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.

At the close of business today, FalconStor released its Q2 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 Mr. Jim McNeil.

Please go ahead, sir.

Thank you, operator. And good afternoon, ladies and gentlemen, and welcome to FalconStor's Q2 2012 earnings call.

Let me start by saying that our Q2 revenues of $16.5 million are a significant disappointment to all of us here at FalconStor. We attribute this shortfall to continued economic pressures in all 3 regions.

While the majority of our business now comes from overseas, you can see that the cautious buying environment in both the European and Asian marketplaces can have a material adverse effect on our overall business. This revenue shortfall has resulted in the company taking a proactive action toward cutting expenses for the balance of this fiscal year by approximately $10 million on an annualized basis.

We have stated in our previous calls that we are focused on maintaining the company's commitment to our existing customers by improving our existing product line, by building a stronger channel, and also by developing and delivering new and innovative products. I'm happy to say that the recent restructuring that we have already executed was designed with these goals in mind.

What I'd like to do in this call is walk you through some recent progress of the last quarter and basically, talk to you about what we're going to do about the situation.

I'm then going to hand it over to Lou Petrucelly, who will give you the details of the financial performance, and then Bernie Wu will give you some comments on some of our strategic partners.

First off, let me reiterate what our corporate strategy is. Our corporate strategy is to focus on data protection.

That's where we're strongest. Number two, we are here to enhance and improve the quality of our products in this area and to deliver those products through a newly developed partner community around the globe.

And then lastly, we believe that the biggest opportunity for the company is to realize our Bluestone objectives, delivering service-oriented data protection and innovative and disruptive products to a waiting market.

In our channel efforts, I'm happy to report that we have successfully rolled out our PartnerChoice award-winning program in all 3 of our major regions. We are continually seeking out and recruiting top partner performers in each of these markets and I expect that this will have a positive impact in our business in the quarters to come.

Last quarter, I'm also happy to report that FalconStor successfully delivered the industry's highest performance VTL and DDP solution. This product is unique in its ability to ingest as much as 80 terabytes an hour.

It's the fastest product going. It's also the most flexible product and that we have implemented inline DD capabilities, which we did not have a before, and we added the option of configuring your system for in-line, post-concurrent and no DDP at all.

All of these factors make this product one of the most flexible in the industry.

And then lastly, it's the most secure product in this category we've ever delivered. It includes advanced encryption standard as well as fixed compliance security, which makes it possible to sell this product into many federal contracts.

The product has been available since April through our existing channel community, but it is not shipping to our strategic partners until Q3. Bernie will comment on that as well.

Additionally, we have released to our channel RecoverTrac 2.5. RecoverTrac 2.5 is one of the first steps towards realizing our Bluestone objectives, which is to deliver on our promise of service-oriented data protection.

RecoverTrac 2.5 delivers in 3 key categories in terms of speed or -- speed in flexibility and in complete recovery. In other words, we have the ability to back up and support any service, anywhere, at anytime.

And the distinct aspect of this product is the fact that it understands what its service is. And let me tell you why this is unique.

In most information technology environments, applications are not simple single apps. They're actually a combination of apps.

So, for instance, a customer web portal, maybe an Apache server, a SharePoint database, a SQL database. If those individual elements are not backed up and protected at the same time and recovered at the same time, the recovery will fail.

RecoverTrac automates this entire process and makes sure that these components are snapped in a coherent way and then returned in the proper order. This is a substantial step forward towards automating system recovery, not just for individual machines, but for multiple machines at the same time, and not just for individual environments, but for entire data centers.

This product is very appealing to a lot of our emerging managed service providers who are providing BCDR as a service, and we have a number of new partners looking at this product as well. So I'm confident that this product is going to have an impact on our business going forward.

Lastly, as I said before, we continue to develop new products for a waiting market. The data key project has a very simple thesis.

The thesis is that the small to medium-sized enterprise of today is dealing with the same data workloads that the large enterprise dealt with just a few years ago. In other words, it's no longer a 1- or 2-terabyte problem for the SME.

