FalconStor Software, Inc.

Gary Quinn - President and CEO Louis J. Petrucelly - EVP, CFO, and Treasurer

John Aniblo Zaro - Bourgeon Capital Management, LLC Steven Friscia - Iridian Asset Management

Thank you, operator, and good evening to everyone or good afternoon on the call. I will begin with a review of our fourth quarter and 2014 annual performance and then turn it over to Lou Petrucelly, our CFO, who will provide a detail of our financial results.

After Lou, I’ll return and we will open-up for Q&A. The 2014 year, as I mentioned on our last call, was an inflection point for FalconStor.

Throughout the year, we’ve stabilized our employees, partners and customers with updates of our new products, discussions of new products on the horizon, and launching of a new FalconStor image and message #BEFREE. As we’ve indicted, the path to profitability will not be a straight line.

As you can see the 2014 year and the Q4 2014 continued with a similar performance from the different geographies around the world. Our EMEA business continued to outperform our internal metrics and goals for 2014, although we do expect an increase in execution in 2015, we do see some headwinds on the horizon in that area.

Our Asia business finished the year nicely and we believe at this time we have a full compliment of sales personnel in place for 2015 and we expect to see a return to the prior year’s performance in China and South Asia. As you remember, we did have a General Manager separation in Asia Pac in 2014 as well as a separation of our Country Manager in Japan, in 2014.

Our Japan business has been stabilized and is showing promise after almost a year of working with the current leadership and we had a good finish in Japan for 2014, which also now has a full compliment of sales resources for the New Year. We continue to have some small challenges in Korea with the business that is heavily focused on government accounts and we need to break into new industries in 2015 to obtain any growth.

Our new products and new incentives for Korea should bring about that change. Finally, our market [ph] business did turnaround in Q4 from a dismal Q3 2014 performance, but we’ve not yet seen any true trends or benefits from some of the -- of our investments made in 2014.

In particular, our Federal business has been slow to develop revenue and our execution in U.S still needs more work, although Q4 2014 was almost equal to the internal metrics and goals that we had set. On this next slide, you'll see that we had many accomplishments in 2014 above and most -- as mentioned above and a most significant accomplishment is the delivery of new products for the 2015 calendar year.

For the first time, in almost 5 years, the Company is delivering in Q1 and Q2 of 2015 new technology that is relevant to the current state of the marketplace around Cloud and Flash. Next week on FalconStor as 15th birthday as a company, we will announce the availability of a new and innovative solution, which is truly agnostic to any server hardware or storage hardware manufacturer.

A software defined storage horizontal platform inclusive of converged data services that we call FreeStor. FreeStor addresses the heterogeneous storage portfolio of just about every large enterprise customer.

It addresses those all-Flash array and Hybrid Flash array hardware manufacturers which do not have a software stack or do not have an enterprise ready software stack, as well as it provides a solution to service providers both managed service providers and private Hybrid Cloud service providers who require a single pane-of-glass view into their customers as well as the availability for an easy and robust migration of data into their services offerings. As you can see from the following slides, FreeStor is a completely new offering from FalconStor and is unlike any other offering we provided in the past.

It's completely transparent to the end-user or the service provider. It provides management monitoring and reporting and provisioning through a web browser, tablet or smartphone, which gives end users or storage administrators the ability to be completely mobile when managing their virtual storage portfolio.

In addition, the ability to easily drill down and see system status and details from anywhere at any time, it is very helpful in today's demanding IT and Cloud environments. Finally, the ability to provide real-time information to a console whether that is a Flash Hybrid hardware console or a service provider administrative console for managed service providers or Cloud service providers, it gives customers and partners the ability to achieve service levels that they're looking to deliver or pay for instantly or over time.

