RESULTS OF OPERATIONS – FOR THE THREE MONTHS ENDED JUNE 30, 2013 COMPARED WITH THE THREE MONTHS ENDED JUNE 30, 2012.
Our primary sales focus is on selling turn-key solutions, whereby our software is integrated with industry standard hardware and sold as one complete integrated solution. As a result, our revenue is classified as either: (i) product revenue, or (ii) support and services revenue. Product revenue consists of both integrated solutions and stand-alone software revenues. Support and services revenues consists of both maintenance revenues and professional services revenues.
Total revenues for the three months ended June 30, 2013 decreased 15% to $14.0 million, compared with $16.5 million for the three months ended June 30, 2012. Our cost of revenues decreased 22% to $3.8 million for the three months ended June 30, 2013, compared with $4.9 million for the three months ended June 30, 2012. Included in our cost of revenues was $0.1 million of share-based compensation expense for the three months ended June 30, 2013 and a benefit of less than $0.1 million for the three months ended June 30, 2012. Our operating expenses decreased 18% from $17.9 million for the three months ended June 30, 2012 to $14.7 million for the three months ended June 30, 2013. Included in the operating results for the three months ended June 30, 2013 was $0.1 million of investigation, litigation and settlement related costs compared with $0.9 million for the three months ended June 30, 2012. Also included in our operating expenses for the three months ended June 30, 2013 and June 30, 2012 was $0.2 million and $1.1 million, respectively, of share-based compensation expense. Net loss for the three months ended June 30, 2013 was $5.2 million, compared with a net loss of $6.6 million for the three months ended June 30, 2012. Included in our net loss for the three months ended June 30, 2013 was an income tax provision of $0.2 million, compared with an income tax provision of $0.2 million for the three months ended June 30, 2012. The income tax provision of $0.2 million was primarily attributable to the impact of our estimated full year effective tax rate on our pre-tax losses for both the three months ended June 30, 2013 and June 30, 2012. No tax benefits were recognized for expected net domestic deferred tax assets for each of the full years 2013 and 2012, respectively, due to the full valuation allowance over these deferred tax assets.
The decrease in total revenues was due to a decrease in product revenues and support and services revenues for the three months ended June 30, 2013, compared with the same period in 2012. In total, our product revenues decreased 17%. Product revenues from our OEM partners decreased 76%, while product revenues from our non-OEM partners decreased 14% for the three months ended June 30, 2013, compared with the same period in 2012. During the quarter, we continued our focus and emphasis on the FalconStor-branded business. However, the decrease in product revenue from our non-OEM partners was primarily attributable to (i) the continued overall macroeconomic conditions which have resulted in significant competitive pricing practices from our competitors, customers subjecting IT spending to stricter ROI returns and overall deal review, and more consideration of traditional storage needs as compared to cloud based alternatives which has all led to elongated sales cycles, and (ii) the impact of questions raised by the Company’s declining cash balances and concerns about the Company’s performance over the past twelve months. The decline in OEM product revenues was primarily the result of continued disruption with one of our largest OEM partners in China, which was part of a significant corporate reorganization which commenced during 2012, and which has led to continued unpredictability in sales volume from this OEM during the first half of 2013.
In total, support and services revenue decreased 14% from $8.6 million for the three months ended June 30, 2012 to $7.4 million for the three months ended June 30, 2013. The decrease in support and services revenue was attributable to a decrease in both maintenance and technical support services revenue and professional services revenues. Maintenance and technical support services revenue decreased from $7.7 million for the three months ended June 30, 2012 to $7.1 million for the three months ended June 30, 2013. Our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. During the three months ended June 30, 2013 the decline in maintenance was primarily attributable to (i) a decline in maintenance revenue from certain legacy OEM customers due to the wind down in our OEM business which commenced in 2009, (ii) a decrease from the previous year in revenue from sales of products that are generally sold with maintenance, and (iii) deeper discounts provided on products in the current economic and competitive environments. Professional services revenue varies from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, (iii) the number of professional services contracts that are performed during the period, and (iv) the number of customers who elect to purchase engineering services. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions.
Overall, our total operating expenses decreased $3.2 million, or 18%, to $14.7 million for the three months ended June 30, 2013, compared with $17.9 million for the same period in 2012. The decrease in total operating expenses was primarily attributable to (i) a decrease in salary and personnel costs including share-based compensation expense due to lower headcount, (ii) a decrease in commissions due to the decrease in revenues during the three months ended June 30, 2013 as compared with the three months ended June 30, 2012, and (iii) a $0.8 million decrease in investigation, litigation, and settlement related costs compared with the same period in 2012. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook and to take actions in areas of the Company that are not performing. Our worldwide headcount was 418 employees as of June 30, 2013, compared with 481 employees as of June 30, 2012.
Revenues
| |
|
Three months ended June 30,
|
|
| |
|
2013
|
|
|
2012
|
|
|
Revenues:
|
|
|
|
|
|
|
|
Product revenue
|
|
$ |
6,542,429 |
|
|
$ |
7,835,568 |
|
|
Support and services revenue
|
|
|
7,431,710 |
|
|
|
8,630,633 |
|
| |
|
|
|
|
|
|
|
|
|
Total Revenues
|
|
$ |
13,974,139 |
|
|
$ |
16,466,201 |
|
| |
|
|
|
|
|
|
|
|
|
Year-over-year percentage change
|
|
|
|
|
|
|
|
|
|
Product revenue
|
|
|
-17 |
% |
|
|
-33 |
% |
|
Support and services revenue
|
|
|
-14 |
% |
|
|
8 |
% |
| |
|
|
|
|
|
|
|
|
|
Total percentage change
|
|
|
-15 |
% |
|
|
-16 |
% |
Product revenue
Product revenue is comprised of sales of licenses for our software integrated on industry standard hardware creating a turn-key solution or integrated solution, and our stand-alone software applications. The products are sold through our OEMs, and through (i) value-added resellers, (ii) distributors, and/or (iii) directly to end-users (collectively “non-OEMs”). These revenues are recognized when, among other requirements, we receive a customer purchase order or a royalty report summarizing stand-alone software applications sold, integrated solutions sold and/or permanent key codes are delivered to the customer.
