FalconStor Software, Inc.

During today's call, there will be discussions that 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 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 McNeil.

Thank you, Lorenzo, and welcome, everyone, to FalconStor's Q1 2012 earnings call. I'm joined here by Bryan Urquhart, our CFO; and Bernie Wu, our VP of Business Development, and I'm happy to share with you the results of our quarter 1 performance.

First, I'd like to talk to you briefly about some of the highlights in our business, in particular what we're doing in our partner channel programs. I'll talk you about our VTL 7.5 launch and then hand it over to Bernie to talk about strategic partnerships and then let Brian go through our financials in more detail.

While we continue to show nominal growth Q over Q, the real story is actually behind the scenes. You'll see that we have continued product or channel growth year-over-year, while our OEM, historic OEM business, has continued to decline.

In fact, over the past 2 years, our compounded annual growth for our partner business is about 19%.

What we're also seeing here is we're at end of the cycle where no more OEM revenue is really going to drag our top line performance, so we expect to see an increase in our overall business performance going forward. That's why we've invested a great deal of time and effort into our partner community.

As we said last year, we launched the PartnerChoice program and the Partner Advisory Council in North America. We followed up with that same program in Europe, and I just finished a 2-week tour in Asia rolling out PartnerChoice in our Asian communities.

The feedback that we get from our Partner Advisory Council and our partner community is instrumental in driving the direction of our product development, and it's indicated in our most recent release of VTL 7.5. One of the points that we received from our customers and our partners is that the acquisition cost of our VTL solution was not as competitive as they'd like it to be because the amount of storage that would be required for the initial deployment of the technology would be nearly equal to that of the primary storage.

And you don't know how much you need until you figure out what your performance is based on dedupe ratios.

Our competitor, Data Domain, has had the ability to allow customers to grow the amount of capacity they need as they determine what their dedupe ratios in their performance departments are, and that's been the advantage for them. I'm happy to report that with the launch of 7.5, we now have added the scale-out capability so our customers can begin their VTL journey with a small footprint, discover what their VTL performance is going to be and then grow that secondary storage footprint as needed.

One of the advantages we have in addition just to scaling out capacity is we are unique in that we can scale out performance. By adding additional heads, we can increase the performance.

And this is one of the reasons why our product is the highest performance VTL and dedupe solution in the marketplace, exceeding that of our competition by 2x to 3x. Our ingest rates are in excess of 28 terabytes an hour, which is an industry-leading standard.

In addition to higher performance, we also have a very, very high cost and feature value benefit. We not only support over 50 different types of tape libraries, we also support 30 different types of tape formats and systems.

We also provide back-end replication, and we have the most flexible dedupe solutions and that we can provide inline and post processing and turbo processing of dedupe loads.

So I'm here to tell you that our VTL product has a lot of room for upside. Every single FalconStor customer who is on a version prior to 7 will be in an upgrade, paid for upgrade position and we have a cost value that is going to compel them to move to the next generation solution.

With that, I'd like to hand this over to Bernie Wu to give you some detail on our strategic partnerships and the progress we're making there. Bernie?

Thank you, Jim. I'd like to provide a brief update on some major business and partner initiatives.

The VTL market for us continues to be strong. Definitely Q1, we closed a major U.S.-based Fortune 500 food products company, as well as a large transportation company located in Europe.

We're also in the process of converting our VTL strategic partners over to our latest version of VTL, VTL 7.5, leveraging the latest array of technologies. We expect this to provide greater cost savings, configuration flexibility and performance competitiveness for our VTL solutions.

In the NSS arena, we are continuing to ramp up data migration services with both of our major partners, Dell and Fujitsu. Training events are being conducted with their professional service and pre-sales teams.

We also had our second major outsourcing win involving NSS over in EMEA during Q1, in which we enabled a high-availability, virtualized clustering environment over distance.

We are, therefore, working on further business development initiatives to expand this type of success to other outsourcers and cloud-computing customers.

With respect to managed services, we continue to work with HP and others to enhance the vast recovery as a service and use of tools such as our RecoverTrac. We're also beginning to see interest from a variety of new partners who are interested in offering VR as a cloud service.

These range from small, highly focused, managed service startups to a major telecommunications service providers. Our NSS product enables them all to address business-class disaster recovery in a single tool that is heterogeneous, virtualized and efficient, as well as provide the industry's best recovery time and recovery point objectives.

With that, I'd like to pass over this call to Bryan to discuss our company's financials.

Thanks, Bernie. Good afternoon, everyone.

For the first quarter of 2012, our total revenues increased 2% to $19.4 million compared with $19 million in the same period a year ago. Product revenue from our OEMs declined by 49% or $700,000 compared with Q1 2011.

