FalconStor Software, Inc.

During today's call, there will be discussions that include non-GAAP results. A reconciliation of 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 and full year 2011 earnings. Copies of the earnings release and supplemental financial information are available on FalconStor's website at www.falconstor.com.

I'm now pleased to turn the call over to Jim McNiel. Please go ahead, sir.

Thank you, operator. Good afternoon, and good day, and welcome to FalconStor's 2011 year end and Q4 earnings call.

As stated, my name is Jim McNiel. I'm the CEO of FalconStor.

And I'm joined here today by Bryan Urquhart, our CFO; by Bernie Wu, our VP of Business Development; and by Seth Horowitz, our General Counsel.

Let me start by saying that the company continues to cooperate fully with the U.S. Department of Justice and the SEC in their continuing investigation of the company.

I am also here to report that we received a demand for $7.5 million as part of -- as a monetary part of a potential settlement with these authorities. The company will continue to work with these authorities and negotiate all aspects of this potential settlement.

Now on to more interesting topics. I'm happy to report that the company reported 2011 revenues in excess of what we did in 2010, halting a declining trend, which we're happy to put behind us.

In fact, our revenues for Q4 of last year were $25.4 million or $6.5 million better than Q3 for 35% increase in revenue.

What I'd like to talk to you about in my part today is a few of the market aspects that we're experiencing today, and how they're affecting our business. And then I will hand it off to Bryan Urquhart to walk you through the numbers in detail and then to Bernie Wu to give you an update on what we're doing with our strategic partnerships and OEM relations.

So some of the things that we're dealing with today that are very, very positive trends actually are a national, or actually global shortage in hard disks. And this is resulting in an increase of 5% to 15% in costs of these hard drives.

And this is forcing IT executives and enterprises to reevaluate how they're acquiring disks. But more importantly, how they're provisioning and allocating the usage of that disk.

And I bring this up because this is a key element of storage virtualization, and thin provisioning is a key aspect of our technology.

Additionally, NSS, or storage virtualization technology, is key to be able to group together disparate types of storage. So hard drive, SATA, SaaS and MAID, as well as SSD.

And the shortage of hard drives is having a lot of companies reconsider the earlier deployment of SSD as a part of their enterprise storage solutions.

Lastly, there is a significant amount of competition in the storage array space, which is a result of recent acquisitions, but also the fact that it's very hotly contested and very rapidly growing market. And this type of competition continues to create movements or churn in the space.

Now the chart you see here is what I call our BCDR stack. FalconStor continues to focus on data protection, and in particular, business continuity and disaster recovery.

In the first part of our stack happens to be file migration or data migration. And FalconStor is uniquely qualified to fulfill this need because we're one of the only software vendors in the industry, actually the only software vendor in the industry that can provide the ability to move data center applications while they're in production.

So we move applications while they're hot.

This capability has been recognized by companies like Fujitsu and just recently, Dell, who have signed global arrangements with FalconStor to resell our NSS technology to facilitate data center application and data center migration.

In fact, one key customer in Europe recently, with over 600 employees in the systems integration space, and a significant outsourcer for SAP has not only used FalconStor to migrate from old storage to new Fujitsu storage, but is also keeping FalconStor around to perform high-availability functionality or stretch cluster, and that leads us to the second part of our stack. Business continuity is a function of keeping things up all the time.

If you're not always up, you're not backing up highly available solutions or what our customers are looking for.

So file migration allows them to refresh their hardware that gives them the confidence to know that things are going to work, and high-availability business continuity makes sure that they can fail over and fail back in the event that something goes wrong. But if something does go wrong in a high-availability environment, you also have the ability to replicate that mistake and that's why you also need DR, disaster recovery, which we support with NSS and CDP.

And we have key partners supporting that technology as well, companies such as HP, nScaled and Global Storage Management. They're using this technology to provide disaster recovery services in the cloud and that continues up our stack.