Product revenue decreased 17% from $7.8 million for the three months ended June 30, 2012, to $6.5 million for the three months ended June 30, 2013. These amounts are net of a return provision of less than $0.1 million recognized during the three months ended June 30, 2013, compared with a provision of $0.3 million in the same period in 2012. Product revenue represented 47% and 48% of our total revenues for the three months ended June 30, 2013 and 2012, respectively. Product revenues from our OEM partners decreased 76%, while product revenues from our non-OEM partners decreased 14% for the three months ended June 30, 2013, compared with the same period in 2012. During the quarter, we continued our focus and emphasis on the FalconStor-branded business. However, the decrease in product revenue from our non-OEM partners was primarily attributable to (i) the continued overall macroeconomic conditions which have resulted in significant competitive pricing practices from our competitors, customers subjecting IT spending to stricter ROI returns and overall deal review, and more consideration of traditional storage needs as compared to cloud based alternatives which has all led to elongated sales cycles, and (ii) the impact of questions raised by the Company’s declining cash balances and concerns about the Company’s performance over the past twelve months. The decline in OEM product revenues was primarily the result of continued disruption with one of our largest OEM partners in China, which was part of a significant corporate reorganization which commenced during 2012, and which has led to continued unpredictability in sales volume from this OEM during the first half of 2013. Product revenue from our non-OEM partners represented 99% and 96% of our total product revenue for the three months ended June 30, 2013 and 2012, respectively. Product revenue from our OEM partners represented 1% and 4% of our total product revenue for the three months ended June 30, 2013 and 2012, respectively.
We continue to focus our investments on the FalconStor-branded non-OEM channel business as we feel this is in line with our long-term outlook.
Support and services revenue
Support and services revenue is comprised of revenue from (i) maintenance and technical support services, (ii) professional services primarily related to the implementation of our software, and (iii) engineering services. Revenues derived from maintenance and technical support contracts are deferred and recognized ratably over the contractual maintenance term. Professional services revenue is recognized in the period that the related services are performed. Support and services revenue decreased 14% from $8.6 million for the three months ended June 30, 2012 to $7.4 million for the three months ended June 30, 2013. The decrease in support and services revenue was attributable to decreases in both maintenance and technical support services revenue and professional services revenues.
Maintenance and technical support services revenue decreased from $7.7 million for the three months ended June 30, 2012 to $7.1 million for the three months ended June 30, 2013. Our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. During the three months ended June 30, 2013, the decline in maintenance and technical support services revenue was primarily attributable to (i) a $0.5 million decline in maintenance revenue from our OEM partners, primarily certain legacy OEM customers due to the wind down in our OEM business which commenced in 2009, (ii) a decrease from the previous year in revenue from sales of products that are generally sold with maintenance, and (iii) deeper discounts provided on products in the current economic and competitive environments.
Professional services revenues decreased from $0.9 million for the three months ended June 30, 2012 to $0.4 million for the same period in 2013. Professional services revenue varies from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, (iii) the number of professional services contracts that are performed during the period, and (iv) the number of customers who elect to purchase engineering services. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions.
Cost of Revenues
| |
|
Three months ended June 30,
|
|
| |
|
2013
|
|
|
2012
|
|
|
Cost of revenues:
|
|
|
|
|
|
|
|
Product
|
|
$ |
963,102 |
|
|
$ |
1,787,186 |
|
|
Support and service
|
|
|
2,861,992 |
|
|
|
3,091,055 |
|
|
Total cost of revenues
|
|
$ |
3,825,094 |
|
|
$ |
4,878,241 |
|
| |
|
|
|
|
|
|
|
|
|
Total Gross Profit
|
|
$ |
10,149,045 |
|
|
$ |
11,587,960 |
|
| |
|
|
|
|
|
|
|
|
|
Gross Margin:
|
|
|
|
|
|
|
|
|
|
Product
|
|
|
85 |
% |
|
|
77 |
% |
|
Support and service
|
|
|
61 |
% |
|
|
64 |
% |
|
Total gross margin
|
|
|
73 |
% |
|
|
70 |
% |
Cost of revenues, gross profit and gross margin
Cost of product revenue consists primarily of industry standard hardware we purchase and integrate with our software for turn-key integrated solutions, personnel costs, amortization of capitalized software, shipping and logistics costs, and share-based compensation expense. Cost of support and service consists primarily of personnel and other costs associated with providing software implementations, technical support under maintenance contracts, training, and share-based compensation expense. Cost of product revenue for the three months ended June 30, 2013 decreased $0.8 million, or 46%, to $1.0 million, compared with $1.8 million for the same period in 2012. The decrease in cost of product revenue was primarily attributable to the decline in the number of fully integrated solutions which included hardware appliances as a percentage of all product revenues as compared with the same period in 2012. Our cost of support and service revenues for the three months ended June 30, 2013 decreased $0.2 million, or 7%, to $2.9 million, compared with $3.1 million for the same period in 2012. This decrease was primarily attributable to a decrease in personnel costs as a result of lower headcount during the second quarter of 2013 compared with the same period in 2012.
Total gross profit decreased $1.4 million, or 12%, to $10.1 million for the three months ended June 30, 2013 from $11.6 million for the same period in 2012. Total gross margin increased to 73% for the three months ended June 30, 2013, from 70% for the same period in 2012. The decrease in our total gross profit for the three months ended June 30, 2013, compared with the same period in 2012, was primarily due to a 15% decrease in our total revenues. Generally, our total gross profits and total gross margins may fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.
Share-based compensation expense included in the cost of product revenue was less than 1% of total revenue for the three months ended June 30, 2013 and June 30, 2012. Share-based compensation expense included in the cost of support and service revenue was less than $0.1 million for both the three months ended June 30, 2013 and the three months ended June 30, 2012. Share-based compensation expense included in cost of support and service revenue was less than 1% of total revenue for the three months ended June 30, 2013 and June 30, 2012.
Operating Expenses
Research and Development Costs
Research and development costs consist primarily of personnel costs for product development, share-based compensation expense, and other related costs associated with the development of new products, enhancements to existing products, quality assurance and testing. Research and development costs decreased $0.5 million, or 9%, to $4.4 million for the three months ended June 30, 2013, from $4.8 million in the same period in 2012. The decrease in research and development costs was primarily the result of a decline in personnel related costs including share-based compensation expense. This decline was also attributable to an increase in capitalized software development costs which increased to $0.2 million for the three months ended June 30, 2013 as compared to $0.1 million for the three months ended June 30, 2012. We believe we continue to provide adequate levels of resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options. Share-based compensation expense included in research and development costs was $0.1 million for the three months ended June 30, 2013 and June 30, 2012. Share-based compensation expense included in research and development costs was less than 1% of total revenue for the three months ended June 30, 2013 and 1% of total revenue for the three months ended June 30, 2012.