The decline compared to the previous year is due to a decrease in revenues from our relationships with EMC and Oracle.

Product revenue from EMC and Oracle was basically 0 in the first quarter of 2012 compared with $600,000 in Q1 2011. Product revenue from our non-OEMs was up $0.1 million compared with the prior Q1 2011.

Each region contributed to a solid revenue performance in Q1, with the Asia-Pacific leading the way in terms of percentage growth.

Our support and service revenues, which is comprised of maintenance and professional services, increased by 13% compared to the previous Q1. Overall, our total revenue for Q1 2012 was up 2% compared to Q1 2011.

Our operating expenses, excluding stock-based comp and investigation cost, increased by 1% in Q1 from $16 million in 2011 to $16.2 million in 2012. We continue as always to evaluate appropriate levels of expenses with each piece of the business, and have and will continue to adjust our expenses and investment as appropriate.

In Q1 2012, we recorded a net reduction of the costs associated with the ongoing government investigation of $1.3 million. This was comprised of a $1.7 million reduction in the accrual for certain costs associated with the possible resolution of the investigation, less $400,000 in legal fees associated with the investigations in the quarter.

Compared with $2.6 million in Q1 2011, which was comprised of $1.1 million of legal fees and $1.5 million related to the accrual at that time.

In Q1, our non-GAAP operating loss was $1.9 million, up from $1.7 million for the same period a year ago. Our non-GAAP operating results exclude costs associated with the ongoing government investigation that I previously discussed.

It also excludes stock-based comp of $1.4 million for Q1 2012 and $1.3 million for Q1 2011. Our non-GAAP net loss for Q1 2012 was $2.3 million or $0.05 per share compared with a net loss of $2 million or $0.04 per share in Q1 2011.

On a GAAP basis, our operating loss in Q1 2012 was $2.1 million compared with an operating loss of $5.7 million in Q1 2011. In Q1 2012, we had a net loss of $2.4 million or $0.05 a share compared with a net loss of $6 million or $0.13 a share in Q1 2011.

As you can see and as Jim showed earlier, our mix of product revenues continues to shift strongly to our a partner-led business globally, with our non-OEM relationships accounting for about 93% of our product revenue business now, up from just over 55% on a full year basis in 2009.

Our new -- our non-OEM FalconStor branded business grew by over 9% quarter-over-quarter. Our mix of revenues continues to remain relatively consistent across all regions of our business.

Revenues from Asia Pacific increased to 30% of total revenue in Q1 2012 from 28% in Q1 2011. Total revenues from North America represented 42% in Q1 2012, down from 44% in Q1 2011, and total revenues from EMEA remained at 28% of total revenue for both period.

We continue to see a relatively soft economy within North America while experiencing growth and opportunity throughout the Asia Pacific region.

We finished the quarter with $37.6 million in cash and cash equivalents equivalent to $0.80 per basic share, down $0.01 at the end of 2011, driven by the increased share count at the end of Q1 2012. We experienced growth in our deferred revenue balances, increasing 3% to $27.9 million compared with $27.1 million at December 31, 2011, or $25.4 million at March 31, 2011.

We have positive cash flows from operations of $0.4 million for Q1 2012.

To summarize, although we continue to experience disruptions within our business related to the ongoing government investigations, which negatively impact the existing and potential customers' use of the company, and as expected, our OEM business product revenue was down 49% from the prior-year quarter, we were successful in growing total revenues by over 2%. We also grew our FalconStor-branded business by 9% compared with the prior year.

We continue to have a strong balance sheet. Our key metrics continue to be positive.

Positive cash flow from operations in Q1 2012, improving DSOs globally, increased deferred revenues on our balance sheet compared with the prior year and prior quarter and, of course, no debt on our balance sheet.

With that, operator, we'd like to open up the call for questions.

A couple of quick questions. First, on the change in the accrual.

It looks like it came down a little bit. Can you talk a little bit about what the process looks like in terms of are you at the point where you're trying to negotiate a final settlement with the SEC?

I think you indicated last quarter, they sent you -- they've given you a request for a dollar amount. So one, can you give any update on that?

Brian, it's Bryan Urquhart here. I'll pass that over to Seth Horowitz, our General Counsel.

Brian, we have discussed the settlement with the Attorney's Office and the SEC. But much more than that, we can't tell you.

There's progress and then we have an obligation to disclose it pre-sale, but until that time, that's all we're able to tell you.

Okay. And then as you look at your business trends, you definitely are finally starting to see some growth as the OEM revenue becomes immaterial to your business.

But as you look forward and you kind of look at the year-on-year comps and then the compares, and general view the year-on-year compares significantly easier one. And 2, outside of the OEM business, were there any anomalies in the March quarter of 2011 that made it particularly strong that you're comping again?

