Luna Innovations, Inc. (NASDAQ:LUNA) Q2 2020 Earnings Conference Call August 6, 2020 5:00 PM ET
Allison Woody – Director of Administration
Scott Graeff – President and Chief Executive Officer
Gene Nestro – Chief Financial Officer
Brian Soller – Senior Vice President and General Manager-Lightwave Division
James Garrett – Senior Vice President and General Manager of Technology Development
Conference Call Participants
Barry Sine – Spartan Capital Securities
Jim Marrone – Singular Research
Dave Kang – B. Riley
Ladies and gentlemen, thank you for standing by, and welcome to the Q2 2020 Luna Innovations, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. [Operator Instructions]
I would now like to hand the conference over to your speaker today, Ms. Allison Woody, Director of Administration. Please go ahead, ma’am.
Thank you. Good afternoon and thank you for joining us today. This afternoon, we issued our second quarter 2020 earnings press release. In addition, we posted to the Investor Relations section of our website, a presentation with supplemental information for the quarter. If you do not have a copy of the release or the supplemental materials, please check our website at lunainc.com. We will also post a replay of this call to our website.
Some of our comments and discussions today are based on non-GAAP measures, specifically adjusted EBITDA. These adjusted numbers exclude the effect of certain non-cash expenses and other items. The adjusted results are a supplement to the GAAP financial statements. Luna believes the presentation and exclusion of these items is useful in order to focus on what we deem to be a more reliable indicator of ongoing operating performance.
Before we proceed with our presentation today, let us remind you that statements made on 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 risks and uncertainties and are subject to changes at any time, including, but not limited to, statements about our expectations regarding future operating results or the ongoing prospects of the company.
Actual results may differ materially as a result of a variety of factors. More complete information regarding forward-looking statements, risks and uncertainties is available in the company’s SEC filings, which can be found on the SEC website and our website. We disclaim any obligation 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, except as required by law.
After our prepared remarks, Scott Graeff, our President and Chief Executive Officer; Gene Nestro, our Chief Financial Officer; Brian Soller, Senior Vice President and General Manager of our Lightwave Division; and James Garrett, Senior Vice President and General Manager of our Luna Labs Division, will be available to take your questions.
And at this time, I’d like to turn the call over to Scott.
Good afternoon, everyone.
As Allison mentioned, we issued our second quarter 2020 press release at market close, and you’ll find it on our website. At the beginning of Q1, I spoke about what an extraordinary time it had been, and today is no different. The pandemic and other recent events continue to show the best and worst of the world in which we live. Most importantly, I hope you and those close to you are staying safe and healthy. And as always, we appreciate the time you’ve taken to join us for this update.
Luna hasn’t been immune to the effects of this pandemic, and I’ll touch upon those effects in a moment. However, as a designated essential organization, we’ve largely been able to stay the course. We will share with you today operational and financial results that were delivered as we expected and when we talked to you last quarter. I’m proud of these results and the fact that we realized record operating income margin this quarter. For that, I’m incredibly grateful to our dedicated employees and to our customers.
Remember that last quarter; we mentioned the seasonality in our business would continue to be weighted to the second half. With the percentage split in the first half of 2020 to be slightly below historical trends. As a reference, in recent years, Luna has recorded approximately 44% to 46% of our revenue in the first half of the year, with a larger portion of the annual results being realized in the second half of the year. We are on track with that seasonality despite the unusual times.
We continue to be mindful of the environment and how fast it can change, but we are vigilant and focused on performing to meet the demands of our customers so that they, in turn, can be as successful as possible navigating through these uncharted waters. And while we continue to be flexible as necessary to meet the changing dynamics of the current environment, we continue to deliver to our expectations, and we believe very strongly in the potential of Luna’s future opportunities. Therefore, we continue to invest strategically in our business and have accomplished or are currently implementing some of the following important foundational items. We hired Gene Nestro as our new CFO. And we hired Jane Bailey into the new position of Head of Marketing and Communications.
Overall, we have hired 29 new talented and committed employees so far this year, some of whom replaced former employees and some of whom were hired into newly created roles. We began our ERP project, which will modernize our back office and give us ample room for growth and expansion without further investment in this platform. We upgraded our 401(k) options for the benefit of our employees, and we just rolled out an employee stock purchase program to provide the opportunity for our employees to participate in the value creation we are focused on driving.
Now on to detail around the second quarter and some recent events leading up to this call. I’ll touch upon three areas during my discussion. First, I’ll highlight recent accomplishments, such as our second quarter financial results as well as some challenges through which we’re navigating. Second, I’ll review organizational actions we’ve taken as we continue to adapt to our evolving new environment, and third, I’ll provide our perspective on the remainder of this year; both operationally as well as financially.
