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LUNA INNOVATIONS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS This Quarterly Report on Form 10-Q, including the sections entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Quantitative and Qualitative Disclosures About Market Risk" under Items 2 and 3, respectively, of Part I of this report, and the section entitled "Risk Factors" under Item 1A of Part II of this report, may contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. All statements other than statements of historical fact are "forward-looking statements" for purposes of these statutes, including those relating to future events or our future financial performance. In some cases, you can identify these forward looking statements by words such as "intends," "will," "plans," "anticipates," "expects," "may," "might," "estimates," "believes," "should," "projects," "predicts," "potential" or "continue," or the negative of those words and other comparable words, and other words or terms of similar meaning in connection with any discussion of future operating or financial performance. Similarly, statements that describe our , business strategy, goals, prospects, opportunities, outlook, objectives, plans or intentions are also forward-looking statements. These statements are only predictions and may relate to, but are not limited to, expectations of future operating results or financial performance, capital expenditures, introduction of new products, regulatory compliance and plans for growth and future operations, as well as assumptions relating to the foregoing. These statements are based on current expectations and assumptions regarding future events and business performance and involve known and unknown risks, uncertainties and other factors that may cause actual events or results to be materially different from any future events or results expressed or implied by these statements. These factors include those set forth in the following discussion and within Item 1A "Risk Factors" of this Quarterly Report on Form 10-Q and elsewhere within this report. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to those statements included elsewhere in this report. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those discussed under "Risk Factors" and elsewhere in this report. Overview We develop, manufacture and market fiber optic sensing and test and measurement products and are focused on bringing new and innovative technology solutions to measure, monitor, protect and improve critical processes in the aerospace, automotive, energy, composite, telecommunications and defense industries. In addition, we provide applied research services, typically under research programs funded by the U.S. government, in areas of advance materials, sensing and healthcare applications. Our business model is designed to accelerate the process of bringing new and innovative products to market. We use our in-house technical expertise across a range of technologies to perform applied research services for companies and government-funded projects. We continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth. Our corporate growth strategy is focused on becoming the leading provider of fiber optic strain & temperature sensing solutions and standard test methods for composite, as well as non-composite materials, structures and systems. We are organized into two main business segments, our Products and Licensing segment and our Technology Development segment. Our Products and Licensing segment develops, manufactures and markets our fiber optic sensing products, as well as test and measurement products, and also conducts applied research in the fiber optic sensing area for both corporate and government customers. We are continuing to develop and commercialize our fiber optic technology for strain and temperature sensing applications for the aerospace, automotive, and energy industries. Our Products and Licensing segment revenues represented approximately 43% and 33% of our total revenues for the three months ended September 30, 2014 and 2013, respectively, and 41% and 37% for the nine months ended September 30, 2014 and 2013, respectively. Our Technology Development segment performs applied research principally in the areas of sensing and instrumentation, advanced materials and health sciences. Our Technology Development segment comprised approximately 57% and 67% of our total revenues for the three months ended September 30, 2014 and 2013, respectively, and 59% and 63% for the nine months ended September 30, 2014 and 2013, respectively. Our Technology Development segment predominantly performs applied research in the areas of sensing and materials. Most of the government funding for our Technology Development segment is 15-------------------------------------------------------------------------------- Table of Contents derived from the Small Business Innovation Research, or SBIR, program coordinated by the U.S. Small Business Administration, or SBA. Our Technology Development segment revenues have historically accounted for a large portion of our total revenues, and we expect that they will continue to represent a significant portion of our total revenues for the foreseeable