Crossroads Systems' (CRDS) CEO Rick Coleman on F2Q 2014 Results - Earnings Call Transcript

Jun. 5.14 | About: Crossroads Systems, (CRDS)

Crossroads Systems, Inc. (NASDAQ:CRDS)

F2Q 2014 Earnings Conference Call

June 5, 2014 16:30 ET

Executives

Rick Coleman - President and Chief Executive Officer

Jennifer Crane - Chief Financial Officer

Analysts

Bill Gibson - Legend Merchant

Edward Schwartz - Schwartz Investments

Steve Smith

Dick Feldman - Axiom Capital

Operator

Good afternoon and thank you for participating in today’s conference call to discuss Crossroads Systems’ Financial Results for the Fiscal Second Quarter ended April 30, 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 Inc., 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 our expectations regarding future growth, operating and financial results, market demand or opportunity for our products and developments and litigation we maybe involved in 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 and 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 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. 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 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.

Rick Coleman

Thank you, Mike. Good afternoon. Last year, Crossroads launched a turnaround strategy to put our product business on a path to profitability and realize the substantial value of our intellectual property assets. Our product distribution strategy had us spending too far ahead of near-term revenue and we were rapidly draining our cash reserves. In addition, our intellectual property monetization efforts were stalled. Our litigation tested 972 portfolio has generated $61 million in revenue, but most of which – most of it had been reinvested in additional research and development. This resulted in a rich patent portfolio, but despite the success of the 972 monetization campaign, the company had not initiated legal action against some of the largest infringers.

Also, nothing had been done to evaluate the assets in our non-972 portfolio. In November, we took the first steps toward monetizing these assets when we engaged a team with IT experts to perform an extensive portfolio analysis and give us our first indication of the portfolio’s potential value.

Today, we will share the highly encouraging results of their analysis. We will also provide an update regarding the 972 litigation recently announced steps to protect our net operating loss and major new developments with StrongBox. Our CFO, Jennifer Crane will start by addressing and discussing our second quarter operating results.

Jennifer Crane

Good afternoon. We issued a press release of the financial results of our fiscal second quarter of 2014. Total revenue was $2.3 million, a decrease of 16% from $2.7 million in the second quarter or the same quarter a year ago. The year-over-year decline in revenue is primarily the result of less recurring intellectual property revenue and declining SPHiNX revenue from our legacy HP relationship. Quarter-over-quarter revenue declined $1.8 million and is mostly attributable to three factors. The first factor is the one-time $550,000 payment we received in Q1 for a terminated service agreement. Because this was the final payment, there was an expected decline quarter-over-quarter.

Secondly, Crossroads received nearly $1 million less recurring IP royalty revenue in Q2 compared to Q1. In our last call, we described the unexpected and dramatic increase in IP royalty revenue to one of our licensees, Texas Memory Systems. The payment came following IBM’s acquisition of the company and our subsequent sales of licensed products. After investigation, we now know this was a one-time event. And consistent with our publicly announced strategy, IBM has transitioned to their own version of the product, which is covered by a fully paid up license. We expect future IBM royalty payments will be insignificant and have adjusted our forecast accordingly.

Finally, in the second quarter, HP OEM SPHiNX product and maintenance revenue decline much faster than anticipated. Although our visibility to HP’s plans for our legacy SPHiNX product has always been limited, we have previously shared with investors our expectations for declining revenues. Nonetheless, the $427,000 decrease in Q2 was well beyond our most pessimistic expectations. Based on this development, we have also updated our forecast to reflect the steeper revenue decline.

StrongBox revenues did increase 145% in Q2 from the same quarter a year ago. StrongBox sales in the second quarter were $621,000 including a final payment of $200,000 from Fujifilm as a result of successfully completing our custom development agreement.

Operating expenses in the second quarter totaled $3.6 million compared to $5.8 million in the same period a year ago. The 37% decrease was primarily due to the October 2013 reduction in force as we adjusted our product distribution strategy. Operating expenses also decreased $265,000 compared to Q1 of 2014. I anticipate our operating expenses for fiscal year 2014 will be within our previously issued guidance of $40 million to $60 million.

