Description

Luna Innovations (LUNA) is a unique business with abundant revenue growth and operating leverage.  It currently trades at a value multiple and should rerate as its results show its inherent growth and profitability.  Currently trading at a $265 million market cap with $26 million in net cash on the balance sheet, the company is underfollowed by Wall Street with only 2 analysts covering the name.  LUNA trades at an Enterprise Value to Revenue (EV/R) ratio of 2.5x on 2021E revenue of $96 million, and an EV / EBITDA ratio of 13.7x on 2021E EBITDA of $17.5 million.  I believe these multiples are very low relative to the sustainable 15%+ topline growth and 40% EBITDA growth of the company going forward.

Luna is a fiber optic testing company that uses fiber in a unique way.  As such, it lacks head-to-head competition in many of its markets.  This lack of competition is obviously a boon to pricing and margins but is also detrimental as no Wall Street analysts are incentivized to cover the company as it has no peers to amortize the coverage effort over or to compare to on a valuation basis.  Luna’s business is split into two divisions, Lightwave and Luna Labs.  In the September 2020 quarter, Lightwave comprised 73% of the total while Luna Labs made up 23%.

The Lightwave division sells fiber optic testing products and is itself split into two parts, Sensing and Non-Destructive Testing and Communications Test and Photronic Control.  The Sensing business uses fiber optic strands as sensors and can measure strain, temperature, acceleration and vibration, and thickness over long distances.  These capabilities can be used in many applications.  For example, when the Polcevara Viaduct bridge in Genoa, Italy, was rebuilt after being destroyed in an earthquake, it was outfitted with fiber optic sensors and measurement systems from Luna to enable real-time health monitoring of the bridge.  Luna works on a handful of similar projects each quarter but this pace could accelerate rapidly if a long-awaited infrastructure bill is passed in the United States.  Smart infrastructure is topical now and Luna would likely benefit from any incremental projects in this area.

Another example of Luna’s Sensing technology was announced on 10/15 where Luna, in partnership with Shell’s GameChanger early-stage-technologies program, developed, for the oil and gas industry, an “innovative concept for measuring in-situ stresses in subsurface rock using its fiber optic sensing solutions.  When deployed, this technique would provide critical measurements with unmatched consistency and depth resolution, allowing safer and more efficient well operations.”   While very early stage this is a large opportunity for the company. 

The company has a partnership with Meggitt, a large aerospace component supplier, to develop a fire sensor to be used on commercial and defense aircraft.  Starting with new Airbus planes, these sensors will likely be retrofitted into the existing aircraft fleet over time.  This opportunity has been pushed out somewhat due to Corona’s impact on the aerospace industry.  While this is a long-term opportunity, it shows the breadth of industries that can take advantage of Luna’s technology.

Luna’s sensors are also used to detect material thickness in composite materials.  In the B-22 Stealth Bomber, the anti-radar coating thickness must be uniform to work properly.  Luna’s sensors can detect micron thickness abnormalities that would cause the bombers to show up on radar.

Luna also recently inked a deal with Land Rover where every new Land Rover Defender has a handful of Luna sensors on it to detect corrosion over time in different environmental conditions.  This is an example of Luna’s sensors being used in production vehicles, not just test cases.

These Sensing examples demonstrate the wide range of end cases of Luna’s technology.  This breadth results in 20%+ growth in this segment each year.  The breakout opportunities include more production deals like Land Rover and Meggitt and the result of an infrastructure buildout in the US.    

The Communication test business can detect and pinpoint flaws in fiber optic networks to the millimeter.  Lockheed Martin uses Luna’s OBR 6200 to test the complex fiber optic networks on its F-22 fighter jets.  While Lockheed has used a few of these testers in the past, it just placed an order for over 100 testers to be delivered this year.  At a $65,000 ASP per tester, this amounts to an order of over $6 million, definitely enough to move the needle at a small company like Luna.  There remains a large opportunity at Lockheed for testers to be used with its other aircraft and additional opportunity for testers to be used at other defense contractors such as Northrop Grumman.

Financial firms that facilitate high-speed trading are also customers of Luna.  Luna’s testers can measure the exact length of the fiber route used in trading and also can detect any latency in such networks.    

Luna’s testers are also important in the production of silicon photonics.  These chips combine silicon circuitry with optical capability and are becoming more prevalent in optical networks.  Luna can test these chips during their fabrication as well as when they are complete to ensure they perform up to specification.    

Luna’s other division is called Luna Labs.  Luna Labs uses government funding to research material science to produce innovative products, that Luna can then use in its Lightwave division.  This business is about 25% of Luna’s entire business.

Luna is experiencing a positive mix shift as its Lightwave business grows faster than its Luna Labs business.  Gross margins in the Lightwave division are about 62% while gross margins in the Luna Labs business are about 28%.  Lightwave is growing about 20% and Luna Labs is growing about 7%.   Thus, over time, overall gross margins will rise as Lightwave becomes a bigger piece of the business.    Also, overall revenue growth will improve as the faster growing Lightwave business becomes a larger part of the overall pie.

What is the right way to think about valuation for this business?  Without any true comps it is necessary to look at absolute valuation for a growth company.  We forecast revenue to grow at a 17% clip for the next few years and EBITDA to grow much faster, at a 40% rate as the company leverages its fixed cost structure.  These assumptions result in $33 million in EBITDA in 2023 on a $131 million revenue base.  Applying a growth multiple of 20x to that EBITDA gets you to a $21 share price, or about a 160% return from current levels.

Catalyst

Continuing revenue growth and operating leverage will cause rapid EBITDA growth and force a rerating of the business.