We will be announcing the availability of the underpinning technology which has been developed over the last 15 months, which will update our existing installed base with technology that is now current, relevant, and competitive to those software point solutions that we see everyday in our sales activities. New versions of NSS and CDP, optimized backup and deduplication, as well as a complete update of all our host-based technology, all of this technology is included in the FreeStor intelligent abstraction core that will be available in the beginning of Q2 2015.

The FreeStor offering is completely modularized and customizable for OEM opportunities with Flash, Hybrid hardware manufacturers, managing Cloud service providers, as well as allowing enterprise customers to insert FreeStor into their existing environments without a rip and replace of their existing hardware, software, or service provider. The other renovation here for customers and service providers is the flexible and simple pricing model of FreeStor.

FreeStor will only be available with an annual subscription capacity license with an annual true-up at the end of the term. What that means is the customer will buy an initial quantity of FreeStor capacity to support one of the four pillars within the -- within FreeStor to support a project within the environment, a data migration project, a stretched cluster or metro cluster project, a disaster recovery and data protection project or optimized backup and deduplication.

The customer will receive the ability to implement any of the four used case pillars with the complete storage resources full of services, converged in the intelligent abstraction core. That intelligent abstraction core will reside on a reference x86 architecture, which the customer or service provider will purchase from their manufacturer of choice.

They then can use any of the services for as much capacity as they wish throughout the year. At the end of the term the customer will provide FalconStor with a usage statement which will determine their fees for year two.

It will be a very simple cost per terabyte for a customer for a year. The cost will then verify their capacity of the management and pay the new invoice for the upcoming year.

The customer does not pay, then they must discontinue the use of the technology, this is not a perpetual license. All the software updates, upgrades, 24x7 support and installation are included in the cost per terabyte per year.

In the case of a service provider, we will work with them as well as OEM hardware manufacturers to match a price which matches the metric day use to charge their customers, a truly flexible and simple pricing and technology use model. We believe that the introduction of this new technology and simplified acquisition model will allow FalconStor to attack the Cloud and Flash Hybrid array marketplace.

By also traditioning -- transitioning itself to the software defined storage marketplace, we believe we will get the visibility we need to attract new customers, partners, service providers and OEM partners to grow in the 20% to 30% range and we can gain the same market share as we have today in a traditional enterprise backup software and BCDR software marketplaces, which today are just growing at 3% and 11% respectively. The Flash Hybrid and private hosted, private Cloud markets are growing at plus 100% to 200% per year, albeit off to smaller numbers.

We believe that if we can attract OEM hardware relationships manage and Cloud service provider relationships, as well as a large enterprise customer adoptions, those events will be indicators of our success and acceptance in 2015. We believe that these relationships once in place will begin to show results in the second half of 2015.

We have been briefing industry analysts, bloggers and editorial luminaries over the last three weeks and have -- we’ve been receiving some very positive feedback. In addition, we’ve scheduled numerous activities with our partners and customers to get the word out about this new and exciting offering from FalconStor.

If the above actions are delivered and positive responses as well as adoption of the technology is executed, we believe by the end of 2015 transition of FalconStor will have been completed. I’d now like to turn it over to Lou, who will take you through our financial results.

Lou?

Thank you, Gary, and good evening, everyone. As we pointed out during our past several calls, we believe it’s most appropriate to measure our results on a sequential basis which will better highlight the progress we are making during this transition period of stabilizing our business, which commenced during the second half of 2013.

Our earnings release distributed earlier today contains our year-over-year results and all the applicable disclosures in accordance with GAAP. As we’ve highlighted all year, we’ve experienced some lumpy quarters and revenues lagged from a GAAP perspective on a year-over-year basis as a result of the overall business transition we’ve gone through over the past 18 months, as well as the mix of business we’ve transacted which offers our customers flexibility in their purchasing preferences.

As we head into 2015, we anticipate that our year-over-year comparison should be more comparable as we enter our second full-year of offering customers flexible purchasing options. Now I'd like to provide you with a brief update on some of the key metrics we used to measure our progress we’ve made during the quarter.

