FalconStor Software, Inc.

Gary Quinn - Chief Executive Officer, President and Director Louis J. Petrucelly - Chief Financial Officer, Principal Accounting Officer, Vice President and Treasurer

David Cohn John Aniblo Zaro - Bourgeon Capital Management, LLC

Thank you, operator, and good evening to everyone, and thank you for joining us. I want to say that I'm extremely pleased about our performance in achieving our goal of profitability in Q4 2013.

While we still need to wind down some leases and contracts, which will further improve our cost structure, we've almost completed the rebalancing of FalconStor. We're looking forward to the 2014 fiscal year, making a number of investments to grow the business.

Our revenue performance was also within the goals we had set internally, and in a moment, Lou will explain more about our total bookings numbers, which are not reflected in our revenue due to the treatment of some transactions that enabled us to increase customer wins as well as expand existing customers in our installed base. Let me give you a few highlights of Q4 2014 (sic) [ 2013 ], starting with some new financial controls and processes.

Under our expense structure -- our expense structures are well under control. Lou and I have complete visibility on a monthly basis to ensure the company continues its momentum into 2014.

Our global deployment of a new financial system will permit real-time access and understanding of our revenue and expense position throughout the quarter for any needed adjustments. Effective January 1, 2014, our regional General Managers are on profit and loss budgets, which are tied to their compensation plans, and which consist of a regional bookings target and a regional operating margin target which includes company-wide allocations for corporate G&A, R&D, technical support and training.

We are creating a performance-oriented culture at FalconStor that is being encouraged by the following newly initiative programs. All non-commissionable employees receive a bonus based upon company performance targets that are set quarterly, based upon achieving predefined financial goals.

If the company hits its goal, the employees will receive their bonus. In addition, our R&D organization is now on performance delivery bonuses to produce quality products on time.

This allows us to produce industry-leading products that customers and partners can feel confident in. Finally, our Q4 2013 performance on a bookings basis met management's expectations, as we look to return FalconStor to its prior position as a leader and top performer in the industry.

A little color on some of our regional performance. We were pleased with the performance of our China business in both Q4 and for the full year of 2013.

In addition, our Huawei business partner returned to a normalized run rate during the quarter. And we are looking forward to a successful year in China as well as renewed excitement with Huawei in the coming year.

We also have invested in our Beijing business further to expand our government opportunities, which we are currently enjoyed by planning a -- to move to a new location where we will create a FalconStor Technology Training Center for government employees using our technology. This was a requirement to further our efforts with the China government.

Our Korean business had a good Q4 in 2013. Upon closer review of this business, we determined that in order to compete better and win more business with systems integrators we needed to change our approach to this business and provide more flexible terms to win more business.

By doing that in Q4 we were able to expand our customer base as well as new prospects. Lou will talk more about this in a moment.

Our European business in Germany and Eastern Europe had a good performance in Q4 2013. We had a number of wins with our HDS partner, as well as continued new growth and expansion of our NSS Solutions with some innovative pricing models that were used up against the competition.

Our Northern territory, which includes the U.K., Ireland and the Nordics, also completed Q4 with a good performance with a number of exciting new wins. This gave us confidence that the turnaround in that region was beginning to take hold under our new leadership that was put in place in 2013.

Finally, our North American business had its best customer maintenance renewal performance in both Q4 and annually in 2013. I believe this is attributed to the value that our technology delivers and the customer service that we are providing.

We still do need to improve upon our new customer revenue in 2014. And we are pleased that we've been able to bring aboard a solid GM along with a new core sales team for North America.

Once again, FalconStor has the ability to deliver what the marketplace needs in this ever-changing world of technology. The affirmation has come through many meetings and phone calls that I have initiated or have received from staff, customers, partners and industry analysts as well as some of you on this call.

We will continue to look for improvements on our cost structures while we grow the company with innovative technology offerings and sales programs. We must be realistic in our efforts and ensure that the foundation upon which we are moving forward is solid and verified.

I must say that I am truly excited and passionate about the future of FalconStor and delivering on the results that our employees, customers, partners and especially shareholders expect. I would like to turn the call over to Lou, who will take you through our financial results for the quarter ended December 31, 2013.

