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FalconStor Software, Inc. (NASDAQ:FALC)

Q1 2010 Earnings Call Transcript

April 29, 2010 4:30 pm ET

Executives

ReiJane Huai – Chairman and CEO

Jim Weber – CFO, VP and Treasurer

Bernie Wu – VP, Business Development

Jim McNiel – VP and Chief Strategy Officer

Analysts

Brian Freed – Morgan Keegan

Abby Butler [ph] – Butler Ventures [ph]

Operator

Good afternoon and thank you for joining us to discuss the FalconStor Software's Q1 2010 earnings. ReiJane Huai, FalconStor's Chief Executive Officer, Bernie Wu, FalconStor's Vice President of Business Development, Jim Weber, FalconStor's Chief Financial Officer and Jim McNiel, FalconStor's Chief Strategy Officer will discuss the company's results and activities and will then open the call for 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 are 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 as 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 2010 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 to ReiJane Huai, Chairman and CEO of FalconStor Software, Inc. Please go ahead, ma'am.

ReiJane Huai

Thank you. Good afternoon. Thank you for joining us for FalconStor's fiscal year 2010 Q1 earnings conference call. I'm ReiJane Huai, Chairman and CEO of FalconStor Software. I'm joined by Bernie Wu, Jim McNiel and Jim Weber.

FalconStor experienced a revenue shortfall for the first quarter of this year, mainly due to lower than expected performance in our branded channel business. Although our results are lower than we anticipated, we do have a strong business pipeline for Q2 and we're leveraging our core competency in storage specialization as a competitive differentiator to bolster our presence in the data protection market by offering data deduplication solutions to complement traditional legacy backup and continuous data protection solutions to greatly enhance the quality of local as well as remote recovery.

Besides offering those products through our organizational channel, the virtualization centric design of our solutions facilitates the integration of our solutions with virtualization servers such as VMware, Microsoft, Hyper-V and the delivery of our system as cloud based services.

As corporate data and associated protection and recovery services become more and more mission critical, the demand of the availability of data and the data protection and recovery services will be of great importance to corporate IT managers and storage service providers.

Because FalconStor solutions are engineered from the ground up as hardware agnostic active clusters, we are differentiated from our competitors by our ability to guarantee the up time and service level agreements for data deduplication, data protection and recovery services.

Bernie will review the progress made regarding strategic partnerships with industry leaders and channel distributors. We are expecting those partnerships to play a major role in strengthening our brand awareness, penetrating Fortune 2000 accounts and accelerating our growth momentum in the data protection market around the world.

Jim McNiel will outline our plan and progress in leveraging our storage virtualization technology, to enable resellers and network service providers to offer our state-of-the-art data protection solutions as cloud based services to complement our organizational channel business.

Regarding operations, effective immediately we have implemented strict expense controls, a hiring freeze to keep spending in check. Through fiscal discipline and focused marketing and sales activities through our most productive orders, we look forward to increasing the momentum and revenue in the coming quarter.

I would now like to turn over the discussion to Jim Weber, our Chief Financial Officer, who will review the company's financials.

Jim Weber

Thank you, Rei. Now I'd like to take a few moments to review the details of our financial results for the first quarter. For the first quarter of 2010, revenues were $17.1 million compared with $21 million for the same period a year ago. Our OEMs accounted for 29% of our revenue, which is down from 36% in Q1 2009.

EMC accounted for 13% of our software license revenue and Oracle accounted for 5%. Software license revenue from EMC declined by $300,000 compared to the same period a year ago and software license revenue from Oracle declined $1.1 million.

The revenue from our non-OEM business grew as a percentage of total revenue, representing 71% of our total revenue compared with 64% in the same period a year ago. Non-OEM software license revenue in North America increased by $900,000 while international non-OEM software license revenue declined by $3.9 million.

We had success in the quarter growing our North America channel and we're beginning to see the signs of an economic recovery in North America. International, we continue to experience a relatively weak economy, especially in Europe. In addition, internationally we saw some deals slip and we also encountered the larger tier one players significantly lowering prices to win business.

