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 Q3 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 Jim McNeil. Please go ahead.

Thank you, operator, and welcome to FalconStor's Q3 earnings call for 2012. I'd like to start off by thanking all of our dedicated employees for their hard work in keeping the lights on at FalconStor during the challenging times of Hurricane Sandy.

We had a number of really committed people who were here almost 24/7 and through their efforts, we suffered 0 interruptions to our business, to our global support and our operations. In fact, we were one of the few companies that was able to offer and extend our facilities including our Internet and our power to our local customers, partners and friends, and I'd like to reiterate that offer and let people know that if there's anything we can do to help them deal with the current challenges brought on by the weather in the Northeast, that we're happy to extend a hand.

So again, I'd like to thank our employees for such a valiant effort and to let you know on the phone that FalconStor suffered no service loss whatsoever during the recent days, even though many of us continue to live without power and are sitting in lines waiting on fuel to get to work.

With that, let me talk about our Q3 performance, and then I'll hand it off to Lou to go through the details on the financials.

First of all, let me say that while our Q3 revenue performance was sequentially higher than Q2, our $17.1 million in revenue fell 9% short of the previous year's quarter. And it also fell short of our internal expectations.

We weren't terrifically happy about the performance. Most of that, we attribute to a significant amount of caution in IT spending in the European and U.S.

marketplace and continued competitive pressures brought on by -- in what is really a competitive field, everyone’s fighting for effectively a smaller number of deals, and it's a really good battle to get things done.

We continue to invest significantly in research and development. And the work that we're doing is going to bring 2 very exciting products to market in the first half of next year, one of which is in the data protection space, the other one, which is the extension of our dedupe and VTL business -- it is really a next generation secondary storage repository.

These products herald a new day of innovation of FalconStor. They're designed to not only be disruptive in the market they're serving, they're also designed to reduce our cost of sales, reduce the time it takes to close a deal and to improve and increase our gross margins, both because of the factors I just mentioned and also by a cost reduction of hardware in the case of dedupe and VTL.

Also, let me say, that the efforts that we took in Q3 to reduce expenses, which actually would add up to about $10 million in total cost reductions on the 2012 budget, are going to start to be realized more significantly in the current quarter, in Q4. So we're happy that we're making good progress there.

I think we're doing a good job at husbanding our cash and being good fiscally responsible managers.

Lastly, the recent changes that we've made to our price book, for both U.S., local and European and Asian operations is going to provide our salespeople to have a much more competitive position and be able to deal with pricing, which is much more Street competitive. And I think that, that's also going to have an impact on our performance in Q4 and the year to come.

Having said all that, it is our job, our fiduciary responsibility to always evaluate options to the company on both the long-term and short-term basis. It's our job to explore strategic alternatives to maximize shareholder value.

To that end, I'm happy to say that we have retained Wells Fargo Securities, LLC as our financial advisor to assist the company in exploring strategic alternatives in order to maximize shareholder value.

We intend to update you on -- regarding this process, only when and if our Board of Directors has decided to conduct the transaction.

So with that, I'd like to hand this over to Lou Petrucelly, and he'll walk you through our detailed financial information. Lou?

Thank you, Jim, and good afternoon, everyone. I would like to take you through a summary of our quarter.

I will discuss our results from the quarter, provide color around the challenges and headwinds we continue to encounter in our business, and finally, outline our plans for moving forward.

For the third quarter of 2012, our total revenues decreased 9% to $17.1 million, compared with $18.9 million in the same period a year ago. We attribute the softer-than-expected revenues from all of our regions, particularly our North America region, to the ongoing uncertainty and overall softness in the global marketplace, which has caused a number of our more significant deals to either be postponed or lost due to budget freezes, deeply discounted competitive pricing or the successful use of misinformation against the company by some of our larger competitors.

Product revenue from our OEMs declined by 49% or $800,000 compared with Q3 2011. This was partly due to disruptions with one of our larger OEM partners in China which underwent an internal reorganization commencing in the second quarter of this year, which has continued into the second half of the year, causing disruptions in their forecasted Q3 and full year 2012 commitments.

