Dale Messick - Chief Financial Officer My Chung - President and CEO

Greg Greenberg from Wells Fargo Advisors

Good day, ladies and gentlemen. Welcome to the second quarter 2013 Luna Innovations earnings conference call. My name is Philip and I'll be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Dale Messick, Chief Financial Officer. Please proceed.

Thank you, Philip. Good afternoon everyone and thank you for joining us today as we review Luna’s results for the second quarter of 2013. Before we proceed with the presentation let me remind each of you that statements made in this conference call as well as in our public filings, releases and websites which are not historical facts may be forward-looking statements that involve risk and uncertainties and are subject to changes at any time, including but not limited to statements about future financial and operating performance. We caution investors that any forward-looking statements made by us are management's beliefs based on currently available information and should not be taken as a guarantee of future results or performance. Actual results may differ materially as a result of a variety of factors discussed in our earnings release and our latest Forms 10-K and 10-Q filed with the Securities and Exchange Commission. We disclaim any obligations to update any such factors or to announce publicly the results of any revisions to any of the forward-looking statements to reflect future events or developments. There is more complete information regarding forward-looking statements, risks and uncertainties in the company's filings with the SEC available on our website. And at this time, I'd like to turn the call over to My Chung, President and CEO of Luna Innovations.

Thank you, Dale. Today I would like to provide you with an update on our strategic growth initiatives and on our overall business performance. Dale will then review our quarterly financial results and we will then open up the call to take any questions that you might have. We transformed Luna into a high growth products company. We had focused on two key strategic growth initiatives. The first of which is the unique and exciting development of fiber optic shapes sensing for minimally invasive surgical applications. At the end of June, we announced that we had entered into an amended agreement with Intuitive Surgical to define development milestone expectations for the next several years. This is significant, as we have historically only executed annual amendments. With the technical accomplishments we have made in the development of our shape sensing product over the past several years, both [initiatives] and as concluded that it is in our mutual best interest to commit to a multi-year plan, one that will move this technology closer towards product commercialization. We are delighted to now have this agreement in place. At the same time, we continue our development efforts with Philips Medical for the use of this technology a non-robotic medical applications. This program is on track and we continue to be excited about the productization opportunity in working with Philips. Our second strategic growth initiatives centers around our ODiSI distributed optical sensing platform, which enables easier more effective and higher resolution measurements of strain and temperature easing optical fiber rather than individual strain gauges or thermocouples. We continue to focus our marketing of the ODiSI products towards automotive, aerospace and energy opportunities and applications. Especially those related to composite materials, complex shapes or environments where conventional electrical strain gauges or thermocouples cannot operate. We are making good progress with this initiative as our sales of ODiSI products in the second quarter were double the sales of ODiSI products in the second quarter of last year. In terms of our overall product sales, I am pleased to report the sales increased 7% over the second quarter of last year and approximately 38% over the first quarter of this year. The increase in ODiSI revenues continues to offset the softness we and other vendors are experiencing in the telecom test and measurement market. Turning to the technology development segment of our business, last quarter I mentioned that within this segment, one of our research groups, our optical systems group experienced a significant decline in their funded backlog at the end of last year which would naturally have an adverse impact on our revenue opportunity for this year. Because of that, earlier this year will give some restructuring and realignment within that group. This restructuring helped to offset the expenses associated with the approximately $1 million decline in the Q2 2013 evident. The other groups within the technology development segment were essentially flat compared to Q2 of 2012. The good news is that we continue to win new contracts and our backlog for future work improved 10% from year end 2012. At this time, we will like to turn the call back over to Dale to review the overall financial results.

