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FALC > SEC Filings for FALC > Form 10-Q on 9-Nov-2012All Recent SEC Filings

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Form 10-Q for FALCONSTOR SOFTWARE INC


9-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements can be identified by the use of predictive, future-tense or forward-looking terminology, such as "believes," "anticipates," "expects," "estimates," "plans," "may," "intends," "will," or similar terms. Investors are cautioned that any forward-looking statements are not guarantees of future performance and involve significant risks and uncertainties, and that actual results may differ materially from those projected in the forward-looking statements. The following discussion should be read together with the consolidated financial statements and notes to those financial statements included elsewhere in this report.

OVERVIEW

As our revenues continue to lag our expectations, we restructured our workforce in the third quarter of 2012 to better align our personnel with our needs, our goals and our anticipated revenues. This restructuring resulted in the termination of thirty five positions, or 7% of our workforce. In addition, the workforce was further reduced due to attrition as we did not fill all of the positions of other employees who left. Our aim is to have a workforce sized to meet our needs to develop and to market new innovative solutions, and to continue to support our existing solutions, but that is also sized so that expenses do not exceed our anticipated revenues. The Company's termination and other associated costs totaled approximately $0.8 million, of which approximately $0.7 million was paid during the third quarter. We expect the restructuring to result in approximately $10.0 million in annualized gross savings.

Revenues totaled $17.1 million, a decline of $1.8 million, or 9%, from the same period in 2011. The economic and competitive landscapes continue to cause us difficulty. Total revenues from North America declined substantially. This was mostly attributable to two reasons. First, sales from one of our major partners declined due to deals lost due to either customer budget freezes, deeply discounted competitive pricing, or the successful use against us of our recent legal issues by some of our larger competitors. Second, as the period since our legacy OEM customers made their last product sales grows, our maintenance revenue from these customers is declining as fewer of their end users renew maintenance for solutions that incorporate our products.

In Asia Pacific, the disruptions with one of our larger OEM partners continued during the quarter. The OEM partner was involved in a reorganization as it was absorbed into its parent company, which caused a lack of focus on the partner's business with us. While we will continue to monitor the situation carefully and to push for renewed focus, we cannot guarantee when or if the business with this OEM partner will return to its previous levels. Our non-OEM product revenue in Asia Pacific was a bright spot, growing 8% compared with the third quarter of 2011 and 9% over the second quarter of 2012.

The economy in Europe continues to be a challenge. The non-OEM product revenues in Europe were down 3% compared with the third quarter of 2011 and up 3% compared with the second quarter of 2012.

Non-OEMs contributed 90% of our product revenues in the third quarter of 2012 and OEMs contributed 10%. No customer accounted for 10% or more of our revenues in the quarter.

Support and services revenue declined 2% on a year-over-year basis. We believe it is significant that, the maintenance fee portion of our support and services revenue, which is more consistent than our professional services revenue, was flat on a year-over-year basis. Normally, zero growth is not a positive metric. But given the decrease in maintenance revenue from our OEMs, specifically our legacy OEMs, the fact that our maintenance revenue did not decline shows that we were able to replace that lost revenue with maintenance revenue from our FalconStor-branded business.

Our net loss for the third quarter of 2012 was $3.6 million, compared with a net loss of $5.4 million for the same period a year ago. Included in the operating results for the third quarter of 2012 was a net reduction of $1.4 million of investigation, litigation and settlement costs. The net reduction of $1.4 million resulted from the recording of a receivable in the third quarter for the recovery of $1.1 million of previously accrued legal fees and $0.4 million of certain costs previously accrued associated with the class action and derivative suits, as a result of a settlement reached with one of our insurance carriers in October 2012. These amounts were partially offset by $0.1 million of overall legal fees not recoverable through insurance. During the same period in 2011, we recorded $0.5 million of costs associated with the then outstanding government investigations and related class actions, which was comprised of overall legal fees.


Index

Operating expenses for the third quarter of 2012 decreased $3.4 million from the third quarter of 2011. The decrease in our operating expenses was primarily attributable to declines in salary and personnel costs, including commissions and share-based compensation due to lower headcount after our workforce reduction and a decrease in investigation, litigation, and settlement related costs compared with the same period in 2011.

Our cash flow from operations for the nine months of 2012 was down significantly from the nine months of 2011, primarily due to the significant declines in our accrued expenses and accounts payable and decline in deferred revenues when compared with December 31, 2011, as opposed to increases in both accrued expenses and accounts payable and deferred revenues for prior year periods. Included in the decline in accrued expenses is the $2.9 million payment we made to the Securities and Exchange Commission ("SEC") and a $1.2 million payment we made to United States Attorney's Office for the Eastern District of New York ("USAO").

