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Crossroads Systems (NASDAQ:CRDS)

Q4 2013 Earnings Conference Call

December 12, 2013 4:30 PM ET

Executives

Richard Coleman Jr. - President and CEO

Jennifer Crane - CFO

Analysts

Bob Johnson - Millennium Partners

William Gibson - Legend Merchant Group

Scott Turkel - Turkel Investments

Zachary Silbersher - Markland Advisors

Operator

Good afternoon and thank you for participating in today's conference call to discuss Crossroads Systems Financial Results for the Fiscal Fourth Quarter Ended October 31, 2013 and our fiscal year ended that same date. With us today are Mr. Rick Coleman, the company's 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 or other proprietary intellectual property protection, market acceptance, future capital requirements, regulatory actions or delays, competition in general, and other factors. These factors may cause actual results to be materially different from our historical results, or from the results anticipated by our 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 and Exchange Commission, for a more complete discussion of these factors and other risks. Crossroad Systems is not obligating itself to publicly update or alter its forward-looking statements, whether as a result of new information and 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.

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

Richard Coleman Jr.

Thank you, Dustin. Good afternoon. Seven months ago, after 13 years of losses as a public company, Crossroads initiated a strategic turnaround, designed to put us on a path to profitability. At that time, the company was spending $3 million a quarter to launch StrongBox, an innovative network attached storage appliance. The company was over extended, pursing a lucrative opportunity with an expected pay-off, well beyond the reach of our financial position.

In May, responding to shareholder concerns, we reconstituted the Board of Directors and I joined the company as Interim President and CEO. Together with the management team, we initiated a thorough review of the company's assets, opportunities and strategic plan. We determined some immediate changes were needed.

Since then, we have taken decisive action to leverage all of the company's assets, stabilize our financial position, and ensure that our investors see returns from both the product and IP sides of our business.

Additionally, last quarter, we announced changes to our StrongBox distribution strategy, and our intent to align ourselves with a select number of strategic and OEM partners. We also took steps to dramatically reduce our 2014 operating expenses, mostly through headcount reductions, facilitated by a more rational and proven approach to the market.

From our January 13 high, 2013 high of 139, our headcount now stands at 47, a 66% reduction. Since labor costs accounted for more than 90% of 2013 operating expenses, investors will see corresponding reductions in our 2014 expenses.

Throughout these changes, we have been mindful of our long term opportunities and have preserved the company's valuable net operating loss, or NOL. This is an important asset we fully expect to utilize as we turn the company towards profitability.

Last month, we took action to defend our intellectual property, by filing suit in Federal District court against Tandberg, Huawei and Dell. These lawsuits and our previously announced lawsuit against Oracle, allege patent infringement related to our family of 972 patents. As we go through today's call, I will provide a more granular view of our patent monetization strategy, and update you on the plan for our other assets.

For those of you new to the Crossroads story, we are managing our growth around five core assets. Our mature products, such as RVA and SPHiNX, our newest product, StrongBox, a network attached storage appliance; our $116 million net operating loss or NOL; our 972 patent family, consisting of 32 patents and pending patents, and our non-972 patent family, consisting of 113 patents and pending patents.

Before I provide more detail on the quarter, year, and plans for 2014, Jennifer will provide a financial report on our fourth quarter and our 2013 fiscal year.

Jennifer Crane

This afternoon, we issued a press release with our fiscal fourth quarter and year-end 2013 financial results, and you can find our press release on the Crossroads website. Total revenue for the fourth quarter was $3.6 million, a decrease of 20% from $4.4 million in the same quarter a year ago. The decrease was mainly due to decreases at our legacy OEM business, and was offset by an increase in StrongBox revenue.

Operating expenses in the fourth quarter totaled $4.9 million as compared to $5.7 million in the same period a year ago. The decrease was due to lower European operating expenses and lower R&D expenses. The reductions were offset by increases in G&A expenses from professional fees.

Net loss available to common stockholders totaled $2.3 million or $0.19 loss per share this quarter, as compared to a net loss of $2.6 million or a $0.23 loss per share in Q4 of 2012.

Now I have been at Crossroads for 10 years, and I can tell you that things are changing. Comparing our fourth quarter performance to last year, simply doesn't tell the whole story. Fourth quarter revenue for example, totaled $3.6 million, which is an increase of $758,000 or 27% over the third quarter, and our highest revenue quarter of the year.