It's really a 20-, 30-, and even 100-terabyte problem. And the problem they're facing is they can't back up and recover this data using the traditional backup and recovery tools.

What they need is the enterprise class solution for what has become an enterprise class problem.

I'm happy to report that our patented snapshot technology is capable of solving this problem, but it must be delivered and packaged in a way that the SME can consume it. In other words, it must be simple to connect, configure and protect.

This product is designed to accomplish this task and become the industry's fastest, simplest and most cost-effective system recovery solution ever. This project is on schedule and should be delivered in the first half of next year.

In summary, the main point that I want to get across is while Q2 was obviously a very significant disappointment for us, this is a company that is in transition. We have new sales leaderships in a couple of regions, which we are developing and maturing.

We're getting the bugs out, but we're also focused on improving our existing products to serve our existing customers, which continue to renew their maintenance and increase our deferred revenue. And we're very much focused on innovating in this category because it is ripe for change and poised for disruption.

So with that, let me hand this over to Lou and I'll have him walk you through our Q2 financial details. Lou?

Thank you, Jim. This afternoon, I'd like to take you through in summary of our quarter.

I will discuss the challenges we faced, the actions we have taken to address those challenges and where we feel we are headed.

For the second quarter of 2012, our total revenues decreased 16%, to $16.5 million, compared with $19.6 million in the same period a year ago.

We attribute the softer-than-expected revenue from all of our regions, particularly in our EMEA region, for the global economic malaise, which resulted in many Q2 deals being postponed or lost due to either budget freezes or deeply discounted competitive pricing.

In Asia-Pacific, total product revenue was down compared to the previous year, primarily due to disruptions with one of our larger OEM importers during the quarter. However, our non-OEM revenue was up slightly year-over-year.

Although the non-OEM product revenue up from Asia-Pacific was up slightly, it still did not meet our expectations, which we believe was probably due to a slowdown of some of our partners' fees as a result of the economic challenges throughout the world.

Product revenue from our OEMs declined by 82%, or $1.5 million, compared with Q2 2011. This was primarily due to a decline of product revenues of approximately $1 million from our largest OEM in China.

That OEM underwent a significant reorganization during the second quarter, which caused disruptions in our forecasted Q2 deals.

Product revenues from our non-OEMs declined 23%, or $2.3 million, compared with Q2 2011. As we have stated, all of our regions have been adversely impacted by the overall soft economy and the lack of a global recovery.

Our support and services revenue, which is comprised of maintenance and professional services, increased by 8% compared with the previous year. The maintenance portion of this revenue increased 6% from $7.3 million in Q2 2011 to $7.7 million in Q2 2012.

Professional services increased 22%, from $700,000 in Q2 2011 to $900,000 in Q2 2012.

Our professional services revenues tend to fluctuate based on the completion of deployments.

Our operating expenses, excluding stock-based compensation and legal costs, decreased 9% in Q2 2012, to $15.9 million from $17.5 million, in 2011.

The decrease in our operating expenses was primarily due to the 12% decline in our sales and marketing cost during the second quarter as compared with the same period a year ago.

These increases were driven by declines in personnel-related costs and lower commissions as a result of the decline of our revenues.

During the second quarter, we incurred $900,000 of costs associated with the ongoing class action and with the finalizing of our government investigations. The $900,000 was comprised of $400,000 for accrual of costs associated with the possible resolution of the class action and $0.5 million of overall legal fees.

During the same period in 2011, we incurred $1.2 million of costs associated with the government investigations and related class actions, which was comprised of $0.5 million of legal fees and an accrual of $700,000 for certain costs associated with the possible resolution of the then outstanding government investigations.

In Q2, our non-GAAP operating loss was $4.4 million, compared with $3.4 million for the same period a year ago. Our non-GAAP operating results exclude stock-based compensation of $1.1 million for Q2 2012 and $1.3 million for Q2 2011 as well as $900,000 and $1.2 million of legal costs I have previously discussed in each of Q2 2012 and 2011, respectively.

Our non-GAAP net loss for Q2 was $4.7 million, or $0.10 per share, compared to net loss of $3.4 million, or $0.07 per share, for the same period a year ago.

