FalconStor Software's (FALC) CEO Gary Quinn on Q4 2015 Results - Earnings Call Transcript

| About: FalconStor Software, (FALC)

FalconStor Software, Inc. (NASDAQ:FALC)

Q4 2015 Earnings Conference Call

February 16, 2016, 16:30 ET

Executives

Gary Quinn - CEO

Louis Petrucelly - EVP & CFO

Analysts

John Zaro - BCM

Operator

Good afternoon and thank you for joining us to discuss FalconStor Software Q4 and Full Year 2015 Earnings. Gary Quinn, FalconStor’s Chief Executive Officer; and Louis Petrucelly, Executive Vice President and Chief Financial Officer, will discuss the Company’s results and activities, and will then open the call to your 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 risks 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 Securities and Exchange Commission, and in the Company’s press release issued today.

During today’s call, there will be discussions that will include non-GAAP results. A 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 Q4 2015 earnings. Copies of the earnings release and supplemental financial information are available on FalconStor’s website at www.falconstor.com.

I am now pleased to turn the call over to Gary Quinn.

Gary Quinn

Thank you, operator, and good afternoon ladies and gentlemen. And welcome to the 2015 Q4 FalconStor earnings call. As I mentioned in our press release we believe that FalconStor aided from it's transition phase when I first took over the company in 2013 July and we are now on a normal operating pattern in 2016 and beyond. Over the last year many of you have wanted more transparency into our performance so that you could measure if we are making progress or not. Since our GAAP numbers don't reflect the transition to a deferred revenue model versus an upfront revenue model and rationalizing the business with many onetime items and exceptions it has been somewhat confusing to see the fires from the trees.

During this call we will provide more insight and we will then measure against that insight during the rest of this year. We will also introduce more metrics as we can obtain them and as they have a more meaningful trend. The marketplace for storage as I am sure many of you know who follow this sector is in a state of transition from legacy suppliers, legacy technologies to new suppliers and newer technologies which have yet to be proven but do look promising. One fact that is overlooked in this transition is what happens to the entire legacy block storage based high performance applications when we hear about cloud, object, flash and hyper converged. Another fact is overlooked is how do enterprise customers and cloud service providers ensure that the transition that we are making to cloud, object, flash and hyper converged is actually delivering better economic performance, human capital performance and better service performance. The only way to know that is by information which is intelligent, predictable and actionable and real time.

I think everyone knows the meaning of this slide so we'll just move forward. During the transition period, we have seen a marketplace in the storage software category that is changing, definitions of the future have been difficult to write down because of the acceleration from traditional legacy block storage based environments to a storage marketplace which has found the need to ensure better use of the investments made obtaining the right performance at the right price in the right locations and finally really delivering on total cost of ownership and human capital maximization. The introduction of cloud, object, flash and hyper converged although probably good but measuring that transition is critical.

We're in FalconStor with our FreeStor flagship product offering believe FreeStor delivers, enterprise class, software defined, intelligent data services combined with predictive analytics across primary or secondary storage hardware in the cloud or on premise. The key term for us here is enterprise class. With FreeStor, we have taken our experience and what is now almost 16 years of being a company to the emerging market world of software defined storage, a category now recognized by IDC with its own segment in the storage software market research reports.

So let's take a look at the available market for FreeStor. What you'll see here is that 2015 according to IDC, the traditional legacy marketplace was approximately $10 billion and was primarily black storage based. The calendar year of 2016 will be a significant transition and push towards the new technologies of object, cloud, flash and hyper converged and that market space is growing from $10 billion in 2015 to $14 billion in 2017.

As we look at this slide, we see that FreeStor currently supports with all it's enterprise price class intelligent data services existing online transaction processing applications. These are block storage based applications and databases which are on primary storage and critical to the existence of most if not all Fortune Global 500 companies today. I recently discovered fact within the FalconStor existing customer install base is that we are delivering value to 23% or 113 of the Global 500 companies in that list today and every day. We make sure the data that runs their companies is protected, available and reliable.

As you transition to the right on this slide you'll see the new technologies that are emerging. No sequel for mobile applications, big data with a dupe [ph] an object as well as a cloud, public, private and hybrid. Over the next 12 to 18 months FreeStor will address and support these emerging technologies to provide a unified block in object storage based environment for high performance applications and databases as well as unstructured data, mobile applications and the ability to take advantage of hybrid cloud typologies in the large enterprises as well as cloud service providers.