And when you take all these snapshots and all this data and you need to put it someplace efficiently, you need optimized storage. And we support that with global dedupe and VTL technology, which again is validated by key strategic partners such as Huawei and Hitachi Data Systems.

In the latter category, we had 2 substantial wins in the recent quarter regarding one large energy company in the United States, the Fortune 500, SAP 500 company in the petroleum and gas industry had recognized that FalconStor was a better value than EMC due to our high availability, our scalability and our overall better total cost of ownership and return on investment.

Additionally, we had a major Fortune 100 retailer in the United States select FalconStor Global Dedupe technology with HBS hardware over CommVault to do key protection of their protected data -- their snapshot data and their backup data.

So these are the things that are driving our business, and I'm happy to say that the stack is resonating very, very well with our newly developed channel.

So with that, let me hand this over to Bryan Urquhart, who could walk you through the details of our fourth quarter financials.

Great. Thanks, Jim.

Good afternoon, everyone. For the fourth quarter of 2011, we had total revenues of $25.4 million compared with $26.5 million in the same period a year ago, and as Jim mentioned, $18.9 million in Q3 2011.

Product revenue from our OEMs declined by roughly 58% or $2.1 million compared with Q4 2010. The decline compared to the previous year is due to the decrease in revenues from our partners EMC and Oracle.

Product revenue from EMC and Oracle combined was less than $135,000 in the fourth quarter of 2011 compared with $1.5 million in Q4 2010. Product revenues from our non-OEM business was up slightly compared with the prior Q4, and each of our 3 regions contributed to this solid revenue performance in Q4.

Our support and services revenues, which are comprised of maintenance and professional services, continued to increase by 13% compared with the previous Q4. Overall, our total revenue for Q4 2011 was down slightly, at 4% compared with Q4 2010 but was up 35% from Q3 2011.

Our operating expenses, excluding stock-based comp, investigation costs and restructuring costs, increased 5% in Q4 2011 from $16.5 million in 2010 to $17.2 million in 2011. We continue to evaluate the appropriate level of expenses for each piece of our business, and we have and will continue to adjust our expenses and investment as appropriate looking forward.

In Q4 2011, we incurred $5.9 million of costs associated with the ongoing government investigation. Including the provisions for the possible resolution of the investigations compared with $1.6 million in Q4 2010.

In Q4, our non-GAAP operating profit was $1.9 million, down from $4 million in the same period a year ago. Our non-GAAP operating results exclude costs associated with the ongoing government investigation and restructuring costs that I previously discussed.

It also excludes stock-based compensation of $1.4 million for Q4 2011 and $1.5 million for Q4 2010. Our non-GAAP net profit for Q4 2011 was $1.2 million or $0.03 per share compared with a net profit of $3.8 million or $0.08 a share in Q4 2010.

On a GAAP basis, our operating loss in Q4 2011 was $5.5 million compared with an operating profit of $800,000 in Q4 2010. In Q4 2011, we had a net loss of $6.1 million or $0.13 per share compared with a net loss in total of $53,000 in Q4 2010.

On a full year business in 2011, we had total revenues of $82.9 million as we noted before, a slight increase when compared with 2010. We experienced growth in our non-OEM product revenue in 2011, which increased by over 6% compared with the prior year.

Product revenues for our OEMs declined by 42% or $4.7 million compared with 2010. And as mentioned before, it was due to a decline in revenues from EMC and Oracle.

Our support and services revenues increased by 8% to $33.4 million compared with $30.9 million in 2010.

As you can see, our mix of revenues continues to shift strongly to our partner life business globally, with our OEM relationships accounting for roughly 13% of our business down from over 50% in 2007.

Our operating expenses on a year-to-date basis, excluding stock-based comp, restructure costs and investigation costs, decreased by 3% from $68.8 million in 2010 to $66.5 million in 2011, reflecting our continued focus on good cost control but also our increased investment in sales and marketing in all regions around the globe.