Thank you, Gary, and good evening, everyone. Historically, we have discussed our results on a year-over-year basis.

However, over the next several quarters, we believe it is more appropriate to measure our results on a sequential basis, which will better highlight the progress we are making of stabilizing our business as a result of the rebalancing efforts which commenced during the second half of this year. Our earnings release distributed earlier today contains our year-over-year and full year results in accordance with GAAP.

As Gary mentioned, we are pleased about our performance and our ability to achieve our goal of profitability in Q4. And I will provide you with a brief update on the progress we have made during the quarter.

As we discussed throughout the year, in order to be more competitive, we are adopting a new business model that meets our customers' purchasing needs. We are entering into deals with customers which provide flexible terms, such as how much capacity is purchased at the point-of-sale versus how much capacity will be purchased in the future, as well as other business terms that provide various forms of flexibility.

As we move more and more to these types of transactions, the timing of our revenue recognition may vary from our historical upfront method. However, we believe this flexibility will ultimately provide us with more opportunities in securing deals and to grow our market share moving forward.

During the quarter, we began to see more transactions utilizing our new flexible model, resulting in lower upfront revenue recognized at the point of sale, while increasing our bookings and deferred revenues. For the fourth quarter of 2013, on a GAAP basis, our total revenues declined less than $100,000 to $14.6 million compared with $14.7 million in the previous quarter.

Product revenues declined slightly to $6.5 million from $6.6 million in the previous quarter, primarily due to the increase in the number of deals we closed using our new flexible model. I will touch on this more in a few moments.

Our support and services revenue, which is comprised of maintenance and professional services, increased 4% compared with the previous quarter. The maintenance portion of this revenue increased to $7.6 million compared with $7.5 million in the previous quarter, and our professional services revenue decreased slightly compared with the previous quarter.

As I mentioned earlier, during the quarter we increased the number of deals whereby we offered various flexible terms, therefore resulting in lower upfront revenues. For example, during the quarter, we decided the most effective way to compete and to grow our Korean business was to offer a flexible pricing model.

This flexible pricing model resulted in substantially all the deals from Korea being recognized on a ratable basis or over the contractual term, as opposed to our traditional upfront recognition model. As a result, we believe product bookings will be an important measure of our progress moving forward.

Product bookings represent the total amount of product revenue ordered during the quarter, but may be recognized either under our traditional upfront model or over the term of the related agreement. During Q4, our product bookings totaled $8.4 million compared with $7.2 million in the previous quarter, an increase of 16%.

On a pro forma basis, our Q4 non-GAAP total revenues were $16.6 million compared with $15.4 million in the previous quarter, an 8% increase. Pro forma non-GAAP total revenues include product bookings plus our existing GAAP support and services revenue.

Going forward, we expect to report on our product bookings as well as our GAAP revenues. While we are pleased with our quarterly revenue results from both a GAAP and non-GAAP, or bookings perspective, we recognize there is still work to be done, and our goal will be to continue to improve our top line results every quarter.

Next I would like to turn to our Q4 non-GAAP results, which exclude restructuring expenses, legal costs, stock-based compensation and other below-the-line nonoperating activities. Our product gross margins increased to 89% from 82% in the previous quarter.

And our support and services gross margins remained consistent at 69%. Overall, our total gross margins increased to 78% as compared with 74% in the previous quarter.

The increase in gross margin was primarily due to the mix of our product revenue, whereby we sold more software-owning solutions versus fully integrated appliances during Q4 as compared with the previous quarter. We reduced our total operating expenses by 18% as compared with the third quarter of this year.

The decrease in our operating expenses was primarily due to a full quarter realization of our restructuring efforts, as well as our focus to overall cost-reduction initiatives. To a much lesser degree, there were expenses recognized during Q4, which we will realize in cost savings in 2014.

We are extremely pleased that we achieved our goal of breakeven or better on a non-GAAP run-rate basis by the end of the quarter. Our operating and net results increased by 150% and 132%, respectively.

We recorded non-GAAP EPS of $0.01 per share in Q4, compared with a loss of $0.04 per share in the previous quarter. On a GAAP basis, in the fourth quarter, our product gross margins increased to 89% from 82% and our support and services gross margins increased slightly to 69% from 68%.

