LUNA INNOVATIONS INC - Quarter Report: 2012 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

For the quarterly period ended September 30, 2012

OR

For the transition period from              to            

COMMISSION FILE NUMBER 000-52008

LUNA INNOVATIONS INCORPORATED

(Exact name of registrant as specified in its charter)

One Riverside Circle, Suite 400

Roanoke, VA 24016

(Address of Principal Executive Offices)

(540) 769-8400

(Registrant’s Telephone Number, Including Area Code)

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    x  Yes    ¨  No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    x  Yes    ¨  No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x  No

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.    x  Yes    ¨  No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: As of October 31, 2012, there were 14,008,869 shares of the registrant’s common stock outstanding.

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CAUTIONARY NOTE REGARDING FORWARD LOOKING STATEMENTS

This Quarterly Report on Form 10-Q, including the sections entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Quantitative and Qualitative Disclosure About Market Risk” under Items 2 and 3, respectively, of Part I of this report, and the section entitled “Risk Factors” under Item 1A of Part II of this report, may contain forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. All statements other than statements of historical fact are “forward-looking statements” for purposes of these statutes, including those relating to future events or our future financial performance. In some cases, you can identify these forward looking statements by words such as “intends,” “will,” “plans,” “anticipates,” “expects,” “may,” “might,” “estimates,” “believes,” “should,” “projects,” “predicts,” “potential” or “continue,” or the negative of those words and other comparable words, and other words or terms of similar meaning in connection with any discussion of future operating or financial performance. Similarly, statements that describe our business strategy, goals, prospects, opportunities, outlook, objectives, plans or intentions are also forward-looking statements. These statements are only predictions and may relate to, but are not limited to, expectations of future operating results or financial performance, capital expenditures, introduction of new products, regulatory compliance and plans for growth and future operations, as well as assumptions relating to the foregoing.

These statements are based on current expectations and assumptions regarding future events and business performance and involve known and unknown risks, uncertainties and other factors that may cause actual events or results to be materially different from any future events or results expressed or implied by these statements. These factors include those set forth in the following discussion and within Item 1A “Risk Factors” of this Quarterly Report on Form 10-Q and elsewhere within this report.

You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. You should carefully review the risk factors described in other documents that we file from time to time with the U.S. Securities and Exchange Commission, or SEC. Except as required by applicable law, including the rules and regulations of the SEC, we do not plan to publicly update or revise any forward-looking statements, whether as a result of any new information, future events or otherwise, other than through the filing of periodic reports in accordance with the Securities Exchange Act of 1934, as amended.

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LUNA INNOVATIONS INCORPORATED

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2012

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PART I. FINANCIAL INFORMATION

Luna Innovations Incorporated

Condensed Consolidated Balance Sheets

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Luna Innovations Incorporated

Condensed Consolidated Statements of Operations

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Luna Innovations Incorporated

Condensed Consolidated Statements of Cash Flows

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Luna Innovations Incorporated

Notes to Unaudited Condensed Consolidated Financial Statements

Nature of Operations

Luna Innovations Incorporated (“we,” “Luna Innovations” or the “Company”) is incorporated in the State of Delaware and headquartered in Roanoke, Virginia. We develop, manufacture and market fiber optic test & measurement, sensing, and instrumentation products and are focused on bringing new and innovative technology solutions to measure, monitor, protect and improve critical processes in the telecommunications, medical, composite and defense industries. We are organized into two main groups, which work closely together to turn ideas into products: our Technology Development segment, and our Products and Licensing segment. Our business model is designed to accelerate the process of bringing new and innovative technologies to market. We have a history of net losses from 2005 through the nine months ended September 30, 2012, attributable to our operations and other charges. We have historically managed our liquidity through cost reduction initiatives, debt financings and capital markets transactions. For the three months ended September 30, 2012, we experienced positive cash flow from operations of $0.6 million and overall positive cash flow of $0.1 million during that period. For the nine months ended September 30, 2012, we experienced negative cash flow from operations of $0.8 million and an overall negative cash flow of $2.2 million during that period.

Since the second half of 2008, the increased turmoil in the U.S. and global capital markets and a global slowdown of economic growth created a substantially more difficult business environment. Our ability to access the capital markets may be limited. Economic and market conditions may not improve significantly during the remainder of 2012 and into 2013 and could get worse.

Although there can be no guarantees, we believe that our current cash balance, in addition to the funds available to us under the Credit Facilities described in Note 3 below, will provide adequate liquidity for us to meet our working capital needs over the next twelve months.

