Quick Pitch: Luna Innovations (LUNA)

Delisting / Potential sale – Multibagger Upside

LUNA stock was down 57% yesterday after Nasdaq delisting notice and subsequent forced-selling. Trading volume was 25x average levels. While the forced-selling creates an opportunity by itself, the setup is actually even more interesting as company’s stock has declined by more than 90% from 2023 levels mostly due to pending restatement of financials and information vacuum during the period.

However, this opportunity is not for faint-hearted. Most investors can open positions only today, as tomorrow LUNA stock will move to Expert Market, restricting trading activity and limiting possibilities to exit any positions. While most brokers will still allow closing orders (IB allows), one can easily end up holding a stock with no real trading market/liquidity. And because of that, a full disclaimer is due: do your own due diligence before investing, my research is rushed to get this post out today, likely has many mistakes and is presented for illustrative and entertainment purposes only. In no way anything described in this post, or Special Situation Investments in general, should be considered an investment advice.

If you are still with me, let’s dig in.

This is the 8K/press release that has driven yesterday’s panic selling:

On December 23, 2024, Luna Innovations Incorporated (the “Company”) notified The Nasdaq Stock Market LLC (“Nasdaq”) that the Company no longer expects to file its previously disclosed delinquent periodic reports with the Securities and Exchange Commission (the “SEC”) and thereby evidence compliance with Nasdaq Listing Rule 5250(c)(1) by March 27, 2025, which is the maximum extension available to the Company under the Nasdaq Listing Rules. As a result, on January 3, 2025, the Company received formal notice (the “Notice”) from Nasdaq that trading in the Company’s common stock will be suspended on Nasdaq effective with the open of business on Tuesday, January 7, 2025.

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Management anticipates that the Company’s shares will be eligible to trade on the OTC Markets’ Pink Limited Information tier for one business day effective with the open of business on Tuesday, January 7, 2025, and on the Expert Market tier effective with the open of business on Wednesday, January 8, 2025, and thereafter. The Expert Market only provides for unsolicited customer orders, and quotations in Expert Market securities are restricted from public viewing and are only available to certain eligible investors.

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Kevin Ilcisin, the Company’s President and Chief Executive Officer, said, “While we are disappointed in the restatement process schedule delays, we are encouraged by the operational discipline and improvements by the entire Luna team since May. During the second half of 2024, we secured notable wins, underscoring our commitment to providing exceptional products and services to our customers.”

Looking ahead, the Company plans to provide a broader business update later this month, including preliminary revenue and booking number for fiscal 2024“

This press release is puzzling / unusual in several ways:

• It appears the company had time till March 27 to comply with Nasdaq listing requirements, but then 3 months before this date voluntarily chose to inform the exchange that it will not be able to meet the deadline, knowing well that this will cause a prompt delisting of the stock.
• In the same press release CEO promises to finally share some financials with investors over the coming 3 weeks. Why not wait till this information is release to the market and only then notify Nasdaq about inability to meet the March deadline?
• And finally, what is the point of 1 day OTC Pink listing before moving to Expert Markets? Is that the usual way in which stocks move to expert markets, with a one day pit stop on Pink Sheets?

I do not have an explanation for these peculiarities, but there may be logical reasons for all of them. If anyone cares to share, please feel free to do so.

But the bottom line is that yesterday’s sell-off was driven by non-economic reasons. The only downside is that the company will once again be unable to file the restated financials. This is nothing new and has been ongoing for a year, alongside many other changes, which I will outline next. From a business perspective, however, the announcement was actually quite positive, highlighting: (1) notable business wins during the second half of 2024, and (2) an upcoming update with financial information to be shared by the newly appointed CEO within the next three weeks.

Despite the information vacuum (the latest financials are as of Q3 2023, and might also get restated), there are several arguments, albeit soft-ish ones, to believe that the underlying business of LUNA continues to perform well and that equity of the company might be worth multiples of the current price. While a return to the previous $8-$10/share trading range (equal to EV of c. $450m) is likely an overly optimistic scenario, even a rebound to the $2/share range – where the stock traded consistently over the last four months – would deliver over 2x upside from current levels. LUNA is still is dominant player in the niche Fiber Optic Sensing market with c. $150m in annual revenues and high profile clients. This business has previously been trading at 2x-3x sales and 20x-40x adjusted EBITDA multiples.

