LUNA INNOVATIONS INC - Quarter Report: 2013 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

For the quarterly period ended June 30, 2013

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 July 31, 2013, there were 14,424,663 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 management transition, 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 JUNE 30, 2013

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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 continuing operations from 2005 through the six months ended June 30, 2013 attributable to our operations and other charges. We have historically managed our liquidity through cost reduction initiatives, debt financings and capital market transactions.

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 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 4 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 Stated 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 for annual financial statements. 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 June 30, 2013, results of operations for the three and six months ended June 30, 2013 and 2012, and cash flows for the six months ended June 30, 2013 and 2012. The results of operations for the three and six months ended June 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013.

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, 2012, included in the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission on March 29, 2013. 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 are prepared in accordance with U.S. GAAP and include the accounts of the Company and our wholly owned subsidiaries. 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.

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, accounts receivable 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.

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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.

Per Share Net Income/(Loss) from Continuing Operations and Net Income/(Loss) Available to Common Stockholders

Basic net income/(loss) per share from continuing operations and net income/(loss) per share available to common stockholders are calculated by dividing net loss from continuing operations or net income/(loss) by the weighted average number of common shares outstanding for the applicable period. Diluted net income/(loss) per share from continuing operations and net income/(loss) per share available to common stockholders are computed based on the weighted average number of common shares outstanding 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 per share data would also include the potential common share equivalents relating to convertible securities by application of the if-converted method.

For the three and six months ended June 30, 2013, there were approximately 2.4 million and 2.4 million common share equivalents, respectively, which included conversion of preferred stock, outstanding warrants and incremental shares from assumed exercise of in-the-money stock options that would have been dilutive to net income from continuing operations had we recorded positive net income from continuing operations. For each of these periods, there were approximately 4.9 million out-of-the-money options to purchase shares that would have been anti-dilutive.

For the three months ended June 30, 2013, there were approximately 2.4 million common share equivalents, which included conversion of preferred stock, outstanding warrants and incremental shares from assumed exercise of in-the-money stock options, that would have been dilutive to net income available to common stockholders had we recorded positive net income available to common stockholders. For the six months ended June 30, 2013, there were approximately 2.4 million common share equivalents, which included conversion of preferred stock, outstanding warrants and incremental shares from assumed exercise of in-the-money stock options, that were dilutive to net income available to common stockholders. For each of these periods, there were approximately 4.9 million out-of-the-money options to purchase shares that would have been anti-dilutive.

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. For restricted stock awards and restricted stock units, we recognize expense based upon the price of our underlying stock at the date of the grant. We have elected to use the Black-Scholes option pricing model to value any option or warrant awards granted. 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. 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 six months ended June 30, 2013 and 2012 was estimated as of the grant date using the Black-Scholes option pricing model with the following assumptions:

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A summary of the activity for our 2003 Stock Plan and 2006 Equity Incentive Plan is presented below for the six months ended June 30, 2013:

At June 30, 2013, the outstanding stock options to purchase an aggregate of 5,378,731 shares had a weighted average remaining contractual term of 6.2 years, and the exercisable stock options to purchase an aggregate of 3,718,293 shares had a weighted average remaining contractual term of 5.2 years.

For the three months ended June 30, 2013 and 2012, we recognized $304,568 and $473,784, respectively, and for the six months ended June 30, 2013 and 2012, we recognized $618,084 and $928,368, 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 $2.1 million in share-based compensation expense over the weighted average remaining service period of 1.8 years for stock options outstanding as of June 30, 2013.

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.

Reclassifications

Certain prior year amounts have been reclassified to conform to the current year presentation.

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.

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On March 1, 2013, we completed the sale of our Secure Computing and Communications group (“SCC”), which was part of our Technology Development segment, to an unaffiliated third party for a gross sales price of $6.1 million of cash. Prior to the sale, SCC provided innovative solutions designed to secure critical technologies within the U.S. government. SCC conducted applied research and provided services to the government in this area, with its revenues primarily derived from U.S. government contracts and purchase orders. Of the purchase price, we received approximately $5.4 million at closing and are to receive $110,000 on December 31, 2013. An additional $600,000 was placed in escrow to be released in tranches over 18 months, subject to certain events and dates and to any indemnification claims of the acquirer. In connection with the sale, we incurred approximately $0.8 million in transaction costs that included various charges related to investment banker and legal fees. In addition, the acquirer has entered into a sublease with us for the facilities historically occupied by SCC through December 31, 2013 for a total of $0.3 million. In the transaction, we sold the equipment, contracts and intellectual property associated with SCC. Approximately 20 employees of the SCC group transferred to the acquirer. Included in the transaction were current assets of approximately $0.2 million and long term assets with a net book value of approximately $0.1 million, at February 28, 2013. SCC accounted for 18.5% of our revenues, and 20.7% of our cost of revenues for the year ended December 31, 2012. We recorded an aggregate after-tax gain on the sale of this group of $4.0 million or $0.24 per diluted share in our first quarter 2013 results.