Selling and Marketing
Selling and marketing expenses consist primarily of sales and marketing personnel and related costs, share-based compensation expense, travel, public relations expense, marketing literature and promotions, commissions, trade show expenses, and the costs associated with our foreign sales offices. Selling and marketing expenses decreased $2.3 million, or 25%, to $6.9 million for the three months ended June 30, 2013, from $9.2 million for the same period in 2012. The decrease in selling and marketing expenses was primarily attributable to (i) a decrease in commissions due to the 17% decline in product revenue compared with the same period in 2012, and (ii) a decrease in salary and personnel costs as a result of lower sales and marketing headcount as well as a decrease in share-based compensation expenses. Share-based compensation expense included in selling and marketing decreased to $0.0 million from $0.4 million for the three months ended June 30, 2013 and 2012, respectively due to the reversal of previously accrued share-based compensation related to the resignations of certain former sales and marketing professionals. Share-based compensation expense included in selling and marketing expenses was equal to 0% of total revenue for the three months ended June 30, 2013 and 2% for the three months ended June 30, 2012.
General and Administrative
General and administrative expenses consist primarily of personnel costs of general and administrative functions, share-based compensation expense, public company related costs, directors and officers’ insurance, legal and professional fees, bad debt expense, and other general corporate overhead costs. General and administrative expenses increased $0.3 million, or 11%, to $3.4 million for the three months ended June 30, 2013, compared with $3.0 million for the same period in 2012. The overall increase within general and administrative expenses was primarily related to an increase in professional fees, severance costs, and other administrative costs which were partially offset by a decrease in share-based compensation. Share-based compensation expense included in general and administrative expenses was $0.1 million for the three months ended June 30, 2013, compared with $0.6 million for the three months ended June 30, 2012 due to the reversal of previously accrued share-based compensation related to the resignation of the Company’s former CEO. Share-based compensation expense included in general and administrative expenses was equal to 1% and 4% of total revenue for the three months ended June 30, 2013 and June 30, 2012, respectively.
Investigation, Litigation and Settlement Related Costs
During the three months ended June 30, 2013, our total investigation, litigation, and settlement related costs totaled $0.1 million, which was comprised of $0.2 million of legal expenses related to the class action and derivative lawsuits and legal fees associated with other settlement related activities, which were partially offset by $0.1 million that are expected to be recoverable through insurance. During the three months ended June 30, 2012, our total investigation, litigation, and settlement related costs of $0.9 million were comprised of (i) $0.5 million of legal fees, and (ii) a $0.4 million accrual associated with the possible resolution of the class action lawsuit. For further information, refer to Note (10) Litigation, to our unaudited condensed consolidated financial statements.
We expect that our operating expenses will continue to be adversely impacted during 2013 due to professional and service provider fees and other costs, resulting from the ongoing stockholder lawsuits and other settlement related activities.
Interest and Other Loss
We invest our cash primarily in money market funds, government securities, and corporate bonds. As of June 30, 2013, our cash, cash equivalents, and marketable securities totaled $21.9 million, compared with $33.6 million as of June 30, 2012. Interest and other loss increased $0.4 million to a loss of $0.5 million for the three months ended June 30, 2013 compared with a loss of $0.1 million for the same period in 2012. The increase in interest and other loss was primarily due to a foreign currency loss of $0.5 million during the three months ended June 30, 2013 compared with a foreign currency loss of $0.1 million for the same period in 2012.
Income Taxes
Our provision for income taxes consists of state, local, and foreign taxes. For both the three months ended June 30, 2013 and June 30, 2012, we recorded an income tax provision of $0.2 million on our pre-tax loss of $5.0 million and $6.4 million, respectively, consisting primarily of state and local and foreign taxes. Our domestic deferred tax assets are realizable on a more-likely-than-not basis and, therefore, we have recorded a full valuation allowance against our domestic deferred tax assets. During the three months ended June 30, 2013, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our expected net domestic deferred tax assets for the full year 2013 estimated annual effective tax rate. As of June 30, 2013, the valuation allowance totaled approximately $40.3 million.
RESULTS OF OPERATIONS – FOR THE SIX MONTHS ENDED JUNE 30, 2013 COMPARED WITH THE SIX MONTHS ENDED JUNE 30, 2012.
Total revenues for the six months ended June 30, 2013 decreased 18% to $29.3 million, compared with $35.8 million for the six months ended June 30, 2012. Our cost of revenues decreased 19% to $8.1 million for the six months ended June 30, 2013, compared with $10.1 million for the six months ended June 30, 2012. Included in our cost of revenues was $0.1 million of share-based compensation expense for the six months ended June 30, 2013 and less than $0.1 million for the six months ended June 30, 2012. Our operating expenses decreased 14% from $34.2 million for the six months ended June 30, 2012 to $29.5 million for the six months ended June 30, 2013. Included in the operating results for the six months ended June 30, 2013 was $0.2 million of investigation, litigation and settlement related costs compared with a benefit of $0.4 million for the six months ended June 30, 2012. Also included in our operating expenses for the six months ended June 30, 2013 and June 30, 2012 was $1.0 million and $2.5 million, respectively, of share-based compensation expense. Net loss for the six months ended June 30, 2013 was $9.6 million, compared with a net loss of $9.1 million for the six months ended June 30, 2012. Included in our net loss for the six months ended June 30, 2013 was an income tax provision of $0.3 million, compared with an income tax provision of $0.4 million for the six months ended June 30, 2012. The income tax provision of $0.3 million was primarily attributable to the impact of our estimated full year effective tax rate on our pre-tax losses for both the six months ended June 30, 2013 and June 30, 2012. No tax benefits were recognized for expected net domestic deferred tax assets for each of the full years 2013 and 2012, respectively, due to the full valuation allowance over these deferred tax assets.
