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Executives

ReiJane Huai - Chief Executive Officer

Bernie Wu - Vice President of Business Development

James Weber - Chief Financial Officer

Analysts

Mark Kelleher - Brigantine Advisors

Brian Freed - Morgan Keegan

FalconStor Software Inc. (FALC) F1Q09 Earnings Call Transcript April 28, 2009 4:30 PM ET

Operator

Good afternoon and thank you for joining us to discuss FalconStor Software’s Q1 2009 earnings. ReiJane Huai, FalconStor's Chief Executive Officer, Bernie Wu, FalconStor's Vice President of Business Development, and Jim Weber, FalconStor's Chief Financial Officer will discuss the Company's results and activities and we will then open the call to your questions. The Company would like to advise all participants that today's discussion may contain what some consider forward-looking statements.

These forward-looking statements involve risk and uncertainties that could cause actual results to differ materially from the forward-looking statements. These risks and uncertainties include delays in product development; market acceptance of FalconStor's products and services; technological change in the data protection and storage in networking industries; competition in the data protection and storage software market; the potential failure of FalconStor's OEM partners to introduce or to market products incorporating FalconStor’s products, intellectual property issues, changes in general economic conditions and other risk factors discussed in FalconStor’s reports on Forms 10-K, 10-Q and other reports filed with the Securities and Exchange Commission.

During today's call, there will be discussions that include non-GAAP results. A reconciliation of non-GAAP results to GAAP has been posted on FalconStor’s website at www.falconstor.com under investor relations.

After the close of business today, FalconStor released its Q1 2009 earnings. Copies of the earnings release and supplemental financial information are also available on FalconStor's website at www.falconstor.com.

I am now pleased to turn the conference over to Mr. ReiJane Huai, Chairman and CEO of FalconStor Software, Incorporated. Please go ahead.

ReiJane Huai

Thank you. Good afternoon, everyone. Thank you for joining us for FalconStor's fiscal 2009 Q1 earnings conference call. I am ReiJane Huai, Chairman and CEO of FalconStor Software. I am joined by Bernie Wu, Vice President of Business Development, and Jim Weber, Vice President and CFO. I will provide an overview of our Company's performance in all areas and recap on ongoing direction for 2009. Bernie will report on the stead of our strategic partnership and Jim will comment in detail on our Q1 financial results.

We continue to see many reasons to be comfortable about our ability to successfully sell our integrated suite of TOTALLY Open Data Protection Solutions throughout 2009 despite the ongoing economic downturn. Regarding our financial performance, I would like to highlight two key points. First, revenues for the first quarter were $21 million compared with $21.8 million for the first quarter last year. Second, revenues for our non-OEM business grew as a percentage of total revenue represented 64% of our total revenue compared with 58% in the same quarter a year ago.

Our plan is always to aim to establish credibility and lay a strong business foundation through our successful relationship with our OEM partners. The combination of OEM validation of our technology and the bullish market awareness while FalconStor continues to facilitate the recruitment of channel partners which have now driving our business to the next level.

Over the past two years, we have stated our plan to expand our channel organization by nurturing relationships with national resellers, system integrators and government reseller on the worldwide basis. While our OEM partners remain a valuable part of our business, we are seeing our long term growth will come from the worldwide expansion of our own channel.

We are pleased with the progress in the activities in the channel. We will continue to invest in sales, marketing and services to create awareness and demand for our solutions to be fulfilled by our channel partners on a worldwide basis. FalconStor’s vision to offer totally open seamlessly integrated data protection solution to lower capital and operational expenditures resonate well with our channel partners and customers. We are delivering through our motivated network of channel partners, exactly what customers needed during today's fiscal crisis and beyond.

As the case in point, our North America sales team close a million dollar deal with a major system integrator in Q1 defeating all the major storage hallway vendors entirely due to our software's unique integrated capabilities to maximize utilization by a factor of 10 through space additions, [net peak], snapshots and offer efficiency a factor of 5 by leveraging our on win optimize always on replication.