In Q2 we completed the financing led by Crossroads’ Chairman, Jeffrey Eberwein and two other existing investors for net proceeds of $4.3 million. The additional capital and significant reductions in our cost structure enabled us to regain NASDAQ compliance on April 8, 2014. In Q2 loan payments to Fortress were $865,000. On May 13, we used a portion of our recent financing proceeds to repay $2 million towards the principal amount on one of our two Fortress loans.

The prepayment will reduce monthly principal payments by $83,000 beginning in July of 2014. Interest expense will also decrease $239,000 over the life of the loan. In Q3 we will pay approximately $1 million towards the Fortress debt. We have made notable progress towards reducing our Fortress debt and our original $10 million loan now have the balance of $6.9 million. Net loss available to common stockholders in the quarter was $1.8 million, a $0.14 loss per share as compared to a net loss of $4.8 million or $0.41 loss per share in Q2 of 2013, a 62% decrease in net loss.

Cash used in the quarter was approximately $900,000 excluding Fortress debt service. We ended the second quarter with the cash balance of $10.7 million compared to $8 million at the end of Q1. On May 23, our Board of Directors approved the tax benefit preservation plan designed to protect one of our most valuable assets, $128 million net operating loss. The ability to benefit from these NOLs is an integral part of our previously announced business plans. Our NOL tax benefits will be used to offset up to $128 million and future tax liabilities for net income including product revenue, intellectual property royalty revenue and income from mitigation settlements or awards at trial.

On May 29, we filed the registration statement with the Securities and Exchange Commission. The S-3 statement registered for shares following the March financing replaces our previously issued S-1 filing and as of many larger (indiscernible) companies who maintain active shelf filings reflect the natural part of our corporate evolution.

I will now turn the call back over to Rick.

Rick Coleman

Thanks, Jennifer. Despite the legacy revenue setbacks Jennifer mentioned, we made dramatic progress this quarter on the evolution of our StrongBox product family. StrongBox revenue was on plan for the year and we still expect modest growth over the next few quarters. More importantly after a year of intense preparation, we are announcing an important milestone in our repositioning of the products to fully leverage our major technology and costs advantages.

In spite of its robust feature set and proprietary technology, our StrongBox opportunities were limited to specific technology environments and to use cases where our customers sell them or never required access to their archive data. Today, all that has changed, we have completed critical development that allows us to aggressively attack the network attached storage market. NAS represents a very high growth $5 billion plus market that is extremely price sensitive.

We are now ready to offer our hybrid disk tape based NAS solution that costs dramatically less than traditional disk based NAS, but with the reliability and performance customers require. This is a game changer. We see no one positioned the way we are to take all the price sensitive NAS market with a clearly lower cost solution for customers with large datasets.

In the second quarter we had high profile StrongBox wins from the Texas Rangers baseball club and Lions Gate one of the world’s leading entertainment companies. We also signed a new partner agreement with Imagine Communications, formerly Harris Broadcasting, the leading provider of media software and networking solutions to more than 3,000 media and broadcast customers.

Overall, we have come a long way from the last year and I am proud of our progress. In July, we will release important new StrongBox functionality that will position us to go head to head with NAS storage leaders like EMC, NetApp and IBM, but with the compelling cost advantage. As I said before, it will take some time for our sales partners to develop a reliable pipeline and quarter-to-quarter revenue will be lumpy during this period. But I am still excited about our long-term prospect for success.

Now, I would like to turn to a discussion of our intellectual property assets. In 1999, our engineering team began inventing the technology that forms the foundation of much of the storage industry today. The patented innovations they created foresaw how companies would address the challenge of storing the world’s valuable and growing content. We are now seeing the evidence of that leadership, not only in the evolution of our own products, but also in the licensing opportunities associated with storage industry products that use our patented technology. For those of you new to Crossroads, we have two distinct intellectual property portfolios. The first, our 972 portfolio has generated over $61 million in revenue and is the focus of our recent patent infringement lawsuits against Oracle, NetApp, Cisco, Quantum, Huawei, Dell and Dot Hill.