On a GAAP basis, our operating loss in Q2 2012 was $6.3 million compared with an operating loss of $6 million in Q2 2011.

In Q2 2012, we had a net loss of $6.6 million, or $0.14 per share, compared to a net loss of $5.9 million, or $0.13 per share, in Q2 2011.

On a year-to-date basis for 2012, our total revenues decreased 7%, to $35.8 million, compared with $38.6 million in the same period a year ago. We grew our total revenue during the first quarter of this year by 2%.

However, the 60% decline in our Q2 revenue has adversely impacted our year-to-date revenues.

Product revenue for our OEMs declined by 67%, or $2.3 million, compared with 2011. This was primarily due to a decline in revenue from our legacy OEMs, such as EMC and others, of approximately $1.7 million as well as a decline of $600,000 from one of our larger OEMs in China.

Product revenue from our non-OEMs declined by 11%, or $2.1 million, compared with 2011. While we had 1% increase in non-OEM product revenue in Q1, this was offset by the 20% decline in non-OEM product revenue during the second quarter, as we have previously discussed.

We continue to experience growth in our support and services revenue, which increased by 10% compared with the previous year. The maintenance portion of this revenue increased 7%, from $14.3 million in 2011 to $15.4 million in 2012, which is an indicator of our installed base's satisfaction with our products.

Professional services increased 40%, from $1.4 million in 2011 to $2 million in 2012. Our operating expenses, excluding stock-based compensation and legal-related costs, decreased 4%, from $33.5 million in 2011 to $32.1 million in 2012.

On a year-to-date basis, our non-GAAP operating loss was $6.3 million, compared with $5.2 million for the same period a year ago. Our non-GAAP operating result excludes stock-based compensation of $2.7 million for 2011 and $2.5 million for 2012, as well as a net reduction of $400,000 and a charge of $3.8 million of legal-related cost for 2012 and 2011, respectively.

Our non-GAAP net loss for 2012 was $7 million, or $0.15 per share, compared with a net loss of $5.4 million or $0.12 per share in 2011.

On a GAAP basis, our operating loss in 2012 was $8.4 million, compared to an operating loss of $11.6 million in 2011. In 2012, we had a net loss of $9.1 million, or $0.19 per share, compared to net loss of $11.9 million, or $0.20 per share, in 2011.

Our mix of revenues remained consistent across all regions of our business. We continue to see a soft economy within all of our regions and we will continue to monitor the impact for the macroeconomic conditions on our business.

To summarize, the softening in expected revenue from all of our regions, the ongoing global economic malaise and the uncertainties surrounding the timing of an economic recovery have resulted in our need to reassess our revenue forecast for the second of this year and on a run-rate basis. While we believe our revenue in Q2 is not indicative of what we expect to achieve on a quarterly basis, it does reflect the uncertainty and difficulties many are facing in this current economic environment.

Our goal is to return the company to break-even, while preserving our ability to possess in new product development. However, due to an ever-changing economic environment and the uncertainty of when we will see a consistent economic global recovery, it is difficult to predict revenue expectations going forward.

Therefore, we believe it is prudent and in the best interest of the company to reduce expenses to a level where we can be reasonably assured that we are managing the company in the most efficient manner during these unsettling times.

To that end, we have engaged in a cost-savings initiative that is expected to result in approximately $10 million of gross annualized savings. The majority of these savings come from personnel costs, including a reduction of approximately 7% of our existing global workforce and the elimination of select positions.

These cost-savings initiatives impact all departments and regions across the company. We believe this action is necessary and critical in response to the changing economic conditions and to ensure that we can continue to focus our resources on our core business while funding our next generation of products.

Going forward, we will continue to evaluate the appropriate levels of expenses for each of our departments with the primary objective of investing on our resources in the most profitable and strategic areas of our business.

On the government investigation front, we were pleased to announce on June 27 that we have reached a settlement with the United States Attorney's Office and the Securities and Exchange Commission for a total of $5.8 million for which we have previously accrued. During the second quarter, we paid $2.9 million of the total $5.8 million.