Overall, total gross margins increased to 78% from 74% in the previous quarter. We reduced our total operating expenses by 16% compared to third quarter of this year, as a result of the initiatives we discussed earlier.

We are pleased that we narrowed our GAAP operating loss by 76% to $1 million from an operating loss of $4.2 million in the previous quarter and recorded positive net income as a result of a $1.9 million gain on the sale of our investment in Blue Whale during the quarter. Finally, we recorded GAAP EPS of a $0.01 per share compared with a loss of $0.05 per share in the previous quarter.

Turning to our balance sheet. As of December 31, we had $28.1 million in cash, cash equivalents and marketable securities, compared with $29.5 million at September 30.

During the quarter, we received a $3 million milestone payment from a joint development activity with Violin Memory, a $3 million payment from the sale of our Blue Whale investment and $900,000 in insurance proceeds. We also made payments during the quarter of $1.7 million and $5 million related to government investigations and class actions, and $900,000 of payments associated with our restructuring efforts.

On an adjusted non-GAAP basis, for the quarter, we generated positive cash flow from operations of $1 million compared with cash used in operations, on an adjusted non-GAAP basis of $2.3 million in the previous quarter. The adjusted non-GAAP cash flow from operations excludes payments in connection with our legal settlements and restructuring activities, and proceeds received from our joint development activities.

As of December 31, our deferred revenues totaled $29.8 million compared with $25.3 million at September 30. The increase in deferred revenues was attributable to the receipt of $3 million during the quarter related to our joint development agreement as well as an increase in our bookings during the quarter of 16% compared with the previous quarter.

As we previously discussed, as we enter into more transactions utilizing our new flexible model, we expect to have lower upfront revenue while increasing our bookings and deferred revenues. We believe deferred revenue will be a key metric in measuring our success in driving growth of our top line moving forward.

Finally, we continue to carry no debt. To summarize, as you can see from our results and from the actions we have taken over the second half of the year, we believe that we have taken steps in the right direction to address the size of our balance sheet, reduce our operating expenses, slow our cash burn and to stabilize and grow our business moving forward.

Our new overhead structure shows our commitment to align our costs with activities directly supportive of top line growth. Heading into 2014, we will maintain our focus on our core products and execute our business plan in a way that will better enable us to capitalize on our strengths and previous successes.

Our goal in 2014 is to break even on a non-GAAP basis and to generate positive cash flow from operations on a full year basis. As we mentioned earlier, some of our new sales programs will cause revenue from certain transactions to be recognized over time, compared with our current upfront revenue model.

Therefore, some quarters may be lumpy, depending on the mix of flexible business we transact. As a result, we will not be giving quarterly or full year 2014 guidance, as we believe we are in a year of transition from both a top line and expense control perspective.

Our focus will be on driving stability within the business, capitalizing on areas where we can reinvest back into the business in support of growth initiatives and growing our deferred revenues and bookings on a sequential basis. We believe we are on the correct path to execute our plans heading into 2014.

While there is more work to be done over the next several quarters, we are excited and focused on executing on our objectives. And Gary and I look forward to updating everyone on our progress on our next call.

I'd like to turn the call over now to the operator to open the line for questions. Operator?

Couple of things, housekeeping questions. What was the book-to-bill in the quarter?

Well, we had -- for the quarter we had 8.3 in product. And, our bill is just under 6.5.

I mean, there were some things on it that came in from a ratable model historic price of Q3, David. I'll give that number -- the exact number afterwards.

Awesome. Huawei, a 10% customer in the quarter?

Huawei is not 10% customer in the quarter. We only had 1, and that was the HDS.

And when you said Huawei returned to a normalized purchasing pattern, can you give us an idea of what is normalized? Because I thought the previous purchases -- the last purchase we had from Huawei was about a $1.5 million -- $2 million was my recollection, in late '12 -- Q4 of '12.

And I don't think we had any, except for the Q4 '13. So what would I use as a normalized Huawei run rate going forward?

Yes, I mean, yes, so I mean, if you're looking back in '11, they did around $1 million in Q4. Then obviously last year we know what happened there.