Let’s begin with recent accomplishments in our second quarter financial results. The team did a solid job of delivering growth this quarter in spite of the pandemic, and I’m very proud of the Luna team for their focus and commitment. As a reminder, we mentioned last quarter that we would begin to report results in our two segments: Lightwave and Luna Labs; changing from our former segments of product and licensing and technology development. This will allow us to more accurately reflect how we operate the business. I’ll be discussing financial results according to these new categories, and you’ll see these names reflected in our financial statements.
For the second quarter, total revenues were up 4% to $18.6 million compared to the prior year’s quarter. The Lightwave segment had an increase of 3% year-over-year to $12.9 million in total revenues. Overall, I’m pleased with the solid growth achieved during this shifting pandemic. We expanded gross margin by 210 basis points, improved our operating income by $800,000 and delivered adjusted EBITDA of $3 million, up $600,000 over last year.
Now let me discuss Lightwave in more detail, particularly as it relates to operational moves we’ve made to adjust for this new normal. The year-over-year 3% increase in Lightwave revenues was primarily driven by increased revenues from our sensing business. As a reminder, Q2 marked the first quarter in which we completely lapped on an apples-to-apples basis, the acquisition of General Photonics.
Let me provide a few additional highlights, starting with our communications testing business. Revenues in our communications test business were down slightly on a year-over-year basis. As a reminder, this is where many of our products have price points over $100,000, and we saw some delays in capital spending globally due to the impact of COVID-19 on the economy, which has driven a lengthened sales cycle.
We continue to make progress with our newest product in this business. The Optical Backscatter Reflectometer, or OBR, Model 6200. As we’ve discussed on previous calls, the OBR 6200 is our new portable OBR test instrument for field test applications and has been designated as support equipment for Lockheed Martin’s F-35 fighter jet. In Q2, we received several new orders for and delivered initial OBR 6200 units for this application. We also received new orders for qualification of the OBR 6200 to support multiple other military aircraft. This marks an important milestone as we look to grow sales of this new product beyond our initial work on the F-35.
Moving to our sensing business, as a reminder, this business includes our ODiSI and HYPERION distributed fiber optic sensing products as well as our Terahertz instruments. Total revenues in Q2 increased by double digits compared to the prior year. This was driven by growth of international sales in both Asia Pacific and Europe as a result of our international expansion efforts as well as the addition of new, strong regional channels over the past year.
Sales of our Terahertz product within the sensing business bounced back in Q2 after a somewhat slower start to 2020. This is a clear example of why we’ve highlighted in past earnings calls that the timing of Terahertz orders can be lumpy throughout the year. We continue to invest in both our Comtest test and sensing businesses; particularly in our sales and engineering capabilities, and we’re seeing the benefits of laying this foundation. We’re well positioned to leverage the growth in fiber optics. As I mentioned earlier, to support this growth, we’ve hired a seasoned Vice President of Marketing and Communications; Jane Bailey, who will lead our MACOM efforts and help to support the Lightwave sales team. Jane joined my executive team this week, and we’re thrilled to have her on the Luna team.
Now let me give you some color about our Lightwave operations during this pandemic. As I outlined on our Q1 earnings call, we began to organize our resources in such a way as to prioritize the health and safety of our employees and the communities in which they live, while endeavoring to ensure continuity of our business operations. We put in place more severe restrictions at that time, including a complete ban on all travel as the pandemic impact was unknown.
As we’ve learned more during the course of this second quarter, we’ve kept many of those initial restrictions in place while adjusting a few others to accommodate for what we now know. We have closely followed and adhered to federal and state guidelines with the safety and well-being of our employee’s utmost in our minds.
Let me outline for you what we are now doing. From an operational perspective, we’ve been able to maintain 100% continuity of operation across all our locations and to continue to deliver to our global network of customers. And we continue to have flexible work schedules and environments to limit employee gatherings in common spaces to maintain significantly enhanced cleaning procedures throughout all of our facilities and to ban all international travel. We’re allowing domestic travel on a very selective basis and with senior level approval required.
From a supply chain perspective, we’re working very closely with our partners. Last quarter, we discussed the relatively minor impact we were seeing on our global supply chain. I am happy to report that those impacts in Q2 continued to be minimal. We continue to see some minor delays in delivery from our supply base, but the impact on our operation has also been minimal.
Looking ahead, we do not anticipate any major disruptions to our supply chain in the second half of the year. Given the constantly changing environment, we are working very closely with all of our global partners to ensure continuity of supply throughout the second half of 2020. On the demand side, we continue to monitor our pipeline of sales opportunities very closely.
In Q2, we did see the lengthening of sales cycles I mentioned earlier due to the global impact of COVID-19. Our core target markets have been affected differently. The main target market for our fiber optic solutions are aerospace, military and defense, communications, infrastructure, energy and automotive. Remember, when we refer to aerospace, we are primarily referring to military with some limited exposure to commercial aerospace.
Demand in military aerospace and infrastructure have remained strong. We have probably seen the most pronounced impact of the virus on the automotive and commercial aerospace industries, with all of our other end markets staying strong. We have seen a lengthening of sales cycle in our communications test business. Our Lightwave business has continued to build a growing pipeline of new opportunities.
However, it’s been more challenging and a bit slower to grow our pipeline because the in-person industry events and trade shows where we normally have the opportunity to meet customers face-to-face, demonstrate our products and close contracts have all been canceled due to COVID and travel restrictions. So we have continued our customer outreach to close these important contracts and to continue to build our pipeline by taking some of the following actions; we’ve proactively moved our marketing efforts to digital platforms.
We’ve executed six webinars over the last three months, where our customers and community of users can join us virtually for interactive demonstrations of the unique capabilities of our products. These webinars have generated over 2,200 registrants, over 1,000 live attendees and more than 1,200 new leads. The level of engagement in our digital platforms has been very strong, and we believe these results are evidence that we will be able to maintain a robust funnel of opportunities throughout the rest of the year.
Having said all this, nothing can replace the in-person closing the deal aspect of sales and therefore, we have seen and expect to continue to see in pockets some lengthening of the sales cycle. This is not completely unusual as we occasionally saw similar delays even before COVID. This is precisely why we don’t provide quarterly guidance, but rather look at the year in totality.
Let’s move on to a discussion of Luna Labs. As a reminder, Luna Labs works in research areas that are outside of our core strategic fiber optic activities. Here, we primarily leverage third-party contract research to build a portfolio of technologies that could be future growth areas for Luna. Mature technologies are commercialized by Luna Labs through direct sales, distributors or licensing agreements. Most of our funding comes from the federal government. So our prime contracts were not materially affected by COVID-19. The in fact, the majority of those contracts are with the Department of Defense. And because of that, we were declared an essential partner, which cleared the way for continuous operations in all of our locations.
Luna Lab’s total revenues were $5.6 million in the second quarter 2020, which represents a 7% increase versus the prior year. As I mentioned on our Q1 call, one of the biggest challenges stemming from the pandemic is that several of our partners, especially academic collaborators have been forced to shut down. As a result, we did have difficulty maintaining output at some of our university lab partners during the quarter, but these delays appear to be over. We are seeing work resume in some form, and that is reflected in the 7% total revenue growth increase during the second quarter. The growth was largely driven by commercial sales and licensing, later stage research and Luna Lab projects as we projected on our last quarter call.
We said in May that we did not expect the COVID impact at Luna Labs to significantly affect our total top and bottom line and that the adjusted contribution still falls within our 2020 outlook ranges. That outlook stands today. Gene and I continue to spend quite a bit of time with our operational and sales teams to understand any trends or forward indicators they might be seeing that could suggest a softening of the business or any other significant changes.
And Brian, James and I continue to reach out to our customers and component suppliers to monitor the ongoing effects of the pandemic on supply chain and on their operations. The four of us; Gene, Brian, James and I, also spent significant time this quarter in reevaluating our forecast assumptions, including completing a full new bottoms-up forecast to inform our decisions and our disclosures. With the information we have today, we have no evidence of a softening in our business that would cause us to alter our guidance. Which is why, as you saw from the press release, we are tightening our guidance range for the full year since we have two quarters behind us.
Our 2020 outlook ranges projects total revenue of $81 million to $83 million and adjusted EBITDA of $10 million to $12 million. As I mentioned earlier, this outlook includes a heavier weighting of results through the second half of the year. This is normal seasonality for Luna, but keep in mind that our pipeline for the second half of the year has forecasted orders of varying sizes and that any delay in one large order could affect our results.
We realize how complex our current environment is, and we’re being as transparent as possible as we see shifts in operational or financial trends. I recognize that this has been a challenging year for numerous stakeholders, including investors to navigate given the pandemic and its effects. However, Luna began 2020 by articulating a strong vision of enabling the future with fiber, and we’re very clear about our purpose. Despite the challenges in our current environment, we continue to feel good about delivering against our goals, including our 2020 outlook with the additional color that I mentioned.
I’ll now hand the call over to Gene for more of the financial details on the quarter. Gene?
Thank you, Scott.
Before I dive into the second quarter financials in more detail, I want to begin by highlighting a number of items for you as you review Q2 2020. First, this quarter, we present our financial results as Lightwave and Luna Labs segments. Recall that I mentioned on our Q1 call, we would provide pro forma financials to make it easier for you to adjust your models to reflect the new reporting structure. Those may be found at the back of our supplemental deck, which is posted on our website.
As you will recall, our former products and licensing segment was primarily comprised of our Lightwave products and, to a lesser extent, product sales related to the commercialization of our Luna Labs technology. Our former Technology Development segment was mostly comprised of our Luna Labs contract research business, along with Lightwave’s, fiber optic sensing and Terahertz related research groups. The new reporting segments combined Lightwave’s product and research businesses into our Lightwave segment and Luna Lab’s contract research and commercialized products into our Luna Lab segment, which reflects how we are now managing our two segments.