Unaudited Interim Financial Information

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP. The unaudited condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and in the opinion of management reflect all adjustments, consisting of only normal recurring accruals considered necessary to present fairly our financial position at September 30, 2012, results of operations for the three and nine months ended September 30, 2012 and 2011, and cash flows for the nine months ended September 30, 2012 and 2011. The results of operations for the three and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

The consolidated interim financial statements, including our significant accounting policies, should be read in conjunction with the audited Consolidated Financial Statements and the notes thereto for the year ended December 31, 2011, included in the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 29, 2012. As used herein, the terms “Luna”, the “Company”, “we”, “our” and “us” mean Luna Innovations Incorporated and its consolidated subsidiaries.

Consolidation Policy

Our consolidated financial statements include the accounts of the Company, our wholly owned subsidiaries and other entities in which we have a controlling financial interest. We eliminate from our financial results all significant intercompany transactions. We do not have any investments in entities we believe are variable interest entities for which we are the primary beneficiary.

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Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between marketplace participants. Various valuation approaches can be used to determine fair value, each requiring different valuation inputs. The following hierarchy classifies the inputs used to determine fair value into three levels:

The carrying values of cash and cash equivalents, contract receivables and accounts payable approximate fair value because of the short-term nature of these instruments. The carrying value of our debt approximates fair value, as we consider the floating interest rate on our credit facilities with Silicon Valley Bank to be at market. Certain nonfinancial assets and liabilities are measured at fair value on a nonrecurring basis in accordance with U.S. GAAP. This includes items such as nonfinancial assets and liabilities initially measured at fair value in a business combination and nonfinancial long-lived asset groups measured at fair value for an impairment assessment. In general, nonfinancial assets including intangible assets and property and equipment are measured at fair value when there is an indication of impairment and are recorded at fair value only when any impairment is recognized.

Use of Estimates

The preparation of our consolidated financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our consolidated financial statements and accompanying notes. Although these estimates are based on our knowledge of current events and actions we may undertake in the future, actual results may differ from such estimates and assumptions.

Net Income/(Loss) per Share

Basic net income/(loss) per share is computed by dividing net income/(loss) available to common stockholders by the weighted average number of shares outstanding during the period. Diluted net income/(loss) per share is computed by dividing net income/(loss) available to common stockholders by the weighted average shares outstanding during the period increased to include, if dilutive, the number of additional common share equivalents that would have been outstanding if potential common shares had been issued using the treasury stock method. Diluted net income/(loss) per share would also include the potential common share equivalents relating to convertible securities by application of the if-converted method.

For the three and nine months ended September 30, 2012 we had a total of 7,002,200 and 6,896,405 common stock equivalents (which include conversion of preferred stock, outstanding warrants and stock options), respectively, all of which are anti-dilutive. For the three months ended September 30, 2011 we had a total of 6,975,633 common stock equivalents (which include conversion of preferred stock, outstanding warrants and stock options), of which 2,228,916 were dilutive and 4,746,717 were anti-dilutive. For the nine months ended September 30, 2011 we had a total of 6,144,661 common stock equivalents (which include conversion of preferred stock, outstanding warrants and stock options) which were anti-dilutive. In those reporting periods in which we have a net loss, anti-dilutive shares comprise the impact of those number of shares that would have been dilutive had we had net income plus the number of common stock equivalents that would be anti-dilutive had we had net income.

Share-Based Compensation

We recognize share-based compensation expense based upon the fair value of the underlying equity award on the date of the grant. We have elected to use the Black-Scholes option pricing model to value any awards granted.

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We amortize share-based compensation for such awards on a straight-line basis over the related service period of the awards taking into account the effects of the employees’ expected exercise and post-vesting employment termination behavior. To compute the volatility used in this model we use the historical volatility of our common stock over the expected life of options granted, or the period since our initial public offering if less than the expected life of the options. The risk-free interest rate is based on U.S. Treasury interest rates, the terms of which are consistent with the expected life of the stock options. The expected life and estimated post employment termination behavior is based upon historical experience of homogeneous groups within our company. We also assume an expected dividend yield of zero for all periods, as we have never paid a dividend on our common stock and do not have any plans to do so in the future.

The fair value of each option granted during the nine months ended September 30, 2012 and 2011 was estimated as of the grant date using the Black-Scholes option pricing model with the following assumptions:

A summary of the activity for our 2003 Stock Plan and 2006 Equity Incentive Plan is presented below for the nine months ended September 30, 2012:

At September 30, 2012, the outstanding stock options to purchase an aggregate of 5,297,511 shares had a weighted-average remaining contractual term of 6.6 years, and the exercisable stock options to purchase an aggregate of 3,575,182 shares had a weighted-average remaining contractual term of 5.5 years.

For the three months ended September 30, 2012 and 2011, we recognized $483,000 and $462,000, respectively, and for the nine months ended September 30, 2012 and 2011, we recognized $1,412,000 and $1,737,000, respectively, in share-based compensation expense, which is included in our selling, general and administrative expenses in the accompanying consolidated financial statements. We expect to recognize $2.3 million in share-based compensation expense over the remaining requisite service period of five years for stock options outstanding as of September 30, 2012.