On a full year basis, our non-GAAP operating loss was $5.6 million compared with $7.3 million for 2010, an improvement of $1.7 million. Our non-GAAP operating results excludes stock-based compensation of $5.5 million for 2011 and $8.7 million for 2010, as well as $10.3 million in investigation costs, and $822,000 in restructure costs in 2011 and $1.6 million of investigation costs in 2010.

Our non-GAAP net loss for 2011 was $6.8 million or $0.15 per share compared with a net loss of $24.3 million or $0.53 a share in 2010, an improvement of $17.6 million.

On a GAAP basis, our operating loss in 2011 was $22.2 million compared with an operating loss of $17.6 million in 2010. In 2011, we had a net loss of $23.4 million or $0.50 per share compared with a net loss of $35.4 million or $0.78 per share in 2010.

We finished the quarter and the year with $37.8 million in cash and cash equivalents through [ph] equivalent of roughly $0.81 per basic share, down 1% from $0.82 per share at the end of 2010, driven by the increased share count at the end of 2011. We also experienced growth in our deferred revenue balances, increasing 15% to $27.1 million compared with $23.5 million at the end of 2010.

To summarize, on a year-to-date basis, we experienced growth of 6% in our FalconStor-branded business compared with the prior year growth of 8% in our support and maintenance revenue compared with 2010.

We continue to have a strong balance sheet. We have positive cash flows from operations of $3.1 million for 2011 compared with a negative $1.7 million burn rate in 2010, a swing over the year of nearly $4.9 million.

Moving on, we wanted to share with you some of our thinking on our future business mix, and how we compared to the general world of software companies. As you can see, we have set ourselves revenue, margin and operating profit goals for the mid- and long-term, and we will be actively working to help move our business toward this target mixes.

Please note, this is not to be construed as guidance, rather it provides you with some visibility into how we view our business mix today and how it may change in the future.

For the medium term, we see our revenue mix continuing to move towards a more normalized use [ph] with gross margins increasing slowly over time and as revenue grows, OpEx as a percentage of revenue will decline and profitability will return to the business. Note these are non-GAAP metrics, as noted on the slide.

In summary, we continue to see the materiality of our legacy OEM business decline and we're seeing good growth in our partner life [ph] business globally and in our service and maintenance revenues. We have a strong focus now on managing our P&L towards software company metrics.

We have a solid balance sheet with positive cash flows from operations of 2011, increasing deferred revenues and no debt. We are operating in growing markets with that growth currently expected to continue in 2012 and 2013.

And now I'd like to ask Bernie to review in more detail our strategic channel partnerships in [indiscernible].

Thank you, Bryan. I'd now like to discuss the progress we made in rebuilding new types of strategic partnerships and where we're going.

EMC, Sun and IBM that all used our VTL software to build, sell and support their own logo-ed enterprise storage appliances.

FalconStor power VTLs were by far the market share leader in that sector. Around that same time frame, all 3 of those partners went through a series of mergers and competitive acquisitions, which disrupted our business and ultimately resulted in the discontinuance of their OEM business with us.

We will continue to support the OEM business model for partners who desire to do so and will offer unique channels or markets.

Huawei is a good example of this. They are using our VTL as part of larger telecommunication solution that they provided their customer base.

Huawei ramps strongly in 2011.

We increased our emphasis on building our own sales channels and increased our efforts to recruit new Tier 1 storage and system industry partners. We believe the continued engagement of Tier 1 is vital to the building of our brand name and ongoing product validation in the marketplace.

Today, we are pleased to display our Tier 1 partnerships in order of their signing. It is important to note that our partnerships have largely shifted towards strategic reseller or service provider arrangements that allow our sales force to partner with these global players and to build FalconStor brand equity.

I'd now like to summarize these new partnerships and describe where we're going with them. The first of these is HDS.

Our partnerships with HDS continued to grow stronger in 2011 as we ramped up our jointly defined VTL and FDS solution offerings.

As you may recall, our partnership was announced and launched in Q2 of 2010. Our overall year-to-year revenue growth with HDS was in excess of 200% from that base starting point.

