LUNA INNOVATIONS INCORPORATED 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, the potential impacts of the COVID-19 pandemic on our business, operations and financial results, 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 of Our Business
We are a leader in advanced optical technology, providing high performance fiber optic test, measurement and control products for the telecommunications and photonics industries, and distributed fiber optic sensing solutions that measure, or "sense," the structures for industries ranging from aerospace, automotive, energy, oil and gas, security and infrastructure.
Our communications test and control products help customers test their fiber optic networks and assemblies with speed and precision in both lab and production environments, accelerating the development of fiber optic products and assuring accurate testing of optical components like photonic integrated circuits and coherent receivers, which are both critical elements of meeting the world's exponentially growing demand for bandwidth. Our distributed fiber optic sensing products help designers and manufacturers more efficiently develop new and innovative products by measuring stress, strain, and temperature at a high resolution for new designs or manufacturing processes. Our distributed fiber optic sensing products ensure the safety and structural integrity or operational health of critical assets in the field, by monitoring stress, strain, and vibration in large civil and industrial infrastructure such as bridges, roads, pipelines and borders. We also provide applied research services, primarily under federally funded development programs, that leverage Luna's sensing and instrumentation technologies to meet the specific needs and applications of our customers. Prior toSeptember 30, 2021 , we were organized into two main reporting segments, our Lightwave segment and ourLuna Labs segment. Our Lightwave segment develops, manufactures and markets distributed fiber optic sensing products and solutions and fiber optic communications test and control products. OurLuna Labs segment performed applied research principally in the areas of sensing and instrumentation, advanced materials and health sciences. Most of the government funding for ourLuna Labs segment was derived from theSmall Business Innovation Research ("SBIR"), program coordinated by theU.S. Small Business Administration . We now have one reportable segment, Lightwave, following the determination that ourLuna Labs segment met held-for-sale and discontinued operations accounting criteria at the end of the third quarter of 2021 and the sale of substantially all of our equity interests inLuna Labs onMarch 8, 2022 . 21
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As we develop and commercialize new products, our revenues will reflect a broader and more diversified mix of products. Our key initiative for long term growth is to become a leading provider of fiber optic test, measurement, control and sensing equipment. Recent acquisitions have added strategic technologies and products that complement our existing suite of sensing products and provided for expansion into high-growth markets such as security and perimeter detection, smart infrastructure monitoring and oil and gas. Our products have historically been strong in long-range, discrete sensing and short range, fully distributed sensing which are best when specific, known locations needed to be monitored. Additional product offerings from these strategic acquisitions have helped us fill a gap for long range, fully distributed acoustic, temperature and strain measurement. 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. The approximate value of our backlog was$47.6 million and$38.4 million atJune 30, 2022 andDecember 31, 2021 , respectively.
Acquisitions
OnMarch 10, 2022 , we acquiredNKT Photonics GmbH andLIOS Technology Inc. (collectively, "Lios") for €20.0 million, or$22.1 million . Lios, based inCologne, Germany and formerly owned by NKT Photonics A/S, provides temperature and strain sensing products which are highly complementary to our existing portfolio of fiber optic offerings.
Discontinued Operations
OnMarch 8, 2022 , we completed the sale of substantially all of our equity interests in ourLuna Labs business to certain members ofLuna Labs' senior management team and a group of outside investors for an initial purchase price of$20.4 million before working capital and escrow adjustments and transaction fees. We had been actively marketing ourLuna Labs segment to prospective buyers during 2021 as part of our growth strategy for our Lightwave segment. We have separately reported the results of ourLuna Labs segment as discontinued operations in our consolidated statement of operations for the three and six months endedJune 30, 2022 and 2021, and presented the related assets and liabilities as held for sale in the consolidated balance sheet as ofDecember 31, 2021 .
Description of Revenues, Costs and Expenses
Impact of COVID-19 Pandemic
The ongoing global COVID-19 pandemic has impacted, and will likely continue to impact, the way we conduct our business, including the way in which we interface with customers, suppliers and our employees. The COVID-19 pandemic has affected how we interact with our customers by reducing face-to-face meetings and increasing our on-line and virtual presence. While increasing our on-line and virtual presence has proven effective, we are unsure of the impact if these conditions continue for an extended period. During 2022, we have experienced and expect to continue experiencing some disruption in our supply chain and delays in revenue from certain customers as a result of shut-downs inChina . While we believe these disruptions are temporary, there is no guarantee we will be able to manage through these disruptions. See "Risk Factors" for further discussion of the potential adverse impacts of the COVID-19 pandemic on our business.
Revenues
We generate revenues from product sales, commercial product development and licensing and technology development activities. Our Lightwave segment revenues reflect amounts that we receive from sales of our products or development of products for third parties and, to a lesser extent, fees paid to us in connection with licenses or sub-licenses of certain patents and other intellectual property. We derivedLuna Labs segment revenues, which are presented as discontinued operations, 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 completed 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. Following our sale ofLuna Labs inMarch 2022 , we will no longer derive revenues fromLuna Labs .
Cost of Revenues
Cost of revenues associated with our Lightwave 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.
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Cost of revenues associated with our
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, amortization of intangible assets and costs related to merger and acquisition activities. These expenses also include compensation for employees in executive and operational functions including certain non-cash charges related to expenses from equity awards, facilities costs, professional fees, salaries, commissions, travel expense and related benefits of personnel engaged in sales, marketing and administrative 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 historicalLuna Labs segment, product development activities not provided under contracts with third parties, and overhead costs related to these activities. The operating expense of ourLuna Labs segment is presented in discontinued operations. Investment Income
Investment income consists of amounts earned on our cash equivalents. We sweep
on a daily basis a portion of our cash on hand into a fund invested in
Interest Expense
Interest expense is composed of interest paid under our term and revolving loans as well as interest accrued on our finance 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 accounting principles generally accepted inthe United States of America . 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 year endedDecember 31, 2021 , as filed with theSecurities and Exchange Commission ("SEC") onMarch 14, 2022 . 23
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Results of Operations
Three Months Ended
Revenues
Revenues for the three months endedJune 30, 2022 increased$4.2 million , or 19%, to$26.2 million compared to$22.0 million for the three months endedJune 30, 2021 . The majority of the increase in revenues for the three months endedJune 30, 2022 , compared to the three months endedJune 30, 2021 , was due to the revenues from Lios which was acquired onMarch 10, 2022 and growth in our sensing product sales.
Cost of Revenues and Gross Profit
Cost of revenues increased by$0.8 million , or 9%, to$10.2 million for the three months endedJune 30, 2022 , compared to$9.4 million for the three months endedJune 30, 2021 . The increase in cost of revenues was in line with our sales growth. Our overall gross margin for three months endedJune 30, 2022 was 61%, compared to 57% for the three months endedJune 30, 2021 . The increase in gross margin was primarily due to a favorable sales mix. Operating Expense Three Months Ended June 30, (in thousands) 2022 2021 $ Difference % Difference Operating expense: Selling, general and administrative$ 15,760 $ 12,805 $ 2,955 23 % Research, development and engineering 2,665 1,810 855 47 % Total operating expense$ 18,425 $ 14,615 $ 3,810 26 % Our selling, general and administrative expense increased$3.0 million , or 23%, to$15.8 million for the three months endedJune 30, 2022 , compared to$12.8 million for the three months endedJune 30, 2021 . Selling, general and administrative expense increased primarily due to the acquired Lios operations. Research, development and engineering expense increased$0.9 million , or 42%, to$2.7 million for the three months endedJune 30, 2022 , compared to$1.8 million for the three months endedJune 30, 2021 . Research, development and engineering expense increased primarily due to the timing of expenses from OptaSense last year and the acquired Lios operations.
Loss from Continuing Operations Before Income Taxes
During the three months endedJune 30, 2022 , we recognized a loss from continuing operations before income taxes of$2.5 million compared to loss from continuing operations before income taxes of$2.2 million for the three months endedJune 30, 2021 . Income Tax Expense/(Benefit) For the three months endedJune 30, 2022 , we recognized income tax expense from continuing operations of$0.4 million , compared to an income tax benefit from continuing operations of$1.0 million for the three months endedJune 30, 2021 . The income tax expense for the three months endedJune 30, 2022 was primarily due to an unfavorable impact from the net Global Intangible Low Taxed Inclusion ("GILTI") and losses for which no benefit can be recorded partially offset by Research & Development ("R&D") tax credits. The income tax benefit for the three months endedJune 30, 2021 was primarily related to the pre-tax loss and deductions on vested RSUs and stock option exercises.
Income from Discontinued Operations, net
For the three months endedJune 30, 2022 and 2021, we recognized income from discontinued operations, net of income taxes, of$0.6 million and$0.9 million , respectively. The results of our discontinued operations for the three months endedJune 30, 2021 include the operations of ourLuna Labs segment that were held for sale. 24
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Six Months Ended
Revenues
Revenues for the six months endedJune 30, 2022 increased$5.6 million , or 13%, to$48.6 million compared to$43.0 million for the six months endedJune 30, 2021 . The majority of the increase in revenues for the six months endedJune 30, 2022 , compared to the six months endedJune 30, 2021 , was due to the revenues from Lios which was acquired onMarch 10, 2022 . Excluding Lios, we also experienced growth in sales of our sensing products.
Cost of Revenues and Gross Profit
Cost of revenues increased$0.3 million , or 2%, to$18.4 million for the six months endedJune 30, 2022 , compared to$18.1 million for the six months endedJune 30, 2021 . This increase in cost of revenues primarily resulted from the Lios business. Our overall gross margin for the six months endedJune 30, 2022 was 62%, compared to 58% for the six months endedJune 30, 2021 . The increase in gross margin was primarily due to a favorable sales mix. Operating Expense Six months ended June 30, (in thousands) 2022 2021 $ Difference % Difference Operating expense: Selling, general and administrative$ 29,862 $ 23,739 $ 6,123 26 % Research, development and engineering 5,207 4,727 480 10 % Total operating expense$ 35,069 $ 28,466 $ 6,603 23 % Selling, general and administrative expense increased$6.1 million , or 26%, to$29.9 million for the six months endedJune 30, 2022 , compared to$23.7 million for the six months endedJune 30, 2021 . Selling, general and administrative expense increased primarily due to the acquired Lios operations and higher integration costs, amortization of intangible assets and share-based compensation. Research, development and engineering expense increased$0.5 million , or 10%, to$5.2 million for the six months endedJune 30, 2022 , compared to$4.7 million for the six months endedJune 30, 2021 . Research, development and engineering expense increased primarily due to the acquired Lios operations.
Loss from Continuing Operations Before Income Taxes
During the six months ended
Income Tax Benefit
For the six months endedJune 30, 2022 and 2021 we recognized an income tax benefit from continuing operations of$0.7 million and$1.7 million , respectively. The income tax benefit for the six months endedJune 30, 2022 was primarily due to the pre-tax loss and R&D tax credits, which was partially offset by an unfavorable impact from the net ("GILTI") and losses for which no benefit can be recorded due to valuation allowances. The income tax benefit for the six months endedJune 30, 2021 was primarily related to the pre-tax loss and deductions on vested RSUs and stock option exercises.
Net Income from Discontinued Operations
For the six months endedJune 30, 2022 and 2021, we recognized income from discontinued operations, net of income taxes, of$11.5 million and$1.7 million , respectively. The results of our discontinued operations for both six month periods include the operations of ourLuna Labs segment that were held for sale. The results of our discontinued operations for the six months endedJune 30, 2022 included a gain of$10.9 million , net of tax, on the sale ofLuna Labs . 25
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Liquidity and Capital Resources
AtJune 30, 2022 , our total cash and cash equivalents were$4.9 million . We require cash to: (i) fund our operating expenses, working capital requirements, and outlays for strategic acquisitions and investments; (ii) service our debt, including principal and interest; (iii) conduct research and development; (iv) incur capital expenditures; and (v) repurchase our common stock. As part of our business strategy, we review acquisition and divestiture opportunities on a regular basis. InMarch 2022 , we completed the disposition ofLuna Labs and the acquisition of Lios, which are discussed elsewhere in this Form 10-Q. The Lios acquisition price of$22.1 million was funded from$13.0 million of initial cash proceeds from the disposition ofLuna Labs with the remainder of funding coming from availability under our revolver and operating cash. InJune 2022 , we completed a refinancing of our previous credit facility to, among other things, extend the maturity date of our Term Loan and Revolving Line and increase our total borrowing capacity.
We believe that the key factors that could affect our internal and external sources of cash include:
•Changes in demand for our products, including as a result of the COVID-19 pandemic, competitive pricing pressures, supply chain constraints, effective management of our manufacturing capacity, our ability to achieve further reductions in operating expenses, our ability to make progress on the achievement of our business strategy goals, and our ability to make the research and development expenditures required to remain competitive in our business. •Our access to bank financing and the debt and equity capital markets that could impair our ability to obtain needed financing on acceptable terms or to respond to business opportunities and developments as they arise, including interest rate fluctuations, macroeconomic conditions, sudden reductions in the general availability of lending from banks or the related increase in cost to obtain bank financing and our ability to maintain compliance with covenants under our debt agreements in effect from time to time. As ofJune 30, 2022 , we had outstanding borrowings under our Term Loan and Revolving Line of$19.9 million and$1.3 million , respectively. We may repay and reborrow advances under the Revolving Line from time to time pursuant to the Revolving Line of Credit Note. The Term Loan matures onJune 21, 2027 . The Term Loan amortizes at a rate equal to 10% for the first year, 15% for years two and three and 20% in years four and five, in each case paid on a quarterly basis. Accrued interest is due and payable on the first day of each month and the outstanding principal balance and any accrued but unpaid interest will be due and payable onJune 21, 2027 . The Term Loan bears interest at a floating per annum rate equal to the sum of (a) the daily simple secured overnight financing rate, or Daily Simple SOFR, plus (b) an SOFR adjustment of ten basis points (0.10%), plus (c) an applicable margin. The applicable margin ranges from 1.75% to 2.50% per annum, depending on the Net Leverage Ratio (as defined in the Loan Agreement). We may prepay the Term Loan without penalty or premium. The Revolving Line expires onJune 21, 2027 . Borrowings under the Revolving Line bear interest at a floating per annum rate equal to the sum of (a) Daily Simple SOFR, plus (b) a SOFR adjustment of ten basis points (0.10%), plus (c) an applicable margin. The applicable margin ranges from 1.75% to 2.50% per annum, depending on the Net Leverage Ratio. Accrued interest is due and payable on the first day of each month and the outstanding principal balance and any accrued but unpaid interest is due and payable onJune 21, 2027 . The unused portion of the Revolving Line accrues a fee equal to 0.20% per annum multiplied by the quarterly average unused amount. The unused Revolving Line totaled$13.7 million atJune 30, 2022 .
Additional details of our Loan Agreement can be found in Note 8, "Debt" in the notes to our unaudited condensed consolidated financial statements included elsewhere in this Form 10-Q.
We believe that our cash and cash equivalents and availability under our revolver as ofJune 30, 2022 will provide adequate liquidity for us to meet our working capital needs over the next twelve months from the date of issuance of the consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. Additionally, we believe that should we have the need for increased capital spending to support our planned growth, we will be able to fund such growth through either third-party financing on competitive market terms or through our available cash. However, these estimates are based on assumptions that may prove to be incorrect, including as a result of the ongoing COVID-19 pandemic and its potential impacts on our business. If we require additional capital beyond our current balances of cash and cash equivalents, this additional capital may not be available when needed, on reasonable terms, or at all. Moreover, our ability to raise additional capital may be adversely impacted by potential worsening global economic conditions and disruptions to and volatility in the credit and financial markets inthe United States and worldwide resulting from the ongoing COVID-19 pandemic. 26
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