Intangible Assets and Other Long Lived Assets

Long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds the fair market value of the asset. Assets to be disposed of are reported at the lower of the carrying amount or fair market value, less cost to sell.

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Recent Accounting Pronouncements

There are no recently issued accounting standards that are expected to have a material impact on our consolidated results of operations, financial position and cash flows.

Inventory consists of finished goods, work-in-process and parts valued at the lower of cost (determined on the first-in, first-out basis) or market. We provide reserves for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about future demand and market conditions.

Components of inventory are as follows:

Silicon Valley Bank Credit Facilities

On February 18, 2010, we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”) to provide us with borrowing capacity of up to $5.0 million, subject to a percentage of our outstanding eligible accounts receivable, at a floating annual interest rate equal to the greater of (a) 6% or (b) SVB’s prime rate then in effect plus 2%. The credit facility was originally scheduled to mature on February 17, 2011, but it was amended to extend the maturity date until May 18, 2011 and to revise the calculation of eligible borrowing base and add certain financial covenants relating to our adjusted EBITDA.

On May 18, 2011, we entered into a Second Loan Modification Agreement (the “Second Loan Modification Agreement”) with SVB. Under the Second Loan Modification Agreement, SVB made a term loan to us in the amount of $6.0 million (the “Term Loan”). The Term Loan is to be repaid by us in 48 monthly installments, plus accrued interest payable monthly in arrears, and unless earlier terminated, matures on the earlier of either May 1, 2015 or an event of a default under the loan agreement. The Term Loan carries a floating annual interest rate equal to SVB’s prime rate then in effect plus 2%.

We may prepay amounts due under the Term Loan for a fee equal to (i) $60,000, if such prepayment is made on or before May 18, 2013; or (ii) zero, if such prepayment is made after May 18, 2013.

In addition to the terms and conditions of the Term Loan, the Second Loan Modification Agreement reduced our maximum borrowing capacity under the revolving credit facility (the “Line of Credit” and together with the Term Loan the “Credit Facilities”) from $5.0 million to $1.0 million and extended its maturity date until May 18, 2012.

Effective as of May 17, 2012, we entered into a Third Loan Modification Agreement (the “Third Loan Modification Agreement”) with SVB. Under the Third Loan Modification Agreement, the Line of Credit maturity date was extended until May 17, 2014.

As modified by the Second Loan Modification Agreement and the Third Loan Modification Agreement, the annual interest rate on the Line of Credit is equal to the greater of (a) 6% or (b) SVB’s prime rate plus 1%, payable monthly in arrears, and we are obligated to pay to SVB an unused Line of Credit fee equal to one-quarter of one

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percent (0.25%), of the unused borrowing capacity payable monthly. We may terminate the Line of Credit for a termination fee of $10,000, which fee would not be payable in the event that the Line of Credit is replaced by another loan facility with SVB.

Amounts due under the Credit Facilities are secured by substantially all of our assets, including intellectual property, personal property and bank accounts.

The Credit Facilities require us to observe a number of financial and operational covenants, including maintenance of a specified liquidity ratio, achievement of certain adjusted EBITDA targets, protection and registration of intellectual property rights, and certain customary negative covenants. As of September 30, 2012, we were in compliance with all covenants.

In addition, the Credit Facilities contain customary events of default, including nonpayment of principal, interest or other amounts, violation of covenants, material adverse change, an event of default under any subordinated debt documents, incorrectness of representations and warranties in any material respect, bankruptcy, judgments in excess of a threshold amount, and violations of other agreements in excess of a threshold amount. If any event of default occurs SVB may declare due immediately all borrowings under the Credit Facilities and foreclose on the collateral. Furthermore, an event of default under the Credit Facilities would result in an increase in the interest rate on any amounts outstanding.

The balance under the Term Loan at September 30, 2012 was $4.1 million, of which $2.5 million was classified as long-term and $1.6 million was classified as short-term. No amounts were outstanding under the Line of Credit at September 30, 2012, and the $1.0 million remains available.

Note Payable to Hansen Medical, Inc.

In January 2010, we issued to Hansen Medical, Inc. (“Hansen”) a note (the “Hansen Note”) in the original principal amount of $5.0 million, which was subordinated to our obligations to SVB. The Hansen Note bore interest at a fixed rate of 8.5% and was secured by substantially all of our assets. On May 23, 2011, in connection with the Second Loan Modification Agreement with SVB, we repaid the Hansen Note in full. We and Hansen agreed upon a final payoff in the amount of approximately $3.0 million as payment in full for all principal and accrued interest under the Hansen Note, which represented a $190,000 discount from the then outstanding balance. The discount will be amortized into income over the remaining life of our Development and Supply Agreement with Hansen. At September 30, 2012, there was approximately $62,000 remaining in deferred credits to be amortized. Upon receipt of this final payment, all security interests in our assets held by Hansen as collateral for our obligations under the Hansen Note were terminated and released.