We have reported the results of operations of SCC as discontinued operations in our consolidated financial statements. We allocated a portion of the consolidated tax expense to discontinued operations based on the ratio of the discontinued group’s income or loss before allocations.

Following the sale of SCC, we have continued to act on behalf of the purchaser and bill the government for certain contracts that have not yet been transferred by the government to the purchaser. We record these amounts as revenues, with an offsetting amount as cost of revenues, within (loss)/income from discontinued operations. We expect to continue recording such revenues and costs until all of these contracts are transferred to the purchaser by the government.

The loss from discontinued operations is the result of the allocation of the alternative minimum tax computation on the company’s results as a whole at June 30, 2013.

The key components of (loss)/income from discontinued operations were as follows:

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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

We currently have a Loan and Security Agreement with Silicon Valley Bank (“SVB”) in which we have a term loan with an original borrowing 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 repay amounts due under the Term Loan at any time with no penalties.

In addition to the terms and conditions of the Term Loan, we also have a revolving credit facility (the “Line of Credit” and together with the Term Loan the “Credit Facilities”) with a maximum borrowing capacity of $1.0 million. The interest rate on the Line of Credit is SVB’s prime rate plus 1.25%, payable monthly in arrears, and we are required to pay an unused Line of Credit fee of one-quarter of one percent (0.25%), 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. The Line of Credit has a maturity date of May 17, 2014.

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

On March 21, 2013, we entered into a Fourth Loan Modification Agreement with SVB that replaced the existing financial covenants with a single covenant that we maintain a minimum cash balance of $5.0 million with SVB. The Credit Facilities also require us to observe a number of operational covenants, including protection and registration of intellectual property rights, and certain customary negative covenants. As of June 30, 2013, we were in compliance with all covenants under the Credit Facilities.

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. As of June 30, 2013, there were no events of default on our Credit Facilities.

The balance under the Term Loan at June 30, 2013 was $3.0 million of which $1.4 million was classified as long-term and $1.6 million was classified as short-term. No amounts were outstanding under the Line of Credit and the available credit capacity is $1.0 million at June 30, 2013.

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The following details our equity transactions during the six months ended June 30, 2013:

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. This segment previously included SCC, which we sold on March 1, 2013, and the amounts below do not include the revenues, expenses and assets of SCC.

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

Through June 30, 2013, 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, 2013).

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The table below presents revenues and operating loss for reportable segments not including discontinued operations:

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 48% and 47% of total consolidated revenues for the three months ended June 30, 2013 and 2012, respectively, and 54% and 60% of total consolidated revenues for the six months ended June 30, 2013 and 2012, respectively.

International revenues (customers outside the United States) accounted for approximately 28% and 20% of total consolidated revenues for the three months ended June 30, 2013 and 2012, respectively, and 27% and 17% of total consolidated revenue for the six months ended June 30, 2013 and 2012, respectively.

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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 June 30, 2013, we had fulfilled the purchase requirement for these tunable lasers.

In April of this year we executed a non-cancelable $0.3 million purchase order for multiple shipments of tunable lasers to be delivered over a five month period beginning in 2013. At June 30, 2013, we had $0.2 million outstanding on this purchase order.

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.

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 two 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. A breakdown of our operating loss by segment, as well as our total assets by segment, is provided in footnote 6 to our condensed consolidated financial statements included in this report.

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 and equipment for measuring strain and temperature using optical fiber. Our Products and Licensing segment is also focused on our two 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 increase the sales of our fiber optic technology for strain and temperature sensing applications for the composite materials industry. Our Products and Licensing segment revenues represented approximately 53% and 42% of our total revenues for the quarters ended June 30, 2013 and 2012, respectively, and approximately 48% and 41% for the six months ended June 30, 2013 and 2012, respectively.

