FalconStor Software, Inc.

Daniel Murale - Chief Financial Officer, Executive Vice President and Treasurer Gary Quinn - President and Chief Executive Officer

Bill Dawkins - Burlison John Zaro - BCM

Thank you, operator. Good afternoon, ladies and gentlemen, and welcome to the FalconStor Q1 2017 Earnings Call.

As we continue to move forward with the adoption of FreeStor with new and existing customers, we were able to achieve one of our goals towards financial stability in 2017, which was a cash flow positive quarter. Dan will give you a little update later in the presentation about our financial performance.

Just to remind it to everyone that this is our Safe Harbor statement. And secondly, just to remind everyone that - on the next slide, just to remind everyone that FreeStor, which started in 2015, is delivering upon the requirements that enterprises and cloud service providers are facing in today's marketplace.

We continued to evolve the FreeStor product to support the storage destinations of today whether that is all-flash arrays, on-premise local data centers or the use of public-private and hybrid cloud configurations. The FreeStor product was built to not - to be not only a hardware agnostic but is now cloud agnostic to permit the movement of customer workloads to the appropriate destination for hardware storage performance, service level objectives or for the best economic benefit.

FreeStor gives customers the ability to choose the right destination for the right workload and, as you can see from this slide, the innovation upon which FreeStor is delivering at quite an incredible pace, which is not only feature-rich, but with the quality that enterprises and cloud service providers demand. Just last week, we announced our fourth update to the FreeStor product, which all of our customers will receive without any additional cost, provided that they have an active license for the product.

Next slide. I'd like to turn over the presentation to Dan to review our operating performance for the quarter.

We've changed our format a bit to support more insight to the performance of FreeStor versus our legacy products. We hope that we have addressed a number of your requests for more information and insight.

Dan?

Thank you, Gary, and good afternoon to everyone. Most of our discussions this afternoon will focus on non-GAAP financial measures and on the key business performance indicators for the quarter.

The balance of our financial details can be found in our press release, which was distributed earlier today, which contains our year-over-year results and the applicable disclosures in accordance with GAAP. During the first quarter of 2017, bookings totaled $5.5 million compared with $8.4 million in the previous quarter and $7.4 million in the first quarter of 2016.

Our consolidated GAAP revenue totaled $6 million in the quarter and decreased 19% compared with $7.4 million in both the previous quarter and the first quarter of 2016. During the quarter, we had one customer which accounted for 10% or more of our total revenue, HDS, which was 10% of our total revenue.

During the quarter, we realized the full impact of our cost rationalization initiatives undertaken during 2016, and as a result, our non-GAAP expenses, which exclude restructuring charges and share-based compensation expense, decreased to $7 million compared with $8.1 million in the previous quarter and $10.7 million in the prior year, a 14% and 34% decrease, respectively. We ended the quarter with 165 employees worldwide compared with 224 employees at the same period last year.

We continually look to optimize our cost structure in order to preserve our cash balance. Our non-GAAP operating loss was $0.9 million in the current quarter compared with $0.7 million in the previous quarter and $3.2 million in the first quarter of 2016.

Our non-GAAP gross margins increased to 77% in the current quarter compared with 74% in the previous quarter and 73% in the first quarter of 2016. Turning to our balance sheet.

We were pleased that we achieved our goal of being cash flow positive for the quarter. As of March 31, our cash and cash equivalents balance increased 1% to $3.4 million as compared with December 31, 2016.

Our number one goal as a company is to continue to preserve our cash balance. Now I would like to discuss our FreeStor performance.

As you can see from the slide, over the last 9 quarters since FreeStor's release, we are gaining traction with our FreeStor platform. Total FreeStor bookings for the first quarter of 2017 was $2 million compared with $3.2 million in the previous quarter and $2.7 million for the first quarter of 2016.

Total FreeStor revenue for the first quarter of 2017 was $1.6 million compared with $1.6 million in the previous quarter and $0.9 million for the first quarter of 2016, a 2% and 79% increase, respectively. We now have 360 active customers utilizing the FreeStor technology representing an increase of 5% compared with December 31, 2016, and 76% compared with March 31, 2016.

Now I would like to turn the call back over to Gary.

Thank you, Dan, for those comments and insight. I believe you can see from these updated charts that although our overall performance still requires some improvement, we have been able to grow FreeStor, but just not at a rate which is faster than the legacy product weakening.

Many of our legacy customers were larger VTL customers who've chosen to update their backup solutions to a modern snapshot technology to achieve a faster backup and recovery performance. In many cases, those VTL customers were part of a field-based OEM hardware partners sales team, which meant FalconStor did not have direct contact to those customers.

Therefore, the customer may not have known that FalconStor could have provided them with both a modern snapshot backup and recovery technology as well as a traditional backup software solution, which was exported out to physical and virtual tape library or to the cloud. With our new release of FreeStor, those customers who purchase FreeStor in the future for physical or virtual tape library functionality will also have access to our snapshot backup and recovery technology or the ability to store tape in Amazon or Azure at no additional cost, which should help us to preserve those customers for the future.

In addition, the legacy maintenance costs are significantly higher than newer licensing model under FreeStor, and as customers are looking to optimize their spending by the use of the cloud and more economic destinations, legacy products not only from FalconStor but from others in the industry are seeing increasing pressure to lower those exorbitant maintenance fees. FreeStor can alleviate those economic pressures with its subscription licensing and pay-as-you-grow primary copy-only true-up model.

As we look at the primary-use cases of FreeStor, we're seeing that customers are beginning to use FreeStor for more than just one use case, the reason for the more than 100% total in the chart, which a positive trend for us and our customers. Many customers will start out with a single-use case such as disaster recovery or DR as a service if you're a service provider, and then add-on additional use cases such as continuity or IT resiliency because they need a higher level of availability or 0 downtime versus minimal downtime.

Additionally, customers may use FreeStor to migrate from disk to flash, site-to-site or site-to-cloud, and once completed, they may want to add a level of data protection using FreeStor versus buying another new solution or a legacy solution from another vendor due to price-performance with FreeStor. All of these FreeStor indicators show that FreeStor is the right product for the marketplace.

Finally, the number of customers using FreeStor for their storage needs continues to grow, as you saw from our previous slides, and more companies are relying upon FreeStor to deliver the flexibility they need, to store their company information in the most reliable, economical and flexible destination. So hopefully you can see that we continue to grow with FreeStor.

We continue to adjust our expense levels to match the performance of that FreeStor growth, and we believe with the introduction of our latest release, we have a path forward for those legacy virtual tape library customers, which will begin to slow the dwindling of those customers. The number of new customers, customer conversions and expansion of those existing FreeStor customers provides a bright light for those of us here at FalconStor.

And with that, operator, can you please compile the Q&A roster?

Can you give me any idea on when we will begin to see sequential growth for FalconStor as a whole?

Sequential growth on a GAAP revenue perspective? Or just inside the actual FreeStor product?

Or the overall product bookings or billings?

Well, do FreeStor and overall. I mean, just a sequential growth in the revenues.

Instead of continuing to see the revenues decline, when will we begin to see the revenues grow?

Dan, do you want to answer that? Or can you see that in the model?

I mean, the deferred model is making up the most of the - I mean, the deferred makes up most of our revenue as we go forward. In this point, we don't really have that much coming from the individual quarter based upon a subscription basis of FreeStor and the FreeStor technology.

Let me do a little more work on that, so we can see where we can model that out for you guys and give you some projections on that as we move forward. Okay?

And what's the current market like out there? Is it still hazy?

You could say you're kind of underwater in a pond with a lot of algae at the moment with a snorkel. It's still fairly tough.

I mean, there are a couple of people - I mean, I think if you saw it yesterday, I mean, I think CommVault had a pretty good result last quarter. I think they've finally got some traction going, but I think overall for most people in the storage industry, I think it's still a fairly significant slog out there.

At some point, it's got to open up. I mean, it's been going on for a little over a year now, and at some point, you've got to get - there's got to be some more opening up and some relief.

Maybe it's due to a little more clearness on the suppliers that are out there, what they can supply. I mean, the surprising thing for us as we continue to add FreeStor customers, both new and conversions, we also didn't mention - I didn't mention in my notes that we also added another OEM in China, which gives us 4, so that's a really good positive for us.

And we had a number of folks also in the United States in Q1, which has kind of been lagging the rest of world in FreeStor new or FreeStor conversions. Those started to happen this quarter.

So I think - I mean, for us, as you could see in those charts, what's really kind of the problem for us is the legacy large customers that have kind of rolled off over time. And they're primarily from our relationships with Hitachi.

I mean, Hitachi is selling our retail product through their sales organization. We did not have a lot of visibility to that, but they were somewhat large and Hitachi is, unfortunately enough, has kind of moved them, if they wanted to move, to something else.

Or what's happening a lot also is EMC took a lot of footprint in the last 12 to 18 months from people prior to the finalization of the Dell-EMC transaction. So it wasn't really our fault.

It was, in a lot of cases, we were a part of the transaction from Hitachi and Hitachi got swept out of the counter off the floor. But I think it's converging.

And the idea would be is to keep working at that and get a crossover of FreeStor from the legacy and see the legacy actually start to stabilize to more of a flatter line at some point in the graph.

And remind me the sequential - or the seasonality of the quarters again. Two and 4 are good, and 1 and 3 are tough?

That's usually how it goes. Yes.

What's Q2 been looking like?

It's looking all right. I mean, it's similar.

I mean, but I think it's looking all right. I mean, this FreeStor activity is there, and it's going along.

And a couple of things, positive things did happen, actually, is that coming back to the same people who kind of caused a little problem with us on the VTL side from 2010, '11, with those big customers, those guys actually have come back to start selling some product again from FreeStor. And they've actually - from FalconStor and actually have sold some FreeStor for us.

So we'll see if that can keep up into this quarter and beyond to the rest of the year.

On new FreeStor customers, the acceleration of growth on that seems to have slowed in the latest quarter. Is that just marketplace circumstance, sales force?

If I'm reading your chart - if I'm reading your thing right.

Yes, so some of that is the perpetual licenses that we sell through FreeStor. So those sales could be a little lumpy quarter-to-quarter, but the FreeStor subscription sales have increased quarter-over-quarter.

Right, but they were going along at a fairly good clip and then this latest quarter, it looks like it was a little slower. And I'm just wondering if that's a circumstance or it's actually slowed a little bit.

It might have looked like it might have slowed a little bit. I mean, Dan just said that they were talking about a couple of hundred thousand dollars difference quarter-to-quarter.

Right. Yeah, I was just looking at the number of people.

Yes, I mean, well, the numbers, when you speak of the numbers, could be is that we had a couple of larger initial transactions versus - multiple small guys versus one or 2 larger guys.

And with changes of basically your employees and sales force and at one point, we were seeing virtually nothing for United States, is that - are those things sort of clearing themselves up or is that still problematic?

Actually, overall, last quarter, I mean, to give you a little color on the geography, is the U.S. actually had a very good quarter last quarter, which - I'd wait until I see a little bit more of trend on that, John, but we did have a very good quarter last quarter in the United States, including things related to the United States, not just the enterprise customers but also around our alliances business in the U.S.

and in our Latin America business. So overall, the Americas was very good.

The European business, we were good in the U.K., Ireland area, we were also good in the Southern area, which includes France, Italy and Spain. We had some challenges in Germany last quarter.

We had some challenges in China, and both of those are large markets for us. But everywhere else in the world, Southeast Asia, Japan for the most part, we were - we met all of our internal targets.

But at the moment, we have a little trouble in Germany. In China, I think China always has an issue with the new year, with the Chinese New Year.

There's a lot of inconsistencies, time off, et cetera. Sometimes we've caught a few things.

I think a year ago, we did 2 OEM transactions there in the first quarter, which may have kind of made us overlook a little bit what the overall China business is. So depending on how those OEMs come through, whether it's the FreeStor OEMs or the Huawei OEM relationship, our outside traditional VAR relationships there are probably about 1/3 of our business, but the OEMs are a little - almost 2/3.

And if we kind of time that correctly, we kind of get a little softness. So that's what happened there.

I think Germany was just a bit of a stumble for us. But they're 2 large markets for us.

The rest of the world, the Americas has actually had an exceptional performance, but I think I'll kind of wait another quarter or two before we see it as the trend.

And is that a - does the Germany and China not, as has happened before, a sales force issue, it's more of just circumstance?

More circumstances in the market. I mean, there was a couple of transactions in Germany that we thought were going to come in but came in at - either came in at a smaller amount or did not come in at all and pushed off.

So a little bit of that could be due to the current situation. Obviously, with us as a company, too, I mean, we are facing some headwinds now more frequently with customers that are a little more - do a little more due diligence, especially on larger transactions.

So what's happening is smaller transactions tend to kind of pass through. People are not performing a lot of due diligence.

When you kind of get into, for us, six-figure deals, and once in a while a seven-figure deal, the due diligence goes up and then the red flags go up a little bit, so we wind up getting a little bit less of a transaction or we get a push on the transaction and people contemplate whether or not they should take the risk or not.

And that's due to the cash balance and the size of the company?

Yes, I mean, I think last quarter, I mean, the cash balance - I think what happens is some of the recent things that happened, most people run a D&B check internationally. And obviously, the going concern that showed up last quarter has shown up through D&B, and so that kind of causes a little extra work on our behalf or basically downsizing the transaction a bit.

All right. Okay.

And as far as sort of looking at trying to help yourself on that, is it still an ongoing process?

We're just going to have to really thread the needle there, John. I mean, I know that's not the greatest answer, but that's the situation that we're in.

Thank you, operator. Just like to say thank you very much for joining our call and supporting us as a company, and we look forward to updating you again on our next call, which will be at the beginning of August.

Thank you very much, and good night.