Thank you, My. For second quarter of 2013, we recognized revenue of $6 million that compared to revenue of $6.7 million in the second quarter of 2012. Product and licensing revenue increased 11% to $3.2 million compared to $2.8 million in the second quarter of last year. Our higher revenues from the product and licensing segment during the quarter were driven by increased sales of our OdiSI products, which is My mentioned were double the Q2, 2012 revenues as well as higher revenue in fiber optic shape sensing development contracts with Intuitive Surgical and Philips Medical. Product and licensing revenues in the second quarter overall increased 69% versus the first quarter of this quarter, including a 38% growth in product sales from Q1 to Q2. Our technology development revenues were $2.8 million in the second quarter of 2013 compared to $3.9 million in the same quarter last year. As My mentioned, the decrease represents primarily decline in contract research projects for optical systems group which completed some large awarded contracts towards the end of the last year and did not have the remaining backlog necessary to sustain that level going into this year. However, we recently improve contract win rates within our overall technology development groups, revenues of $2.8 million in the second quarter represents an increase of 7% compared to the first quarter of this year and our backlog for future work at June 30 improved a $1 million compared to the backlog at March 31. Our overall gross margins remain steady at approximately 40% for Q2 of 2013 and 2012. Operating expenses increased slightly to $3.3 million for the most recent quarter compared to $3.1 million in the second quarter of last year. This increase includes the recognition of a $125,000 in a provision for roughly calculate to one of our international distributors. Excluding that unusual charge, operating expenses would have increased only 2% compared to same period last year. Our resulting loss from continuing operations was approximately $951,000 in the second quarter of 2013, compared to a loss from continuing operations of $442,000 in the same period last We recognized income tax benefit of $161,000 in the most recent quarter, which represents the utilization of available NOLs to offset the tax impact of the gain we recognized on the sales of our secure computing group in the first quarter of this year. You will see this income tax benefit to continuing operations is offset by the impact of tax on the sales computing group recognized in the discontinued operation section of our income statement for the quarter. After the recognition of discontinued operations, our net loss attributable to common shareholders for the quarter was $978,000 or $0.07 per share compared to a net loss to common shareholders of $269,000 for $0.02 per share for the second quarter of last year. Year-to-date, we recognized revenues of $10.5 million compared to $13.4 million for the first six months of last year. The decrease in revenues year-to-date is primarily driven by a $2.4 million decline in technology development revenues with the most significant factors being the decline in our optical systems group as I mentioned a moment ago. Operating expenses increased 3% compared to the first six months of last year with the increase reflecting predominantly a higher level of internally funded product R&D activity in the first quarter of this year. After recognizing the gain we realized on the sales of a secured computing group in the first quarter of the year, we recognized a net income for the first six months of 2013 of $1.8 million, or $0.11 per diluted share compared to a net loss of $638,000 or $0.05 per diluted share for the first half of 2012. We ended the second quarter with $8.7 million of cash on hand compared to $6.3 million at the end of last year and $10.3 million at the end of the first quarter of this year. Our cash flow for the quarter was adversely impacted by the timing of our revenue recognition in the second quarter, being very heavily weighted toward the last month of the quarter and therefore not yet collected by the end of the quarter. Our account receivable balance accordingly increased $1.1 million at June 30, compared to March 31, which again had a negative impact on our cash flow for the second quarter. Offsetting the balance of our outstanding term loan our net cash was $5.7 million at June 30, compared to $2.7 million at the end of 2012. With that, I’d like to now turn the call back over to My.

And with that, we’ll open up the call for any questions that you might have.

(Operator Instructions). Your first question comes from the line of (inaudible).

Could you speak, fractionally speaking how big a part of your overall business is from the telecom sector and I’d like a follow-up on that also?

The telecom sector is part of the product and licensing revenues and it’s about 60% of it.

Okay. And thank you Dale for that. And the reason I asked you, we listen to this calls quarter-after-quarter and you folks can’t change the economy, I wish I could which can’t, but we hear you say continually that part of the problem there if you will impact is due to softness in the telecom sector and you just have to wonder how long you continue down that road, I mean you domestically say and it is not good. And when do you begin to say that is part of our basis is probably never going to evolve or roll that much based on the current environment and what is going to continue to be down the road? And also on that same note, has the headcount changed for the products that are involved and expect at all?

Okay, so it’s just a little bit about the history, just before Luna Innovations decided to take the company public this was back in 2006, they reincorporated into Luna Innovations a spin-out that they had Luna Technologies. Luna Technologies was founded to go after the telecom test market and during that telecom boom era of 2000. So the basis of the product side when the company went public was for the most part all 100% telecom. I came to on board in 2011, by then the company had decided that they needed to diversify away from the telecom market at which point it’s got into the sensing space. And they introduced their first sensing product in July of 2011. So since then we have seen transitioning our product revenue from a 100% telecom to now still a majority telecom, but it’s as Dale said roughly now about 60% rather than 100% and increasing the growth coming from our OdiSI which has a bigger market size for us in the telecom space. So the answer to your question directly, the telecom will continue to be a part of Luna, but it will become less and less of a part by us executing on our strategic growth initiative and it was kind of stable out in our opinion as the telecom market does recover. And the players that are in that space to track to see how that industry is doing or people like JDSU are adjuvant, which are very large players in the telecom space. And there is one third player and they are called Expo. And you see that all three players have been hit just as hard as we have in the space. Did that answer your question?

It did. And the second part is as your headcount remain relatively the same?

It's roughly the same. The headcount in that division really consists not only of development engineers for the telecom products, but it's been shifted over to OdiSI, as well as those development engineers also work on the development agreements that we have with Intuitive as long as with Philips.

Very good. And could you expand just a little on your multiyear deal with Intuitive, is it relatively the same financial deal going forward, is there anything you can expand on or tell us other than the fact that it's a multiyear deal instead of a just an annual?

It is a little bit more expanded than in previous years, right. The rate that we charge similar the same. The specifications that they’ve outlined for us to achieve in this multiyear plan is a little bit tighter, at which point the development dollars that we're looking at for this period is slightly higher than we traditionally have had.

And I guess lastly, are you satisfied with the direction you are headed? I realized you only have been at two years, but where we now? Obviously (inaudible) not where you want to be in the future, but are you satisfied in the general direction the company is headed?

I am. I believe that we're headed in the right direction. I think the challenges that we've had clearly has been things somewhat out of our control. The telecom market going soft and in 2011 didn’t help things. And also what's been happening in the U.S. government was sequestration and all the tightening back on the government spending has clearly impacted our research side. The combination of those two kind of discount some of the growth that we're seeing on ODiSI, but restructuring that we've done, the cell, cyber security thing, put cash on our balance sheet. So I would say right now, I think we're headed in the right path. We’ve got enough headroom, have a multiyear agreement with Intuitive gives us the comfort that we're both committed to this space and that we're excited about where we are at today and where it is going to take us. So it's taken a longer than I had anticipated by all means, but I think that we have made the right moves and that we are well positioned at this point in time.

Okay. Thank you very much.

Your next question comes from the line of Greg Greenberg from Wells Fargo Advisors. Greg Greenberg - Wells Fargo Advisors: Hi good afternoon, again congratulations on the multi-year agreement with Intuitive Surgical, obviously very little detail on the press release and nothing filed until the next quarterly report, but I know the (inaudible) achievement in very development milestones through 2015. Should we expect any product revenues on that collaborations before 2016 or am I misunderstanding that quote?

So there I don’t know how much detail I want to get into. I guess certainly as the development progress, we do provide prototype kind of units, evaluation kind of units for put them to work with and as we get closer to the end date, then of course 10 units for trials and what not. So we should see some product revenue coming in, but the growth for product standpoint is going to ramp much more significantly once the product is launched commercially with them. Greg Greenberg - Wells Fargo Advisors: Okay. And then I know you recently hosted five different trade shows vis-à-vis attending to the end of October, any new trade shows or any of the units representing that?

I think they are pretty consistent with ones we’ve done in the past. Greg Greenberg - Wells Fargo Advisors: Okay. And as far as exploring partnership opportunity through some of the other projects that are either coming out of your technology development as of now or in the past which will be the water coatings you had some interesting live post about coatings and F16 airplanes with, what’s the status of trying to partner some of those technologies out?

We continue to be in discussions with the number of players interested in different technologies that we have, but none of them are quite yet at a point that were rate diverged but My would say there is a good mix of companies that have approached us about exploring the partnerships or even possibly acquiring the technology. Greg Greenberg - Wells Fargo Advisors: Okay, and back to OdiSI, give me that an interesting, you are talking about some new ways that it gotten better and I think in spite of that talked about there are new options available for purchase and can you give any color as far as what percent that adds to selling some prices on high margin type margin products adding on OdiSI?

I say that all the options that we have introduced will become high margins options. Fundamentally its additional capabilities, higher speed, acquisition that we have enabled and it’s gone to actually a lot of attraction, the highest speed that we can now sample at is 250 hertz whereas previously is 100 hertz. Greg Greenberg - Wells Fargo Advisors: Okay, is this the highest quarter built by you for OdiSI, that kind of guesses they are on 25, which is the highest quarter?

None actually that was highest quarter but it was pretty close. Greg Greenberg - Wells Fargo Advisors: Okay, and then lastly you mentioned that Philip Healthcare relationship is any extra color you can give upon that project?

I think this, I would just say that our relationship with Philips is continued, there is, it was worth of it, was (inaudible) here in Q2, that’s included in the results here. We're happy with the partnership and look forward to continue to work with them. Greg Greenberg - Wells Fargo Advisors: Okay, well great news as far as being the product revenue increase, obviously we would love have to see the other side as well not decline. But I'm excited about OdiSI just moving in to Intuitive Surgical and saw opportunities two or three years out. And nice work. Thanks.

(Operator Instructions) And your next question comes from the line of Chris [Bast] from Private Investor. Please proceed.

Congrats on the sequential growth here. I was just wondering if you could shed some color on where are you seeing the strength with the OdiSI product, last call you gave a little bit more talking about being active in the aerospace market and winning some opportunities in the automotive market. Is it more of the same there or can you talk about any actual design wins in the aerospace market as of yet or is it most to the coming from auto still?

Most of it is coming from auto, because the auto industry is different in a way that they design new vehicles every years, whereas aerospace is a long design cycle and so if you get in the right space. So aerospace continues to be one that we advance in, but the ones that we're booking today are predominantly in the automotive space.

Is that with domestic player or international as well?

International.

So if you had to put a TAM on each of those markets, which is the better opportunity for the company? I mean long-term is it aerospace or is automotive bigger?

I think they are both equal. We have a lot more players in the automotive industry which you have budgets every year. On aerospace, you have the big players, right, Boeing, Airbus, [Mavick], COMAC in China. We already believe few but when they do test, they buy a lot of the equipment.

So with respect of these wins in the auto space, it would be great to see given you got a new technology trying to replace an older technology and you’re really one of the kind here. Is there any? What's the pushback on trying to get some announcements out there from some of these customers?

I think it is similar to what we've seen previously. A lot of people don’t want to publicize what they are doing and they are fairly large structures whereby the approval process to get a press release out in this sort of technologies like (inaudible).

On the medical side of the business, with respect to Intuitive, you talked about, obviously the length of the contract. Can you kind of give us some parameters around when do you think this will actually be a commercial product that they are using? And then second to that, if you could on the Philips, I’d ask another question on this, but was that deal that you signed in a May of last year, was that a multi-year deal? Was that an annual deal? Are you looking to extend that with the new if it is just a one year deal you signed?

They may announce or an Intuitive is that what you are asking for a year ago or so?

No, sorry, is that a one year deal, was it a multi-year deal, one that was really signed or are you working hard to get some kind of extension if it was not a multi-year deal?

Yeah. The agreements that we have with all has been pretty much development project related certain milestones if they look for price it out that way, all right. And to answer your first question in terms of visibility is to when the product will become commercial for either Intuitive or Philips Medical is somewhat out of our hands remember. If it goes in to their end product and we are not really engaged in terms of how long that development cycle is.

So this could be, so you are not, it could be 2015, potentially it could be 2014, do you feel, has there any kind of guidance that (inaudible) given the benefits that does bring to a biotic surgeries, is there push for this or I am very thankful to see the extension of the deal but can you kind of give up some kind of, what's your goal obviously a lot depends on what you guys do internally and it also a lot depends on them. Do you think it’s ready today with what you have or how long we take you to get to where you think Intuitive need you to be for them to put this into their product line?

I guess that based upon the multi-year agreement that we just signed that’s kind of timeframe that you’re looking at. For us to get to spec points that they are looking for to feel comfortable that it achieves the overall systems spec that they are looking at from their perspective.

And lastly with respect to the order coming closing initiatives you guys, that’s the right way to term it, I thought that there was a test or follow-up test that was going to be done maybe in the July is that occurred or is that still to happen with the army and if did occur can you give update on how you did?

Yeah, I don’t think that has occurred yet, I think you slipped a little bit so there have been no actual tax that I know that we done and so.

Great. Congrats again in the quarter and good to see some growth with ODiSI and good luck moving forward.

Ladies and gentlemen, this will conclude the question-and-answer portion of today’s conference. I would now like to turn the call over to My Chung for closing remarks.

All right, well, thank you everyone for joining us today. As you can see we are excited about our continued progress and we look forward to speaking with you again at the conclusion of the third quarter.

Ladies and gentlemen, that concludes today's conference. Thank you for your participation and you may now disconnect. Have a wonderful day.