While this OEM did perform significantly better compared to the second quarter, it was still well below our expectations and the OEMs' prior-year performance.

Product revenue from our non-OEMs declined by 9%, or $800,000 compared with Q3 2011. As we have stated, all of our regions continue to be impacted by the soft economy, lack of a global recovery and overall uncertainty in the marketplace.

In Asia Pacific, our non-OEM product revenue was up 8% year-over-year and 9% sequentially, which is a positive indication of the potential market stabilization in our Asia Pacific channels. While our non-OEM product revenue from Asia Pacific shows solid year-over-year and sequential growth, it still did not meet our expectations, which we believe was partly due to a slow down some of our partners faced as a result of the economic challenges throughout the world.

In North America, non-OEM product revenue was down, in part, due to a decline in revenues from one of our larger partners compared to the prior year. Additionally, there were larger deals with this partner scheduled to be closed during the third quarter that were ultimately postponed due to budget freezes and misinformation used against the company in an attempt to derail these deals.

Overall, the North American non-OEM product revenue contribution was below our expectations and prior-year performance, which we believe was due to all the challenges and headwinds we have discussed.

In our European markets, non-OEM product revenue was down slightly year-over-year, while increasing slightly sequentially. The overall uncertainty in the European financial markets has made it difficult to forecast particular revenue expectations from this region in the near term.

Our support and services revenue, which is comprised of maintenance and professional services, decreased by 2% compared with the previous year. The maintenance portion of this revenue remain consistent at $7.9 million for both Q3 2012 and 2011.

While we typically experience growth in our maintenance revenue year-over-year, our third quarter maintenance was adversely impacted by the number of deals that required increased pricing discounts in the competitive environment, the timing of when deals are closed in relation to the quarter end and a decline in current period product revenues, specifically from our OEM partners when compared to Q3 2011.

Professional services decreased 15% from $800,000 in Q3 2011 to $700,000 in Q3 2012. Professional services revenue tend to fluctuate based on the completion of deployments.

Next, I will turn to our Q3 non-GAAP results, which exclude legal costs, restructuring expenses and stock-based compensation. Our product gross margins decreased to 82% in Q3 2012 from 86% in the same period in 2011.

The decrease of product gross margin was primarily attributable to an increase in the number of fully integrated offerings, which include hardware appliances and a decline of product revenues in Q3 2012, compared with the previous quarter.

As we have stated in the past, the mix of our product revenues, for example, the number of software-only solutions versus fully integrated appliances sold during a period and the level of product revenues can materially impact our gross margins.

Our support and services gross margin decreased slightly to 62% in Q3 2012 from 63% in Q3 2011. The decrease in gross margin was primarily attributable to the decline in our services revenue during the quarter.

Overall, our total gross margins decreased to 72% in Q3 2012 compared with 75% in Q3 2011. However, it has increased from 70% in Q2 2012.

Our operating expenses decreased 7% in Q3 2012 to $15.4 million from $16.5 million in 2011. The net decrease in our operating expenses was primarily due to a 50% decline in our sales and marketing cost during the third quarter compared with the same period a year ago.

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

During the third quarter, we recorded a net reduction of $1.4 million of investigation, litigation and settlement costs. The net reduction resulted from the company recording a receivable in the third quarter with a recovery of $1.1 million of previously accrued legal fees and $400,000 of certain costs that were previously accrued associated with the class action [indiscernible] lawsuits as a result of a settlement reached with one of our insurance carriers in October of 2012.

These amounts were partially offset by $100,000 of overall legal fees that were not recoverable through insurance. In the same period of 2011, we recorded $0.5 million of legal fees which were associated with the then government investigation and related class action.

Finally, as we've discussed during our Q2 earning call, after the close of our second quarter we completed the restructuring which was composed of a workforce reduction of approximately 35 goal [ph] positions, or 7% [ph] of our then-existing workflows from various departments across the company. These actions were intended to better align our core structure with the skills and resources required to more effectively execute our long-term growth strategy, drive operational efficiencies and to support the anticipated revenue levels we expect to achieve on a go-forward basis.