The IDC storage software market forecast shows a number of segments which make up the total addressable market for FreeStor. The key takeaway here is that FreeStor addresses a market segment that is growing at a 62% CAGR over the next four years. So we believe we are in the right marketplace and looking at our performance for approximately the last six months of 2015.

We captured 0.1% of the 2016 SDS marketplace with pure subscription transactions. Overall we captured more than that with traditional perpetual licensing to enterprise customers and OEMs. But we’re looking to become almost 100% subscription based with the FreeStor if permitted and we believe that FreeStor and SDS will both require pay to grow or pay to use licensing for the most cost competitive performance for customers. We have already made the switch as a company which has contributed to our GAAP revenue decline during the transition period, but that is behind us now and as you can see. Our normalized deferred revenue balance is increasing minus our one time joint development transaction.

So let's take a look at the addressable market specific to FreeStor. These are the segments with any IDC storage software marketplace report that we address today for our portfolio of technology and the use cases we can address. We are addressing these in a prior the order based upon market adoption, market size and attainable targets that we have set internally. We are focused in the largest growth segment here on this chart. During the next 12 to 18 months to ensure that we can achieve the growth targets for the SDS CAGR. Although some may appear small, we have to develop technology in a way that makes sense from our heritage [ph] offerings, we've also built models internally that capture the entire IDC market but these topics are based primarily on new, new customer acquisition either with FreeStor which is subscription based or new-new point solutions which are perpetual based. We're not forecasting any new to existing customers or maintenance renewal increases during the period on the SDS CAGR, but we’re using the overall IDC software market report CAGR of 5.8% to forecast new to existing customer increases. So what is SDS or software defined storage.

According to IDC there is a discrete model which run storage workloads, software only which is FreeStor and there is a converged model where compute and storage workloads are combined on the same node. We are in a discrete model. IDC has indicated that both models will co-exist in enterprises and service providers depending on their needs. I look at these differences with the following analogy. It's a primary care physician versus a specialist in the medical profession. Both are great for customers and derive more value, the difference is that it depends on where your company started as to where you are software only which is a generalist or converged which is a specialist. Gartner, another prominent industry analyst has a similar view whether these are control plane or a data plane. FreeStor in the control plane because we do not produce nor do we ship hardware with the FreeStor solution. We provide a reference architecture of an x86 off the shelf Linux server for our software and then allow the customer to choose from an extensive list of all flash arrays, hybrid flash arrays and HDD's for their specific needs. Once again Gartner also believes both will co-exist in the marketplace and the customer or service provider needs to make the choice which is best for them.

So as you can see. FreeStor supports the views of both of the industry leading analysts in the marketplace today and we believe we have built and delivered the only software only enterprise class offering that the market can enjoy at this moment. So this is a graphic of who plays where today. As you can see where a number of the players are and this is where the future is going to hyper scale and we believe that a software only solution is the only way for Fortune Global 500 companies to reach what Google, Amazon and Facebook have accomplished with commodity compute hardware and commodity storage hardware.

Now I would like to turn it over to Lou to review the financial results from Q4 and for the year. Lou?

Louis Petrucelly

Thank you, Gary and good afternoon to everyone. As we have all well-documented over the past two years the company has restructured its operations to better align its cost structures to support our future business we have changed our licensing and pricing schemes which are geared towards a ratable and subscription based models and finally we completed product transition in early May with a new flagship product offering FreeStor. All these changes are made difficult for our investors to gauge the progress the company has made over this time, the difficult to provide clear trends moving forward. We are cognizant of these challenges, [indiscernible] and we've been tracking and collecting data on various metrics over the past two years such as new product versus legacy products sales, new customer acquisitions, migration of legacy customers and new product offerings, average life and revenue waterfall effect of the deferred revenues just name a few.

We plan on providing these key metrics in a more systematic and clear manner beginning in 2016 which we believe will provide more meaningful data for investors and shares moving forward. Most of the our discussion this evening will focus on non-GAAP financial measures and key business performance indicators for the quarter. The balance of our financial details can be found in our supplemental and press release which was distributed earlier today which containers our year-over-year results and all the applicable disclosures in accordance with GAAP.

For the fourth quarter of 2015 our consolidated GAAP revenues totaled 9.4 million down 3% compared with the previous quarter in Q3 and down 20% compared with the prior year. During the quarter we had one customer which accounted for [indiscernible] total revenues which was HDS which totaled 34% of our total revenue. As many of you are aware as the strengthening of the U.S. dollar compared several foreign currencies continues to provide some additional headwinds for the company and approximately 60% of our total bookings over the past several years are derived from international markets.