In Q1, our non-GAAP loss from operations was $5.8 million compared with operating income of $1.3 million in Q1 2009. Our non-GAAP net loss for the quarter was $3.8 million or $0.08 per share, compared with non-GAAP net income of $600,000 or $0.01 per share in Q1 2009.

Our non-GAAP results exclude stock-based compensation expense of $2.7 million in Q1 2010 and $2.2 million in Q1 2009 and are also net of the related income tax effects of stock-based compensation.

Due to the less than expected non-OEM revenue internationally, we have taken immediate steps to lower our R&D and SG&A expenses. Most of these cost reductions will not have a full effect until Q3. Until we experience a return to year-over-year revenue growth, we do not intend to increase headcount.

On a GAAP basis our operating loss was $8.5 million compared with an operating loss of $800,000 in Q1 2009 and GAAP net loss was $5.5 million or $0.12 per share, compared with a net loss of $900,000 or $0.02 per share in the same period a year ago.

As of the end of Q1 our cash, cash equivalents and marketable securities balance was $40.5 million and our cash flow from operations was negative $500,000. Our deferred revenue balance at the end of Q1 was $23 million, which is an increase of 5% compared with Q1 2009.

Now I'd like to ask Bernie to review in more detail our strategic and channel partnerships and initiatives.

Bernie Wu

Thank you, Jim. In the area of our VTL and FDS partnerships, we saw a continued decline from our business with EMC due to their increased sales emphasis on the Avamar and Data Domain product lines. Although, the Sun-Oracle merger was completed in January, uncertainty over the future direction of their storage strategy has resulted in a steeper drop-off in business.

As part of an ongoing meeting with channel focus, we are starting to build a significant pipeline of deals with HDS and we expect the partnership to continue to expand and deepen. We established a distribution agreement as well for Fujitsu America to allow them to offer VTL solutions with their servers and storage.

Another one of our OEMs, Copan was acquired by Silicon Graphics and is expected to relaunch their product line shortly. DSI closed a large Department of Defense deal involving VGL.

On the storage virtualization and continuous data protection front, 3Com H3C is now part of HP and we are in dialogue with HP and awaiting the outcome of the future direction of that division.

We are continuing to partner with VMware on joint marketing activities. We are also expected to launch storage as a service through a tier one vendor by the end of this year. We are pleased with the launch and the debut of the Hyper FS file system earlier this month at the National Association of Broadcasters conference.

We announced an OEM relationship with SeaChange as part of their universal media library and also a distribution partnership with Rorke Data.

The Hyper FS file system is now released and we deployed a major end user in the post-production digital cinema marketplace in Q1. Several major proof of concept evaluations and sales cycles have resulted from this launch.

We signed Tech Data as a distributor in Q1 to help ramp up our transactional and appliance business and improve our coverage of VMware channel partners.

We are continuing to make progress in the federal sector and with major system integrators in terms of building a pipeline of opportunities and improving our awareness. We won the best-of-show award at the recent Federal Office Systems Exposition. We also closed deals with agencies such as the NGA, DISA, CBO and Army.

In summary, FalconStor has experienced an unusually high level of revenue disruption resulting from strategic partner acquisitions that has impacted our OEM business. However, we believe a new foundation of partnerships is now well on the way to being put in place that will allow for future growth and scaling of the company.

We expect two new tier one partnerships to be in place in the second half of this year. In addition, we have recruited several major system integrators and national resellers and have built co-marketing alliances with server virtualization suppliers and have positioned ourselves to take advantage of the explosion in unstructured data and content, starting first in the media and entertainment sector.

I'd now like to turn over the discussion to Jim McNiel, our Chief Strategy Officer, who will discuss an update on our alliances.

Jim McNiel

Thank you, Bernie. I'd like to talk about a few of the macro technology trends that are driving our business and our decisions. Most importantly, the rapid adoption of virtualization technology is having a significant impact on our current and our future business. The adoption of virtualization by most large enterprises was designed to reduce energy costs, reduce computer space and data centers, to reduce CapEx and OpEx expenses.

As a result of these investments, companies have been experiencing higher efficiency and a much greater data application mobility. This latter point is what I'm really driving towards. The fact that virtualization is driving data and application mobility is creating an incredible amount of business agility and the message that is being well-received by enterprises today is the ability to package up and move servers, applications and entire data centers is creating an entire business model in a different paradigm.

