FalconStor Software, Inc.

Gary Quinn – President and Chief Executive Officer Louis Petrucelly – Executive Vice President, Chief Financial Officer, and Treasurer

John Zaro – BCM Investments Jim Kennedy – Marathon Capital Management.

Thank you, operator, and good evening ladies and gentlemen on the call. The first half of 2015 has been a tale of two cities story or in the case of FalconStor, the beginning of a new era in the winding down of the past.

We could fairly look back at the performance in the first half of 2015, but I would prefer to look forward at what we have accomplished during the first half of 2015, which should then give everyone a perspective on what is possible for the future of FalconStor. As many of you on the call tonight can appreciate, the world of storage is rapidly if not instantly changing.

We see many strong branded companies looking at the future in quite a different way than they did 12 months ago, six months ago or one quarter ago. The transformation of the industry into a world of customers looking for choice, economic performance, and pay for results is coming into focus more and more.

When looking back, the past is very clear. Buying from vendors who do not innovate or vendors who do not charge you -- who charge you more but provide you job security, this is no longer the way forward.

The demand for flexible solutions that allow for choice of hardware, location and price is what is driving a transformational change in the IT industry, not only for storage but for everything that a company is looking to consume for their IT needs. At the highest levels of focus you may call it the Internet of Things, coming down a few thousand feet, you may call it software-defined data centers, coming down further into focus you may call it software-defined storage.

This too has a few definitions of which there is hyper-converged, converged and de-coupled or an abstraction layer. We here at FalconStor believe that in order to lead that transformation, we must give customers choice and allow them to make their own decisions on what hardware and what location they choose to store their most critical assets, information or data.

So when you look in the direction which FalconStor is headed with its new flagship product FreeStor, you will see that we are providing customers and those who provide services to customers, the freedom of choice with a software defined storage offering which is de-coupled or abstracted from the hardware. We provide customers and service providers, a reference architecture that allows them to choose the performance they need to achieve with their hardware selections as well as the location of that critical information on premise in their own enterprise or through a services provider that is private for their needs.

In addition the economic performance that FreeStor offers gives both customers and service providers the ability to pay as they grow. The days of buying point solutions, which are based upon projected or forecasted growth with unknown maintenance renewal cost are coming to an end.

Customers are demanding and service providers are delivering solutions and economic performance that are almost risk free. The result is that if a solution is provided with hardware choice, location choice and superior quality, low cost inventory with predictable future costs, the possibility of losing your job to your business is greatly reduced.

We here at FalconStor are providing that path forward with FreeStor. As I've mentioned before, the adoption of FreeStor and FreeStor technology through our three pronged approach to the marketplace will be a significant indicator of the success that FalconStorcan achieve as we move toward the future in the modern data center.

A remainder of that three pronged approach and the alignment of our goals will be laid out as follows. Number one, an OEM strategy for our technology to those storage hardware manufacturers who have no software stack or partial gaps to compete against the branded giants.

Primarily, with the ability to deliver synchronous replication with high availability in an IO cluster, IO multi-way cluster or stretch cluster environment. Number two, is embedding our data services into those private and hosted private cloud service providers to support their infrastructure as a service platforms along with DR as a service, backup as a service and migration of data to, from and across the customer premise or premises.

And finally number three, reach those enterprise customers looking to modernize their data centers with agility, efficiency, lower risk and more productivity to the creation of private on premise clouds with new technology such as OpenStack and use of commoditized storage from up and coming component manufactures. FreeStor delivers that evolutionary approach versus the revolutionary Greenfield hyper-converged marketers for enterprise customers.

We do not believe there is a better way of hyper-converged versus decoupled or an abstraction layer, we believe we support the environment as demands decoupled. I also mentioned previously that validation of our strategy and execution will come from customer and partner adoption of our new technology.

I'm excited to share that we have multiple proof points across all three prongs of our strategy. In our first prong to OEM to hardware manufacturers, I'm pleased to announce that during the quarter we have executed agreements with and received orders from Kaminario, the leading all flash storage array provider for mid-range enterprises and a visionary in the Gartner 2015 Magic Quadrant for Solid-State Arrays.

In addition to that, we have executed an agreement with X-IO Technologies who provides worry free storage that uniquely adapts between the SAN and software-defined storage worlds. And finally, we also executed an agreement with an additional Asia-based manufacturer, to private label our technology into that geography.

As part of our second prong, in our strategy to embed our data services into those hosted private cloud providers, I'm also pleased to announce that during the quarter, we entered into agreements with and received orders from Telefonica Empresas Chile who provides telecommunication services including data transmission, mainly through IP-based services. In addition to that, Computacao e Comunicacao, C&C, a provider of business-critical services to small and medium-sized businesses in Brazil has been completed.