The following details our equity transactions during the nine months ended September 30, 2012:

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Our operations are divided into two operating segments—“Technology Development” and “Products and Licensing”.

The Technology Development segment provides applied research to customers in our areas of focus. Our engineers and scientists collaborate with our network of government, academic and industry experts to identify technologies and ideas with promising market potential. We then compete to win fee-for-service contracts from government agencies and industrial customers who seek innovative solutions to practical problems that require new technology. The Technology Development segment derives its revenue primarily from services.

The Products and Licensing segment derives its revenue from product sales, funded product development and technology licenses.

Through September 30, 2012, our Chief Executive Officer and his direct reports collectively represented our chief operating decision makers, and they evaluated segment performance based primarily on revenue and operating income or loss. The accounting policies of our segments are the same as those described in the summary of significant accounting policies (see Note 1 to our Financial Statements, “Organization and Summary of Significant Accounting Policies,” presented in our Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 29, 2012).

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The table below presents revenues and operating loss for reportable segments:

The table below presents assets for reportable segments:

There are no material inter-segment revenues for any period presented.

The United States Government accounted for approximately 66% and 70% of total consolidated revenues for the three months ended September 30, 2012 and 2011, respectively, and 66% and 64% of total consolidated revenues for the nine months ended September 30, 2012 and 2011, respectively.

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International revenues (customers outside the United States) accounted for approximately 17% and 6% of total consolidated revenues for the three months ended September 30, 2012 and 2011, respectively, and 15% and 12% for the nine months ended September 30, 2012 and 2011, respectively.

We are from time to time involved in certain legal proceedings in the ordinary course of conducting our business. While the ultimate liability pursuant to these actions cannot currently be determined, we believe these legal proceedings will not have a material adverse effect on our financial position or results of operations.

In September 2011 we executed a non-cancelable $1.2 million purchase order for multiple shipments of tunable lasers to be delivered over a 12-month period beginning in 2012. At September 30, 2012, approximately $0.4 million of this commitment remained.

We have entered into indemnification agreements with our officers and directors, to the extent permitted by law, pursuant to which we have agreed to reimburse the officers and directors for legal expenses in the event of litigation and regulatory matters. The terms of these indemnification agreements provide for no limitation to the maximum potential future payments. We have a directors and officers insurance policy that may, in certain instances, mitigate the potential liability and payments.

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The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to those statements included elsewhere in this report. In addition to historical financial information, the following discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and timing of selected events may differ materially from those anticipated in these  forward-looking statements as a result of many factors, including those discussed under “Risk factors” and elsewhere in this report.

Overview

We develop, manufacture and market fiber optic test & measurement, sensing, and instrumentation products and are focused on bringing new and innovative technology solutions to measure, monitor, protect and improve critical processes in the telecommunications, medical, composite and defense industries. Our business model is designed to accelerate the process of bringing new and innovative products to market. We use our in-house technical expertise across a range of technologies to perform applied research services for companies and government-funded projects. We continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth.

Our corporate strategy focuses on three key objectives for growth as we seek to commercialize our technologies:

We are organized into two main business segments, our Products and Licensing segment and our Technology Development segment. Our Products and Licensing segment develops, manufactures and markets our fiber optic test and measurement, sensing, and instrumentation products and also conducts applied research in the fiber optic sensing area for both corporate and government customers. Revenues in this segment are currently largely derived from sales of test and measurement equipment for optical components and networks. Our Products and Licensing segment is also focused on two of our key strategic objectives. We are working to develop and commercialize our fiber optic shape sensing technology in the medical industry with the goal of supplying fiber optic shape sensing components for use in robotic and minimally invasive surgical systems. We are also working to develop and commercialize our fiber optic technology for strain and temperature sensing applications for the composite materials industry. Our Products and Licensing segment revenues represented approximately 39% and 30% of our total revenues for the quarters ended September 30, 2012 and 2011, respectively. A breakdown of our operating loss by segment, as well as our total assets by segment, is provided in footnote 5 to our condensed consolidated financial statements included in this report.

Our Technology Development segment performs applied research for government funded projects and includes our secure computing and communications group, or SCC. Our Technology Development segment constituted approximately 61% and 70% of our total revenues for the quarters ended September 30, 2012 and 2011, respectively. SCC provides innovative solutions designed to secure critical technologies within the U.S. government. SCC conducts applied research and provides services to the government in this area, with its revenues primarily derived from U.S. government contracts and purchase orders. SCC is focused on our strategic objective of developing a leading technology for ensuring the integrity of integrated circuits used in defense systems. Our Technology Development segment also performs applied research in the areas of sensing and materials. Most of the government funding in the part of our Technology Development segment outside of SCC is derived from the Small Business Innovation Research, or SBIR, program coordinated by the U.S. Small Business Administration, or SBA.