Deferred revenue at September 30, 2012 was $23.6 million a decrease of 5%, compared with the balance at September 30, 2011.

RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2012 COMPARED WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2011.

Our primary sales focus is on selling turn-key solutions, whereby our software is integrated with industry standard hardware and sold as one complete integrated solution. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. Product revenue consists of both integrated solutions and stand-alone software revenues. Support and services revenues consists of both maintenance revenues and professional services revenues.

Total revenues for the three months ended September 30, 2012 decreased 9% to $17.1 million, compared with $18.9 million for the three months ended September 30, 2011. During the three months ended September 30, 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 global positions from various departments. The restructuring charges related to the 2012 reduction totaled approximately $0.8 million. During the three months ended September 30, 2011, we completed a restructuring which was composed of a workforce reduction of approximately 25 global positions from various departments and the closing of a satellite facility. The restructuring charges related to the 2011 reduction totaled approximately $0.8 million. The restructuring charges for both the three months ended September 30, 2012 and 2011 have been segregated from each of the respective expense line items and are included within "restructuring costs" in our unaudited condensed consolidated statement of operations. Our cost of revenues increased 2% to $4.9 million for the three months ended September 30, 2012, compared with $4.8 million for the three months ended September 30, 2011. Included in our cost of revenues were less than $0.1 million of share-based compensation expense for the three months ended September 30, 2012 and $0.1 million for the three months ended September 30, 2011. Our operating expenses decreased 18% from $19.2 million for the three months ended September 30, 2011 to $15.8 million for the three months ended September 30, 2012. Included in the operating results for the three months ended September 30, 2012 was a $1.4 million benefit from investigation, litigation and settlement related costs compared with an expense of $0.5 million for the three months ended September 30, 2011. Also included in our operating expenses was $0.8 million of restructuring costs for each of the three months ended September 30, 2012 and 2011. In addition, included in our operating expenses for the three months ended September 30, 2012 and 2011 was $1.0 million and $1.3 million, respectively, of share-based compensation expense. Net loss for the three months ended September 30, 2012 was $3.6 million, compared with a net loss of $5.4 million for the three months ended September 30, 2011. Included in our net loss for the three months ended September 30, 2012 was an income tax provision of $0.1 million, compared with an income tax provision of $0.2 million for the three months ended September 30, 2011. The income tax provision of $0.1 million was primarily attributable to the impact of our estimated 2012 full year effective tax rate on our pre-tax losses for the three months ended September 30, 2012. The income tax provision of $0.2 million was primarily attributable to the impact of our estimated 2011 full year effective tax rate on our pre-tax losses for the three months ended September 30, 2011. No tax benefits were recognized during either period for our domestic losses due to the full valuation allowance over our domestic deferred tax assets.


Index

Overall, the decrease in total revenues was primarily due to a decrease in product revenues for the three months ended September 30, 2012, compared with the same period in 2011. In total, our product revenues decreased 16%. Product revenues from our OEM partners decreased 49%, while product revenues from our non-OEM partners decreased 9% for the three months ended September 30, 2012, compared with the same period in 2011. The decline in OEM product revenues was primarily the result of disruption with one of our largest OEM partners in China which was part of a significant corporate reorganization which commenced during the second quarter of 2012. While the business improved from this OEM partner during the third quarter of 2012, the OEM continued to face disruptions related to the reorganization throughout the third quarter of 2012, and revenues from the OEM were significantly less than our expectations. In addition, as we have previously reported, our OEM product revenues from legacy OEM partners continued to decline and in some cases cease, as a result of consolidation within the industry, and, more recently, end-of-life programs implemented by some of those OEM partners. We do not anticipate that any of our legacy OEM partners will contribute over 10% of our annual revenues for the foreseeable future. During the quarter, we continued our focus and emphasis on the FalconStor-branded business. However, the overall decrease in our non-OEM product revenues was primarily attributable to the weak macroeconomic environment around the globe and uncertainty in the market place. In addition, the recently concluded government investigation has also contributed to the challenges and disruptions we faced in our business. These disruptions have contributed to the difficulties we continue to experience primarily surrounding the overall product revenue growth within our non-OEM business.

Overall, our total operating expenses decreased $3.4 million, or 18%, to $15.8 million for the three months ended September 30, 2012, compared with $19.2 million for the same period in 2011. The decrease in total operating expenses was primarily attributable to a decrease in salary and personnel costs including share-based compensation expense due to lower headcount and to a decrease in investigation, litigation, and settlement related costs compared with the same period in 2011. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook. Our worldwide headcount was 436 employees as of September 30, 2012, compared with 487 employees as of September 30, 2011.