Last month, we reached a licensing agreement with Tandberg Data, one of the smaller defendants and that suit has now been resolved. While the settlement demonstrates our commitment to our strategy of enforcement against infringers of the 972 patent family the infringing revenue in this case was small and the financial impact of the settlement was not material to our operations.

We understand there is a lot of interest in our enforcement efforts, but I want to remind investors that we will be cautious about protecting our litigation strategy and very selective about our public announcements. The cases are moving forward and we are now scheduled to have the single Markman hearing on October 6 and 7 2014 with all 7 remaining defendants. These dates are still subject to change and we will not be providing real-time updates to the court’s calendar. However, court documents are publicly available for interested investors.

The October Markman will be Crossroads 4 related to the 972 patent family. In previous cases, the Western District Court of Texas has typically issued a Markman ruling within a couple of months after the hearing. Another detail investors should remember is that each lawsuit has a distinct set of products we believe infringe on our patents. The manufactured source, unit sales, and precise revenue figures of the infringing products are generally not available to us until they are revealed in discovery. Therefore, the potential value to Crossroads of each lawsuit may vary significantly. Many of you have asked for financial guidance regarding our litigation with the 7 remaining defendants.

I will do my best and provide some context, but as a matter of company policy and good legal judgment, we won’t provide estimates regarding the potential revenue from settlements or from jury awards. For products that are found to infringe in litigation, awards primarily hinge on the amount of revenue generated from the infringing products. Companies with the highest infringing sales generally represent the highest potential value for Crossroads. Unfortunately is seldom possible to know a company’s sales volume for a particular product until that information is provided in discovery or in confidential settlement discussions.

Settlements of litigation often include a lump-sum settlement for past infringement and a royalty on future sales through the life of the patents. It’s also worth noting that companies sometimes trade for cross license patents in lieu of or in addition to cash settlements. In some previous cases, Crossroads has negotiated a fully paid up license combined with the cross license to patents of the licensee. Some historical context may also be helpful.

Over the last 13 years, Crossroads has received over $61 million from companies using our patented technology. Crossroads is now in litigation with some of the industry’s largest storage companies. The royalty rates on patent awards depend on many factors, including the possibility of cross licensing patents, which may have valued the Crossroads and on the specific payment structure. In a prior case in the Western District Court of Texas, Crossroads was awarded 3% and 5% royalties on two different infringing products. Past success is no guarantee of future success, but it does help provide some guidance to the fact that we believe Crossroads could receive a meaningful amount of revenue here toward successful in litigation.

Now, let’s turn to the non-972 patents. The portfolio consists of 117 patents and pending patents that have not been the focus of the licensing campaign. In July 2013, Crossroads completed an IP backed line of credit with an affiliate of Fortress Investment Group guaranteed in part by the non-972 portfolio. During due diligence their intellectual property experts performed their own review of the patents and Fortress’ analysis was sufficient to justify the line of credit. Shortly thereafter we initiated additional analysis to help us determine the best course of action for our shareholders. After considering several firms, Crossroads selected a well respected patent valuation team to begin an in depth analysis.

The principles of the firm have decades of history researching, valuing, selling and licensing patent portfolios. They were paid a flat fee and task to provide an unbiased stack based professional opinion on the monetization potential of the portfolio. We did not guide them to any specific outcome and we did not see the results until their five months analysis was complete. Obviously, the goal of the research was to provide us an indication of the infringing products revenue associated with the patents and thus their potential life time value.

As I mentioned a higher infringing products revenue number would imply a higher potential licensing value. Before we present their findings let me provide some background on the patents and some details on how the analysis was performed. The non-972 patents were developed over the course of 14 years during our extensive research and development efforts. As you might expect most of the patents related to data storage innovations. The average remaining life on the patents is 11.3 years. This is a favorable term when considering the potential value of the portfolio because the patents have been in use long enough to be incorporated into many revenue bearing products, but have also long enough remaining life to represent continued value for Crossroads.