Second, we recorded a solid Q2, considering the environment in which we were working. Our sales, profitability and cash position are all healthy. Third, we all recognize that the impact of COVID-19 has created a challenging business environment and has reduced the velocity of business. However, we remain bullish on the key megatrends that support Luna, fiber; 5G, lightweighting, civil structure monitoring and we contain planning for future growth.
Fourth, the main impact of COVID has been an extension in the time it takes for us to get a purchase order through our sales pipeline. We have not seen cancellations in orders, although a few contracts are taking longer than expected to obtain final signatures. Fifth, as Scott mentioned in his discussion of our ongoing investments, we continue to make progress with our back office and infrastructure initiatives. Moving to Cloud-based systems, implementing a new ERP to streamline operations and upgrading our IT infrastructure. And sixth, on a more technical note, Q2 marks the first full quarter of lapping the General Photonics acquisition. Thus, year-over-year comparisons do not contain any first year acquisitive results. With that as context, I’ll now shift to cover our second quarter results.
Our revenues for Q2 2020 were $18.6 million compared to revenues of $17.8 million for Q2 2019, representing a 4% year-over-year increase. The increase in revenues year-over-year was composed of a 3% increase in our Lightwave segment and a 7% increase in our Luna Lab segment. Within the Lightwave segment, year-over-year growth was driven by strong performance from our sensing business. Within Luna Labs, growth was driven by later stage commercial products. Our gross profit increased to $9.5 million for the quarter compared to $8.8 million for the same quarter last year; representing a gross margin rate of more than 51% in Q2 2020 compared to approximately 49% in Q2 2019. The gross margin improvement was primarily due to acquisition-related charges in Q2 2019 and a favorable product mix in Q2 2020.
In Q2 2020, approximately 70% of our revenues stemmed from the Lightwave segment, which is similar to what we achieved in Q2 2019. Operating expenses were $7.7 million or approximately 41% of revenue in Q2 2020 compared to $7.7 million or about 43% of revenue in Q2 2019. Our Q2 2020 reflects appropriate expense control combined with continued operating leverage on our increasing sales. There was only a slight increase in Q2 2020 SG&A expenses at $6.2 million compared to the prior period. This increase was primarily driven by the same two items we previously discussed. These are both the incremental expense associated with last year’s acquisition as well as higher sales and marketing expenses in Lightwave as we continue to support that division’s increasing sales.
Q2 2020 G&A included approximately $400,000 in recurring non-cash amortization expense associated with the acquisitions of General Photonics and Micron optics. With the revenue growth and gross margin expansion, our operating profit improved to $1.8 million in Q2 2020 compared to a loss of $1 million in Q2 of last year. Net income from continuing operations for Q2 2020 was $1.4 million or $0.04 per share compared to $0.8 million or $0.02 per share for Q2 2019.
And finally, a key metric reflecting our underlying operations is adjusted EBITDA. As Scott mentioned, adjusted EBITDA increased to $3 million for the second quarter 2020 versus $2.4 million for Q2 2019. This solid performance was driven primarily by top-line growth from both our legacy businesses and those businesses we acquired, combined with our ongoing expense management.
Let me move now to the balance sheet. We ended the quarter with $26.5 million of cash and cash equivalents compared to $25 million at the end of 2019. Our working capital was $44.8 million at June 30 compared to $41.1 million at December 31, 2019. Without repeating the 2020 outlook Scott provided, I want to outline a few areas that informed our decision to reaffirm and tighten our previous guidance range.
First is the comprehensive bottoms-up analysis that Brian and James conducted, which provided good insight into our forecast for the remainder of this year. This is predicated on assumptions that customer orders are delayed, not canceled. Second, I want to reiterate what I said on last quarter’s call. We take providing an outlook very seriously and know that you, our investors, do as well. We continue to monitor and evaluate the effects from this pandemic on a daily basis. We believe we will still come in at the lower end of our guidance range. We’ve just tightened our top-line outlook a bit with two quarters now under our belt. We will continue to be transparent, and should things change significantly, where we’ll communicate that information.
With that, I will turn the call back over to Scott.
Thank you, Gene.
At this time, I’d like to open up the call for questions. Brian Soller, Senior Vice President and General Manager of our Lightwave Division and James Garrett, Senior Vice President and General Manager of our Luna Labs Division, are with Gene and me at this time and are also available to address questions.
I wanted to ensure that the proper folks were on the call today to address any specific business questions you might have.
[Operator Instructions] Spartan Capital Securities.
Hey. Good afternoon, gentlemen.
Hey. Just to go back on the impacts of COVID, it sounds like there was a negative revenue impact. You had some purchase orders push out the labs, had some academic partners able to operate. I mean, is that fair? But it doesn’t sound like it was a huge number, but the revenue would have been higher without COVID?