For the fourth quarter of 2014, GAAP revenues just totaled $11.8 million compared with $11.2 million in the previous quarter. Total revenues in the Americas improved 11% as compared with the previous quarter, primarily driven by increases in new product license revenues, while maintenance revenues remained flat.

Total revenues in the EMEA market increased 7%, while total revenues in Asia Pacific remain flat as compared with the previous quarter. During the fourth quarter, we have two customers which accounted for more than 10% of total revenues, HDS and Huawei, each contributed 12% and 11% respectively to our total Q4 total revenues.

From a bookings perspective, our bookings -- Q4 bookings totaled $13.6 million compared with $8.9 million in the previous quarter. While we are pleased with the rebound from a disappointing Q3 performance, our total bookings during the quarter just fell short of our internal expectations.

Geographically bookings for our Americas regions improved significantly from a disappointing Q3, but just fell short of our internal Q4 expectations. Our EMEA region over achieved our Q4 internal expectations with a strong Q4 bookings performance and significantly improved over the previous quarter's performance.

Finally, Asia-Pacific region also improved significantly over Q3 and was within our Q4 internal expectations. We continue to see improved maintenance renewal rates from our store base and our primary focus continues to be improving on our new customer acquisitions and expansions within our store base of new license sales, which will be the primary driver of growth opportunity moving forward.

Overall, the Americas, EMEA, and Asia Pacific regions each contributed 35%, 37%, and 28% respectively of our total Q4 bookings. Approximately 9% of our Q4 bookings were derived from new customers.

Finally, we anticipate that we may continue to experience some bumps along the way as we continue to work closely with each local region, partners and customers through this transition period in an effort to build a more robust and particular pipeline within each region. Now I’d like to turn to our non-GAAP expenses, which exclude restructuring charges, legal costs and stock-based compensation.

As part of our rebalancing efforts, we reduced our overhead to a level commensurate with a company of our size, and we aligned our operating expenses to the Company's capital resources. We are pleased that we’ve maintained our cost structure and during the quarter, our non-GAAP expenses totaled $14 million, compared with $13.1 million in the previous quarter.

Our non-GAAP operating expenses were $11.3 million compared with $10.6 million in the previous quarter and our non-GAAP operating loss was $2.2 million compared with $2 million in the previous quarter. The increase in our non-GAAP operating expenses of 7% as compared with the previous quarter was primarily related to increased commission costs associated with the higher bookings achieved in the current quarter as compared with the previous quarter as well as to the timing of investments we've made back into the business during the second half of 2014, specifically around our corporate rebranding and marketing efforts, as we head into the New Year.

Finally, during the quarter we did recognized some incremental costs associated with our ongoing cost structure optimization initiatives, which we believe we have substantially completed at year-end. With the exception of potential outstanding litigation costs associated with the streamlining of our workflows [ph] in our southern European locations over the past 18 months.

Our non-GAAP gross margins were 78% compared with 77% in the previous quarter, and we closed the quarter with 263 employees worldwide compared with 273 in Q3. As we’ve discussed on previous calls, we will continue to strategically reinvest back into our business, both from a sales and marketing and product development perspective.

We believe we have completed substantially all of our expense structure acquisition during 2014 and as we head into 2015, we expect to have a consistent expense run rate throughout the year even as we make incremental expenses in support of our near-term objectives. However, we will continue to monitor our expense structure closely and continue to drive a bottom line culture across the entire company.

Finally, on a full-year basis for 2015, our goal will be to achieve breakeven or better of operating income on a non-GAAP basis. Turning to our balance sheet, as of December 31, we had $21.8 million in cash, cash equivalents and marketable securities compared with $26.6 million in the previous quarter.

Our Q4 2014 cash balances include a $3 million milestone payment received from our joint development activities, $200,000 of payment associated with our restructuring efforts, and a $4.7 million payment to acquire 4.3 million shares of our common stock from the Estate of ReiJane Huai which brought our shares outstanding account balance of 40.9 million as of December 31. During the previous quarter, we received $1.5 million in milestone payments from our joint development activities and we made $300,000 of payments associated with our restructuring efforts.