When we say normalize, David, what we're talking about is they're coming in steadily with their transactions. We're -- this is what we're expecting going forward.

I think as we go through '14, we'll have more clarity as to the volume. But I think we're seeing the stabilization that we were expecting during '13 that came through at the end -- and during Q4, I should say.

So, David. Just to give you a little more on that.

I mean, as you know, what took place with Huawei in 2012, subsequently, the follow-up is that Huawei basically returned to making purchases with FalconStor again on a number of transactions that they were closing in the Q4 time frame. Basically, it was a healthy performance by them.

It was -- they were done with the previous transaction from 2012. And they're back on buying from FalconStor as needed as they have more and more and more customers coming along.

So we had some good meetings with them back in, as I mentioned -- in the previous quarter we were looking to meet them in Q4. We hooked up with them when I was over there a few times.

And everything is moving ahead. Their changes in their business model from the original division that we had done the transaction with and moving on to meet the parent were completed and all of the dust had settled and the business has come back well for us.

So we're very pleased with that. And I know it's something that many of you were interested as to what happened with Huawei and especially some of the political stuff that surrounds them.

But we feel good about them moving into the new year.

So you would anticipate then that they will make -- that you will see some orders from them in the current quarter as well?

That is correct.

Excellent. Okay, and then we didn't mention anything about IBM in the call.

And I know they've now sold their server business or are in the process of selling their server business to Lenovo. How will that affect your opportunity with IBM?

So that's a great question. And the status with IBM is the following: we actually closed a number of transactions in the quarter with IBM business partners.

As we mentioned, we originally had a pipeline building and we expected to close a couple in Q4 possibly. We actually were able to accomplish that.

The situation with IBM with the Lenovo transaction is that our arrangement with them and Avnet, which is really where the transaction took place in their IBM/OEM hardware agreement with Avnet, will discontinue on March 13 of this year because of that change. And for us, we don't really actually believe that to be a problem for us at all.

I mean, we continue to work with IBM business partners in satisfying mid-market clients who need deduplication technology that FalconStor produce. We have a number of IBM business partners that are on board now that are up and trained and then actively building pipeline with us.

So they're actually sourcing the hardware on their own, however they're able to do that. And as I mentioned before, we primarily felt that would be more of a software transaction with IBM business partners sourcing the complete solution for hardware or other things that they needed from a networking side or PS [ph] side.

And we always really envisioned it as a software sale for us, which is a better sale for us. And we still feel good about that business and it's moving ahead nicely with a nice pipeline building.

Good, okay. Can you remind me, you received $3 million from your arrangement with Violin Memory in the quarter.

Can you remind me what is left to be received? And at what point in time will you be able to discuss what the next-generation technology opportunity is for you as a result of that agreement?

So another great question. Just to remind everyone, we had [indiscernible] into a joint development agreement with Violin Memory to develop some technology for the flash memory platform.

We achieved 2 milestones, 1 in Q3 of 2013, 1 in Q4 of 2013. There were subsequently 2 more milestones to be met, that we believe we have no issues with meeting during the 2014 calendar year, which means there's a balance left of $6 million across those 2 milestones.

As far as announcing new technology, couple of things are happening next week. We will release our combination reunification of our VTL and NAS offering onto a single platform with our optimize, dedupe and backup 8.0 product.

We are also releasing the first of our quarterly releases that we've committed to under the leadership of Rob Zecha, our new Chief Product Officer. So our NSS network storage server product and CDP product are basically being updated with new features and functions to be more competitive, as well as to support our existing install base.

What's happening in FalconStor is that we are driving quarterly releases of products on the existing product set. We are reunifying some technology under the joint development agreement that we have.

And some time later this year, we will talk about announcing something new from FalconStor, but at the moment we're focused on our existing roadmap between now and the middle of the summer.

Okay. So we should expect to see some type of a product in the latter part of the year based upon the -- that technology?

That's correct.

Okay, excellent. And then, I guess I'll let whoever is next in line ask, but I wanted to come back and just ask you about your -- what you see as the specific growth drivers for the year, and if you could just elaborate further on what you see as the product direction for the year.