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Our Technology Development segment performs applied research for government funded projects and previously included our secure computing and communications group, or SCC. Our Technology Development segment, excluding SCC, represented approximately 47% and 58% of our total revenues for the quarters ended June 30, 2013 and 2012, respectively and approximately 52% and 59% for the six months ended June 30, 2013 and 2012, respectively. Our Technology Development segment predominantly performs applied research in the various areas of sensing applications and technologies, innovative materials and biomedical activities. Most of the government funding for our Technology Development segment is derived from the Small Business Innovation Research, or SBIR, program coordinated by the U.S. Small Business Administration, or SBA.

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 decreased to $2.8 million for the three months ended June 30, 2013 as compared to $3.9 million for the same period in 2012 and they decreased to $5.4 million for the six months ended June 30, 2013 as compared to $7.8 million for the same period in 2012, due primarily to our Optical Systems group completing certain large contracts in 2012 that were not renewed or replaced in 2013.

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 $11.3 million at June 30, 2013, compared to $10.3 million at December 31, 2012, excluding a backlog of $3.3 million related to discontinued operations and $15.2 million at June 30, 2012, excluding a backlog of $2.5 million related to discontinued operations.

Our product and licensing segment includes primarily sales of our sensing systems and products that make use of light-transmitting optical fibers, or fiber optics and revenues earned from the funded development of our fiber optic shape sensing systems for medical applications. 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.

As described below, on March 1, 2013, we sold our SCC business. As a result of the sale, we have reported the results of operations from SCC as discontinued operations in our condensed consolidated financial statements included elsewhere in this report. Net loss from continuing operations was $0.8 million for the three months ended June 30, 2013, compared to $0.4 million for the three months ended June 30, 2012. Net loss from continuing operations was $1.9 million for the six months ended June 30, 2013, compared to $1.1 million for the six months ended June 30, 2012. After giving effect to the results of discontinued operations, including the $3.9 million gain, net of taxes, we recognized on the sale of SCC, we recorded net income attributable to common stockholders of approximately $1.8 million for the six months ended June 30, 2013, compared to a net loss attributable to common stockholders of approximately $0.6 million for the six months ended June 30, 2012, and a net loss attributable to common stockholders of approximately $1.0 million for the three months ended June 30, 2013, compared to a net loss attributable to common stockholders of approximately $0.3 million for the three months ended June 30, 2012.

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We expect to continue to 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, 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 2013 and beyond remains uncertain.

Sale of Secured Computing and Communications Group

On March 1, 2013, we entered into an Asset Purchase Agreement with MacAulay-Brown, Inc. (“Mac-B”) under which we sold SCC to Mac-B for $6.1 million in cash. Of the purchase price, $0.1 million will be payable on December 31, 2013 and an additional $0.6 million was placed in escrow to be released in tranches over 18 months, subject to certain events and dates and to any indemnification claims of Mac-B. Mac-B acquired all of the assets of SCC, including SCC’s intellectual property, in the transaction. We estimate that the net proceeds received upon the closing of the transaction, after the payment of our transaction expenses and assuming our receipt of the $0.7 million of aggregate purchase price payable in the future as described above, will be approximately $5.2 million. In connection with the transaction, Mac-B also entered into a sublease with us that will permit Mac-B to continue operating the SCC business in our Roanoke, Virginia headquarters through December 31, 2013. During 2013, we expect to collect approximately $0.3 million in sublease payments from Mac-B.

In light of the significance of SCC to our business, we expect the sale of SCC will have a significant impact on our financial results. SCC accounted for 18.5% of our revenues, and 20.7% of our cost of revenues for the year ended December 31, 2012. Additionally, we expect the sale of SCC to result in a reduction in annual operating expenses of approximately $0.8 million, including the effects of the sublease described above.

Description of Our Revenues, Costs and Expenses

Revenues

We generate revenues from technology development, product sales and 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 47% and 58% of our total revenues for the quarters ended June 30, 2013 and 2012, respectively, and approximately 52% and 59% for the six months ended June 30, 2013 and 2012, respectively.

Our Product and License 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 53% and 42% of our total revenues for the quarters ended June 30, 2013 and 2012, respectively, and approximately 48% and 41% for the six months ended June 30, 2013 and 2012, 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 and overhead allocated to each of these activities.

