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Crossroads Systems, Inc. (NASDAQ:CRDS)

F1Q 2014 Results Earnings Conference Call

March 06, 2014 04:30 PM ET

Executives

Rick Coleman - President and CEO

Jennifer Crane - Chief Financial Officer

Analysts

Bill Gibson - Legend Merchant

Operator

Good afternoon and thank you for participating in today’s conference call to discuss Crossroads Systems Financial Results for the Fiscal First Quarter Ended January 31, 2014.

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 Incorporated, which can be identified by use of forward-looking terminology 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 the expectations regarding future growth, operating and financial results, and market demands 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 and other proprietary intellectual property protection, market acceptance, future capital requirements, regulatory actions or delays, competition and 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 Security and Exchange Commission and our Form 10-Q that will be filed with the Security and Exchange Commission for a more complete discussion of these factors and other risks. Crossroads Systems is 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 for 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.

Rick Coleman

Thank you, Tanisha. Good afternoon everyone. Last year, we reevaluated our product and intellectual property strategies and moved decisively to put Crossroads on a path to profitability. We’ve made a number of course corrections and we took aggressive action to maximize shareholder value. I am pleased to report that we’re continuing to make progress on our 2014 plan.

Last year, our operating expenses were $22 million. This year, our operating expenses should be between $14 million and $16 million, a reduction of 27% to 37%. As I mentioned last quarter, we also expect to generate positive cash flow from operations. This measure is important because while we expect significant returns from our IP monetization strategy, we also hold ourselves accountable to operate the product side of our business with financial discipline, while our products gain broader market acceptance.

On a quarter-over-quarter basis, total revenue rose 16%. StrongBox revenue increased 29% and operating expenses declined 21%. Our cash balance in the quarter increased $203,000 from last quarter, aided by $1.1 million from the termination of a service agreement and by $550,000 from the StrongBox custom development payment associated with the same agreement.

In Q1, we also continued to execute on our commitment to deliver shareholder value through Crossroads litigation tested intellectual property portfolio. Since October of last year, we filed 7 lawsuits alleging infringement related to our 972 Patent Family. The defendants are Oracle; Dell; Tandberg, now Overland Storage; Huawei; Cisco Systems; NetApp; and Quantum. Later in the call, I’ll update you on our intellectual property monetization activities including additional companies we’re pursuing for infringement and our timing expectations for first Markman hearing.

Now, I’ll turn the call over to our CFO, Jennifer Crane, who will provide you financial details on the quarter.

Jennifer Crane

This afternoon, we issued a press release with the financial results for our fiscal quarter of 2014. You can find the press release on the Crossroads website. Total revenue for the first quarter was $4.1 million, an increase of 16% from $3.6 million in the same quarter a year ago. The increase was primarily due to growth in recurring product maintenance revenue and intellectual properties royalty revenue.

Every customer who purchases our product also purchases the maintenance contract. Revenue from these maintenance contracts are recognized over the service period and not included in our product revenue line. As StrongBox and SPHiNX revenue continues to increase, we expect that the maintenance revenue increase proportionally. One of the other components in the IP license royalty and other revenue line is IP royalty revenue, which increased from 188,000 in Q1 of last year to 1.1 million in Q1 of this year, the five-fold increase is attributable to one of our 972 patent licensees whose volume of license products has dramatically increased. Although we don’t have visibility into their expected product shipment, we think this customer [owe us] some leverage potential in our IP licensing model.

Revenue increases throughout the business were partially offset by a 37% reduction in our HP OEM SPHiNX revenue. We expect HP revenue to continue to decline as they transition to their own virtual tape solution. However, we see these reductions in revenue being offset this year by Crossroads branded SPHiNX product sale.

Operating expenses in the first quarter totaled $3.9 million compared to $5.7 million in the same period a year ago. The decrease was primarily due to October reduction in force as the company adjusted its product distribution strategy.

In line with guidance we provided last quarter, operating expenses decreased $1 million compared to Q4, so pleased to tell you that we are on track to meet our guidance of $14 million to $16 million in operating expenses. I also want to make it clear to investors that this forecast includes projected legal expenses relating to our intellectual property law suites.

In Q1 we reduced our loss from operations to $395,000. We also recorded $1.1 million gain on the termination of a previous service contract resulting in net income before interest and derivative expenses of $655,000. This compares to a net loss of $3.1 million in the same quarter a year ago.