We believe that this relationship will continue to grow this year and plan to launch new versions of our joint solutions later this year.

Our HP partnership centers on DR as a service, using our FalconStor NSS software. We've launched in 2011 but has ramped slowly.

HP recently assigned a new executive to oversee this area, and we see renewed focus.

Recently, we assisted them in their first worldwide training program on our product offering. We are optimistic that we will see a more aggressive business ramp through 2012.

Our partnership with Fujitsu commenced in Q4 2011 and was off to a good start. It centers on the use of our NSS for data migration services and a reseller relationship for storage virtualization and business continuity.

With respect to migration, Fujitsu previously partnered with EMC for storage and built up a significant customer base, which they would now like to migrate to their own branded storage.

On the storage virtualization business continuity front, we closed a 7-figure deal in Q4 to provide that kind of infrastructure to a leading SAP outsourcing service in Germany. We plan to expand this approach with other outsources as we continue into 2012.

A recently announced Dell partnership centering on data migration is also related to their former partnership with EMC and their subsequent acquisitions of EqualLogic and Compellent. Dell recognized the versatility of our NSS solution for heterogeneous online data migrations and selected us.

Although this partnership has just commenced, we are pleased with the intensity that Dell is moving forward with their launch. Standardized and customized migration configurations have been released to their sales force, training commenced, and some initial migration projects are underway.

Although the initial partnership is centered on the use of our NSS as a data migration service, we all -- we believe we will also see new reseller opportunities for disaster recovery and business continuity, resulting from the exposure we are getting within Dell and our customer base. And we will be working to streamline that up-sell fulfillment process going forward.

And now we'd be happy to take your questions. Operator, please?

So I have several quick questions for you. So the first, Jim, the verbiage around the monetary provision to the SEC, I think you mentioned they sent you a demand letter requesting $7.5 million.

I think in your past commentary, you've made accruals but have never suggested there was a demand letter. Am I reading -- is that a correct interpretation of that commentary?

So Brian, I'm going to answer this very carefully by asking Seth to answer it. We're really very, very restricted in terms of what we can comment on.

So we're going to play this entirely by the book.

Yes, and Brian, all I'm going to say is that we didn't say it was a demand letter. What we said and what Jim said is that we have received a demand of $7.5 million as part of a -- the monetary part of a potential settlement for both actions.

Okay. And is the jargon around that statement different than several quarters ago when you made your initial accrual?

I don't think that we have previously said that the demand was received from the government.

Okay, that's what I wanted to double check. The second question I had, I think that Bryan, you talked a little bit about your midterm goals in terms of mix and margins.

And the kind of upward trend in gross margin to 75% from 73% in the midterm. What do you guys kind of think of as midterm?

Are we talking 2 or 3 years or are we talking quarters?

No, certainly not a quarterly view. And as I noted, this is not intended to be, nor should it be construed as guidance.

It's really about a balanced business mix. And as you probably know, getting the right mix in product maintenance and services helps drives not only gross margin, but profitability as well.

And that's really what we're aiming for in the medium-term. Obviously, I'm not going to put a definitive time frame on that.

But I think it's fair to say, it's not over the next quarter or 2. It's a medium-term goal, and companies differ on how they define medium-term.

But generally, it's in that range of something between the next 2 to 5 years.

Okay. And then following kind of in the same vein, you guys didn't give explicit 2012 guidance.

But as you look at the landscape and the kind of shift in the partner ecosystem, do you think that there's a strong likelihood that you can start to deliver solid year-on-year revenue growth going into 2012?

Well, as you noted yourself, we don't give guidance. So to give you a percentage or a number, I would in fact be giving you guidance.

But I think as we mentioned in our presentation, we do see that we operate in markets that continue to grow. Therefore, that gives us cause for optimism in the future.

And Jim, do you want to add some comments on that based on your...

Well, I think, Brian, we've also had this conversation before that we're not avoiding guidance because we don't like it. We are not providing it yet because we're not confident that we have all of the key data points in place in a predictable and a reliable way to provide you guidance that we can count on.

