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Executives

James P. McNiel - Chief Executive Officer, President and Director

Louis J. Petrucelly - Chief Financial Officer, Principal Accounting Officer, Vice President and Treasurer

Falconstor Software (FALC) Q1 2013 Earnings Call April 25, 2013 4:30 PM ET

Operator

Good afternoon, and thank you for joining us to discuss FalconStor Software's Q1 2013 Earnings. Jim McNiel, FalconStor's Chief Executive Officer; and Louis Petrucelly, Executive Vice President and Chief Financial Officer, will discuss the company's results and activities.

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 risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. These risks and uncertainties are discussed in FalconStor's reports on Forms 10-K, 10-Q and other reports filed with the Securities and Exchange Commission, and in the company's press release issued today.

During today's call, there will be discussions that include non-GAAP results. A reconciliation of the 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 2013 earnings. Copies of the earnings release and supplemental financial information are available on FalconStor's website, at www.falconstor.com.

I'm now pleased to turn the call over the Jim McNeil.

James P. McNiel

Thank you, operator, and welcome, everybody. First of all, I'd like to start off by mentioning that our process with Wells Fargo continues, and at the point that we have something material to report, we will certainly do so in a prompt manner. Second, I like to say that while we are disappointed in our Q1 earnings, there are many things that we're doing to mitigate the impact of these earnings on our future outlook for 2013, so I'd like to discuss that at this point now.

Primarily, we suffered a significant setback in our Asia-Pacific region, a region that has historically had very strong continuous double-digit growth for us. It was under some pressure from tensions on the Korean Peninsula and governmental changes in Korea, Taiwan and China. We believe most of these events to be somewhat of an anomaly and expect those regions to return to their former performance in the quarters to come.

In the European region, we continued to have sluggish performance, specifically in the southern parts of Europe. We intend to focus increased attention on those areas that showed stronger promise such as our northern and central areas.

I'm happy to report that customers are demonstrating their loyalty to our products through a continued strong renewal of maintenance agreements and that in the first quarter, we've reported [indiscernible] 50 new logos. These new acquisitions -- these new customers are to some degree the result of a new demand-generation program that we put together to concentrate on targeting key customers that are budgeted and ready to move forward with FalconStor life solutions. This program, implemented by Gary Quinn's team, is providing us a stronger pipeline with higher-quality opportunities and better conversion rates, and we'll be taking this program globally. As you know, Gary has been promoted to the position of Chief Operating Officer responsible for all customer-facing activity, including sales and marketing on a global basis.

On the technology front, we're all aware that our industry is going into a substantial transformation and considering its opportunities in storage and computer virtualization as well as cloud computing. And this provides both near-term and long-term opportunities for FalconStor. On the near-term front, we are positioned to assist companies and enterprises to move their corporate data and applications into public and private clouds through our NSS technology and our migration services. We have developed relationships with Fujitsu and Dell to perform this function, and we intend to expand our migration ecosystem with other partners and expanded partnerships.

This program is ongoing, and I believe it will have a positive impact on the balance of our year and our year's revenue.

We also, on a long-term basis, are uniquely positioned to help companies develop both private and public cloud solutions both for storage virtualization infrastructure as well as for business continuity and disaster recovery. We continue to work on developing enhancements to our existing product line as well to move down the path of delivering new products in the year to come.

We also have to undergo a transformation within our own engineering department, which has been going on for quite some time. Primarily we need to become more adept at adjunct development, behavioral-driven development, web related or web services oriented technology as well as Software-as-a-Service technology to support managed service providers that have multi-tendency implementations. To that end, we've appointed Rob Zecha as our Chief Product Officer, where he will be responsible for all aspects of product development including product management, QA, software development and engineering, and research and development. Rob will be driving this process forward, and I'm confident that he will help us to achieve our goals of delivering product in a timely manner and maintaining an innovative approach to the marketplace.

In summary, I think that both Rob and Gary will help us to focus on improving efficiencies, on adopting best practices and propagating those processes around the company globally.

Now, I'm going to hand this over to Louis so he can provide you the details behind my statements. And then we'll wrap up at the end. Lou?

Louis J. Petrucelly

Thank you, Jim and, good afternoon, everyone. I would like to take through a summary of our quarter. I will discuss our results in the quarter, provide color around some of the challenges we've experienced and finally discuss some of the steps we are taking to address the current environment which we have been operating in.

For the first quarter of 2013, our total revenues decreased 21% to $15.3 million, compared with $19.4 million in the same period a year ago. Our overall revenues fell well below our internal expectations. While total revenues from all of our regions declined on a year-over-year basis, declines in product revenues, primarily in EMEA and Asia-Pacific regions, as well as the decrease in maintenance revenues from our legacy OEMs, where the primary drivers of the soft revenue performance in Q1. We continue to see uncertainty and overall softness in the global marketplace, resulting in deeply discounted competitive pricing in both higher-value deals and sub-six-figure deals.

