Executives: Todd Brooks - CEO Patrick McClain - CFO

Analysts: Allen Zwickler - First Manhattan Co. Bill Dawkins - Burleson Dawkins Inc.

Operator: Good afternoon and thank you for joining us to discuss FalconStor Software Fourth Quarter 2017 Earnings Call. Today’s call is being recorded. Todd Brooks, FalconStor's Chief Executive Officer; and Patrick McClain, Chief Financial Officer, will discuss the company's results and activities, and we'll then open the call to your questions. The company would like to advise all participants that today's discussion may contain what some consider forward-looking statements. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from the forward-looking statements. These risks and uncertainties are discussed in FalconStor's reports on Forms 10-K, 10-Q, and other reports filed with the Securities and Exchange Commission and in the company's press release issued today. During today's call, there will be discussions that include non-GAAP results. A reconciliation of the non-GAAP results to GAAP has been posted on FalconStor's website at www.falconstor.com, under Investor Relations. After the close of business today, FalconStor released its fourth quarter and full year 2017 earnings. Copies of the earnings release and supplemental financial information are available on FalconStor's website at www.falconstor.com. I am now pleased to turn the call over to Todd Brooks.

Todd Brooks: Thank you, Christie, and thanks for everyone that took your time today to join our Q4 earnings call. As we discussed last time during our Q3 earnings call, since its launch in 2000. FalconStor has been a leader within what has been known as - or what’s become known as the software defined storage industry. Our market was reported in 2017 by IDC to be sized at approximately $7 billion and predicted to grow at a compounded annual growth rate of over 13% through 2021. Our products and solutions play a valuable role in managing and protecting critical data within large enterprise organizations around the world. Our customers depend on our solutions to effectively, efficiently and securely protect their critical data from unexpected disasters, malicious cyberattacks and unplanned outages. They rely on FalconStor to ensure mission critical business continuity. We're excited about the progress that we've made in our operating performance during the second half of 2017. And it provides clear support that FalconStor has the opportunity to excel and deliver long term value to its shareholder base. During the quarter, through Q4, we focused on three key initiatives. One, on continuing to adjust our expense base to ensure we are operating on a healthy and profitable foundation. Second, on deepening our global partner and end user base relationships to reenergize sales. And finally, thirdly, to - in securing the funding needed to enable the long term success of the company. And for the balance of today's call, we're going to dive - we’re going to elaborate a little more on each of these key initiatives, and then at the end we'll open up the phone line for any questions that you may have. So first on profitability. Q4 continues the return to profitability that we first delivered last quarter in Q3 of 2017 and powered the company to an annual profit for 2017, which is actually the first annual profit since 2008. The strategic restructuring that we launched earlier in 2017 and the additional focus we applied during Q4, allowed the company to generate a non-GAAP net operating income in excess of $1.5 million during the quarter. This is a $2.2 million improvements from the $700,000 net or non-GAAP net operating loss generated in Q4 2016. Our performance during Q3 and then also Q4 of last year, allowed us to deliver an annual non-GAAP net operating income of over $1.3 million in 2017. That’s a $9 million improvement from the non-GAAP net operating loss of nearly $7.8 million in 2016. Our work and resulting performance during the last two quarters, will certainly serve as critical support for long term profitable performance and growth. But creating a stable financial foundation is not simply driven by a profitable expense base. It’s also a result of stable year over year bookings and resultant revenue retention, and ultimately growth. In my experience, top - mature enterprise software companies can only create commercial stability by first focusing on install base value and growth. This requires spending significant time with decision makers from existing partners and customers to uncover the business value they receive when they utilize our products. As discussed during the Q3 call, we continue to have an extensive installed base. And our reengagement efforts continue to yield positive results in 2000 - or in Q4. So to support this statement, let me highlight three steps from the quarter. To begin, our largest global partner increased their FalconStor billings by over 60% in the second half of 2017, as compared with the first half of 2017. Secondly, billings for FreeStor, which is our flagship product, increased by 122% in Q4 of 2017, as compared to Q4 2016. And then finally, new customer billings delivered from our partners for our three point solution products, increased by 21% during Q4 as compared to the same quarter last year. So we're very encouraged by the progress that we delivered in Q4. Next, as a final step to ensure the long term viability of the company, during Q4 we closed the $3 million financing commitment secured from Hale Capital. Let me turn it over to Pat McClain, our CFO now and to provide some additional detail on that financing, and then also details on the Q4 financial results. Pat?