One subset of this innovation is the basic concept of enhanced business continuity and as a business continuity subset we are talking about backup and disaster recovery.

Historically, in the data backup and protection area, we know that backup was the method that we developed to protect company data. In a subset of backup came the concept of disaster recovery. We can take a series of tapes and we could reassemble a system or even an entire data center to put a company back into business.

An assumption of that was the concept of data mobility, the ability to take a tape and say, go off to Albany and start another business with this tape, because it replicates everything you need to get that business done.

In the world of virtualization, these steps are reversed. It starts with data mobility, which is made possible through virtualization and as a subset of that, because we can capture or place into a single object an entire server or application, we have the ability to instantly recover that server or application in a number of different places or spaces, in a local company, a remote office or in the cloud. And then a subset of that is the ability to move these applications and servers around the enterprise.

So in summary, this means that we have the ability to move any data anywhere in the enterprise or the world at any time and this is what FalconStor happens to excel at. When I talk about any data, I'm talking about applications, databases, e-mail servers, structured data and unstructured data. And one of our core competencies happens to be the ability to speak to a number of different databases and e-mail services and to understand how to protect that data synchronously, meaning when we capture or snapshot this information, it's done in a careful and concise way to avoid any data corruption.

When I talk about anywhere, I'm talking about multiple platform support, a heterogeneous support and the ability to allow information to leave one platform and move into another platform. At any time, speaks about, obviously the rapidity at which we move data and also the frequency in which we can snapshot and protect data.

As a result of this, companies gain a great deal of flexibility and they're gaining a lot of capabilities that go well beyond standard disaster backup and recovery. So this trend helps to drive our business thinking and the area in which we can gain the greatest amount of traction happens to be in the rapidly growing VMware space.

We've been placing a strong emphasis on the VMware channel and in February we went to the VMware partner exchange and we addressed the entire VMware North American sales force and explained to them that we have the only VMware certified, SRM compliant, failover and failback solution.

As a result of that we were able to put forth four legged sales calls to go out and speak to prime VMware resellers and since that time we have signed 10 new registered VMware-focused resellers.

We have of these -- 20 additional resellers in our pipeline to be signed in the coming months. We've also signed Tech Data as a VMware-focused distributor and yesterday we held a webinar -- joint webinar with Joel Davis at VMware and Wendy Petty, our VP of Sales and addressed 150 resellers and partners who are interested in representing FalconStor product in the channel.

We've also joined the VMware Top Gun program, which is exactly what it sounds like, it's designed to develop an elite core of sales professionals who can go in and deliver solutions.

We've also put together three competitive and strategic bundles using our continuous data protector product to provide a solution both at the core and the edge of the enterprise for complete disaster recovery and protection and these bundles are made available through our VMware channel and are getting a lot of positive attention.

So the VMware space also enables us to address probably one of the most dynamic and growing spaces. Data mobility makes something available to the average enterprise that historically has only been available to the very wealthy or well-funded companies. The gold standard for disaster recovery and business continuity in the past was the ability to replicate all of your hardware in an off-site location, say at Sun Guard and when disaster occurred you would move your people to that location and turn on the servers and you'd be up and running.

But because of virtualization, we now have the ability to provide that technology, that capability, to a much larger audience and that is what the managed service providers are focused on.

By supporting any x86 environment we can take servers from the remote office or a medium or large-sized enterprise, move it into the cloud and provide for individual file restore, mailbox restore, server restore or entire data center restore. So we provide services from the edge into the data center, in the private cloud today for many of our customers and ultimately into the public cloud.

So in the MSP space we've broken down our strategy into two key phases. The first phase, which is currently being implemented, allows our continuous data protector service to be deployed by MSP partners such as Mapletronics and Scale then others who are using our technology to do collect data from their clients, move it into the cloud and make it available for recovery. We provide a shared revenue model to support these companies and this is moving forward nicely.

Phase two of our MSP strategy is to provide a much more global view of the MSP environment, making sure that they can have complete accounting capabilities, the ability to manage and control all of their MSP clients from a single pane of glass and this will be targeted at much larger MSPs, such as telcos, cable companies and large global network providers.