For the fourth quarter, total StrongBox revenue was $880,000; unit sales, excluding onetime custom development revenue were $510,000. This represents a 33% increase over last quarter. Custom development revenue from partners totaled $370,000, $17,000 less than last quarter.

The custom development revenue this quarter is attributable to Fujifilm as part of our OEM agreement that allows them to private label StrongBox. We anticipate recognizing our final payment of $200,000 in our second fiscal quarter of 2014.

For the fourth quarter, operating expenses were $4.9 million, a decrease of $765,000 or 13% less than the third quarter. Last quarter, we projected a $400,000 G&A expense reduction, and we beat that forecast by over $100,000. A remainder of the expense reduction is attributable to decreases in sales and marketing expenses related to our OEM and strategic partner distribution model.

At the end of Q4, we reduced approximately 40% of our workforce. While the impact of the reduction was not apparent in our Q4 expenses, next year quarterly operating expenses will be $1 million to $1.5 million lower.

In 2014, we expect total operating expenses to be in the range of $3.5 million to $4 million per quarter. This represents a decrease in operating expenses of between 20% and 30%. IP legal expenses could vary between quarters. Our net loss available to common shareholders was $2.3 million or $0.19 loss per share, versus a net loss of $4.1 million or $0.34 loss per share last quarter.

Now I will discuss the financial results for the entire fiscal year that ended in October. Our 2013 revenue totaled $12.6 million compared to $14 million in fiscal 2012, a decrease of 10%. Increased StrongBox sales partly offset anticipated decreases in our legacy HP business, as expected, HP revenues will continue to decline. However, we are working to add other strategic partners to offset the reduction in revenue.

For fiscal year 2013, operating expenses were $22.1 million, an increase of 3% over 2012. However, in 2014, we expect operating expenses to be in the range of $14 million to $16 million, a decrease of between 27% and 37%.

Net loss to common stockholders was $14.3 million or $1.20 loss per share, compared to a net loss of $10.7 million or $0.95 loss per share in fiscal 2012. Part of this increase in net loss is due to the complex accounting treatment of the Series F preferred funding, that we closed in March, and additionally, quarter-over-quarter, we may experience fluctuations in the net loss, due to changes in the valuation of the derivative liability that's associated with our preferred stock offering.

We ended the year with a cash balance of $7.8 million compared to $6.9 million at the end of the previous year. In fiscal year 2013, principal and interest payments to Fortress will be $3.8 million. But excluding the Fortress debt, we no longer expect to burn cash. Over the past year, we have reduced our expenses, and laid the foundation for profitability.

So, for the first time in the company's history, we believe we will have positive cash flow from operations in fiscal year 2014.

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

Richard Coleman Jr.

Thank you, Jennifer. 2013 was a pivotal year for Crossroads. In the last seven months, we stabilized and refocused the business. We reduced our cost structure dramatically, rationalized our distribution strategy, revived dormant product lines, and reenergized our smaller, more nimble workforce. In short, we have taken the steps necessary to transform Crossroads into a profitable company, not in few years, but in few quarters.

Our new strategy has energized our customers, our employees and our shareholders. It’s a relief, but we are beginning to see positive measurable results.

In Q4, we exceeded our revenue guidance of $2.8 million to $2.9 million. As we projected, StrongBox revenues were up slightly, and about half of our new StrongBox sales were generated by our strategic or OEM partners. This reflects early signs of success, as we transition to our new distribution model.

Our products are natural adjuncts to those provided by storage industry leaders. Rather than following the long expensive path of going to market alone, we are building strong relationships with our partners, and leveraging their sales strength. We are also using our partners' customer and market insights to drive our product roadmap. This ongoing process is gradually increasing our worldwide market presence and our ability to deliver products without linear increases in sales and support expenses.

To illustrate how StrongBox helps partner some more into products, I'd like to highlight our partnership with Hitachi Data Systems, in a sale we jointly made to the Australian Government.

Hitachi Data Systems added StrongBox to the competitive bid proposal, to make the total solution more cost effective. Together, StrongBox and HDS provide an elegant and seamless solution that delivers integrated data protection, at a fraction of the cost of alternative solutions.