Many case studies of this nature will be published by the marketing department to help encourage prospective customers to asses and deploy our solutions to maximize their operating efficiency. Today, we are focusing on three critical areas; storage and server of virtualization, data deduplication and most importantly, the redesign our back up and disaster recovery. These are key initiatives for every enterprise society in order to meet today's demands for 24/7 availability, immediate data recovery always is a failure and datacenters capability with guaranteed service level agreement.

All three areas are complementary. All three areas are addressed by FalconStor's common platform by piece which both operational platform for all our services products. In Q1, FalconStor's Network Storage Server or NSS heterogenous storage utilization solution received honor being then the number two product of year, second only to VMWare by Storage Magazine. FalconStor and VMWare are coordinated on many few level activities to promote our complementary virtualization and replication solution to join customers.

Regarding the duplication, we started to ship our new file-interface deduplication systems which were announced in Q4. FDS extends our capacity deduplication capability beyond our industry leading VirtualTape Library interface into the local area network allowing IT manager to deduplicate data at the block level for any foul system underlying. Our sales team and channel partners are poised to leverage FalconStor's close front of synergy to promote a scalable solution packaged at the virtual applies for the new office or a turnkey departmental storage supply or a multi-node [8.50] cluster attended by datacenter or the DR side.

We believe that FalconStor is well positioned for long-term success with extremely competitive value driven product portfolio endorsed by strategically end partners and validated by elite Fortune 100 accounts. FalconStor solution will continue to expand in key effectiveness of the storage market but leverage our unique product synergy and offering tenfold business value that the say enriched customers revenue in the bottom line.

Now, I would like to ask Bernie Wu, our Vice President of Business Development to review our strategic partnership and the industry alignment.

Bernie Wu

Thank you, Rei. Now, I would like to review where we are in terms of the strategic partnerships, business direction and provide an update on our ongoing process of building global alliances.

In the VTL area, EMC revenues were down significantly compared to Q1 2008 and on their conference call, they reported sluggish end-user spending and challenging macroeconomic conditions. They and we believe that business will improve in the second half of this year. Sun's revenues increased by about 25% over Q1 last year and we believe that the merger with Oracle, once completed, will have a positive effect for us. We have built strong relationship with both companies, seeing no overlap of products with the respect to our offerings and support both Oracle analytics and cellar of operating systems as well as integrate with the Oracle database.

Overall, we believe the underlying demand for VTL remain strong once macroeconomic conditions improve. Regarding FalconStor CDP and NSS, we continue to work on ramping up our median to channel programs with HP, Sun and select tier-two partners such as Pillar Data Systems. Activities include joint webinars and seminars with those partners. Our relationship with VMWare continues to grow into an ever stronger partnership on every level, from product development to solution integration in the channel as we complement and complete each other's virtualization and data protections solutions.

We recently announced our support for VMWare's cloud computing initiative vSphere and we will be taking off a nine city tour with VMWare user groups this quarter here in America. As Rei mentioned, we are increasing our investments in building out our own channels and brand equity. One new class of channel partner we are focused on are the Global System Integrators. In Q1, we continue to make progress with building alliances with those players. We closed our first seven-figure deal with the Global System Integrators who leveraged our technology in its own SAP development and test areas to reduce storage cost and improve their multi-site operations.

We will be working with those, we are working to bring those benefits to that Global System Integrators clients as well and we are also making good progress building relationships with several other major system integrators who will be working with us to promote the adoption of our entire product offering. We put additional focus on the growing public sector and established a full time federal time. We also exhibited for the first time at the Federal Office Systems Exposition in March and as a result of that, identified several major opportunities.

We are now engaged with several system integrators focused on the public sector including CSC, CACI, Booz Allen, Northrop Grumman on both civilian and Department of Defense opportunities and we have found that FalconStor's vision for storage infrastructure in the datacenter is well aligned with the Federal IT initiatives.