The total expenses incurred with respect to our 2012 restructuring plan were approximately $800,000. This action is expected to result in an annualized run rate cost savings of approximately $10 million versus our 2012 budget and the full quarterly impact will be recognize beginning in Q4.

In Q3 our non-GAAP operating loss was $3.1 million compared with $2.3 million for the same period a year ago. Our non-GAAP operating results excludes stock-based compensation expenses of $1.1 million for Q3 2012 and $1.4 million for Q3 2011.

$800,000 of restructuring cost for both Q3 2012 and 2011, and a net benefit of $1.4 million versus an expense of $0.5 million of legal costs that I have previously discussed for each of Q3 2012 and 2011, respectively.

Our non-GAAP net loss for Q3 2012 was $3.1 million or $0.07 per share compared to a net loss of $2.6 million or $0.06 per share in the same period a year ago. On a GAAP basis, our operating loss in Q3 2012 was $3.6 million compared with an operating loss of $5.1 million in Q3 2011.

In Q3 2012, we had a net loss of $3.6 million or $0.08 per share compared to a net loss of $5.4 million or $0.12 per share.

On a year-to-date basis for 2012, our total revenues decreased by 8% to $52.9 million compared with $57.4 million in the same period a year ago. Product revenues from our OEMs declined by 61% or $3.1 million compared with 2011.

This was primarily due to a decline in revenue from our legacy OEMs, such as EMC and others of approximately $1.9 million, as well as a decline of $1 million from one of our larger OEMs in China.

Product revenue for our non-OEMs declined by 10% or $2.9 million compared with 2011. As we have previously discussed, all of our regions, in particular, our North America and European regions, continue to be adversely impacted by the soft economy, the lack of a global recovery, highly competitive environment for market share, and overall uncertainty in the marketplace.

However, despite the global slowdown and competitive environment, we have been successful in growing our non-OEM business in Asia by 3% on a year-to-date basis.

While this was below our expectations, it is a positive indication of our ability to gain market share in that region during difficult economic times.

We continue to experience growth in our support and services revenue, which increased by 6% compared with the previous year. The maintenance portion of this revenue increased 5% from $22.2 million in 2011 to $23.2 million in 2012, which is an indicator of our install [ph] base's satisfaction with our products.

While we have experienced growth in our maintenance revenues, this growth was impacted particularly over the past 2 quarters, by increased pricing discounts in the current competitive market, the timing of when deals are closed in relation to the quarter end and a decline in current-period product revenues, specifically from our OEM partners. Professional services increased 21% from $2.2 million in 2011 to $2.6 million in 2012.

Now turning to our year-to-date non-GAAP results. Our product gross margins decreased to 80% in 2012 from 84% in the same period in 2011.

The decrease of product gross margin was primarily attributable to an increased number of fully integrated offerings, which accrued [indiscernible] and a decline of product revenues in 2012 compared with 2011.

Our support and services gross margin increased to 63% in 2012 from 61% in 2011. The increase in support and services gross margin was primarily attributable to increases in both our support and services revenues during the year.

Overall, our total gross margin decreased to 72% in 2012 compared with 74% in 2011.

Our operating expenses, excluding stock-based compensation, restructuring expenses and legal-related costs, decreased 5% from $50 million in 2011 to $47.5 million in 2012.

On a year-to-date basis, our non-GAAP operating loss was $9.4 million compared with $7.5 million for the same period a year ago. Our non-GAAP operating result excludes stock-based compensation expenses of $3.6 million for 2012 and $4.1 million for 2011, $800,000 of restructuring costs for both 2012 and 2011 and a net benefit of $1.8 million versus an expense of $4.3 million of legal costs that I have previously discussed for each year 2012 and 2011, respectively.

Our non-GAAP net loss for 2012 was $10.1 million or $0.21 per share, compared with the net loss of $8 million or $0.17 per share in 2011.

