FalconStor Software's (FALC) CEO Gary Quinn on Q1 2016 Results - Earnings Call Transcript

| About: FalconStor Software, (FALC)

FalconStor Software, Inc. (NASDAQ:FALC)

Q1 2016 Earnings Conference Call

April 27, 2016 4:30 PM ET

Executives

Gary Quinn – Chief Executive Officer

Louis Petrucelly – Executive Vice President and Chief Financial Officer

Analysts

Laura Drynan – Bourgeon

Operator

Please, standby. Good afternoon and thank you for joining us to discuss FalconStor Software Q1 2016 Earnings. Today’s call is being recorded. 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 the 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 Q1 2016 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, good afternoon ladies and gentlemen. I believe that we should get straight to the financial performance of the company today, so I am going to have Lou Petrucelly go through those numbers first and then I am going to give you an updated overview of the software-defined storage marketplace and how FreeStor is doing in that marketplace with routes to market numbers, customers and growth.

I want people to understand that we did not meet our overall internal targets this quarter as a company, but we did meet and exceed our FreeStor metrics. We recognize that some of you maybe disappointed by the accounting numbers, but the FalconStor Company with FreeStor is making great strides in outperforming many privately-backed software-defined storage companies. We believe we remain capable to continue through the year and build up on the FreeStor momentum to achieve our annual goals.

I’ll turn you over to Lou. Lou?

Louis Petrucelly

Thank you, Garry. Good afternoon to everyone. Most of our discussions this afternoon will focus on non-GAAP financial measures and on the 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 contains our year-over-year results and all the applicable disclosures in accordance with GAAP.

For the first quarter of 2016, our consolidated GAAP revenues totaled $7.4 million compared with $9.4 million in the previous quarter and $8.7 million in the previous year, excluding $11.3 million of revenue that was associated with our joint development agreement. During the quarter, we had one customer, which accounted for more than 10% of our total revenues, which was HDS and that was 11% of our total revenue.

From a bookings perspective, our Q1 total bookings were $7.4 million compared with $10 million in the prior quarter and $11.7 million in the prior year. As Gary just indicated while we do not hit our overall internal targets for both the bookings and GAAP revenue perspective, we were pleased there are new product platform FreeStor, exceeded our bookings from all of 2015 as this platform continues to gain market acceptance and adoption. However, the bookings associated with the FreeStor platform failed to makeup the declines in our traditional product lines, which we will touch on later in the presentation.

Next, I want to turn to our non-GAAP expenses, which exclude 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 $10.6 million compared with $10.7 million in the previous quarter and $13 million in the prior year. Our non-GAAP operating expenses were $8.7 million compared with $8.5 million in the previous quarter and $10.7 million in the previous year.

Included in our non-GAAP expenses for the quarter was approximately $360,000 of cost associated with the exclusive source code license and development agreement with Cumulus Logic, related to our newly enhanced functionality of predictive analytics for the FreeStor platform. Our non-GAAP gross margins were 73% compared with 77% in the previous quarter and 72% in the previous year. We closed the quarter with 224 employees worldwide compared with 254 at the same period last year. And we believe our existing expense structure has been optimized but we will continue to focus on improving the productivity of existing resources while prudently investing back into the business.

Turning to our balance sheet, as of March 31, we had $11.4 million of cash, cash equivalents and marketable securities compared with $13.4 million as of December 31. As we discussed over the past 12 months, we have continued to make strategic investments back into the business in support of our new product releases. We have also made incremental investments in advanced technology activities to further develop available of FreeStor for future generations including FreeStor analytics, which we completed during the first quarter.

We will also continue to make marketing investments to support the marketplace awareness of the FreeStor platform. Finally, as of March 31, our deferred revenue totaled $25.7 million, which was flat compared to previous quarter and deferred revenue continues to be the key metric for our company and one of our primary focuses is to maintain and grow our deferred revenue balances as we continue to focus on securing bookings and improving our maintenance to support renewals. As of March 31, approximately 29% of our deferred revenue balances were related to product revenues compared with 28% at year-end and the average life of our deferred revenues was approximately 2.3 years.