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We generate revenues through technology development services provided under contractual arrangements, product sales, product development under contractual relationships and license fees. Our Technology Development segment revenues have historically accounted for a large portion of our total revenues, and we expect that they will continue to represent a significant portion of our total revenues for the foreseeable future. Our Technology Development segment revenues have decreased to $4.9 million for the quarter ended September 30, 2012, from $6.2 million for the same period in 2011, due primarily to an increase in our SCC group’s 2011 revenue from four short duration contracts being won and completed during the quarter.

Within the Technology Development segment, we have historically had a backlog of contracts for which work has been scheduled, but for which a specified portion of work has not yet been completed. We define backlog as the dollar amount of obligations payable to us under negotiated contracts upon completion of a specified portion of work that has not yet been completed, exclusive of revenues previously recognized for work already performed under these contracts, if any. Total backlog includes funded backlog, which is the amount for which money has been directly authorized by the U.S. Congress and for which a purchase order has been received by a commercial customer, and unfunded backlog, representing firm orders for which funding has not yet been appropriated. Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. The approximate value of our Technology Development segment backlog was $17.5 million at September 30, 2012, compared to $24.5 million at September 30, 2011, due primarily to a lower acceptance rate in our Optical Systems Group.

Revenues from product sales currently represent a smaller portion of our total revenues, and, historically, we have derived most of these revenues from the sales of our sensing systems and products that make use of light-transmitting optical fibers, or fiber optics. We continue to invest in product development and commercialization, which we anticipate will lead to increased product sales growth. Although we have been successful in licensing certain technology in past years, we do not expect license revenues to represent a significant portion of future revenues. Over time, however, we do intend to gradually increase such revenues. In the near term, we expect revenues from product sales and product development to be primarily in areas associated with our fiber optic instrumentation, test and measurement and sensing platforms. In the long term, we expect that revenues from product sales will represent a larger portion of our total revenues and that, as we develop and commercialize new products, these revenues will reflect a broader and more diversified mix of products.

We incurred net losses attributable to common stockholders of approximately $0.3 million and $0.9 million for the three and nine months ended September 30, 2012, respectively.

We may incur increasing expenses as we expand our business, including expenses for research and development, sales and marketing and manufacturing capabilities. We may also grow our business in part through acquisitions of additional companies and complementary technologies, which could cause us to incur transaction expenses, the potential for amortization or write-offs of intangible assets and other acquisition-related expenses. As a result, we expect to incur net losses for the foreseeable future, and these losses could be substantial.

Global economic conditions have experienced a significant prolonged downturn and remain uncertain. This slowing of the economy has reduced the financial capacities of our customers and possibly our potential customers, thereby slowing spending on the products and services we provide. The outlook for the economy for the remainder of 2012 and into 2013 remains uncertain.

Description of Our Revenues, Costs and Expenses

Revenues

We generate revenues from technology development, product sales, commercial product development and licensing activities. We derive Technology Development segment revenues from providing research and development services to third parties, including government entities, academic institutions and corporations, and from achieving milestones established by some of these contracts and in collaboration agreements. In general, we complete contracted research over periods ranging from six months to three years, and recognize these revenues over the life of the contract as costs are incurred or upon the achievement of certain milestones built into the contracts. Our Technology Development segment revenues represented approximately 61% and 70% of our total revenues for the three months ended September 30, 2012 and 2011, respectively, and 65% and 63% of our total revenues for the nine months ended September 30, 2012 and 2011, respectively.

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Our Products and Licensing segment revenues reflect amounts that we receive from sales of our products or development of products for third parties, as well as fees paid to us in connection with licenses or sublicenses of certain patents and other intellectual property, and represented approximately 39% and 30% of our total revenues for the three months ended September 30, 2012 and 2011, respectively, and 35% and 37% of our total revenues for the nine months ended September 30, 2012 and 2011, respectively.

Cost of Revenues

Cost of revenues associated with Technology Development segment revenues consists of costs associated with performing the related research activities including direct labor, amounts paid to subcontractors and overhead allocated to Technology Development segment activities.

Cost of revenues associated with our Products and Licensing segment revenues consists of license fees for use of certain technologies; product manufacturing costs including all direct material and direct labor costs; amounts paid to our contract manufacturers; manufacturing, shipping and handling; provisions for product warranties; and inventory obsolescence, as well as overhead allocated to each of these activities.

Operating Expense

Operating expense consists of selling, general and administrative expenses, as well as expenses related to research, development and engineering, depreciation of fixed assets and amortization of intangible assets. These expenses also include compensation for employees in executive and operational functions including certain non-cash charges related to expenses from option grants, facilities costs, professional fees, salaries, commissions, travel expense and related benefits of personnel engaged in sales, product management and marketing activities; costs of marketing programs and promotional materials; salaries, bonuses and related benefits of personnel engaged in our own research and development beyond the scope and activities of our Technology Development segment; product development activities not provided under contracts with third parties; and overhead costs related to these activities.