Yes, that’s correct. Yes, we had a couple of orders, quite frankly, that were expected in and related to COVID-19, purchasing some folks on purchasing weren’t in the office that last week of June and some receiving folks were not in due to some changing schedules. And so we had several orders not come in by June 30 and actually, quite frankly, came in the first couple of days of July, second and third. So yes, there was a piece of that was not meaningful, but it was – you are correct in noting that there were several hundred thousands of orders that – still within our – what we were guiding towards from a percentage standpoint, but yes, you’re correct
And you went through at length the process in your thinking in terms of our guidance and how it may or may not be impacted by COVID. One of the things you’ve talked about is push out of purchase orders. My experience, a lot of times when customers start pushing out decisions, that’s a prelude to not making – the deciding not to go forward with the purchase. The higher up’s maybe trying to control the budget until they have visibility and if things don’t turn around, they pull a plug on the purchase order. So you’re more optimistic than that. You’re assuming that your delayed purchase orders that have been in the pipeline will get approved and will come through in the second half?
Yes, that’s correct. We’re not looking at this with kind of rosy goggles on here. This is something that we are in touch with those customers. And every – we are not hearing any of that in what – when we used our bottoms-up analysis. These are not – if there’s anyone that we felt was in that camp, they’re not in our – in the evaluation that we did to look at the rest of 2020.
Okay. And then I’m trying to understand better why the second half implied guidance implies much stronger year-over-year percentage growth than what we just saw in the second quarter. I understand that there’s generally an uneven mix between first half and second half revenue, but that should impact the year-over-year growth rate and what you’re guiding to implies a much stronger growth rate in the second half of the year. And then on a – to break that down, if you could talk about which segment do you expect to really accelerate and why?
Yes. Well, as you know, the last month, maybe of Q1 and throughout Q2, you had – we had some companies that had closed down completely. So we had more slippage into the second half of the year than we would typically see. Like I said, if you look the last five years, the range of H1 revenue to the total revenue for the year is in the range of 44% to 46%. And we thought we’d be at the lower end or median slightly below that. I think we’re spot on in that 44%-ish range when you look at the annual guidance. So it’s really not out of whack of what we’ve seen when we look historically on what it is. We will see – we do believe we’ll see – yes, you’ll have higher year-over-year growth when we deliver what we’re guiding to in the second half. You’re right about that.
Specifically, in any particular segment, Brian, do you want to talk a little bit about that?
Yes. I mean, I think the impact in the first half of the year, as we discussed, as it relates to the lengthening of the sales cycle was stronger in our communications test business than it was in our sensing business. And so we expect that to impact the second half of the year to the positive, which will increase the year-over-year growth numbers there.
And then as we talked about in the past, we do have some expectations for the second half for our new product, the 6200 that we’ve been working with some major customers with over the course of the last few years that we do have in the plan for the second half of the year. So that will also help to accelerate the communication test segment.
Yes. And Barry, I did mention also the Luna Labs division was affected by when academia kind of shutdown for a while. So some of those things did affect the revenue in the first half, specifically the second quarter, and we expect those to pick up. So James, I think that’s right. We have more opportunity in the second half in Luna Labs in the contracts now that they’re back open fully.
Yes. I think we’ll see some of core is projecting a higher year-over-year in leveled than the first part of the year.
And that higher second half growth is partially driven by academic lab facilities reopening?
Yes, we were – this is James. We were low on subcontracts in the first half of the year because those academic labs were shutdown. We’re starting to see them come back. We expect some of those labs to be back by the end of the month now. So subcontracts will come back in the second half of the year, those academic subcontract labs will be back. And then we expect some other things to come back in the second half. So year-over-year growth for Luna Labs, it should be stronger in the second half of the year than the first half of the year. So we’ll contribute to some of that as well.
Yes. Keep in mind, Barry; these are contracts that are in backlog. This is a matter of executing on contracts that are in-house and being fully worked upon. But in some ways, we are limited if we have these subcontracts. Where we could move some of them, we did. Some of them were not worth giving up that – the progress they had already made and just kind of weighed out until that lab back opened. And that’s what we did, and we’ll see the benefit of that in the second half.
Okay. And financial question. Gene, first of all, thank you for that last slide with the historic breakdown of the new segment, it’s very helpful. You mentioned, I think the number was – you hired 29 employees. If you could put that in some perspective, what’s the increase in headcount? What is the new headcount number? Is that a significant percentage increase? And then a breakdown outside, how many of those are quota-bearing sales reps that are going to drive revenue? And how many of those are kind of back-office that are going to drive expenses?
Yes, sure. So about half were new positions that were created. And there were only a few back-offices, more so on sales and marketing.
Yes. Barry, I asked HR for those numbers. I wanted to reiterate that we are continuing to move forward and that we have the work to do. So when she gave me that raw number, it is 29, like I said, about half of them are replacements of some positions, half new. That includes some summer interns in it, maybe five, six, some are interns that we would typically have in our Atlanta office, our Charlottesville office, Blacksburg, Chino.
