusion of share based compensation and expenses and the additional infrastructure and expenses associated with the company's transition to a public entity.

For the year ended December 31, 2006, the company incurred a net loss of $9.4 million compared to net loss of $2 million in 2005, which was within our guidance -- our previous guidance for the year, of a net loss ranging from $9.3 million to $10.3 million. The increase of $7.4 million year-over-year in net loss consists of a -- I'm sorry. The increase of $7.4 million year-over-year, consists of a $7 million increase in revenues providing an incremental $3.6 million in gross margin contribution, offset by $11.1 million increase in expenses, as I've just mentioned.

Turning to the balance sheet, as of December 31, 2006, we ended the year with $17.9 million of cash, and I'll talk about cash flows in a moment. Accounts receivable grew to $7.2 million, a 41% increase over December 31, 2005, consistent with our 51% growth in revenues for the fourth quarter. As we talked about on our last earnings call, we do not see a deterioration of the aging or our assessment of collectability in the growth of these receivables.

Inventory grew to approximately $843,000, reflecting not only the organic growth of the products business segment, but also the inventory of laser parts that we acquired along with IP in December. Property and equipment of $5.7 million includes leasehold improvements associated with our facilities expansions and $0.5 million of fixed assets acquired in the tunable laser product acquisition. Similarly, the $2 million of intangible assets includes $0.6 million ascribed to the intellectual property acquired in the laser acquisition.

Turning to cash flows, our loss for the year of $9.4 million equated to $9.1 million of cash used in operations. Non-cash charges including share based compensation and depreciation, amortization were $2.9 million in the aggregate. Other significant changes in working capital include the $2 million increase in accounts receivable that I just mentioned, offset from a cash flow perspective by a $0.7 million increase in accounts payable and accrued liabilities.

Cash paid for capital spending during 2006 was $2.8 million, which as noted previously, included $0.5 million of assets acquired in support of the laser product, and approximately $0.5 million of leasehold improvements associated with our facilities expansion to accommodate our headcount and operational growth. Cash paid for intellectual property additions was also $0.6 million. Cash provided by financing activities of $17.9 million for the year, primarily related to the net proceeds of our IPO in June of 2006, resulting in a net increase in cash for the year of $5.4 million.

And now with 2006 behind us, I'll turn to our expectations for 2007. For the coming year, we anticipate continued strong growth in both of our business segments. Technology Development has a strong backlog entering the year, and we expect to continue hiring to meet the demand for our research activities.

We expect revenues in this area to be in the range of $23 million to $24 million, compared to the approximately $19 million earned in 2006. We also anticipate continued strong demand for our Optical Test and Measurement equipment, building off the gains we experienced in the fourth quarter of 2006.

Sales of our medical products, particularly EDAC, while coming off of a low base in 2006, are anticipated to accelerate toward the latter part of 2007 as we build a sales pipeline following the ultimate receipt of FDA clearance. Overall, we are forecasting product and license revenue of $7 million to $8 million in 2007, an increase of 58% year-over-year at the mid point of the range. Combined, we are currently anticipating full-year revenues of $30 million to $32 million.

The growth rate that we experienced in overhead and infrastructure costs, during 2006, will be significantly less in the current year. We do expect to increase our expenses in 2007, primarily in the areas of product development, both in fiber optics and in medical products and in sales and marketing activities for those product lines. Based on these factors, we currently anticipate a net loss for the full year 2007 of approximately $9 million to $9.5 million or $0.91 per share to $0.96 per share based upon our currently outstanding share base of 9.9 million shares.

It's important to remember that our revenues have a significant seasonality influence. We typically have lower product and license revenues in the first half of the year and higher product revenue in the last two quarters. For example, in the first quarter of 2006, product and license revenues were approximately $600,000, compared to $2.2 million in the fourth quarter. We expect to see significant quarterly fluctuations in 2007 as well.