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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 Expense

Interest expense is composed of interest paid under our bank loans as well as interest accrued on our capital lease obligations.

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, 2012, as filed with the Securities and Exchange Commission on March 29, 2013. There have been no material changes to the descriptions therein.

Results of Operations

Three Months Ended June 30, 2013 Compared to Three Months Ended June 30, 2012

Revenues

Revenues from our Technology Development segment decreased by $1.1 million from $3.9 million in the quarter ended June 30, 2012 to $ 2.8 million for the same period in 2013. This was due primarily to a decrease in our research revenues from our Optical Systems group caused by a reduced amount of contract work.

Our Products and Licensing segment revenues increased due in part to a $0.1 million increase in sales of our fiber optic test and measurement equipment in the second quarter of 2013 as compared to the second quarter of 2012, resulting primarily from increased orders of our ODiSI products. We also experienced a $0.2 million increase in product development work in the second quarter of 2013 as compared to the second quarter of 2012.

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Cost of Revenues and Gross Profit

The cost of our Technology Development segment revenues decreased primarily due to a reduction of $0.2 million in direct labor due to staff reductions in our Optical Systems group earlier this year, a reduction of $0.2 million in direct subcontractor cost and a reduction of $0.1 million in other direct costs.

The slight increase in cost of revenues in our Products and Licensing segment was primarily the result of the $0.1 million increase in revenue from product sales described above, which resulted in a corresponding increase in cost of revenue. While our revenue from product development work increased, the costs associated with this work decreased slightly, thereby positively affecting our gross margins, as described below.

Because of the overall decrease in revenues of 11% compared to the quarter ended June 30, 2012, which was partially offset by a decrease in costs of revenue of 11%, our resulting gross profit was $2.4 million for the quarter ended June 30, 2013, compared to $2.7 million for the corresponding quarter in 2012.

Operating Expense

Our selling, general and administrative costs increased 5% during the second quarter of 2013, as compared to the same period in 2012. The increase was primarily due to an increase in bad debt expense of approximately $125,000 and consulting fees of approximately $107,000, partially offset by a decrease in share-based compensation expense of approximately $170,000.

Research, development, and engineering expense increased by 10% during the second quarter of 2013 as compared to the same period in 2012, primarily due to increased engineering expenses in our Products and Licensing segment due to internal product development.

Other Income

During the three months ended June 30, 2013, we recognized other income of approximately $15,000, which consisted primarily of the amortization of the discount on the Hansen debt, which was fully amortized during the second quarter of 2013.

During the three months ended June 30, 2012, we recognized $23,000 of other income as a result of the amortization of the discount on the Hansen debt.

Interest Expense

Interest expense for the three months ended June 30, 2013 was approximately $50,000 compared to interest expense of approximately $74,000 during the same period in 2012. The monthly average loan balance during the second quarter of 2013 was $3.0 million compared to $4.5 million for the same period in 2012. The lower average loan balance accounted for the decrease in interest expense.

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Loss from Continuing Operations

As a result of the foregoing, during the three months ended June 30, 2013, we incurred a net loss from continuing operations of approximately $0.8 million, compared to a net loss of approximately $0.4 million for the three months ended June 30, 2012.

Loss/Income from Discontinued Operations

For the three months ended June 30, 2013, we recognized a net loss from discontinued operations of $0.2 million, due to the allocation of the alternative minimum income tax calculation. For the three months ended June 30, 2012, we recognized net income from discontinued operations of $0.2 million.

Six Months Ended June 30, 2013 Compared to Six Months Ended June 30, 2012

Revenues

Revenues from our Technology Development segment decreased by $2.4 million from $7.8 million in the six months ended June 30, 2012 to $5.4 million for the same period in 2013. This decrease was due primarily to a decline in revenues from our optical systems group of $1.9 million due to the completion of certain large contracts during the second half of 2012, which contracts were not renewed or replaced in 2013.

Our Products and Licensing segment revenues decreased primarily due to a $0.8 million decrease in sales of our fiber optic test and measurement equipment in the first half of 2013 as compared to the first half of 2012. This decrease resulted primarily from fewer orders of our OBR and OVA products in 2013 as compared to 2012, which was partially offset by an increase of $0.3 million in revenues from ODiSI sales during the first half of 2013, as compared to the same period in 2012. Revenue for product development was virtually unchanged for the first half of 2013 as compared to the same period in 2012.

Cost of Revenues and Gross Profit