The decrease in total revenues was due to a decrease in product revenues and support and services revenues for the six months ended June 30, 2013, compared with the same period in 2012. In total, our product revenues decreased 23%. Product revenues from our OEM partners decreased 79%, while product revenues from our non-OEM partners decreased 19% for the six months ended June 30, 2013, compared with the same period in 2012. During the first six months of 2013, we continued our focus and emphasis on the FalconStor-branded business. However, the decrease in product revenue from our non-OEM partners was primarily attributable to (i) the continued overall macroeconomic conditions which have resulted in significant competitive pricing practices from our competitors, customers subjecting IT spending to stricter ROI returns and overall deal review, and more consideration of traditional storage needs as compared to cloud based alternatives which has all led to elongated sales cycles, and (ii) the impact of questions raised by the Company’s declining cash balances and concerns about the Company’s roadmap over the past twelve months. The decline in OEM product revenues was primarily the result of continued disruption with one of our largest OEM partners in China, which was part of a significant corporate reorganization which commenced during 2012, and which has led to continued unpredictability in sales volume from this OEM during the first half of 2013.
In total, support and services revenue decreased 14% from $17.3 million for the six months ended June 30, 2012 to $15.0 million for the six months ended June 30, 2013. The decrease in support and services revenue was attributable to a decrease in both maintenance and technical support services revenue and professional services revenues. Maintenance and technical support services revenue decreased from $15.4 million for the six months ended June 30, 2012 to $14.1 million for the six months ended June 30, 2013. Our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. During the six months ended June 30, 2013 the decline in maintenance and technical support services revenue was primarily attributable to (i) a decline in maintenance revenue from certain legacy OEM customers due to the wind down in our OEM business which commenced in 2009, (ii) a decrease from the previous year in revenue from sales of products that are generally sold with maintenance, and (iii) deeper discounts provided on products in the current economic and competitive environments. Professional services revenue varies from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, (iii) the number of professional services contracts that are performed during the period, and (iv) the number of customers who elect to purchase engineering services. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions.
Overall, our total operating expenses decreased $4.6 million, or 14%, to $29.5 million for the six months ended June 30, 2013, compared with $34.2 million for the same period in 2012. The decrease in total operating expenses was primarily attributable to (i) a decrease in salary and personnel costs including share-based compensation expense due to lower headcount and (ii) a decrease in commissions due to the decrease in revenues during the six months ended June 30, 2013 as compared with the six months ended June 30, 2012. These decreases were partially offset by a $0.6 million increase in investigation, litigation, and settlement related costs compared with the same period in 2012 primarily due to the $0.4 million net recovery recorded in the six month period ended June 30, 2012. We will continue to evaluate the appropriate headcount levels to properly align our resources with our current and long-term outlook and to take actions in areas of the Company that are not performing.
Revenues
| |
|
Six months ended June 30,
|
|
| |
|
2013
|
|
|
2012
|
|
|
Revenues:
|
|
|
|
|
|
|
|
Product revenue
|
|
$ |
14,301,885 |
|
|
$ |
18,498,521 |
|
|
Support and services revenue
|
|
|
14,957,071 |
|
|
|
17,335,752 |
|
| |
|
|
|
|
|
|
|
|
|
Total Revenues
|
|
$ |
29,258,956 |
|
|
$ |
35,834,273 |
|
| |
|
|
|
|
|
|
|
|
|
Year-over-year percentage growth
|
|
|
|
|
|
|
|
|
|
Product revenue
|
|
|
-23 |
% |
|
|
-19 |
% |
|
Support and services revenue
|
|
|
-14 |
% |
|
|
10 |
% |
| |
|
|
|
|
|
|
|
|
|
Total percentage growth
|
|
|
-18 |
% |
|
|
-7 |
% |
Product revenue
Product revenue decreased 23% from $18.5 million for the six months ended June 30, 2012, to $14.3 million for the six months ended June 30, 2013. These amounts are net of a benefit of $0.1 million recognized during the six months ended June 30, 2013, compared with a benefit of $0.3 million in the same period in 2012, resulting from the impact of our collection efforts of previously reserved accounts receivable. Product revenue represented 49% and 52% of our total revenues for the six months ended June 30, 2013 and 2012, respectively. Product revenues from our OEM partners decreased 79%, while product revenues from our non-OEM partners decreased 19% for the six months ended June 30, 2013, compared with the same period in 2012. During the first six months of 2013, we continued our focus and emphasis on the FalconStor-branded business However, the decrease in product revenue from our non-OEM partners was primarily attributable to (i) the continued overall macroeconomic conditions which have resulted in significant competitive pricing practices from our competitors, customers subjecting IT spending to stricter ROI returns and overall deal review, and more consideration of traditional storage needs as compared to cloud based alternatives which has all led to elongated sales cycles, and (ii) the impact of questions raised by the Company’s declining cash balances and concerns about the Company’s performance over the past twelve months. The decline in OEM product revenues was primarily the result of continued disruption with one of our largest OEM partners in China, which was part of a significant corporate reorganization which commenced during 2012, and which has led to continued unpredictability in sales volume from this OEM during the first half of 2013. Product revenue from our non-OEM partners represented 98% and 94% of our total product revenue for the six months ended June 30, 2013 and 2012, respectively. Product revenue from our OEM partners represented 2% and 6% of our total product revenue for the six months ended June 30, 2013 and 2012, respectively.
We continue to focus our investments on the FalconStor-branded non-OEM channel business as we feel this is in line with our long-term outlook.
Support and services revenue
Support and services revenue decreased 14% from $17.3 million for the six months ended June 30, 2012 to $15.0 million for the six months ended June 30, 2013. The decrease in support and services revenue was attributable to decreases in both maintenance and technical support services revenue and professional services revenues.
Maintenance and technical support services revenue decreased from $15.4 million for the six months ended June 30, 2012 to $14.1 million for the six months ended June 30, 2013. Our maintenance and technical support service revenue is expected to result primarily from (i) the purchase of maintenance and support contracts by our customers, and (ii) the renewal of maintenance and support contracts by our existing and new customers after their initial contracts expire. During the six months ended June 30, 2013, the decline in maintenance was primarily attributable to (i) a $0.9 million decline in maintenance revenue from our OEM partners, particularly certain legacy OEM customers due to the wind down in our OEM business which commenced in 2009, (ii) a decrease from the previous year in revenue from sales of products that are generally sold with maintenance, and (iii) deeper discounts provided on products in the current economic and competitive environments.
Professional services revenues decreased from $2.0 million for the six months ended June 30, 2012 to $0.9 million for the same period in 2013. Professional services revenue varies from period to period based upon (i) the number of solutions sold during the existing and previous periods, (ii) the number of our customers who elect to purchase professional services, (iii) the number of professional services contracts that are performed during the period, and (iv) the number of customers who elect to purchase engineering services. We expect professional services revenues to continue to vary from period to period based upon the number of customers who elect to utilize our professional services upon purchasing any of our solutions.