Next, we executed an agreement with Sunrise who is the largest private telecommunications provider in Switzerland, which covers all areas of telecommunications, mobile, landline, internet and digital TV. And finally last quarter, we executed an agreement with Egenera, whose automation and management solutions enable enterprise IT organizations and service providers to quickly create scalable secure and highly reliable private, public, and cloud services.

In the final prong of our strategy to support enterprise customers looking to modernize on their own with our heterogeneous platform. I'm pleased to announce that our membership into the open stack community during this quarter and our interaction at their most recent event in Vancouver, Canada, has started the FalconStor engineering team down a path to enable FreeStor to embrace the OpenStack platform and provides enterprise class data services to that community.

OEM and service provider partners will execute their own go to market initiatives in different ways to satisfy their individual business needs. We will describe those efforts in more detail in the future through joint public announcements as they determine the best way to communicate their message with FalconStor to better drive their market segments.

We now have concluded a total of six OEM hardware relationships and four cloud service provider transactions during the first half of 2015. Each of these transactions has various revenue commitments branding options and marketing opportunities.

I can tell that each of them has completed an order with FalconStor since the beginning of the year. As we continue to drive our three prong strategy, we believe we still need to do more in getting adoption of our FreeStor platform to achieve the success that all of us believe is possible for FalconStor.

As we look around the globe at the FalconStor business the point solution offerings although still in use at many of FalconStor's customers, we are seeing increased acceleration in the market need to move to another paradigm. We believe we are able to address that with FreeStor.

The performance of our existing geographies this quarter show that our Asia-Pacific and Japan regions have achieved our internal goals even with some of the currency headwinds that we are seeing. Our EMEA business year-over-year was down due to currency issues with the euro.

However on a constant currency basis, the region was up 9% year-over-year. In the Americas, we are pleased that we're able to gain two new service providers in Latin America as well as a U.S.

based service provider along with two new OEM opportunities, but we have made organizational changes in our U.S. management structure that we believe will allow us a more tactical focus of our sales assets in the U.S.

and Canada. These changes are now aligned to the future vision of FalconStor around new customer acquisition, products, and FreeStor.

We are already seeing pipeline generation for FreeStor with these changes as they continue to be implemented throughout the quarter. I would now like to turn the call over to Lou, for a review of the financials.

Thank you, Gary. And good evening to everyone.

As we pointed out on our last call during 2015 we believe that our year-over-year comparisons should be more comparable as we enter our second full year of offering customers flexible parking [ph] options and the introduction of our subscription-based FreeStor platform. As we have highlighted over the past 18 months, we may still experience some bumpy revenue quarters from a GAAP perspective as a result of the mix of business we transact which offers our customers flexibility in their purchasing preferences.

Our earnings release distributed earlier today contains our year-over-year results in all the applicable disclosures in accordance with GAAP. Now, I'd like to provide you with a brief update on some of the key metrics we use to measure the progress we've made during the quarter.

For the second quarter of 2015 GAAP revenues totaled $9.6 million compared with $11.3 million in the second quarter of 2014. As you heard Gary discuss in his comments, Q2 marked a true product transition period for the Company with release in May of our new flagship product offering, FreeStor.

The effects of the product transition were experienced throughout all of our geographies, which resulted in transactions associated with our existing point solutions being negatively impacted as customers' delayed purchases and renewals as they evaluate our new product offerings and how they intend to transition their existing infrastructures. During the quarter approximately 58% of our total product bookings resulted in ratable recognition as compared with approximately 46% in the same period in 2014, which also contributed to the decline in the total revenues.

During the quarter, we had one customer, which accounted for more than 10% of our total revenues, which was HDS, it's accounted for 30% of total revenues. From a bookings perspective our Q2 bookings sold $8.3 million compared with $13.3 million in Q2 of '14.

Overall while we fell short of our internal expectations, which in large part were due to our product transition, we were pleased with our booking performance in the Asia-Pacific markets despite the aforementioned product transition challenges and the continued currency challenges faced specifically in our Japan market. As we indicated in our previous call, we anticipate some headwinds as a result of the impact of foreign currency exchange rates specifically in our EMEA and Japan markets.

On a constant currency basis, Q2 bookings would have totaled $9 million or 8% increase over the actually reported bookings $8.3 million. Geographically the Asia Pacific region met our Q2 internal expectation and was just below the prior year's performance, primarily due to the average decline of the Japanese yen of approximately 70% on a year-over-year basis.

