Pratchaya
Introduction
A few months ago, Luna Innovations (NASDAQ:LUNA) started to look like a potential multibagger, thanks to great technology and an experienced management team. Today, however, the company is plagued by accounting problems, an internal investigation and a management team in shambles. Now, the company is potentially looking to sell itself (as the company is doing a “strategic review”), as it might not want to continue to rebuild the company from the current crisis. How much could investors expect from a potential suitor? In this article, we explore what went wrong and what we can expect moving forward.
After the current collapse, I believe the worst is probably behind us. That’s why I’m not giving a SELL rating. Investors who wanted to sell should have sold on the first day the problems came out (12 – 13 of March). However, if you are stuck with a very large position in Luna, then it might still be wise to reduce your position due to the current uncertainty surrounding its financial numbers. So take this into consideration when making your investment decisions.
A little bit of history on Luna Innovations
Luna Innovations really seemed like a rising star.
The company was founded in 1990 by an electrical engineer and went public in 2006. And right now, anno 2024, the company has more than 375 employees, 760 patents, and operates in 14 locations worldwide. The company offers more than 3000 products for detection and photonic testing, measurement, and control.
I believe that Luna has deep expertise in optical technology (Fiber Optic Sensing), offering unique solutions via fiber optics for testing, sensing, monitoring, and measurement. Its previous management team highlighted multiple times in investor presentations that Luna is the only company in the world that can provide certain services. Of course, I’m not a technical engineer, but below I will give some examples that (in my opinion) show Luna’s expertise.
To give you an example of what the company was able to accomplish: in November 2023, the Trans-Anatolian Natural Gas Pipeline became active. This pipeline is crucial for transporting natural gas from Azerbaijan to Europe.
Now that Russia is no longer an energy partner of Europe, this pipeline is of high strategic importance to The Old Continent. So it’s very important that this pipeline is being monitored 24/7. Because of Luna’s sensors, the health of the pipeline can be monitored, plus they can detect when someone would try to sabotage the pipeline. Also, areas where the pipeline is above ground, are being secured by Luna.
To give you an idea on how big this project is: the Trans-Anatolian Natural Gas Pipeline is 1811 kilometers long. I suggest to research for yourself to see how massive this is. The fact that Luna can secure a project like this, proofs how highly regarded its product portfolio is.
Also, Luna’s technology is being used to monitor the health of the fiber connections in the F-35 new generation fighter jets. Products like the 0BR 622 and the OBR 6235 are the only commercially available OFDR-based portable reflectometers.
When White Hat Capital Partners announced their investment in Luna at the end of 2023, they also stated that they believe “Luna would be the largest pure-play company to address the rising demand for fiber optic sensing solutions in its key end markets”. And thus, I think we can conclude that Luna does have a valuable product portfolio.
As the revenues of the company grew, from 30 million to more than 100 million dollars, its share price was also taking off. The stock went from $1.5 in 2017 to more $12 at its peak in 2021. Since then, the stock had cooled a bit, sitting between $6 and $10. But was still up +400% at the midpoint, compared to its 2017 level.
Many investors were speculating that Luna was ready to level up from micro-cap status to small cap or maybe even midcap status.
Management was projecting a doubling of its revenues in the next 5 years, driven by several megatrends in Infrastructure monitoring, Industrial and Energy applications. Meaning, Luna would be looking to book more than $200 million in revenue by 2030. Juicy prospects. Combine this with a projected 20% EBITDA margin, and Luna would be highly profitable and seriously undervalued at a 285 million market cap (its valuation before the recent collapse).
And with a growing list of impressive clients in recent years, like Northrop Grumman (NOC), Lockheed Martin (LMT) and Intuitive Surgical (ISRG), everything seemed to be going well for the company. And trust in the company was growing.
The CEO at the time, Scott A. Graeff, seemed super confident in Luna’s long-term prospects and was touting in recent Investor Conferences how Luna had grown from a small company to a professional organization with great leaders and experienced managers.