But I'll come back, and we'll see if there are some other questions.

He asked a couple of questions that I had, but you guys seem to have lots of good things going on from the Huawei to these new contracts that you brought on. And I guess the question is because of this new way that you're booking things, should we see, and I don't mean this to sound as ominous as it sounds, but an acceleration of orders?

Because given all of these different things that you're doing and all these -- Huawei and the rest of these people that you've signed up and the office in Korea and the rest of these things and the new products. It just seems like you're going to have a little bit more acceleration than we saw this quarter.

Am I -- I don't want to put words in your mouth, but it just seems like...

Yes, so John, I think my -- and I've told people on this previous call and the one before that. At the moment, we need to take 1 quarter at a time, all right?

And there were number of things that were going on at FalconStor that were really good. Some of them were never really brought forward to the marketplace and I'm talking primarily around technology.

Secondly, in the field, our go-to-market strategy, let's just talk about selling and product licensing and transactions with customers, was very restrictive and was very one-way of doing business. And my view is that we need to put customers first.

And however a customer wishes to buy from FalconStor, whether it's directly to us, through a distributor, through a partner, as an embedded service or embedded on an appliance, we need to address all those things because that's what our competitors are doing. And if the customer says, I want to buy upfront, that's great.

If they want to buy over time, that's great. Once we've proven that the technology provides business value to them, we should not have the financial transaction hinder the ability to close that business.

And as we know, the longer a deal stays on the street, the chances of it being swiped up by a competitor or getting into a big dog fight is very, very highly probable. So I've looked at the enterprise business where we're focused.

I think I understand how enterprise customers wish to buy. And what we've done together, myself and Lou, is found the way to allow customers to buy the way that they want.

And the result of that has been that the way that we recognize revenue was always in the past all upfront, but that type of a transaction isn't always the best for a customer. So now what's going to happen is that revenue will recognize over time for the life of the contract.

To say that will accelerate our business, the jury is still out on that. I mean, we were in a difficult situation the second half of 2013.

The ability to pull down as much business as we did in Q4, we feel very good about. And that's only a good thing going into 2014.

But at the moment, as Lou mentioned, we don't -- we're not forcing these transactions. These are coming naturally from the customers.

So we don't know if some quarters are going to have more revenue, less revenue. I think what we really need to do is follow the deferred revenue balance, the bookings and the cash at the end of the day.

And I think eventually the real revenue and the expenses will take care of themselves. Would you agree, Lou, or [indiscernible]...

Yes, I mean, that's exactly -- that's a great way of putting it. I mean, as Gary said, we're not pushing one model or the other.

And we're not being -- we're just going out there. We're trying to win the deal and then we'll figure out the best way to book that deal with the customer depending on how they want to buy.

So it's where -- that's why, as I said, we're not going to give guidance yet, because we don't know how it's going to all play out, John, in terms of the mix of traditional upfront transactions or over a period of time.

Yes. No, no, I understand.

I was just -- I'm sitting back listening to all these different things that you're doing and all these different sort of positives that are out there that you've seen. And it just seems like that there's a lot -- that you have a little bit more momentum than I would have thought.

But anyway, that's great -- it's great, it's all good. Anyway, I will now let David ask his next 5 questions.

Oh, no, if you've got another one, go ahead. Go ahead.

No, go ahead, John. I -- we go ahead, John.

Should I ask my usual standard question? Have we made any progress with the old roving idiots, the family?

As we've mentioned on that, our position is that we chose to get a conclusion through the court system on that. We think that's the best way to handle that in an unbiased manner and a not emotional manner.

And that's where that sits. So as you know, it takes a while to get on people's calendars and the court system and go through the procedures.

And that's just basically carrying on. I mean, we believe all of the clouds over FalconStor have now moved on.

As Lou mentioned, the government is behind us, the payments are behind us and we don't really view that as a business distraction at all. It's something that's going on, I mean, almost offline somewhere.

And when the decisions are made eventually by the court system, we will live by those.

Okay. And then the final thing is.

So we've settled all these class actions and everything, so that should all get distributed out and it's all -- that part of it's done.

That's correct. Our -- what Lou is showing you is a cash balance.