On a GAAP basis, our operating loss in 2012 was $12 million compared with an operating loss of $16.8 million in 2011. In 2012, we had a net loss of $12.6 million or $0.27 per share compared to a net loss of $17.3 million or $0.37 per share in 2011.

Our mix of revenues continues to remain relatively consistent across all regions of our business. We continue to see some slippage in the contribution from our North America and EMEA regions as a result of the soft economy and other factors that we have previously discussed, and we are monitoring the impact the global slowdown and uncertainty may have on our growth and opportunity throughout our Asia Pacific region.

To summarize, our third quarter results fell short of our expectations, which we believe was due in large part to the ongoing uncertainty and overall softness in the global marketplace, which has resulted in deals being postponed or lost due to either budget freezes, deeply discounted product pricing.

In addition, to these challenges that we -- our peers have also encountered, we are starting to experience headwinds as a result of our competitors' successful use of their size, market share and financial strength against us.

We completed the restructuring during the quarter. This action was intended to better align our cost structure to support the anticipated revenue levels we expect to achieve on a go-forward basis while preserving our ability to invest our resources in the most profitable and strategic areas of our business.

This action is expected to result in an annualized run rate cost savings of approximately $10 million versus our 2012 budget, and a full quarter impact will be recognized beginning in Q4.

As we head into Q4 and into 2013, we believe we have properly aligned our resources with the objectives we set forth in our restructuring plan. We will continue to monitor our costs closely and invest our capital in all areas of the business as the needs arise, and are in a position to execute on our plans of delivering new and disruptive technology in 2013 with the intention of returning the company to profitability in the near term.

Turning to our balance sheet. As of September 30, we have $25.8 million in cash and cash equivalents, which is equivalent to $0.54 per basic share.

Although we had negative cash flow from operations of $9.6 million for the 9 months ended September 30, this amount does include $4.1 million of settlement payments made during the year, as well as $800,000 of restructuring payments as well.

Additionally, the lower-than-expected revenues of Q2 and Q3 and the ongoing macroeconomic uncertainties has dampened our cash flows on a year-to-date basis. We feel as we head into Q4 and into 2013, having the majority of our large cash payments behind us, have adjusted for our expense structure based on our current outlook and that historically our cash flows from operations typically tend to be strongest in Q4 and Q1 of each year, we expect to return to cash flow positive in the near-term.

Finally, our deferred revenue declined by 5% to $23.6 million in Q3 compared to $25 million at the end of Q3 2011. The decline was due to a decline in maintenance revenue from certain legacy OEM customers due to consolidation in the industry and decline in product revenues from one of our larger existing OEM partners in China and deeper discounts providing our product due to current economic and competitive environment.

And now, I'll turn the call over to the operator for questions. Damian?

A couple of quick questions. I guess, first, you talked a bit about the competitive environment out there, but when you look at gross margins, they actually ticked up a little bit sequentially.

Would you say that competitive environment in September was fairly consistent with that of June, or was there some mix shift that was beneficial to gross margin?

I think the competitive environment, Brian, is just as competitive in Q3 as it was in Q2. The margins as you say are really indicative of the mix of our revenues.

So as we sell more software or capacity with our products, and the less of hardware, it will obviously benefit our product gross margin.

So in the September quarter, did you see more of a skew to software versus appliances or was it pretty consistent?

It's pretty consistent.

Okay. I was just trying to determine if it was getting progressively worse or kind of steady state competitive and it sounds like it's probably more of the second.

My second question was around your restructuring. You talked about $10 million annualized cost saving.

So as we look at the annualized cost savings, what are we benchmarking that against? So if you look at full year operating expenses last year, you had I think on a non-GAAP basis it was $66.4 million, if you assumed it was $10 million lower than that annualized, you are at about $13.5 million a quarter -- or is it kind of compared to maybe the December or March quarter where you were at, I guess, $16 million and $17 million in OpEx?

It's really based off of what we -- our budgets we came into 2012 with, Brian. We came into the year, obviously, with certain revenue and expense targets and we adjusted our expenses by -- as we discussed, the $10 million of annualized savings.