My guess is that the current issues will be sorted out shortly and the company will either be relisted on Nasdaq, just at a much higher share price levels, or will be sold. So I hope not be stranded in holding an Expert Market stock for too long. Several potential short-term catalysts can be expected also: a post-sell-off rebound (not sure we will see any in Expert Market though) and an update on the financials expected this month.

Optimistic Signs

Here is a list of my ‘optimistic signs’ – read these together with the timeline of the recent events (provided below), these will make more sense when put into perspective.

• In yesterday’s press release, the CEO expressed optimism about operational discipline improvements and key wins in H2 2024. If the business performance aligns even partially with this sentiment and has remained stable, the company looks significantly oversold.
• Strategic review is ongoing, with a clear focus on selling the company. The sale is being driven by LUNA’s main financier, PE firm White Hat Capital Partners.
• White Hat continues to pump money into LUNA, signaling confidence that the restatement of financials and strategic review are headed in the right direction. The PE fund made its initial $50m investment (used for debt paydown and and an acquisition) in Dec’23 through preferred shares, which are convertible at $6.7/share. By July 2024, just months after LUNA’s accounting issues surfaced, White Hat provided an additional $15m loan with a Sep’24 maturity with extension option if LUNA secured a buyer and signed a binding sale agreement by then. When that didn’t happen, White Hat had a clear chance to push the company into bankruptcy on loan default, but instead, in October, the PE fund doubled down, increasing the debt facility to $30m and extending the sale deadline to June 2025. Curiously, White Hat also bought an extra $3m in preferred shares (seemingly at the same terms as previously). I do not think they are just throwing good money after bad. It would seem White Hat sees a positive outcome down the road and just provides the necessary funding just to push the company through to that point.
• More credible players have stepped in, also staking their reputations LUNA’s future. In May 2024, John Roiko was appointed as CFO, and the company brought on Alex Davern and Kevin Ilcisin as consultants for the strategic review. All three were senior executives at National Instruments (Alex as CEO, Kevin as Senior VP, and John as Chief Accounting Officer), which was sold for $8.2bn in October 2023. In July, Kevin took over as LUNA’s CEO. It’s hard to believe these guys would dive this deep if the situation were truly unsalvageable or if the bankruptcy (as implied by the current share price) was imminent
• In October, William Phelan took over as CFO (John Roiko remained as advisor). Phelan previously served as Chief Accounting Officer at MiMedx Group, where he oversaw the company’s financial restructuring, improving SEC compliance and internal controls following an accounting fraud scandal. Phelan joined MiMedx when the stock was at $3.50/share, and within a year, it went up to $10/share. His experience in these types of turnaround situations is a solid positive for the thesis.
• In Autumn, two major new shareholders joined LUNA’s register (buying seemingly at $1.5-$1.6/share): Wasatch Advisors (6.7%), and Ameriprise Financial (6.9%, as of Nov 14). Another shareholder, Royce & Associates increased its stake from 4% to 8% in mid-October.
• One additional, more anecdotal point, is that Liberty Park Capital, a small PE fund with $30-$40m in AUM, stated in its Q1’24 letter that it didn’t view LUNA’s accounting issues as particularly significant. LPC is a fairly concentrated fund, and, at the time, LUNA was its largest position. Then, in Q3 the fund reduced its stake. From Q1:

“Obviously, we were disappointed by the update. We do not expect a dramatic restatement to financials and do not expect a meaningful impact to the company’s business going forward (i.e., Luna is not a fraud). In our view, fiber optic sensing remains a game-changing, next-generation technology, and Luna owns most of the intellectual property around it. As such, we view the stock’s collapse as an extreme overreaction.”