We are gaining similar market traction with our Fujifilm OEM relationship; our partnership with ViON in federal markets and the public sector, with Mainline, one of IBM's largest resellers, and with several other strategic partners. We will continue to focus our efforts on enabling our partner success, and I look forward to profiling additional customer wins in coming quarters.

In 2014, StrongBox product sales should grow steadily, as we continue to nurture relationships with our key partners, empower their sales teams and clearly identify joint value propositions, aligned with specific market segment requirements.

Expenses for StrongBox are now in line with anticipated revenues, and our development programs are targeted to specific features requested by our OEM and strategic partners. In the coming year, as our partnerships continue to mature, Crossroads should be positioned for a steeper growth trajectory.

Part of our 2014 plan involves more effectively leveraging our entire product line and making appropriate resource allocations. Two of our mature products, the Read Verify Appliance or RVA and SPHiNX, received little attention in 2013, as the company focused heavily on StrongBox. Both RVA and SPHiNX meet important customer needs and we will receive renewed emphasis in 2014.

Last quarter, we discussed our $116 million net operating loss or NOL, and the work that we did to preserve this valuable asset. The NOL can be utilized to shield the company's earnings from taxes, as Crossroads reaches profitability. It will also be valuable, when Crossroads receives license payments, settlements, or awards from our intellectual property assets.

Earlier on the call, I mentioned our plan to defend Crossroads intellectual property. The company's previous strategy treated IP licensing and settlement revenues as the source of product development funding. Going forward, we will operate with a disciplined expectation for the products side of our business to be self-sustaining. With a clear and unwavering commitment to becoming a profitable operating company, we will treat Crossroads intellectual property assets as a complement to resource shareholder value.

In July, Crossroads entered into an IP-backed financing with an affiliate of Fortress Investment Group, involving our non-972 patents. These 113 patents and pending patents have not been the focus of infringement or licensing activity. Until recently, little work had been done to quantify the licensing potential of the non-972 patents.

In order to better evaluate our options, last month we engaged a team of intellectual property experts, to analyze the non-972 portfolio. We expect to review the findings with our Fortress partners in late January, and evaluate our options at that time.

In contrast, our 972 patents have a 13 year successful licensing and enforcement history. I'd like to provide some additional details.

In layman's terms, these 32 patents and pending patents address the capability to provide host-based access controls to virtual local storage using (inaudible). The invention covered by these patents, allows users to control which hosts, such as servers, can access which storage devices, whether tape or disk.

A few key points; these patents have generated over $61 million in revenue for Crossroads. 51 companies have licensed patents from Crossroads. 17 of those companies license our patents without litigation. 34 companies have taken licenses as a result of successful litigation related settlements. We have brought 13 distinct lawsuits, including the four most recent, Oracle, Tandberg, Dell and Huawei. All of these suits have been filed in the Western District court of Texas.

We went to trial in one case, and received a verdict of infringement and validity. The case was appealed for the Federal Circuit and we won the appeal. In one other case, we received a default judgment. In one case, based on a request filed with the United States Patent and Trademark Office by the defendant, the USPTO conducted a reexamination of several patents within the 972 patent family. They examined over 200 prior art references and ultimately recertified our patent claims, including the 972 and 035 patents, without amendment.

We have had three positive Markman rules, none or negative. We have never lost a case or a significant ruling.

On the strength of our litigation and licensing success, our legal team made up of two premier law firms focused on IP have agreed to represent Crossroads on a contingency basis, thus insulating us from the full cost of potentially expensive litigation. We believe there are still many companies that should be taking a license to our 972 patents. We will continue our efforts to create long term partnerships by negotiating licenses to our proven and patented technology, but we will vigorously pursue both large and small infringers if necessary.

Counsel has advised us to provide no guidance on the potential value of settlements or licenses, therefore we will be careful not to lead investors to any conclusions about the potential outcome of our actions. We are confident in the strength of our claims and in the ability of our IP counsel to successfully represent the interest of our shareholders.

In closing, Crossroads is building a solid foundation to become a profitable product company. Our lawsuits from product operations will continue to narrow, as our strategic partners train their sales forces and as we continue to enhance our products. IP revenue and expenses are likely to fluctuate, due to the unpredictable timing of license, revenues, litigation costs, and potential legal settlements.

Though smaller, our team is focused. We are also energized by our recent progress and by our revised strategy. Crossroads is dedicated to delivering innovative, reliable and affordable data protection solutions, by partnering with world class industry leaders we jointly empower customers to take control of their data, ensuring that information is available when and where is it needed.

Finally, I'd like to add that I have the greatest admiration for our team of professionals. The dramatic progress we have made since May, and our prospects for building meaningful shareholder value, led me to accept the permanent role of President and CEO on November 22nd. Our Board and our investors have been patient and supportive, and I am committed to achieving Crossroads' potential as a successful and highly profitable company.

Now, we will open it up for any questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from the line of Bob Johnson with Millennium Partners.

Bob Johnson - Millennium Partners

I just wanted to ask you a couple of questions. We haven't heard anything on the Iron Mountain partnership. Could you give us some color on that please? And I have a follow-up question after that?

Richard Coleman Jr.

Yeah Bob. What I'd say about that, is that we are still working to wrap things up with Iron Mountain. But I can't really talk too much about their plans or the status of that at the moment.

Bob Johnson - Millennium Partners

Okay. And can you comment at any type of settlement with Oracle or Dell, how likely that might be?

Richard Coleman Jr.

No. We are still early in the process. So we don't know what the outcome might be, and if we had any idea, I probably couldn't say any way.

Bob Johnson - Millennium Partners

Okay. Thank you very much.

Operator

Our next question comes from the line of Bill Gibson with Legend Merchant.

William Gibson - Legend Merchant Group

Hi Rick. I wanted to zero back in on the product lines as opposed to the IP; and what I think I heard was positioned for a steeper growth curve. Is there any way we can define that as to just how big these products could be?

Richard Coleman Jr.

During the remainder of this year, we are still implementing the transition to our new distribution strategy. It's going to take a while for us to really get an appreciable understanding of what that means from a revenue standpoint. We are dealing with very large companies. We are a part of their product line, we think a very important part. We are getting their attention and we are moving in the right direction. But we are farther down the path with some than we are with others and really can't make any revenue predictions at this time.

William Gibson - Legend Merchant Group

Thank you.

Operator

Our next question comes from the line of (inaudible).

Unidentified Analyst

Thank you. Few questions. Is it fair to assume the positive operating cash flow guidance doesn't include any settlement revenue, and if there was, there would be upside?

Jennifer Crane

That's exactly right. The net income from operations does not -- it includes recurring IP revenue we have recorded and we receive revenues and nothing else.

Richard Coleman Jr.

We have previous settlements that are very predictable built into that number, but it doesn't include the effect of any additional IP settlements or expenses.

Unidentified Analyst

Great. And just, you had 80% gross margins this quarter, which is terrific. What do you expect to steady gross margin of StrongBox, particularly as it ramps?

Jennifer Crane

Well, 80% is overall. But we would anticipate that it should be near that 80% mark going forward.

Unidentified Analyst

Well okay. And, I guess on the last question, I was just curious; because in previous conference calls, you have said that StrongBox is in a multibillion dollar market. If we look out in a few years, is there a number that we could expect -- like is it a $20 million, a $15 million, $100 million, any context at all?

Richard Coleman Jr.

No.

Unidentified Analyst

That's honest.

Richard Coleman Jr.

I can't really say at this point what the potential of the company is from a product standpoint. But I think its -- I am very optimistic about it, let me put it that way. There is absolutely no reason, based on the profile of customers that we have seen so far. Some we talked about, some we haven't. But there is no reason that we should expect anything different, as we get a broader distribution footprint in the US and beyond. Companies of all sizes are struggling with data growth, data explosion and StrongBox solves many other problems.

Unidentified Analyst

And just one last, any update on the NASDAQ compliance?

Richard Coleman Jr.

Yeah. I could say we have been in communication with the NASDAQ. We filed a remediation plan with them, and they did respond with an extension which we are working with them, to fully understand, and to do everything we can to retain that listing.

Unidentified Analyst

Okay. Thank you.

Operator

(Operator Instructions). And we do have a question from the line of Scott Turkel with Turkel Investments.

Scott Turkel - Turkel Investments

Thank you for taking the call. On a New Year [story], so would you tell me why a customer would buy a StrongBox, what does it have to offer?

Richard Coleman Jr.