And now, I would like to turn the call back over to Gary, while he’ll provide you an update on the FDS marketplace and some color on FreeStor routes to market and adoption success rates. Gary?

Gary Quinn

Thank you Lou for that update and now I'd like to turn to the marketplace and provide you with some color on what is happening today in the storage hardware, storage software and the storage cloud opportunity.

As you see in this slide from our Q4 2015 earnings call and I would like to remind you that the storage business in all categories is going through probably the greatest transformation to hit the storage marketplace since its beginning. We see tremendous growth opportunities, but there is going to be some shakeout of traditional suppliers and there will be new entrance for the repositioning of existing suppliers.

We believe that FalconStor with its FreeStor solution has consciously made the transformation at the technology level and continues to make progress with FreeStor on the commercial side of the business although not enough yet. Just a reminder that the space we are addressing is known as the software-defined storage, or SDS. It is predicted by IDC according to their reports in September 2015 to grow at a 62% CAGR.

I will review some additional reporting from Gartner and the 451 Group to show you the progress of this market's adoption and trajectory. As you could see from this slide, the available markets that FalconStor has addressed and will address in the coming 18 to 36 months include not only blocked or performance storage, which is used for applications and databases, but also objects which is more a scale out focus for unstructured data. It is not heavily adopted yet except for the use of the public cloud based solutions, which are primarily being used for backup business service, Disaster Recovery-as-a-Service and for development and testing activities.

A lot of companies have not moved their primary workloads into the cloud and these workloads are either block-based storage or file-based storage. Our most successful route to market for FreeStor is the managed service provider marketplace, which is providing backup business service, Disaster Recovery-as-a-Service and database as a service because they’re usually block-based and we are adding a number of requirements from that installed-based of FreeStor customers in the very near future.

Secure multi-tenancy, auto-tiering along with quality of service are our next most important objectives for our block based offering under FreeStor. We do need to find a partner or an acquisition target of object based storage to include into FreeStor. We have not yet identified that opportunity.

As you could see from this most recent Gartner research slide dated April 2016, the SDS marketplace although predicted to grow at a significant pace has not been adopted by a large part of the storage community whether that is hardware, software or cloud-based. According to Gartner, approximately 7% are in full deployment [Audio Dip] believing we have some more share through the early introduction of our FreeStor offering in 2015. Coming back to some data about the marketplace, which is based upon reporting by customers, who are using on-premise storage, you'll see that SAN based block and NAS based or file is still the dominant footprint for many customers.

And as those customers refreshed to all flash and hybrid flash, we think the opportunity to provide software defined storage, hardware agnostic platform will be embraced by many enterprise customers as well as service providers, who are serving customers in both the on-premise and hosted private cloud model. Object is not still not been adopted by many customers in their own infrastructures and it's primarily seen more in the public cloud-based backup business service, DR-as-a-Service and database as a service offerings that many enterprises are using today. It is part of the primary reason for storage hardware declines in enterprises, views that they are not being in need for secondary storage in a customer’s on-premise location. We see here in 2015 the adoption of Amazon Web Services and Microsoft Azure as a growing storage platform form for many customers.

In 2017, we see that the predicted adoption of Amazon Web Services and Microsoft Azure continue to grow more and that is one of the reasons why we here at FalconStor see the need for FreeStor to support connectors to seamlessly allow enterprise customers and service providers to take advantage of the superior cost performance of these public clouds for backup as a service and Disaster Recovery-as-a-Service through connecting FreeStor to those platforms with ease. Finally, the 451 Group also sees the adoption of software-defined storage, or SDS, to be quite small at this time, but growing over the next two to three years with some significance.

So now let’s take a look at our FreeStor offerings adoption by our routes to market of OEMs, managed service providers and enterprise customers as well as traditional perpetual licensing versus subscription licensing. First, I'd like to remind you that we delivered the FreeStor analytics product on April 12th, a couple of weeks ago. This deliverable is a culmination of our acquisition of Cumulus Logic's technology and working with their technical team to integrate a real-time predictive analytics capability, which changes the storage software landscape.

Heterogeneous real-time analytics brings a myriad of opportunities to not only a disparate storage portfolio at an enterprise or service provider, but also brings tremendous additive value to a commodity storage platform, ODM storage platform, or component storage manufacturer thinking about moving up to system's value chain.