The analysis followed an extensive and disciplined process. First the patents were grouped into five logical patent families. The team also identify the subset of patents that have the deepest reach into commercial markets and then painstakingly performed a claim by claim analysis to determine the strength of each patent. After identifying the applicable commercial markets the size of each market was estimated using publicly available market research. Each commercial market was subsequently adjusted lower to exclude potential foreign revenue because most of the Crossroads patents are only filed in the United States.

After estimating the market share of possibly infringing companies using publicly available information one final adjustment was made because some companies have historically been granted licenses to portions of the non-972 portfolio those companies were completely excluded from the commercial estimates. The remaining available market is an estimate of the amount of past and future products revenue from products that potentially infringe on our non-972 patents. This is the number that gives us our first insight into the portfolio’s potential value.

After all the downward adjustments, the third party valuation team estimates the Crossroads may be entitled to a share of over $82 billion in estimated industry sales over the life of our patents. In other words, past and projected revenues of products that may infringe our patents are estimated to be over $82 billion. Investors may question how this number could possibly be so high? The answer to that is partly in the rapid growth of the industry and partly in the fact that in some cases, our patents anticipated the evolution of industry standards by a period of years. This means that years before the industry agreed upon a particular solution to a particular problem, Crossroads was already focused on this problem and have conceived of that very solution. Quoting the analysis report, the company did this not once, not twice, but three independent times and continuing to quote. Crossroads is probably the most innovative company in the entire SAM, or storage area networking market.

Our future efforts will be directed to determining which of the companies, whose products comprised of revenue impacted by our patents should fairly compensate Crossroads and our investors for their infringement of our intellectual property. $82 billion is a massive opportunity. And we spent many hours challenging this number before deciding to provide this information to investors. In the end, we concluded that while the precise $82 billion estimate is only an indication of potential value, investors should be well informed of the enormous scope of this opportunity. There is much work to be done and many factors will come into play as we move down the monetization patents.

I also want to be very clear I am not guiding investors to a specific revenue number instead I am quantifying the sizable market opportunity upon which the company can mount a new licensing campaign. Similar to our 972 campaign, the outcome is uncertain, may take years and could be costly. Nonetheless, the magnitude of the opportunity is staggering and even a modest recovery rate on a small portion of the potentially infringing revenue would mean a significant return for our stockholders. In the coming months, we will be reviewing our monetization alternatives. We have not yet settled on the strategy in the development of a specific course of action may take several months.

In summary, I am excited about our future. We still have challenges, but they are small compared to our opportunities. We have made dramatic progress. There is unrealized value in Crossroads product family and our intellectual property may represent an even larger payoff for patient investors. In total, we believe our IP assets represent disproportionate value to the size of our company or to our market capitalization. We won’t unlock this value overnight, but Crossroads has a proven core competency at developing and monetizing technology. Our management team and Board of Directors are aligned with our stockholders and excited about delivering strong returns to our investors.

Now, let’s open the call up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Bill Gibson with Legend Merchant.

Bill Gibson - Legend Merchant

Hi, Rick.

Rick Coleman

Hi, Bill.

Bill Gibson - Legend Merchant

It’s hard to get my brain around the $82 billion potential sales number.

Rick Coleman

We have a big problem.

Bill Gibson - Legend Merchant

So, I want to focus back on operations. I mean, we had a disappointing second quarter. And I thought I heard you were stating by your revenue guidance, but I know before you planned on being cash flow positive from operations this fiscal year, is that still the case or do we burn a little cash?

Rick Coleman

I’d say at this point it’s too soon for me to change our revenue guidance.

Bill Gibson - Legend Merchant

Okay, good. Well, thank you. And I mean it’s going to be fascinating going forward. I am glad you took steps to preserve the NOLs.

Rick Coleman

Thank you.

Operator

Your next question is from Edward Schwartz with Schwartz Investments.

Edward Schwartz - Schwartz Investments

Hey, Rick. Hello and thank you for taking the call.

Rick Coleman

Of course.

Edward Schwartz - Schwartz Investments

I would like to say as an investor, your Investor Relations department is very good at getting back to me and the other people I know that have invested in, in Crossroads on a timely basis. So, we thank you. And I have a question on the shelf registration that you recently did, do you – suppose you tell me about your plans between now and the end of the year for doing any secondaries?