And what was that again, Lou, at the end of the quarter?

Our cash balance?

Yes.

$28.1 million.

Okay. That $28.1 million, that is -- that -- we've already taken out, John, any of the payments to the shareholders, to the government and any other things that were outstanding.

That is our balance going into the quarter.

We [indiscernible] during the quarter, John.

All right. So I guess John didn't want to ask the question.

So with respect to your opportunity for the balance of 2014, what do you see as the product roadmap? What you see as your -- what do you see as your opportunity?

So, as you asked me a little bit before, where were we going from a product roadmap, when do we expect to be delivering some new product. Like I said, next week we'll be delivering a few components that will position us for the reunification of a number of our storage services into a common platform.

In addition to that, as I mentioned, the joint work that's going on in the flash memory space is also helping us to address that marketplace, whereby, as we know, although the flash memory providers -- a lot of them are new companies, some difficulties with some of them, some are highfliers, some are more highfliers, but that technology is real, and it is moving into the enterprise. It is currently probably less than 10% of a enterprises storage portfolio today.

There is a lot of expectation to see more of that growing throughout the year. And as part of that, you have to have the ability to provide services across both the traditional HDD or spindle environment as well as SSD in flash.

And customers are looking for products and tools that can cross those platforms. In addition to that, customers have many service-level obligations to their applications and end users that ultimately generate revenue for their businesses.

And many enterprises are struggling with cobbling together multiple offerings from multiple vendors with limited IT resources. And as I mentioned earlier, as you roam through FalconStor, and you look, there's been a -- there was a tremendous technology portfolio here, a lot of it unrealized, though, due to the last couple of years, because of the situation we were in.

And we believe that we were able to bring to market that technology to address those needs of customers from an always-on environment to disaster recovery to optimize backup and deduplication, as well as just straightforward copy. And we have that capability.

We just need to bring it to market, and that is some things that will come out over time this year. So you say, where is that opportunity?

If you look at what customers are doing today, they're struggling with multiple solutions across a heterogeneous environment with limited human capital. And we believe that we have the capability to address that in a big way.

I've shown the Gartners in the world, the IDCs of the world our plans for 2014. We are spot on what the marketplace is looking for.

And we're excited about that.

Are there any other joint development opportunities for you, similar to the one that you've executed?

We are always -- we are always open to these opportunities as they come along. I think currently we need to get to a certain stage in the joint development that is happening at -- right now.

And as we get to a certain point with that engineering work, I think we can explore other opportunities with other people in the industry, not only hardware, but also from an embedded service for cloud providers and managed service providers. And as you move into those other ways to go to market, David, you have to have a different way of pricing your product, licensing your product, supporting your product.

So some of the steps that we made in Q4 are also laying the groundwork for what we believe to be a different paradigm in delivering technology to the marketplace.

Right. Well, considering where we were 6 months ago, you guys have done a great job righting the ship.

So now it's just a matter of what is the product direction, what is the market opportunity, what drives your growth going forward? So you've got everything in place.

Now you just need to go out and execute. The stock is still extraordinarily inexpensive.

It still trades less than 1x revenues, including cash. I hadn't seen any additional purchases by the board.

I did see that you made a fairly sizable purchase. Has there been any discussion amongst the -- is there anything that precludes the other board members from making additional share purchases?

No, David. I think we've gone through this over and over, right.

There's -- we don't discuss who can and can't buy. I mean, that's -- it's at everybody's discretion.

And if the board members choose to buy, they will. You'll see it on public filings, but we're not concerning ourselves with who's buying the stock and not.

We have a job here to do, and we're focused on executing our plan.

I just wanted to point out to the 2 of you that I did not ask that question.

Thank you.

Thank you, John. Operator?

Okay. Ladies and gentlemen on the call tonight, we appreciate your support over the last 6 months here at FalconStor.

Myself, Lou and the entire FalconStor team has come together as one company, with one mission and one goal in life here. And we appreciate all of your patience with us.

We're actually having some fun. It was a difficult second half.

I'm looking forward to 2014 as an opportunity for all of us. And we look forward to the next call to report our results and any other things that we may be able to accomplish throughout the quarter.

Thank you very much, and have a very great night.