As of December 31, our deferred revenues totaled $36.5 million compared with $34 million as of September 30, a 7% increase. If we exclude the impacts from our joint development agreements, our deferred revenue balance increased approximately $1.7 million compared with the previous quarter and $1.5 million on a year-over-year basis.

During 2015, we expect to recognize approximately $1.4 million per quarter associated with a milestone payments received from a joint development agreement, which we completed in November of 2014 and currently is included in our deferred revenue balances as of December 31. We are pleased that we’ve been able to maintain our deferred revenue balances and continue to focus on securing bookings and improving our maintenance to support renewals.

As of December 31 and September 30, approximately 39% and 37% respectively of our deferred revenue balances were related to product revenues. For the quarter, we generated $0.5 million of cash flow from operations compared with cash flows used in operations of $1.5 million in the previous quarter.

On a full-year basis, we generated $0.5 million of cash flow from operations as compared with cash flows used in operations of $11.1 million in 2013. We are pleased that we were successful in achieving our goal of breakeven or better on cash flows from operations on a full-year basis, which once will -- which will once again be our goal in 2015.

Finally, as we’ve stated throughout 2014, we believe we are on the correct path to execute our plan. We continue to look to improve on all of our internal objectives primarily on growth of bookings and revenue and remain -- we remain excited and focused on executing on our objectives and Gary and I look forward to updating you on our progress on the next call.

At this time, I'll return the call back over to Gary. Gary?

Thank you, Lou. At this time, I'd like to ask the operator to compile the Q&A roster.

And while we wait for that to happen, we will then take the first question.

Hey, guys.

Hello, John.

Hi, John.

How are you?

Good.

Good.

Are we going to see roadmap, the [indiscernible] roadmap of where we’re going this year?

From a financial roadmap or a technology roadmap?

Well, it’s sort of the technology roadmap laid out of where we’re going?

So I think actually on the last quarter we did a presentation that we did that showed what we were doing. So just -- I’ll just give you a summary of those, John.

So we are delivering an update to all of the underlying technology that FalconStor has which is included in today's point solution. So as I mentioned we sell NSS and CDP, we sell an optimized backup and deduplication technology and then we also have a number of host-based technologies.

All of that technology has been refreshed and is generally available. Next week on February 18, when we announce the availability of FreeStor, that technology which is the underpinning of FreeStor is also being utilized to pursue Flash OEM arrangements as well as Cloud embedded services arrangements.

Subsequently following that, we will be delivering generally available a complete FreeStor offering for enterprise customers to purchase directly from FalconStor.

Okay. And then, what we have sort of -- we talked about this before, are we going to have sort of signposts along the way to see how that’s going as oppose to …?

Yes, so I think the way that you will know whether or not we are gaining acceptance in the community, whether that is true, the industry analysts, traditional bloggers or editorial luminaries, as well as adoption by hardware manufacturers or service providers, our goal, John is to publish every one of those as we come out with them, provides you if there is any type of financial information around that transaction at the time of signing or to give you then report out on a quarterly basis the results of those signings which we believe will be happening in the near future.

Okay. So we’d -- you'd expect -- you had some people who have already, I'm assuming have had the system testing it?

Yes. I mean, at the moment we’re not going to pre-announce any relationships that we have until those relationships materialize into a bonafide contract go to market and financial evaluation, okay?

But sort of, I mean, forgetting to see how -- forgetting good traction, or we're not getting good traction sort of three to nine months process -- six to nine months process?

I think with some of the -- some of the transactions we’re talking about at the moment, some of them are go to market type transactions, which you will see like you said maybe three to nine months. Other ones are currently working with customers and just looking for a finalized quality generally available code to deliver to those particular customers which would then result in a payment.