Rick Coleman

At this point, we don’t have any plans. We are always paying attention to the market and we are always aware of the potential that we may need to raise money again. But at this point that’s all I can say.

Edward Schwartz - Schwartz Investments

Okay. So based on your projections, if things fall the way you see they are going to fall you don’t think there will be any secondary by the end of the year?

Rick Coleman

I can’t say they will, I can’t say that they won’t, all I can say is that we are going to pay attention closely to market conditions and what the needs of the company might be going forward. We got a lot of work to do to really understand the impact of – in particular the non-972 patent family and what that will need. And so that’s just where we are at.

Edward Schwartz - Schwartz Investments

Okay thank you and best of luck.

Rick Coleman

Thank you very much.

Operator

(Operator Instructions) And at this time this concludes our question-and-answer session. I would now like to turn the call back over… We have a call from (Steve Smith). Your line is open.

Steve Smith

Yes, I have a question I want to know when do you think that you were have quarters that it should be a profitable and you would have some kind of results that investors are waiting for, I was hoping that this company is a turnaround company, I hope I am right and I wanted to see that if you have the same feeling or not and how soon do you think that you would show profits and show a tremendous increase in revenues? Thank you.

Rick Coleman

I will address the last part of your question first and tell you that we have got approximately 50 incredibly talented and incredibly motivated and incredibly focused employees who believe this is a dramatic turnaround. We are working everyday to make that happen. As far as the first part of your question is to when we could expect to have a profitable quarter, I think in the short-term much of that depends on the outcome of some of our intellectual property work. Longer term as our OEM and strategic partners gain traction in the market with StrongBox especially with our new positioning and to a much larger market, I think we are going to continue to see product growth. But again unfortunately can’t predict when we are going to cross that line.

Steve Smith

But do you have feeling that I mean that when you work for the company and you represent the company, you should have for the good idea or better idea than I view as an investor that whether resulting in the matter of three months, six months, one year, two years?

Rick Coleman

Our previously issued guidance was that we would be cash flow positive from operations in 2014. And as I have mentioned earlier at this point I think it’s soon for me to change that guidance.

Steve Smith

Okay. And my last question is that do you think that the next quarter I mean your third quarter would be better than your second quarter as far as revenue and income?

Rick Coleman

Certainly, my hope and further desire, that every quarter will be better than the previous one.

Operator

(Operator Instructions) Your next question is from Dick Feldman with Axiom Capital.

Dick Feldman - Axiom Capital

Hi and thanks for taking my question. You talked about in July rolling out the new form of StrongBox, does that automatically go to all your existing distributors and have they already previewed the product and have you gotten any feedback from them?

Rick Coleman

We have gotten feedback from them about the product’s capabilities. We have been talking to them and to a number of customers about this for quite some time back as with most really successful and innovative product development. The idea typically comes from a customer. So we made a lot of different product enhancements in the quarter and those include a number of major performance and user interface initiatives, a dramatic pricing simplification with more options for unlimited capacity. And we have provided now a simple and integrated way to move files off of primary disk storage and on to the StrongBox. The enhancement in July will give us the last major thing that we need to really go head to head with industry’s major players. And we know for a fact that much of the industry’s data is stored on storage license that are simply inappropriate. We have a much better solution that is much less expensive.

Dick Feldman - Axiom Capital

And to what extent will you be able to – are you going to use your partners marketing resources and to what marketing resources can you on your own focus upon this potential?

Rick Coleman

As you recall last year we withdrew most of our sales and marketing resources so that we could focus on a distribution strategy that takes us to market with OEM and strategic sales partners or value added resellers that is still our strategy. But there is the potential down the road that we can begin reinvesting in more sales and marketing on our own.

Operator

At this time, this concludes our question-and-answer session. I would now like to turn the call back over to Mr. Coleman. Sir, please proceed.

Rick Coleman

Thanks operator. Thanks everyone for joining us today. I think we have had quite a bit of exciting news. We are certainly excited here. I hope you share our enthusiasm 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.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!