Additionally, in July, we paid another installment of $1.2 million with the balance of $1.7 million to be paid in December of 2013.

We continue to have a strong balance sheet, with $33.6 million in cash and cash equivalents, which is equivalent to $0.31 per basic share. Although we had negative cash flow from operations of $2.5 million for the 6 months ended June 30th, this does include the $2.9 million settlement payment made during the second quarter.

Finally, we made various growth of deferred revenues which grew 2% to $26.3 million in Q2, compared with 26.5 -- $25.8 million at the end of Q2 2011.

And now, I'll turn the call to Bernie Wu, who will provide you with an update on OEM departments. Bernie?

Thank you, Lou. Although we've decided to be fiscally conservative by scaling back our expenses to deal with the near-term macroeconomic uncertainty, we believe the partnerships we've established will anchor future long-term growth.

As Jim mentioned, we released VTL version 7.5 in April, and we are now in the process of completing qualifications with our strategic retail partners and we expect them to launch this quarter. Cost reductions, performance improvements and greater configuration flexibility are the main benefits of this release.

Our VTL deal pipeline has also improved from last quarter and we continue to be confident in the long-term viability of the VTL market and our competitiveness. We are seeing increased interest in our Network Storage Server product for managed disaster recovery and backup services, not only with our larger strategic partners, but also with smaller, more traditional bars.

We are establishing new business models to engage these partners in this fashion and in the process of rolling out better DR automation and management through tools such as RecoverTrac 2.5. However, as these new business models are subscription-based, it will take some time for these new revenue streams to build up.

Data migration services for storage infrastructure upgrades continue also to be a focus of us for NSS and we are in the process of rolling out a more expanded co-marketing effort with one of our current strategic partners in this area. We're also seeing stronger interest in using NSS as a permanent bridge between legacy SANs, and cloud computing, and also solid-state storage disk tiers and are working on several initiatives with strategic partners to enable joint sales.

In summary, we continue to see strong long-term demand for VTLs, Falconstor's VTL and dedupe as well as the CDP NSS product lines. And now, we would be happy to take your questions.

Operator, please?

Actually, I have a couple of questions here. I guess, first and foremost, Jim, you cite macro factors, but the reality out there is your competitors managed through it a lot better.

You're losing share and I'm actually a little disturbed that you aren't taking a little bit more ownership of what went wrong. So can you talk a little bit about what besides macro factors went wrong?

Well, Brian, I think you're correct in saying that our competitors weathered the storm better than we did. We are seeing significant competitive discounts across the board, which is an issue, and we have had considerable FUD that we're dealing with that are spread by our competitors about the corporate long-term viability of the company.

It hasn't been helpful operating under the specter of a U.S. Attorney and SEC investigation for the last 20 months.

It's been a factor. I'm really happy to be able to put that behind us.

I think that we looked very, very carefully at our pricing and our discount structures and we're making some changes there. I think, historically, the MSRP for the product has been higher than the street, and the discounts have been historically steeper.

And so these are the areas that we want to address. Also, I think, historically, that our hardware margins had been somewhat less than ideal.

The more hardware we sell the more it impacts our margins. And we need to address that as well.

In terms of ownership for what transpired here, one of the things that we have to do a better job of is we have to do a much better job of regeneration and opportunity creation. And in our recent restructuring, we've made changes in terms of how we're doing marketing on a going forward basis, and that's going to be addressed on a regional basis so that each of our leaders have ownership in those categories.

Also in terms of product delivery, we have restructured engineering in a manner that allows us to have specific, dedicated product teams so that we can stay focused on our delivery schedules that make sure that we meet the objectives that we lay for ourselves. So we're not trying to shirk the responsibility and I respect the question, but we do see substantial slowness in the marketplace, which is really kind of extraordinary for us.

And we're doing everything we can to address it going forward.

Okay. And my second question, and I guess it's a little more strategic, but at what point in time and in what benchmarks would you be looking for, at which point you determine that FalconStor isn't of the necessary scale to be a viable, stand-alone publicly traded company?

Well, I think that's more of a question that you're supposed to answer, Brian. I mean, certainly, we're not happy about trading it at $2.

I mean, it's not something that we're focused on, but we're not happy about it. I think our goal is to return the company to steady growth in the near term so that, as Lou said, we can achieve our break-even targets and then introduce innovative technologies in the year to come, which is going to return us to a much more attractive growth.

That in turn is going to impact our stock price and return us to a much more healthy, viable public company. But to say that we're focused on stock price would not be fair and accurate.

We're really not. We're focused on improving performance, as you pointed out in your previous question.

That's what we should be doing.

Okay. And then my final question and then I'll cede the floor is, with respect to the SEC settlement, can you talk about the impact in terms of the customer facing side of things?

Did you see any relief from customers? Any reduction in FUD?

Or did you actually see it get worse, given the wording and nature of the settlement?

I would have to say that this is obviously a kind of an editorial comment, subjective comment, subject to comment. It's -- I'd say it's somewhat neutral right now.

I think that as we get distance between the separation and our current business or the settlement and our current business, it's going to get better. This quarter certainly is going to be something that our competitors are going to want to wave in front of our customers.

So we have to do a much better job of communicating the real value that we provide. And that's one of the reasons why I spent time talking about VTL and RecoverTrac today, because those products have the value promise that can't be matched by our competitors and we have to do a much better job of communicating our total cost of ownership and our value benefits.

That is going to turn the tide for us, because when customers get substantially greater value from our products, the risk factor becomes less and less of an issue. So that's where we have to really execute.

Okay. And then if I can ask one more and this one you probably won't appreciate as much, but since you've got in here, the company has been through a couple of CFOs, a couple of heads of sales, why are you the right guy to lead this some continuing forward?

Well, I guess that's a decision for the board to make, Brian. My feeling is that this company was a company that was positioned to go over $100 million in sales based on a historical business model that did not come to fruition.

And I walked in at the time when the company had an infrastructure that was targeting $100 million. So it had an operating expense budget, which was -- it's far exceeded its potential.

We have a product line that is maturing and it needs to be refreshed significantly. And so we've had to create a new product direction for the company and a strategic direction, which we've done, which I have done.

And it doesn't get corrected overnight. So I think that, as I said, the board and shareholders are always capable of changing leaders and I respect those decisions.

I think I'm providing the company with the kind of leadership it needs to move forward and in regards to the changes we've made in sales and in financial officers, on the sales front, if sales doesn't perform at the level you need to, then you need to make a change, as you're indicating with your CEO comment. And if the Chief Financial Officer has a substantial different opinion as to what's important and what's valuable for the company, then you need to make a change as well.

So I would rather err on the side of hiring slow and firing fast than trying to manage my company for optics. We are really hell-bent on delivering positive results for this company and moving us into a new era of growth in products and I'm not going to manage the company for optimal optics in the marketplace.

Well, as one of your shareholders, I mean, what I'm a little puzzled by, and sort of following up on Brian's issue is, we went through and hired a whole sales force. Remember, we trained them before we had the product and they couldn't sell anything because we didn't have the right products?

So I'm a little puzzled by why suddenly -- I mean, that was 9 months ago, 3 quarters ago. What happened with these salespeople?

Well, what happened with them? Here is -- in here, I'm going to take full credit for this.

I hired a sales professional from Symantec, believing that we had the right guy with the right vision to build a professional sales organization that knew how to sell and he went out and recruited a number of very talented individuals who have sold Oracle, who have sold SuccessFactors, who have sold EMC, some of them Symantec, others -- a number of different products. I believe I underestimated the technical aspect of our products and the fact that we need to have people on the street who really understand some of the finer nuances of our technology.

Historically, the people who have been able to sell our products and do so well are people who are well-versed in the value that our products bring. And somebody who is recently selling an Oracle database or a SuccessFactors solution did not come up to speed in that category, despite all of the efforts we put forth to educate them.

So does that mean we need a new sales force or we already have a new sales force?

It means -- well, yes, we have a number of salespeople who historically have made their numbers. The ones who don't make their numbers, we retire and we bring on new people who are in the mold of the people who are performing.