Right. So zero to three months type thing?

Yes, some are zero to three, some three to nine.

Got it. Okay.

I think in looking at it, Lou mentioned that we’re looking to now go to year-over-year comparisons by quarters, because we think we’ve smoothened out the business now. We don’t really have any unforeseen, we don’t think issues that may come up.

We have a lot better handle on our business. We can see our business a lot better.

I think you should start to see year-over-year performances to judge, and subsequently finance as we get FreeStor into the market, as we get more OEM arrangements that bring money -- start bringing money in, you should start to see that building up into the -- I would say, I think I mentioned second half of 2015, Q3 and Q4.

Got it.

But I think -- and before that you should look for, did we get any transactions with anybody and did we describe those to you, and what the value of those are. And then obviously they’re going to then flow through into the market place throughout the rest of the calendar year.

Got it. Okay.

By the way just so you guys know, unless there is something around my system here, nothing has showed up on your Web site.

What do you mean?

The presentation and the earnings announcement?

Yes, I actually saw them personally being posted, so I don’t know maybe just refresh something, but they’re up there.

Got it. Okay.

Thanks.

Yes.

Okay. All right.

Hi, gentlemen. In the past there’s been tremendous seasonality in the FalconStor performance with the first and third quarters being the poorest.

Is this model designed to change that and in what kind of timeframe might that happen?

Jack, I think that -- I think what we had mentioned as we have been running the company myself and Lou, that we felt during 2014 that the seasonality that is traditionally seen in the technology industry or the software industry as you said, Q1 and Q3, and this kind of Q4 and Q2 and Q4 are better for different reasons. We basically told people that we think that until FalconStor starts executing in a better way that the seasonality wouldn’t come into play.

So, at the moment I think if you look at our performance we’re probably fairly consistent quarter-to-quarter except for in Q3 we had a little bit of a hiccup there. I can't say for sure yet if we’re going to return to the traditional seasonality that you saw in the past as a company until we get through a little bit more time.

Okay. Second question, on the gentlemen’s previous question I’m unsure of what the answer is.

As you get orders for your various programs et cetera, are you going to announce those orders as they occur or are you going to accumulate them which has been the history of the company, and only have announcements that are based on the quarterly reports just like you’re giving today.

So, there’s kind of two ways to do that. One is to say, hi, I just announced the relationship with XYZ.

Hardware manufacturer, FalconStor will be shipping its technology as part of an OEM arrangement with this particular manufacturer. We expect to see orders within a certain period of time or there was a committed value to the contract where they’re basically saying, we would like to -- we will give you guys 500,000, and we’ll burn through that licensing over some period of time and we’ll come back for more.

I would expect to announce the relationships, what they mean, and what the expected financial impact of the company is. If there has been a pre-committed amount or when you should expect to see orders from that particular relationship in what quarter.

Does that answer the question?

I’m taking that to mean, is if there is a definitive order it will be announced when it is done. Is that correct, sir?

That’s correct. On the initial relationship we will announce that publicly because it will be something that will be valuable to the company.

Obviously throughout the quarter -- the future quarters after that announcement we will start to tell you if we’re getting any fruit out of that particular relationship.

Thank you very much gentlemen.

Okay. Thank you, Jack.

Next question, operator.

Hi, guys, congratulations on a good quarter and transitioning the business. My question relates to these OEM arrangements, cellular code for Flash arrays.

Could you talk about the competition? Who you’re competing against in that space?

I know that there’s been a lot of consolidation in your space over the past five or ten years. And potentially you’re in a very good spot because you’re independent.

But could you maybe just talk about who you’re competing against?

Sure. So, great question, Steve.

Thank you very much. So, we’re doing -- there’s different ways to do the OEM relationship with the hardware manufacturers or with a Cloud or managed service provider.