Cost of Revenues
| |
|
Six months ended June 30,
|
|
| |
|
2013
|
|
|
2012
|
|
|
Cost of revenues:
|
|
|
|
|
|
|
|
Product
|
|
$ |
2,262,756 |
|
|
$ |
3,807,672 |
|
|
Support and service
|
|
|
5,870,395 |
|
|
|
6,252,411 |
|
|
Total cost of revenues
|
|
$ |
8,133,151 |
|
|
$ |
10,060,083 |
|
| |
|
|
|
|
|
|
|
|
|
Total Gross Profit
|
|
$ |
21,125,805 |
|
|
$ |
25,774,190 |
|
| |
|
|
|
|
|
|
|
|
|
Gross Margin:
|
|
|
|
|
|
|
|
|
|
Product
|
|
|
84 |
% |
|
|
79 |
% |
|
Support and service
|
|
|
61 |
% |
|
|
64 |
% |
|
Total gross margin
|
|
|
72 |
% |
|
|
72 |
% |
Cost of revenues, gross profit and gross margin
Cost of product revenue for the six months ended June 30, 2013 decreased $1.5 million, or 41%, to $2.3 million, compared with $3.8 million for the same period in 2012. The decrease in cost of product revenue was primarily attributable to the decline in the number of fully integrated solutions which included hardware appliances as a percentage of all product revenues as compared with the same period in 2012. Our cost of support and service revenues for the six months ended June 30, 2013 decreased $0.4 million, or 6%, to $5.9 million, compared with $6.3 million for the same period in 2012. This decrease was primarily attributable to a decrease in personnel costs as a result of lower headcount during the first six months of 2013 compared with the same period in 2012.
Total gross profit decreased $4.6 million, or 18%, to $21.1 million for the six months ended June 30, 2013 from $25.8 million for the same period in 2012. Total gross margin was 72% for each of the six months ended June 30, 2013 and 2012. The decrease in our total gross profit for the six months ended June 30, 2013, compared with the same period in 2012, was primarily due to an 18% decrease in our total revenues. Generally, our total gross profits and total gross margins may fluctuate based on several factors, including (i) revenue growth levels, (ii) changes in personnel headcount and related costs, and (iii) our product offerings and mix of sales.
Share-based compensation expense included in the cost of product revenue was less than 1% of total revenue for the six months ended June 30, 2013 and June 30, 2012. Share-based compensation expense included in the cost of support and service revenue was $0.1 million for both the six months ended June 30, 2013 and less than $0.1 million for the six months ended June 30, 2012. Share-based compensation expense included in cost of support and service revenue was less than 1% of total revenue for the six months ended June 30, 2013 and June 30, 2012.
Operating Expenses
Research and Development Costs
Research and development costs decreased $0.6 million, or 6%, to $9.0 million for the six months ended June 30, 2013, from $9.6 million in the same period in 2012. The decrease in research and development costs was primarily the result of a decline in personnel related costs including share-based compensation expense. These decreases were partially offset by higher capitalization of software development costs in the six months ended June 30, 2012 of $0.5 million as compared to $0.2 million during the six months ended June 30, 2013. We believe we continue to provide adequate levels of resources in support of our research and development activities to continue to enhance and to test our core products and in the development of new innovative products, features and options. Share-based compensation expense included in research and development costs decreased to $0.2 million from $0.4 million for the six months ended June 30, 2013 and June 30, 2012, respectively. Share-based compensation expense included in research and development costs was 1% of total revenue for the six months ended June 30, 2013 and June 30, 2012.
Selling and Marketing
Selling and marketing expenses decreased $5.2 million, or 27%, to $13.7 million for the six months ended June 30, 2013, from $18.9 million for the same period in 2012. The decrease in selling and marketing expenses was primarily attributable to (i) a decrease in commissions due to the 23% decline in product revenue compared with the same period in 2012, and (ii) a decrease in salary and personnel costs as a result of lower sales and marketing headcount as well as a decrease in share-based compensation expenses. Share-based compensation expense included in selling and marketing decreased to $0.3 million from $0.9 million for the six months ended June 30, 2013 and 2012, respectively due to the reversal of previously accrued share-based compensation related to the resignations of certain former sales and marketing professionals . Share-based compensation expense included in selling and marketing expenses was equal to 1% of total revenue for the six months ended June 30, 2013 and 2% of total revenue for the six months ended June 30, 2012.
General and Administrative
General and administrative expenses increased $0.5 million, or 8%, to $6.6 million for the six months ended June 30, 2013, compared with $6.1 million for the same period in 2012. The overall increase within general and administrative expenses was primarily related to an increase in professional fees, severance costs, and other administrative costs which were partially offset by a decrease in bad debt expense and share-based compensation. Share-based compensation expense included in general and administrative expenses was $0.5 million for the six months ended June 30, 2013, compared with $1.2 million for the six months ended June 30, 2012 due to the reversal of previously accrued share-based compensation related to the resignation of the Company’s former CEO. Share-based compensation expense included in general and administrative expenses was equal to 2% and 3% of total revenue for the six months ended June 30, 2013 and June 30, 2012, respectively.
Investigation, Litigation and Settlement Related Costs
During the six months ended June 30, 2013, our total investigation, litigation, and settlement related costs totaled $0.2 million, which was comprised of $0.5 million of legal expenses related to the class action and derivative lawsuits and legal fees associated with other settlement related activities, which were partially offset by $0.3 million that are expected to be recoverable through insurance. For the six months ended June 30, 2012, our total investigation, litigation, and settlement related costs resulted in a net reduction of $0.4 million, which was comprised of (i) $0.9 million of legal fees, (ii) a $0.4 million accrual related to possible resolution of class action lawsuits, and (iii) a $1.7 million accrual reduction. For further information, refer to Note (10) Litigation, to our unaudited condensed consolidated financial statements.
We expect that our operating expenses will continue to be adversely impacted during 2013 due to professional and service provider fees and other costs, resulting from the ongoing stockholder lawsuits and settlement related activities.