Revenues

                                     Three months ended September 30,
                                         2012                  2011
Revenues:
  Product revenue                  $       8,550,551       $  10,176,275
  Support and services revenue             8,538,462           8,680,115

Total Revenues                     $      17,089,013       $  18,856,390

Year-over-year percentage growth
  Product revenue                                -16 %               -10 %
  Support and services revenue                    -2 %                14 %

Total percentage growth                           -9 %                -1 %

Product revenue

Product revenue is comprised of sales of licenses for our software integrated on industry standard hardware creating a turn-key solution or integrated solution, and our stand-alone software applications. The products are sold through our OEMs, and through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users (collectively "non-OEMs"). These revenues are recognized when, among other requirements, we receive a customer purchase order or a royalty report summarizing stand-alone software applications sold, integrated solutions sold and/or permanent key codes are delivered to the customer.

Product revenue decreased 16% from $10.2 million for the three months ended September 30, 2011, to $8.6 million for the three months ended September 30, 2012. These amounts are net of a benefit of $0.2 million recognized during the three months ended September 30, 2012, compared with an expense of $0.3 million in the same period in 2011, resulting from the impact of our collection efforts of previously reserved accounts receivable. Product revenue represented 50% and 54% of our total revenues for the three months ended September 30, 2012 and 2011, respectively. Product revenues from our OEM partners decreased 49%, while product revenues from our non-OEM partners decreased 9% for the three months ended September 30, 2012, compared with the same period in 2011. The decline in OEM product revenues was primarily the result of disruption with one of our largest OEM partners in China, which was part of a significant corporate reorganization which commenced during the second quarter of 2012. While the business improved from this OEM partner during the third quarter of 2012, the OEM continued to face disruptions related to the reorganization throughout the third quarter of 2012, and revenues from the OEM were significantly less than our expectations. In addition, as we have previously reported, our OEM product revenues from legacy OEM partners continued to decline and, in some cases ceased, as a result of consolidation within the industry, and more recently, end-of-life programs implemented by some of those OEM partners. We do not anticipate that any of our legacy OEM partners will contribute over 10% of our annual revenues for the foreseeable future. During the quarter, we continued our focus and emphasis on the FalconStor-branded business. However, the overall decrease in our non-OEM product revenues was primarily attributable to the weak macroeconomic environment around the globe and uncertainty in the market place. In addition, the recently concluded government investigation has also contributed to the challenges and disruptions we faced in our business. These disruptions have contributed to the difficulties we continue to experience primarily surrounding the overall product revenue growth within our non-OEM business. Product revenue from our non-OEM partners represented 90% and 83% of our total product revenue for the three months ended September 30, 2012 and 2011, respectively. Product revenue from our OEM partners represented 10% and 17% of our total product revenue for the three months ended September 30, 2012 and 2011, respectively.

We continue to focus our investments on the FalconStor-branded non-OEM channel business as we feel this is in line with our long-term outlook. We anticipate that our investments in the FalconStor-branded business will result in our non-OEM generated product revenue growing at a greater rate in future years when compared to our OEM generated product revenue.

Support and services revenue

Support and services revenue is comprised of revenue from (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenues derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Support and services revenue decreased 2% from $8.7 million for the three months ended September 30, 2011 to $8.5 million for the three months ended September 30, 2012. The decrease in support and services revenue was attributable to a decrease in professional services revenues.

Maintenance and technical support services revenue remained relatively consistent at $7.9 million for the three months ended September 30, 2012 and 2011. As we are in business longer, and as we license more integrated solutions and stand-alone software applications to new customers and grow our installed customer base, we expect the amount of maintenance and technical support contracts we have to grow as well. The anticipated growth in our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. During the three months ended September 30, 2012, the growth in maintenance revenue in the non-OEM channel business was offset by (i) a decline in maintenance revenue from certain legacy OEM customers due to consolidation in the industry, (ii) less revenue from one of our largest OEM partners in China, (iii) a decrease from previous years in revenue from sales of products that are generally sold with maintenance, and (iv) deeper discounts provided on product in the current economic and competitive environments.


Index

Professional services revenues decreased from $0.8 million for the three months ended September 30, 2011 to $0.7 million for the same period in 2012. Professional services revenue varies from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, and (iii) the number of professional services contracts that are performed during the period. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions.

Cost of Revenues

                           Three months ended September 30,
                               2012                  2011
Cost of revenues:
  Product                $       1,562,359       $   1,467,141
  Support and service            3,318,558           3,339,448
Total cost of revenues   $       4,880,917       $   4,806,589

Total Gross Profit       $      12,208,096       $  14,049,801

Gross Margin:
  Product                               82 %                86 %
  Support and service                   61 %                62 %
Total gross margin                      71 %                75 %

Cost of revenues, gross profit and gross margin

Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of purchased and capitalized software, shipping and logistics costs, and share-based compensation expense. Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, and share-based compensation expense. Cost of product revenue for the three months ended September 30, 2012 increased $0.1 million, or 6%, to $1.6 million, compared with $1.5 million for the same period in 2011. The increase in cost of product revenue was primarily attributable to slight increases in hardware costs and amortization of capitalized software costs compared with the same period in 2011. Our cost of support and service revenues remained relatively consistent at $3.3 million for the three months ended September 30, 2012 and 2011.