We believe there are three pillars to the storage marketplace in the future that provides not just technology value, but deliver true business value similar to the way server virtualization with VMware changed the game over 15years ago. Storage virtualization and the extraction of data services from the hardware platform all flash, hybrid flash or cloud is the first pillar. Second is the addition of real-time and over time analytic data that helps enterprises and service providers make better decisions achieve SLAs or service-level agreements or objectives and enable self-provisioning which further drives out cost in the investment portfolio.

The final pillar of intelligent action makes automation and storage at the enterprise or service provider a reality similar to the iCloud and Google Drive services enjoyed by consumers today. Some of advantages of FreeStor’s new analytics is the ability to have personnel and optimization which is a real dollar savings, service-level objective achievements which is real revenue generators or optimization of assets for an enterprise.

Self-service allows for lower cost which can be passed along to customers or the enterprise can charge back to their individual users and departments. It’s all about driving out cost from the organization with FreeStor. There are some world numbers that have been derived from our existing FreeStor customer base and our internal benchmarking of activities. As you can see there is real business value here and cost savings, people savings as well as software license savings with the use of FreeStor.

So now let’s take a look at the FreeStor adoption for FalconStor. As you can see from this slide, we have been able to gain some significant adoption with household names from around the world, our three-pronged approach to go to market as work to rebuild creditability, reliability and confidence in the FalconStor brand with FreeStor.

Although our OEM channel has seen some cooling off with consolidation in an ultra competitive marketplace, our earliest OEM relationships with our two China based suppliers have achieved our annual commitments and look to continue forward into the new 2016, 2017 year.

We are expecting our third China based supplier to do the same in Q2 of 2016, other OEMs with or without commitments have not performed as well. The positive perception of FreeStor started though with these early adopters. The MSP route to market we believe is the strongest route into the future, as customers look to utilize their services for back to business service, DR as a Service, Database as a Service and eventually moving of workload to their hosted private cloud.

We also believe these service providers will utilize and manage Amazon Web Services and Microsoft Azure on behalf of their customers which will also have a significant play for FreeStor in the very near future. Finally, enterprise customers are adopting FreeStor a little slowly as you’ve seen from the previous research along with existing customers migrating to FreeStor.

Just to remind everyone, our goal was to convert 50% of our installed base of legacy products to the FreeStor platform during this calendar year, and during our next call we will give you an update on those actual numbers and achievements.

So let’s take a look at our 2015 bookings and that breakdown. As you can see our mix was somewhat lopsided to the existing installed base with renewals, expansions, technical refreshes to new point solutions. And we had a successful start of FreeStor and if we end – if we were a private venture-backed company. This actually would have been a great start.

We have here the bookings results for Q1 2015 which shows no subscription based FreeStor yet due to the general availability in Q2 of 2015, we had some traditional perpetual licenses from the OEM partnerships and a few existing customers who adopted FreeStor technology prior to general availability under a traditional licensing model.

Q1 2016 shows a better mix of FreeStor versus existing customer renewals, expansions and technical refreshes. Our customer additions are growing at a good pace, we are seeing more existing customers looking to convert to FreeStor. Although many could not because the new FreeStor analytics released they are not become generally available until April 12, which was post the end of Q1 2016.

Here we are seeing the improvement in a number of transactions related to FreeStor on a year-over-year quarterly basis. We are seeing good growth in all routes to market in a comparison to all of our 2015 bookings versus just the Q1 2016 bookings as you can see from this slide. We have sold almost three times as much FreeStor in the MSP route to market in the Q1 2016 versus all of 2015.

We grew our FreeStor enterprise subscription licensing by achieving in Q1 2016 almost 50% of what we sold in all of 2015. Our OEMs have reached our commitments in two of the three China base relationships with expectations of the third one delivering in Q2 2016 our other relationships have not reached their commitments yet and our early indications are that they will not even though the full year will not be reached to the end of Q3 2016.

Finally, existing customers and new customers who are unable to purchasing the subscription model although they are still subjected to annual true-ups is on pace to exceed the results of 2015.