Interest Income/Expense

Interest expense is composed of interest paid under our bank loans and, for the periods prior to our repayment of the note in May 2011, the convertible promissory note issued to Hansen Medical, Inc., as well as interest accrued on our capital lease obligations. Interest income includes amounts earned on our cash deposits with financial institutions.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the amounts reported in our financial statements and the accompanying notes. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or judgments. Our critical accounting policies are described in the Management’s Discussion and Analysis section and the notes to our audited consolidated financial statements previously included in our Annual Report on Form 10-K for the period ended December 31, 2011, as filed with the Securities and Exchange Commission on March 29, 2012. There have been no material changes to the descriptions therein.

Results of Operations

Three Months Ended September 30, 2012 Compared to Three Months Ended September 30, 2011

Revenues

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Revenues from our Technology Development segment decreased by $1.3 million during the third quarter of 2012 as compared to the prior year quarter, due primarily to revenue decline of $0.9 million in our SCC group, which won and completed four short-duration contracts during the third quarter of 2011, which generated revenue of $0.8 million and which did not recur during 2012. In addition, revenue of our materials systems group declined by $0.3 million due to an unusually high amount of subcontract work toward the end of the third quarter of 2011, which led to a higher than expected revenue during that quarter.

Our Products and Licensing segment revenues increased by $0.5 million during the third quarter of 2012 as compared to the prior year quarter, primarily due to sales of our recently launched ODiSI products for measuring strain using optical fiber as a sensor.

Cost of Revenues and Gross Profit

The cost of our Technology Development segment revenues decreased only slightly for the third quarter of 2012 compared to the same period in 2011, while the corresponding revenues in this segment decreased 21% over the same period. The additional $0.8 million of revenue generated by SCC in the third quarter of 2011, described above, did not require significant incremental costs; therefore the reduction in SCC revenue in the third quarter of 2012 did not result in a corresponding expense reduction. In addition, approximately $0.4 million of internal research and development costs incurred during the three months ended September 30, 2011 that would have normally have been included in technology development cost of revenues were instead directed toward internal research and development projects in the SCC group and were therefore expensed as research, development and engineering expense in the third quarter of 2011. We did not have a corresponding amount of internal development expense in SCC in the third quarter of 2012. Our Products and Licensing segment cost of revenues decreased $0.4 million from the third quarter of 2011 to the third quarter of 2012 due to a reduction in development revenue for some of our medical shape sensing applications.

Our resulting gross profit was $3.1 million for the quarter ended September 30, 2012, compared to $3.5 million for the corresponding quarter in 2011. This decline is attributable to both our decrease in revenue and corresponding decrease in costs.

Operating Expense

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Our selling, general and administrative expense increased $0.4 million, or 16%, during the third quarter of 2012 as compared to the same period in 2011. The increase was primarily driven by an increase in commissions paid to third-party product representatives. Research, development, and engineering expense decreased $0.2 million, or 25%, during the three months ended September 30, 2012 compared to the same period in 2011. This decrease was primarily due to the decrease in internal research and development projects within our SCC group, as described above, partially offset by an increase in engineering expenses due to a decline in contract development contracts, which resulted in less of our funded engineering cost being allocated to cost of revenues.

Interest Income (Expense)

Interest expense for the three months ended September 30, 2012 was $68,000 compared to interest expense of $92,000 during the same period in 2011. The monthly average loan balance during the third quarter of 2012 was $4.2 million compared to $5.7 million for the same period in 2011. The lower average loan balance accounted for this decrease.

Other Income

During the three months ended September 30, 2012, we recognized a total of $38,000 of other income, primarily the result of $23,000 in amortization of the discount on the Hansen debt, described in Note 3 to our condensed consolidated financial statements included in this report. This compares to other income of $22,000 from the amortization of debt discount during the three months ended September 30, 2011.

Nine Months Ended September 30, 2012 Compared to Nine Months Ended September 30, 2011

Revenues

Revenues in our Technology Development segment declined primarily due to decreases in revenue in our SCC group, which decrease was due to $1.2 million of revenue from short-duration contracts performed in the second and third quarters of 2011 (including the $0.8 million recognized in the third quarter, as described above), which did not recur in 2012.

Revenues in our Products and Licensing segment decreased primarily due to a $0.5 million decrease in sales of our fiber optic test and measurement products during the first three quarters of 2012, compared to the same period in 2011, reflecting lower volume sales of our OBR products. In addition, our product development revenue decreased $0.9 million due to reductions in contracted product development activities with our commercial customers.