Foreign currency movement had minimal impact on sequential basis however the strengthening of U.S. dollar compared to certain foreign currencies had more adverse impact on our year-over-year results. From a bookings perspective our Q4 total bookings were $10 million up 40% sequentially and down 22% on a constant currency basis compared with prior year. Geographically, all of our regions out-performed the prior quarters booking performances. Sequentially, our Asia Pacific region was flat on both as reported and on a constant basis. Our EMEA region was up approximately 30% on both as reported and constant currency and finally our Americas business was up approximately 12% on both as reported and constant currency.

On a year-over-year basis all were regions were down 20% or more primarily due to a number of large six figure deals which were completed during the fourth quarter of 2014 primarily involving our BTL [ph] solutions which we did not repeat during this year. For a full year of 2015 18% of our total bookings with the rights of new product sales compared to our internal target of 35%. Total bookings of existing product sales which were 40% compared with our internal target of 25% and finally total booking for means renewals were 42% compared with our internal target of 40%.

As you can see we have been successful in achieving our mix of bookings goals for both our existing progress and means renewals and we will continue to focus on improving our new product putting results in 2016. We believe this is the upper mix of bookings to support our growth initiatives to expand our store base of customers and grow our new customer acquisitions.

With the introduction of Greenfield [ph] technology in early 2015 in FreeStor subscription platform in late May, over 170 customers have purchased and placed in production these solutions with a subscription or perpetual model. We have 15 customers which is under [indiscernible] of data that are utilizing the FreeStor subscription model which will either [indiscernible] monthly, quarterly or annually depending on the specific contractual arrangements. As we true up customers we will provide metrics on capacity growth to provide enhanced color around expectations of existing FreeStor customer expansions based upon these stroke [ph] trends. We are pleased with the early adoption rate of the Greenfield technology considering our historical sales cycle of nine months to one year of our legacy products. We continuously pipeline growth of our FreeStor product line and response to our early success and positive feedback from within the industry.

Next, I will turn to non-GAAP expenses which excludes any restructuring charges, legal cost and stock based compensation. We are pleased that we have maintained our cost structure and during the quarter our non-GAAP expenses totaled $10.7 million compared with $11.8 million in the previous quarter. Our non-GAAP operating expenses were $8.5 million compared with $9.4 million in the previous quarter and our non-GAAP loss from operations improved to $1.3 million as compared with $2.1 million in the previous quarter.

Our non-GAAP gross margins were 77% compared with 75% in the previous quarter. We closed the quarter with 220 [ph] employees worldwide compared with 263 last year. We believe our existing expense structure has been optimized and we expect to have a consistent expense run rate throughout the year even as we make incremental investments in support of our near term objectives. We continue to focus on improving the productivity of our existing resources while prudently investing into the business.

Turning to our balance sheet, as of December 31th, we have $13.4 million in cash, cash equivalents and marketable securities compared with $21.8 million as of December 31st, 2014. As we discussed throughout the year, we continue to make strategic investments back into the business in support of our new product releases. During 2015 we spent approximately $1 million on both milestone and development service payments associated with the exclusive source code license agreement we entered into with Cumulus Logic during the second half of 2015. We have also made incremental investments in advanced technology activities deferred available of FreeStor for future generations including FreeStor analytics which we expect to release by the close of Q1.

We have also increased field marketing investments of over 50% from the prior year to support of marketplace awareness of the FreeStor platform. We continually monitor our cash balances and evaluate each quarter the best use of our cash and our stock as currency to enhance our shareholder value to invest in sales, marketing and technology services. Based on our go to market activities the early adoption rates of our FreeStor technology and our internal forecast, our goal will be to breakeven or better on cash flow from operations our full year basis for 2016.

Excluding the historical impacts of our join development agreements as a December 31, our deferred revenue totaled 25.7 million compared with 25.2 million for the same period in 2014 and 24.8 million with the previous quarter, an increase of 2% and 4% respectively. We are pleased that we have been able to maintain our deferred revenue balances and continue to focus on securing bookings and improving our maintenance and support renewals.

As of December 31, approximately 20% of our deferred revenue balances were related to product revenues as compared with 22% at December 31, 2014 and the average life of our deferred revenue was approximately 2.1 years.

Finally I want to point out to our shareholders that in the coming days we'll be following a formal S3 registration statement once we file our annual Form 10-K. You may recall that we've entered into an exclusive source code license agreement with Cumulus Logic during the third quarter of 2015 and we anticipate the completion of those milestones within the next 90 days.

