This month we’re going deep into the world of high-speed sensing and communications with an unknown micro-cap stock specializing in fiber optic technologies.
This isn’t another of those boom-to-bust components manufacturers that crush it when data centers are expanding and fall apart when capex falls. Rather, it’s a company that specializes in fiber optics for industrial, transportation and construction applications, such as in airplanes, vehicles, buildings and space stations.
It’s not a low-risk investment. But the potential is huge – if management can execute on its growth plan.
Zoom into the February Issue for all the high-speed details!
Cabot Small Cap Confidential 249
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The Big Idea
Fiber optic components are one of the building blocks of high-speed data and communications networks. This market gets a lot of press coverage and investors are generally well aware of fiber optic component suppliers for the telecom and datacom markets.
A lesser known, but increasingly important market for fiber optics is emerging now. It involves sensing, testing and measurement in industrial, aerospace, transportation and construction markets. This technology provides a way to monitor and improve performance of existing structures, vehicles and parts, and helps designers and engineers develop better ones for the future.
Fiber optics work so well in these applications for the same reasons they work in networking applications, namely because the strands of optically pure glass can carry digital information long distances and at higher bandwidths than electrical cables.
But there is another key attribute – flexible fiber optic cables can conform to the shape of most any object or structure, and can even be imbedded in many materials. This allows for continuous monitoring, which not only opens the door to more use cases but could allow for subscription-based pricing models in the future.
Consider these use cases:
Electric vehicles (EVs) are the way of the future but they face unique design challenges as compared to gas-powered vehicles. One challenge surrounds the EV battery back, which must store enough energy to allow a car to travel reasonable distances, be recharged quickly and handle widely varying temperatures. High definition fiber optic sensors can be embedded in EV battery packs to take continuous measurements of battery health and help diagnose issues.
The DEFIANT is the New York Yacht Club’s entry in the 36th America’s Cup (held March 2021 in New Zealand). It’s a monohull design with hydrofoils, which lift the hull out of the water above a certain speed to help the boat reach insane speeds of around 50 knots (57.5 MPH). Fiber optic sensing devices are being used to help design the boat as well as monitor it while underway.
The Hong Konk-Zhuhai-Macau Bridge (HZMB) is the longest sea-crossing link ever built, spanning 55 kilometers and consisting of three cable-stayed bridges, one undersea tunnel and two artificial islands. Real-time monitoring of parts of the system are of paramount importance given likelihood of typhoons, earthquakes and occasional impact from cargo vessels. Fiber optic sensing systems were installed to keep tabs on the bridge and alert authorities when maintenance and repairs are necessary.
Imagine a world in which autonomous vehicles have become commonplace. What happens when there’s no driver keeping track of the vehicle? Drivers occasionally hit potholes, curbs, wild animals, etc. and retain knowledge of these impacts and factor them into maintenance and repair schedules. Fiber optic sensors can be embedded in components of autonomous vehicles, creating smart parts to inform maintenance and repair schedules.
Clearly, there are a lot of use cases beyond high-speed networking for fiber optics. One small company is working on all the use cases I just described, and many more. Its fiber optic sensing equipment is currently being used in the America’s Cup boat, the HZMB Bridge and many more structures and vehicles around the world, and beyond.
It’s a tiny company that few investors know about. Yes, the risks are significant as it pursues emerging market opportunities. But so are the potential rewards. This is its story.
The Company
Luna Innovations (LUNA) is a $246 million market cap company that specializes in fiber optic sensing technologies for the automotive, aerospace, energy and infrastructure industries, and fiber optic test products for the telecommunications industry. These products are part of the company’s Lightwave Division and generated roughly 65% of revenue in the most recent quarter.
Luna also has a contract research division that is primarily funded by the U.S. government. This business does work in the advanced materials, sensing and healthcare areas with the ultimate goal of accelerating the commercialization of new products. In most cases Luna retains the intellectual property. This segment accounted for the other 35% of revenue in the most recent quarter.
The company’s fiber optic sensing products have two primary use cases. First, they are used by designers and manufacturers to help develop new products. Fiber optic sensors are incredibly powerful at detecting stress, strain and temperature measurement. That information can influence product designs and/or manufacturing processes.