And that's the exercise that we're going through with Gary Quinn right now and he's doing a very good job.

Have we -- so have we already cut the -- I mean, the way you used Symantecs in 2 or 3 different ways and that both you and the CFO said it, have you already cut the expenses?

Yes.

Okay. So you're already done through the cutting?

Yes. We didn't make that perfectly clear.

So as of last week, we've executed our reduction in workforce and we're moving forward.

Now going back to Brian's issue and you and I have discussed this before, my concern on this all is not so much of you, the products or whether you're the right leader or anything else, but mine's sort of a different ilk, which is this is a really difficult thing to do, to turn around a company that has all sorts of different problems. And obviously, as you got in there, there were a much bigger -- there were much bigger problems and no sooner did you get there than the indictment came out.

And I guess the question is, given the environment and given where we are and given how hot certain parts of the markets are that you're involved in, is it really worth the risk of trying to spend a bunch of money and another year fighting the teeth of the recession to try and get the true value, because I know that you can't -- I know that you say that you're not running it for your stockholders, but your stock has went from $4 to the lowest price it has been way before the indictment?

Well, let me just correct one thing that you said.

So, all I'm saying to you is that you can't really address -- you can't really say, well, I'm not running -- I know you're running it for the shareholders, but you also have to look at your stock price. You can't just run it into the ground and then say, "It's not going to work."

Right. I respect that and so there's 2 comments I want to make.

My point is that we haven't been running it to maintain a stock price as our sole focus, because if you want to do that then you're going to have a short-term opportunity here. We could do a 20% rev and reduce expenses down and turn it into a cash cow and if that's the course and direction the shareholders want to take, they can communicate that to us.

The reason I would not advise doing that is because the IP portfolio in this company is really well-suited to solve some of the biggest problems that most enterprises are dealing with today. And the challenge is to package that technology in a way in which it can be consumed.

So the best way for us to address our near-term stock issues are to not repeat what we did in Q2, to actually execute in Q3 and Q4 so that we finish this year at break-even or better, deliver the technology that we've committed to deliver and then also deliver the data key project in the first half of next year, which is going to be a big breakout opportunity for us. That's the vision that we have.

Right. But given what you've seen so far and given what you're now well into the next quarter, one month, I mean, and given what's going on in the environment, I mean, I would assume there's going to be some time here in the next 3 or 4 months, where you're going to say, "Wow, this is either not working or it's not working as fast and we can't show up with more losses."

I mean, I guess we can go to one but, I mean, it's -- I mean you have to have -- I don't -- again, I'm not trying to beat you up, but you have to have some sense of the fact of what the value is to these -- I mean, to the shareholders.

Right.

This is not a huge human experiment in which you're riding off into the sunset and if it doesn't work, tough luck.

No, John. I don't view it as an experiment at all.

I think we're dead serious about what we're trying to do here. We're trying to, obviously, preserve the livelihood of over 450 employees and the investments of many, many shareholders and return them a significant return based on our future opportunities.

I fully believe, John, that Q2 was the anomaly for us. It was a very, very difficult quarter and we have, as Bernie indicated, we have a growing pipeline in our VTL category, which contributes substantially to our top line.

And we are going to transition in each of our regions. So these things have an effect on organizations.

The next couple of sign posts that we should be looking for, presuming we're still on sort of the, gee, if we can get it solved to get the class action suit settled, if possible, and then go after the estate. Are we still on that sort of time line?

Well, the class action suits we filed for dismissal on those, those are being managed as should be, and the company will take whatever actions it needs to, to make itself whole.

Right. But we don't -- but are those sort of the most important next time lines that we're looking at or are we looking at more optimistic announcements of sales wins?

Well, I think those are going to run their ordinary course of business, John. I mean, I'm much more focused on the revenue and in closing a good year.

So the other stuff is going to fall into place.

Okay. Well first of all, Brian and John, thank you very much for your questions.

They're hard to ask and they're hard to answer, but they're important. Thank you, everybody, for joining us on this Q2 call and I mean it sincerely when I say that we are all committed to achieving much better results in the second half of this year.

Thank you, and have a good evening.