Our EMEA region was under our Q2 return expectations in the prior year performance in part due to the average decline in the euro of approximately 20% on a year-over-year basis. However on the upside on a year-to-date our EMEA region increased their bookings by 9% on a constant currency basis.

In our Americas business, we continue to experience the softness as a [indiscernible] 0:16:08 both our internal expectations and prior year performance. As Gary indicated earlier, we have made some organizational changes in our Americas management profile, and streamlined our sales assets in the U.S.

account which we anticipate will better align our go-to-market strategies and pipeline generations. We continue to see improved mainstream rates from our installed based that elect to continue on our point solutions.

However, we do anticipate as mainstream renewals from customers who are not currently on our FreeStor technology as solutions come, they may elect to refresh their environments with our FreeStor technology solutions which will result in initial shift from maintenance revenues to product license revenues or subscription revenues moving forward. Our primary focus continues to be on improving our new customer acquisitions and expansions within our installed base of new sales licenses and which will be the primary driver of growth opportunity as it moves forward.

Overall, the Americas, EMEA and APAC regions each contributed 28%, 29% and 43% respectively of our total Q2 bookings. Approximately 25% of our Q2 bookings were derived from new customers.

Next, I'll turn to our non-GAAP expenses, which exclude restructuring charges, legal costs and stock-based compensation. We are pleased that we have maintained our cost structure and during the quarter our non-GAAP expenses totaled $12.3 million compared with $14.1 million in 2014.

Our non-GAAP operating expenses were $9.6 million compared with $11.5 million in Q2 of '14. Our non-GAAP loss from operations improved to $2.7 million compared with $2.8 million in 2014 despite the decline in our GAAP revenue.

On a non-GAAP basis, gross margins were 73% compared with 76% in the second quarter of 2014. We closed the quarter with 247 employees worldwide compared with 263 in Q4.

As we discussed on previous calls we will continue to strategically reinvest back into our business both from sales and marketing and product development perspectives. We believe our existing expense structure has been optimized and we expect to have a consistent expense run rate throughout the year even as we make incremental investments to support of our near term objectives.

However, we will continue to manage our expense structures closely and continued to have a bottom line culture across the entire Company. For the quarter, cash flow used in operations totaled $1.4 million compared with the cash flows from operations of $1.1 million in the same period 2014.

Our goal continues to remain break even or better on cash flow from operation on a full year basis for 2015. Turning to our balance sheet, as of June 30th, we had $18.8 million cash, cash equivalents and marketable securities compared with $21.8 million as of December 31st.

Our Q2 '15 cash balances include $250,000 and $400,000 of payments associated with restructuring efforts in dividends on our Series A preferred stock. In addition, as we announced on our last call, the Company's Board of Directors approved a new three-year buyback program, whereby the Company has the authority to repurchase up to 5 million shares of the common stock based upon pre-defined cash requirements.

During the quarter, we repurchased approximately 90,000 shares of Company's common stock in open market purchases for $138,000 or $1.50 per share. While we continue to monitor our cash balances, we will evaluate each quarter the best use of our cash and our stock as currency to enhance our shareholder value through investments within sales, marketing, and technology services.

As of June 30th, our deferred revenues was $26.4 million compared with $36.5 million at December 31st, a decrease of 28%. If we exclude the impacts on our previous joint developments agreements, our deferred revenue balance increased approximately $1.2 million or 5% compared with December 31st and $800,000 or 3% compared with Q2 of '14.

We are pleased that we have been able to grow our deferred revenue balances and continue to focus on securing bookings and approving our maintenance renewal rates. As of June 30th, approximately 27% of our deferred balance was related to product revenues compared with 22% as of 12/31, and 70% as of June 30th of '14.

Finally while we recognize that our earnings release this quarter has many moving parts, specifically with the year-over-year comparison which include a benefit from litigations [indiscernible] 2014. Sequential quarter comparison which included $9.9 million of accelerated revenue recognition and finally our new product [indiscernible] during the current quarter may make it difficult to clearly see our progress we have made during our transition and success we had on executing our plan.

As we have stated over the past six quarters, the key metrics in measuring the success during this transitions are, one, maintaining balance sheet strength. Two, ensuring operating expenses are streamlined and at peak efficiency.

Three, driving cash flow generation and finally four, delivering new innovative product offerings. We believe we are well positioned on all of these metrics as we head into the second half of 2015.

We have maintained our cash balances while strategically reinvesting back into the business. We have grown our deferred revenues year-over-year compared to 12/31.