So it’s a number that you have to take with the grain salt, but I want to – no layoffs, and that we are continuing with our plans that we would because we have the work to perform. So that’s why it is a raw number, and I didn’t break it out. I think it was three back-office. Jane Bailey is one of those three. An FP&A person was another one of those three, and I believe kind of a staff accountant was another one.
So as we continue to move forward, most of that is engineers as we go forward. And keep in mind that the folks that we hire in Luna Labs is the increased stability that we have. They don’t show up in G&A that – as it relates to the folks that work in Luna Labs, that’s in your above the line.
So we had in the budget. I will – just to put it out, we had in the budget to hire five new sales folks worldwide. Through today, we’ve hired four of them and the REC is open to the fifth one. So if you add the MACOM person, Jane Bailey, that’s five sales and marketing folks that we hired so far this year.
Okay. And then shifting gears to a question on M&A. Obviously you’ve got a lot of cash burning a hole in your pocket there and no debt on the balance sheet. I’m thinking that it’s much more difficult to make an acquisition in this environment. I can understand you might be able to get by in terms of selling product with webcast meetings. But if somebody wants’ to sell you a business, the companies you bought have been proprietors who were selling a business they created. I can’t see them agreeing to sell to somebody who they’ve only met over a Zoom meeting. Is that fair or is that – is the current environment slowing down M&A?
I would not say that’s fair, to be honest with you. I would say that we are the type of business, the space that we’re in, we’re not someone that hires the banker to come in and pitches ten things from Volvos to Chevy’s to Fords. We know the folks in the space, and how we have found the acquisitions we’ve done in the past are people that we knew. That was not an investment banker pitching us on some long slide deck looking for us to bite on one of them.
So the folks that we continue to have conversations with, and we are continuing to be active in this space, are folks that we knew. When you go to the trade shows and are around in this space, we kind of know the players that are in the sensing space or the communications test space, and we’re engaging those folks because we know them, not because a banker throws a name, and we say, “Oh, I would have never thought of them.” That’s just not how M&A gets done in our particular space.
So why haven’t we seen a transaction? Obviously, you have the capital to do it. You’ve indicated a desire to do it. You’ve just indicated that you know what’s available out there for sale, but we haven’t seen anything. And sitting there with that much cash on the balance sheet is not preferable to having additional revenue and earnings?
Certainly, certainly. Keep in mind; a lot of the folks that we talk with and that I talk with are not people that are out being pitched through some information memorandum. They are folks that I’m talking to and saying why I believe being part of us is a better path forward for them. So it takes some time. There’s a lot of kind of dating, if you will, before you get involved in the actual ceremony.
So I think it just takes some time. I’m not willing to get out of the discipline that we’ve stuck with. We’ve always said it’s going to fit within our organization. That’s covered because I’m not talking to folks that don’t fit. It’s going to be accretive; either immediately or shortly thereafter. And quite frankly, we’re not talking to folks that don’t fit that mold either. But I think not overpaying, the third thing I’ve always said is not overpaying. And I think that’s critical to stick to that discipline.
And I believe with the organic growth that we’re having, certainly, I want to give you more revenue. There’s no doubt, I want to give everyone more revenue, but I don’t want to chase something just to chase it. I believe that doing the right deal will make all the sense. And I think history shows that we’ve chosen two really good acquisitions over the last, whatever it’s been, 1.5 years, and we’ll continue to follow that approach.
And hopefully meet your expectations and not let that hole in my pocket get too big.
Yes. All right. We’ll continue to sit there and wait for the press release. Thank you.
Your next question comes from the line of Jim Marrone with Singular Research.
Yes. I kind of want to discuss perhaps a little bit about going forward. You mentioned some supply line disruptions. And I was curious on exactly which product lines that would be affected the most? And if you could give – just give some comment in regards to the OBR line on how that could be impacted in terms of supply. Also, you mentioned that there’s been an expansion from the F-35, and perhaps you can discuss some of the other type of machinery or applications that the Lightwave is expanding to within the military application or even outside military? Thank you.
Yes. Sure. I’ll let Brian talk a little bit about the supply side. He’s got his finger on the pulse of that. I will say, you can see – when you look at the suite of products that are out there, certainly, the F-35, we’ve talked a lot about you can look at Lockheed suite and see that the F-22, the C-130. There’s the F-16, the F-18, F-15; all folks that we have been talking to that is a natural fit in this military aircraft space. And all of them continuing to have – we watched this stage happen with the F-35 and the process it takes to get specked into that and things like that, and we are advancing down the path with those different aircraft.
Now on the supply side, I’ll let Brian talk a little bit more about.
Hey, Jim, this is Brian. It was really – for the commercial side of the business, the Lightwave product side, we develop manufacturer ship products out of four locations: Blacksburg, Atlanta, Ann Arbor, Michigan and Chino, California. And I would say all four locations experienced some minor issues or delays in the first half of the year, primarily early in the year out of our supply base in Asia, but that really – by Q2 that really was resolved.