Cost of Revenues

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The Technology Development segment’s cost of revenues decreased to a lesser degree than revenue in the first three quarters of 2012 as compared to the same period in 2011, due to the revenue decline in SCC having lower associated costs than our normal technology development contracts. In addition, approximately $0.4 million of internal research and development costs incurred during the first three quarters of 2011 that would normally have been included in technology development cost of revenues were instead directed toward internal research and development projects in the SCC group and were therefore expensed as research, development and engineering expense in the first three quarters of 2011. We did not have a corresponding amount of internal development expense in SCC in the first three quarters of 2012 and, therefore, these costs were allocated to technology development cost of revenues The decrease in Products and Licensing segment’s cost of revenues in the first three quarters of 2012 as compared to the same period in 2011 corresponded with a reduction in our product sales and product development during the first three quarters of 2012.

Operating Expense

In the first three quarters of 2012, selling, general and administrative expense decreased by $1.2 million as compared to the same period in 2011, primarily due to a decrease in our share-based compensation expense of $0.3 million associated with stock options that have fully vested, a decrease in consulting fees of $0.3 million associated with Dr. Kent Murphy’s consulting contract that has expired, and the non-recurrence of $0.4 million in legal and other expenses incurred with respect to the threatened proxy contest in 2011. We also had a $0.3 million decrease in incentive compensation and recruiting fees in the first three quarters of 2012 compared to the prior year period. Our research, development and engineering expense has remained relatively flat during the first three quarters of 2012 compared to the same period in 2011.

Interest Income (Expense)

Interest expense for the nine months ended September 30, 2012 was approximately $222,000 compared to interest expense of approximately $291,000 during the same period in 2011. The monthly average loan balance during the first three quarters of 2012 was $4.5 million compared to $5.9 million for the same period in 2011. The lower average loan balance along with our lower average interest rate under the SVB credit facilities accounted for this decrease.

Liquidity and Capital Resources

At September 30, 2012, our total cash and cash equivalents were approximately $6.7 million.

We have a term loan with SVB, which at September 30, 2012 had a balance of $4.1 million. This term loan matures on May 1, 2015. We also maintain a revolving line of credit of up to $1.0 million with SVB, under which no amounts are outstanding and the full borrowing capacity of $1.0 million remains available. The line of credit is currently scheduled to expire on May 17, 2014. The terms and conditions of our term loan and line of credit are described in Note 3 of our condensed consolidated financial statements included in this report.

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We believe that our current cash balance, combined with our expected operating cash flows and the funds available to us under the line of credit with SVB, provide adequate liquidity for us to meet our working capital needs over the next twelve months.

Discussion of Cash Flows

Recent Activity

During the first three quarters of 2012, operations used $0.8 million of net cash, as compared to the same period in 2011 in which operations provided $0.6 million of net cash. In the first three quarters of 2012, our net loss of $0.8 million and $2.2 million of net cash outflows from changes in operating assets and liabilities were offset by $2.3 million in non-cash expenses. The net cash outflows from changes in working capital of $2.2 million was primarily the result of a $1.8 million increase in accounts receivable during the first three quarters of 2012, as sales in the third quarter were concentrated later in the quarter and therefore not yet due for collection. During the first three quarters of 2011, our net loss of $1.0 million was offset by $2.8 million in non-cash expenses and $1.2 million in net cash outflows from changes in operating assets and liabilities.

Our cash used in investing activities is composed solely of purchases of equipment and capitalized costs associated with the prosecution of patents. During the first three quarters of 2012, we made $243,000 in equipment purchases, compared to $290,000 during the same period of the prior year, and we incurred $132,000 in patent costs associated with certain intangible assets, primarily associated with our fiber optic platform, compared to $273,000 in such costs during the same period of the prior year.

Net cash used in financing activities during the first three quarters of 2012 included the scheduled repayments of principal for our debt and lease obligations, which in the aggregate resulted in net cash outflows of $1.1 million as compared to $0.4 million for the same period last year. In May 2011, we received $6.0 million in term loan proceeds from SVB, which we used to repay the then outstanding balance on our revolving line of credit with SVB of $2.5 million and the then outstanding balance on our Hansen Note of approximately $3.0 million, which results in higher principal repayments each quarter. We also received $85,000 and $263,000 from the exercise of warrants and stock options during the nine months ended September 30, 2012 and 2011, respectively.

Off-Balance Sheet Arrangements

We have no material off-balance sheet arrangements as defined in Regulation S-K Item 303(a) (4) (ii).

Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. We do not hold or issue financial instruments for trading purposes or have any derivative financial instruments. Our exposure to market risk is limited to interest rate fluctuations due to changes in the general level of United States interest rates.

