The
number of shares of Common Stock issued and outstanding as of May 2, 2008 was
51,394,961 and 48,250,861.
FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
FORM
10-Q
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31
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32
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PART I. FINANCIAL INFORMATION
Item
1. Condensed
Consolidated Financial Statements
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED
CONSOLIDATED BALANCE SHEETS
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Assets
|
|
(unaudited)
|
|
|
|
|
|
Current
assets:
|
|
|
|
|
|
|
|
Cash
and cash
equivalents
|
|
$ |
32,402,875 |
|
|
$ |
32,219,349 |
|
|
Marketable
securities
|
|
|
23,068,694 |
|
|
|
30,684,206 |
|
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Accounts
receivable, net of allowances of $8,577,847 and
$8,780,880,
respectively
|
|
|
22,338,128 |
|
|
|
26,141,636 |
|
|
Prepaid
expenses and other current
assets
|
|
|
2,035,214 |
|
|
|
1,625,417 |
|
|
Deferred
tax assets, net
|
|
|
3,807,325 |
|
|
|
3,807,325 |
|
|
|
|
|
|
|
|
|
|
|
|
Total
current
assets
|
|
|
83,652,236 |
|
|
|
94,477,933 |
|
|
|
|
|
|
|
|
|
|
|
|
Property
and equipment, net of accumulated depreciation of
$15,005,202 and
$13,861,313,
respectively
|
|
|
8,169,295 |
|
|
|
7,945,258 |
|
|
Long-term
marketable
securities
|
|
|
1,320,585 |
|
|
|
- |
|
|
Deferred
tax assets, net
|
|
|
5,988,364 |
|
|
|
5,969,778 |
|
|
Other
assets,
net
|
|
|
2,766,016 |
|
|
|
2,831,878 |
|
|
Goodwill
|
|
|
3,512,796 |
|
|
|
3,512,796 |
|
|
Other
intangible assets,
net
|
|
|
431,079 |
|
|
|
443,909 |
|
|
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
$ |
105,840,371 |
|
|
$ |
115,181,552 |
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
and Stockholders' Equity
|
|
|
|
|
|
|
|
|
|
Current
liabilities:
|
|
|
|
|
|
|
|
|
|
Accounts
payable
|
|
$ |
1,440,993 |
|
|
$ |
1,779,720 |
|
|
Accrued
expenses
|
|
|
6,493,125 |
|
|
|
6,711,231 |
|
|
Deferred
revenue,
net
|
|
|
14,842,972 |
|
|
|
14,142,145 |
|
|
|
|
|
|
|
|
|
|
|
|
Total
current
liabilities
|
|
|
22,777,090 |
|
|
|
22,633,096 |
|
|
|
|
|
|
|
|
|
|
|
|
Other
long-term
liabilities
|
|
|
250,352 |
|
|
|
251,094 |
|
|
Deferred
revenue,
net
|
|
|
5,004,295 |
|
|
|
4,818,985 |
|
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities
|
|
|
28,031,737 |
|
|
|
27,703,175 |
|
|
|
|
|
|
|
|
|
|
|
|
Commitments
and contingencies
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stockholders'
equity:
|
|
|
|
|
|
|
|
|
|
Preferred
stock - $.001 par value, 2,000,000 shares authorized
|
|
|
- |
|
|
|
- |
|
|
Common
stock - $.001 par value, 100,000,000 shares authorized,
51,352,868
and 51,340,268 shares issued, respectively and 48,408,768
and
50,156,168 shares outstanding, respectively
|
|
|
51,353 |
|
|
|
51,340 |
|
|
Additional
paid-in capital
|
|
|
125,521,541 |
|
|
|
122,294,782 |
|
|
Accumulated
deficit
|
|
|
(23,958,244 |
) |
|
|
(25,292,001 |
) |
|
Common
stock held in treasury, at cost (2,944,100 and 1,184,100
shares,
respectively)
|
|
|
(23,530,701 |
) |
|
|
(9,053,824 |
) |
|
Accumulated
other comprehensive loss, net
|
|
|
(275,315 |
) |
|
|
(521,920 |
) |
|
|
|
|
|
|
|
|
|
|
|
Total
stockholders' equity
|
|
|
77,808,634 |
|
|
|
87,478,377 |
|
|
Total
liabilities and stockholders' equity
|
|
$ |
105,840,371 |
|
|
$ |
115,181,552 |
|
See
accompanying notes to unaudited condensed consolidated financial
statements.
FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
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|
|
Three
Months Ended March 31,
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|
|
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|
|
|
|
|
|
Revenues:
|
|
|
|
|
|
|
|
Software
licence revenue
|
|
$ |
15,318,919
|
|
|
$ |
10,437,505 |
|
|
Maintenance
revenue
|
|
|
5,114,247 |
|
|
|
4,333,539 |
|
|
Software
services and other revenue
|
|
|
1,373,494 |
|
|
|
1,569,634 |
|
|
|
|
|
21,806,660 |
|
|
|
16,340,678 |
|
|
|
|
|
|
|
|
|
|
|
|
Operating
expenses:
|
|
|
|
|
|
|
|
|
|
Cost
of maintenance, software services and other revenue
|
|
|
3,314,488 |
|
|
|
2,769,824 |
|
|
Software
development costs
|
|
|
5,878,785 |
|
|
|
5,516,185 |
|
|
Selling
and marketing
|
|
|
8,958,751 |
|
|
|
6,968,751 |
|
|
General
and administrative
|
|
|
1,901,221 |
|
|
|
1,937,780 |
|
|
|
|
|
20,053,245 |
|
|
|
17,192,540 |
|
|
Operating
income
(loss)
|
|
|
1,753,415 |
|
|
|
(851,862 |
) |
|
|
|
|
|
|
|
|
|
|
|
Interest
and other income, net
|
|
|
559,261 |
|
|
|
499,371 |
|
|
|
|
|
|
|
|
|
|
|
|
Income
(loss) before income taxes
|
|
|
2,312,676 |
|
|
|
(352,491 |
) |
|
|
|
|
|
|
|
|
|
|
|
Provision
for income taxes
|
|
|
978,919 |
|
|
|
202,084 |
|
|
|
|
|
|
|
|
|
|
|
|
Net income
(loss)
|
|
$ |
1,333,757 |
|
|
$ |
(554,575 |
) |
|
|
|
|
|
|
|
|
|
|
|
Basic
net income (loss) per share
|
|
$ |
0.03 |
|
|
$ |
(0.01 |
) |
|
Diluted
net income (loss) per share
|
|
$ |
0.03 |
|
|
$ |
(0.01 |
) |
|
|
|
|
|
|
|
|
|
|
|
Basic
weighted average common shares outstanding
|
|
|
49,590,008 |
|
|
|
48,594,410 |
|
|
Diluted
weighted average common shares outstanding
|
|
|
51,690,245 |
|
|
|
48,594,410 |
|
See
accompanying notes to unaudited condensed consolidated financial
statements.
FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
| |
|
Three
Months Ended
March
31,
|
|
|
|
|
|
|
|
|
|
Cash
flows from operating activities:
|
|
|
|
|
|
|
|
Net
income (loss)
|
|
$ |
1,333,757 |
|
|
$ |
(554,575 |
) |
|
Adjustments
to reconcile net income (loss) to net cash provided by operating
activities:
|
|
|
|
|
|
|
|
|
|
Depreciation
and amortization
|
|
|
1,135,532 |
|
|
|
878,940 |
|
|
Share-based
payment compensation
|
|
|
2,247,242 |
|
|
|
2,169,236 |
|
|
Non-cash
professional services expenses
|
|
|
92,404 |
|
|
|
20,849 |
|
|
Tax
benefit from stock option exercises
|
|
|
(955,860 |
) |
|
|
- |
|
|
Provision
for returns and doubtful accounts
|
|
|
1,051,587 |
|
|
|
1,192,345 |
|
|
Deferred
income taxes
|
|
|
978,919 |
|
|
|
- |
|
|
Changes
in operating assets and liabilities:
|
|
|
|
|
|
|
|
|
|
Accounts
receivable
|
|
|
2,756,714 |
|
|
|
3,375,343 |
|
|
Prepaid
expenses and other current assets
|
|
|
(392,660 |
) |
|
|
(191,391 |
) |
|
Other
assets
|
|
|
170,509 |
|
|
|
45,278 |
|
|
Accounts
payable
|
|
|
(351,962 |
) |
|
|
(30,299 |
) |
|
Accrued
expenses
|
|
|
(443,984 |
) |
|
|
(1,251,837 |
) |
|
Deferred
revenue
|
|
|
880,512 |
|
|
|
2,638,305 |
|
|
|
|
|
|
|
|
|
|
|
|
Net
cash provided by operating
activities
|
|
|
8,502,710 |
|
|
|
8,292,194 |
|
|
|
|
|
|
|
|
|
|
|
|
Cash
flows from investing activities:
|
|
|
|
|
|
|
|
|
|
Sale
of marketable securities
|
|
|
34,730,999 |
|
|
|
20,046,190 |
|
|
Purchase
of marketable securities
|
|
|
(28,540,184 |
) |
|
|
(26,840,353 |
) |
|
Purchase
of property and equipment
|
|
|
(1,188,953 |
) |
|
|
(1,039,456 |
) |
|
Security
deposits
|
|
|
(17,000 |
) |
|
|
- |
|
|
Purchase
of intangible assets
|
|
|
(51,339 |
) |
|
|
(51,626 |
) |
|
|
|
|
|
|
|
|
|
|
|
Net
cash provided by (used in) investing activities
|
|
|
4,933,523 |
|
|
|
(7,885,245 |
) |
|
|
|
|
|
|
|
|
|
|
|
Cash
flows from financing activities:
|
|
|
|
|
|
|
|
|
|
Payments
to acquire treasury stock
|
|
|
(14,476,877 |
) |
|
|
- |
|
|
Proceeds
from exercise of stock options
|
|
|
- |
|
|
|
4,127,801 |
|
|
Tax
benefit from stock option exercises
|
|
|
955,860 |
|
|
|
- |
|
|
|
|
|
|
|
|
|
|
|
|
Net
cash (used in) provided by financing activities
|
|
|
(13,521,017 |
) |
|
|
4,127,801 |
|
|
|
|
|
|
|
|
|
|
|
|
Effect
of exchange rate changes on cash and cash equivalents
|
|
|
268,310 |
|
|
|
(26,754 |
) |
|
|
|
|
|
|
|
|
|
|
|
Net
increase in cash and cash equivalents
|
|
|
183,526 |
|
|
|
4,507,996 |
|
|
|
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents, beginning of period
|
|
|
32,219,349 |
|
|
|
16,105,009 |
|
|
|
|
|
|
|
|
|
|
|
|
Cash
and cash equivalents, end of period
|
|
$ |
32,402,875 |
|
|
$ |
20,613,005 |
|
|
|
|
|
|
|
|
|
|
|
|
Cash
paid for income taxes
|
|
$ |
202,817 |
|
|
$ |
241,311 |
|
The
Company did not pay any interest for the three months ended March 31, 2008 and
2007.
See
accompanying notes to unaudited condensed consolidated financial
statements.
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 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)
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.
The Company’s more significant estimates include those related to revenue
recognition, accounts receivable allowances, deferred income taxes and
accounting for share-based compensation expense. Actual results could differ
from those estimates.
(d)
Unaudited Interim Financial Information
The
accompanying unaudited interim condensed consolidated financial statements 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, 2008, and the results of its operations for the three
months ended March 31, 2008 and 2007. The results of operations of any interim
period are not necessarily indicative of the results of operations to be
expected for the full fiscal year.
(e)
Cash Equivalents and Marketable Securities
The
Company considers all highly liquid investments with maturities of three months
or less when purchased to be cash equivalents. As of March 31, 2008 and December
31, 2007, the Company’s cash equivalents consisted of money market funds and
commercial paper, and are recorded at fair value. At March 31, 2008, the fair
value of the Company’s cash equivalents, as defined under Financial Accounting
Standards Board “FASB” Statement of Financial Accounting Standards “SFAS”,
No. 157, Fair Value
Measurements, amounted to approximately
$22.0 million. As of March 31, 2008 and December 31, 2007, the Company’s
marketable securities consisted of corporate bonds, certificate of deposits,
auction rate securities and government securities, and are recorded at fair
value. As of March 31, 2008, the fair value of the Company’s marketable
securities as defined under SFAS No. 157 was approximately $23.1 million. In
addition, at March 31, 2008, the Company had an additional $1.3 million of
long-term marketable securities that required a higher level of judgment to
determine the fair value, as defined under SFAS No. 157. As of December 31,
2007, the Company’s cash equivalents amounted to approximately $21.3 million,
and marketable securities amounted to approximately $30.7 million. All of the
Company’s marketable securities 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,
net of tax.
As of
March 31, 2008, the Company had $1.5 million (at par value) of auction rate
securities included within its portfolio of marketable securities. These auction
rate notes are classified as available-for-sale, and accordingly, any unrealized
gains and losses are reflected as a component of accumulated other comprehensive
loss in stockholders’ equity, net of tax. During the three months ended
March 31, 2008, the Company recorded approximately $179,000 of unrealized losses
on these auction rate notes. The Company determined the decline in market value
below cost to be temporary based upon the Company’s ability to retain the
investment over a period of time, which would be sufficient to allow for any
recovery in market value. Accordingly, based upon the Company’s intent and
ability to retain these investments over a period of time believed to be
sufficient to recover the value, it has classified the auction rate securities
as long-term marketable securities on its consolidated balance sheet as of March
31, 2008. See Note (7) Fair
Value Measurements for
additional information.
(f)
Revenue Recognition
The
Company recognizes revenue from software licenses in accordance with Statement
of Position (“SOP”) 97-2, Software Revenue Recognition,
as amended by SOP 98-4 and SOP 98-9, and related interpretations to determine
the recognition of revenue. Accordingly, revenue for software licenses is
recognized when persuasive evidence of an arrangement exists, the fee is fixed
and determinable and 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 code 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. 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 maintenance, software service and other revenues. The Company
provides an allowance for software product returns as a reduction of revenue,
based upon historical experience and known or expected trends.
Revenues
associated with software implementation and software engineering services are
recognized as the services are completed. Costs of providing these
services are included in cost of maintenance, software services and other
revenue.
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, if any, are complete and the software product master is delivered and
accepted.
The
Company has transactions in which it purchases hardware and bundles this
hardware with the Company’s software and sells 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
fees is recognized as revenue when the software or hardware is delivered based
on the relative fair value(s) of the delivered element(s).
For the
three months ended March 31, 2008, the Company had two customers that together
accounted for 38% of revenues, and two customers that together accounted for 24%
of the accounts receivable balance at March 31, 2008. For the three months
ended March 31, 2007, the Company had two customers that together accounted for
42% of revenues, and three customers that together accounted for 30% of the
accounts receivable balance at March 31, 2007.
(g)
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 $1,032,493 and $801,109 for the three months
ended March 31, 2008 and 2007, 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.
(h)
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 SFAS No. 142, Goodwill and Other Intangible
Assets, the Company has not amortized goodwill related to its
acquisitions, but instead tests the balance for impairment. The Company’s annual
impairment assessment is performed as of December 31st of each
year, and an assessment is made at other times 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 and recorded as part of general and
administrative expenses. Amortization expense was $64,169 and $54,355
for the three months ended March 31, 2008 and 2007, respectively. The gross
carrying amount and accumulated amortization of other intangible assets as of
March 31, 2008 and December 31, 2007 are as follows:
|
|
|
March
31,
|
|
|
December
31,
|
|
|
|
|
2008
|
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
Patents:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Gross
carrying amount
|
|
$ |
1,340,833 |
|
|
$ |
1,289,494 |
|
|
Accumulated
amortization
|
|
|
(909,754 |
) |
|
|
(845,585 |
) |
|
Net
carrying amount
|
|
$ |
431,079 |
|
|
$ |
443,909 |
|
(i)
Software Development Costs and Purchased Technology
In
accordance with the provisions of SFAS No. 86, Accounting for the Costs of Software
to be Sold, Leased or Otherwise Marketed, 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.
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 $207,148 and $246,017, net of accumulated amortization of
$5,170,283 and $5,131,414, is included in other assets as of March 31, 2008 and
December 31, 2007, respectively. Amortization expense was $38,869 and
$25,536 for the three months ended March 31, 2008 and 2007, respectively.
Amortization of purchased software technology is recorded at the greater of the
straight line basis over the products’ estimated remaining life or the ratio of
current period revenue of the related products to total current and anticipated
future revenue of these products.
(j)
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. In determining the period in which related tax benefits are
realized for book purposes, excess share-based compensation deductions included
in net operating losses are realized after regular net operating losses are
exhausted. The Company recognizes interest and penalties accrued related to
unrecognized tax benefits as part of income tax expense in its condensed
consolidated statements of operations.
The
Company accounts for uncertain tax positions in accordance with FASB
Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, (“FIN 48”). FIN 48 is an interpretation of SFAS No. 109, Accounting for Income Taxes,
and addresses the determination of whether tax benefits claimed or expected to
be claimed on a tax return should be recorded in the financial
statements. Under FIN 48, the Company may recognize the tax benefit
from an uncertain tax position only if it meets the “more likely than not”
threshold that the position will be sustained on examination by the taxing
authority, based on the technical merits of the position. The tax benefits
recognized in the financial statements from such a position should be measured
based on the largest benefit that has a greater than fifty percent likelihood of
being realized upon ultimate settlement. FIN 48 also provides guidance on
de-recognition, classification, interest and penalties on income taxes,
accounting in interim periods, and also requires increased disclosures. To date,
no adjustments have been made to the recognized benefits from the Company’s
uncertain tax positions. See Note (6) Income Taxes for additional
information.
(k)
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.
(l)
Share-Based Payments
The
Company accounts for stock-based awards under the provisions of SFAS No. 123(R),
Share-Based Payment,
which establishes the accounting for transactions in which an entity exchanges
its equity instruments for goods or services. Under the provisions of SFAS No.
123(R), share-based compensation expense is measured at the grant date, based on
the fair value of the award, and is recognized as an expense over the requisite
employee service period (generally the vesting period), net of estimated
forfeitures. The Company estimates the fair value of share-based payments using
the Black-Scholes option-pricing model. The estimation of stock-based awards
that will ultimately vest requires judgment, and to the extent actual results or
updated estimates differ from the Company’s current estimates, such amounts will
be recorded as a cumulative adjustment in the period estimates are revised. The
Company considers many factors when estimating expected forfeitures, including
types of awards, employee class and historical experience. Stock option
exercises and restricted stock awards are expected to be fulfilled with new
shares of common stock.
The
Company accounts for stock option grants and grants of restricted shares of
common stock to non-employees in accordance with SFAS No. 123, Accounting for Stock-Based
Compensation, and Emerging Issues Task Force (“EITF”) Issue
No. 96-18, Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services, which requires that the fair
value of these instruments be recognized as an expense over the period in which
the related services are rendered.
(m)
Financial Instruments
As of
March 31, 2008 and December 31, 2007, 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.
(n)
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 condensed consolidated
statements of operations within interest and other income, net. Such
amounts have historically not been material.
(o)
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
the net loss for the three months ended March 31, 2007, all common stock
equivalents were excluded from diluted net loss per share for the periods. As of
March 31, 2008, potentially dilutive vested and unvested common stock
equivalents included 9,065,012 stock option awards and restricted stock awards
outstanding.
The
following represents a reconciliation of the numerators and denominators of the
basic and diluted earnings per share (“EPS”) computation:
|
|
|
Three
Months Ended March 31, 2008
|
|
|
Three
Months Ended March 31, 2007
|
|
|
|
|
Net
Income(Numerator)
|
|
|
Shares
(Denominator)
|
|
|
Per
Share
Amount
|
|
|
Net
Loss
(Numerator)
|
|
|
Shares(Denominator)
|
|
|
Per
Share
Amount
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
EPS
|
|
$ |
1,333,757 |
|
|
|
49,590,008 |
|
|
$ |
0.03 |
|
|
$ |
(554,575 |
) |
|
|
48,594,410 |
|
|
$ |
(0.01 |
) |
|
Effect
of dilutive securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock
options and restricted
stock
|
|
|
|
|
|
|
2,100,237 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted
EPS
|
|
$ |
1,333,757 |
|
|
|
51,690,245 |
|
|
$ |
0.03 |
|
|
$ |
(554,575 |
) |
|
|
48,594,410 |
|
|
$ |
(0.01 |
) |
(p)
Comprehensive Income (Loss)
Comprehensive
income (loss) includes: (i) the Company’s net income (loss), (ii) foreign
currency translation adjustments, (iii) unrealized (gains)/losses on marketable
securities, net of tax, and (iv) minimum pension liability adjustments, net of
tax, pursuant to SFAS No. 158, Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements
No. 87, 88, 106, and 132(R).
The
Company’s comprehensive income (loss) is as follows:
|
|
|
Three
Months Ended March 31,
|
|
| |
|
|
2008
|
|
|
|
2007
|
|
| |
|
|
|
|
|
|
|
|
|
Net
income (loss)
|
|
$ |
1,333,757 |
|
|
$ |
(554,575 |
) |
|
Other
comprehensive income (loss):
|
|
|
|
|
|
|
|
|
|
Foreign
currency translation gain
(loss) adjustments
|
|
|
304,995 |
|
|
|
(41,212 |
) |
|
Unrealized
gain (loss) on marketable
securities, net of tax
|
|
|
(62,467 |
) |
|
|
23,896 |
|
|
Other
comprehensive income
|
|
|
4,077 |
|
|
|
- |
|
|
Other
comprehensive income (loss)
|
|
|
246,605 |
|
|
|
(17,316 |
) |
|
Comprehensive
income (loss)
|
|
$ |
1,580,362 |
|
|
$ |
(571,891 |
) |
(q) Investments
As of
March 31, 2008 and December 31, 2007, the Company maintained certain cost-method
investments aggregating $1,116,457, respectively, which are included in “Other
assets” in the accompanying condensed consolidated balance sheets. During the
three months ended March 31, 2008 and 2007, the Company did not recognize any
impairment charges related to any of its cost-method investments.
(r)
New Accounting Pronouncements
In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations. SFAS
No. 141(R) establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any noncontrolling interest in the acquiree
and the goodwill acquired. SFAS No. 141(R) also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. SFAS No. 141(R) is effective for fiscal years beginning
after December 15, 2008. The Company is currently evaluating the potential
impact, if any, of the adoption of SFAS No. 141(R) on its consolidated financial
statements.
In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51. SFAS No. 160 establishes accounting and reporting standards
for ownership interests in subsidiaries held by parties other than the parent,
the amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS No. 160 also establishes disclosure requirements that
clearly identify and distinguish between the interests of the parent and the
interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal
years beginning after December 15, 2008. The Company is currently evaluating the
potential impact, if any, of the adoption of SFAS No. 160 on its consolidated
financial statements.
In
February 2008, the FASB issued FASB Staff Position No. FAS 157-2,
Effective Date of FASB
Statement No. 157 (“FSP 157-2”), to partially defer SFAS
No. 157, Fair Value
Measurements. FSP 157-2 defers the effective date of SFAS No. 157
for nonfinancial assets and nonfinancial liabilities, except those that are
recognized or disclosed at fair value in the financial statements on a recurring
basis (at least annually), to fiscal years, and interim periods within those
fiscal years, beginning after November 15, 2008. The Company is currently
evaluating the potential impact, if any, SFAS No. 157 will have to nonfinancial
assets and liabilities (principally goodwill and intangible assets) to the
fiscal year beginning after November 15, 2008 on its consolidated financial
statements.
(s) Reclassifications
Certain
reclassifications have been made to prior periods’ unaudited condensed
consolidated financial statement presentations to conform to the current
periods’ presentation.
(2)
Share-Based Payment Arrangements
As of May
1, 2000, the Company adopted the FalconStor Software, Inc. 2000 Stock Option
Plan (the “2000 Plan”). The 2000 Plan is administered by the Board of Directors
and, as amended, provides for the grant of options to purchase up to 14,162,296
shares of Company common stock to employees, consultants and non-employee
directors. Options may be incentive (“ISO”) or non-qualified. ISOs granted must
have exercise prices at least equal to the fair value of the common stock on the
date of grant, and have terms not greater than ten years, except those to an
employee who owns stock with greater than 10% of the voting power of all classes
of stock of the Company, in which case they must have an option price at least
110% of the fair value of the stock, and expire no later than five years from
the date of grant. Non-qualified options granted must have exercise prices not
less than eighty percent of the fair value of the common stock on the date of
grant, and have terms not greater than ten years. All options granted under the
2000 Plan must be granted before May 1, 2010. As of March 31, 2008, 330,320
shares were available for grant under the 2000 Plan.
On May
14, 2004, the Company adopted the FalconStor Software, Inc. 2004 Outside
Directors Stock Option Plan (the “2004 Plan”). The 2004 Plan is administered by
the Board of Directors and provides for the granting of options to non-employee
directors of the Company to purchase up to 300,000 shares of Company common
stock. Exercise prices of the options must be equal to the fair market value of
the common stock on the date of grant. Options granted have terms of ten years.
All options granted under the 2004 Plan must be granted within three years of
the adoption of the 2004 Plan. As of March 31, 2008, 250,000 shares remain
outstanding from the 2004 Plan and no additional options are available for grant
under the 2004 Plan.
On May
17, 2006, the Company adopted the FalconStor Software, Inc. 2006 Incentive Stock
Plan (the “2006 Plan”). The 2006 Plan was amended on May 8, 2007 and
May 8, 2008. The 2006 Plan is administered by the Board of Directors and
provides for the grant of incentive and nonqualified stock options, and
restricted stock, to employees, officers, consultants and advisors of the
Company. The number of shares available for grant or issuance under
the 2006 Plan, as amended, is determined as follows: If, on July
1st
of any calendar year in which the 2006 Plan is in effect, the number of shares
of stock to which options may be granted is less than five percent (5%) of the
number of outstanding shares of stock, then the number of shares of stock
available for issuance under the 2006 Plan is automatically increased so that
the number equals five percent (5%) of the shares of stock outstanding. In no
event shall the number of shares of stock subject to the 2006 Plan in the
aggregate exceed twenty million shares, subject to adjustment as provided in the
2006 Plan. On July 1, 2007, the total number of outstanding shares of the
Company’s common stock totaled 49,615,610. Pursuant to the 2006 Plan, as
amended, the total shares available for issuance under the 2006 Plan thus
increased by 2,170,731 shares to 2,480,781 shares available for issuance as of
July 1, 2007. As of March 31, 2008, 278,381 shares were available for grant
under the 2006 Plan. Exercise prices of the options must be equal to the fair
market value of the common stock on the date of grant. Options granted have
terms of not greater than ten years. All options and shares of restricted stock
granted under the 2006 Plan must be granted within ten years of the adoption of
the 2006 Plan.
On May 8,
2007, the Company adopted the FalconStor Software, Inc. 2007 Outside Directors
Equity Compensation Plan (the “2007 Plan”). The 2007 Plan was amended on May 8,
2008. The 2007 Plan is administered by the Board of Directors and
provides for the issuance of up to 300,000 shares of Company common stock upon
the vesting of options or upon the grant of shares with such restrictions as
determined by the Board of Directors to the non-employee directors of the
Company. Exercise prices of the options must be equal to the fair market value
of the common stock on the date of grant. Options granted have terms of ten
years. Shares of restricted stock have the terms and conditions set by the Board
of Directors and are forfeitable until the terms of the grant have been
satisfied. As of March 31, 2008, 235,000 shares were available for grant under
the 2007 Plan.
The
following table summarizes stock option activity during the three months ended
March 31, 2008:
|
|
|
Number
of
Options
|
|
|
Weighted
Weighted
Average
Exercise
Price
|
|
|
Average
Remaining
Contractual
Life
(Years)
|
|
|
Aggregate
Intrinsic
Value
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
Outstanding at December 31, 2007
|
|
|
9,667,374 |
|
|
$ |
6.79 |
|
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Granted
|
|
|
808,900 |
|
|
$ |
8.44 |
|
|
|
|
|
|
|
|
Exercised
|
|
|
- |
|
|
|
- |
|
|
|
|
|
|
|
|
Canceled
|
|
|
(162,875 |
) |
|
$ |
8.56 |
|
|
|
|
|
|
|
|
Forfeited
|
|
|
(15,200 |
) |
|
$ |
8.43 |
|
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
Outstanding at March 31, 2008
|
|
|
10,298,199 |
|
|
$ |
6.88 |
|
|
|
6.27 |
|
|
$ |
17,346,320 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
Exercisable at March 31, 2008
|
|
|
7,222,782 |
|
|
$ |
5.64 |
|
|
|
5.07 |
|
|
$ |
16,356,129 |
|
Stock
option exercises are fulfilled with new shares of common stock. There were no
stock option exercises during the three months ended March 31, 2008. The total
cash received from stock option exercises for the three months ended March 31,
2007 was $4,127,802. The total intrinsic value of stock options
exercised during the three months ended March 31, 2007 was
$6,309,312.
The
Company recognized share-based compensation expense for awards issued under the
Company’s stock option plans in the following line items in the condensed
consolidated statements of operations:
| |
|
Three
Months Ended |
|
|
Three
Months Ended |
|
| |
|
March
31, |
|
|
March
31, |
|
|
|
|
2008
|
|
|
2007
|
|
| |
|
|
|
|
|
|
|
|
|
Cost
of maintenance, software services and other revenue
|
|
$ |
280,598 |
|
|
$ |
284,849 |
|
|
Software
development costs
|
|
|
849,598 |
|
|
|
923,656 |
|
|
Selling
and marketing
|
|
|
994,949 |
|
|
|
718,917 |
|
|
General
and administrative
|
|
|
214,501 |
|
|
|
262,663 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ |
2,339,646 |
|
|
$ |
2,190,085 |
|
The
Company began issuing restricted stock in 2006. During 2006, the Company granted
225,000 shares of restricted stock to certain officers and employees at an
average fair value per share at date of grant of $7.06 per share. During 2007,
the Company granted a total of 373,000 shares of restricted stock at various
times to certain outside directors, officers, employees and non-employee
consultants. The fair value of the restricted stock award grants are being
expensed at either the fair value per share at date of grant (outside director,
officers and employees) or at the fair value per share as of each reporting
period (non-employee consultants) which range from $9.87 to $15.30 per share.
During the three months ended March 31, 2008, the Company granted a total of
382,000 shares of restricted stock at various times to certain officers,
employees and non-employee consultants. The fair value per share of the
restricted stock award grants are being expensed at either the fair value per
share at date of grant (outside director, officers and employees) or at the fair
value per share as of each reporting period (non-employee consultants) which
range from $7.14 to $9.29 per share.
As of
March 31, 2008, an aggregate of 980,000 shares of restricted stock had been
issued, of which, 87,950 had vested and 25,000 had been canceled. As of March
31, 2007, an aggregate of 225,000 shares of restricted stock had been issued, of
which, none had vested or been cancelled.
The
following table summarizes restricted stock activity during the three months
ended March 31, 2008:
|
|
|
Number
of Restrcited
Stock
Awards
|
| |
|
|
|
|
Non-Vested
at December 31, 2007
|
|
|
497,650 |
|
| |
|
|
|
|
|
Granted
|
|
|
382,000 |
|
|
Vested
|
|
|
(12,600 |
)
|
|
Canceled
|
|
|
- |
|
| |
|
|
|
|
|
Non-Vested
at March 31, 2008
|
|
|
867,050 |
|
Options
granted to officers, employees and directors during fiscal 2008, 2007 and 2006
have exercise prices equal to the fair market value of the stock on the date of
grant, a contractual term of ten years, and a vesting period generally of three
years. Based on each respective group’s historical vesting experience
and expected trends, the estimated forfeiture rate for officers, employees and
directors, as adjusted, was 11%, 24% and 9%, respectively. All options granted
through December 31, 2005 had exercise prices equal to the fair market value of
the stock on the date of grant, a contractual term of ten years, a vesting
period of generally three years and an estimated forfeiture rate ranging from 5%
- 15%.
Options
granted to non-employee consultants have exercise prices equal to the fair
market value of the stock on the date of grant and a contractual term of ten
years. Restricted stock awards granted to non-employee consultants have a
contractual term equal to the lapse of restriction(s) of each specific award.
Vesting periods for both options granted and restricted stock awarded to
non-employee consultants range from one month to three years depending on the
respective service requirements.
The
Company estimates expected volatility based primarily on historical daily
volatility of the Company’s stock and other factors, if applicable. The
risk-free interest rate is based on the United States treasury yield curve in
effect at the time of grant. The expected option term is the number of years
that the Company estimates that options will be outstanding prior to exercise.
The expected term of the awards issued after December 31, 2007 was determined
based upon an estimate of the expected term of “plain vanilla”
options as prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 110. The
expected term of the awards issued prior to January 1, 2008, was determined
using the “simplified method” prescribed in SAB No. 107.
As of
March 31, 2008, there was approximately $18,605,122, of total unrecognized
compensation cost related to the Company’s unvested options and restricted
shares granted under the Company’s stock plans.
(3) 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 2008 and 2007, and the location of long-lived assets as of March 31,
2008 and December 31, 2007, are summarized as follows:
|
|
|
Three
Months Ended March 31,
|
|
|
|
|
2008
|
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
Revenues:
|
|
|
|
|
|
|
|
United
States
|
|
$ |
14,881,742 |
|
|
$ |
11,744,748 |
|
|
Asia
|
|
|
2,674,447 |
|
|
|
1,885,764 |
|
|
Other
international
|
|
|
4,250,471 |
|
|
|
2,710,166 |
|
|
|
|
|
|
|
|
|
|
|
|
Total
revenues
|
|
$ |
21,806,660 |
|
|
$ |
16,340,678 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March
31,
|
|
|
December
31,
|
|
|
|
|
2008
|
|
|
2007
|
|
|
|
|
|
|
|
|
|
|
|
|
Long-lived
assets:
|
|
|
|
|
|
|
|
|
|
United
States
|
|
$ |
19,960,007 |
|
|
$ |
18,483,889 |
|
|
Asia
|
|
|
1,743,969 |
|
|
|
1,720,098 |
|
|
Other
international
|
|
|
484,159 |
|
|
|
499,632 |
|
|
|
|
|
|
|
|
|
|
|
|
Total
long-lived assets
|
|
$ |
22,188,135 |
|
|
$ |
20,703,619 |
|
|
|
|
|
|
|
|
|
|
|
(4)
Stock Repurchase Program
On February 6, 2008, the Company
announced that its Board of Directors had increased the October 2001
authorization to repurchase the Company’s outstanding common stock from two
million shares to five million shares in the aggregate. 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 three months ended March 31, 2008, the Company repurchased 1,760,000 shares
of its common stock in open market purchases for a total cost of $14,476,877.
During 2007, the Company repurchased 318,900 shares of its common stock in open
market purchases for a total cost of $3,273,661. As of March 31, 2008, the
Company had repurchased a total of 2,944,100 shares of its common stock at an
aggregate purchase price of $23,530,701, and had the authorization to repurchase
an additional 2,055,900 shares of its common stock under the February 6, 2008
authorization.
(5)
Commitments and Contingencies
The Company has an operating lease
covering its corporate office facility that expires in February 2012. The
Company also has several operating leases related to offices in the United
States and foreign countries. The expiration dates for these leases range from
2008 through 2015. The following is a schedule of future minimum lease payments
for all operating leases as of March 31, 2008:
|
2008
|
|
$ |
1,741,536 |
|
|
2009
|
|
|
2,142,210 |
|
|
2010
|
|
|
1,692,090 |
|
|
2011
|
|
|
1,404,496 |
|
|
2012
|
|
|
379,668 |
|
|
Thereafter
|
|
|
426,094 |
|
|
|
|
$ |
7,786,094 |
|
The
Company is 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, such matters are not
expected to have a material adverse effect on the Company’s financial condition
or operating results.
On
December 31, 2007, the Company entered into an Employment Agreement (“Employment
Agreement”) with ReiJane Huai. Pursuant to the Employment Agreement, the Company
agreed to continue to employ Mr. Huai as President and Chief Executive Officer
of the Company effective January 1, 2008 through December 31, 2010, at annual
salaries of $310,000, $341,000 and $375,100 for calendar years 2008, 2009 and
2010, respectively. The Employment Agreement also provides for the payment of
annual bonuses to Mr. Huai, in the form of shares of the Company’s restricted
stock, based on the Company’s operating income (or “bonus targets” as defined in
the Employment Agreement) and for certain other contingent benefits set forth in
the Employment Agreement. Pursuant to the Employment Agreement, the 2008 annual
bonus of restricted stock due to Mr. Huai shall be issued within seventy-five
(75) days of the end of fiscal 2008, assuming the bonus targets are achieved.
The restricted stock is subject to a three-year vesting period commencing from
the date of grant. During the three months ended March 31, 2008, and in
accordance SFAS No. 123(R), the Company recognized approximately $69,000 of
share-based compensation expense, which was classified as a liability award
within the Company’s condensed consolidated balance sheets, based upon the
Company’s projected bonus award due to Mr. Huai for 2008.
(6)
Income Taxes
The
Company’s provision for income taxes consists of U.S. and foreign taxes in
amounts necessary to align the Company’s year-to-date tax provision with the
effective rate that the Company expects to achieve for the full year. The
Company’s 2008 annual effective tax rate is estimated to be approximately 42%
(which includes U.S., state and local and foreign taxes) based upon the
Company’s anticipated earnings both in the U.S. and in its foreign
subsidiaries.
For the three months ended March 31,
2008, the Company’s provision for income taxes was $978,919, which consisted of
U.S., state and local and foreign taxes. For the three months ended March 31,
2007, the Company’s provision for income taxes was $202,084, which consisted
primarily of U.S. federal alternative minimum taxes and state minimum taxes that
were expected to be incurred (despite the Company’s pre-tax book loss) primarily
as a result of the then limitations on its ability to utilize net operating
losses under the alternative minimum tax system and the non-deductibility of
certain share-based compensation expense for income tax purposes that had been
recognized for financial statement purposes. In addition, the provision for
income taxes for the three months ended March 31, 2007, also included discrete
items for (i) $57,058 related to state income taxes incurred in periods prior to
2007, and (ii) $120,000 related to a change in the Company’s estimate of amounts
due in certain foreign jurisdictions for periods prior to 2007, based upon the
Company’s evaluation of information obtained in 2007.
The Company’s total unrecognized tax
benefits as of March 31, 2008 and December 31, 2007 were each approximately $4.4
million, which, if recognized, would affect the Company’s effective tax rate. As
of March 31, 2008, the Company had approximately $43,793 of accrued interest and
penalties.
(7)
Fair Value Measurements
The Company adopted the provisions of
SFAS No. 157, as amended by FSP FAS 157-1 and FSP FAS 157-2, on
January 1, 2008. Pursuant to the provisions of FSP FAS 157-2, the Company
will not apply the provisions of SFAS No. 157 until January 1, 2009
for nonfinancial assets and liabilities.
Fair Value
Hierarchy
SFAS No. 157 specifies a hierarchy
of valuation techniques based upon whether the inputs to those valuation
techniques reflect assumptions other market participants would use based upon
market data obtained from independent sources (observable inputs) or reflect the
Company’s own assumptions of market participant valuation (unobservable inputs).
In accordance with SFAS No. 157, these two types of inputs have created the
following fair value hierarchy:
|
·
|
Level 1 – Quoted prices
in active markets that are unadjusted and accessible at the measurement
date for identical, unrestricted assets or liabilities. The Level 1
category includes money market funds of $12.3 million, and government
treasuries of $12.7 million, which are included within cash and cash
equivalents and marketable securities in the condensed consolidated
balance sheets.
|
| |
|
|
· |
Level 2 – Quoted prices
for identical assets and liabilities in markets that are not active,
quoted prices for similar assets and liabilities in active markets or
financial instruments for which significant inputs are observable, either
directly or indirectly. The Level 2 category includes commercial paper of
$3.9 million, and government securities and corporate bonds of $16.2
million, which are included within cash and cash equivalents and
marketable securities in the condensed consolidated balance
sheets.
|
| |
|
|
· |
Level 3 – Prices or
valuations that require inputs that are both significant to the fair value
measurement and unobservable. The Level 3 category includes
$1.3 million of auction rate securities, which are included within
long-term marketable securities in the condensed consolidated balance
sheets.
|
SFAS
No. 157 requires the use of observable market data if such data is
available without undue cost and effort.
Measurement
of Fair Value
The
Company measures fair value as an exit price using the procedures described
below for all assets and liabilities measured at fair value. When available, the
Company uses unadjusted quoted market prices to measure fair value and
classifies such items within Level 1. If quoted market prices are not available,
fair value is based upon internally developed models that use, where possible,
current market-based or independently-sourced market parameters such as interest
rates and currency rates. Items valued using internally generated models
are classified according to the lowest level input or value driver that is
significant to the valuation. Thus, an item may be classified in Level 3
even though there may be inputs that are readily observable. If quoted market
prices are not available, the valuation model used generally depends on the
specific asset or liability being valued. The determination of fair value
considers various factors including interest rate yield curves and time value
underlying the financial instruments.
As of March 31, 2008, the Company
held certain assets that are required to be measured at fair value on a
recurring basis. Included within the Company’s marketable securities portfolio
are investments in auction rate securities, which are classified as
available-for-sale securities and are reflected at fair value. However, due to
recent events in the U.S. credit markets, the auction events for these
securities held by the Company failed during the first quarter of 2008.
Therefore, the fair values of these securities are estimated utilizing a
discounted cash flow analysis or other type of valuation model as of
March 31, 2008. These analyses consider, among other items, the collateral
underlying the security, the creditworthiness of the issuer, the timing of the
expected future cash flows, including the final maturity, and an assumption of
when the next time the security is expected to have a successful auction. These
securities were also compared, when possible, to other observable and relevant
market data, which is limited at this time.
As
of March 31, 2008, the Company recorded an unrealized loss of $179,415 to
accumulated other comprehensive loss as a result of the declines in the fair
value of auction rate securities. The auction rate securities at March 31,
2008, totaled $1,500,000 (at par value), and are collateralized by student loan
portfolios, which are almost fully guaranteed by the United States government.
Because there is no assurance that auctions for these securities will be
successful in the near term as of March 31, 2008, $1,320,585 of the auction
rates securities was reclassified from short-term investments to long-term
investments. Any future fluctuation in the fair value related to these
securities that the Company deems to be temporary, including any recoveries of
previous write-downs, would be recorded to accumulated other comprehensive loss.
If at any time in the future the Company determines that a valuation adjustment
is other-than-temporary, it will record a charge to earnings in the period of
determination.
Items
Measured at Fair Value on a Recurring Basis
The
following table presents the Company’s assets that are measured at fair value on
a recurring basis at March 31, 2008 consistent with the fair value
hierarchy provisions of SFAS No. 157:
| |
|
|
|
|
Fair
Value Measurements at Reporting Date Using
|
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Quoted
Prices in
Active
Markets for
Identical
Assets
(Level
1)
|
|
|
Significant
other
Inputs
(Level
2)
|
|
|
Significant
Unobservable
Inputs
(Level
3)
|
|
|
Cash
equivalents:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Money
market funds and commercial paper
|
|
$ |
16,161,977 |
|
|
$ |
12,264,772 |
|
|
$ |
3,897,205 |
|
|
$ |
- |
|
|
Marketable
securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporate
bonds and government securities
|
|
|
28,913,274 |
|
|
|
12,713,327 |
|
|
|
16,199,947 |
|
|
|
- |
|
|
Auction
rate securities
|
|
|
1,320,585 |
|
|
|
- |
|
|
|
- |
|
|
|
1,320,585 |
|
| |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
assets measured at fair value
|
|
$ |
46,395,836 |
|
|
$ |
24,978,099 |
|
|
$ |
20,097,152 |
|
|
$ |
1,320,585 |
|
Based on
market conditions, the Company changed its valuation methodology for auction
rate securities to a discounted cash flow analysis or other type of valuation
model during the first quarter of 2008. Accordingly, these securities changed
from Level 1 to Level 3 within SFAS No. 157’s hierarchy since the
Company’s initial adoption of SFAS No. 157 on January 1, 2008. The
following table presents the Company’s assets measured at fair value on a
recurring basis using significant unobservable inputs (Level 3) as
defined in SFAS No. 157 at March 31, 2008:
| |
Fair Value
Measurements Using Significant Unobservable
Inputs
|
| |
(Level
3)
|
| |
|
|
|
Auction Rate Securities
|
|
Balance
at December 31, 2007
|
|
$ |
- |
|
|
Transfers
to Level 3
|
|
|
1,500,000 |
|
|
Total
unrealized losses in accumulated other comprehensive
loss
|
|
|
(179,415 |
) |
|
Balance
at March 31, 2008
|
|
$ |
1,320,585 |
|
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
results for the first quarter of 2008 reflected continued solid
growth. Both our revenues and our gross margins increased from the
same period in the prior year.
Revenues
for the first quarter of 2008 increased 33% to $21.8 million compared with
revenues of $16.3 million in the first quarter of 2007. Revenues from both our
OEM partners and our resellers increased from the same period last
year.
EMC
Corporation accounted for 23% of our revenues in the quarter. We
anticipate that EMC will account for 20% or more of our revenues for the full
year 2008. Sun Microsystems was not a 10% customer in the first
quarter as it had been in the past. However, we do anticipate that
Sun will account for 10% or more of our revenues for the full year
2008.
JPMorgan
Chase signed an enterprise software license agreement with us in the first
quarter of 2008 and accounted for 15% of our revenues in the
quarter. This is the largest enterprise license that we have entered
into to date.
In
addition to increased revenues, the other indicators we use to assess our
performance and growth continued to be positive.
We had
net income of $1.3 million for the three months ended March 31, 2008. This
positive result includes $2.3 million of share-based compensation expense
related to SFAS No. 123(R). Cash flows from operations in the first quarter of
2008 were again positive. We continue to believe that our ability to fund our
own growth internally bodes well for our long-term success.
Deferred
revenue at March 31, 2008 increased 12%, compared with the balance at March 31,
2007. We consider the continued growth of our deferred revenue as an important
indicator of the success of our products. We believe that support and
maintenance renewals, which comprise the majority of our deferred revenue,
indicate satisfaction with our products and our support organization from our
end users.
Operating
expenses increased by $2.9 million, or 17%, compared with the first quarter of
2007. Operating expenses include $2.3 million in share-based compensation
expense for the first quarter of 2008, and $2.2 million in share-based
compensation expense for the first quarter of 2007. We are pleased that our
revenues, on both an absolute and a percentage basis, continue to grow at a
higher rate than our expenses.
Our gross
margins increased to 85% for the first quarter of 2008 from 83% for the first
quarter of 2007. Share-based compensation expense within cost of maintenance,
software services and other revenue was 1% of revenue in the first quarter of
2008 and 2% in the first quarter of 2007.
For the
first quarter of 2008, we recorded an income tax provision of $1.0 million
compared with a provision of $0.2 million for the first quarter of
2007. Due to the previous use of net operating losses, and
limitations on the use of our remaining net operating losses, 2008 will be the
first year in which our earnings will reflect the full impact of the federal,
state, local and foreign taxes to which we are subject. We are projecting that
the combined federal, state, local and foreign tax burden will be equal to
42%.
At March
31, 2008 we had 439 employees compared with 364 at March 31, 2007. We plan to
continue adding research and development and sales and support personnel, both
in the United States and worldwide, as necessary. We also plan to continue
investing in infrastructure, including both equipment and property.
We
continue to monitor our management structure to determine whether changes or
additional resources will help to continue or to accelerate the positive
momentum. During the third quarter of 2007 we reorganized our marketing team to
help to realize the full potential of our existing opportunities, to establish
our visibility in the marketplace, and to generate additional business
prospects.
We
continue to operate the business with the goal of long-term growth. 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 additional
growth among existing resellers, OEMs and end users, and will drive our strategy
to attempt to engage additional OEM partners and to expand the FalconStor
product lines offered by these OEMs.
RESULTS
OF OPERATIONS – FOR THE THREE MONTHS ENDED MARCH 31, 2008 COMPARED WITH THE
THREE MONTHS ENDED MARCH 31, 2007.
Revenues
for the three months ended March 31, 2008 increased 33% to $21.8 million
compared with $16.3 million for the three months ended March 31, 2007. Our
operating expenses increased 17% from $17.2 million for the three months ended
March 31, 2007 to $20.1 million for the three months ended March 31, 2008.
Included in our operating expenses for the three months ended March 31, 2008 and
2007 was $2.3 million and $2.2 million, respectively, of share-based
compensation expense in accordance with SFAS No. 123(R). Net income for the
three months ended March 31, 2008 was $1.3 million compared with a net loss of
$0.6 million for the three months ended March 31, 2007. Included in our net
income (loss) for the three months ended March 31, 2008 and 2007, was an income
tax provision of $1.0 million and $0.2 million, respectively. The growth in
revenues was due to significant increases in our software license revenue, and
modest growth of our maintenance revenues. The increase in revenues was
primarily driven by increases in (i) demand for our network storage solution
software, (ii) maintenance revenue from new and existing customers and (iii)
sales to our resellers, direct end-users and OEM partners. These increases in
revenue were slightly offset by a decline in our software services and other
revenues. Revenue contribution from our OEM partners increased in absolute
dollars for the three months ended March 31, 2008 as compared with the same
period in 2007. Revenue from resellers, distributors and direct end-users
increased in both absolute dollars and as a percentage of total revenue for the
three months ended March 31, 2008 as compared with the same period in 2007.
Expenses increased in all aspects of our business to support our continued
growth, except for general and administrative, for which expenses remained
consistent. In support of our continued growth and expansion both domestically
and internationally, we increased our worldwide headcount to 439 employees as of
March 31, 2008, as compared with 364 employees as of March 31, 2007. Finally, we
continue to invest in our infrastructure by increasing our capital expenditures
particularly with purchases of equipment for support of our existing and future
product offerings.
Revenues
|
|
|
Three
months ended March 31,
|
|
|
|
|
|
|
|
|
|
|
Revenues:
|
|
|
|
|
|
|
|
Software
license revenue
|
|
$ |
15,318,919 |
|
|
$ |
10,437,505 |
|
|
Maintenance
revenue
|
|
|
5,114,247 |
|
|
|
4,333,539 |
|
|
Software
services and other revenue
|
|
|
1,373,494 |
|
|
|
1,569,634 |
|
|
|
|
|
|
|
|
|
|
|
|
Total
Revenues
|
|
$ |
21,806,660 |
|
|
$ |
16,340,678 |
|
|
|
|
|
|
|
|
|
|
|
|
Year-over-year
Percentage Growth
|
|
|
|
|
|
|
|
|
|
Software
license revenue
|
|
|
47%
|
|
|
|
84%
|
|
|
Maintenance
revenue
|
|
|
18%
|
|
|
|
67%
|
|
|
Software
services and other revenue
|
|
|
-12%
|
|
|
|
67%
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
percentage growth
|
|
|
33%
|
|
|
|
77%
|
|
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 47% from $10.4 million for the three months ended
March 31, 2007 to $15.3 million for the three months ended March 31, 2008.
Software license revenue represented 70% of our total revenues for the three
months ended March 31, 2008 and 64% of our total revenues for the same period in
2007. As a result of broader market acceptance of our software applications, new
product offerings and increased demand for our products from our expanding base
of customers, we continue to experience increased sales from our OEM, reseller
partners and direct end-users, which were the primary drivers of the increase in
software license revenue. Software license revenue increased from our OEM
partners, direct end-users and resellers. Revenue from our reseller partners and
direct end-users increased as a percentage of total revenue. We expect our
software license revenue to continue to grow in future periods.
Maintenance
revenue
Maintenance
revenue is comprised of software maintenance and technical support services.
Revenues derived from maintenance and technical support contracts are deferred
and recognized ratably over the contractual maintenance term. Maintenance
revenues increased 18% from $4.3 million for the three months ended March 31,
2007 to $5.1 million for the three months ended March 31, 2008.
The major
factor behind the increase in maintenance 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 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. We expect our maintenance revenue to continue
to increase primarily because (i) the majority of our new customers
purchase maintenance and support contracts, and (ii) the majority of our growing
existing customer base renewed their maintenance and support contracts after
their initial contracts expired.
Software
services and other revenue
Software
services and other revenues are comprised of professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. 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 in which
the services are completed. During the three months ended March 31, 2008 and
March 31, 2007, we had transactions in which we purchased hardware and bundled
this hardware with our software and sold this bundled solution to our customer
base. 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). Software services and other revenue decreased
12% from $1.6 million for the three months ended March 31, 2007 to $1.4 million
for the three months ended March 31, 2008.
The
decrease in software services and other revenue was primarily due to a decrease
in bundled hardware solutions we sold, which decreased from $1.4 million for the
three months ended March 31, 2007 to $1.0 million for the same period in 2008.
This decease was partially offset by growth in our professional services sales,
which increased from $0.2 million for the three months ended March 31, 2007 to
$0.4 million for the same period in 2008. This increase in professional services
revenue was related to the increase in our software license customers who
elected to purchase professional services and/or the number of professional
services contracts that were completed during the quarter. We expect
professional services revenues to continue to increase as we continue to grow
the number of software license customers. The bundled solutions revenue will
vary from quarter to quarter based upon the number of customers who wish to have
us bundle hardware with our software for one complete solution.
Cost
of Revenues
|
|
|
Three
months ended March 31,
|
|
|
|
|
|
|
|
|
|
| |
|
|
|
|
|
|
|
|
|
Total
Revenues:
|
|
$ |
21,806,660 |
|
|
$ |
16,340,678 |
|
|
|
|
|
|
|
|
|
|
|
|
Cost
of maintenance, software services and other revenue
|
|
$ |
3,314,488 |
|
|
$ |
2,769,824 |
|
|
Gross
Profit
|
|
$ |
18,492,172 |
|
|
$ |
13,570,854 |
|
|
|
|
|
|
|
|
|
|
|
|
Gross
Margin
|
|
|
85 |
% |
|
|
83 |
% |
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, training, amortization of
purchased and capitalized software and share-based compensation expense
associated with SFAS No. 123(R). 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, 2008 increased by 20% to $3.3 million compared with $2.8 million for
the same period in 2007. The increase in cost of maintenance, software services
and other revenue was primarily due to the increase in personnel and related
costs for the three months ended March 31, 2008 as compared with the same period
in 2007. As a result of our increased sales from maintenance and
support contracts, we hired additional employees to provide technical support.
Our cost of maintenance, software services and other revenue will continue to
grow in absolute dollars as our revenues from these services also
increase.
Gross
profit increased $4.9 million from $13.6 million for the three months
ended March 31, 2007 to $18.5 million for the three months ended March 31, 2008.
Gross margins increased from 83% for the three months ended March 31, 2007 to
85% for the three months ended March 31, 2008. The increase in our gross profit
and corresponding gross margins was primarily due to our continued revenue
growth and to our continued focus on our cost structure. Generally, our 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 service mix of sales. Share-based compensation expense
included in the cost of maintenance, software services and other revenue
remained consistent in absolute dollars at $0.3 million for both the three
months ended March 31, 2008 and March 31, 2007. Share-based compensation expense
was equal to 1% and 2% of revenue for the three months ended March 31, 2008 and
March 31, 2007, respectively.
Software
Development Costs
Software
development costs consist primarily of personnel costs for product development
personnel, share-based compensation expense associated with SFAS No. 123(R), and
other related costs associated with the development of new products,
enhancements to existing products, quality assurance and
testing. Software development costs increased 7% to $5.9 million for
the three months ended March 31, 2008 from $5.5 million in the same period in
2007. The major contributing factors to the increase in software development
costs were higher salary and personnel related costs as a result of increased
headcount to enhance and test our core network storage software product and the
development of new innovative features and options. Share-based compensation
expense included in software development costs decreased in absolute dollars to
$0.8 million from $0.9 million for the three months ended March 31, 2008 and
March 31, 2007, respectively. Share-based compensation expense included in
software development costs was equal to 4% and 6% of revenue for the three
months ended March 31, 2008 and March 31, 2007, respectively. We intend to
continue recruiting and hiring product development personnel to support our
software development process.
Selling
and Marketing
Selling
and marketing expenses consist primarily of sales and marketing personnel and
related costs, share-based compensation expense associated with SFAS No. 123(R),
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 29% to $9.0 million for
the three months ended March 31, 2008 from $7.0 million for the same period in
2007. The increase in selling and marketing expenses was primarily due to (i)
higher commissions paid as a result of our 33% increase in revenue, (ii) higher
salary and personnel related costs as a result of increased sales and marketing
headcount and (iii) higher advertising and marketing related expenses as a
result of our new product offerings/enhancements, new product branding and
related advertising and marketing of such initiatives. Share-based compensation
expense included in selling and marketing increased in absolute dollars to $1.0
million from $0.7 million for the three months ended March 31, 2008 and March
31, 2007, respectively. Share-based compensation expense included in selling and
marketing expenses was equal to 5% and 4% of revenue for the three months ended
March 31, 2008 and March 31, 2007, respectively. In addition, we continued to
hire new sales and sales support personnel and to expand our worldwide presence
to accommodate our anticipated revenue growth. We anticipate that as we continue
to grow sales, our sales and marketing expenses will continue to increase in
support of such sales growth.
General
and Administrative
General
and administrative expenses consist primarily of personnel costs of general and
administrative functions, share-based compensation expense associated with SFAS
No. 123(R), public company related costs, directors and officers insurance,
legal and professional fees, and other general corporate overhead
costs. General and administrative expenses remained constant at $1.9
million for the three months ended March 31, 2008 and March 31, 2007,
respectively. Increased compensation and personnel related costs as a result of
increased headcount to support our general and administrative needs was offset
by decreases in legal and professional fees and various administrative expenses
during the three months ended March 31, 2008 as compared with the same period in
2007. Share-based compensation expense included in general and administrative
expenses decreased in absolute dollars to $0.2 million from $0.3 million for the
three months ended March 31, 2008 and March 31, 2007, respectively. Share-based
compensation expense included in general and administrative expenses was equal
to 1% and 2% of revenue for the three months ended March 31, 2008 and March 31,
2007, respectively. Additionally, as our revenue and number of
employees increase, our overall general corporate overhead costs have generally
increased and are likely to continue to increase.
Interest
and Other Income
We invest
our cash primarily in money market funds, commercial paper, government
securities and corporate bonds. As of March 31, 2008, our cash, cash equivalents
and marketable securities totaled $56.8 million compared with $52.3 million as
of March 31, 2007. Interest and other income increased to $0.6 million for the
three months ended March 31, 2008 compared with $0.5 million for the three
months ended March 31, 2007. The higher average cash balance invested during the
three months ended March 31, 2008 as compared with the same period in 2007
resulted in the increase in interest income.
Income
Taxes
Our
provision for income taxes consists of U.S. and foreign taxes in amounts
necessary to align our year-to-date tax provision with the effective rate that
we expect to achieve for the full year. For the three months ended March 31,
2008, our provision for income taxes was $978,919, which consisted of U.S.,
state and local and foreign taxes. For the three months ended March 31, 2007,
our provision for income taxes was $202,084, which consisted primarily of U.S.
federal alternative minimum taxes and state minimum taxes that were expected to
be incurred (despite our pre-tax book loss) primarily as a result of the then
existing limitations on our ability to utilize net operating losses under the
alternative minimum tax system and the non-deductibility of certain share-based
compensation expense for income tax purposes that had been recognized for
financial statement purposes. In addition, the provision for income taxes for
the three months ended March 31, 2007, also included discrete items for (i)
$57,058 related to state income taxes incurred in periods prior to 2007, and
(ii) $120,000 related to a change in our estimate of amounts due in certain
foreign jurisdictions for periods prior to 2007, based upon our evaluation of
information obtained in 2007.
As of January 1, 2008, we had
approximately $5.1 million of federal net operating loss carryforwards available
to offset future taxable income. These net operating loss carryforwards relate
to excess compensation deductions from exercises of stock options and the
resulting benefits will be credited to additional-paid-in-capital when realized.
As of March 31, 2008 and December 31, 2007, our deferred tax asset, net of a
valuation allowance was $9.8 million.
Critical
Accounting Policies and Estimates
Our critical accounting policies and
estimates are those related to revenue recognition, accounts receivable
allowances, deferred income taxes and accounting for share-based compensation
expense.
Revenue Recognition. 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.
Accounts Receivable. We review
accounts receivable to determine which ones are doubtful of
collection. In making the determination of the appropriate allowance
for uncollectible accounts and returns, we consider (i) historical return rates,
(ii) specific past due accounts, (iii) analysis of our accounts receivable
aging, (iv) customer payment terms, (v) historical collections, write-offs and
returns, (vi) changes in customer demand and relationships, and (vii)
concentrations of credit risk and customer creditworthiness. 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,
creditworthiness of customers, general economic conditions and other factors may
impact the level of future write-offs, revenues and our general and
administrative expenses.
Deferred Income Taxes.
Consistent with the provisions of SFAS No. 109, we regularly estimate our
ability to recover deferred income taxes, and report such deferred tax assets at
the amount that is determined to be more-likely-than-not recoverable, and we
have to estimate our income taxes in each of the taxing jurisdictions in which
we operate. This process involves estimating our current tax expense together
with assessing any temporary differences resulting from the different treatment
of certain items, such as the timing for recognizing revenue and expenses for
tax and accounting purposes, as well as estimating foreign tax credits. These
differences may result in deferred tax assets and liabilities, which are
included in our consolidated balance sheet. We are required to assess the
likelihood that our deferred tax assets, which include net operating loss carry
forwards and temporary differences that are expected to be deductible in future
years, will be recoverable from future taxable income or other tax planning
strategies. If recovery is not likely, we have to provide a valuation allowance
based on our estimates of future taxable income in the various taxing
jurisdictions, and the amount of deferred taxes that are ultimately realizable.
The provision for current and deferred taxes involves evaluations and judgments
of uncertainties in the interpretation of complex tax regulations. This
evaluation considers several factors, including an estimate of the likelihood of
generating sufficient taxable income in future periods, the effect of temporary
differences, the expected reversal of deferred tax liabilities, past and
projected taxable income, and available tax planning strategies. As of March 31,
2008 and December 31, 2007, our deferred tax asset, net of a valuation
allowance, was $9.8 million.
Accounting for Share-Based
Payments. As discussed further in Note (2) Share-Based Payment
Arrangements, to our unaudited condensed consolidated financial
statements, we account for stock-based awards under SFAS No.
123(R).
We have used and expect to continue to
use the Black-Scholes option-pricing model to compute the estimated fair value
of share-based compensation expense. The Black-Scholes option-pricing model
includes assumptions regarding dividend yields, expected volatility, expected
option term and risk-free interest rates. The assumptions used in computing the
fair value of share-based compensation expense reflect our best estimates, but
involve uncertainties relating to market and other conditions, many of which are
outside of our control. We estimate expected volatility based primarily on
historical daily price changes of our stock and other factors. The expected
option term is the number of years that we estimate that the stock options will
be outstanding prior to exercise. The estimated expected term of the stock
awards issued after December 31, 2007 was determined pursuant to SEC Staff
Accounting Bulletin (“SAB”) No. 110. The expected term of the awards issued
prior to January 1, 2008, was determined using the “simplified method”
prescribed in SAB No. 107. Additionally, we estimate forfeiture rates based
primarily upon historical experiences, adjusted when appropriate for known
events or expected trends. We may adjust share-based compensation expense on a
quarterly basis for changes to our estimate of expected equity award forfeitures
based on our review of these events and trends, and recognize the effect of
adjusting the forfeiture rate for all expense amortization after January 1,
2006 in the period in which we revised the forfeiture estimate. If other
assumptions or estimates had been used, the share-based compensation expense
that was recorded for the three months ended March 31, 2008 and 2007 could have
been materially different. Furthermore, if different assumptions or estimates
are used in future periods, share-based compensation expense could be materially
impacted in the future.
Impact
of Recently Issued Accounting Pronouncements
In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations. SFAS
No. 141(R) establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any noncontrolling interest in the acquiree
and the goodwill acquired. SFAS No. 141(R) also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. SFAS No. 141(R) is effective for fiscal years beginning
after December 15, 2008. We are currently evaluating the potential impact,
if any, of the adoption of SFAS No. 141(R) on our consolidated financial
statements.
In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51. SFAS No. 160 establishes accounting and reporting standards
for ownership interests in subsidiaries held by parties other than the parent,
the amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS No. 160 also establishes disclosure requirements that
clearly identify and distinguish between the interests of the parent and the
interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal
years beginning after December 15, 2008. We are currently evaluating the
potential impact, if any, of the adoption of SFAS No. 160 on our consolidated
financial statements.
In
February 2008, the FASB issued FASB Staff Position No. FAS 157-2,
Effective Date of FASB
Statement No. 157 (“FSP 157-2”), to partially defer SFAS
No. 157, Fair Value
Measurements. FSP 157-2 defers the effective date of SFAS No. 157
for nonfinancial assets and nonfinancial liabilities, except those that are
recognized or disclosed at fair value in the financial statements on a recurring
basis (at least annually), to fiscal years, and interim periods within those
fiscal years, beginning after November 15, 2008. We are currently
evaluating the potential impact, if any, SFAS No. 157 will have to nonfinancial
assets and liabilities to the fiscal year beginning after November 15, 2008 on
our consolidated financial statements.
LIQUIDITY
AND CAPITAL RESOURCES
|
|
|
Three
months ended March 31,
|
|
|
|
|
|
|
|
|
|
|
Cash
provided by (used in):
|
|
|
|
|
|
|
|
Operating
activities
|
|
$ |
8,502,710 |
|
|
$ |
8,292,194 |
|
|
Investing
activities
|
|
|
4,933,523 |
|
|
|
(7,885,245 |
) |
|
Financing
activities
|
|
|
(13,521,017 |
) |
|
|
4,127,801 |
|
|
Effect
of exchange rate changes
|
|
|
268,310 |
|
|
|
(26,754 |
) |
|
|
|
|
|
|
|
|
|
|
|
Net
increase in cash and cash equivalents
|
|
$ |
183,526 |
|
|
$ |
4,507,996 |
|
Our
principal sources of liquidity are cash flows generated from operations and our
cash, cash equivalents, and marketable securities balances. Our cash and cash
equivalents and marketable securities balances as of March 31, 2008 totaled
$56.8 million compared with $62.9 million as of December 31, 2007. Cash and cash
equivalents totaled $32.4 million and marketable securities totaled $24.4
million at March 31, 2008. As of December 31, 2007, we had $32.2 million in cash
and cash equivalents and $30.7 million in marketable securities.
During
the three months ended March 31, 2008, we continued making investments in our
infrastructure to support our current and long-term growth. We increased our
total number of employees as well as our investments in property and equipment
to support our growth. As we continue to grow, we will continue to make
investments in property and equipment and we will need to continue to increase
our headcount. In the past, we have also used cash to purchase software licenses
and to make acquisitions. We will continue to evaluate potential software
license purchases and acquisitions and if the right opportunity presents itself,
we may continue to use our cash for these purposes. However, as of the date of
this filing, we have no agreements, commitments or understandings with respect
to any such acquisitions.
We
currently do not have any debt and our only significant commitments are related
to our office leases.
In
October 2001, our Board of Directors authorized the repurchase of up to two
million shares of our outstanding common stock. On February 6, 2008, our Board
of Directors increased the authorization to repurchase our outstanding common
stock from two million to five million shares. During the three months ended
March 31, 2008, we repurchased 1,760,000 shares at an aggregate purchase price
of $14.5 million. We did not repurchase any shares during the three months ended
March 31, 2007. During 2007, we repurchased 318,900 shares at an aggregate
purchase price of $3.3 million. Since October 2001, we have repurchased a total
of 2,944,100 shares at an aggregate purchase price of $23.5 million. As of March
31, 2008, we had the authorization to purchase an additional 2,055,900 shares of
our common stock based upon our judgment and market conditions.
Net cash
provided by operating activities totaled $8.5 million for the three months ended
March 31, 2008, compared with net cash provided by operating activities of $8.3
million for the same period in 2007. The increase in net cash provided by
operating activities during the three months ended March 31, 2008, as compared
with the same period in 2007, was primarily related to the growth in our net
income adjusted for: (i) the impact of non-cash charges, particularly relating
to stock-based compensation, depreciation and amortization and provision for
doubtful accounts; and (ii) adjustments for net changes in operating assets and
liabilities, particularly changes in our accounts receivable, deferred revenues,
and accrued expenses. These amounts were primarily offset by the adjustment for
the impact from the tax benefits recognized as a result of excess stock-based
compensation deductions and exercises of stock options. SFAS No. 123(R) requires
tax benefits relating to excess stock-based compensation deductions to be
presented as cash outflows from operating activities. We recognized tax benefits
related to stock-based compensation deductions of $1.0 million for the three
months ended March 31, 2008. There were no adjustments for the impact of
non-cash income tax benefits for the three months ended March 31,
2007.
Net cash
provided by investing activities was $4.9 million for the three months ended
March 31, 2008, compared with net cash used in investing activities of $7.9
million for the same period in 2007. Included in investing activities for both
the three months ended March 31, 2008 and March 31, 2007, are the sales and
purchases of our marketable securities. These represent the sales, maturities
and reinvestment of our marketable securities. The net cash provided by
investing activities from the net sales (purchases) of securities was $6.2
million for the three months ended March 31, 2008 and ($6.8) million for the
same period in 2007. These amounts will fluctuate from period to period
depending on the maturity dates of our marketable securities. The cash used to
purchase property and equipment was $1.2 million and $1.0 million for the three
months ended March 31, 2008 and 2007, respectively. We continually evaluate
potential software licenses and we may continue to make similar investments if
we find opportunities that would benefit our business. We anticipate continued
capital expenditures as we continue to invest in our infrastructure to support
our ongoing growth and expansion both domestically and
internationally.
Net cash
used in financing activities was $13.5 million for the three months ended March
31, 2008, compared with net cash provided by financing activities of $4.1
million for the same period in 2007. Cash outflows from financing activities
result from the repurchase of our outstanding common stock. During the three
months ended March 31, 2008, we repurchased 1,760,000 shares of our common at an
aggregate purchase price of $14.5 million. We did not repurchase any shares of
our common stock during the three months ended March 31. 2007. Cash inflows from
financing activities primarily results from the proceeds received from the
exercise of stock options. We received proceeds from the exercise of stock
options of $4.1 million for the three months ended March 31, 2007. There were no
stock options exercised during the three months ended March 31, 2008. During the
three months ended March 31, 2008, cash inflows from financing activities was
also impacted by the tax benefits recognized as a result of excess stock-based
compensation deductions and exercises of stock options. SFAS No. 123(R) requires
tax benefits relating to excess stock-based compensation deductions be presented
as cash inflows from financing activities. We recognized tax benefits related to
stock-based compensation deductions of $1.0 million for the three months ended
March 31, 2008. There were no tax benefits related to stock-based compensation
deductions recognized during the three months ended March 31, 2007.
As
discussed in Note (7) Fair Value Measurements, to
our unaudited condensed consolidated financial statements, we adopted the
provisions of SFAS No. 157 effective January 1, 2008. We utilize
unobservable (Level 3) inputs in determining the fair value of auction
rate securities we hold totaling $1.5 million at March 31,
2008.
As of
March 31, 2008, $1.5 million (at par value) of our investments was
comprised of auction rate securities. Liquidity for these auction rate
securities is typically provided by an auction process, which allows holders to
sell their notes, and resets the applicable interest rate at pre-determined
intervals. During the first quarter of 2008, we began experiencing failed
auctions on auction rate securities. An auction failure means that the parties
wishing to sell their securities could not be matched with an adequate volume of
buyers. In the event that there is a failed auction, the indenture governing the
security requires the issuer to pay interest at a contractually defined rate
that is generally above market rates for other types of similar short-term
instruments. The securities for which auctions have failed will continue to
accrue interest at the contractual rate and continue to reset the next auction
date every 28 or 35 days until the auction succeeds, the issuer calls the
securities, or they mature. Because there is no assurance that auctions for
these securities will be successful in the near term and due to our ability and
intent to hold these securities to maturity, the auction rate securities were
reclassified from short-term investments to long-term investments in our
unaudited condensed consolidated balance sheet as of March 31,
2008.
Our
auction rate securities are classified as available-for-sale securities and are
reflected at fair value. In prior periods during the auction process, which took
place every 28-35 days for most securities, quoted market prices were
readily available, which would qualify as Level 1 under SFAS No. 157.
However, due to events in credit markets during the first quarter of 2008, the
auction events for most of these instruments failed, and, therefore, we have
determined the estimated fair values of these securities utilizing a discounted
cash flow analysis or other type of valuation model as of March 31, 2008.
These analyses consider, among other items, the collateral underlying the
security, the creditworthiness of the issuer, the timing of the expected future
cash flows, including the final maturity, associated with the securities, and an
assumption of when the next time the security is expected to have a successful
auction. These securities were also compared, when possible, to other observable
and relevant market data, which is limited at this time. Due to these events, we
reclassified these instruments as Level 3 during the first quarter 2008 and
recorded a temporary unrealized decline in fair value of approximately $179,000,
with an offsetting entry to accumulated other
comprehensive loss. We currently believe that this temporary decline in fair
value is primarily due to liquidity concerns, because the underlying assets for
the majority of securities are almost entirely backed by the
U.S. Government. In addition, our holdings of auction rate securities
represented approximately 2% of our cash equivalents, and marketable securities
balance at March 31, 2008, which we believe allows us sufficient time for
the securities to return to full value. Because we believe that the current
decline in fair value is temporary and based primarily on liquidity issues in
the credit markets, any difference between our estimate and an estimate that
would be arrived at by another party would have no impact on our earnings, since
such difference would also be recorded to accumulated other comprehensive loss.
We will re-evaluate each of these factors as market conditions change in
subsequent periods.
We
currently do not have any debt and our only material cash commitments are
related to our office leases. We have an operating lease covering our corporate
office facility that expires in February 2012. We also have several operating
leases related to offices in the United States and foreign countries. The
expiration dates for these leases range from 2008 through 2015. Refer to Note
(5) Commitments and
Contingencies to our unaudited condensed consolidated financial
statements.
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.
Off-Balance
Sheet Arrangements
As of
March 31, 2008 and December 31, 2007, we had no off-balance sheet
arrangements.
Item
3. Qualitative
and Quantitative Disclosures About Market Risk
Interest Rate Risks. Our
return on our investments in cash, cash equivalents and marketable securities
which aggregated to $56.8 million as of March 31, 2008, 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, 2008, 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, 2008, 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, 2008, 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.
We are
affected by risks specific to us as well as factors that affect all businesses
operating in a global market. The significant factors known to us that could
materially adversely affect our business, financial condition, or operating
results are set forth in Item 1A to our Annual Report on Form 10-K for the year
ended December 31, 2007 (the “2007 10-K”). The information below sets
forth additional risk factors or risk factors that have had material changes
since the 2007 10-K, and should be read in conjunction with Item 1A of the 2007
10-K.
We
are dependent on certain key customers and a significant portion of our
receivables is concentrated with one customer.
We tend
to have one or more customers account for 10% or more of our revenues during
each fiscal quarter. For the quarter ended March 31, 2008, two
customers together accounted for 38% of our revenues. One of these customers,
EMC Corporation, is an OEM customer. While we believe that we will continue to
receive revenues from this customer, our agreement does not have any minimum
sales requirements and we cannot guarantee continued revenue. If our contract
with this customer terminates, or if the volume of sales from this customer
significantly declines, it would have a material adverse effect on our operating
results. The other customer, JPMorgan Chase & Co. (“JPMC”), signed an
enterprise license with us in the quarter. We will continue to offer
additional and new products to JPMC, but there can be no guarantee that JPMC
will choose to license any additional products.
In
addition, as of March 31, 2008, two customers together accounted for a total of
24% of our outstanding receivables. While we currently have no reason to doubt
the collectibility of these receivables, a business failure or reorganization by
these customers could harm our ability to collect these receivables and if we
were unable to collect these receivables, it would have a material adverse
effect on our cash flow.
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.
Historically,
information technology spending has been highest in the fourth quarter of each
calendar year, and slowest in the first quarter. Our quarterly
results reflected this seasonality in first quarter of 2008, and we anticipate
that our quarterly results for the remainder of 2008 will show the effects of
seasonality as well.
Our
future performance will depend on many factors, including:
|
|
·
|
the
timing of securing software license contracts and the delivery of software
and related revenue recognition;
|
|
|
·
|
the
seasonality of information technology, including network storage
products, spending;
|
|
|
·
|
the
average unit selling price of our
products;
|
|
|
·
|
existing
or new competitors introducing better products at competitive prices
before we do;
|
|
|
·
|
our
ability to manage successfully the complex and difficult process of
qualifying our products with our
customers;
|
|
|
·
|
new
products or enhancements from us or our
competitors;
|
|
|
·
|
import
or export restrictions on our proprietary technology;
and
|
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.
Foreign
currency fluctuations may impact our revenues.
Our licenses and services in Japan are
sold in Yen. We anticipate that sales of our licenses and services in Europe,
the Middle East and Africa, will at some point in 2008 begin to be made in
European Monetary Units (“Euros”).
Changes in economic or political
conditions globally and in any of the countries in which we operate could result
in exchange rate movements, new currency or exchange controls or other
restrictions being imposed on our operations.
Fluctuations
in the value of the U.S. dollar may adversely affect our results of operations.
Because our combined financial results are reported in U.S. dollars, translation
of sales or earnings generated in other currencies into U.S. dollars can result
in a significant increase or decrease in the amount of those sales or
earnings. Significant changes in the value of these foreign currencies
relative to the U.S. dollar could have a material adverse effect on our
financial condition.
Fluctuations
in currencies relative to currencies in which our earnings are generated make it
more difficult to perform period-to-period comparisons of our reported results
of operations. For purposes of accounting, the assets and liabilities of our
foreign operations, where the local currency is the functional currency, are
translated using period-end exchange rates, and the revenues, expenses and cash
flows of our foreign operations are translated using average exchange rates
during each period.
In
addition to currency translation risks, we incur currency transaction risk
whenever we enter into either a purchase or a sales transaction using a currency
other than the local currency of the transacting entity. Given the volatility of
exchange rates, we cannot be assured we will be able to effectively manage our
currency transaction and/or translation risks. Volatility in currency exchange
rates may have a material effect on our financial condition or results of
operations. Currency exchange rate fluctuations have not, in the past, resulted
in a material impact on earnings. However, we may experience at times in the
future an impact on earnings as a result of foreign currency exchange rate
fluctuations.
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 trailing twelve
months ended March 31, 2008, the closing market price of our common stock as
quoted on the NASDAQ Global Market fluctuated between $6.85 and $15.30 per
share. The market price of our common stock may be significantly affected by the
following factors:
|
·
|
actual
or anticipated fluctuations in our operating
results;
|
|
·
|
variance
in actual results as compared to financial
estimates;
|
|
·
|
changes
in market valuations of other technology companies, particularly those in
the network storage software
market;
|
|
·
|
announcements
by us or our competitors of significant technical innovations,
acquisitions, strategic partnerships, joint ventures or capital
commitments;
|
|
·
|
loss or
addition of one or more key OEM customers;
and
|
|
·
|
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.
We
have a significant number of outstanding options, the exercise of which would
dilute the then-existing stockholders’ percentage ownership of our common stock,
and a smaller number of restricted shares of stock, the vesting of which will
also dilute the then-existing stockholders’ percentage ownership of our common
stock.
As of
March 31, 2008, we had an aggregate of 10,298,199 outstanding options to
purchase our common stock and 867,050 outstanding restricted shares. If all of
these outstanding options were exercised, and all of the outstanding restricted
stock vested, the proceeds to the Company would average $6.35 per share. We also
had 843,701 shares of our common stock reserved for issuance under our stock
plans with respect to options (or restricted stock) that have not been granted.
In addition, if, on July 1st of any calendar year in which our 2006 Incentive
Stock Plan (the “2006 Plan”) is in effect, the number of shares of stock to
which options may be granted is less than five percent (5%) of the number of
outstanding shares of stock, then the number of shares of stock available for
issuance under the 2006 Plan shall be increased so that the number equals five
percent (5%) of the shares of stock outstanding (as is currently the situation).
In no event shall the number of shares of stock subject to the 2006 Plan in the
aggregate exceed twenty million shares, subject to adjustment as provided in the
2006 Plan (see Note (2) Share-Based Payment
Arrangements to our unaudited condensed consolidated financial
statements).
The
exercise of all of the outstanding options and/or the vesting of all outstanding
restricted shares and/or the grant and exercise of additional options and/or the
grant and vesting of restricted stock 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.
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.
| Item
2. |
Unregistered Sales of Equities
Proceeds and Use of Proceeds |
Shares of
common stock repurchased during the quarter ended March 31, 2008:
|
|
|
Shares
Purchased
|
|
|
Average
Price
Paid
per Share
|
|
|
Total
Number of Shares
Purchased
Announced
Plan
|
|
|
the
Plan at Month End
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
February
2008
|
|
|
795,000 |
|
|
$ |
8.82 |
|
|
|
795,000 |
|
|
|
3,020,900 |
|
|
March
2008
|
|
|
965,000 |
|
|
$ |
7.73 |
|
|
|
965,000 |
|
|
|
2,055,900 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
1,760,000 |
|
|
$ |
8.23 |
|
|
|
1,760,000 |
|
|
|
2,055,900 |
|
On
February 6, 2008, the Company announced that its Board of Directors increased
its October 2001 authorization to repurchase the Company’s outstanding common
stock from two million shares to five million shares in the aggregate. As of
March 31, 2008, the Company had repurchased 2,944,100 shares. The program has no
expiration date.
| |
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. § 1350)
|
| |
|
|
|
|
32.2
|
Certification
of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 (18 U.S.C. § 1350)
|
| |
|
|
| |
99.1 |
Form
of Restricted Stock Letter Agreement for Executive
Officers
|
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.
|
|
|
|
|
|
|
|
|
|
|
|
James
Weber
Chief
Financial Officer, Vice President and Treasurer
(principal
financial and accounting
officer)
|
May 9,
2008