So in summary, I believe that we have a very strong technology to service the virtualization growth in the marketplace today and by virtue of that also be a strong player in the MSP space.

And with that, Brian, I'll hand it back to you.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of Brian Freed with Morgan Keegan. Please go ahead with your question.

Brian Freed – Morgan Keegan

Good afternoon. Thanks for taking my call. A couple of quick questions and I guess first of all as you think about the last couple quarters and the shortfalls you've seen there, you guys have done a pretty good job of explaining what you're not going to do in terms of not spending on additional headcount and showing some pretty progressive expense control there.

But can you talk a little bit more about what specific steps you're taking in terms of driving improvement there? You hinted at some of the initiatives, but how do those specifically impact you guys organizationally in terms of restructuring, changing your pipeline, your forecasting methodologies, anything like that you can talk about?

Jim Weber

I presume you're talking about some of the cuts we're making, Brian? More detail about that?

Brian Freed – Morgan Keegan

Well, I would just -- I know you guys are reducing spending but I guess what I'm trying to understand is what specific initiatives are you putting in place to improve your executional consistency, what disciplines are you putting in place to improve your forecasting methodology that type of thing.

Jim Weber

Yes. As far as -- let me just start by talking about some of the cuts. We looked at the headcount we have and the revenue we've had in the past couple of quarters, so since the end of the quarter we have made some cuts and when we did that we kind of looked at the areas where we were getting the least productivity. So those were really the first areas of focus and then we also looked at some areas that maybe we were using as far as consultants and we kind of took that in-house.

And now we're developing, as Jim mentioned, we're doing a lot more work with VMware and more qualified resellers and we're trying to do a better job of training our resellers, getting them more up to speed with our product and this way should build a stronger pipeline and a pipeline that we could rely on a little bit more.

So those are some of the things we're trying to do and work a little bit closer with those partners and make sure they're up to speed with the technology. And also on the technology side, to make sure that the technology is easier to deploy and also make sure that it's properly packaged for the channel, especially as we're shipping more from the OEM business to the channel business.

Brian Freed – Morgan Keegan

Okay. And a second question and kind of building on that, if you look at your packaging and your products, particularly in light of your MSP initiatives going forward, yes, typically, I would say the MSP customers, the tier one specifically have historically been a much better direct sales force model versus a channel model in terms of success rates from competitors and counterparts in the storage arena. Do you feel like you have the appropriate sales structure in place to address the tier one MSP opportunities?

Jim McNiel

I would say, Brian, I'd say early on I think we're positioned for that. Bernie's development team is involved in that and my team is involved in that. So we are using our own internal resources to speak directly to the MSPs. I don't anticipate that we're looking to serve 50 or 100 MSPs, I think we're looking to serve less than 50. And as we develop that business we'll be able to invest more in the resources that can support them, but currently where we are right now, we're doing fine.

Bernie Wu

Yes. The other comment I'd make about the MSP opportunities and things such as the tier one opportunity I referenced is that the effect of those kind of relationships will also help to drag additional channel business, because the -- basically there'll be what we call a networking effect. Once you have a large player using our technology and offering his storage as a service, then clients -- there's actually a virtuous effect where you'll be able to sell more easily the nodes because there is a possibility of using a self installed powered disaster recovery center or storage as a service center as an alternative location. So I think you'll see a feedback effect between us selling our products through the channel and then also working with the various MSPs, including the tier one to ramp up storage as a service.

Jim McNiel

Okay. Thank you. Brian, one more additional point which I didn't mention in my comments is that our MSP offering is unique in a number of ways, but one of the most compelling aspects of it is that our architecture provides for local replication and instant recovery with a guaranteed SLA at the customer's site. So before they even have to go to the cloud, they have a local solution and so MSPs find that very appealing.

Brian Freed – Morgan Keegan

Okay. Okay. And then lastly and this is really probably more directed at Rei than anybody else, as you look at your technology and what you have in-house now with deduplication, CDP, NSS, clustered file system how do you think of your positioning today and more specifically, do you feel like you have enough tools in the toolbar then your R&D efforts should probably be more around refining them, simplifying the management in limitation or do you feel like there's additional significant pieces of technology you need to develop internally?