Unfortunately due to complex accounting rules, the increase in our stock price this quarter reduced our net income from $3.4 million. Therefore net loss available to common stockholders totaled $3.5 million or $0.28 loss per share this quarter as compared to a net loss of $3.1 million or $0.27 loss per share in Q1 of 2013.

It’s important for investors to understand that $3.4 million or 97% of this quarter’s $3.5 million loss is attributable to the change in value of derivative instruments. The derivative instruments causing this change in our income statement are the warrants associated with our Series F preferred stock, the warrants are mark-to-market each quarter. When our stock price fluctuates, our income statement is also impacted. At the end of Q4 our stock price was $1.03 compared to $2.95 at the end of Q1 or an increase of 186%.

The good news is that when the [record] feature tied to the warrants expires then our income statement will no longer be subject to these fluctuations and $3.4 million expense from this quarter will be reported as income in our second quarter. After the second quarter, our income statement will no longer be affected by changes in our stock price.

There is one other issue; I would like to clarify for investors. Recently Crossroads sell two registration statements related to previous financing. These are not registrations of new stock. We filed an F-1 in conjunction with the 2010 common stock offering and another F-1 in 2013 to register the common shares underlying the Series F preferred stock. We repeat guidance of our legal counsel to replace the F-1 filings with F-3 filings to simplify their management of our SEC requirements. The [page] reduces our expenses and clarifies our financial reporting. Yesterday the SEC declared both registration statements effective.

In Q1 loan payments to Fortress totaled $495,000. This amount will increase to $895,000 in Q2 as we pay a full quarter of principal payment on one of our two loans. The principal payment on the second loan begins in July. We ended the quarter with the cash balance of $8 million, a $200,000 increase compared to $7.8 million at the end of Q4.

Now I’ll turn the call back over to Rick.

Rick Coleman

Thanks, Jennifer. In the first quarter, we continued to solidify our distribution strategy that emphasizes a select group of OEM and strategic partners. All of our major partners contributed to our StrongBox product sales in the first quarter, including new accounts, follow-on unit purchases from existing customers and capacity upgrades to deployed units.

As you may remember, our technology and business model allow us to provide StrongBox’s feature enhancements and software-based capacity upgrades remotely and without service interruption. As our customers continue to experience rapid data growth, we expect this capability to make a more important contribution to our financial results.

Additionally, we made significant progress with our partners, including fine-tuning our partners’ value propositions, providing sales and support training and improving product messaging.

As StrongBox momentum increases, we’re listening carefully to our partners and to our customers regarding their technology requirements. When combined with our own view of the market, their guidance allows us to provide a systematic and evolving roadmap for the development of new StrongBox features. While there may be several quarters before we realize the full benefits of our distribution strategy, our strategic partners are continuing to gain traction and integrate Crossroads’ products into their market offerings.

Mainline, one of IBM’s largest premier business partners is a great example. For more than 20 years Mainline has worked closely with IBM developing and implementing cutting edge business technology. Mainline has a well earned reputation as a trusted supplier of storage solutions and are proving to be a valuable and innovative partner for Crossroads as well.

In January we presented our product line over 200 sales and engineering professionals at their annual sales kick-off event. Mainline and Crossroads believe we’re beginning to understand how to unlock the potential for meaningful StrongBox and SPHiNX sales opportunities to their large and growing base. Mainline’s IBM customers represent a huge StrongBox opportunity, but also ideal prospects for SPHiNX Virtual Tape Solution. We’re excited to be working with Mainline and have greater expectations from our partnership.

I’d like to take a few moments to share some of our more notable customer wins this quarter. In December (inaudible) show purchased the StrongBox to improve workflow and facilitate their editing process. Also in the quarter one of the premier cable and satellite networks completed a proof-of-concept study and purchased their initial StrongBox. Wins like these demonstrate our favorable positioning in the media and entertainment space.

This month we strengthened our position by adding a new StrongBox utility that enables seamless archiving from Avid Interplay environments. With more than 1,400 deployments, Avid Interplay is the leading media production and asset management platform and is used by every major broadcaster and most post production companies. This new utility gives our partners the ability to sell StrongBox in this important and growing vertical market.

Our engineering team also added key performance in data protection enhancements designed to maintain StrongBox’s position as the industry’s best performing and most cost effective solution for long-term data preservation.