So you really will start seeing a true run rate business from the expense end starting in Q4.

Okay. So as I'm trying to model Q4, should I be thinking an expense base in the range of $14 million a quarter in OpEx?

Or is that more aggressive than the $10 million savings would imply?

No. It's tough to -- we're not really giving the guidance on where we're going with our OpEx, obviously.

So all I can really say is that, it's based off of our budget -- our internal budgets and you will start to see a normalized run rate from expenses starting in Q4 and also into Q1.

And then from a product perspective, this may be more a question for Jim. A couple of things this quarter, you went GA and kind of got through the eval [ph] and test and some new product rollouts.

Additionally, you've got some accolades out of VMworld. Can you talk any about kind of what's been the -- both the end customer as well as OEM response to the new products?

Are you seeing any appreciable build in your longer-term pipeline?

Well, there's a lot more focus and attention on the capabilities of RecoverTrac. So the accolades that I think you are referring to are -- the fact that RecoverTrac won Best of Show at VMworld this past August, which we're really proud of.

And RecoverTrac is fairly unique in its ability to automate and orchestrate complex recoveries in large enterprises. We're continuing to expand capabilities of that product.

In fact, we're going to be changing the way VMware recoveries are performed in a manner that can possibly save an average customer between $25,000 and $50,000 in savings by using RecoverTrac. So the interest in that is high.

The interest in using RecoverTrac to provide for more predictable recovery performance is high. We also have a lot of people, certainly in Europe, that are leveraging the stretch cluster capabilities of NSS and we are going to -- we really normalized that capability in the next release of NSS.

So that's going to continue to, I think, be a very, very high value proposition on a storage virtualization basis. The ability to do business continuity, fail over, fail back in a Metro cluster, that's going to be very, very appealing.

So we're getting a lot of attention there. And I think also we continue to compete very handily against the dedupe and VTL customers -- I mean, competitors out there.

Our products are selected consistently for having the ability to scale for high availability and for really high dedupe ratios and really good value. So we're getting strong, larger accounts there.

There's a number of EMC customers that are coming off lease after the last 3 years. And so there's a lot of Data Domain customers looking to see if it makes us to go back to Data Domain or to look for other alternatives.

We are having some of those conversations as well.

Okay, great. And then the other question is we think about the value of the intellectual property portfolio, both that recognized in terms of the products and the revenues you're generating, but also from a patent basis.

So as you think about strategic alternatives, are all options on the table in terms of patent licensing, sale of patent? And if so, what areas of your technology portfolio do you see as now having particular value given the market focus on the software [indiscernible] storage?

The main purpose behind retaining Wells Fargo Securities, LLC is to explore all strategic alternatives. We have a sizable R&D pipeline, if you will.

There's a number of key products that we would like to invest in. We've got 2 significant product initiatives that I alluded to in my opening remarks.

One in disaster recovery, the other one in the next generation of dedupe and secondary storage repository. Those initiatives are being funded from operations.

And that's why we've opted to operate the company at a break-even basis because we fully intend to return to double-digit growth when we release those products to market. They're disruptive, they're innovative, they're exciting.

But there are other projects, Brian, that we would love to fund. But we can't do it from operations.

So part of the conversation with people like Wells Fargo is to help us to figure out how to realize that opportunity.

So just to reiterate, what we just talked about with Brian, I think the company is well-positioned to return to cash flow positive in Q4 to get back to profitability in the near term. We're very, very excited about the products that we're bringing to market in the first half of next year, both enhancements to existing products in the category of RecoverTrac and NSS and VTL, and also substantial new product deliveries in Q2 in a highly disruptive way, which is going to improve our gross margins, improve our volume and improve our cost of sales.

So the company is rather bullish about those opportunities.

And with that, I'd like to thank you for your time. And for all of you on the East Coast, I wish you well in weathering this current storm we're in, and I hope everyone gets power.

Thank you very much and have a pleasant evening.