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FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended MARCH 31, 2005
---------------------------------------------
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
------------------ -----------------------
COMMISSION FILE NUMBER 0-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0216135
(State of Incorporation) (I.R.S. Employer Identification No.)
2 HUNTINGTON QUADRANGLE, SUITE 2S01
MELVILLE, NEW YORK 11747
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: 631-777-5188
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes X No
The number of shares of Common Stock issued and outstanding as of April 27, 2005
was 47,967,286 and 47,565,186, respectively.
-1-
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
Page
PART I. Financial Information 3
Item 1. Consolidated Financial Statements 3
Consolidated Balance Sheets at March 31, 2005
(unaudited) and December 31, 2004 3
Unaudited Consolidated Statements of Operations for
the three months ended March 31, 2005 and 2004 4
Unaudited Consolidated Statements of Cash Flows for
the three months ended March 31, 2005 and 2004 5
Notes to the Unaudited Condensed Consolidated
Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 12
Item 3. Qualitative and Quantitative Disclosures about Market Risk 24
Item 4. Controls and Procedures 24
PART II. Other Information 24
Item 1. Legal Proceedings 24
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 24
Item 5. Other Information 25
Item 6. Exhibits 25
-2-
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
MARCH 31, 2005 DECEMBER 31, 2004
----------------- -------------------
ASSETS (UNAUDITED)
Current assets:
Cash and cash equivalents ..................................................... $ 17,335,370 $ 15,484,573
Marketable securities ......................................................... 16,481,269 18,488,616
Accounts receivable, net of allowances of $2,995,962 and $2,551,616,
respectively ................................................................ 10,203,302 10,269,822
Prepaid expenses and other current assets ........................................ 764,320 629,036
------------ ------------
Total current assets ................................................. 44,784,261 44,872,047
Property and equipment, net ...................................................... 4,592,827 4,662,269
Goodwill ......................................................................... 3,512,796 3,512,796
Other intangible assets, net ..................................................... 274,465 307,620
Other assets, net ................................................................ 2,385,584 2,719,460
------------ ------------
Total assets ......................................................... $ 55,549,933 $ 56,074,192
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable .............................................................. $ 748,049 $ 821,433
Accrued expenses .............................................................. 3,100,726 3,501,034
Deferred revenue .............................................................. 4,831,781 4,097,279
------------ ------------
Total current liabilities ............................................ 8,680,556 8,419,746
Deferred revenue ................................................................. 1,291,315 1,290,496
------------ ------------
Total liabilities .................................................... 9,971,871 9,710,242
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized .... -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
47,967,286 and 47,768,755 shares issued, respectively and 47,565,186
and 47,491,655 shares outstanding, respectively ............................ 47,967 47,769
Additional paid-in capital .................................................... 85,670,946 85,400,740
Accumulated deficit ........................................................... (37,086,265) (36,952,436)
Common stock held in treasury, at cost (402,100 and 277,100 shares,
respectively) ............................................................... (2,627,870) (1,714,775)
Accumulated other comprehensive loss .......................................... (426,716) (417,348)
------------ ------------
Total stockholders' equity ........................................... 45,578,062 46,363,950
------------ ------------
Total liabilities and stockholders' equity ........................... $ 55,549,933 $ 56,074,192
============ ============
See accompanying notes to unaudited consolidated financial statements.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
2005 2004
------------- -------------
Revenues:
Software license revenue ........................................ $ 6,282,509 $ 3,547,831
Maintenance revenue ............................................. 1,530,174 821,853
Software services and other revenue ............................. 579,353 889,114
----------- -----------
8,392,036 5,258,798
----------- -----------
Operating expenses:
Amortization of purchased and capitalized software ........... 222,583 415,048
Cost of maintenance, software services and other revenue ..... 1,327,217 978,005
Software development costs ................................... 2,667,391 2,161,916
Selling and marketing ........................................ 3,505,219 3,313,538
General and administrative ................................... 986,026 810,643
----------- -----------
8,708,436 7,679,150
----------- -----------
Operating loss ....................................... (316,400) (2,420,352)
----------- -----------
Interest and other income ....................................... 186,586 202,925
----------- -----------
Loss before income taxes ............................... (129,814) (2,217,427)
Provision for income taxes ...................................... 4,015 4,080
----------- -----------
Net loss ............................................... $ (133,829) $ (2,221,507)
----------- -----------
Basic and diluted net loss per share ............................ $ (0.00) $ (0.05)
=========== ===========
Weighted average basic and diluted shares
outstanding .................................................. 47,528,874 46,638,740
=========== ===========
See accompanying notes to unaudited consolidated financial statements.
-4-
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
THREE MONTHS ENDED
MARCH 31,
2005 2004
---------------- -----------------
Cash flows from operating activities:
Net loss .............................................................. $ (133,829) $ (2,221,507)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation and amortization ................................... 869,972 891,555
Non-cash professional services .................................. (91,546) 6,753
Equity-based compensation expense ............................... -- 7,969
Provision for returns and doubtful accounts .................... 873,535 768,067
Changes in operating assets and liabilities:
Accounts receivable, net ........................................ (807,015) (531,360)
Prepaid expenses and other current assets ....................... (135,284) 3,281
Other assets .................................................... 111,293 (65,465)
Accounts payable ................................................ (73,384) 212,190
Accrued expenses ................................................ (400,308) (291,199)
Deferred revenue ................................................ 735,321 696,534
------------ -------------
Net cash provided by (used in) operating activities .......... 948,755 (523,182)
------------ -------------
Cash flows from investing activities:
Sale of marketable securities ......................................... 16,653,977 13,084,605
Purchase of marketable securities ..................................... (14,640,475) (7,570,637)
Purchase of property and equipment .................................... (515,688) (640,880)
Purchase of software licenses ......................................... -- (25,000)
Purchase of intangible assets ......................................... (29,104) (23,634)
Security deposits ..................................................... -- (4,501)
------------ -------------
Net cash provided by investing activities .......................... 1,468,710 4,819,953
------------ -------------
Cash flows from financing activities:
Proceeds from exercise of stock options ............................... 361,950 270,622
Payments to acquire treasury stock .................................... (913,095) --
------------ -------------
Net cash (used in) provided by financing activities ................ (551,145) 270,622
Effect of exchange rate changes on cash and cash equivalents ............. (15,523) 64,077
------------ -------------
Net increase in cash and cash equivalents ................................ 1,850,797 4,631,470
Cash and cash equivalents, beginning of period ........................... 15,484,573 8,486,144
------------ -------------
Cash and cash equivalents, end of period ................................. $ 17,335,370 $ 13,117,614
============ =============
Cash paid for income taxes ............................................... $ 6,294 $ --
============ =============
The Company did not pay any interest expense for the three months ended
March 31, 2005 and 2004. See accompanying notes to unaudited consolidated
financial statements.
-5-
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) The Company and Nature of Operations
FalconStor Software, Inc., a Delaware Corporation (the "Company"),
develops, manufactures and sells network storage infrastructure software
solutions and provides the related maintenance, implementation and engineering
services.