Interest Rate Risk

We do not use derivative financial instruments as a hedge against interest rate fluctuations, and, as a result, interest income earned on our cash and cash equivalents and short-term investments is subject to changes in interest rates. However, we believe that the impact of these fluctuations does not have a material effect on our financial position due to the immediately available liquidity or short-term nature of these financial instruments.

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We are exposed to interest rate fluctuations as a result of our term loan and line of credit with SVB each having a variable interest rate. However, the loan facility has a minimum fixed interest rate of 6%, which has been the actual interest rate in effect since 2011. We do not currently use derivative instruments to alter the interest rate characteristics of our debt. For the principal amount of $4.1 million outstanding under the term loan as of September 30, 2012, an increase in the interest rate by one percentage point for one year would result in an increase in our annual interest expense of $33,000.

Although we believe that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in our credit quality, composition of our balance sheet and other business developments that could affect our interest rate exposure. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by this estimate.

Foreign Currency Exchange Rate Risk

As of September 30, 2012, all payments made under our research contracts have been denominated in United States dollars. Our product sales to foreign customers are also generally denominated in U.S. dollars, and we generally do not receive payments in foreign currency. As such, we are not directly exposed to currency gains or losses resulting from fluctuations in foreign exchange rates.

Evaluation of Disclosure Controls and Procedures

We maintain “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which are controls and other procedures that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. In addition, the design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Because of the inherent limitations in a control system, misstatements due to error or fraud may occur and not be detected.

Under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report. Based on this evaluation, our principal executive officer and our principal financial officer have concluded that, as of September 30, 2012, our disclosure controls and procedures were effective at the reasonable assurance level.

Changes in Internal Control over Financial Reporting

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the quarter ended September 30, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

None.

You should carefully consider the risks described below before deciding whether to invest in our common stock. The risks described below are not the only ones we face. Additional risks not presently known to us or that we currently believe are immaterial may also impair our business operations and financial results. If any of the following risks actually occurs, our business, financial condition or results of operations could be adversely affected. In such case, the trading price of our common stock could decline and you could lose all or part of your investment. Our filings with the Securities and Exchange Commission also contain forward-looking statements that involve risks or uncertainties. Our actual results could differ materially from those anticipated or contemplated by these forward-looking statements as a result of a number of factors, including the risks we face described below, as well as other variables that could affect our operating results. Past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.

RISKS RELATING TO OUR BUSINESS GENERALLY

We rely and will continue to rely on contracts and grants awarded under the SBIR program for a significant portion of our revenues. A finding by the SBA that we no longer qualify to receive SBIR awards could adversely affect our business.

We compete as a small business for some of our government contracts. As described above, our revenues derived from the SBIR program account for a significant portion of our consolidated total revenues, and contract research, including SBIR contracts, will remain a significant portion of our consolidated total revenues for the foreseeable future.

We may not continue to qualify to participate in the SBIR program or to receive new SBIR awards from federal agencies. In order to qualify for SBIR contracts and grants, we must meet certain size and ownership eligibility criteria. These eligibility criteria are applied as of the time of the award of a contract or grant. A company can be declared ineligible for a contract award as a result of a size challenge filed with the SBA by a competitor or a federal agency.

In order to be eligible for SBIR contracts and grants, under current SBA rules we must be 51% owned and controlled by individuals who are U.S. citizens or permanent resident aliens. In the event our institutional ownership significantly increases, either because of increased buying by institutions or selling by individuals, we could lose eligibility for new SBIR contracts, public contracts, grants and other awards that are set aside for small businesses, including SBIR grants.

Also, in order to be eligible for SBIR contracts and grants, the number of our employees, including those of any entities that are considered to be affiliated with us, cannot exceed 500. As of September 30, 2012, we had approximately 174 full-time employees. In determining whether we are affiliated with any other entity, the SBA will analyze whether another entity controls or has the power to control us. Carilion Clinic is our largest institutional stockholder. We understand that the SBA is in the process of performing a formal size determination that will focus on whether or not Carilion is our affiliate. Although we do not believe that Carilion has the power to control our company, we cannot assure you that the SBA will interpret its regulations in our favor on this question. Under its regulations, the SBA may conclude that a stockholder that is large compared to others has the power to control us and is our affiliate. If the SBA were to make a determination that we are affiliated with Carilion, we would exceed the size limitations, as Carilion has over 500 employees. In that case, we would lose eligibility for new SBIR grants and other SBA contracts, public contracts, grants and other awards that are set aside for small businesses based on the criterion of number of employees, and the relevant government agency would have the discretion to suspend performance on existing SBIR grants.

In addition, it is possible that the sale of common stock in the future by our founder, Dr. Kent Murphy, could negatively affect the interpretation of SBA regulations on this question of affiliation, as well as possibly result in an increase in our institutional ownership. Dr. Murphy has advised us of his intent to exercise his right to require us to register his shares for resale in a registered offering on Form S-3. If Dr. Murphy pursues the registration of his

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