Second, Luna’s fiber optic sensors are used to monitor structural integrity and operational health of civil structures, such as bridges, buildings and tunnels, and vehicle and aircraft components, such as airplane wings and space capsules.
In the telecommunications market, Luna’s fiber optic test products are used to develop fast and accurate fiber optic components and networks that will, in turn, deliver the speed, accuracy, reliability and other key attributes expected of them.
The company has been in business since 1990 and went public in 2006. It hasn’t always turned in impressive performance, but over the last two years things have begun to change, starting with the hiring of a new CEO, Scott Graef, in 2017.
At that time Luna also began to refocus its business around fiber optic testing, measurement and sensing. That meant divesting a few lines of business, such as an optoelectronics components and sub-assemblies business, and making a few acquisitions.
The first acquisition was Micron Optics (for $5 million) in October 2018. Micron specializes in optical measurement equipment. The acquisition expanded Luna’s optical sensing and measurement business by adding the ability to take higher speed measurements, such as vibrations, and to place measurement instruments over structures that span long distances, such as bridges.
The second acquisition was General Photonics in March 2019 (for $20 million). This company makes components, modules and test equipment focused on generation, measurement and control of polarized light critical in fiber-optic-based applications. Prior to the acquisition Luna already used General Photonics’ products in several of its instruments.
Largely because of these acquisitions revenue began to climb, initially jumping by 30%, to $42.9 million, in 2018. That year Luna was profitable for the first time in 14 years as it delivered adjusted EPS of $0.04. In 2019, factoring in the General Photonics acquisition, revenue is expected to rise around 63%, to $70 million. EPS should be up around 375%, to $0.19.
Moving forward as Luna is composed today, management sees the company’s average growth rate between 15% and 20%. That assumes the Lightwave Division grows in the mid-to-upper 20% range while the contract research side grows in the mid-to-upper single digits. If management plays its cards right Luna could achieve more of the success that has powered the stock higher since mid-2018.
Customer Stories
Many of Luna’s customers and related projects aren’t publicly disclosed, but we do know of a few projects that are worth discussing.
NASA Moon to Mars Exploration study
In October 2019, NASA announced Luna is one of only 14 companies to partner with the agency’s Moon to Mars Exploration study. As part of a $2 million award Luna’s fiber optics sensors will be embedded within inflatable space habitats to monitor their structural health and safety and help determine if they represent a viable solution for space habitats. Other award winners include SpaceX (refueling couplers), Blue Origin (cryogenic propellant), Blue Canyon Technologies (autonomous navigation software) and Accion Systems (propulsion).
Lockheed Martin F-35 Fighter Jet
In August 2018, Luna was recognized as an “Evolutionary Technology Supplier” by Lockheed Martin, acknowledging how Luna’s technologies have helped in the support, testing and manufacturing of the F-35 fighter jet (900 expected to be produced by 2022). Luna’s equipment, including the newest release of the portable OBR 6200, ensure aircraft communications networks are operating properly.
Unnamed Customer – Bridge Monitoring
Luna recently delivered the first of its new generation of fiber-optic-sensing equipment for bridge monitoring that includes cloud connected data and storage. This capability is a natural extension of infrastructure monitoring and, while in the early stages, could lead to subscription pricing models for monitoring. Stay tuned!
Meggitt – Next-Gen BALD Systems
Meggitt specializes in components and sub-systems for the aerospace, defense and energy markets. One of its projects involve use of optical sensors to create next-gen Bleed Air Leak Detection (BALD) systems, which, among their many functions for ensuring passenger and crew safety, detect hot air leakage from bleeding air ducts. Meggitt supplies 15 airframers and five engine manufacturers, and a new exclusive partnership with Luna to supply fiber optic components for BALD systems will help improve the reliability and safety in the next generation of composite aircraft.
The Product
Lightwave Division – Structural Sensing & Testing Products
Luna’s fiber optics sensing solutions are designed to be integrated on or in (i.e. embedded) advanced materials and structures to measure physical quantities, including strain, temperature and acceleration. Doing so can inform the design of new materials and new applications for existing materials, increase the quality and reliability of structures, and provide a critical feedback loop on the structural integrity of structures. Sensing and testing products make up roughly half of Lightwave Division revenue.
Optical Distributed Sensor Interrogator (ODiSI)
Luna’s ODiSI products measure strain and temperature in composites and other advanced materials used in the aerospace and automotive industries, including airplane wings and car frames, for up to 50 meters in length. Fiber can be embedded or mounted on the surface, require no electrical source, and feed data back into a CAD model with up to 1,000 measurements per meter of fiber. In Q3 2019 management announced product improvements that include longer sensor lengths, larger strain measurement range, and improved performance in harsh environments.
Hyperion
This is Luna’s long-range, high-speed sensing solution, capable of covering several kilometers of civil structures and delivering static, periodic, or dynamic real-time monitoring. These products are currently being used to monitor Mount Rushmore, the Parthenon (Greece), the Como Cathedral (Italy), the Manhattan Bridge and many more structures around the world. Management just announced that a 50-unit order was received from Luna’s largest security systems integrator for a perimeter intrusion detection system.
TeraMetrix
Luna’s TeraMetrix products are used to measure and verify physical properties of manufactured products, to slash raw materials use, and to fine-tune manufacturing costs, processes and quality control. These solutions use terahertz (THz) measurement technologies, which are similar to x-ray images and can help detect things like flaws in sprayed-on-foam insulation (think of the space shuttle program), detection of banned objects in airline checked baggage lines, moisture content in consumer products, thickness of manufactured products, and leaking gas. Management recently disclosed an Air Force contract to develop and install Terahertz process control sensors to aid in the refurbishment of aircraft at Hill Air Force Base.
Lightwave Division – Communications Test & Measurement
Luna’s communications business is focused on meeting the growing need for more bandwidth in high-speed communications networks, which are enabled by optical fibers. Use cases span the design, manufacturing and test markets in telecommunications & data networks, cloud computing environments, 5G mobile networking, aircraft communications, and industrial equipment. Communications test and measurement products make up roughly 50% of Lightwave segment revenue. Luna continues to invest in engineering and sales resources to better pursue opportunities in this market.
Products in this segment include Optical Vector Analyzers (OVA), which are used in optical component development and manufacturing and enable the push behind 5G networks, Optical Backscatter Reflectometers (OBR), which can pinpoint even the smallest issues in a fiber optic network (bends, crimps, bad splices), and a range of Polarization instruments and photonics controllers.
Luna Labs – Contract Research / Technology Development
Luna Labs provides applied research for customers in areas of sensing and materials science (coatings, adhesives, composites, bio-engineered materials). The goals of the business are to generate revenue, identify promising emerging technologies and develop IP that could be commercialized later. Several products have come out of this business, including a corrosion monitoring system for aircraft, electrically conductive structural adhesives, and a 3D shape and positioning sensing technology. Luna Labs historically accounted for 35% of revenue in the most recent quarter. Expect a high-single-digits growth rate once the current higher-than-expected growth (22% in Q3) subsides.
The Business Model
Luna’s current business model is a mix of product sales (65% of revenue in Q3) and contract research services (35% of revenue in Q3). Product customers include defense agencies, government system integrators, researchers, OEMs, VARs, distributors and testing labs. Ultimately, we want product sales to represent the bulk of revenue as they’re more sustainable and offer better profit margin potential. Additionally, there is potential for recurring revenue through structure monitoring, a potential revenue stream that is just now being evaluated.
The Bottom Line
Luna’s 30% revenue growth rate and EPS of $0.04 in 2018 was a big improvement from a 21% revenue contraction and -$0.02 EPS loss in 2017. The trend has continued in 2019, with revenue up 69%, 80% and 72%, respectively, over Q1, Q2 and Q3. EPS has hovered between $0.02 and $0.04 in each of these quarters. Acquisitions have helped. But Luna has now lapped the General Photonics acquisition (completed October 2018) and will do the same to the Micron acquisition in March 2020.
Looking closer at Q3 2019 (reported November 5), revenue was up 72%, driven by 122% growth in the Lightwave division and 22% growth in Luna Labs. Gross margin improved from 44% to 50% as Lightwave generated 65% of total revenue. Management is spending more on sales and administrative functions but still, Q3 adjusted EPS came in at $0.04, consistent with the year-ago quarter.
Management has guided for full-year 2019 revenue of $69 million to $70 million, implying 63% revenue growth. That suggests adjusted EPS of around $0.19, which would be 375% higher than the $0.04 delivered in 2018. Management sees a normal growth rate, once both acquisitions are lapped, of 15% to 20%.
The company ended Q3 with $21.4 million of cash equivalents, down $2.1 million from Q2 due to share repurchases. I expect management is actively looking at more acquisitions and will try to put excess capital to work relatively soon.
Risk
Changes in End Market Dynamics: Luna is all about fiber optic test, sensing and measurement solutions. It is not a diversified business. If market demand for these technologies fails to fulfill expectations revenue, and the stock, will suffer.
Greater Focus on Product Sales: Luna’s acquisitions have bumped product sales up to two-thirds of revenue, but contract research remains a significant portion (the other third) of the revenue mix. Given that this revenue source could fluctuate due to a wide variety of factors investors shouldn’t place too much emphasis on it.
Micro-cap Stock With Low Trading Volume: Luna is a small company with essentially zero analyst coverage and very little coverage from the media. While this could work in our favor (i.e. we’re getting in “early”) it could also work against us if Luna turns in lackluster performance (i.e. no “buzz”) and demand for limited shares of stock falls.
New Senior Leadership: Luna has recently hired a new CEO and a new CFO. While I think these are good moves and the stock has reacted positively, there’s no guarantee new leadership will steer the ship in the right direction.
Competition
There isn’t a great head-to-head competitor to highlight. Rather, Luna competes with a number of public and private companies that offer a variety of sensor-based test and measurement solutions and/or fiber optic solutions for similar markets, including Timbercon, Proximion AB (part of the Hexatronic Group) and Vishay Precision Group (VPG), as well as numerous companies and organizations that also pursue contract research contracts.
The Stock
Trading Volume: Luna Innovations has a market cap of $246 million and trades an average of 243,000 shares daily. That means roughly $2 million worth of stock trades each day. Our subscriber group could move this stock so please factor that in if the stock jumps soon after this Issue is published. Daily trading volume has surpassed 500,000 shares one dozen times over the last six months.
Historical Price: LUNA went public at 6 back in 2006 and peaked at 10.45 before the Great Recession struck and shares fell to below a dollar. Momentum began to build again in 2018 and LUNA jumped above 4 in March 2019. It climbed to 6.9 in early September before consolidating for a few months in the 5.4 to 7.0 range through early November. Since then it’s been trending higher with a few pullbacks to just below the 50-day line. The current pullback (LUNA is 6% off its high) looks buyable.
Valuation & Projected Price Target: Putting a price target on Luna is a total crapshoot because it’s a micro-cap stock that’s just turned profitable, has grown significantly through acquisitions, and has a relatively small revenue base to begin with so any outperformance, or underperformance, in a given quarter could have a dramatic impact on annual revenue. That said, if we assume 20% revenue growth in 2020, we get to $84 million in sales. Provided current trends persist (expanding market opportunities, EPS rising, etc.) the stock should earn a higher EV/Revenue multiple (currently at 2.8) a year from now. If we bump that multiple up to 3.5 then our 2020 year-end price target is 50% higher than today, or roughly 12.3.
Buy Range (next two months): In the immediate term purchases should be made between 7 and 8.75. We can buy down to 6.5 where LUNA should find support (if it dips that low) and up to 9.
The Next Event: Management should announce Q4 2019 results and host a conference on or around March 4.
| Luna Innovations (LUNA 8.13) Roanoke, VA www.lunainc.com |
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Updates on Current Recommendations
Buy means accumulate shares at or around the current price.
Hold means just that; hold what you have. Don’t buy, or sell, shares.
Sell means the original reasons for buying the stock no longer apply, and I recommend exiting the position.
Sell a Half means it’s time to take partial profits. Sell half (or whatever portion feels right to you) to lock in a gain, and hold on to the rest until another ratings change is issued.
Updates
Updates – to be sent tomorrow (Friday 2/7) in a Weekly Update
Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.
The next Cabot Small-Cap Confidential issue is scheduled for March 5, 2020.
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