(b) Principles of Consolidation
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
(c) Unaudited Interim Financial Information
The unaudited interim consolidated financial statements of the Company as
of and for the three months ended March 31, 2005 and 2004, included herein, have
been prepared, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission ("SEC"). Certain information and note
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States of America
have been condensed or omitted pursuant to such rules and regulations relating
to interim financial statements.
In the opinion of management, the accompanying unaudited interim condensed
consolidated financial statements reflect all adjustments, consisting only of
normal recurring adjustments, necessary to present fairly the financial position
of the Company at March 31, 2005 and the results of its operations for the three
months ended March 31, 2005 and 2004.
(d) Cash Equivalents and Marketable Securities
The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$13.0 million and $10.9 million at March 31, 2005 and December 31, 2004,
respectively. Marketable securities at March 31, 2005 and December 31, 2004
amounted to $16.5 million and $18.5 million, respectively, and consisted of
corporate bonds and government securities, which are classified as available for
sale, and accordingly, unrealized gains and losses on marketable securities are
reflected as a component of accumulated other comprehensive loss in
stockholders' equity.
(e) Revenue Recognition
The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, Software Revenue Recognition. Accordingly,
revenue for software licenses is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable, the software is delivered
and collection of the resulting receivable is deemed probable. Software
delivered to a customer on a trial basis is not recognized as revenue until a
permanent key is delivered to the customer. Reseller customers typically send
the Company a purchase order only when they have an end user identified. When a
customer licenses software together with the purchase of maintenance, the
Company allocates a portion of the fee to maintenance for its fair value based
on the contractual maintenance renewal rate. Software maintenance fees are
deferred and recognized as revenue ratably over the term of the contract. The
long-term portion of deferred revenue relates to maintenance contracts with
terms in excess of one year. The cost of providing technical support is included
in cost of revenues. The Company provides an allowance for software product
returns as a reduction of revenue.
Revenues associated with software implementation and software engineering
services are recognized as the services are performed. Costs of providing these
services are included in cost of revenues.
-6-
The Company has entered into various distribution, licensing and joint
promotion agreements with OEMs and distributors, whereby the Company has
provided to the reseller a non-exclusive software license to install the
Company's software on certain hardware or to resell the Company's software in
exchange for payments based on the products distributed by the OEM or
distributor. Nonrefundable advances and engineering fees received by the Company
from an OEM are recorded as deferred revenue and recognized as revenue when
related software engineering services are complete, if any, and the software
product master is delivered and accepted.
For the quarters ended March 31, 2005 and 2004, the Company had a limited
number of transactions in which it purchased hardware and bundled this hardware
with the Company's software and sold the bundled solution to its customer. Since
the software is not essential for the functionality of the equipment included in
the Company's bundled solutions, and both the hardware and software have stand
alone value to the customer, a portion of the contractual fee is recognized as
revenue when the software or hardware is delivered based on the relative fair
value of the delivered element(s).
For the three months ended March 31, 2005, the Company had one customer
that accounted for 17% of revenues and 12% of the accounts receivable balance at
March 31, 2005.
(f) Property and Equipment
Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets (3
to 7 years). Depreciation expense was $585,130 and $424,764 for the three months
ended March 31, 2005 and 2004, respectively. Leasehold improvements are
amortized on a straight-line basis over the term of the respective leases or
over their estimated useful lives, whichever is shorter.
(g) Goodwill and Other Intangible Assets
Goodwill represents the excess of the purchase price over the estimated
fair value of net tangible and identifiable intangible assets acquired in
business combinations. Consistent with Statement of Financial Accounting
Standards ("SFAS") 142, Goodwill and Other Intangible Assets, the Company has
not amortized goodwill related to its acquisitions, but instead tested the
balance for impairment. The Company's annual impairment assessment is performed
as of December 31st of each year, and additionally if events or changes in
circumstances indicate that it is more likely than not that the asset is
impaired. Identifiable intangible assets are amortized over a three-year period
using the straight-line method. Amortization expense was $62,259 and $51,743 for
the three months ended March 31, 2005 and 2004, respectively. The gross carrying
amount and accumulated amortization of other intangible assets as of March 31,
2005 and December 31, 2004 are as follows:
March 31, December 31,
2005 2004
---------- ----------
Customer relationships and purchased technology:
Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (198,779) (180,708)
---------- ----------
Net carrying amount $ 18,071 $ 36,142
========== ==========
Patents:
Gross carrying amount $ 552,727 $ 523,623
Accumulated amortization (296,333) (252,145)
---------- ----------
Net carrying amount $ 256,394 $ 271,478
========== ==========
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(h) Software Development Costs and Purchased Technology
Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility in
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs. Software development costs were fully
amortized as of March 31, 2005. Amortization of software development costs is
recorded at the greater of straight line over three years or the ratio of
current revenue of the related products to total current and anticipated future
revenue of these products.
Purchased software technology of $823,223 and $1,045,806, net of
accumulated amortization of $4,087,777 and $3,865,194, is included in other
assets in the balance sheets as of March 31, 2005 and December 31, 2004,
respectively. Amortization expense was $222,583 and $407,167 for the three
months ended March 31, 2005 and 2004, respectively.
(i) Income Taxes
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
(j) Long-Lived Assets
The Company reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of the asset may not
be recoverable. If the sum of the expected future cash flows, undiscounted and
without interest, is less than the carrying amount of the asset, an impairment
loss is recognized as the amount by which the carrying amount of the asset
exceeds its fair value.
(k) Accounting for Stock-Based Compensation
The Company applies the intrinsic-value based method of accounting
prescribed by Accounting Principles Board ("APB") Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations including the Financial
Accounting Standards Board ("FASB") Interpretation No. 44, Accounting for
Certain Transactions involving Stock Compensation, an interpretation of APB
Opinion No. 25 to account for its fixed-plan stock options. Under this method,
compensation expense is recorded only if on the date of grant the current market
price of the underlying stock exceeded the exercise price. SFAS No. 123,
Accounting for Stock-Based Compensation, established accounting and disclosure
requirements using a fair-value-based method of accounting for stock-based
employee compensation plans. As allowed by SFAS No. 123, the Company has elected
to continue to apply the intrinsic-value-based method of accounting described
above, and has adopted the disclosure requirements of SFAS No. 123.
Had the Company determined stock-based compensation cost based upon the
fair value method under SFAS No. 123, the Company's pro forma net loss and
diluted net loss per share would have been adjusted to the pro forma amounts
indicated below:
-8-
For the Three Months Ended March 31,
2005 2004
------------ ------------
Net loss as reported $ (133,829) $(2,221,507)
Add stock-based employee compensation expense included
in reported net income, net of tax $ -- $ 7,969
Deduct total stock-based employee compensation expense
determined under fair-value-based method for all
awards, net of tax $(2,656,988) $(2,032,235)
----------- -----------
Net loss - pro forma $(2,790,817) $(4,245,773)
=========== ===========
Basic net loss per common share-as reported $ (0.00) $ (0.05)
Basic net loss per common share- pro forma $ (0.06) $ (0.09)
The per share weighted average fair value of stock options granted was $7.65 and
$6.59 for the three months ended March 31, 2005 and 2004, respectively, on the
date of grant using the Black-Scholes option-pricing method with the following
weighted average assumptions:
2005 - expected dividend yield of 0%, risk free interest rate of 3.5%, expected
stock volatility of 166%, and an expected option life of five years for options
granted to employees of the Company;
2004 - expected dividend yield of 0%, risk free interest rate of 3.5%, expected
stock volatility of 176%, and an expected option life of five years for options
granted to employees of the Company.