In summary, we are making good progress in executing our strategy in building brand equity and positioning ourselves to leverage the growing public sector IT initiatives by partnering with these major system integrators. I would now like to introduce Jim Weber, our CFO, who will review the Company's financials.

Jim Weber

Thank you, Bernie. Now I would like to take a few moments to review the details of our financial results in the first quarter. Based upon the current macroeconomic environment, we are pleased with our Q1 results. The first quarter of 2009, revenues were $21 million compared with $21.8 million for the same period a year ago and decline 10% from Q4 2008. Due to the seasonality in our business, we typically experience a decline in Q1 compared with Q4 of the previous year. This decline has averaged about 18% over the past several years therefore a decline of 10% in the current year is better than normal.

The revenue from our non-OEM business grew as the percentage of total revenue representing 64% of our total revenue compared with 58% in the same period a year ago. EMC accounted for 30% of our total revenue and Sun was 11% of our total revenue. In Q1, our non-GAAP income from operations was $1.3 million or an operating margin of 6% compared with $4.1 million or a 19% operating margin in Q1 2008. Our non-GAAP net income for the quarter was $600,000 or $0.01 per share compared with $2.9 million or $0.06 per share in Q1 2008.

Our non-GAAP results excludes stock-based compensation expense of $2.2 million in Q1 2009 and $2.3 million in Q1 2008 and are also net of the related income tax effects for stock-based compensation. On a GAAP basis, our operating loss was $800,000 compared to operating income of $1.8 million in Q1 2008 and GAAP net loss was $900,000 or $0.02 per share compared with net income of $1.3 million or $0.03 per share in the same period a year ago.

Even though our revenue declined compared to Q1 as a result of macroeconomic environment, we continue to hire and invest for the long term growth of the Company. As a result of our continued investments whereby we increase our headcount from 439 at the end of Q1 2008 to 521 at the end of Q1 2009, our margins and profits were lower than the same period in the prior year. As you heard from Rei, even during these tough economic times, we continue to invest in our future. Although these investments will cause our operating profits and margins to be lower than we would like, we believe that we should continue to invest to make sure we are properly positioned for long-term growth.

Even with these investments, we continue to be profitable on a non-GAAP basis and we enjoy strong cash flows from operations. There are many companies who are cutting back expenses and laying off employees. Although we could do this to improve our EPS in the short term, we do not believe this would be beneficial in the long term. We will continue to monitor the macroeconomic environment and we will make decisions for the long-term outlook.

As of the end of Q1, our cash, cash equivalents and marketable securities balance was $41.8 million and our cash flow from operations was $3.3 million. Though in Q1, we spent $1.5 million in repurchasing a total of 600,000 shares and average price of $2.69, we now have 6.6 million shares available for repurchase. We will continue to be active with our stock repurchase program in Q2. Our deferred revenue balance at the end of Q1 was $21.9 million which is an increase of 10% compared with Q1 of 2008. Within the context of the current worldwide economic environment, we are pleased with our Q1 results.

On the income statement side, we have non-GAAP operating profit of 6% while investing in a long term future of the Company. Our balance sheet also remains very strong with $41.8 million in cash and cash equivalents even after spending $1.5 million in repurchasing shares. Our cash flow from operations remains strong at $3.3 million and our deferred revenue balance grew to $21.9 million.

Based in our Q1 results, we believe we are on track to achieve our previous full year guidance of revenues in the range of $96 million to $100 million and non-GAAP EPS in the range of $0.18 to $0.21 per share excluding the effect of stock-based compensation net of taxes. Now, at this point, we would be happy to take your questions. Operator, please?

Question-and-Answer Session

Operator

(Operator's instruction) Your first question comes from the line of Mark Kelleher - Brigantine Advisors.

Mark Kelleher - Brigantine Advisors

Could you talk a little bit about what you anticipate from the Sun merger with Oracle? Could there be, I know longer term it sounds pretty good but could there be some short term dislocation there of revenue?