So I guess, the summary of that question is, is there more than just the absence of OEM revenue that makes for an easier comp moving forward?

Good question, Brian. I think in general, ultimately, that trail of OEM revenue declined, it becomes easier and net dollar has more impact on gross growth, if you like, on the top line.

So in terms of comps being easier, no quarter is easy, right? It's always you got to go fight in the marketplace and win your business.

But I do think that headwinds had declined significantly over the last 18 months, and what's remaining of it will continue to decline through the course of this year. There are no other significant anomalies in Q1 2012 that we want to comment on.

Okay. And then the last question.

I guess, this is probably best suited for Bernie. So as you look at your partner relationships, you've announced a number of partnerships with Dell, HP, Fujitsu and HDS over the past year or so.

I know is HDS is really the primary Go-to-Market partner for the VTL side of your business. So how do you see the launch of the new VTL 7.5 affecting that?

One. And two, do you see opportunities to expand any of the other partnerships as a result of this launch?

Yes. So with the launch of VTL 7.5, the 2 major partners that are going to run with it; HDS, of course, and as we mentioned in other calls, we have Huawei over in China.

Both of them are switching over to VTL 7.5. And as Jim mentioned, one of the advantages we now have is we can have a more flexible architecture, when spec-ing these things out to end users so we can start small and grow big.

So because of that, what we have found is that a lot of customers, once you get them to adopt your technology, they become an ongoing revenue stream in terms of capacity, expansion and et cetera. So our model becomes much more competitive with Data Domain where we can start with a small configuration and then really, rock by rock, additional capacity and -- or performance engines as we go on.

So the flexibility of 7.5, I think, could be very significant in our competitive posture, as well as the significant performance advantage we've showed in that chart that Jim showed in this call.

Okay. And then my last question for you, Jim.

As you look forward into the Q2 time frame, how do you feel about the macro environment? We've got good comps, but do you feel like the macro environment is stable to support kind of normal seasonality?

Or do you see more headwinds than in the past?

Well, I think we're pretty singling out the performance of Asia. Asia continues to execute very, very well.

North America, we still see some slow growth, but we're starting to gain momentum in North America in building better partnerships and getting invited to more opportunities. I think that the pricing shift for VTL is going to open up a broader segment of the market for our VTL and dedupe technology.

As Bernie just indicated, it does open up a broader opportunity for us. And we continue to win predominantly in Asia and Europe with NSS.

I had a number of instances to visit customers in Asia who have deployed our NSS CDP technology to do Tier 1 primary production app protection and then looking to expand that out from 40 servers to 1,000. And one of the things that we have to think about is how do we do a better job of enterprise licensing our technology so that it becomes much more attractive.

They don't want to pay, say, $2 a gigabyte for non-Tier 1 production apps. They want to have a scaled price.

And so I think that one of the things that we're very much focused on right now is being a lot more thoughtful and analytical in terms of the value, our technology brings to the customer and being a little bit more flexible in terms of tiering that value to meet their needs. And so I think this opportunity there.

We have a very a solid product stack as we talked about in our last call, starting with migration going to business continuity, up to disaster recovery and then optimize storage. Then we continue to execute on that.

So I'm starting to see a much healthier dialogue with customers and a much clearer message.

A question for you. Can you talk a little bit more about the search for more partners and other partners to deal with?

Yes. I think, actually, in terms of search from our partners, I mean, Bernie is in a hunt for very, very good, powerful partners who have a solid customer footprint, and can benefit from the value of our technology.

Primarily he's getting a lot of traction in and around companies that want to be in a cloud business. And that ranges from companies that are maturing from being value-added resellers and distributors to a lot of telcos.

Telcos who want to increase their offering by moving from just broadband connectivity and to managed services such as continuity disaster recovery. That's one of the areas, John, in which we have to continue to evolve our technology so that we could provide a solid multi-tenancy support, good security and ease of management for a single MSP delivering services to thousands of customers.

So that's an ongoing effort and that's actually part of the Bluestone roadmap. I would also have to say that the real opportunity for us is in teaching our partners about the significant opportunity of having a business continuity and disaster recovery practice.

If we look at the total global market for that business, it's about $15 billion in software but $39 billion in total, including hardware and services. And then the lion's share of that, over $21 billion of it, is in the services category.

And that's because BCDR is a continuum inside of a company. They don't have the core competency.

They don't want to focus on it, and they need a subject matter expert to walk in and say, "This is how you get the recovery times that you need to be able to stay in business, and this is how you do it in a cost effective way, and this is how you do it in a matter that can actually bring you real business value and not just be an insurance policy. We are investing in building that core subject matter expertise inside of our walls, the certified business continuity disaster recovery personnel and then bringing that methodology and that practice into our partners so that they can build a profitable practice around BCDR.

And that is getting a lot of traction with our partners. So that's a big area for focus for us, and I think it's going to have an impact.

And then I always have to ask this. Do you guys, feel as if another quarter is behind you and your sort of, you feel like you have more stable ground under your feet so that each quarter going forward now is going to be a little bit progressively easier and you don't have so much -- quite so much pressure on you?

Well, I guess you say it's not easy to walk a straight line during an earthquake?

Exactly.

Yes, I guess it's true. I think every quarter we get behind us gives us a chance to benefit from the investments we've been making over the course of the last 8 quarters.

I think we're seeing good positive feedback from our partner community. And I think we talked about before, John, the goal for us is not to have thousands of partners.

The goal for us is to have really have hundreds of highly motivated, effective and invested partners. And so we're getting good progress there.

Yes. But you've got good -- you've got this crew now in there that's all brand-new and that's trained and you've got different people sort of out there marching for you.

So at least you got that going whereas 6 months ago, 9 months ago, you didn't really have that.

The one thing that we have to be very practical about is that the time that it takes to train large numbers of professionals out there is a factor. As Bernie indicated, we've got ongoing efforts to train Dell and Fujitsu personnel.

But that's actually easier in some ways because they're very organized companies, going out and training 100 unique partners. That's much harder to do.

So we're actually, we just hired a new practice leader in our education department and we're investing in our education function.

And would you guys -- if you sign up larger partners, are you going to announce those or not until you’re on these calls?

We'll announce them as they take place.

So now that you have VTL 7.5 out of the way, what does the new product roadmap look like for the rest of the year?

Well, there's going to be increased work in automated recovery. So we're going to add value in the recovery track product line.

I'm not going to preannounce it, but I'm giving you indication of that. And there's also increased work to be done in the storage hypervisor world, if you will, in NSS and storage virtualization or replication.

We'll be able to do something with that before the end of the year. And then most importantly, and what we're really excited about is the delivery of data key in the first half of next year.

So we're absolutely confident that, that technology is going to be a major game changer.

Yes, okay. And I imagine there's stuff to quantify, but how much faster do you think you'd be growing if you had the legal issues behind you?

I think it's impossible to quantify, Jeff. Yes, I wish I knew that answer.

I just know that there have been a number of circumstances historically that would've gone in a different direction if we didn't have that cloud hanging over us. It's hard to quantify it, but it does exist.

Just circling back, as you look at you kind of core products, so NSS, VTL and CDP, can you talk a little bit about what you think is the, I guess, growth rate opportunity for each of those markets? And particularly on the NSS, your storage hypervisor, can you talk a little bit about what there might be in terms of partnership opportunities as flash begins to take more hold?

Are you starting to see interest in people looking to migrate from flash appliances back to more traditional discs?

Wait, wait, did you say migrate from flash back to traditional storage, Brian?

Yes, as the data gets sale and it starts to get really...

Okay. So a period solution?

Correct.

Okay. Okay.

Brian, I'll comment on that. We're working with the major flash system providers, people like Violin that we've worked with for quite a while.

A matter of fact, we've just updated our certification to reflect the latest Violin systems. But we are working with some other players, and I see the same thing that you might be seeing there that there is an interest in tiering between flash and conventional rotating disk arrays.

I think there definitely is a play there for NSS and the storage hypervisor category. So absolutely, there's some initiatives that we're doing in business development.

I can't explain them all right now, but we are working with the flash players and we recognize that as this is going to be a market segment.

Brian, Ross is starting to see some evidence that there's a renewed interest in the virtual appliance or the VSAN. And that's coming from a couple of different directions, and companies are revisiting ways in which they can get to a flexible high-quality performance model or VMware environment using commodity x86 equipment and, say, JBOD.

Our NSS technology is very well suited for that. And there are things we can do going forward to make that much more easy to the deploy and much more clear to understand in terms of the value that it's delivered.

So I think that NSS or IPStor has always been one of the crown jewels in this company. I think there's a great, great opportunity to leverage that going forward.

And then kind of back of the envelope, how would you -- what would you guess is the approximate contribution of NSS, VTL and CDP as a percentage of your license revenue? One, and two, what do you think are the growth rate of opportunities in those markets?

Bryan, do you want to do this?

Sure. It varies [indiscernible] like particularly given individual transactions.

But you normally it splits out -- you could say 30-30-40 as a rough estimate. And that's probably true kind of in a macro level.

Below that, 28 1 quarter and 31 another quarter, yes, but I think the 30-30-40 kind of rule is pretty close to where we sit today.

Thank you, Lorenzo. Thank you, everybody, for your time and participation in this quarter's earnings call.

And we look forward to updating you in the near future, and we're excited about the quarter to come. So thank you for your time.