(l) Financial Instruments
As of March 31, 2005 and December 31, 2004, the fair value of the Company's
financial instruments including cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, approximates book value due to the short
maturity of these instruments.
(m) Foreign Currency
Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations.
(n) Earnings Per Share (EPS)
Basic EPS is computed based on the weighted average number of shares of
common stock outstanding. Diluted EPS is computed based on the weighted average
number of common shares outstanding increased by dilutive common stock
equivalents. Due to net losses for the periods presented, all common stock
equivalents were excluded from diluted net loss per share. As of March 31, 2005,
potentially dilutive common stock equivalents included 9,776,136 stock options
outstanding and 750,000 warrants outstanding.
(o) Comprehensive Loss
Comprehensive loss amounted to $143,197 and $2,305,106 for the three months
ended March 31, 2005 and 2004, respectively. Comprehensive loss includes the
Company's net loss and foreign currency translation adjustments of $(15,523) and
$64,077 for the three months ended March 31, 2005 and 2004, respectively.
Additionally, comprehensive loss includes the Company's unrealized gain and loss
on marketable securities of $6,155 and $(147,676) for the three months ended
March 31, 2005 and 2004, respectively.
(p) Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
-9-
(q) New Accounting Pronouncements
In December 2004, the FASB issued SFAS No. 123 (R), Share Based Payment
("SFAS 123(R)"). This statement replaces SFAS No.123, Accounting for Stock Based
Compensation and supersedes APB No. 25, Accounting for Stock Issued to
Employees. SFAS 123 (R) requires all stock based compensation to be recognized
as an expense in the financial statements and that such cost be measured
according to the grant date fair value of the stock options or other equity
instruments. SFAS 123 (R) will become effective for the Company on January 1,
2006. The Company is currently evaluating the impact that the adoption of this
statement will have on the Company's consolidated financial statements, although
the Company expects that there will be a negative impact on its results of
operations.
(r) Reclassifications
Certain reclassifications have been made to prior year's consolidated
financial statements to conform to the current year's presentation.
(2) SEGMENT REPORTING
The Company is organized in a single operating segment for purposes of
making operating decisions and assessing performance. Revenues from the United
States to customers in the following geographical areas for the three months
ended March 31, 2005 and March 31, 2004 and the location of long-lived assets as
of March 31, 2005 and December 31, 2004 are summarized as follows:
Three Months Ended March 31,
Revenues: 2005 2004
------------- --------------
United States $ 5,760,793 $ 2,614,073
Asia 1,383,320 1,183,454
Other international 1,247,923 1,461,271
------------- --------------
Total revenues $ 8,392,036 $ 5,258,798
============= ==============
March 31, December 31,
2005 2004
------------- --------------
Long-lived assets
(includes all non-current assets):
United States $ 9,345,066 $ 9,929,214
Asia 1,116,105 950,387
Other international 304,501 322,544
------------- --------------
Total long-lived assets $ 10,765,672 $ 11,202,145
============= ==============
(3) STOCK REPURCHASE PROGRAM
On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases may be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions. During the quarter ended March 31, 2005,
-10-
the Company purchased 125,000 shares of its common stock in open market
purchases for a total cost of $913,095. As of March 31, 2005, the Company had
repurchased a total of 402,100 shares for $2,627,870.
(4) CONTINGENCIES
We are subject to various legal proceedings and claims, asserted or
unasserted, which arise in the ordinary course of business. While the outcome of
any such matters cannot be predicted with certainty, we believe that such
matters will not have a material adverse effect on our financial condition or
operating results.
-11-
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
Our revenue for the first quarter of 2005 increased 60% compared with the
same period last year. Revenues for the first quarter were lower than for the
fourth quarter of 2004. The decrease from the fourth quarter was due to lower
revenues from our OEM partners. Historically, spending on network storage
products in the first quarter of each calendar year is lower than spending in
the fourth quarter of the previous year, and we experienced this seasonality.
Our revenues from our resellers increased in the first quarter of 2005 as
compared with the fourth quarter of 2004, while the revenues for all but one of
our significant OEM partners were lower in the first quarter.
Our net loss for the quarter was $0.1 million. Despite this net loss, our
cash flow from operations in the quarter was $0.9 million.
We expect that revenues from our VirtualTape Library software, both
FalconStor branded and OEM branded, will grow at a higher rate than our other
products during 2005. We have not yet seen significant revenue from our iSCSI
products, but we expect that revenues from these products will begin to increase
this year.
We consider the 86% growth in deferred revenue since March 31, 2004, and
14% growth since December 31, 2004, to be an important indicator of the success
of our products. The higher percentage increases in deferred revenue as compared
with total revenues is primarily attributable to the renewal of support and
maintenance agreements by existing end users. We view these support and
maintenance renewals as expressions of satisfaction with our products and
support organization from the end users.
We remain pleased with our ability to scale our business. The 60% increase
in revenues was accomplished even though our operating expenses grew only 13%
for the first quarter of 2005 compared with the same period in 2004. Our gross
margins increased from 74% for the first quarter of 2004 to 82% for the first
quarter of 2005.
We continue to operate the business with the goal of long term growth. Our
increase in headcount on both a year-over-year and a quarter-over-quarter basis
was concentrated in research and development, quality assurance and other
technical areas. We believe that our ability to continue to refine our existing
products and features and to introduce new products and features will be the
primary driver of our growth among existing resellers, OEMs and end users, and
will drive our strategy to attempt to engage additional OEM partners.
RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED MARCH 31, 2005 COMPARED TO
THE THREE MONTHS ENDED MARCH 31, 2004.
Revenues for the three months ended March 31, 2005 increased 60% to $8.4
million compared with $5.3 million for the three months ended March 31, 2004.
Our operating expenses increased 13% from $7.7 million for three months ended
March 31, 2004 to $8.7 million for the three months ended March 31, 2005. Net
loss decreased 94% from $2.2 million for the three months ended March 31, 2004
to $0.1 million for the three months ended March 31, 2005. The increase in
revenues was mainly due to an increase in demand for our network storage
solution software, the introduction of our new products and the successful
launch in the second quarter of 2004 by one of our OEMs of a solution powered by
our product. Revenue contribution from our OEM partners increased in absolute
dollars and as a percentage of our total revenue for the quarter ended March 31,
2005. Revenue from resellers and distributors also increased in absolute
dollars. Expenses increased in all aspects of our business to support our
-12-
growth. For the three months ended March 31, 2005, we increased the number of
employees and continued to invest in our infrastructure by purchasing additional
computers and equipment. We increased the number of employees from 187 employees
as of March 31, 2004 to 223 employees as of March 31, 2005.
REVENUES
Software license revenue
Software license revenue is comprised of software licenses sold through our
OEMs, value-added resellers and distributors to end users and, to a lesser
extent, directly to end users. These revenues are recognized when, among other
requirements, we receive a customer purchase order or a royalty report
summarizing software licenses sold and the software and permanent key codes are
delivered to the customer. We sometimes receive nonrefundable royalty advances
and engineering fees from some of our OEM partners. These arrangements are
evidenced by a signed customer contract, and the revenue is recognized when the
software product master is delivered and accepted, and the engineering services,
if any, have been performed.
Software license revenue increased 77% from $3.5 million for the three
months ended March 31, 2004 to $6.3 million for the three months ended March 31,
2005. Increased market acceptance and demand for our product, the introduction
of our new products and the successful launch in the second quarter of 2004 by
one of our OEMs of a solution powered by our product were the primary drivers of
the increase in software license revenue. Software license revenue increased
from both our OEM partners and from our resellers. Revenue from our OEM partners
increased as a percentage of total revenue. We expect our software license
revenue to continue to grow and the percentage of future software license
revenue derived from our OEM partners to increase.
Maintenance, software services and other revenue
Maintenance, software services and other revenues are comprised of software
maintenance and technical support, professional services primarily related to
the implementation of our software, engineering services, and sales of computer
hardware. Revenue derived from maintenance and technical support contracts is
deferred and recognized ratably over the contractual maintenance term.
Professional services revenue is recognized in the period that the related
services are performed. Revenue from engineering services is primarily related
to customizing software product masters for some of our OEM partners. Revenue
from engineering services is recognized in the period the services are
completed. In the first three months of 2005, we had a limited number of
transactions in which we purchased hardware and bundled this hardware with our
software and sold the bundled solution to our customer. A portion of the
contractual fees is recognized as revenue when the hardware or software is
delivered to the customer based on the relative fair value of the delivered
element(s). Through March 31, 2005, the software and hardware in bundled
solutions have been delivered to the customer in the same quarter. Maintenance,
software services and other revenue increased 23% to $2.1 million for the three
months ended March 31, 2005 from $1.7 million for the three months ended March
31, 2004.
The major factor behind the increase in maintenance, software services and
other revenue was an increase in the number of maintenance and technical support
contracts we sold. As we are in business longer, and as we license more
software, we expect these revenues will continue to increase. The majority of
our new customers purchase maintenance and support and most customers renew
their maintenance and support after their initial contracts expire. Maintenance
revenue increased from $0.8 million for the three months ended March 31, 2004 to
$1.5 million for the three months ended March 31, 2005. We expect maintenance,
software services and other revenues to continue to increase. Software services
and other revenue decreased from $0.9 million for the three months ended March
31, 2004 to $0.6 million for the three months ended March 31, 2005. The major
factor contributing to the decrease in software services and other revenue was a
decrease in professional services revenue, which decreased from $0.4 million for
the three months ended March 31, 2004 to $0.2 million for the three months ended
March 31, 2005. The decrease in professional services revenue is attributable to
more of our OEM and reseller partners performing the professional services
themselves. Additionally, our hardware sales decreased from $0.5 million for the
three months ended March 31, 2004 to $0.4 million for the three months ended
March 31, 2005.
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COST OF REVENUES
Amortization of purchased and capitalized software
To remain successful in the network storage solutions market, we must
continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations we have purchased or licensed various software for resale since
2001. As of March 31, 2005 and 2004, we had $4.9 million of purchased software
licenses that are being amortized over three years. For the three months ended
March 31, 2005 and March 31, 2004, we recorded $0.2 million and $0.4 million of
amortization related to these purchased software licenses, respectively. We will
continue to evaluate third party software licenses and may make additional
purchases, which would result in an increase in amortization expense.
The Company did not capitalize any software development costs until our
initial product reached technological feasibility in March 2001. At that point,
we capitalized $0.1 million of software development costs, which are being
amortized at the greater of straight line over three years or the ratio of
current revenue of the related products to total current and anticipated future
revenue of these products. Amortization of capitalized software costs was $7,881
for the three months ended March 31, 2004. Capitalized software costs were fully
amortized as of the end of the first quarter of 2004.
Cost of maintenance, software services and other revenue
Cost of maintenance, software services and other revenues consists
primarily of personnel and other costs associated with providing software
implementations, technical support under maintenance contracts, and training.
Cost of maintenance, software services and other revenues also includes the cost
of hardware purchased that was resold. Cost of maintenance, software services
and other revenues for the three months ended March 31, 2005 increased by 36% to
$1.3 million compared with $1.0 million for the three months ended March 31,
2004. The increase in cost of maintenance, software services and other revenue
was principally due to an increase in personnel. As a result of our increased
sales of maintenance and support contracts, we required a higher number of
employees to provide technical support. Our cost of maintenance, software
services and other revenue will continue to grow in absolute dollars as our
revenue increases.
Gross profit for the three months ended March 31, 2005 was $6.8 million or
82% of revenues compared with $3.9 million or 74% of revenues for the three
months ended March 31, 2004. The increase in gross profit and gross margin was
directly related to the increase in revenues. Additionally, the increased
percentage of revenue from our OEM partners contributed to the increase in gross
margin since revenues from our OEM partners have higher gross margins.
SOFTWARE DEVELOPMENT COSTS
Software development costs consist primarily of personnel costs for product
development personnel and other related costs associated with the development of
new products, enhancements to existing products, quality assurance and testing.
Software development costs increased 23% to $2.7 million for the three months
ended March 31, 2005 from $2.2 million for the three months ended March 31,
2004. The increase in software development costs was primarily due to an
increase in employees required to enhance and test our core network storage
software product, as well as to develop new innovative features and options. In
addition, as we entered into agreements with new OEM partners, we required
additional employees to test and integrate our software with our OEM partners'
products. We intend to continue recruiting and hiring product development
personnel to support our development process.
SELLING AND MARKETING
Selling and marketing expenses consist primarily of sales and marketing
personnel and related costs, 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
increased 6% to $3.5 million for the three months ended March 31, 2005 from $3.3
million for the three months ended March 31, 2004. As a result of the increase
in revenue and interest in our software, our commission expense and travel
expenses increased. We believe that to continue to grow sales, our sales and
marketing expenses will continue to increase.
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GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of personnel costs of
general and administrative functions, public company related costs, directors
and officers insurance, legal and professional fees, and other general corporate
overhead costs. General and administrative expenses increased 22% to $1.0
million for the three months ended March 31, 2005 from $0.8 million for the
three months ended March 31, 2004. The increase in general and administrative
expenses was primarily due to an increase in professional services associated
with our compliance with the provisions of the Sarbanes-Oxley Act of 2002.
INTEREST AND OTHER INCOME
We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
remained consistent at $0.2 million.