Patrick McClain: Thank you, Todd. As previously announced, on November 17, we entered into a $500,000 secured short term loan with Hale Capital and announced their financing commitment to the company. With the closing of this $3 million financing commitment on February 26, 2018, we received an additional $2.5 million, with the $3 million loan rolled into a maturity - a longer term maturity note that matures June 30, 2021. We're also pleased to report that Hale Capital has agreed to postpone the date of the mandatory redemption of the series A preferred stock, from August 5, 2017 to July 31, 2021 and waive all prior breaches of the terms of the series A preferred stock. The continued support of Hale Capital and specifically the closing of this financing, provides the company with a solid financial foundation for the future. As Todd mentioned, the financial highlight to the quarter was the delivery of $1.1 million in non-GAAP operating income, which represents a 24% operating margin. Although we delivered a 3% increase in revenues versus 3Q - third quarter, our revenues continue to decline versus 4Q 2016, as we closed the quarter at $6.3 million, representing a year over year quarterly decline of approximately 16%. Bookings exceeded third quarter by 63%, but primarily due to our large maintenance renewal days in Q4, although this did - although we did show a significant decline of 32% in comparison to Q4 2016. Our expectation is that bookings and resulting revenues will stabilize over the next few quarters as we continue to reengage our customer base and implement our reforecast commercial strategy. Gross margin continues to trend higher, increasing to 83% from 80% for Q3 and 74% for Q4 2016. This increase is attributable to cost reductions in product mix. As a result of our cost control and our realignment initiatives, our non-GAAP operating expenses continue to trend lower at $4.7 million, representing a decline of 5% over Q3 and 41% over Q4 2016. Moving to our annual results. We experienced a year over year revenue decline of 17%, with full year revenue coming in at $25.2 million, versus $30.3 million in 2016. Gross margin increased from 73% to 78% on product mix and cost reductions during the second half of 2017. To re-emphasize Todd’s earlier statement, we are pleased to report the first profitable full year results since 2008, with non-GAAP net operating income of $1.3 million. Turning now to the balance sheet. We ended the quarter with a cash balance of just over $1 million, down from $1.8 million at the end of Q3. However, net working capital, excluding deferred revenue, ended at $584,000, which was up by $900,000 from the previous quarter, primarily on the strength of December billings of $3.4 million. We closed the year with accounts receivable at $4.2 million, up from $2.2 million at the end of Q3. Accounts payable and accrued expenses ended at $5.5 million, with over $1.3 million coming due in Q1 2018. Todd, I’ll turn it back to you for your final comments.

Todd Brooks: Thank you, Pat. Appreciate that. So in summary, we are very pleased with the progress that the team has made in Q4 at FalconStor. Now, we still have significant work ahead of us, but we do believe the company’s performance in Q3 and Q4, mark an important pivot point for FalconStor. So to our shareholders and all our customers who may be - who have joined this call today or that might listen to the recording later, we are committed to delivering value and we look forward to exciting days at FalconStor. So at this time, I’ll ask Christie to begin the question-and-answer session. Christie?

Operator: [Operator instructions]. We’ll take our first one from Allen Zwickler from First Manhattan. Your line is open.

Allen Zwickler: Good afternoon. Just two numerical questions. If one were to - and I couldn't just use this term, fully dilute the share count at this point, could you - do you guys have an estimate as to how many shares are outstanding currently?

Patrick McClain: Well, based on the - yes, absolutely. This is Pat McClain. Yes. Based on the commitment that is funded so far, which is just $3 million of the $4 million potential offering, we would have roughly $500 million, about $550 million with the option pool, with the management pool.

Allen Zwickler: So you had $50 million before, right, roughly?

Patrick McClain: Yes. We had $100 million authorized. Fully diluted, we have $55 million roughly.

Allen Zwickler: Okay. So - I'm sorry. So you had $55 million fully diluted and if all of Hale’s shares, you’re going to go to $550 million? Did I hear that right?

Patrick McClain: That's right. There’ll be an offering that will come out where our current shareholders can participate alongside Hale in purchase units. I think that that's been disclosed in our 8-K filings. So that - it could be as much as 700 million shares when we get - if we get - if the offering is fully funded.