Total gross profit decreased $1.8 million, or 13%, to $12.2 million for the three months ended September 30, 2012 from $14.0 million for the same period in 2011. Total gross margin decreased to 71% for the three months ended September 30, 2012, from 75% for the same period in 2011. The decrease in our total gross profit for the three months ended September 30, 2012, compared with the same period in 2011, was primarily due to a 9% decrease in our total revenues. Generally, our total gross profits and total gross margins may fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.

Share-based compensation expense included in the cost of product revenue was less than 1% of total revenue for both the three months ended September 30, 2012 and September 30, 2011. Share-based compensation expense included in the cost of support and service revenue decreased to less than $0.1 million for the three months ended September 30, 2012, from $0.1 million for the three months ended September 30, 2011. Share-based compensation expense related to cost of support and service revenue was less than 1% for the three months ended September 30, 2012, and 1% for the three months ended September 30, 2011.


Index

Operating Expenses

Research and Development Costs

Research and development costs consist primarily of personnel costs for product development, share-based compensation expense, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $0.4 million, or 8%, to $4.6 million for the three months ended September 30, 2012 from $5.0 million in the same period in 2011. The decrease in research and development costs was primarily the result of a decline in salary and personnel costs, including share-based compensation expense, as a result of lower research and development headcount. These declines were partially offset by a decrease in the total capitalized costs associated with software development of approximately $0.1 million. We believe we continue to provide adequate levels of resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options. Share-based compensation expense included in research and development costs decreased to $0.1 million from $0.2 million for the three months ended September 30, 2012 and September 30, 2011, respectively. Share-based compensation expense included in research and development costs was 1% of total revenue for the three months ended September 30, 2012 and 2011.

Selling and Marketing

Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, share-based compensation expense, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses decreased $1.6 million, or 16%, to $8.3 million for the three months ended September 30, 2012, from $9.9 million for the same period in 2011. The decrease in selling and marketing expenses was primarily attributable to (i) a decrease in commissions due to the 16% decline in product revenue compared with the same period in 2011, and (ii) a decrease in salary and personnel costs, including share-based compensation expenses, as a result of lower sales and marketing headcount. Share-based compensation expense included in selling and marketing decreased to $0.4 million from $0.6 million for the three months September 30, 2012 and 2011, respectively. Share-based compensation expense included in selling and marketing expenses was equal to 2% of total revenue for the three months ended September 30, 2012, and to 3% of revenues for the three months ended September 30, 2011.

General and Administrative

General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based compensation expense, public company related costs, directors and officers' insurance, legal and professional fees, bad debt expense, and other general corporate overhead costs. General and administrative expenses increased $0.6 million, or 19%, to $3.5 million for the three months ended September 30, 2012 compared with $2.9 million for the same period in 2011. The overall increase within general and administrative expenses was primarily related to a $0.5 million increase in bad debt expense related to accounts receivable from two customers which were deemed uncollectible during the third quarter of 2012. Share-based compensation expense included in general and administrative expenses were $0.5 million for each of the three months ended September 30, 2012 and 2011. Share-based compensation expense included in general and administrative expenses was equal to 3% of total revenue for each of the three months ended September 30, 2012 and 2011.

Investigation, Litigation and Settlement Related Costs

During the three months ended September 30, 2012, our total investigation, litigation, and settlement related costs resulted in a net benefit of $1.4 million. The net benefit of $1.4 million resulted from the Company recording a receivable in the third quarter of 2012 for the recovery of $1.1 million of previously accrued legal fees and $0.4 million of certain costs previously accrued associated with the class action and derivative suits, as a result of a settlement reached with one of our insurance carriers in October 2012. These amounts were partially offset by $0.1 million of overall legal fees not recoverable through insurance. During the three months ended September 30, 2011, our total investigation, litigation, and settlement related costs of $0.5 million related to legal fees were incurred in connection with the government investigations. For further information, refer to Note (9) Litigation, to our unaudited condensed consolidated financial statements.


Index

We expect that our operating expenses will continue to be adversely impacted during 2012 and beyond due to professional and service provider fees and other costs, resulting from the ongoing stockholder lawsuits.

Restructuring costs

During the three months ended September 30, 2012, we completed a restructuring which was composed of a workforce reduction of approximately 35 global positions . . .

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