So I think Bryan's response is appropriate. I mean you know the markets that we serve are growing.

You also know that the share we have with those markets is nominal at this time. And we do believe we have the substantial opportunity because of the strength of our operating to increase our share in those markets.

As we get to better pipelines and a better predictable forecast, which we continue to improve, we're going to get to a point where we can start talking about guidance.

Okay. And then I have 2 more quick ones, these are product [indiscernible].

First, on the R&D line, you highlighted the percentage of your spend that's going to R&D. Can you give a little bit of color around the progress in new product development, particularly around Bluestone, which has been somewhat delayed?

Can you talk a little bit about how you're rolling out your next iteration of products?

Well, I could tell you that there's been substantial investment and progress made in the continued evolution of our global dedupe products. 7.5 has been released.

And as Bernie mentioned, there'll be additional features and products coming with our HDS offering, which would be an HDS data solution. We're excited about that.

In regards to Bluestone, Bluestone is the top of the stack. It basically controls all of the services that we offer through a single pane of glass.

And we continue to make good progress on that. We were able to move all of the interfaces from our existing console into the server component and now we're moving towards getting that completed for the whole product line.

It's a large task, it requires a different level of coding than the company historically has done, which is a lot of web-based coding, but we're making very solid progress there. So I'm not going to give you a date as to when that first version of that product is going to ship but it will be -- I guess less than the medium-term, as Bryan defines it.

Okay, great. And then my final question, if you look at your product segmentation, you kind of broadly defined as VTL, FDS, PDP and then your NSS storage hypervisor, it's notable to me that most of your recent OEM partnerships are around the storage hypervisor layer.

And I'm seeing increased industry traction for that type of technology as people migrate both between brands and also as they look to implement new big data solutions like dedupe and want to migrate their existing data on the dedupe clusters. Can you talk a little bit about what you're seeing in terms of increasing opportunities and market traction for storage hypervisors?

Well, when you're looking at the environment that we talked about at the beginning of the call, which is it's a pretty frothy environment in terms of storage array vendors and offerings. And so there's a fair bit of motion, and the enterprise is moving from one storage vendor to another.

You know that FalconStor's one of the only heterogeneous providers of storage virtualization or as you call it, storage hypervisor. I think that there's an increased emphasis on enterprises to deploy technology that has vendor independence, that doesn't have vendor lock down or vendor tyranny.

So the migrations that Bernie has been successful in putting in place is concerted effort to move companies from their EMC storage to new Fujitsu or Dell storage. That's the trend that we're very happy with.

The other thing that we talked about is when you're trying to get the right balance or mix of storage solutions in your environment, you need to have flexibility to be able to deploy SSD, SATA, SaaS, various types of hard drives because we've got increasing hard disk cost for the time being. That's another reason why you want to be able to use storage virtualization.

I think that storage virtualization, Brian, doesn't gain the same level of global acknowledgment from large vendors that server virtualization gets because most of the array vendors out there want to keep everybody on their platform. And storage virtualization democratizes or commoditizes the underlying storage.

Our smarter customers get that. And lastly, when you have the ability to move workloads through a mix or a tiered group of storage devices, you have the utmost in enterprise flexibility, which supports the cloud offering.

And it also supports the model you're talking about when companies want to move big data to Hadoop environment. And they want to do without impacting production, we can do that in the background very seamlessly.

So we actually have increased our R&D expenses and effort in the NSS or storage virtualization way to get to higher forms of availability and way [ph] type architectures, and we'll continue to drive that.

And just in general, Brian, on the marketplace, I would confirm there's a lot more interest coming out of the marketplace and in the slide of Tier 1 interest the you've noted, there's also quite a few Tier 2s and next-generation SSD vendors that are interested in this kind of technology to improve their competitors against -- I guess incumbents. So we are definitely seeing that.