INCOME TAXES
We did not record a tax benefit associated with the pre-tax loss incurred
for the period due primarily to the uncertainty of recoverability of the related
deferred tax assets. Accordingly, we provided a full valuation allowance against
our net deferred tax assets. Our income tax provision consists primarily of tax
liabilities related to our foreign subsidiaries.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies are those related to revenue recognition
and accounts receivable allowances. We recognize revenue in accordance with the
provisions of Statement of Position 97-2, Software Revenue Recognition, as
amended. Software license revenue is recognized only when pervasive evidence of
an arrangement exists and the fee is fixed and determinable, among other
criteria. An arrangement is evidenced by a signed customer contract for
nonrefundable royalty advances received from OEMs or a customer purchase order
or a royalty report summarizing software licenses sold for each software license
resold by an OEM, distributor or solution provider to an end user. The software
license fees are fixed and determinable as our standard payment terms range from
30 to 90 days, depending on regional billing practices, and we have not provided
any of our customers extended payment terms. When a customer licenses software
together with the purchase of maintenance, we allocate a portion of the fee to
maintenance for its fair value based on the contractual maintenance renewal
rate.
We review accounts receivable to determine which are doubtful of
collection. In making the determination of the appropriate allowance for
uncollectible accounts and returns, we consider historical return rates,
specific past due accounts, analysis of our accounts receivable aging, customer
payment terms, historical collections, write-offs and returns, changes in
customer demand and relationships, concentrations of credit risk and customer
credit worthiness. Historically, we have experienced a somewhat consistent level
of write-offs and returns as a percentage of revenue due to our customer
relationships, contract provisions and credit assessments. Changes in the
product return rates, credit worthiness of customers, general economic
conditions and other factors may impact the level of future write-offs, revenues
and our general and administrative expenses.
IMPACT OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2004, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 123 (R), Share Based Payment ("SFAS 123(R)"). This statement replaces
SFAS No.123, Accounting for Stock Based Compensation and supersedes APB No. 25,
Accounting for Stock Issued to Employees. SFAS 123 (R) requires all stock based
compensation to be recognized as an expense in the financial statements and that
such cost be measured according to the grant date fair value of the stock
options or other equity instruments. SFAS 123 (R) will become effective for the
Company on January 1, 2006. We are currently evaluating the impact that the
adoption of this statement will have on our consolidated financial statements,
although we expect that there will be a negative impact on our results of
operations.
LIQUIDITY AND CAPITAL RESOURCES
Our total cash and cash equivalents and marketable securities balance as of
March 31, 2005 decreased by $0.2 million compared to December 31, 2004. Our cash
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and cash equivalents totaled $17.3 million and marketable securities totaled
$16.5 million at March 31, 2005. As of March 31, 2004, we had approximately
$13.1 million in cash and cash equivalents and $22.5 million in marketable
securities.
We continued to invest in our infrastructure to support our long-term
growth during the three months ended March 31, 2005. We made investments in
property and equipment and we increased the number of employees during the first
quarter of 2005. As we continue to grow, we will continue to make investments in
property and equipment and will need to continue to increase our headcount.
In connection with our acquisition of IP Metrics in July 2002, we were
required to make cash payments to the former shareholders of IP Metrics, which
were contingent on the level of revenue from IP Metrics products for a period of
twenty-four months through June 30, 2004. In 2004, we made payments to the
former shareholders of IP Metrics totaling $214,009. We believe that we have no
further payment obligations.
In October 2001, our Board of Directors authorized the repurchase of up to
two million shares of our outstanding common stock. Since October 2001, 402,100
shares have been repurchased at an aggregate purchase price of $2.6 million.
During the first quarter of 2005, 125,000 shares were repurchased at an
aggregate purchase price of $0.9 million.
Net cash provided by operating activities totaled $0.9 million for the
three months ended March 31, 2005, compared with net cash used in operating
activities of $0.5 million for the three months ended March 31, 2004. The main
reason for the change in the cash provided by operating activities compared to
the prior year was a decrease in our net loss from $2.2 million to $0.1 million.
The decrease in net loss is mainly attributable to our increases in revenues.
Net cash provided by operating activities of $0.9 million was primarily derived
from increases in deferred revenue. The cash used in operating activities for
the three months ended March 31, 2004 was mainly comprised of our net loss of
$2.2 million and a decrease in accrued expenses of $0.3 million. These amounts
were partially offset by non-cash charges of $0.9 million consisting of
depreciation and amortization, non-cash professional services expenses, and
equity-based compensation. Additional offsetting amounts include decreases in
net accounts receivable of $0.2 million and increases in accounts payable and
deferred revenue totaling $0.9 million.
Net cash provided by investing activities was $1.5 million for the three
months ended March 31, 2005, due primarily to net sales of marketable securities
of $2.0 million. This amount was partially offset by purchases of property and
equipment of $0.5 million. Net cash provided by investing activities was $4.8
million for the three months ended March 31, 2004, due primarily to net sales of
marketable securities of $5.5 million. This amount was partially offset by
purchases of property and equipment of $0.6 million.
Net cash used in financing activities was $0.6 million for the three months
ended March 31, 2005. We received proceeds from the exercise of stock options of
$0.4 million and we made payments of $0.9 million in the first quarter of 2005
to acquire treasury stock. Net cash provided by financing activities was $0.3
million for the three months ended March 31, 2004. This amount was related to
proceeds from the exercise of stock options.
We currently do not have any debt and our only material commitments are
related to our office leases. We have an operating lease covering our primary
office facility that expires in February, 2012. We also have several operating
leases related to a second domestic office and offices in foreign countries. The
expiration dates for these leases range from 2004 through 2012. The Company's
contractual obligations related to these leases have not changed significantly
from that disclosed in the Company's 2004 form 10-K.
We believe that our current balance of cash, cash equivalents and
marketable securities, and expected cash flows from operations will be
sufficient to meet our cash requirements for at least the next twelve months.
RISK FACTORS
WE HAVE HAD A HISTORY OF NET LOSSES AND MAY NOT BE ABLE TO RETURN TO OR TO
MAINTAIN PROFITABILITY.
For the first quarter of 2005, we had a net loss of $0.1 million. The only
profitable quarter in our Company's history was the fourth quarter of 2004.
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Prior to that we had a history of losses, including the full year ended December
31, 2004, in which we had a net loss of $5.9 million. Our business model depends
upon signing agreements with additional OEM customers, further developing our
reseller sales channel, and expanding our sales force. Any difficulty in
obtaining these OEM and reseller customers or in attracting qualified sales
personnel will hinder our ability to generate additional revenues and achieve or
maintain profitability.
FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING
RESULTS.
Achieving our anticipated growth will depend on a number of factors, some
of which include:
o retention of key management, marketing and technical personnel;
o our ability to increase our customer base and to increase the sales of our
products; and
o competitive conditions in the network storage infrastructure software market.
We cannot assure you that the anticipated growth will be achieved. The
failure to achieve anticipated growth could harm our business, financial
condition and operating results.
WE HAVE SIGNIFICANT LEASE COMMITMENTS THAT COULD IMPACT OUR PROFITABILITY.