Interest and Other Loss
Interest and other loss increased $0.6 million to a loss of $0.8 million for the six months ended June 30, 2013 compared with a loss of $0.2 million for the same period in 2012. The increase in interest and other loss was primarily due to a foreign currency loss of $0.8 million during the six months ended June 30, 2013 related primarily to declines in foreign exchange for both the Japanese Yen and the Euro compared with a foreign currency loss of $0.3 million for the same period in 2012, partially offset by $0.1 million of interest income.
Income Taxes
Our provision for income taxes consists of state, local, and foreign taxes. For the six months ended June 30, 2013, we recorded an income tax provision of $0.3 million as compared with a provision of $0.4 million for the same period in 2012, consisting primarily of state and local and foreign taxes. Our domestic deferred tax assets are realizable on a more-likely-than-not basis and, therefore, we have recorded a full valuation allowance against our domestic deferred tax assets. During the six months ended June 30, 2013, our conclusion did not change with respect to our domestic deferred tax assets and therefore, we have not recorded any benefit for our expected net domestic deferred tax assets for the full year 2013 estimated annual effective tax rate. As of June 30, 2013, the valuation allowance totaled approximately $40.3 million.
Critical Accounting Policies and Estimates
Our critical accounting policies and estimates are those related to revenue recognition, accounts receivable allowances, deferred income taxes, accounting for share-based payments, goodwill and other intangible assets, software development costs, fair value measurements and litigation.
Revenue Recognition. As discussed further in Note (1) Summary of Significant Accounting Policies, to our unaudited condensed consolidated financial statements, we recognize revenue in accordance with the authoritative guidance issued by the FASB on revenue recognition. Product 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, a customer purchase order, and/or a royalty report summarizing software licenses sold for each software license resold by an OEM, distributor or reseller to an end user. Product 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 with extended payment terms during the three and six months ended June 30, 2013. When a customer purchases our integrated solutions and/or licenses software together with the purchase of maintenance, we allocate a portion of the fee to maintenance based upon vendor-specific objective evidence (“VSOE”) of the fair value of the contractual optional maintenance renewal rate. If professional services are included in our multi-element software arrangements, we allocate a portion of the fee to these services based on its VSOE of fair value which is established using rates charged when sold on a stand-alone basis.
Accounts Receivable. We review accounts receivable to determine which receivables 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, (vii) actual cash collections on our accounts receivables and (viii) concentrations of credit risk and customer credit worthiness. When determining the appropriate allowance for uncollectable accounts and returns each period, the actual customer collections of outstanding account receivable balances impact the required allowance for returns. Due to cash collections of previously reserved accounts receivable balances, we recorded benefits of approximately $0.4 million and $0.3 million for the six months ended June 30, 2013 and June 30, 2012, respectively. These amounts are included within our unaudited condensed consolidated statement of operations in each respective year. Changes in the product return rates, credit worthiness of customers, general economic conditions and other factors may impact the level of future write-offs, revenues and our general and administrative expenses.
Income Taxes. As discussed further in Note (1) Summary of Significant Accounting Policies, to our unaudited condensed consolidated financial statements, in accordance with the authoritative guidance issued by the FASB on income taxes, we regularly evaluate our ability to recover deferred tax assets, and report such deferred tax assets at the amount that is determined to be more-likely-than-not recoverable. Deferred tax assets and liabilities are recognized for 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 financial reporting purposes, excess share-based compensation deductions included in net operating losses are realized after regular net operating losses are exhausted.
We account for uncertain tax positions in accordance with the authoritative guidance issued by the FASB on income taxes, which addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return, should be recorded in the financial statements. Pursuant to the authoritative guidance, we 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. In addition, the authoritative guidance addresses de-recognition, classification, interest and penalties on income taxes, accounting in interim periods, and also requires increased disclosures.
Accounting for Share-Based Payments. As discussed further in Note (1) Summary of Significant Accounting Policies and Note (2) Share-Based Payment Arrangements, to our unaudited condensed consolidated financial statements, we account for share-based awards in accordance with the authoritative guidance issued by the FASB on stock compensation.
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 for our stock option grants. 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 has been determined pursuant to SEC Staff Accounting Bulletin SAB No. 110. Additionally, we estimate forfeiture rates based primarily upon historical experience, 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 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 and six months ended June 30, 2013 and 2012 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.
Goodwill and Other Intangible Assets. As discussed further in Note (1) Summary of Significant Accounting Policies, to our unaudited condensed consolidated financial statements, we account for goodwill and other intangible assets in accordance with the authoritative guidance issued by the FASB on goodwill and other intangibles. The authoritative guidance requires an impairment-only approach to accounting for goodwill and other intangibles with an indefinite life. Absent any prior indicators of impairment, we perform an annual impairment analysis during the fourth quarter of each of our fiscal years.
As of each of June 30, 2013 and December 31, 2012, we had $4.2 million of goodwill. As of each of June 30, 2013 and December 31, 2012, we had $0.2 million (net of amortization), of other identifiable intangible assets. We do not amortize goodwill, but we assess for impairment at least annually and more often if a trigger event occurs. We amortize identifiable intangible assets over their estimated useful lives. We evaluate the recoverability of goodwill using a two-step process based on an evaluation of the reporting unit. The first step involves a comparison of a reporting unit’s fair value to its carrying value. In the second step, if the reporting unit’s carrying value exceeds its fair value, we compare the goodwill’s implied fair value and its carrying value. If the goodwill’s carrying value exceeds its implied fair value, we recognize an impairment loss in an amount equal to such excess. We evaluate the recoverability of other identifiable intangible assets whenever events or changes in circumstances indicate that its carrying value may not be recoverable. Such events include significant adverse changes in business climate, several periods of operating or cash flow losses, forecasted continuing losses or a current expectation that an asset or asset a group will be disposed of before the end of its useful life. As of June 30, 2013 and December 31, 2012, we did not record any impairment charges on either our goodwill or other identifiable intangible assets.
Software Development Costs. As discussed further in Note (1) Summary of Significant Accounting Policies, to our unaudited condensed consolidated financial statements, we account for software development costs in accordance with the authoritative guidance issued by the FASB on costs of software to be sold, leased or marketed.
As of June 30, 2013 and December 31, 2012, we had $1.2 million of software development costs, net of amortization. The authoritative guidance requires that the costs associated with the development of new software products and enhancements to existing software products be expensed as incurred until technological feasibility of the product has been established. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established and assumptions are used that reflect our best estimates. If other assumptions had been used in the current period to estimate technological feasibility, the reported product development and enhancement expense could have been affected. Annual amortization of capitalized software costs is the greater of the amount computed using the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product or the straight-line method over the remaining estimated economic life of the software product, generally estimated to be five years from the date the product became available for general release to customers. Software development costs are reported at the lower of amortized cost or net realizable value. Net realizable value is computed as the estimated gross future revenues from each software solution less the amount of estimated future costs of completing and disposing of that product. Because the development of projected net future revenues related to our software solutions used in our net realizable value computation is based on estimates, a significant reduction in our future revenues could impact the recovery of our capitalized software development costs. We amortize software development costs using the straight-line method.
Fair Value Measurement. As discussed further in Note (1) Summary of Significant Accounting Policies and Note (4) Fair Value Measurements, to our unaudited condensed consolidated financial statements, we determine fair value measurements of both financial and nonfinancial assets and liabilities in accordance with the authoritative guidance issued by the FASB on fair value measurements and disclosures.
The FASB authoritative guidance establishes three levels of inputs that may be used to measure fair value. Each level of input has different levels of subjectivity and difficulty involved in determining fair value.
Level 1 - instruments represent quoted prices in active markets. Therefore, determining fair value for Level 1 instruments does not require significant management judgment, and the estimation is not difficult.
Level 2 - instruments include observable inputs other than Level 1 prices, such as quoted prices for identical instruments in markets with insufficient volume or infrequent transactions (less active markets), issuer credit ratings, non-binding market consensus prices that can be corroborated with observable market data, model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated with observable market data for substantially the full term of the assets or liabilities, or quoted prices for similar assets or liabilities. These Level 2 instruments require more management judgment and subjectivity compared to Level 1 instruments.
Level 3 - instruments include unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities. The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. All of our marketable debt instruments classified as Level 3 are valued using an undiscounted cash flow analysis, a non-binding market consensus price and/or a non-binding broker quote, all of which we corroborate with unobservable data. Non-binding market consensus prices are based on the proprietary valuation models of pricing providers or brokers. These valuation models incorporate a number of inputs, including non-binding and binding broker quotes; observable market prices for identical and/or similar securities; and the internal assumptions of pricing providers or brokers that use observable market inputs, and to a lesser degree non-observable market inputs. There were no instruments classified as Level 3 as of June 30, 2013 or December 31, 2012.
Other-Than-Temporary Impairment
After determining the fair value of our available-for-sale debt instruments, gains or losses on these investments are recorded to other comprehensive income, until either the investment is sold or we determine that the decline in value is other-than-temporary. Determining whether the decline in fair value is other-than-temporary requires management judgment based on the specific facts and circumstances of each investment. For investments in debt instruments, these judgments primarily consider the financial condition and liquidity of the issuer, the issuer’s credit rating, and any specific events that may cause us to believe that the debt instrument will not mature and be paid in full; and our ability and intent to hold the investment to maturity.
Litigation. As discussed further in Note (10) Litigation, to our unaudited condensed consolidated financial statements, in accordance with the authoritative guidance issued by the FASB on contingencies, the Company accrues anticipated costs of settlement, damages and losses for claims to the extent specific losses are probable and estimable. The Company records a receivable for insurance recoveries when such amounts are probable and collectable. In such cases, there may be an exposure to loss in excess of any amounts accrued. If, at the time of evaluation, the loss contingency related to a litigation is not both probable and estimable, the matter will continue to be monitored for further developments that would make such loss contingency both probable and estimable and, the Company will expense these costs as incurred. If the estimate of a probable loss is a range and no amount within the range is more likely, the Company will accrue the minimum amount of the range.
Impact of Recently Issued Accounting Pronouncements
See Item 1 of Part 1, Condensed Consolidated Financial Statements – Note (1) Summary of Significant Accounting Policies – New Accounting Pronouncements.
LIQUIDITY AND CAPITAL RESOURCES
| |
|
Six months ended June 30,
|
|
| |
|
2013
|
|
|
2012
|
|
|
Cash provided by (used in):
|
|
|
|
|
|
|
|
Operating activities
|
|
$ |
(6,822,981 |
) |
|
$ |
(2,471,635 |
) |
|
Investing activities
|
|
|
1,014,780 |
|
|
|
2,316,612 |
|
|
Financing activities
|
|
|
697,500 |
|
|
|
624,155 |
|
|
Effect of exchange rate changes
|
|
|
(246,987 |
) |
|
|
(242,694 |
) |
| |
|
|
|
|
|
|
|
|
|
Net (decrease) increase in cash and cash equivalents
|
|
$ |
(5,357,688 |
) |
|
$ |
226,438 |
|
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 balance as of June 30, 2013 totaled $21.9 million, compared with $29.9 million as of December 31, 2012. Cash and cash equivalents totaled $13.3 million, restricted cash totaled $0.8 million and marketable securities totaled $7.8 million at June 30, 2013. As of December 31, 2012, we had $18.7 million in cash and cash equivalents, $0.8 million in restricted cash and $10.5 million in marketable securities.
As of June 30, 2013 and December 31, 2012, the Company had $0.8 million of restricted cash. The restricted cash serves as collateral related to deposit service indebtedness with the Company’s commercial bank. As of June 30, 2013 and December 31, 2012, the Company did not have any debt service indebtedness with the Company’s bank.
Over the past several years, we have been through multiple transitions, which included various senior management changes, new sales leadership in all of our regions, changes within our North American sales force structure, and restructurings. We continually evaluate our cost structure to ensure our resources are aligned to effectively execute our long-term growth strategy, drive operational efficiencies and support the anticipated revenue level we expect to achieve on a go forward basis. As we enter the second half of 2013, we will be addressing the parts of our business that have been underperforming and we intend to make the necessary adjustments in our cost structure including among other things, evaluating appropriate headcount levels to properly align all of our resources with our current and long-term outlook. We will continue to evaluate potential software license purchases and acquisitions, and if the right opportunity presents itself, we may use our cash for these purposes. As of the date of this filing, we have no agreements, commitments or understandings with respect to any such license purchases or acquisitions.
After the close of the second quarter, we reached an agreement in principle, and we signed a term sheet, for an investment of between $7.5 million and $15.0 million from a private equity group. The investment will be in the form of redeemable convertible preferred stock. Closing of the investment is subject to the negotiation of definitive documents and certain other conditions.
After the close of the second quarter, we also signed an Equity Transfer Agreement, to sell our interest in Tianjin Zhongke Blue Whale Information Technologies Co., Ltd. (“Blue Whale”) for $3.0 million. Closing of the sale is subject to certain conditions, including the approval of the appropriate government entities in China.