And then in the beginning of Q2, is really – we do have suppliers in Europe and North America. And the shutdowns really kind of caused some delays really more than anything. We were able to manage those pretty well. We said on our last call, we expect it to be fully caught up, I think we said by the end of May, that did happen. And we still have a little – a few things here and there, but for the most part, they’re really manageable. And we don’t – as we said, expect to see anything throughout the rest of the year that isn’t something we can’t manage through.
And specifically to your question on the 6200; no impacts to that product.
Okay. Thanks you, gentlemen.
All right. Thanks, Jim.
[Operator Instructions] Your next question comes from the line of Dave Kang with B. Riley.
Thank you. Good afternoon. First question is regarding OpEx, came in at $7.7 million, I’m assuming you guys kind of benefited from a lot of your employees working from home. What do you think the normalized level will be once things become more normal?
Yes. We saw some benefit from that. But as we talked about previously, we are sticking to our plan of building up our infrastructure, not just on the IT side, but also our people side. So we had a plan when we went into this year to get set up for growth. And we have not deviated from that plan other than we’ve been delaying some of the hires as we go through the year because the sales were soft. So what I would tell you is if you look back and you look back on our operating income, we were negative 6% in Q1 of last year, and we’ve had steadily been increasing that. That’s kind of our plan as we go forward. So what we’re trying to do is match our increasing operating income with our revenues so that we see quarter-on-quarter operating income growth. And so we’re going to layer in the OpEx as we see fit based on sales?
Yes. I think, Dave, we were very pleased to see the tick up in the gross margin. And as I said on my call, for us to hit 10% operating margin was a first for Luna and certainly a goal internally, and we continue to set going forward that bar higher. But that was a – that’s a real metric that we monitor here inside of Luna on that operating income. And because we know we will continue to manage the expense side of the business. So if we can continue to pull-through that operating margin, we’ll see EPS increase as we move forward.
Actually, that was my follow-up question was on speaking of gross margin, 51%, nicely above my estimate. I’m just wondering if that’s – how should we think about out quarters? Should we be using 51% rather than something lower than that?
I think you would want to look at it in our segments because each segment is slightly different. So Luna Labs had a really good and a really strong gross margin in the first half of the year. It was somewhat COVID-related. So if you get into the bowels of how these contracts work, we actually had less third-party costs coming in and more of our internal folks working on the project. And so that tends to give us a little higher gross margin. And so we think that’s going to creep back more too normal as we get through the year on Luna. So I think you saw a little bit of a COVID-impact there on higher gross margins in first half versus second half.
When you take a look at Lightwave, we do expect year-on-year to see a higher gross margin than what we had last year. Again, the timing on quarter-to-quarter is when our revenue is going to come in and hit and cover our fixed cost. So I guess what I would say is for the full year, we do – we are expecting a full year gross margin versus 2019, a little bit higher on Lightwave, and I think Luna Labs will be right around where they were for the full year in 2019.
Yes. You can imagine, Dave, we did give Brian a little grief for coming in at 59.9%. I don’t know how you don’t find another 0.1% to be over 60%, but we’ll take it.
Just a couple more. So it sounds like your military segment seems to be fine, not affected by COVID, but it sounds like your commercial aerospace and automotive verticals seem to be impacted. Can you just tell us roughly how big those two verticals are?
Yes. We’ve talked about in the fiber sensing business, in that segment that we talk about, the sensing, that it really was future growth. When we talk about – and you’ve seen on my – some of my presentations where we refer to it as kind of a central nervous system in these different structures, whether it relates to commercial aerospace, putting the fiber on the plane, things like that. That was something – we’re still working with our partner, Meggitt and some of the other big players in doing that in the development segment. So we never had that really factored in, in 2020 or really 2021. That was future revenue growth. So we don’t have a lot of impact. Do you have the specifics about what that?
Yes. In terms of size, Dave, our communications, from a market perspective, if you look at the communications telecom datacom market, that represents about 20% of our revenues. Government defense comes in just a little bit under that. If you look at H1, about 17%. So those are the two biggest slices. Aerospace is third. That’s about 15%. But as Scott was saying, if you look at aerospace, the commercial side, we have seen a pretty significant slowdown other than in our work with Meggitt. But that’s a smaller slice than the military defense side of aerospace.
Probably closer to 5%. Is that 5% automotive, what, 2%-ish?
Is that right?
Well, for the first half of this year, because of the impact yet.
Got it. And my last question is, it seems like the optical com, speaking of telecom optical communication industry seems to be actually benefiting from this COVID because of increased telecommuting. Can you give us an update how your Luna 6415 for 400 gig, it seems like there’s a lot of pent-up demand for that, just how that is shaping up for second half this year?