During the third quarter of 2003, we signed a lease for new office space
that commenced on November 1, 2003 and continues through February, 2012. This
commitment along with several operating leases related to our foreign offices
could impact our ability to achieve or to maintain profitability.
DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE SOFTWARE
MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING REVENUE FOR FUTURE PERIODS
AND APPROPRIATELY BUDGETING FOR EXPENSES.
The rapidly evolving nature of the network storage software market in which
we sell our products, and other factors that are beyond our control, reduces our
ability to accurately forecast our quarterly and annual revenue. However, we
must use our forecasted revenue to establish our expense budget. Most of our
expenses are fixed in the short term or incurred in advance of anticipated
revenue. As a result, we may not be able to decrease our expenses in a timely
manner to offset any shortfall in revenue.
OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.
The operating results of our business depend in part on the overall demand
for network storage software. Because our sales are primarily to major corporate
customers, any softness in demand for network storage software may result in
decreased revenues.
WE ARE DEPENDENT ON CERTAIN KEY CUSTOMERS.
We tend to have one or more customers account for 10% or more of our
revenues during each fiscal quarter. In addition, during the fiscal year ended
December 31, 2004, one customer accounted for 16% of our revenues. While we
believe that we will continue to receive revenue from these clients, our
agreements typically give these customers the ability to terminate the
relationship upon 90 days notice. If our contracts with these partners are
terminated, or if the volume of sales from these clients declines, it would have
a material adverse effect on our operating results.
THE MARKETS FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE STILL
MATURING, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT CONTINUE TO DEVELOP AS WE
EXPECT.
The continued adoption of Storage Area Networks (SAN) and Network Attached
Storage (NAS) solutions is critical to our future success. The markets for SAN
and NAS solutions are still maturing, making it difficult to predict their
potential sizes or future growth rates. If these markets develop more slowly
than we expect, our business, financial condition and results of operations
would be adversely affected.
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THE MARKET FOR IP-BASED STORAGE AREA NETWORKS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.
The rapid adoption of IP-based Storage Area Networks (SAN) is critical to
our future success. The market for IP-based SANs is still unproven, making it
difficult to predict the potential size or future growth rate. Most potential
customers have made substantial investments in their current storage networking
infrastructure, and they may elect to remain with current network architectures
or to adopt new architecture in limited stages or over extended periods of time.
We are uncertain whether a viable market for our products will develop or be
sustainable. If this market fails to develop, or develops more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.
THE MARKET FOR DISK-BASED BACKUP SOLUTIONS IS NEW AND UNCERTAIN, AND OUR
BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE EXPECT.
The rapid adoption of disk-based backup solutions is critical to our future
success. The market for disk-based backup solutions is still unproven, making it
difficult to predict the potential size or future growth rate. Most potential
customers have made substantial investments in their current tape backup
infrastructure, and they may elect to remain with their current infrastructure
or to adopt new solutions in limited stages or over extended periods of time. We
are uncertain whether a viable market for our products will develop or be
sustainable. If this market fails to develop, or develops more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.
WE MAY NOT BE ABLE TO PENETRATE THE SMALL/MEDIUM BUSINESS, SMALL OFFICE AND HOME
OFFICE MARKETS.
We have announced plans to offer products for the small/medium business
(SMB) and small office/home office (SOHO) markets. We may not be able to design
or offer products attractive to the SMB and the SOHO markets, or to reach
agreements with OEMs and resellers with significant presences in the SMB and
SOHO markets. If we are unable to penetrate the SMB and SOHO markets, we will
not be able to recoup the expenses associated with our efforts in these markets
and our ability to grow revenues could suffer.
IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE SOFTWARE MARKET, OUR OPERATING RESULTS MAY SUFFER.
The network storage software market continues to evolve and as a result
there is continuing demand for new products. Accordingly, we may need to develop
and manufacture new products that address additional network storage software
market segments and emerging technologies to remain competitive in the data
storage software industry. We are uncertain whether we will successfully qualify
new network storage software products with our customers by meeting customer
performance and quality specifications or quickly achieve high volume production
of storage networking software products. Any failure to address additional
market segments could harm our business, financial condition and operating
results.
OUR PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.
Our current products are only one part of a SAN or NAS system. All
components of these systems must comply with the same industry standards in
order to operate together efficiently. We depend on companies that provide other
components of these systems to conform to industry standards. Some industry
standards may not be widely adopted or implemented uniformly, and competing
standards may emerge that may be preferred by OEM customers or end users. If
other providers of components do not support the same industry standards as we
do, or if competing standards emerge, our products may not achieve market
acceptance, which would adversely affect our business.
OUR COMPLEX PRODUCTS MAY HAVE ERRORS OR DEFECTS THAT COULD RESULT IN REDUCED
DEMAND FOR OUR PRODUCTS OR COSTLY LITIGATION.
Our IPStor platform is complex and is designed to be deployed in large and
complex networks. Many of our customers have unique infrastructures, which may
require additional professional services in order for our software to work
within their infrastructure. Because our products are critical to the networks
of our customers, any significant interruption in their service as a result of
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defects in our product within our customers' networks could result in lost
profits or damage to our customers. These problems could cause us to incur
significant service and engineering costs, divert engineering personnel from
product development efforts and significantly impair our ability to maintain
existing customer relationships and attract new customers. In addition, a
product liability claim, whether successful or not, would likely be time
consuming and expensive to resolve and would divert management time and
attention. Further, if we are unable to fix the errors or other problems that
may be identified in full deployment, we would likely experience loss of or
delay in revenues and loss of market share and our business and prospects would
suffer.
FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.
We have entered into agreements with resellers and OEM partners to develop
storage appliances that combine certain aspects of IPStor functionality with
third party hardware to create single purpose turnkey solutions that are
designed to be easy to deploy. If the storage appliances are not easy to deploy
or do not integrate smoothly with end user systems, the basic premise behind the
appliances will not be met and sales would suffer.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers require that
each of our products undergo an extensive qualification process, which involves
interoperability testing of our product in the OEM's system as well as rigorous
reliability testing. This qualification of a product by an OEM does not assure
any sales of the product to the OEM. Despite this uncertainty, we devote
substantial resources, including engineering, sales, marketing and management
efforts, toward qualifying our products with OEMs in anticipation of sales to
them. If we are unsuccessful or delayed in qualifying any products with an OEM,
such failure or delay would preclude or delay sales of that product to the OEM,
which may impede our ability to grow our business.
WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.
Almost all of our sales come from sales to end users of our products by our
OEM customers and by our resellers. These OEM customers and resellers have
limited resources and sales forces and sell many different products, both in the
network storage infrastructure software market and in other markets. The OEM
customers and resellers may choose to focus their sales efforts on other
products in the network storage software market or other markets. The OEM
customers might also choose not to continue to develop or to market products
which include our products. This would likely result in lower revenues to us and
would impede our ability to grow our business.
ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.
As part of our sales channel, we license our software to OEMs and other
partners who install our software on their own hardware or on the hardware of
other third parties. If the hardware does not function properly or causes damage
to customers' systems, we could lose sales to future customers, even though our
software functions properly. Problems with our partners' hardware could
negatively impact our business.
WE MUST MAINTAIN OUR EXISTING RELATIONSHIPS AND DEVELOP NEW RELATIONSHIPS WITH
STRATEGIC INDUSTRY PARTNERS.
Part of our strategy is to partner with major third-party software and
hardware vendors who integrate our products into their offerings and/or market
our products to others. These strategic partners often have customer or
distribution networks to which we otherwise would not have access or the
development of which would take up large amounts of our time and other
resources. There is intense competition to establish relationships with these
strategic partners. Some of our agreements with our OEM customers grant to the
OEMs limited exclusivity rights to portions of our products for periods of time.
This could result in lost sales opportunities for us with other customers or
could cause other potential OEM partners to consider or select software from our
competitors for their storage solutions. In addition, the desire for product
differentiation could cause potential OEM partners to select software from our
competitors. We cannot guarantee that our current strategic partners, or those
companies with whom we may partner in the future, will continue to be our
partners for any period of time. If our software were to be replaced in an OEM
solution by competing software, or if our software is not selected by OEMs for
future solutions, it would likely result in lower revenues to us and would
impede our ability to grow our business.
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THE NETWORK STORAGE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND INTENSE
COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.
The network storage software market is intensely competitive even during
periods when demand is stable. Some of our current and potential competitors
have longer operating histories, significantly greater resources, broader name
recognition and a larger installed base of customers than we have. Those
competitors and other potential competitors may be able to establish or to
expand network storage software offerings more quickly, adapt to new
technologies and customer requirements faster, and take advantage of acquisition
and other opportunities more readily.
Our competitors also may:
o consolidate or establish strategic relationships among themselves to lower
their product costs or to otherwise compete more effectively against us; or
o bundle their products with other products to increase demand for their
products.
In addition, some OEMs with whom we do business, or hope to do business,
may enter the market directly and rapidly capture market share. If we fail to
compete successfully against current or future competitors, our business,
financial condition and operating results may suffer.
OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.
Our previous results are not necessarily indicative of our future
performance and our future quarterly results may fluctuate significantly.
Our future performance will depend on many factors, including:
o the timing of securing software license contracts and the delivery of
software and related revenue recognition;
o the seasonality of information technology, including network storage
products, spending;
o the average unit selling price of our products;
o existing or new competitors introducing better products at competitive prices
before we do;
o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;
o new products or enhancements from us or our competitors;
o import or export restrictions on our proprietary technology; and
o personnel changes.
Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.
OUR STOCK PRICE MAY BE VOLATILE
The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, during the past twelve months ended
March 31, 2005, the closing market price of our common stock as quoted on the
NASDAQ National Market System fluctuated between $5.03 and $9.75. The market
price of our common stock may be significantly affected by the following
factors:
o actual or anticipated fluctuations in our operating results;
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o failure to meet financial estimates;
o changes in market valuations of other technology companies, particularly
those in the storage networking software market;
o announcements by us or our competitors of significant technical innovations,
acquisitions, strategic partnerships, joint ventures or capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
OUR RESULTS OF OPERATIONS WILL BE NEGATIVELY IMPACTED BY THE REQUIREMENT THAT WE
RECOGNIZE THE FAIR VALUE OF STOCK OPTIONS GRANTED AS AN EXPENSE.
The Financial Accounting Standards Board ("FASB") has required companies to
recognize the fair value of stock options and other stock-based compensation to
employees as compensation expense in the statement of operations. In accordance
with SEC rules, FalconStor must implement the FASB rules effective in the first
quarter of 2006. While it is too early to tell the exact impact of this
requirement, there will be a negative impact on our results of operations.
WE HAVE A SIGNIFICANT AMOUNT OF AUTHORIZED BUT UNISSUED PREFERRED STOCK, WHICH
MAY AFFECT THE LIKELIHOOD OF A CHANGE OF CONTROL IN OUR COMPANY.
Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control. Finally, we have entered into change of
control agreements with certain executives.
WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF
OUR COMMON STOCK.
As of March 31, 2005, we had outstanding options and warrants to purchase
an aggregate of 10,526,136 shares of our common stock at a weighted average
exercise price of $5.13 per share. We also have 1,697,665 shares of our common
stock reserved for issuance under our stock option plans with respect to options
that have not been granted.
The exercise of all of the outstanding options would dilute the
then-existing stockholders' percentage ownership of common stock, and any sales
in the public market of the common stock issuable upon such exercise could
adversely affect prevailing market prices for the common stock. Moreover, the
terms upon which we would be able to obtain additional equity capital could be
adversely affected because the holders of such securities can be expected to
exercise or convert them at a time when we would, in all likelihood, be able to
obtain any needed capital on terms more favorable than those provided by such
securities.
OUR BUSINESS COULD BE MATERIALLY AFFECTED AS A RESULT OF A NATURAL DISASTER,
TERRORIST ACTS, OR OTHER CATASTROPHIC EVENTS
In August, 2003, our business was interrupted due to a large scale blackout
in the northeastern United States. While the headquarters facilities we moved in
to in November, 2003 contain redundant power supplies and generators, our
domestic and foreign operations, and the operations of our industry partners,
remain susceptible to fire, floods, power loss, power shortages,
telecommunications failures, break-ins and similar events.
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Terrorist actions domestically or abroad could lead to business disruptions
or to cancellations of customer orders or a general decrease in corporate
spending on information technology, or could have direct impact on our
marketing, administrative or financial functions and our financial condition
could suffer.
THE INTERNATIONAL NATURE OF OUR BUSINESS COULD HAVE AN ADVERSE AFFECT ON OUR
OPERATING RESULTS.
We sell our products worldwide. Accordingly, our operating results could be
materially adversely affected by various factors including regulatory,
political, or economic conditions in a specific country or region, trade
protection measures and other regulatory requirements, and acts of terrorism and
international conflicts.
Our international sales are denominated primarily in U.S. dollars. An
increase in the value of the U.S. dollar relative to foreign currencies could
make our products more expensive and, therefore, potentially less competitive in
foreign markets.
Additional risks inherent in our international business activities
generally include, among others, longer accounts receivable payment cycles,
difficulties in managing international operations, decreased flexibility in
matching workforce to needs as compared with the U.S., and potentially adverse
tax consequences. Such factors could materially adversely affect our future
international sales and, consequently, our operating results.
IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, OUR BUSINESS WILL SUFFER.
Our success is dependent upon our proprietary technology. Currently, the
IPStor software suite is the core of our proprietary technology. We have one
patent issued, multiple pending patent applications, numerous trademarks
registered and multiple pending trademark applications related to our IPStor
product. We cannot predict whether we will receive patents for our pending or
future patent applications, and any patents that we own or that are issued to us
may be invalidated, circumvented or challenged. In addition, the laws of certain
countries in which we sell and manufacture our products, including various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.
We also rely on trade secret, copyright and trademark laws, as well as the
confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.
OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS.
In recent years, there has been significant litigation in the United States
involving patents, trademarks and other intellectual property rights.