future. Our Technology Development segment revenues were $3.1 million for each of the three months ended September 30, 2014 and 2013. Within the Technology Development segment, we have historically had a backlog of contracts for which work has been scheduled, but for which a specified portion of work has not yet been completed. We define backlog as the dollar amount of obligations payable to us under negotiated contracts upon completion of a specified portion of work that has not yet been completed, exclusive of revenues previously recognized for work already performed under these contracts, if any. Total backlog includes funded backlog, which is the amount for which money has been directly authorized by the U.S. Congress and for which a purchase order has been received by a commercial customer, and unfunded backlog, representing firm orders for which funding has not yet been appropriated. Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. The approximate value of our Technology Development segment backlog was $15.6 million at September 30, 2014 and $8.7 million at December 31, 2013. Revenues from product sales are mostly derived from the sales of our sensing systems and products that make use of light-transmitting optical fibers, or fiber optics. We continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth. Although we have been successful in licensing certain technology in past years, we do not expect license revenues to represent a significant portion of future revenues. Over time, however, we do intend to gradually increase such revenues. In the near term, we expect revenues from product sales and product development to be primarily in areas associated with our fiber optic instrumentation, test and measurement and sensing platforms. In the long term, we expect that revenues from product sales will represent a larger portion of our total revenues and that as we develop and commercialize new products, these revenues will reflect a broader and more diversified mix of products. As described in Note 2 to our consolidated financial statements included in this report, during the quarter ended March 31, 2014, we sold our medical shape sensing business to affiliates of Intuitive Surgical Inc., or Intuitive. As a part of this transaction, we entered into a revocable license agreement with Intuitive pursuant to which we have the right to use all of our transferred technology outside the field of medicine and in respect of our existing non-shape sensing products in certain non-robotic medical fields. Furthermore, in March 2013 we sold the assets associated with our secure computing and communications group, or SCC, to MacAulay-Brown, Inc., or Mac-B, another defense contractor. As a result of these sales, we have reported the results of operations from our medical shape sensing business and SCC as discontinued operations in our consolidated financial statements included elsewhere in this report. Net loss from continuing operations was $0.5 million for the quarter ended September 30, 2014, compared to $0.8 million for the quarter ended September 30, 2013. After giving effect to the results of discontinued operations, which consisted of a $0.3 million loss, as a result of the intraperiod allocation of income taxes, we recorded net loss attributable to common stockholders of approximately $0.8 million for the quarter ended September 30, 2014. For the quarter ended September 30, 2013, we recorded a net loss attributable to common stockholders of approximately $0.6 million, which included the results of operations of our medical shape sensing business for the period, net of tax and tax expense associated with the sale of SCC. We may incur increasing expenses as we seek to expand our business, including expenses for research and development, sales and marketing and manufacturing capabilities. We may also grow our business in part through acquisitions of additional companies and complementary technologies, which could cause us to incur transaction expenses, amortization or write-offs of intangible assets and other acquisition-related expenses. As a result, we expect to incur net losses for the foreseeable future, and these losses could be substantial. In recent years, economic conditions around the world deteriorated, and the outlook for 2014 and beyond remains uncertain. This slowing of the economy, both in the United States and globally, reduced the financial capacities of some of our customers and potential customers, thereby slowing spending on the products and services we provide. Furthermore, reductions in government spending may impact the availability of new program awards in 2014. For example, the Budget Control Act commits the U.S. Government to reduce the federal deficit by $1.2 trillion over ten years through a combination of automatic, across-the-board spending cuts and caps on discretionary spending, or sequestration. Automatic across-the-board cuts required by sequestration could have a material adverse effect on our technology development revenues and, consequently, our results of operations. While the exact manner in which sequestration will impact our business is unclear, funding for programs in which we participate could be reduced, delayed or canceled. Our ability to obtain new contract awards also could be negatively affected. Our sales of SCC in 2013 and of our medical shape sensing business in 2014 are expected to result in lower revenues than historically realized until we can increase revenues significantly, primarily from product sales. As a result, we may incur greater net losses than we have in prior years. 16-------------------------------------------------------------------------------- Table of Contents Description of Our Revenues, Costs and Expenses Revenues We generate revenues from technology development, product sales and commercial product development and licensing activities. We derive Technology Development segment revenues from providing research and development services to third parties, including government entities, academic institutions and corporations, and from achieving milestones established by some of these contracts and in collaboration agreements. In general, we complete contracted research over periods ranging from six months to three years, and recognize these revenues over the life of the contract as costs are incurred or upon the achievement of certain milestones built into the contracts. Our Technology Development segment revenues represented approximately 57% and 67% of our total revenues for the three months ended September 30, 2014 and 2013, respectively, and 59% and 63% for the nine months ended September 30, 2014, and 2013, respectively. Our Products and Licensing segment revenues reflect amounts that we receive from sales of our products or development of products for third parties, as well as fees paid to us in connection with licenses or sublicenses of certain patents and other intellectual property, and represented approximately 43% and 33% of our total revenues for the three months ended September 30, 2014 and 2013, respectively, and 41% and 37% for the nine months ended September 30, 2014, respectively. Cost of Revenues Cost of revenues associated with Technology Development segment revenues consists of costs associated with performing the related research activities including direct labor, amounts paid to subcontractors and overhead allocated to Technology Development segment activities. Cost of revenues associated with our Products and Licensing segment revenues consists of license fees for use of certain technologies, product manufacturing costs including all direct material and direct labor costs, amounts paid to our contract manufacturers, manufacturing, shipping and handling, provisions for product warranties, and inventory obsolescence as well as overhead allocated to each of these activities. Operating Expense Operating expense consists of selling, general and administrative expenses, as well as expenses related to research, development and engineering, depreciation of fixed assets and amortization of intangible assets. These expenses also include compensation for employees in executive and operational functions including certain non-cash charges related to expenses from option grants, facilities costs, professional fees, salaries, commissions, travel expense and related benefits of personnel engaged in sales, product management and marketing activities, costs of marketing programs and promotional materials, salaries, bonuses and related benefits of personnel engaged in our own research and development beyond the scope and activities of our Technology Development segment, product development activities not provided under contracts with third parties, and overhead costs related to these activities. Interest Expense Interest expense is composed of interest paid under our bank loans as well as interest accrued on our capital lease obligations. Critical Accounting Policies and Estimates Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the amounts reported in our financial statements and the accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or judgments. Our critical accounting policies are described in the Management's Discussion and Analysis section and the notes to our audited consolidated financial statements previously included in our Annual Report on Form 10-K for the period ended December 31, 2013, as filed with the Securities and Exchange Commission on April 10, 2014 and amended on April 15, 2014. There have been no material changes to the descriptions therein. Results of Operations Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 17-------------------------------------------------------------------------------- Table of Contents Revenues Three Months Ended September 30, 2014 2013 Change Revenues:Technology development revenues $ 3,067,022 $ 3,130,206 $ (63,184 ) (2 )% Products and licensing revenues 2,303,508 1,568,646 $ 734,862 47 % Total revenues $ 5,370,530 $ 4,698,852 $ 671,678 14 % Revenues from our Technology Development segment for the three months ended September 30, 2014 were substantially unchanged from the same period last year at $3.1 million. Revenues from our Products and Licensing segment increased $0.7 million for the three months ended September 30, 2014 compared to the same period last year. This increase resulted primarily from growth in sales of our ODiSI products for fiber optic sensing. Cost of Revenues and Gross Profit Three Months Ended September 30, 2014 2013 Change Cost of revenues: Technology development costs $ 2,379,105 $ 2,282,061 $ 97,044 4 % Products and licensing costs 908,175 739,646 $ 168,529 23 % Total cost of revenues $ 3,287,280 $ 3,021,707 $ 265,573 9 % Gross Profit $ 2,083,250 $ 1,677,145 $ 406,105 24 % The cost of our Technology Development segment revenues for the three months ended September 30, 2014 did not change significantly compared to the third quarter of 2013. The costs from our Products and Licensing segment increased $0.2 million from $0.7 million during the third quarter of 2013 to $0.9 million during the third quarter of 2014, due to increased materials costs associated with the growth in sales of our ODiSI products. Because of the overall increase in revenues of 14% in the three months ended September 30, 2014 compared to the three months ended September 30, 2013, and an associated increase of 9% in cost of revenues, our gross profit increased to $2.1 million for the three months ended September 30, 2014 compared to $1.7 million for the three months ended September 30, 2013. As the growth in revenues was driven by product sales, which typically have higher margins than revenues earned in our Technology Development segment, our overall gross margins increased to 39% during the third quarter of 2014 compared to 36% for the same period of 2013. Operating Expense Three Months Ended September 30, 2014 2013 Change Operating expense: Selling, general and administrative $ 2,329,713 $ 2,447,972 $ (118,259 ) (5 )% Research, development and engineering 473,527 531,185 $ (57,658 ) (11 )% Total operating expense $ 2,803,240 $ 2,979,157 $ (175,917 ) (6 )% 18-------------------------------------------------------------------------------- Table of Contents Our selling, general and administrative expense decreased 5% during the three months ended September 30, 2014, as compared to the same period in 2013. The decrease in expense was primarily driven by reductions in administrative headcount in the first half of 2014 and by reduction in investment banking fees related to our efforts to sell the medical shape sensing business. Research, development and engineering expense decreased 11% primarily due to lower amortization costs of patents and lower costs of third party consultants. Other Income During the three months ended September 30, 2013, we recognized approximately $70,000 of rent from Mac-B for the partial sublease of our Roanoke facility. This sublease expired on April 30, 2014. Therefore, we had no similar rent revenues for the three months ended September 30, 2014. Interest Expense Interest expense for the three months ended September 30, 2014 was approximately $21,000 compared to interest expense of approximately $43,000 during the same period in 2013. The monthly average loan balance during the three months ended September 30, 2014 was $1.2 million compared to $2.7 million for the same period in 2013. The lower average loan balance accounted for the decrease in interest expense. Net Loss from Continuing Operations As a result of our revenues of $5.4 million offset by cost of revenues of $3.3 million and operating expenses of $2.8 million during the three months ended September 30, 2014, we incurred a loss from continuing operations before income taxes of approximately $0.7 million, compared to a loss from continuing operations before income taxes of approximately $1.3 million for the three months ended September 30, 2013. We recorded an income tax benefit related to our net operating losses of $0.3 million and $0.5 million for the three months ended September 30, 2014 and 2013, respectively. After recognition of the tax benefit, our net loss from continuing operations was $0.5 million for the three months ended September 30, 2014 compared to a net loss from continuing operations of $0.8 million for the three months ended September 30, 2013. Net (Loss)/Income from Discontinued Operations For the three months ended September 30, 2014, we recognized net loss from discontinued operations of $0.3 million, compared to net income from discontinued operations of $0.2 million for the same period in 2013. For the three months ended September 30, 2014, this loss resulted from the intraperiod allocation of income taxes in the third quarter of 2014 in connection with the sale of our medical shape sensing business that occurred during the first quarter of 2014. For the three months ended September 30, 2013, net income from discontinued operations consisted of $0.7 million of operating income from our medical shape sensing business, which was partially offset by a $0.3 million intraperiod allocation of income taxes for the third quarter of 2013. Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 Revenues Nine Months Ended September 30, 2014 2013 Change Revenues:Technology development revenues $ 8,961,909 $ 8,564,743 $ 397,166 5 % Products and licensing revenues 6,108,799 5,070,441 $ 1,038,358 20 % Total revenues $ 15,070,708 $ 13,635,184 $ 1,435,524 11 % Revenues from our Technology Development segment increased $0.4 million for the nine months ended September 30, 2014, compared to the same period in 2013, due primarily to growth in our biomedical and nanomaterials groups, which largely resulted from higher costs of subcontractors, whose costs were passed through to the customer and resulted in revenues to us during the second quarter of 2014. These higher subcontractor costs may not recur at such levels in future quarters. 19-------------------------------------------------------------------------------- Table of Contents Revenues from our Products and Licensing segment increased by $1.0 million for the nine months ended September 30, 2014, compared to the same period in 2013. This increase in our Products and Licensing revenues was primarily attributable to higher sales of telecom test and measurement equipment. Cost of Revenues and Gross Profit Nine Months Ended September 30, 2014 2013 Change Cost of revenues: Technology development costs $ 6,793,061 $ 6,676,133 $ 116,928 2 % Products and licensing costs 2,654,305 2,322,776 $ 331,529 14 % Total cost of revenues $ 9,447,366 $ 8,998,909 $ 448,457 5 % Gross Profit $ 5,623,342 $ 4,636,275 $ 987,067 21 % The cost of our Technology Development segment remained relatively unchanged for the nine months ended September 30, 2014, compared to the same period in 2013. The cost of revenues in our Products and Licensing segment increased 14% commensurate with the growth in product sales for the for the nine months ended September 30, 2014. Because of the overall increase in revenues of 11% in the nine months ended September 30, 2014 compared to the nine months ended September 30, 2013, and an associated increase of 5% in cost of revenues, our gross profit increased to $5.6 million for the nine months ended September 30, 2014, compared to $4.6 million for the nine months ended September 30, 2013. Operating Expense Nine Months Ended September 30, 2014 2013 Change Operating expense: Selling, general and administrative $ 7,551,512 $ 7,986,541 $ (435,029 ) (5 )% Research, development and engineering 1,707,190 1,932,966 $ (225,776 ) (12 )% Total operating expense $ 9,258,702 $ 9,919,507 $ (660,805 ) (7 )% Our selling, general and administrative expense decreased 5% during the nine months ended September 30, 2014, as compared to the same period in 2013. The decrease was primarily due to cost reduction initiatives in the second quarter of 2014 following the sale of our medical shape sensing business. These savings resulted from headcount reductions in administrative roles and reduced professional fees for legal and investor relations services. Research, development and engineering expense decreased 12% due to lower headcount following the transfer of certain engineering employees to Intuitive as part of the sale of our medical shape sensing business in January 2014. Other Income We recognized approximately $102,000 and $185,000 of rent for the nine months ended September 30, 2014 and 2013, respectively, from Mac-B for the partial sublease of our Roanoke facility. As noted above, this sublease expired on April 30, 2014. Also, for the nine months ended September 30, 2013, we recognized approximately $48,000 in other income in connection with the receipt of an insurance policy profit share. Interest Expense Interest expense for the nine months ended September 30, 2014 was approximately $81,000 compared to interest expense of approximately $151,000 during the same period in 2013. The monthly average loan balance during the nine months ended September 30, 2014 was $1.5 million compared to $3.0 million for the same period in 2013. The lower average loan balance during the nine months ended September 30, 2014 accounted for the decrease in interest expense. 20-------------------------------------------------------------------------------- Table of Contents Net Loss from Continuing Operations As a result our revenues of $15.1 million offset by our cost of revenues of $9.4 million and operating expenses of $9.3 million, during the nine months ended September 30, 2014, we incurred a loss from continuing operations before income taxes of approximately $3.6 million, compared to a loss from continuing operations before income taxes of approximately $5.2 million for the nine months ended September 30, 2013. We recorded an income tax benefit related to our net operating losses of $1.4 million and $2.0 million for the nine months ended September 30, 2014 and 2013, respectively. After recognition of the tax benefit, our net loss from continuing operations was $2.2 million for the nine months ended September 30, 2014 compared to a net loss from continuing operations of $3.1 million for the nine months ended September 30, 2013. Net Income from Discontinued Operations For the nine months ended September 30, 2014, we recognized net income from discontinued operations of $9.1 million, compared to net income from discontinued operations of $4.3 million for the same period in 2013. For the nine months ended September 30, 2014, this income resulted from net gain related to the sale of our medical shape sensing business that occurred during the first quarter of 2014. For the nine months ended September 30, 2013, net income from discontinued operations consisted of a $3.4 million net of tax, gain on the sale of our SCC business in addition to $0.9 million of net operating income from our medical shape sensing business and our SCC business for the two months prior to its sale on March 1, 2013. |