Some of the manufacturers look for us to actually completely private label all of our code so that there’s no reference to FalconStor, and then in some cases it could be provided onboard the array or embedded into array for the best performance. But the most common way of doing it is through a gateway model where the software resides on a server, the array sits behind that server.

And then that allows for other arrays to be plugged into the server, and you can start to take advantage of the horizontal platform. Okay, so there’s multiple ways to do it.

Multiple levels of OEM’ing to either show FalconStor or disguise FalconStor, and so it looks like one solution, one throat to choke for the hardware guy. Many of these hardware guys as you know up and coming, now I’m not going to say that some of the Tier 1 guys, I mean obviously EMC and IBM have their own offerings.

The pure guys have some very nice software, so does nimble. But there’s a number of people, if you look at the Gartner, Magic Quadrant that are primarily hardware folks.

Some of them have a little bit of functionality around data services. Many of them, when they find out when they reach the enterprise, they’re not enterprise class or enterprise quality.

So, those guys are looking for a player like us. And as you said, who else is out there.

There is another company that’s a private company called DataCore, they’ve been around for 18 years. They came up with FalconStor in the industry at a very similar time.

They are currently competing with us in our traditional point solution space around our NSS technology. There is belief that there are some possible opportunities where they maybe introducing some new technology to perform in a Flash environment.

So that’s somebody who’s up and coming. The other people who are out there are primarily Steve, guys who are attached hardware vendors.

So when I showed a slide on the last call there’s a number of people who claim to be software defined. EMC has something called VPLEX or ViPR.

IBM has something called SBC. If you look at people like Fujitsu and others they have a software stack comparable to FalconStor’s.

As you mentioned, we are hardware agnostic, okay. We give the customer or partner an X86 architecture; we let them know that they can buy that from whoever they wish.

If they don’t want to do that they can certainly get a server from us and we’re based upon the Dell platform, but our pricing is not very aggressive. We don’t ship a lot of hardware these days.

So those are kind of things. Software -- DataCore is really the only software only guy who is still out there.

The rest of the people on the block that you see offering these services are some of the new kids on the block and software defined, and they are also attached to more than likely a specific box that they’ve branded underneath them. The question is, how robust is their offering, and do they have the capability to perform in some of those Flash array environments.

As you know a lot of people are buying Flash for the performance, the resiliency and high availability. And software tends to some times slow that down.

We had a great opportunity the last year doing a joint development agreement with one of the Flash manufacturers. We learned a lot from that, and our performance is significant.

We have an active, active architecture now because there can be no fell [ph] over in Flash. We are also -- have significantly reduced our latency capabilities which is another thing.

The Flash guys do not want to have a penalty on their box due to software. So, we’ve spent a lot of time with that and learned a lot.

So, at the moment, as we gone through -- the only person that we’ve really run into looking at OEM’ing to the Flash hardware guys and the Tier 2, Tier 3 model has been DataCore.

Great. Thank you very much.

That was helpful.

Okay. Thank you.

Operator, can you take a look for another question.

Okay. Thank you very much operator.

So we have no more questions. Take a look at our website, the presentation is there as well as some background information.

Next week on February 18, we will be launching the availability of all our new technology with a very extensive review of that technology for customers, for partners and future prospects. We’d like to tap into that.

As an investor, you’re more than free to do that. Just check our website and register for one of the briefings and you can jump on there.

Over the next 12 months, we believe that we’ve got the company positioned for success. As Lou, mentioned all of our work around cost containment, modifying our business, getting it set up correctly, making it streamline, execute better is completed and done.

We do not expect any further adjustments there. I think you will see, after we go through Q1, we will be fairly consistent regarding any type of expenses or cash throughout the year.

Yes, as we mentioned before, the path to profitability and growth will not be a straight line. But we do believe that FalconStor finally has the technology to address to Flash and Cloud marketplace, and we believe that we’re in an excellent position to take advantage of that and return to growth.

So, thank you very much for joining us tonight and I still remain optimistic about the future for FalconStor. Good night.