We have continued to stay within our expense budgets while not compromising resources to achieve our durables. We believe we still have the ability to achieve our cash flow from operations on a full year basis for '15, and we have delivered our new product portfolio.

As of June 30th, we had 80 adopters of the new technology and we are strongly encouraged by the early adoption rate, customer feedback and interest in our new product offerings, which we anticipate will help fuel our second half success. Despite all this confusion, we believe we are on the correct path of executing our plan.

We continue to look to improve on all of our key metrics and remain excited and focused, and Gary and I look forward to updating everyone on our progress on our next call. Now, I'll turn the call back over to Gary.

Gary?

Thank you, Lou. As you can see our past performance and our future opportunities are at opposite ends of the spectrum.

I believe we have the ability with FreeStor to compete in the software-defined storage market place, as evidenced by the early adoption of our technology, by the many partners described earlier, their commitments to FalconStor as well as the customers already in place. We'll continue to drive more adoption and awareness around our new flagship offering FreeStor.

It's time to close the book on the past and look forward to the future at FalconStor. Thank you.

Now operator can we compile the Q&A roster.

Hey guys. Before I let David let at you, I'm going to ask you a question and then I'm going to run.

All of these different OEMs and thinks that you guys signed up, congratulations and they've all given you orders since they've signed up, are any of those orders that came in after the quarter?

No.

No.

No, okay. Then, are you totally situated now in the U.S., so you can look forward?

We believe so, and for those of you that have been on the call maybe for the first time, we have had some challenges in the U.S. market place.

We believe that those were primarily execution issues, personnel issues et cetera. Based upon the fact that the FreeStor technology and FreeStor product have been adopted by a number of folks throughout the world.

At the moment from an enterprise customer perspective in the U.S. we believe the same thing is true.

We made changes to the organization. We've tightened the organization.

We've put in place throughout the quarter, new marketing efforts, new pipeline generation efforts and we are already seeing some traction on that. So, I believe that we have made the adjustments and we should be able to capitalize on those over the coming quarters, and we'll keep you posted.

Great. Then, on these OEMs and these other groups that you signed up, would it be fair to say that, that has really been most of the focus?

I mean obviously you're trying to get your older customers to sign up and you're trying to get some new customers as well, but the real focus has been trying to get these guys across the finish line and get them sort of teed up, so you're ready to go forward?

So let me give color on that. For some of those people that know me, or have kind of caught up with me over the last six to nine months, the efforts that are culminating now during this quarter are primarily due to a few people within FalconStor, as we've developed FreeStor as we brought the product out to these individual partners before it was generally available and then ultimately walk them through the product, got the product suited for their particular service or their particular hardware platform and then ultimately work through the quality of that product to harden it and make it ready and available.

That has been done by just a people, about four or five in its entirely with inside of FalconStor, primarily the management team and the engineering organization. The field itself of traditional sales individuals has been focused on delivering the free store message to customers that is what has resulted in customers who are existing point solution FalconStor owners to evaluate whether or not they should move to a new platform.

There's also a new licensing scheme. It's no longer a traditional license with a maintenance contract that is perpetual.

It is now a platform of services, capacity based, that's term based with a true up on an annual time frame. So that has then caused customers to say should I start making the transition or should I just renew my existing product and that's really impacted our field organization, but the business that we've done here to get credibility and early adoption has been primarily done with a very focused group of four or five individuals.

So as time goes on, we expect enterprise customers that are looking to move to a conversed data services platform that's heterogeneous, implementation of OpenStack or projects around OpenStack in the coming year in 2016, we expect our field organization to handle those as we continue to handle cloud providers and hardware OEMs. Is that good John?

Yeah, that's great, that's great. So, I mean, this will be really sort of going forward as you said looking forward.

You're going to really be able to have a two pronged full push to --?

Yeah, I mean, it's actually as I mentioned its three, one is hardware OEM --

Three, yeah.

Which will be primarily done at the corporate level due to the engineering requirements, we have a mix on the service provider space where we have local field personnel with some corporate people. In the earlier ones we've handle those more because we wanted to have the right engineering resources, the right capabilities within the product.

And last, as they move to enterprise customers not that I wouldn't want to go visit a fantastic enterprise customer, but we're hoping that the field can handle those transactions on their own.

Okay. Great.

Thanks very much and I will talk to you tomorrow.

Sure. Have a good day.

Hi, Gary. Hi, Lou.

Hi, Jim. How are you?

Good, good. In generalities, obviously you can't talk about the actual customers, but could you just speak to the anticipated business model on the OEM and the cloud side of things.

If you had your druthers how does that unfold? What type of revenue potential exists there and in what form might it show up?

Okay. So it's a good question and it's not that I don't want to speak in detail on each one of these partners that have done business with us and executed business with us.

A number of these partners are looking go to market and talk to analysts on their own, I mean, you have to remember, we are in an OEM models. So sometimes it's a FalconStor branded model.

In other case, it's a private labeled model and in the case of private label, we certainly don't want to compromise any of their, I don't want to say secrecy but the way that they've positioned themselves in the market.

Sure. I understand.

So in the case of the OEMs, those are -- there's two models there. One of them is traditional capacity based off of a list price of the FreeStor technology.

So, if someone looks at our price book and sees the cost per terabyte, the OEM could be getting a traditional discount probably higher than traditional OEM discount not like a reseller -- to basically bundle our software either branded or private labeled. In other cases, a couple of these models are also revenue shares, okay, where they basically are selling a system.

It's complete, contains servers, storage, and software combined and we are getting a percentage of the system transaction. Okay?

And Gary, is that a model that you all encourage or one that is pushed back on you?

Actually at the momentum Jim, to be quite frank with you, we've been very flexible in adopting that. I think as over time goes on we will have a preferred model.

At the moment right now we're really happy just to get the product into the marketplace and adopted. It's not to say that we're going -- we're leaving money on the table.

At the moment, it's been -- we don't want to impose our model on to someone else who is distributing our product. So we've been flexible.

We think the percentage we get out of revenue share are adequate or absolutely match what we would get for a cost per terabyte based upon the system sizes that they're selling. On the service provider model, as you know, when you're selling infrastructure as a service, when you're doing recovery as a service, backup as a service, migration services, all of those are under different model.

So traditionally, they may be capacity based, they may be node or host based. They could also be based upon a point in time in the case of migration.

So you migrate a certain amount and it's basically a one-time fee. So with each of these individuals here at the moment, I would have to say that everyone on this list at the moment I mentioned tonight is a capacity based model just as if we would to sell to an enterprise customer.

So they're basically consuming capacity and as opposed to truing up on an annual basis, some of them are truing up monthly or quarterly because they're service providers. So as they add more customers -- I don't know if you know more model, but the FreeStor model to an enterprise customer is you commit to an amount of capacity, you can run that capacity for 12 months, you can exceed that capacity without any additional payments until the end of the year and that's when you true up with us.

In the case of a service provider model they're adding customers all the time, so we're truing up on a more frequent basis that is not onerous. So, typically it's quarterly but in some cases it's monthly.

Got you.

Okay.

Yup, yup, okay.

All right. Good to hear from you.

Okay. And then I would assume

[indiscernible] go ahead.

No, I was just going to say Gary, moving forward obviously those are a lot of moving parts for Lou to track. Do you have any anticipations in terms of -- this sounds like there is going to be an awful lot of blended margin here.

Do we just have to wait and see how that all plays through?

Actually, it's all pure software Jim and it's capacity based or rev share based. I think you're going to -- I don't think you're going to see an erosion of margin.

At the moment, I think what happened is, we're a little light this quarter and therefore that's why our margins came down right now, but we don't expect coming in to the software business, we expect to be able to get it to maintain higher margins based upon revenue streams and controlled expenses. So I don't expect that to really happen because the software is really actually a very good business to be in from a margin side.

I think the compares are tough because of all the moving parts from a year ago, with the settlement with the estate, the unexpected acceleration of revenue from the joint-development agreement that we did. I think unforeseen any other one-time items which at the moment we don't see any on the horizon, I think you should us start to settle in, in Q3 and Q4.

We'll have one more compare in Q1 of 2016 against the accelerated revenue for the joint-development agreement and then on that basis, we should be fairly straightforward.

Got you. Okay, great, thanks guys.

All right. Thank you.

Operator, I don't see any more calls in the queue. So I will like to wrap up tonight.

So, everyone on the phone as I mentioned I really view and I said this earlier in the day to some of our Board members, I think sometimes you may look at this and say well, we went into the locker room down 21 to zero at half time and our goal is to basically win 28 to 21 in the second half. So, on the second half for us, as I mentioned on previous calls would be the proof point of whether or not FalconStor was able to get its technology adopted into the market space, get visibility and actually get money.

I believe it's happening and it's beginning to move forward and we're very excited here as a Company. We have a lot of things going on within our three prongs of approach and we believe there is certainly more to come.

So thank you much for joining us tonight, we will update you again in October and enjoy the rest of your summer. Good night.