Now we realized that although FreeStor is growing quite well, even in the adoption of SDS is still building, it’s not yet – not enough yet to be comfortable. We recognized that Q1 2016 was not up to our expectations and probably not yours but we are still confident that FreeStor and FalconStor are in a position to capture the SDS marketplace in the very near future. The management team, the employees and the board are all cognizant of our current position and committed to delivering the result you demand as our shareholders.

Thank you and now operator you can compile the Q&A roster.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] And I’m showing no questions in the queue.

Gary Quinn

Okay. Well, operator, thank you very much for your assistance this evening.

Operator

Pardon me, interruption, but we do have a question. We’ll take Laura Drynan with Bourgeon.

Laura Drynan

Good evening everyone.

Gary Quinn

Hi, Laura. How are you?

Laura Drynan

Hi, good. How are you?

Gary Quinn

Good.

Laura Drynan

I would like to see if you could follow-up a little bit with your comments on AWS and Azure and how you see that ruling out a little bit more definitively and how that may be benefitting you in the next year or two, three going out?

Gary Quinn

Okay, that’s a great question, Laura, because I think a lot of people out there today and I’m sure a lot of our own shareholders believe that Amazon is going to achieve world domination, okay. Actually Amazon has done a fantastic job of providing a utility based Infrastructure as a Service, which includes, compute, storage, very easy to spin up capacity with an account. And it has been actually a very excellent tool for people to actually provide backup copies of their data the hard copies of their data depending on the service over requirements, environments to do development and testing, without having the need to go out and buy new hardware, okay.

So I think you’re seeing a number of the traditional hardware vendors around spindles obviously that’s declining quite rapidly. It’s being replaced by capacity from the all-flash array and hybrid flash array vendors. But the flexibility to spin up, compute and storage for short periods of time or even long periods of time without having to going out and buy physical hardware has become very attracted to a number of customers. More so in the small and medium business space as well as well small enterprise space.

But many enterprise customers today are saying, you know what, there’s nothing wrong with putting some data out into Amazon or into Microsoft Azure, especially if it’s for archive purposes, I don’t really have a need to bring it back quickly. I may only have to search for once in a while. And at the moment today, a lot of people are trying to do that or like to do that more easily.

So FreeStor today has been primarily built for a service provider model with multi-tenancy. A number of enhancements are going on with that product right now, a little bit later delivery and after the summer, to support that largest growing route to markets for us. But those service providers have also asked us to provide connectability into the public cloud markets such as Amazon, Microsoft Azure, as well as Google. So those connectors today do not exist.

Today FreeStor does run in the Amazon cloud. It does run in the Microsoft Azure cloud so a customer could use an on-premise version, as well as a version of FreeStor in that public cloud. But at the moment that is not something that we see a lot of adoption at the immediate time, although people are starting to come back to us and saying, well, we're running a copy in Amazon, we're running a copy out at Microsoft Azure, could you make that a little bit more formal.

So we are doing that and what does that mean for us? It means that it will enable customers to adopt FreeStor more and more and take advantage of public clouds if they're looking to provide just copies of their data in that public cloud for use that is not, let's just say, immediately needed to return. If you have a FreeStor on both ends at your on-premise or in your public cloud environment, we will be able to allow you to get better service levels because we'll be managing both sides of the equation with FreeStor.

So we think that is something that we need to do, some other people have done that here and there. But I also think that many customers that are continuing to use block-based high-performance applications and databases, that storage I do not believe runs that work load in the public cloud. I think the public cloud is really more for transactional – not transactional applications that do not have high level service requirements such as trading systems, retail ordering systems, et cetera. And that data is something that I think people would just want to store copies out of the public cloud with.

Does that answer your question, Laura?

Laura Drynan

Yes. Thank you very much.

Gary Quinn

Okay.

Operator

[Operator Instructions] It appears there are no further questions.

Gary Quinn

Operator, it doesn't appear that we have any other people in the queue. I’d like to thank everyone who was on our call tonight. We look forward to speaking to you again in July at our next call and give you an update on the growth of FreeStor, our customers and our opportunity in the marketplace. Thank you very much and good night.

Operator

This concludes today’s call. Thank you for your participation. You may now disconnect.

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