Additionally we also anticipate achieving milestones in 2016 associated with the independent marketing agreement with RFA [ph] and Prime Marketing we had during the second quarter of 2015. Both these agreements provides for issuance of the company's common stock as payment for services and/or achievements of milestones and [indiscernible] for the registration of such stock issuance as applicable.

In summary as I stated earlier, we recognize maybe difficult to clearly see the progress we have made during the transition and success we've had in executing our plan. As we head into 2016 we plan on expanding our key metrics to better highlight our path to success and work to improve on all of our key metrics. We remain excited and focused and Gary and I look forward to updating everyone on our progress on our next call. This concludes the financial highlights and I'll now turn the call back over to Gary. Gary?

Gary Quinn

Thanks, Lou. You want to give me some breakdown of the routes to market and license types associated with them. As you can see from this slide we've delivered FreeStor and FreeStor technology to approximately 170 customers. The subscription model is associated with enterprise customers and managed service providers. As we true up those customers either monthly, quarterly or annually we will begin to show you the modeling of how many customers true up. How much additional capacity they are adding and how much they're paying on average. As you can see for the next couple of slides. This is just a hypothetical example of what happens when you sell a subscription model to a FreeStor customer or to a service provider.

If we had a single customer in the year and $35,000 with 100 terabytes and we renew that customer in year two and they grow 20% and we could sell to another customer in year two $35,000 at 100 terabytes and then in year three we have two customers both renewing and growing at 20% per year and we add an additional third customer in year three at the same $35,000 of 100 terabytes that finally in year four we now have three customers who all started with 100 terabytes, they've grown 20% each year and we’ve added a fourth customer in year four The result is we have got from an annual subscription revenue model of $35,000 in year one to $196,000 in year four. This is how we expect to grow with new, new FreeStor customers over the next four years and achieve the IDC SDS CAGR growth rates.

So at the moment as I mentioned we sold a subscription deferred revenue model in 2015 0.1% of the 2016 SDS estimate by IDC. Our goal is to achieve over period of time from 2016 to 2019, 1% to 2% of the SDS IDC market forecast for the next four years.

That’s the end of our presentation. Operator can you compile the Q&A roster.

Question-and-Answer Session

Operator

[Operator Instructions]. Our first question today comes from [indiscernible] with AIGH Investment Partners. Your line is open.

Unidentified Analyst

In terms of the actual renewal cycles when you mentioned at the end of the call what we will be able to see. You know when do those renewal cycles actually start? Is it May of this year or is it the last year May when do we really begin to see what the customer are doing? The early customers?

Gary Quinn

I know a number of the investors out there as well as industry analysts are trying to understand how FreeStor works, the licensing, the subscription and when do you see the progress. So to refresh everyone's memory FreeStor was initially released for general availability in May of 2015. We brought our first few customers in that quarter in June of 2015. So we have seen one of those customers who was on a quarterly true up model begin to already true up into Q3 and Q4. The other customers were on an annual basis. To answer your question directly we should start to see the first annual or additional quarterly true ups from those Q2 customers beginning in the end of Q2?

Unidentified Analyst

And then in terms of reaching your goal for the year-end in terms of cash flow does that mean that it's going to be by definition more back-end loaded just because that’s when you’re going to see the renewal?

Gary Quinn

Well we also have renewals from our other customers from the traditional perpetual licenses that you saw where we are selling more to existing customers or just renewing our normal maintenance contracts, but at the moment from the model that we've built internally it's probably not as back end loaded as we were over the last two years where we expected to be positive by Q4 it's a little sooner than that if everything goes as planned.

Unidentified Analyst

Okay. And finally HDS [ph] how do we view them on a go forward basis as a piece of the pie?

Gary Quinn

Okay. So HDS I would view as opportunistic for us. HDS was a larger partner back in the 2011, 12, 13 time frame. We were selling both large part hardware configurations as well as software with them on a legacy practical [ph] virtual table library as if you follow the sector traditional backup or backup to a virtual tape target or even tape although it still existed is not really growing it's quite saturated, there is probably some share shift going on between EMC and Data Domain and a couple of others that relationship has transformed over the years to a non-FalconStor hardware relationship, it's purely software. About a year and a half ago, HDS bought a product called Sepaton which is a competitor to FalconStor's offering. Their sales organization has started to sell that. So I would not view them as a contributor going forward, it's really more opportunistic on a one off deal here and there where our technology is better than Sepaton or we have existing installed base costumers who like the technology and are renewing and expanding and that continually happens today.

We've also seen a number of people who are originally Hitachi customers moved to a back to business service model so we went from perpetual based with annual maintenance contracts to now subscription based on monthly fees based upon capacity. But I would consider that HDS as more opportunistic if anything else.

Operator

Our next question will come from [indiscernible]. Your line is open.

Unidentified Analyst

Question in respect to this refilling, can you be specific on what the restrictions on the shares would be?

Louis Petrucelly

Restrictions were purely around the actual registration of the shares itself which is why we’re filing the share registration bill?

Unidentified Analyst

Meaning they can sell the shares?

Louis Petrucelly

Yes once the registration goes effective if the shares had been issued, they are clear and free to be solved that’s correct.

Unidentified Analyst

And the date of that is what?

Louis Petrucelly

The filing? We’re not filing a conjunction, we file our 10-K so I would expect it this week.

Unidentified Analyst

And as FreeStor begins to ramp up on that sequential growth basis, do you’ve an internal goal for that?

Louis Petrucelly

I'm not sure if I understand.

Unidentified Analyst

I just noticed that I can't go back on this meeting, but you showed sequential growth on FreeStor 4% I think, Q3 to Q4?

Louis Petrucelly

That’s on deferred revenue piece.

Operator

[Operator Instructions]. We will go next to John Zaro with BCM. Your line is open.

John Zaro

The S3, how many shares are it for?

Gary Quinn

It's for a dollar amount actually, it's not the number of shares.

John Zaro

And as time goes on you guys will, I'm assuming will have some -- I mean you've kind of modeled out an example of what would happen in the back of this? And what would happen for each of these subscription model for FreeStor as opposed to the perpetual? But I'm assuming that we'll be able to put some dollar numbers around those -- as we go by quarter to quarter.

Gary Quinn

Yes, so John I mean I think you can extrapolate at the moment the 0.1% of the 2016 SDS value from the IDC report, okay is what we’ve achieved in the second half of '15 already. In addition to perpetual licenses that came through OEMs or customers who just we're not able to move on a subscription model to be their procurement organization. So those numbers are significantly higher like you said we have a 172 customers in total, 15 are on the subscription model so far. We are leading with three stores in the subscription model in every deal in our pipeline today. Some of those will drop out to traditional perpetual models just because the customers unable to act on a subscription.

To answer your question, we will start to produce – you could probably back into it, if you look at the chart which shows new customers, existing customers’ renewals if you back that into the bookings values from the company. I think you could basically start to model that out, but we will start in Q1 to give you new customer counts, buy licensed model, buy value and go forward from there. So, then you will be able to populate your model, but at the moment we are giving you just a little bit. We just want to really do that in whole of 2016. It is a little too confusing I think to model out 2015 at the moment.

Louis Petrucelly

To answer that John, we will also add on as we have indicated when they renew and the growth they have so kind of get a hopefully get a feel for a trend for what customers are growing on the renewals.

John Zaro

And not the sort of I think I know your answer so I won't be offended. You’re supposed to be cash flow breakeven or start to see that in the third quarter?

Louis Petrucelly

Of what?

John Zaro

2016.

Louis Petrucelly

I think we have our internal target as Gary indicated that we plan on as opposed to '15 we were very heavy back-loaded I think our internal targets it's in our forecast what we see in the pipeline. We expect that to be sooner and also sooner you can hopefully use your judgment [on what you want to say] but I mean I'm not saying it's going to be the fourth quarter. Again it's all around us are executing on our pipeline.

John Zaro

And you don't want to put a revenue number on what that’s going to be?

Gary Quinn

Again we are more focused on the bookings of billing side right now John. The revenue will take care of itself as we are able to build that pipeline of booking and billings...

Operator

And with no questions remaining, I would like to turn the call back over to management for any additional or closing comments.

Gary Quinn

Well I think as you can see we reached out to a number of investors over the last year. We’ve commented on what we are providing, what they would like to see. I think there's a lot more to talk about inside FalconStor today with the FreeStor product offering. The software defined storage marketplace is actually quite exciting I think it's important for you to know that it's either software only or it's a hybrid converged and there's a number of legacy players as well as new kids on the block as we like to call them. And the opportunity is big, it's a large growth market over the next few years. And we think we find ourselves right in the middle of that at this moment. So I'd like to thank everybody for their patience with us over the last couple years in the transition and we look forward to a very nice 2016. Thank you very much and good night.

Operator

Ladies and gentlemen that does conclude today's conference. We thank you for your participation.

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!