Allen Zwickler: And Hale would own what percentage of those shares if that were the case?

Patrick McClain: It depends on …

Allen Zwickler: Well, assuming nobody as we sit today.

Patrick McClain: As we sit today, if no one participates, Hale would own 73%.

Allen Zwickler: 73%. Okay, got it. And secondly, could you disclose who your largest one or two customers are? If they're not over 10%, we wouldn't get to know that. So could you let us know?

Todd Brooks: Yes. Prefer not to right now. In the future, we probably will begin to discuss that, but not today.

Allen Zwickler: Okay. But are these recognizable companies that - because you talked about them increasing their…?

Todd Brooks: Yes.

Allen Zwickler: Okay, great. That’s all I have. Thank you very much.

Todd Brooks: We have several - I can just give a little bit of color on it. We’ve got quite a few - a large number of really large global partners.

Allen Zwickler: Okay, great. Thank you very much.

Operator: [Operator instructions]. We’ll go next Bill Dawkins from Burleson Dawkins Incorporated. Your line is open.

Bill Dawkins: Hey guys. I know you talked about these next couple of quarters, things really stabilizing. Could you to give me an estimate of where you think the bottom of the revenue line is?

Todd Brooks: Good question. I don't know that we want to peg an exact number, Bill. But I think in - there's going to be some, maybe not even perfectly quantifiable right now effect from the accounting 606 changes. But I think in general, if you kind of look at it from a generic business perspective, we feel like we're beginning - with the reengagement that we’ve had with the customer base, we believe that we by and large arrested the decline. Now, guys will be surprised obviously, but we're feeling pretty good that we've got the ship pointed in the right direction again, and we can begin to now focus on where we're going to put our efforts for growth.

Bill Dawkins: And going along those lines of growth, once you all get this thing stabilized and hopefully this company can begin to ramp again, how - trying to think, how rapidly can this company ramp once you all get this thing stabilized and grow these customers out?

Todd Brooks: There’s a lot, Bill. It depends upon - we will likely employ, as we go forward, kind of a dual strategy of organic and inorganic. So organic growth through our existing product set and then growth on the back of strategic acquisitions. And so a lot of it just depends on the - largely on the types of companies that we might go and acquire. I think on the organic side, the mature software companies like FalconStor, it would be naive to think that you would turn that base product set into a super high growing product set again. But I do think that we can deliver some modest amount of organic growth while we are also then adding growth via M&A.

Bill Dawkins: The reason for my question is, I mean we talk about the size of this market. We’ve got this little bitty company in this big market, but it just never really showed up on the topline with FalconStor and that's why I ask is, this product - I mean as your press releases state, I mean you’ve got a pretty damn good product. It’s just I haven't ever seen the damn product ramp. That’s what I’m…

Todd Brooks: Yes. Well, we covered just a little bit, Bill from - in the Q3 call. And I agree with you. The product is fantastic. The - I think where the company struggled historically was just in commercial execution, right? And so I can't speak because we weren’t here obviously exactly where they fell down. But as we look at rebuilding the relationships, it's all about discipline, proper account management, keeping in touch with the customers. A lot of customers that we’ve reengaged with, hearing comments like oh, we haven’t heard from you guys in two or three years is not uncommon, right? So who knows? We might be surprised with what we can drive organically, but I don't want to be naïve and think that all of a sudden, core FalconStor products are going to become just super high growth products. But they can serve as a fantastic foundation to grow via M&A.

Bill Dawkins: Got you. So we can be the core of something bigger as far as the package is concerned?

Todd Brooks: Absolutely.

Bill Dawkins: Okay. Thanks.

Todd Brooks: And storage, as you well know, is centric to a lot of enterprise software applications, right? And so I think as we begin to lay out our strategic roadmap going forward and we begin to think about other areas in which we might go into, there are a lot of interesting opportunities for enterprise software that is storage centric.

Bill Dawkins: Got you. Thank you.

Operator: [Operator instructions]. We have no more questions in the queue. I’d like to turn it back to you for any closing remarks.

Todd Brooks: No, I'm good, Christie. Thank you very much. And once again, thanks everyone for attending today, taking your time out of your busy schedule to attend our call. We look forward to our call next quarter. Thank you.

Operator: And that concludes our call for today. Thank you for your participation. You may now disconnect.