Timeline

• Oct 17, 2023 – long time CFO resigned.
• Dec 21, 2023 – White Hat invested $50m through preferred shares, convertible at $6.7/share. The proceeds were partially allocated to acquire Silixa, a UK-based provider of fiber optic systems and solutions, and to repay LUNA’s debt owed to PNC Bank. The preferred shares carry an annual cumulative dividend of 8.5% (or 10% PIK). White Hat appointed their managing director to LUNA’s board.
• Mar 12, 2024 – LUNA delayed its Q4 and full-year 2023 financial release due to ongoing investigation into certain Q2 and Q3 transactions where revenue had been improperly recognized under U.S. GAAP. The company stated it was looking into its “disclosure controls and internal control over financial reporting” and expected to report material weaknesses in its internal controls related to evaluating customer arrangements for proper revenue recognition. The stock price plummeted 35%, from $6.30/share to $4.10/share.
• Mar 25, 2024 – the long-time CEO resigned and stepped down from the board. He had agreed to cooperate with the company during the investigation and accepted clawback provisions. These provisions allowed LUNA to reclaim his compensation if the investigation uncovered misconduct.
• April 19 – accounting issues turned out to be bigger than expected. The company noted that its 2022 financials could also not be relied upon due to revenue recognition issues. The independent review was still ongoing, and the full extent of the impact had yet to be determined.
• April 26 – board approved termination of CTO/VP of corporate development “for cause” (misconduct).
• April 26 – LUNA concluded that the ex-CEO engaged in conduct that constituted cause, and the clawback provision was exercised.
• April 26 – CFO resigned without entitlement to any severance or additional benefits, suggesting the departure may have also been for cause (misconduct). The board approved termination of CTO/VP of corporate development for cause. 7 additional employees got fired.
• May 1 – strategic review was launched. Potential options could include a sale.
• May 1 – John Roiko was appointed as LUNA’s new CFO. Additionally, LUNA retained Alex Davern and Kevin Ilcisin as consultants for the strategic review. All 3 were previously senior executives at National Instruments (Alex – CEO, Kevin – Senior VP, John – Chief Accounting Officer), which was sold for $8.2bn in Oct’23.
• July 12 – executive chairman resigned as a result of personal health issues. Warren B. (Barry) Phelps III was appointed non-executive Chair of the Board.
• July 19 – LUNA entered into a loan agreement with White Hat, securing a delayed draw term loan facility of up to $15m. The most intriguing aspect of the deal is that the loan would mature early if LUNA failed to meet a key “Sale Process Milestone” – finding a buyer and signing a definitive sale agreement by September 30, 2024. The floating interest rate was initially set at SOFR +10%.
• July 19 – Kevin Ilcisin became CEO and joined the board on August 1. He’s on an “at-will” contract, meaning either side can walk away anytime. His base salary is $133k/month, and his firm, Juniper Strategies Advising (co-owned with Alex Davern), is pulling in an extra $31.25k/month in consulting fees.
• October 16 – CFO changed again – John Roiko transitioned to a consulting role, and William L. Phelan stepped in as the new CFO. Phelan had been serving as an advisor since May 2024. Phelan previously served as Chief Accounting Officer at MiMedx, where he played a key role in the company’s restructuring, regaining SEC compliance, and improving internal controls.
• October 25 – The White Hat loan was amended, increasing the facility by an additional $15m for a total of $30m. The previous Sale Process Milestone deadline was moved from September 2024 to June 2025. Curiously, White Hat also acquired an additional $3m in preferred shares.
• January 6, 2025 – LUNA announced its delisting from Nasdaq. For only one day (January 7) the stock will be tradeable on the Pink Sheets, before moving to the Expert Market on January 8. The delisting was attributed to the company’s inability to meet the March 27, 2025 deadline to file its previously delayed SEC filings to regain compliance. The strategic review is still ongoing, with a business update, including preliminary 2024 revenue and bookings, expected later this month. The CEO hinted at positive operational discipline improvements since he took over in May.

Business background

Luna is a leader in advanced optical technology, specializing in high-performance fiber optic sensing solutions. These are mission-critical devices used to test, monitor, and control structures in industries like aerospace, automotive, oil & gas, security, etc. Here are a few examples that highlight the importance of Luna’s tech:

• Luna provided monitoring systems for the 1,811 km Trans-Anatolian Gas Pipeline connecting Azerbaijan to Europe. Activated in November 2023, the pipeline is a critical piece of infrastructure for Europe, especially during the ongoing Ukraine war. Securing this contract (in partnership with ABB) highlights the trust in Luna’s solutions.
• Luna’s technology is used to monitor the health of fiber connections in the F-35 next-generation fighter jets.
• The Polcevera Viaduct Bridge in Italy, rebuilt after an earthquake, was outfitted with Luna’s fiber optic sensors for real-time health monitoring, ensuring structural safety.
• Luna contributed to Shell’s GameChanger Program by developing an advanced solution for measuring in-situ stresses in subsurface rock for the oil and gas industry. This technique provides unmatched accuracy, enabling safer and more efficient well operations.
• In partnership with Meggitt, Luna developed fire sensors for commercial and defense aircraft. Starting with new Airbus planes, these sensors could eventually be retrofitted into older aircraft fleets.

For more background on Luna’s business, check out this Seeking Alpha article and this VIC pitch.

Historical performance and valuation: