FalconStor Software, Inc.

Todd Oseth - CEO Dan Murale - CFO

Bill Dawkins - Burleson Dawkins Inc.

Thank you, operator. Good afternoon, ladies and gentlemen.

Welcome to FalconStor's second quarter 2017 earnings call. The second quarter delivered 6.7 million in revenue, a 12% increase compared with Q1.

While we're continuing to take tangible actions to improve our cash flow, our earnings per share on a non-GAAP basis increased by 50% sequentially. Our costs also increased slightly to 7.2 million.

However, this was a result of severance expense of roughly $800,000 related to our cost reduction initiative in order to ensure the company is focused on more profitable revenues. We believe our products are world class and we have a bright future ahead, but it requires living within our means and greater focus on our customers and partners.

During Q2, the company removed over $10 million of annualized operating costs and has developed a focused program to enhance revenues in its existing customer base of over 1300 customers. New programs are being established to incentivize our customers to enhance their suite of products and move to the FreeStor platform.

All of the technology of our legacy point solution products are now available within FreeStor and we feel that we can support and serve our customers best on the FreeStor platform. Most of you know by now that a great differentiator for FalconStor is that our prices are based on the amount of primary storage managed and we don't charge for the secondary copies, as many of our competitors do.

For customers having FreeStor in their environment, we'll provide them great flexibility and functionality to allow them to manage much larger environments with fewer people and lower cost. This really becomes a win-win for our company and our customers.

This slide is just to remember about the Safe Harbor statement. The FreeStor product line is positioned well in the storage market, particularly with cloud management and data protection.

Of FreeStor's many storage management functions, we are focusing on three main capabilities where FalconStor has been able to capture market share. The first is virtual tape libraries or VTL.

FalconStor has been a leader in this market for many years and the market remains strong at over $2 billion annually. The second is continuous data protection or CDP.

For those customers in need for very fine levels of recovery, our CDP product is able to recover down to the microsecond, a capability that far outperforms the marketplace and this market continues to grow with a current market of nearly $5 billion and growing. The last focus area is cloud mobility.

The FreeStor product treats the cloud like any other storage resource, so it seamlessly integrates into our customer's environments. This market is growing the fastest and it's currently estimated at about $1.5 billion annually.

In summary, our focused strategy on developing our current customer base along with aligning our costs to the base should allow us to obtain profitability faster. The current FreeStor product line performs well against its competitors, allowing the company to enhance its offerings without an increase in our overall development expenses.

Now, I'd like to turn it over to Dan for a more complete look at our financials. Dan?

Thank you, Todd and good afternoon to everybody. 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 all the applicable disclosures in accordance with GAAP. During the second quarter of 2017, our consolidated GAAP revenue increased 12% sequentially to 6.7 million, compared with 6 million in the previous quarter and decreased 17% from 8.1 million in the second quarter of 2016.

Our bookings totaled 3.9 million compared with 5.5 million in the previous quarter and 8.8 million in the second quarter of 2016. During the quarter, we continued our cost rationalization initiatives in order to align our cost structure with our revenue outlook, and we anticipate that the actions taken will result in annualized cost savings of $10 million.

Our non-GAAP expenses, which exclude restructuring charges and share-based compensation expense, totaled 7.2 million compared with 7 million in the previous quarter and 10.5 million in the prior year, a 3% increase and 32% decrease respectively. Excluding severance costs of 800,000 recorded in the second quarter, our 2017 non-GAAP expenses decreased 600,000 or 9% sequentially.

Our non-GAAP operating loss decreased to 400,000 in the current quarter compared with 900,000 in the previous quarter and 2.4 million in the prior year, a 55% and 82% decrease respectively. Included in those results for the three months ended June 30, 2017 and 2016 was severance expense of 800,000 and 600,000 respectively.

Our non-GAAP gross margins were 74% in the current quarter compared with 77% in the previous quarter and 72% in the prior year. Turning to our balance sheet, as of June 30, our cash and cash equivalents balance decreased to 1.6 million compared with 3.4 million as of December 31, 2016, and our deferred revenue balance decreased to 21.3 million compared with 23.7 million as of December 31, 2016.

Now, I would like to discuss our FreeStor performance. Our total FreeStor revenue for the second quarter was 1.9 million compared with 1.6 million in the previous quarter and 1.1 million in the prior year, a 17% and 71% increase respectively.

Total FreeStor bookings for the second quarter was 1.3 million compared with 2 million in the previous quarter and 4.2 million in the prior year. We now have 381 active customers utilizing the FreeStor technology, representing an increase of 6% sequentially and 47% compared to the prior year.

As you can see from the slide, our legacy product performance continues to decline at a faster rate and we are able to grow our FreeStor installed base. And that's why, as Todd mentioned earlier, our go forward plan focuses on stabilizing and supporting our existing installed base in order to reduce and eventually reverse that decline.

Now, I'd like to turn the call back over to Todd. Todd?

Thanks, Dan. As we move forward with our focus on our existing customers in our three use cases, I believe we can transform this business into profitable growth in the future.

Our products are highly reliable and perform the necessary functions for our customers to reduce their cost of management of their storage infrastructure. As the cloud becomes more important to each of these environments, our approach of treating it like all other storage resources will become a welcome experience for the marketplace.

I'd like to open up the call to any questions that you might have. With that operator can you compile the Q&A roster for us?

I was going to ask you, could you again tell me the market sizes for each of the use cases.

So the CDP market is a little over 5 billion. The VTL market is a little over 2 billion, and currently the cloud mobility market is around 1.5 billion, growing very rapidly to around 3 billion.

And let me ask you, so we have 380 customers utilizing FreeStor now? Is that what you said?

Yes, the FreeStor platform or the FreeStor technology.

And that creates 1.9 million in revenue, so how much does on average these customers spend on FreeStor a quarter?

Well, the revenue can vary, some of it, not all of it subscriptions, some of it can be upfront revenue recognition and some as ratable, so the revenue can vary from quarter to quarter. But in average, FreeStor sales per 100 terabytes…

50k to 100k. It is probably in the $50,000 to $100,000 range.

Much of it is based upon the size of the environment that we are fitting into.

I mean I understand all those, it seems like 380 customers would create more than 1.9 million of revenues; but anyway, I wanted to just ask you that.

It must be on average that these are not large install bases.

So let me ask you this, so your future customer base, what will that look like as far as size of the enterprise?

So our future customer base is really going to be trying to get our existing customers to expand the use of FreeStor and all of its capabilities. One of the things that FreeStor has added in the last six months is a front-end or a GUI that actually ends up being quite useful.

And with that GUI, we have a whole set of new analytics that are available allowing storage resource administrators to be able to identify when they're starting to run out of storage and be able to justify to their management when they need to purchase more storage. And it makes it just a whole lot easier to manage those larger environments.

So much of our activities will be looking at companies trying to expand their base by 50%, 70%. In the next 12 months, our focus really is our existing customer base.

After that, we'll start moving into new logos, new customers, and making sure that they understand all of the different features and functions that come with the FreeStor platform. But it really starts with being outside the overall data center and performing activities that the entire environment is not dependent upon.

And then as we have success, it will slowly move inward into the rest of the environment.

And what kind of market size do you think you have in your current customer base?

That's a little bit hard to say is that, a lot depends upon how rapidly they are expanding themselves and how fast they're growing. The Asian customers are growing quite rapidly, you can actually see potentially a doubling in the amount of storage they need to manage on a yearly basis.

Europe doesn't grow that fast, so you may end up having only a 20% or 30% increase on a yearly basis. The United States runs somewhere between 50% and 75% increases per year.

So much of that is dependent upon the environment, the customer that we're working with.

So not really a dollar figure like --?

Yeah, and unfortunately because it changes all the time on how much more they're going to need. One of the industry changes that we did do and it's yet to be recognized in the industry is that we're only charging it for the primary copies of the storage.

And what that means is that when you do replication or you do the backups and you're creating the identical data somewhere else, in most other cases, companies are charging for both sets, so if you had one terabyte under management and you replicated, you'd have two terabytes. Well then they'd be charging for two terabytes.

We on the other hand only charge for one, so there is no penalty to have a high available system when you're working with FalconStor.

And could you talk a little bit about job opportunity in China.

China is an area that's growing very fast for us , especially around the CDP marketplace, the continuous data protection. Many of the banks, medical hospitals, we see this continuing to grow, and as they get more and more involved in international activities, the need for highly available systems continues to grow.

So we're going to be spending a lot of time in Asia in trying to take advantage of this growth that China is experiencing this year and next year and probably the next three or four years.

Thank you, operator. I want to just thank all of you for participating and listening to our moving forward strategy of focusing on these use cases.

We believe that the concept is not a new one, many software organizations go through what we refer to as enterprise license agreements where we start to give as many deals and opportunities to our customers to use all the services and benefits we can provide. Our product line remains strong; it's a matter of getting to these customers and executing the sales process as fast as possible.

So, I look forward to talking to you again in another few months for the Q3 results. I hope you all have a great night.

Bye now.