As a result of a focused campaign initiated during the quarter, ViON, our strategic partner in the federal state and local government space signed a counterpart to Colorado. This particular sale is a great example of how StrongBox solved the problem for a customer facing overwhelming data growth, but with an extremely limited budget.

For these other customer, StrongBox is enabling controlled storage cost, offering unmatched scalability and performance and ensuring secure data availability.

Our OEM relationship with Fuji film announced in Q3 of 2013 continues to show great promise. Fujifilm announced in Q3 of 2013 continues to show great promise. Fujifilm’s tape market leadership and brand recognition provide a platform for customer adoption as they begin to rollout their strong StrongBox based solutions. The Eternity, the Fujifilm branded product line will be formally launched in the U.S. market throughout March and April. A full working demonstration will premiere at the April National Association of Broadcasters show in Las Vegas. We should begin to see Fujifilm’s OEM product sales ramp up later in the year.

In Europe, our relationship with Hitachi Data Systems or HDS also continues to mature. Last year we estimated that 10% of our European opportunities would come from Hitachi related deals. Now it’s almost 40% and over the next year we expect Hitachi opportunities to represent 60% of our European deal pipeline.

Our relationship with HDS and their sales partners continues to grow as we work together to reinforce our value to the HDS storage ecosystem community. StrongBox makes Hitachi’s storage products more cost effective and delivers more value to end users hungry for performance, scalability and cost savings.

Overall I am pleased with the progress we are making on the product side of our business both in the U.S. and in Europe, because our distribution partnerships are still young and our revenue base is relatively small investors should still expect lumpiness in our quarter-over-quarter product revenues. However we are confident we have set the foundation for robust future product growth.

On the patent side of the business we continue to execute on our intellectual property licensing strategy and took decisive action to defend our rights. I will start with the recent activity in our 972 patent family which is comprised of 32 patents in pending patents all related to secure and efficient access to network storage systems. On November 26th, we filed suit to against Dell, Huawei and Tandberg Data now over one storage, in Federal Western District Court in Austin Texas, [and letting] infringement of our patents. On February 18th, shortly after a first quarter ended, we also filed suit against Cisco Systems, NetApp and Quantum.

Crossroads now has eight active lawsuits in the Federal Western District Court including our previously announced lawsuits against Oracle and Dot Hill. We should now be crystal clear to shareholders and to companies who maybe infringing on our patents that we have a responsibility to our shareholders to maximize the value of the millions of dollars we have invested in our intellectual property. Furthermore when necessary, we are willing to pay legal action to defend our rights.

Crossroads’ historical strategy was to selectively pursue infringers and avoid the potential for business conflicts. When necessity this limited the scope of a IT monetization activity and excluded some of the largest opportunities.

Nonetheless even this limited approach proved highly successful and brought the company over $60 million in revenue. Whenever possible, we preferred to negotiate a license to our patents. However we are confident in the strength of our legal position and willing to have our patent disputes settled in court if necessary.

Investors have repeatedly asked us how much the company might run this successful in court. Our policy is to avoid providing estimates because they vary substantially. Above all, I don’t to mislead investors with rough approximations. We have eight active lawsuits and we simply can’t predict the outcomes. There may be early licensing settlements or the lawsuits may go to trial and/or appeal. There may be large awards or we may get nothing. There may be lump sums payments or there may be licensing agreements tie to future revenue from infringing products or a combination of both. What I can say is that as a general rule I would anticipate the settlement or trial award to be proportional to company’s revenue from the sale of infringing products.

The first measure step in our lawsuits will be the mark and hearings. Based on recent indications from the court we believe the first mark and hearing will take place before the end of the year. We expect the court to provide an exact date within the next 60 days and we’ll update investors as soon as we know.

On last quarter’s conference call I indicated there were other companies who should join the group of 51 who have a license to our 972 family of patents. We recently sent letters to 40 additional companies urging them in the strongest possible language to contact us to negotiate licensing terms. Our strategy regarding the 972 patent family is simple and direct. We will continue to aggressively protect our patent rights and pursue infringing companies regardless of size or market positioning.

Now let’s turn to the non-972 family. A group of a 117 patents and pending patents held in partnership with Fortress. In November, we hired a team with intellectual property experts to analyze the non-972 portfolio. The team has nearly completed the initial phase of their work and we expect to receive the results of their research in the second quarter. The work they’re doing to analyze the patent is complex and tedious especially when you consider the non-972 portfolio is over three times larger than the 972 portfolio.

When the analysis is completed we’ll consult with our fortress partners and evaluate our options. As a reminder, our non-972 patents have never been the focus of any IP licensing campaign or litigation. On our next conference call, I hope to shed additional light on the non-972 portfolio and on our strategy.

In summary, I’m pleased with the positive trends in our business. During the first quarter product and IP revenues were up, while expenses were down. We took action to protect our intellectual property rights by filing three more lawsuits and we sent new or follow-up letters to 40 companies who we think should license our technology.

Also Crossroads is carefully managing a $116 million net operating loss or NOL to shield our future profits from taxation. As we focus on increasing product sales, monetizing our IP and exercising operational discipline, it is foremost in our minds that Crossroads’ success depends on our customers’ success.

Our fundamental purpose is to help customers simply and improve business critical IT operations. Our commitment to solving complex problems with our innovative products provides ongoing value to our customers, partners and shareholders (inaudible).

Finally thank you to our domestic and international team of professionals who continue to exceed customer expectations with world class products and service. I would also like to thank our shareholders for their continuing support.

Now let’s open the call up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Bill Gibson with Legend Merchant.

Bill Gibson - Legend Merchant

Hi Rick. That was a pretty good summary; I just had a clarification question on the settlement gain of the $1 million. Now, does that include the 550,000 StrongBox development payment?

Rick Coleman

Yes. Good question, thanks Bill. We actually had two settlements, the one settlement payment which was $1.1 million and then a $550,000 payment that represented the last obligation for work that had been completed on schedule.

Bill Gibson - Legend Merchant

Okay. Now does that show up in the -- where does that $550,000 payment show up?

Jennifer Crane

That is shown within our revenue line under the IP license royalty and other.

Bill Gibson - Legend Merchant

Okay, that’s it, that was -- I just went so quick I missed it, IP licensing. And I just got a comment for Jennifer, don’t you just love the GAAP accounting on derivatives, is anything I have to run across?

Jennifer Crane

Let me just take a [bite of it].

Rick Coleman

Yes, call probably on that day.

Bill Gibson - Legend Merchant

Thank you.

Jennifer Crane

Thanks.

Rick Coleman

Thanks Bill.

Operator

(Operator Instructions) Your next question comes from the line of Mike Davis with Millennium.

Unidentified Analyst

Hey, how are you? If you could just somehow quantify the market for StrongBox; I know you’ve touched on it briefly last conference call, but is there anything you could say in regard to that?

Rick Coleman

Mike, it’s a huge growing market, that’s all I can say. Every time we pick up the paper to read the trade journals, it’s growing by orders of magnitude. We are looking at the market that’s billions of dollars. Some of it is the displacement of disk; some of it is just ongoing data growth.

Unidentified Analyst

So, what is a fair estimate, what you think you might be able to capture over the next couple of years, is there internal estimate?

Rick Coleman

I think it’s too soon to say. We are going to have to see how distribution partnerships and the OEM partnerships begin to ramp up, we’ve got great confidence in them. But you know these are sales to data centers with limited budgets and the complex purchasing process. So sales don’t happen overnight, sometimes it takes several months. So, we got two things happening, a relatively long sales cycle combined with some distribution partners who are very powerful but in some cases just getting started.

Unidentified Analyst

Great. And also as a follow up, can you -- the patent infringers Cisco, Dell, the others, are they still actively using the product or is it something that they moved on from already?

Rick Coleman

In some cases yes and in some cases no. Some of the products have been discontinued, replaced by others and some are still in use today.

Unidentified Analyst

Can you say which ones are being used today itself, from which companies, or would it make a difference?

Rick Coleman

No, I can’t really say. And it makes a difference because obviously there -- any company who is still using our technology is still generating revenue from it and we deserve a slice of that.

Unidentified Analyst

Right. And is there any estimate on as far as how much revenue that these companies have infringed upon, is there number that you have internally that you haven’t given to the street?

Rick Coleman

We don’t have anything that we can share.

Unidentified Analyst

Okay. Well, I appreciate it. Keep up the good work. Thank you very much.

Rick Coleman

Thanks Mike.

Operator

And there are no further questions on the phone line at this time.

Rick Coleman

All right, thank you operator. Thanks everyone. We appreciate your support and we look forward to talking to you next time.

Operator

This concludes today’s conference call. You may now disconnect.

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