Additionally, as decision-makers in IT departments are now contemplating their traditional storage needs versus cloud-based alternatives, we are starting to experience headwinds in the form of elongated sales cycles and pressure upon deal sizes.

Product revenue from our OEMs decreased 81% or $600,000 compared with Q1 of 2012. This was due to a decrease in revenue from one of our largest OEM partners in China. This OEM underwent an internal reorganization in 2012, which disrupted their business operations, resulting in unpredictable performance. As we entered 2013, we continued to experience the unpredictable performance from this OEM, making it difficult to predict revenue on a quarter-over-quarter basis.

Product revenue from our non-OEMs declined by 23% or $2.3 million compared with Q1 of 2012. All of our regions continued to be impacted by the uncertainties in the global markets, soft economy, competitive environments around securing market share and the transformational change in the industry.

In our European markets, non-OEM product revenue was down approximately 25%, representing the largest decline of all of our regions year-over-year. The EMEA region continues to be one of our more adversely impacted regions, particularly in our southern European market, due to the overall uncertainty in the European marketplace and its financial markets. In Asia-Pacific, our non-OEM product revenue was down 19% year-over-year. In addition to the factors we've previously discussed, the fact that there was a slowdown in spending based upon the uncertainties surrounding the pending elections or governmental changes within China, Korea, Taiwan and for parts of Southeast Asia.

In North America, non-OEM product revenue was down approximately 16% year-over-year, largely due to the impact of the current economic competitive environments.

Our support and service revenue which is comprised of maintenance and professional services decreased by 14% compared with the same period a year ago. The maintenance portion of this revenue declined 8% from $7.6 million in Q1 of 2012 to $7 million in Q1 of 2013. I will address the topic in greater detail later in my presentation.

Professional services decreased 52% from $1.1 million in Q1 of 2012 to $500,000 in Q1 of 2013. Professional services tend to fluctuate based on a number of end users who use FalconStor to help deploy the solutions and the completion of those deployments.

Next, I will turn to our Q1 non-GAAP results, which exclude legal costs and stock-based compensation. Our product gross margin increased to 83% in Q1 from 81% in the same period in 2012. The increase in product gross margin was primarily attributable to a decrease in the number of fully integrated offerings, which include hardware appliances, as a percentage of all product sales compared with the same period a year ago. As we have stated in the past, the mix of our product revenues, for example, the number of software-only solutions versus fully integrated appliances sold during a period, and the level of product revenues can materially impact our gross margins.

Our support and services gross margin decreased to 61% in Q1 from 64% in Q1 of 2012. The decrease in gross margin was primarily attributable to the decline in our overall support and services revenues compared with the prior year. Overall, total gross margins decreased to 72% in Q1 from 74% in Q1 of 2012.

Our operating expenses decreased 14% in Q1 to $13.9 million from $16.2 million in 2012. The net decrease in our operating expenses was primarily due to the 29% decline in our sales and marketing costs during the first quarter compared to the same period a year ago. These decreases were driven by declines in personnel-related costs and lower commissions as a result of the decline of our revenues.

During the first quarter, we incurred approximately $100,000 of costs associated with the settlement of the Class Action and legal fees associated with both the Class Action and Derivative Action that may not be recoverable through insurance. During the same period in 2012, we reported a net reduction of $1.3 million, which was comprised of $1.7 million reduction in the accruals for certain costs associated with the then outstanding government investigations and in expenses of $400,000 in various legal fees.

In Q1, our non-GAAP operating loss was $2.9 million compared to a loss of $1.9 million for the same period a year ago. Our non-GAAP operating results exclude stock-based compensation expenses of $900,000 for Q1 2013 and $1.4 million for Q1 of 2012, and an expense of $100,000 and a net reduction of $1.3 million of legal cost in each of Q1 2013 and 2012, respectively. Our non-GAAP net loss for Q1 was $3.4 million or $0.07 per share compared with a net loss of $2.3 million or $0.05 per share in the same period a year ago.

On a GAAP basis, our operating loss in Q1 was $3.9 million compared to an operating loss of $2.1 million in Q1 of 2012. In Q1, we had a net loss of $4.4 million or $0.09 per share compared to a net loss of $2.4 million or $0.05 per share in Q1 of '12.

Our mix of revenues continues to remain relatively consistent across all regions of our business. However, we continue to see slippage in the contribution from all of our regions as a result of the factors we have previously discussed.