Yes. No, it’s shaping up really well. I’d say what we’re seeing is exactly what you said, Dave, on the demand side there, we’re growing relative to last year in a tough market. The only thing I would add to that is that the majority of our products, as you know, they are over that $100,000 price point. So what happens is we’re just seeing some delays in getting those purchases approved and moving. So the pent-up demand is there. It’s kind of like we’re pushing a [indiscernible] here into the second half of the year. And we’re looking forward to seeing that in the next year as well. The demand is certainly there. And then we just manage through some of these issues with getting POS over the finish line.
I was just going to say, we’ve received some POs where the customer said, we don’t have the receiving guys working on a regular schedule. So if you could just ship that in August or ship that in September or July. I mean, there’s some of those things.
So it’s almost mechanical, and people are trying to figure out how to make sure their labs are for staffed and making good product and set up and that sort of thing. I think we’re through most of that.
Yes. Yes. At least that’s with the sales guys –
And once that gets going, do you think that could become a needle mover or just wondering how we’re thinking about in terms of trajectory?
Yes. I mean what I’d say about that in the second half of the year is we do expect our communications test segment to be the strongest element of our overall growth. We have new products there. We’ve got the 6200. We’ve got 6415. We’ve seen pretty steady demand in the other products in that space. Our GP products out of Chino have actually performed very well in the first half of the year, and we’re expecting to see them do very well again in the second half of the year.
So I guess, depending on how you define needle mover, we’re looking at a good second half of that segment.
Well, and I think it’s important to state that one of the hires in the sales side that we made was a seasoned executive sales guy that will be focused in Europe on the communications test business. They will carry all of the General Photonics products on the Photonics side as well as our communications test side. A senior fellow that came out of 20 years with [indiscernible]. So we’re excited to have him on board. I think he started yesterday – this week, yes, Monday. So we believe that as that European market is growing, it needed some special attention, the guys are very busy there chasing the sensing side of the business as well as the communications test. And so we’re starting to give some dedication to some sales folks over there, and it was a big [indiscernible] for us to land someone with his background to sell our communications test products.
Got it. Thank you.
And your next question comes from the line of Charles Moles [ph].
Hey, good evening.
Yes, as usual, I can’t follow what all you all are into, but it’s impressive. First, this is just an aside on that bridge you’re building in Morgan County. My mother’s from Oakdale, that’s Morgan County and Frozen Head is a great park. And do you know where that bridge is that they’re replacing?
I do not specifically know where that bridge is, Charles.
Okay. And then to – it’s interesting that fiber can replace steel. That’s just great. But on this computerized the optical coherence tomography, which I’d never heard of before reading your blog, can it be thought of as similar to the CAT scan but just using ultrasound? And is this a device that you people fit into like a CAT scan or MRI, or how does that work?
Well, you can think of it as – it’s an imaging message that can image through tissue. It’s not exactly like a CAT scan or MRI because I can’t see through the whole body, but it can see through opaque tissue with very fine resolution. So it’s used primarily today in the eye to image the retina, and specifically, to see through the surface down to subsurface layers where you might have a cancerous lesion. And there are other applications as well as – in arteries and others; sub-skin, et cetera.
We actually supply most of the world’s major manufacturer of those because it’s an optical technique to produce that imaging. We supply through our General Photonics product line in Chino, OEM components that form the insides, if you will, of those products. So that’s what that blog post was about. We’re trying to get our name out there a little bit so we get more exposure to some of the other players. But it turns out, if you look at the mix of our products out there that ends up being a fairly significant chunk of our sales. So that’s why you saw that blog.
And how does it do the endoscopic gastrointestinal imaging?
Well, it goes along as a tool or alumin at the end of endoscopic tool. And then it images through the – as I said, it can image through really any tissue so it goes through the bowel, the wall of the bowel as well. Anywhere where you could have a subsurface, say, for instance, cancerous lesion that you might want to find.
And reading the blog, it sounds like you need more than five salesmen. I generally go by how Scott sounds in the presentation and where he’s doing.
Right. Those are five additional sales folks, Chuck. We have a lot more of them, about 15 worldwide. So – and then we use a lot of partners, distributors, reps, things like that. So yes, it’s much, much larger. We’re adding five. So it is a nice move up for us to get more feet on the street working every day thinking nothing but about Luna products.
Thanks for the good news. Catch you next time.
Thank you. Appreciate it.
[Operator Instructions] And there are no final questions over the phone line. I would now like to hand the conference back over to Mr. Scott Graeff, President and CEO for his final remarks.
All right. Well, thank you, everyone, for joining us today. You’ve heard me say repeatedly that we believe we’re on the right path with the right vision. Given the environment we are in, I believe our financial and operational success during this first half of 2020 underscores this belief. We continue to believe in our potential that we are on the right side of a market shift in trends towards lightweight and 5G. In fact, our capabilities can help to accelerate these trends.
Please feel free to reach out to Gene, Allison or myself with any questions, and we look forward to speaking with some of you soon. Thanks for your time and interest in Luna Innovations, and operator that concludes the earnings call.
Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect.