Description

LUNA INNOVATIONS (Nasdaq: LUNA)

“Change always comes bearing gifts.”

~Price Pritchett~

Summary

Luna Innovations is a mispriced equity with strong growth opportunities and a solid balance sheet.

While shares have performed well over the past 12 months as the Company has executed on its business plan, they have been hit by what we think will be a temporary setback on the heels of its recent Q2 2016 earnings report.  LUNA’s selloff following that report was dramatic, sending the stock down from $1.50 to as low as $1.16, with a record 1.2M shares changing hands in two days.  This pocket of liquidity and advantageous pricing is a perfect time to build a position in a materially undervalued Company that is executing on all fronts against the backdrop of an optical components industry that is still in the early stages of robust growth.

History

Luna Innovations was founded in 1990 and taken public in 2006.  The early focus of the Company was on developing technologies with the intent to sell them prior to commercialization. The venture capital market in the early to mid 2000’s was hot, thus this strategy offered great promise. Luna has had several successes in monetizing technology over the years, but also has some notable failures having emerged from bankruptcy in 2010 following a lawsuit with Hansen Medical. The bankruptcy filing was a tactical approach at the time used to force Hansen into a settlement. It is especially noteworthy that upon emergence from Chapter 11, Luna paid all of their creditors 100% and the existing equity remained intact with Hansen receiving additional shares for 9.9% of the company.  In Dec 2009, as part of LUNA’s reorg, Hansen Medical (HNSN) was awarded a large block of LUNA shares.  Hansen disclosed that they sold their position during the first quarter of this year – this created an enormous overhang during that time as they shopped their block to investors, pressuring shares to the sub $1.00 range.

My Chung took over as CEO in 2011, following a leadership transition. Chung is an experienced industry executive with a strong track record of success having formerly served as president and CEO of Circadiant Systems, a provider of optical test systems to optical component developers, network equipment manufacturers, and telecom service providers.  Chung was instrumental in the sale of Circadiant to JDS Uniphase Corporation in 2008.  

At the time of Chung’s appointment, LUNA owned three technologies that held large commercial opportunity. Chung proceeded to sell two of them, and held the one he thought had the most potential – fiber optic sensing.  Chung’s sales were substantial – he sold LUNA’s cyber security business to MacAulay Brown for $6.1 mln in 2013; and LUNA’s medical shape sensing technology to Intuitive Surgical (ISRG) in a deal valued up to $30 mln. The last piece of the Intuitive relationship was bought out in late 2015 by ISRG for $9M cash.  The sales demonstrated Chung’s ability as a dealmaker and his willingness to create value over holding on to legacy assets.

Today, LUNA’s fiber optic sensing business is stable and starting to grow as major manufacturing changes in the Aerospace and Automotive industries take hold. The company recently updated the platform and indicated two “well known” aerospace companies as customers which would suggest a very material pipeline. But Chung was not content on being a pure play sensing business given the opportunity that would soon present itself.

API Merger

In early 2015, Luna merged with Advanced Photonix (API), a publicly traded company. API is a maker of high speed optical components, optoelectronic subsystems and terahertz sensing systems.  The Company had struggled in 2014, disappointed investors, and ran into balance sheet troubles, with limited cash and a small debt load. The merger rationale was based not only on the attractiveness of API’s distressed valuation, but more importantly on their strong technology in telecom optics where Luna and API sell to a similar customer base.

The merger closed in May of ’15 and created a major dislocation for API shareholders, with the stock falling as much as 40% in the weeks that followed. Over the past 12+ months, Luna has announced several noteworthy contracts for API including a $4M fiber to the home supply agreement, as well as a $7M order for its industry leading 100G coherent receivers. More recently, they completed a new modern facility which will enable the company to manufacture optical products without the outsourcing of any process, and thus drive notably higher margins.

LUNA’s Business Segments

Technology Development Division (TDD) - Luna has historically generated a significant amount of revenue from its TDD. This group conducts applied research on a fee for service basis for third parties, generally retaining the rights to the technology and patents developed under those contracts. Their patent portfolio is substantial, containing in excess of 275 issued patents. TDD is self-sustaining with $10-$12 mln in steady revenue per year. The division has realized over $190 mln in contract wins over the past decade with a backlog approaching $20 mln today.

Lightwave Division – This is a high-growth business unit, with a focus on commercializing new technologies in the testing (strain, stress, temperature) of advanced materials such as composites used in emerging Aerospace and Automotive applications. These end markets represent large market opportunities which Luna is only just beginning to penetrate. Both the Aerospace and Automotive industries are moving away from metals like aluminum and towards composite materials like carbon fiber or other synthetics. Composites offer a tremendous value proposition in terms of strength and weight, which drive fuel and other engineering efficiencies. One of the key challenges with using composite materials is to ensure its structural uniformity, especially when using overlapping carbon fibers. More advanced material testing is required, given very stringent regulatory oversight, and Luna’s Lightwave Division is uniquely positioned to benefit from the increased utilization of composite materials. This division is one of the more exciting growth catalysts for the company, which we think can quickly start to grow 20% per year or more.

The use of composites is growing 20% per year with the highest contribution from the Aerospace industry, as both industry giants Boeing and Airbus are making substantial commitments to utilize composite materials in next generation commercial aircraft. Boeing has stated that using composites in their 787 can increase fuel efficiency by 20%, relative to traditional aluminum designs. Automotive manufacturers are also adopting composite materials, with fuel-efficiency being a key driver. BMW pioneered composite materials in cars when it introduced its i3 model into production during 2013, a move that came with great attention in the automotive world. Composites are also finding their way into many other industrial applications including bridges, tunnels, nuclear cooling towers, however these are markets outside of Luna’s current focus.

The fiber optic sensing market is over $1+ bln today and expected to grow to over $3 bln by 2018. The addressable market within Luna’s focus is estimated at $325 mln today with growth projected to $450+ mln by 2018.

Advanced Photonix (API)

Historically, API has operated under three business units – High Speed Optical Receivers (HSOR), Optoelectronic Solutions, and Terahertz.

HSOR - The Company moved into this opportunity following its acquisition of Picometrix, which has a successful 20+ year history. They have developed next generation 100 Gigabit coherent receivers with penetration in the rapidly expanding Chinese market. They also developed products targeted at the access and transmission market, and the high volume fiber to the home market. This industry is growing rapidly today despite a competitive and price sensitive market. Industry growth is being driven by insatiable bandwidth demand globally, driven by video, HD video, streaming services, and mobile data consumption in particular. Their products are needed by companies building large data centers and those providing faster bandwidth speeds to the consumer and commercial markets. Customers include global players such as Alcatel Lucent, ZTE, Finisar, etc.

Given notable wins of $7M in ’15 to a leading telecom in China, as well as an announced $4M fiber to the home project, we feel confident that their pipeline is building. The recently completed facility suggests confidence by management to invest valuable cash in the growth of this segment.

Optoelectronic Solutions - API has offered innovative optoelectronic solutions over the past 25 years to its customers. The group specializes in the custom design of highly advanced electronic and circuitry components to meet the needs of a wide range of hallmark customers who seek a lower volume, but highly customized solution. The business model is typically contract oriented and carries a higher gross margin than other Luna business lines. Their technology can be found in a wide array of use cases including military, healthcare, professional audio applications to name a few.

Terahertz Solutions - Terahertz is a new and potentially disruptive sensor technology for the non-destructive testing, imaging and process control markets. The Terahertz technology can see through most materials, determine chemical composition, and measure multiple properties simultaneously (such as moisture, density, weight, and thickness). The frequency technology being used lies between microwave and infrared ultra violet. The U.S. Government, and specifically Homeland Security, has spent considerable time and resources in exploring the use of technology in this arena for security applications. Many companies have invested large amounts of capital into this technology, but scalable commercial opportunities have yet to be clearly identified. API has technology that is allegedly further along than competitors, but their investment in recent years had driven a majority of API’s overall corporate losses. Though the adoption of the technology has admittedly been slower than expected, some progress has been made with management noting wins on recent conference calls. We believe Luna management has focused on government-funded developmental contracts going forward, which are lower risk and will allow for further development of the technology, while leveraging external funding sources. Although not identified as the strategic direction of management, we believe the business unit has the potential to be sold for $5-10 mln to a strategic buyer, given the underlying value of its technology and patents, and would regard this as a lower-probability value-creation catalyst.

Current Opportunity

After digesting a merger with Advanced Photonix (API) in 2015, LUNA is now on the verge of 20%+ growth driven by strong industry tailwinds starting to take hold. The acquired API business struggled in 2014, but showed signs of growth last year which are likely to be realized further in the upcoming quarters. Our thesis for owning Luna stock today is predicated on benefitting from growth in both primary operating segments which have equally strong potential in the near term to drive results forward. Over the next few quarters, we believe that the fundamental story will greatly improve with both top line revenue acceleration, as well as margin expansion, both of which should drive greater profitability. Downside is limited at its current valuation due to strong fundamentals, a robust balance sheet, and an active corporate buyback program.

What gets us excited most about Luna is the explosive growth in the optical sector, highlighted by three main drivers (Source on main drivers: Northland Securities)

New Customers – Cloud and Internet Content providers have emerged as a major force in the deployment on 40/100G optical networking technology both within and between data centers. As a group the top 4 Cloud/ICP companies will spend nearly $30B in capex in 2015, up from just over $10B in 2012 and about half of what Tier 1 US Telco, Wireless and Cable MSOs will spend. Moreover, the rapid growth and flexible operational mindset of this new optical customer base has served to shorten sales cycle and speed the introduction of new technologies.

New Bandwidth demand drivers – These include the Web scale traffic growth, movement of enterprise applications to the Cloud, mobile broadband and streaming/OTT video as the primary driver of consumer

bandwidth demand.

New Technology drivers – Developments at both the silicon and compound component levels, highlighted by Coherent and Photonic Integrated Circuit technologies, respectively, have combined to improve network scaling and economics as the strengths of both the Si and III/V technology ecosystems are deployed.

Current Valuation

Luna has trailing 4Q revenue of $57M and EBITDA of $116k. With 27.7M shares outstanding, the current market cap is $33.2M at a price per share of $1.20.  Shares are currently trading 0.45x trailing revenue, net of cash.

Balance Sheet & Buyback Program

Luna closed 2Q with net cash of $8.6M consisting of $13.8M in cash, plus $5.2M in outstanding bank debt. The company has been operating around EBITDA breakeven the past few quarters and is unlikely to burn cash going forward. In 2Q, cash fell $1.2M due to capital expenditures related to completing the manufacturing facility improvements. A separate and notable use of cash is their current stock repurchase program. In June of this year, the company announced a $2M buyback of which they have only purchased 59k shares at average price of $1.22 through June.  The statement made by the CEO at the time of the buyback read as follows, “Our management team and Board of Directors believe strongly in our long-term growth prospects and our ability to improve our profitability and cash flow. The initiation of this stock repurchase program demonstrates our commitment to building shareholder value as well as confidence in achieving long-term growth,”


Target Valuation

We looked at M&A in the Optical Components sector over the last few years in addition to current EV/Sales multiples for a number of Companies in the sector:

If we take away the lowest (.3x) and the highest (4.5x) multiples, the average is 1.75x

Publicly traded optical networking firms:

Name                                  EV/Sales (ttm)

Adva Optical (ADV.DE)        .65x

Cinea (CIEN)                          1.3x

Finisar (FNSR)                        1.5x

Infinera (INFN)                       1.2x

Lumentum (LITE)                   2.0x

MRV (MRVC)                           .7x

Neophotonics (NPTN)            1.3x

Oclaro (OCLR)                      1.7x

Taking out the lowest (.7x) and the highest (2.0x) multiples, the average is 1.27x

API had $28m of sales when it was acquired by LUNA.  We think that API is at a run rate of $35m in sales today, moving to $40m+ by this time next year using modest growth assumptions.

Even though M&A multiples are averaging 1.75x and current multiples are averaging 1.27x, let’s be ultra conservative and say that API is only worth 1x sales

Value of API at 1x fwd sales: $40m

Value of Terahertz (low end) $5m

Net Cash: $8.6m

Total Value: $53.6m

Total Market cap at $1.20 per share (27.7m shares out) = $33m

Investors are thus paying negative $20.6m for Luna’s core fiber optic and contract research businesses.

At a firm-wide multiple of 1x EV/Sales we get to a market cap approaching $65M (revenue + net cash) or a price per share of $2.35, ~96% above current prices. As revenue and profitability accelerates though ’16 into ’17, metrics such as a multiple of EBITDA will likely point to even higher valuations.  Keep in mind, we believe that LUNA will continue to show an increase in positive EBITDA throughout the year.

Very modest revenue growth assumptions get us to $1m in EBITDA per quarter, or $4m per year.  At this level, LUNA will re-rate from an arcane microcap tech company to a growth stock in an attractive vertical.   

Catalysts

• Continued announcement of customer wins

• Acceleration of stock buyback:– the Board believes shares are undervalued due to recent decision

• Terahertz business: Could present monetization event

Risks

• Slump in telecom infrastructure spending

• Failure to execute on large customer wins

Catalyst

• Continued announcement of customer wins

• Acceleration of stock buyback:– the Board believes shares are undervalued due to recent decision

• Terahertz business: Could present monetization event