We have already been subject to one action alleging that our technology
infringes patents held by a third party. While we settled this litigation, the
litigation was expensive and diverted management's time and attention. Any
additional litigation, regardless of its outcome, would likely be time consuming
and expensive to resolve and would divert management's time and attention and
might subject us to significant liability for damages or invalidate our
intellectual property rights. Any potential intellectual property litigation
against us could force us to take specific actions, including:
o cease selling our products that use the challenged intellectual property;
o obtain from the owner of the infringed intellectual property right a license
to sell or use the relevant technology or trademark, which license may not be
available on reasonable terms, or at all; or
o redesign those products that use infringing intellectual property or cease to
use an infringing product or trademark.
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DEVELOPMENTS LIMITING THE AVAILABILITY OF OPEN SOURCE SOFTWARE COULD IMPACT OUR
ABILITY TO DELIVER PRODUCTS AND COULD SUBJECT US TO COSTLY LITIGATION.
Many of our products are designed to include software or other intellectual
property licensed from third parties, including "Open Source" software. At least
one intellectual property rights holder has alleged that it holds the rights to
software traditionally viewed as Open Source. It may be necessary in the future
to seek or renew licenses relating to various aspects of these products. There
can be no assurance that the necessary licenses would be available on acceptable
terms, if at all. The inability to obtain certain licenses or other rights or to
obtain such licenses or rights on favorable terms, or the need to engage in
litigation regarding these matters, could have a material adverse effect on our
business, operating results, and financial condition. Moreover, the inclusion in
our products of software or other intellectual property licensed from third
parties on a nonexclusive basis could limit our ability to protect our
proprietary rights in our products.
THE LOSS OF ANY OF OUR KEY PERSONNEL COULD HARM OUR BUSINESS.
Our success depends upon the continued contributions of our key employees,
many of whom would be extremely difficult to replace. We do not have key person
life insurance on any of our personnel. Worldwide competition for skilled
employees in the network storage software industry is extremely intense. If we
are unable to retain existing employees or to hire and integrate new employees,
our business, financial condition and operating results could suffer. In
addition, companies whose employees accept positions with competitors often
claim that the competitors have engaged in unfair hiring practices. We may be
the subject of such claims in the future as we seek to hire qualified personnel
and could incur substantial costs defending ourselves against those claims.
WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.
We have made, and may continue to make, acquisitions of other companies or
their assets. Integration of the acquired products, technologies and businesses,
could divert management's time and resources. Further, we may not be able to
properly integrate the acquired products, technologies or businesses, with our
existing products and operations, train, retain and motivate personnel from the
acquired businesses, or combine potentially different corporate cultures. If we
are unable to fully integrate the acquired products, technologies or businesses,
or train, retain and motivate personnel from the acquired businesses, we may not
receive the intended benefits of the acquisitions, which could harm our
business, operating results and financial condition.
IF ACTUAL RESULTS OR EVENTS DIFFER MATERIALLY FROM OUR ESTIMATES AND
ASSUMPTIONS, OUR REPORTED FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOR
FUTURE PERIODS COULD BE MATERIALLY AFFECTED.
The preparation of consolidated financial statements and related disclosure
in accordance with generally accepted account principles requires management to
establish policies that contain estimates and assumptions that affect the
amounts reported in the consolidated financial statements and the accompanying
notes. Note 1 to the Consolidated Financial Statements in this Report on Form
10-Q describes the significant accounting policies essential to preparing our
financial statements. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosures. We base our
estimates on historical experience and assumptions that we believe to be
reasonable under the circumstances. Actual future results may differ materially
from these estimates. We evaluate, on an ongoing basis, our estimates and
assumptions.
LONG TERM CHARACTER OF INVESTMENTS.
Our present and future equity investments may never appreciate in value,
and are subject to normal risks associated with equity investments in
businesses. These investments may involve technology risks as well as
commercialization risks and market risks. As a result, we may be required to
write down some or all of these investments in the future.
UNKNOWN FACTORS
Additional risks and uncertainties of which we are unaware or which
currently we deem immaterial also may become important factors that affect us.
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ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risks. Our return on our investments in cash, cash equivalents and
marketable securities is subject to interest rate risks. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities. If interest rates were to change by
10% from the levels at March 31, 2005, the effect on our financial results would
be insignificant.
Foreign Currency Risk. We have several offices outside the United States.
Accordingly, we are subject to exposure from adverse movements in foreign
currency exchange rates. The effect of foreign currency exchange rate
fluctuations have not been material since our inception. If foreign currency
exchange rates were to change by 10% from the levels at March 31, 2005, the
effect on our other comprehensive income would be insignificant. We do not use
derivative financial instruments to limit our foreign currency risk exposure.
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including
our principal executive officer and principal financial officer, we have
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this report, and,
based on their evaluation, our principal executive officer and principal
financial officer have concluded that these controls and procedures are
effective. No changes in the Company's internal controls over financial
reporting occurred during the quarter ended March 31, 2005, that have materially
affected, or are reasonably likely to materially affect, the Company's internal
controls over financial reporting.
Disclosure controls and procedures are procedures that are designed to ensure
that information required to be disclosed by us in the reports that we file or
submit under the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported, within the time periods specified in the
Securities and Exchange Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by us in the reports that we
file under the Exchange Act is accumulated and communicated to our management,
including our principal executive officer and principal financial officer, as
appropriate to allow timely decisions regarding required disclosure.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are subject to various legal proceedings and claims, asserted or unasserted,
which arise in the ordinary course of business. While the outcome of any such
matters cannot be predicted with certainty, we believe that such matters will
not have a material adverse effect on our financial condition or operating
results.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Shares of common stock repurchased during the quarter ended March 31, 2005:
TOTAL NUMBER OF MAXIMUM NUMBER
SHARES PURCHASED OF SHARES THAT MAY
TOTAL NUMBER OF AVERAGE PRICE AS PART OF PUBLICLY YET BE PURCHASED
SHARES PURCHASED PAID PER SHARE ANNOUNCED PLAN UNDER THE PLAN
February, 2005 43,200 $7.31 43,200 1,679,700
March, 2005 81,800 $7.30 81,800 1,597,900
Total 125,000 $7.30 125,000 1,597,900
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The Company's Board of Directors approved a program, effective October 24, 2001,
to repurchase up to two million shares of the Company's common stock. The
program has no expiration date.
ITEM 5. OTHER INFORMATION
On May 10, 2005, at our Annual Meeting of Stockholders, Alan W. Kaufman was
elected to our Board of Directors to fill a newly created directorship. Mr.
Kaufman was elected to serve a three year term and until his successor is
elected and qualified.
ITEM 6. EXHIBITS
Exhibits
31.1 Certification of the Chief Executive Officer
31.2 Certification of the Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350)
32.2 Certification of Chief Financial Officer pursuant to Section 906
of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss. 1350)
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FALCONSTOR SOFTWARE, INC.
/s/ James Weber
-------------------------------------------
James Weber
Chief Financial Officer, Vice President
and Treasurer
(Principal Accounting Officer)
May 10, 2005
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