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Crossroads Systems (NASDAQ:CRDS)

Q3 2013 Earnings Call

September 12, 2013 4:30 pm ET

Executives

Richard Kenneth Coleman - Chief Executive Officer, President, Director and Member of Executive Committee

Jennifer Ray Crane - Chief Financial Officer

Operator

Good afternoon, and thank you for participating in today's conference call to discuss Crossroads Systems financial results for the fiscal third quarter ended July 31, 2013. With us today are Mr. Rick Coleman, the company's Interim President and Chief Executive Officer; and Ms. Jennifer Crane, the company's Chief Financial Officer. Following their remarks, we will open up the call for questions.

Before we begin today's call, I will provide the necessary cautions regarding forward-looking statements made during this call. During this call, the company's management will make certain forward-looking statements related to the businesses of Crossroads Systems Inc., which can be identified by the use of forward-looking terminologies such as believes, expects, plans, intends, anticipates and variations of such words or similar expressions, but their absence does not mean that the statement is not forward-looking. Statements in this announcement that are forward-looking include, but are not limited to, statements made by Mr. Coleman or Ms. Crane about our expectations regarding future growth, operating and financial results and market demand for our products, as well as statements about our business plans and objectives. Such forward-looking statements involve known and unknown risks and uncertainties including uncertainties relating to product development and commercialization, the ability to obtain or maintain patent of other proprietary intellectual property protection, market acceptance, future capital requirements, regulatory actions or delays, historical results or from the results as anticipated by forward-looking statements. You should review our most recent Form 10-K filed with the Securities and Exchange Commission and our Form 10-Q that will be filed with the Securities, not obligating itself to publicly update or alter its forward-looking statements, whether as a result of new information, future events or otherwise.

I would like to remind everyone that a webcast replay of this call will be available via the link provided in today's press release as well as available on the company's website at crossroads.com.

Now I would like to turn the call over to Mr. Rick Coleman. Sir, please proceed.

Richard Kenneth Coleman

Thank you, Chris. Good afternoon. As most of you know, I joined the company in May as Interim President and CEO. Since then, I've worked extensively with our board and executive team to determine the best path to achieve Crossroads' tremendous potential and maximize shareholder value.

In the third quarter, we completed a comprehensive review of our operating strategy, with the goal of leveraging each of Crossroads' 5 core assets. For those of you new to the company, those assets are: our newest product, StrongBox; our OEM products, SPHiNX and RVA; our net operating losses; our '972 patent portfolio; and 108 other patents we refer to as our non-'972 patent portfolio.

We also took definitive steps to implement our revised strategies and I'll provide those updates on today's call.

We still haven't hit full stride, but I do see ongoing revenue growth, a path to profitability and reasons for optimism. I'll talk more about this after Jennifer walks us through the Q3 numbers. Jennifer?

Jennifer Ray Crane

This afternoon, we issued a press release with our fiscal third quarter 2013 financial results. The press release is available for download on the Crossroads website.

For the third quarter, revenue totaled $2.8 million. This represents a decrease of 21% or $700,000 from the same quarter a year ago. The decrease is attributable to a one-time deal with a large RVA customer in 2012, and declines in Iron Mountain custom development revenue. Gross margin percentages remain consistent year-over-year at 75%.

StrongBox revenue from unit sales and partners totaled $770,000. Revenue from StrongBox units were $383,000. Custom development revenue from partners totaled $387,000, with $158,000 from Iron Mountain and $229,000 from Fujifilm. This is the initial amount recognized from our recently announced OEM agreement that allows Fujifilm to private label StrongBox.

We anticipate recognizing at least as much revenue from Fujifilm again in Q4.

Operating expenses totaled $5.7 million in Q3 compared to $5.8 million in the same quarter a year ago. Research and development cost decreased as expected. However, our G&A expenses increased $800,000 over last quarter, due to an increase in professional fees and the accelerated recognition of severance expenses. We expect G&A expenses to be at least $400,000 lower in Q4.

Our net loss for the quarter was $4.1 million or $0.34 loss per share versus a net loss of $3.2 million, or $0.29 loss per share in the same quarter a year ago. The increased loss is primarily due to a reduction of revenue, one-time severance expenses and GAAP accounting associated with the valuation of our preferred stock and Fortress transactions. Rick will discuss our Fortress financing in more detail later in the call.

We ended the quarter with a cash balance of $9.9 million, compared to $6 million at the end of Q2. We received a net amount of $7 million in July from our Fortress financing after subtracting expenses and repaying our debt to Silicon Valley Bank.

Now I'd like to turn the call back over to Rick.

Richard Kenneth Coleman

Thank you, Jennifer. Before we discuss the company's assets and the progress we've made, I'd like to provide some background. We saw some positive trends in the third quarter. Revenue from StrongBox unit sales and strategic partners was up, although modestly. Expenses were down quarter-over-quarter and we instituted significant cost controls that should lead to a further 25% reduction in operating expenses in fiscal 2014.

During the quarter, we took important steps in our revitalized IP monetization strategy. We also made a significant change in our StrongBox market strategy, returning to Crossroads' previously successful distribution model of leveraging OEM and other strategic partners. In a moment, I will explain how the changes we've made this quarter will lead to improved revenue performance. We have a lot of work to do, but we are moving in the right direction.

As I mentioned earlier, Crossroads has 5 valuable core assets. In addition to StrongBox, these are our OEM products, RVA and SPHiNX, $116 million in accumulated net operating losses, the '972 patent family and our non-'972 patents.

Of course, StrongBox has been the company's primary focus for over 2 years. StrongBox is a network-attached storage appliance designed to lower the cost of long-term data retention, while improving data accessibility. For companies struggling to keep up with exploding growth, StrongBox provides built-in data protection, online access and simplified file management.

StrongBox solves real and increasing pain for a multibillion-dollar market. Our early successes in different market segments have validated customer demand and provided valuable customer feedback. Based on positive market response, the adoption of StrongBox into our partners' core solution sets and our unique product positioning, I believe the industry is beginning to acknowledge our value proposition.

We have impressive wins and repeat business from customers, such as Jet Propulsion Labs, industry leaders like Hitachi Data Systems, Fujifilm, ViON, Mainline and Iron Mountain have all recognized our market opportunity.

However, achieving the potential for this product will take longer than originally anticipated. Driven by early optimism, the company overextended itself by spending too far ahead of revenue. Therefore, this quarter, we have taken aggressive action to adjust our strategy and align our expenses with revenue growth.

I want to be clear about this though. There is still gold in this product. It's just buried deeper than expected.

The primary challenge for StrongBox is not one of demand, but of distribution and messaging. Launching StrongBox, we pursued relationships with numerous small-channel partners, each with specific skills in niche markets but requiring intensive Crossroads support. These are still valuable channels, but they don't provide significant economies of scale. Pursuing multiple narrow market segments is an expensive strategy. However, as a start-up product, this course let us develop our StrongBox market presence and proof of concept in niche markets before returning to the company's historic strength of larger strategic sales relationships.

In the third quarter, we refocused our sales strategy on fewer and larger partners. These are partners with significant technical expertise, established customer relationships and sales teams capable of addressing a broader market. We are focusing more effort on partners who can deliver a total solution, whether embedded with their own product suite or as part of a service delivery model. These partners see StrongBox as an opportunity to strengthen their positions in the storage industry. Mainline, ViON, Fujifilm and Hitachi, are partners who fit this profile.

During the third quarter, we advanced our relationships with these and other partners and they're beginning to include StrongBox as an integral part of their customer value propositions. StrongBox is a cost-effective and proven solution to known and growing data storage problems. This is the time to build on our early market validation, control our expenses and begin building a larger, more reliable distribution model.

We've also simplified our StrongBox product message. Previously, Crossroads had positioned StrongBox broadly in the market and sought to educate customers on its extensive capabilities. Our experience has given us important insights and the ability to clearly describe the problems we solve. StrongBox is now positioned as an appliance that works as part of a complete data solution. StrongBox simplifies complex storage environments and fills holes in other companies' product portfolios. StrongBox allows our partners to sell more of their own hardware and software and that makes us an ideal partner.

For example, Hitachi recently brought us into a large competitive bid where StrongBox completed the total customer solution. Our portion of the sale was a relatively small piece of the total contract award. But in some ways, it was the most important because StrongBox reduced the customer's total cost of ownership enough to win the bid for Hitachi.

We're seeing similar developments worldwide, where our partners are presenting a complete data solution, including StrongBox, to large accounts that represent multi-petabyte opportunities. Our partners are working to close numerous 6-figure StrongBox deals and more are in earlier discussion phases.

In Q3, StrongBox revenue was up 123% quarter-over-quarter. We won accounts such as Sony and WYCC, a Chicago PBS station. Jet Propulsion Labs gave us their third order. Mainline, one of IBM's leading resellers, joined our list of impressive partners. Just 3 weeks ago, we broadened our relationship with Fujifilm making them an OEM partner who will now private label StrongBox to help drive their Permivault business.

Two of our existing customers, FotoKem and Loft London purchased more StrongBox capacity and 3 more have requested quotes for upgrades.

Recurring capacity licensing is a unique StrongBox attribute and provides revenue growth without a lengthy sales cycle or technician dispatch. The shift in our distribution model, improved in store messaging and positive Q3 trends all signal StrongBox's revenue growth.

Now let's discuss our OEM products, SPHiNX and RVA. Although these are mature products, they are reliable, have a loyal following and provide us predictable cash flow to fund operations. In the third quarter, this business was down slightly, as expected, and we still continue to add new business and expect this revenue stream to be flat or decline slightly over time.

To some of you, our next asset may not appear valuable, but it is. Crossroads has accumulated a $116 million NOL, or net operating loss, which can be used to offset taxes on our future profits. Tax laws concerning NOLs are complex. So during the third quarter, we had this tax attribute revalidated by a leading tax accounting firm.

I know you're familiar with our next asset, the '972 patent family. This asset has delivered over $60 million to the company since our licensing campaign started in 2001. Our 32 access control patents are litigation-tested and have never been successfully challenged in court. The '972 patents represents significant current and future value to the company.

As part of our balanced asset approach, yesterday, Crossroads filed suit in Federal District Court against one of our licensees, Dot Hill, in part for failing to fully pay license fees as stipulated in our 2006 agreement. We take our patent rights very seriously and intend to pursue this matter aggressively on behalf of our shareholders.

During the quarter, we evaluated numerous alternatives. And within the next 45 days, I will share specific details about our plans to further monetize this important asset.

During the third quarter, we also monetized our other intellectual property asset, the non-'972 patents. In July, we announced the $10 million credit facility with an affiliate of Fortress Investment Group, a well-known and respected financial services firm active in the intellectual property space. It's important to note that the product-related patents involved in this transaction are not the '972 patents, which have been the focus of our previous license agreements. As part of the Fortress agreement, Crossroads retains the right to repay the financing and regain control of the patents. We've not fully evaluated our next steps with the non-'972 patents, but we'll perform an assessment in coming months to better understand our alternatives. We're excited about our relationship with Fortress and recognize the value of their strength and experience.

I'd like to provide investors some guidance for the fiscal fourth quarter that ends October 31. I estimated our total fourth quarter revenue should be in the range of $2.8 million to $2.9 million. For StrongBox, revenue will be flat or slightly higher as our largest partners begin to ramp up their sales operations.

Q4 will also show a significant decrease in expenses as we realize the full benefits of our cost controls.

None of our revenue guidance or financial plans has ever included the Iron Mountain service program, which we have always considered a distant revenue opportunity. For over a year, Crossroads has invested heavily to develop a custom version of our StrongBox product for Iron Mountain. We have previously reported quarterly progress and payments that noted that the program barely covered our implementation costs. Further, with a major portion of our engineering team focused on this custom version of our product, we have pulled on other opportunities and built substantial complexity into our operations.

Last week, we were informally advised of Iron Mountain's intent to terminate its cheap reliable storage project and wind down its current relationship with Crossroads. Iron Mountain is reevaluating its future relationship with Crossroads regarding other opportunities and confirm their intent to continue as a Crossroads investor. I want to emphasize that we've not received anything formal from Iron Mountain, but we will be talking with them over the next several weeks. We understand investors will want more information on this development and we will provide details as they are known. This is obviously a significant event for our engineering team, who designed, built and managed the custom and distinct Iron Mountain version of StrongBox over many months. In addition to simplifying our development challenges, our engineering resources can now be redirected to the needs of our largest partners in support of our standard StrongBox product.

Before I open the call up to questions, I want you to know, we have a dedicated and highly skilled workforce doing the hard work needed to turn Crossroads into a profitable company. On a daily basis, we're making the necessary changes in the business. Over the next 2 quarters, we will continue to focus on major distribution partners who see StrongBox as an integral part of their storage solution ecosystem. We will be carefully managing expenses in order to sustain a cost structure that gives us as much time as possible to implement our plans and we're reviewing our IP strategy and should have some news to share in the next 45 days. We strongly believe that patient investors will be amply rewarded. Now we will open it up for any questions.

Question-and-Answer Session

Operator

[Operator Instructions] And it appears we have no questions in queue at this time.

Richard Kenneth Coleman

All right, thank you, operator. Thanks for joining us today and we look forward to the next update.

Operator

Thank you, ladies and gentlemen, for joining us today for our presentation. This concludes today's call. You may now disconnect.

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