ReiJane Huai

Very good question, Brian. Let me just answer this question in a very concise manner. And when it comes to software, if you try to view solutions and do solutions that are not related, the software development cost and the sustaining cost, marketing cost, everything will be extremely high. And now you mentioned data deduplication, CDP and the virtual file -- the cluster file system, those three elements are closely related.

They will be a part of the common platform. You can imagine this is the same base cluster file system as a repository. I mean and did you allow us to support the conventional, the legacy tape backup system. On the other hand, what those customers are looking for are more than a much better way of recovering the data, how to better protect their mission critical involves them down to have a solution like CDP.

So from a solution point of view, they're absolutely cohesive and complementary, which means we'll have better leverage, which also means our reseller will have much less cost in learning the solution and bringing the solution to the channel and we do not anticipate us expanding into other fields beyond our core competence. And you know we can't forward our backup, data protection background and we're maximizing our knowledge in the past and also coupling our knowledge and discipline with available technology in order to bring the best solution to the customers.

At this point, we have sufficient solutions and they will build upon a common platform, which means our sustaining costs will be less into the future and our mission, our focus at this point is really to build up the sales pipeline, maximizing the market recognition so we can see the acceleration of the sales growth.

Brian Freed – Morgan Keegan

Okay. Great. Thanks.

ReiJane Huai

Thank you.

Operator

Thank you. At this time, I show our next question is from the line of Abby Butler [ph] with Butler Ventures [ph]. Please go ahead with your question.

Abby Butler – Butler Ventures

Good afternoon. Can you give us some background on what the situation is with FalconStor in China, number one? And then my second question would be to Jim, Jim, can you explain how you end up with $40 million in cash, which is the same amount you had in the previous quarter, yet we had a major loss? I'm not quite able to reconcile that with the cash flow. Thank you.

ReiJane Huai

Okay, Abby, to answer the question on China, we are the market leader when it comes to data replication, disaster recovery in China and we'll continue to work with our franchise, although H3C was acquired by HP, but they will continue to sell the solution at least till the end of this year. So we expect the revenue coming in from H3C on a quarterly basis.

Besides H3C, we also have the OEM relationship with Hauwei Symantec, which is a joint venture established between Hauwei systems and Symantec about three or four years ago. It's the only product licensed by Hauwei Symantec around the world. It's our deduplication technology the Hauwei Symantec is actively selling our VTL dedup solution known in China both for the country and outside of China as well.

Besides Hauwei and the HP in China, also have other OEM partners such as Weichert [ph] et cetera. So we expand our business and continue to grow in China. Furthermore, we have a joint venture and we expect us to expand the scope of our joint venture to cover other sort of [ph] areas as well in the very near future. So we are fully committed to the China market and we are well prepared to expand our presence and to capitalize on growth in China.

Jim Weber

Then as far as the cash balance, Abby, what happened is usually most of our revenues are back-end loaded, so that basically means that in Q4 the revenue that we booked, we didn't really collect the cash, it was in receivables. So in Q1, we typically collect the receivables related to Q4, so we had pretty good collections related to those sales.

In addition, we're also very fortunate with our maintenance stream and our deferred revenue balance has continued to increase. So as more and more people are renewing their maintenance, it might be multiple-year maintenance, where they may pay us up front, so that helps with as far as the cash flow. So that's why we still have a cash balance of $40 million and we do expect our deferred revenue balance to continue to increase like it has in the past.

Abby Butler – Butler Ventures

Thank you.

Operator

At this time, I am showing no further questions. I'd now like to hand the call back over to Jim Weber.

Jim Weber

Thank everybody for calling in and thank you for your interest in FalconStor. We look forward to reporting strong results for Q2. Thank you.

Operator

Ladies and gentlemen, this concludes the FalconStor Software Q1 2010 earnings conference call. If you would like to listen to a replay of today's conference, please dial 1-800-406-7325 and dial 4285982 followed by the pound. ACT would like to thank you for your participation. You may now disconnect.

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Source: FalconStor Software, Inc. Q1 2010 Earnings Call Transcript

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