Also, in the first quarter of 2007, we expect operating expenses to be above our normal recurring levels, principally due to an additional $300,000 to be spent in engineering costs to customize our new tunable laser and start up the manufacturing process. For the first quarter of 2007, we're expecting revenue of approximately $6.9 million and a net loss of approximately $3.3 million or 23 -- or sorry, $0.33 per share.

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

Thank you, Dale. Before I open up the call for questions, I just want to mention our recent 8-K filing announcing that the company and certain of its officers and employees entered into extended lock-up agreements. The agreements to extend the lock-up period for two more years, reflects a high level of confidence in Luna Innovations. All of us remain committed to building a great company, and we believe that the new lock-up schedule benefits the company and its investors.

Eric, we are now ready to receive questions from the participants.

[OPERATOR INSTRUCTIONS]

Your first question comes from the line of David Edwards with ThinkEquity Partners. Please proceed, sir.

Congratulations, guys.

Okay, thanks very much Dave.

I wanted to ask a question a little bit about the -- if you could talk a little bit about how to break down the revenue among the -- in the product segments, so both as we look as past into 2006, but also forward into 2007. I understand EDAC will ramp towards the end of the year. But any color you can give us in terms of how the different businesses will break down would be great.

Yes. I think that you're going to see a similar trend in the product business in 2007 to what we saw in 2006. With the product side of the business, we're going to be -- we'll be looking at revenues of about $1 million in the first quarter.

You look at -- that's going to ramp for $7 million to $8 million for the full year, still largely driven by the Optical Test and Measure -- like I said, with the EDAC system, we're looking at the sales really kicking in the -- late in the year. So, it's not going to drive that much of the full-year performance yet. We've got to get the FDA clearance out of the way and build that pipeline based on it.

Do you have any thoughts yet on sort of how much of the product business will still be Optical Test and Measurement as sort of as you exit the year? Or, is it too early to tell?

It's a little bit early. But clearly, it'll still be --.

Still be --?

It'll still be the majority at the end of the year.

Okay. Great, and also on the contract side, as you said, you've got -- you had $22 million in contract sales there in 2006. Is the right way to think about that that the majority of those will carry forward into 2007?

Yes. What we said was, we were awarded $22 million of new contracts -- new contract value during 2006. So, we had $19 million of revenue that we recognized. So, that means we grew the backlog a little bit going into next year. Those contracts typically take a year to two years to complete.

Okay, great. All right, excellent. That's all I've got, thanks a lot.

I appreciate it, Dave. Thank you.

Thanks, Dave.

Your next question comes from the line of John Roy with Hambrecht. Please proceed.

Hey Dale, I actually have a pretty simple question. You said that there was $300,000 of non-recurring cost this quarter.

Yes.

What was that for again? And was there anything else that was non-recurring?

We had a contractual dispute.

Okay, so it's legal expense?

Yes. It's mostly legal expense related.

Was there anything that was non-recurring in the quarter?

We had some -- the start-up costs for the -- couple of new products that we introduced. There's an optical switch and this new tunable laser. And we had about 100 -- just under $200,000 of costs associated with those in the fourth quarter. Now, as I said, we do expect to have about $300,000 of that recurring in the first quarter of 2007, but just as we get those products up and into the portfolio, manufactured and online. But, we don't expect that expense to continue after the first quarter of '07.

Right, but you will hopefully continue to introduce new products. So, you'll probably have new introduction costs?

Yes. These were just above and beyond the normal level, because we acquired these from outside and actually had to --.

Oh, okay. I get it. I see what you're saying, because they're above and beyond the normal. Okay.

Right.

So, maybe another 200K of real non-recurring this quarter?

That's correct.

Okay, great. Thank you, guys.

Thank you, John.

Thanks, John.

[OPERATOR INSTRUCTIONS]

Ladies and gentlemen, it appears we have no more questions at this time. I would like to turn the call back over to Dale Messick. Please proceed.

Thank you very much for your interest in Luna and participating on the call today. And we look forward to seeing many of you in the future and speaking with you again on our First Quarter Earnings Call.

Thank you for your participation in today's conference. This concludes our presentation. You may now disconnect. Have a good day.

Thank you.