Bernie Wu

I think my opinion sort of the uncertainty has been removed so that should help us. On the other hand, prior to the Oracle announcement, there was some downsizing of the Sun organization and a shift toward channels so I think there may some short term adjustments but they were not really related to the specific Oracle acquisition.

Mark Kelleher - Brigantine Advisors

Okay, and maybe since we are on the OEM, you talked about your relationship with EMC. That seems like a pretty low contribution for the quarter even with every quarter.

Bernie Wu

Yes, there was a low contribution this quarter but the fundamentals I think are very strong with EMC. As I mentioned, we do not, we and EMC do not see a fundamental shift in the VTL market or anything like that. We just attribute this to external macroeconomic conditions. A lot of the business was involved in large multiple, large multi-unit purchases with large financial institutions, etc.

Operator

Your next question comes from the line of Brian Freed - Morgan Keegan.

Brian Freed - Morgan Keegan

Rising strength out of Sun in light of all thing but can you talk a little bit about your mix between your various product segments? I have seen some pretty good commentary around CDP from the channels. Can you give us a little bit of flavor in terms of the mix between CDP, VTL and NSS?

Jim Weber

We usually do not give specific details but just on general terms, VTL and deduplication combined are still about 50% of our business as the percentage of revenue maybe down compared to last year and that is really just we are seeing a lot of interest in growth on the CDP side and the NSS side and if you look at CDP and NSS, both of those are pretty fairly even between the other 50%. So, we are definitely seeing a lot of demand on the CDP and NSS side.

Brian Freed - Morgan Keegan

Okay and secondly, outside of our two big OEMs, EMC and Sun, can you give a little bit of qualitative color in terms of the trajectory and trends you are seeing out of your smaller OEM?

Bernie Wu

I think those, the smaller OEMs, the last quarter also had a little bit of difficulty with the macroeconomic conditions. So, I mean we have in that category people like Pillar, we have COPAN, we have Spectra Logic and basically a similar softness there.

Brian Freed - Morgan Keegan

Okay and then the final, can you give us a real quick remind us what the headcount was in Q4 and also can you talk about what your plan trajectory is in terms of headcount adds for the remainder of the year?

Jim Weber

Yes, at the end of Q4, it is 505. So, we ended up Q1 of 521. I think you will see us continuing to add to that headcount. We will review this on a quarterly basis, looking at our pipeline, looking at the macroeconomic condition but we think there is lot of opportunities out there especially working with the channel. I think Bernie touched upon a lot of them in the federal space with system integrators so I think there will be a need for us and I think it will be advantageous for us to continue to add headcount on the sales and marketing side so I think you will continue to see us do that. I am not going give out any specific numbers. We are just going to continue to evaluate that on a quarterly basis.

Brian Freed - Morgan Keegan

Okay and then one final question is if Sun goes into their fiscal yearend and you kind of look at their forecast, do you expect normal seasonality out of Sun or potentially below normal seasonality given the pending acquisition?

Bernie Wu

Like I mentioned earlier, I think it is hard to say I mean the uncertainty, the good news again is short term between now and the end of their fiscal year is the uncertainty of what is going to happen is removed but again, before that occurred, there was a significant downsizing of their field organization. There is a shift in their business trying to move everything toward the channel which is actually good for us because we are investing in the channel but it is hard to say how that transition is going to work itself through.

Operator

(Operator's instruction) Management, there are no further questions at this time. Please continue with any closing comments you might have.

Jim Weber

Okay, I would like to thank everybody for their interest in FalconStor. We are very excited about the opportunities that we have even in this macroeconomic environment so I think you will see us continue to spend wisely, invest with the long term outlook and we look forward to reporting our results in the next quarterly conference call. Thank you very much.

Operator

Thank you and ladies and gentlemen, that concludes the FalconStor Software Q1 2009 earnings conference call. If you would like to listen to a replay of today’s conference, you can do so by dialing 1-800-405-2236 or 303-590-3000 and put the access code 11130511. ACT would like to thank you very much for your participation. You may now disconnect. Have a very pleasant rest of your day.

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