As mentioned earlier, the company was also able to secure an interesting strategic investment from White Hat Capital Partners when Luna decided to buy Silixa. A UK-based fiber optic sensing company with complementary products to Luna’s offering. In total, White Hat Capital Partners decided to invest $50 million in the company via preferred shares. These preferred shares have a conversion price of $6.7. This boosted the status of Luna as a legit growth company, as the company now got validation from a reputable strategic investor.
However, the risks in Luna were always visible. The company was not reporting any free cash flow yet and was still in need of external funding to achieve its growth plans. Plus, it was still a microcap, which always has a higher than normal risk profile. But despite this, everything seemed to be going well.
The collapse of Luna
On the 12th of March 2024, the problems started for Luna. The company posted a news article on its investor relations website stating that the company was delaying the release of its fourth quarter and full year 2023 financial results as a Special Committee of the Board of Directors was conducting an independent review of certain transactions for which revenue was recognized in Q2 and Q3 of 2023 that did not qualify for revenue recognition under U.S. generally accepted accounting principles. Immediately it seemed like this was not “a small mistake” as the company disclosed that it was investigating “the company’s disclosure controls and internal control over financial reporting”.
Two weeks later, on the 25th of March, the CEO (Scott Graeff), who was with the company for 21 years, decided to leave his role as President and CEO, and also stepped down from the Board of Directors.
The Board of Directors decided to accept his retirement and also would still provide benefits to Mr. Graeff in exchange for his continued assistance and compliance with other obligations, as set forth in a Separation Agreement. So Scott Graeff would still get severance payments in the form of a continuation of his base salary for nine months, and he would get an accelerated vesting of 10,000 shares. But this Agreement also contained certain covenants, including a covenant to cooperate with the Company in connection with any investigation of any claims or demands asserted against it and with respect to matters arising from events that occurred during his period of employment with the Company. The Agreement also contained clawback policies.
In addition, the Separation Agreement contains clawback provisions pursuant to which, in addition to any required clawback under applicable law or listing requirements and the Company’s clawback policies, 100% of all cash severance payments and accelerated RSUs provided to Mr. Graeff under the Separation Agreement are subject to clawback upon (A) the Board’s determination, in its reasonable good faith discretion, that Mr. Graeff engaged in conduct that constituted “Cause” under his employment agreement, (B) the Board’s determination, in its reasonable good faith discretion, that Mr. Graeff materially breached his continued obligations to the Company, or (C) a finding by a court that Mr. Graeff engaged in bad faith conduct. – SEC filing
In short: Scott Graeff was still kept on as an advisor, to help with the internal investigations within the company. However, later the company stated that Scott Graeff engaged in conduct that constituted “Cause”. So the clawback agreement was executed.
Further, in connection with the Special Committee of the Board’s continuing independent review into the Company’s historical financial statements, Chief Technology Officer Brian Soller was terminated from his position for cause effective today, and the Company also terminated the employment of seven additional employees. The Board has also determined that former President and Chief Executive Officer, Scott Graeff, engaged in conduct that constituted “Cause” under his employment agreement, triggering certain clawback provisions in his separation agreement dated March 24, 2024. – Source
Maybe we could have seen the problems coming because long-term CFO Gene Nestro decided to leave Luna Innovations at the end of 2023. He was replaced by George Gomez-Quintero. The company — at the time — stated explicitly, “Nestro’s departure is not a result of any disagreement regarding the company’s financial statements or disclosures”.
All I can say is that the departure of the CFO at the end of 2023 was pretty suspicious in my opinion, as 3 months later the company finds out that its fiscal 2022 and 2023 numbers can no longer be relied upon. Especially since at the time, the company was probably already in negotiations surrounding the strategic investment it was seeking from White Hat Capital Partners (which was announced 2 months later).
By the time the CEO left the company, on the 25th of March, Luna’s stock was already down -43% from when the announcement concerning the accounting issues was made public.
On April 19th, the company announced that the accounting issues were bigger than expected and mentioned that the financial statements of 2022 could also not be trusted. More importantly, the company mentioned that the independent review was still ongoing. And that the full extent of the impact was still to be determined. The stock was at that point down -55% as compared to prior to the concerns.
Based on this assessment, the Audit Committee has determined that the Company’s disclosure controls and procedures were ineffective as of each of the Affected Balance Sheet Dates. The Audit Committee has also concluded that, based on its determination that the Company’s internal control over financial reporting was not effective as of December 31, 2022, Management’s Report on Internal Control over Financial Reporting included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022 should no longer be relied upon. – SEC filing
On April 29th, the new CFO, George Gomez-Quintero, decided to leave the company as well. He was replaced by John Roiko.
Chief Technology Officer Brian Soller was also terminated from his position for cause. 7 other employees were also fired.
By April 29th, the stock was down -67%.
So what now?
We still don’t know what the real financial figures are for 2022 and 2023. These figures will be crucial in determining Luna’s real value as a company.
In my opinion, since the problems started, more or less 2 months ago, the company had a deep cleansing of potential bad actors (note: nothing illegal has come out of the investigation thus far) and has hired some new talented, skilled and trustworthy people. People who might be able to turn things around. Including 3 top people (Alex Davern, Kevin Ilcisin and John Roiko) who previously worked for National Instruments, a company that was sold to Emerson Electric for 8.2 billion dollars.
However, time seems to be running out for Luna.
If Luna doesn’t publish its 10-K (annual report of 2023) by June 3, 2024, Nasdaq might delist the company. Which would make it unable for investors to sell or buy shares in the company.
Because of all the distractions going on within the company, its Q1 2024 figures will probably be terrible.
Luna has lost a lot of employees, who may or may not have been crucial to the company’s prior growth. We also don’t know how existing and potential customers have reacted to the problems within the company. Maybe some of them have chosen a more stable competitor for future business.
I would not be surprised if we saw a -20% revenue drop based on the implementation of new, accurate, accounting practices and maybe the loss of some customers. Its Q3 2023 results (the latest that we can see right now) were not good already, with marginal revenue growth (+5%) and declining margins (net profit declined -60%).
Because of the mounting concerns, Luna has now stated that it is “evaluating every strategic option” for the company. Meaning, it might be looking to sell the company altogether.
Conclusion
As mentioned above, determining the true value of the company at this point is difficult. We really need to wait and see what comes out of the investigation and what the financial statements will look like for fiscal year 2023 and 2022.
But considering Luna’s interesting growth profile and its high value technological assets (patents) and know how, it might still be able to get anywhere between 100 and 200 million dollars if it were to sell itself. And that might even be a low number if the restated financial figures turn out to be a small difference compared to the published figures so far. But this is very unlikely.
However, again, there is no certainty, and we need to wait for the real results to come out to make a real appraisal.
I believe the recent bounce in the share price of Luna is due to takeover speculation and shorts covering their bets. The company is now quoted at 1x its book value. Which seems fair for now, as the company might not be worth much more, compared to its assets minus liabilities.
All I can say is that I hope Luna investors will get a fair price for their shares, and hopefully, there is a good ending to this traumatic experience for regular retail investors.
As for now, investors should make sure that Luna is a very small position in their portfolio (if they are still holding the stock) because a continued “death spiral” could be the real risk here. We don’t know for certain how much the company’s sales and profit numbers have been negatively impacted because of the internal problems, but my guess is that it might be substantial, as we are now 2 months into the investigation and the annual report still hasn’t been published.
Caution is advised. Don’t just buy it because it “looks cheap” when looking at the graph.
On the other side though, if you still hold a small stake, selling now might seem almost useless as most of the damage has been done. It might be best to just hold what’s left of your investment, as the worst seems to be over for now. The stock is already down significantly from before the problems started and the previous leaders of the company have been forced out (or left voluntarily), while a new team has been put in place.
Maybe the market will start to look forward again, and perhaps Luna could become a great turnaround story. Luna does seem to have interesting products and valuable IP, that might make it an interesting target for a potential acquirer. The real value of the company is to be determined when we get the restated 2023 and 2022 figures.
Luckily for Luna, the investment of White Hat Capital Partners came at the right time, as they were able to use the proceeds to finance the Silixa acquisition and repay the company’s 17 million dollar term loan with PNC Bank, which strengthened the balance sheet.
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