I probably don't want to go into all the different product capabilities on the call. Would be happy to set up a separate call with you if you'd like and give a detailed review.

Scott Turkel - Turkel Investments

I would encourage a second call, thank you. But can you just tell me when a customer is searching for a product, why would the choose your product? You spent a lot of time on the StrongBox product over the year, I am just trying to ask you what market do you see yourself penetrated?

Richard Coleman Jr.

The key markets that we are penetrating is the data archival market for large companies with massive amounts of data that they need to access readily. If they doled out their disk arrays and the traditional storage architecture that they are using to access their data, they can't back things up fast enough, they can't grow the company fast enough or grow the data center fast enough, and they can't access their data fast enough. What the StrongBox does, is use those industry standards and a well established patented architecture, to allow access to take as a solution. Without the degradation traditionally associated with it.

Scott Turkel - Turkel Investments

Okay. That's a good answer. Thank you. Who do you see as competition in your space?

Richard Coleman Jr.

We don't really think we have any direct competition that is specifically targeted at StrongBox. There are a lot of companies with similar products. But obviously we think that the StrongBox is unique.

Scott Turkel - Turkel Investments

And, last question -- actually I have two more, sorry. You made a reference to StrongBox being part of someone else's product portfolio, like your JV or OEM partners. How do you control your own destiny in that kind of a model and what kind of visibility do you have for your customers?

Richard Coleman Jr.

At this time, we have got a lot of visibility to our customers, because we are very early in developing those strategic relationships. I think as the markets grow for each one of our strategic partners, by necessity, we will be further removed, and our sales teams will have the knowledge of the customer, and the customer requirements, but they will also have the knowledge that they need of our products, and know how to present them appropriately.

Scott Turkel - Turkel Investments

Last two, I am sorry. In terms of your headcount, your direct sales force I think it was going after additional opportunities, what's the headcount of that?

Richard Coleman Jr.

A handful. Our sales force is targeted at working with our partners. That's our strategy.

Scott Turkel - Turkel Investments

Okay. So would you say that you have a team of two or three of your 47 employees dedicated to each partner?

Richard Coleman Jr.

No. I wouldn't say that at this point.

Scott Turkel - Turkel Investments

Okay. And upon conversion of your Series F, what would be your fully diluted share count?

Jennifer Crane

That would be about 20 million.

Scott Turkel - Turkel Investments

20 million. And can you tell me at what price that convert ticks in?

Jennifer Crane

Well the preferred shares were priced at -- and the warrants were priced at 2.0625.

Scott Turkel - Turkel Investments

And that effectively doubled the outstanding share count of the company?

Jennifer Crane

With the warrant attached to them, that's assuming the warrants also.

Scott Turkel - Turkel Investments

All right. Okay. That's all I had. I appreciate your time. Thank you very much.

Richard Coleman Jr.

Okay. We have time for one more quick question.

Operator

Our last question comes from the line of Zachary Silbersher with Markland Advisors.

Zachary Silbersher - Markland Advisors

Yes, I just have two quick questions. The first one is, in addition to the pending lawsuit against Oracle, Huawei and so forth, would you like to comment on any additional targets or lawsuits in terms of filing and enforcement of the 972 patent portfolio?

Richard Coleman Jr.

Not specifically, but I will say this. Its not our intent to file a lawsuit at the first step. We would prefer that companies who are using our patents, contact us and take a license, and that's always our first step. Lawsuits are the last resort, when we don't get a response or when we get an unfavorable response.

Zachary Silbersher - Markland Advisors

Okay. That makes sense. And so following up on that, I was wondering if you'd like to comment on either licensing enforcement efforts of the nonn-972 patent portfolio?

Richard Coleman Jr.

The non-972 patent portfolio needs some work. We need to understand really what companies might infringe on those patents and what the natural groupings of the patents might be. That's the work that we have contracted to have done, preliminarily do by the end of January. We will review the results with our partner, Fortress, and we will decide what actions to take next.

Zachary Silbersher - Markland Advisors

Okay. Thank you.

Richard Coleman Jr.

Thank you. Thank you, operator.

Operator

We have no further questions.

Richard Coleman Jr.

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

Operator

Ladies and gentlemen, thank you for joining us for today's conference call. We thank you for your participation. You may all disconnect.

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