We have typically experienced a growth in our maintenance revenue year-over-year. However, our first quarter total maintenance revenue was adversely impacted by varying factors within our OEM and non-OEM businesses. First, on the OEM business front, we continue to see our legacy OEM business decline first, from a product revenue perspective, commencing in 2009, and more recently, with the wind-down of related maintenance revenue. We anticipate that this trend will continue through 2013, and we look to continue to replace the loss of our legacy OEM maintenance revenues with revenue from our channel and strategic partners.

While we have historically replaced our legacy OEM maintenance revenues with revenue from our channel and strategic partners, in Q1 we saw a slight decline in our year-over-year non-OEM maintenance performance. There were several factors that contributed to this decline: first, the impact of the increase of our deals that required a higher level of pricing discounts in the competitive environment over the past 12 months; second, the overall decline in product revenues commencing in the second quarter of 2012 as a result of the current macro economic environment; and finally, the impact of lower maintenance rates on new bookings commencing over the past several years as compared to prior historical rates.

Overall, we anticipate that we will continue to experience these challenges surrounding maintenance revenue in 2013. However, we are focusing our efforts on minimizing this impact by expanding our market penetration within our [indiscernible] base and with new customer in verticals, where we have had more recent success.

Turning to our balance sheet. As of March 31, we had $28.2 million in cash, cash equivalents and marketable securities, which was equivalent to $0.59 per basic share. Our cash flows from operations were a negative $1.8 million for Q1. Our deferred revenue was $23.7 million compared with $24.1 million at the end of 2012. The slight decline was largely due to the wind-down of maintenance revenue from our certain legacy OEM customers and to deeper discount per volume while securing deals in the competitive environment over the past year. Additionally, we continued to see more customers opting to purchase 1-year maintenance agreements at the original point of sale versus multiyear maintenance agreements in response to the tightening of budgets and cash flows in the current economic environment.

To summarize, Q1 was a challenging quarter for the company, which we do not believe is indicative of performance of our business going forward. However, it does reflect the uncertainty and difficulties many are facing in this current economic environment, as well as the uncertainty within the industry surrounding traditional storage solutions business versus cloud-based alternatives.

There have been varying challenges that the company has faced over the past 24 to 36 months, ranging from operationally-based problems to legal issues and, more common among all companies, the global economic issues.

As we previously announced, the impact of our legal issue has cost the company significant time, effort and resources, which adversely impacted both our financial position and more importantly, the company's perception in the marketplace. The recent resolutions of our outstanding legal issues should allow us to move on from the events of the past and focus all of our efforts on the delivery of new and innovative technology to market. We anticipate, as we move further away from these events, this should reduce the potential of our competitors to raise concerns about the company's business conduct and long-term viability and allow us to compete with our competitors based on the quality and value of our products.

As we continue to see the materiality of our legacy OEM business decline, we continue to focus on the channel and strategic partner-led business to replace these revenues resources, and we anticipate that we will continue to successfully drive our revenues through the channel and strategic partner community in the future.

Finally, we recently announced the appointment of 2 key management positions, Gary Quinn as Chief Operating Officer; and Rob Zecha as Chief Product Officer. Gary will oversee and support growing operations, with a concentration on all customer-facing functions, including global sales and marketing, education, product support and professional services. Over the past year, Gary has demonstrated and executed on this skill set in North America, and we now look forward to having Gary replicate his success [indiscernible] directed to data protection and business continuity issues faced by today's enterprises and lead and execute the company's product strategy to ensure the continued evolution of our suite of data protection products.

We believe we are in a position to execute on our plan of delivering new and disruptive technology in 2013 with the intention of returning the company to profitability. We believe our solutions provide value to both the traditional storage infrastructures in place today and the evolving cloud storage solutions of the future, which current customers, partners and prospects are all contemplating and that our future solutions will enable the cloud, both private and public.

And now, I'll turn the call back over to Jim for closing remarks. Jim?

James P. McNiel

Thank you, Lou. To summarize, as Lou said, we have a committed, qualified and experienced senior executive team. We have a committed workforce, and we're getting down to brass tacks. We're focused on the elements that will drive our business forward. In the sales and marketing area, we're focused on improving our pipeline, getting better quality opportunities and focusing on the engagements that we know we can consistently win given the current market we're dealing with.

On the engineering side, we understand that we have a roadmap, which is appropriate for the market that we're addressing, and we're getting down to business at delivering that roadmap in a manner that is timely for us to move our company forward.

So with that, we hope you can stay with us, and we'll work hard to earn your trust. Thank you very much. Operator, back to you.

Operator

Ladies and gentlemen, this concludes FalconStor Software's Q1 2013 Earnings Conference Call. If you'd like to listen to a replay of today's conference, please dial 1 (800) 406-7325 or (303) 590-3030 with the access code of 4614280. We'd like to thank you for your participation. You may now disconnect.

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