I also mentioned in my presentation that there's a lot of interest from an example of an outsourcer. So because of consolidation and outsourcing, things are becoming more business-critical, and our technology NSS is ideal for creating disaster recovery, able to call business continuity or high-availability clusters.

So there are some particular new used cases that are also starting to crop up that are much more favorable for us.

So talking about the Dell agreement, what are you expecting -- how are you expecting the revenues? I mean, is this going to take a little bit of time for them to ramp up?

Is this something we expect more to see towards the end of the year? What are your kind of expectations for this?

From the get-go, they've just launched this service on March 1. And we are in the process of completing training of several dozen people to provide professional services for this.

So I think there will actually be a fairly significant number of personnel toward the end of the year on the Dell side that will be providing data migration services. But at this point, we're not giving any specific guidance as to what our revenue expectations are.

I think, Susan, one thing to consider is the fact that there's a lot of incumbent Dell storage out there and saying that, it's really EMC storage. Dell has been selling EMC for many, many years, and their intent is to migrate that over to Dell storage and they're measuring it in the multiples of extra bytes [ph] .

Yes, I could say that we have a very strong backing from Dell, the migration as you can imagine with our acquisition of Compellent, EqualLogic is the high-priority project. So again, what I was saying earlier was I'm very pleased with the launch so far.

And we fundamentally are going to get compensated as -- based on the amount of data that is being migrated.

Okay. So you guys have kind of in the past hinted when there was a potential for a new partnership.

Is there anything in the future we should be looking for later down the line?

Well, there's only so many Tier 1s out there. But I can tell you that because of these new relationships, there are always adjunct areas within those organizations where you can expand.

So we are definitely working on those kind of activities as well.

Yes, I think at this point, with the key partners that Bernie has in place, the land and expand type of approach is the right way to go about it.

Okay. All right, so last quarter, some of the things you talked about was some weakness in Europe.

How did the geographies play out this quarter?

Susan, it's Bryan. I'll handle that.

So we saw a good performance, as I mentioned, in Q4 from all of our regions. I think even with the turmoil in the capital markets in Europe, we still see our business starting to come back.

We have a new leader over there, in Philippe Bernard, who came on board in November. So it's middle of Q4, and had an immediate positive impact on the team there.

Our business in Asia continues to perform, and our business in North America went through a significant restructuring in 2011, it really started to hit its stride as well. So overall, we were fortunate in that all 3 parts of the business that contributed to the Q4 revenue number.

So Susan, just an additional comment, we placed a whole lot of emphasis and focus on North America with putting in new processes, putting in forecasting methodologies, building a partner program, building strong channel relationship. And then once we had that set of dialed in and working, we replicated that over to Europe to be managed by Philippe and over to Asia to be managed by Suresh.

And we're starting to see the positive results of that normalized data, normalized process, consistent predictable keys in the business. So I'm hoping that we're going to see continued improvement in all 3 of those regions.

Okay, great. So actually you kind of hit on the new leader you have in Europe, he started -- you starting to see some results from him.

And you said you saw an immediate result so that's been very positive for you?

Yes, he's doing a very good job and he's building a very strong team, and he's just a very capable manager. We hired him out of Brocade.

Okay, let's see. So last quarter, you guys have also talked about some of the sales and marketing talent upgrade.

You were really trying to get some new people. How is their maturation process?

Are they starting to sell in line with some of your -- the guys that have been around for a while or how is that going?

Well, I'm not so sure if I really get the question but I have to say that what's really positive about what's going on in the company is that sales and marketing, you always need to say in one sense because we have a very team-oriented approach. We work hand-in-glove to develop opportunities in the marketing side that's utilized by our sales people in the field.

We've added talent on the product management side, and we will continue to do so because that's really critical to our ongoing product development, our product focus. So I'm actually pleased with the progress we've made on the marketing side, but I'm more pleased about the tight integration of marketing with sales globally.

Ladies and gentlemen, thank you very much for joining us on today's call. And we look forward to speaking to you again for our Q1 earnings call in the near future.

Thank you. Have a good day.