As discussed further in Part II, Item 1 – Legal Proceedings of this quarterly report on Form 10-Q, in June 2012, we settled charges arising from investigations conducted by the United States Attorney’s Office and the Securities and Exchange Commission for a total of $5.8 million. During 2012, we paid $4.1 million of the $5.8 million investigation settlement, with the balance of $1.7 million due in December 2013.
In addition, we are among the defendants named in class action and derivative lawsuits. In accordance with our by-laws and Delaware law, we have been paying for the costs of defense of these actions for the other named defendants. If liability is ultimately assessed some of the other named defendants may be entitled to claim indemnification from us. We have incurred, and continue to incur significant expenses, primarily for legal counsel, due to the class action and derivative lawsuits. In January, 2013, the parties to the Class Action reached an agreement in principle to settle the Class Action. Pursuant to a Memorandum of Understanding signed by counsel for the class plaintiffs and by counsel for all defendants, the Company will pay $5.0 million to settle the Class Action. This amount includes damages, plaintiffs’ attorneys’ fees, and costs of administration of the settlement. We expect to pay this settlement with a combination of cash on hand and insurance proceeds. A stipulation of settlement and a joint motion for preliminary approval of the settlement were submitted to the court for its approval on June 14, 2013. Final settlement of the Class Action is subject to certain conditions and to approval by the court. We cannot predict if or when the court might approve the settlement. Certain of the defendants may be entitled to indemnification by the Company under the laws of Delaware and/or our by-laws. In addition, we may be entitled to seek the recovery of certain costs and payments from certain former Company employees. On March 5, 2013, the Suffolk County Division of the Supreme Court of the State of New York granted a motion made by all of the defendants in the Derivative Action, except Mr. Lin, and dismissed the Derivative Action as to all defendants other than Mr. Lin. The stockholders have filed a notice of appeal of the dismissal of the Derivative Action.
At various times from October 2001 through February 2009 our Board of Directors authorized the repurchase of up to 14 million shares of our outstanding common stock in the aggregate. We did not repurchase any of our outstanding common stock during each of the three and six months ended June 30, 2013 and 2012. Since October 2001, we have repurchased a total of 8,005,235 shares at an aggregate purchase price of $46.9 million. See Note (7) Stockholders’ Equity to our unaudited condensed consolidated financial statements for further information.
Net cash used in operating activities totaled $6.8 million and $2.5 million for the six months ended June 30, 2013 and June 30, 2012, respectively. The decrease in net cash provided by operating activities during the six months ended June 30, 2013, compared with the same period in 2012, was partially the result of our net loss of $9.6 million compared with a net loss of $9.1 million, respectively, adjusted for: (i) the impact of non-cash charges, particularly relating to stock-based compensation, depreciation, amortization, and provisions for returns and doubtful accounts; and (ii) adjustments for net changes in operating assets and liabilities, primarily changes in our accounts receivable, prepaid expenses, inventory, accounts payable, accrued expenses and deferred revenues.
Net cash provided by investing activities was $1.0 million and $2.3 million for the six months ended June 30, 2013 and June 30, 2012, respectively. Included in investing activities for the six months ended June 30, 2013 and June 30, 2012, are the sales and purchases of our marketable securities, which include the sales, maturities and reinvestment of our marketable securities. The net cash provided by investing activities from the net sales of securities was $2.7 million for the six months ended June 30, 2013, and $4.5 million for the same period in 2012. 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 $1.1 million for the six months ended June 30, 2013 and $1.6 million for the same period in 2012. The cash used in the capitalization of software development costs was $0.2 million for the six months ended June 30, 2013 and $0.5 million for the same period in 2012. We continually evaluate potential software license purchases and acquisitions, and we may continue to make such investments if we find opportunities that would benefit our business. The cash used for security deposits was $0.3 million for the six months ended June 30, 2013 and less than $0.1 million for the same period in 2012. We anticipate continued capital expenditures, including capitalized software costs, as we continue to invest in our infrastructure and expand and enhance our product offerings.
Net cash provided by financing activities was $0.7 million and $0.6 million for the six months ended June 30, 2013 and June 30, 2012, respectively. Cash inflows from financing activities represent proceeds received from the exercise of stock options.
We currently do not have any debt and our only significant commitments are related to our employment agreement with Gary Quinn, our President and Chief Executive Officer, the $1.7 million remaining settlement payment to the United States Attorney’s Office, which is due in December 2013 and our office leases. In addition, on January 20, 2013, we announced we had reached a proposed settlement of the Class Action lawsuit between the Company and class plaintiffs for $5.0 million which is pending approval by the court. We cannot predict if or when the court might approve the settlement.
On June 28, 2013, the President and Chief Executive Officer, and a Director, of FalconStor Software, Inc. (the “Company”), James P. McNiel, resigned from all of his positions with the Company, effective immediately. The Company also entered into a Severance Agreement and General Release (the “Agreement”), with Mr. McNiel. Pursuant to the Agreement, among other things, the Company agreed to pay to Mr. McNiel $400,000 in severance pay and to purchase certain office furniture from Mr. McNiel for $20,000. These payments were made in July 2013.
We have an operating lease covering our corporate office facility that expires in April 2021. We also have several operating leases related to offices in the United States and foreign countries. The expiration dates for these leases range from 2013 through 2017. Refer to Note (8) Commitments and Contingencies to our unaudited condensed consolidated financial statements.
In addition, as of June 30, 2013 and December 31, 2012, our liability for uncertain tax positions totaled $2.5 million.
With the cash infusions mentioned above, we believe that our 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. However, both the private equity investment and the sale of our Blue Whale investment are subject to various closing conditions, including, with regard to the Blue Whale investment sale, government approvals, and there can be no guarantee that either transaction will close. If the private equity investment does not close and the Company continues to incur losses, there can be no guarantee that we will have cash, cash equivalents and marketable securities, and expected cash flows from operations, sufficient to meet our needs for the next twelve months.
Off-Balance Sheet Arrangements
As of June 30, 2013 and December 31, 2012, we had no off-balance sheet arrangements.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risks. Our cash, cash equivalents and marketable securities aggregated $21.9 million as of June 30, 2013. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. All of our cash equivalent and marketable securities are designated as available-for-sale and, accordingly, are presented at fair value on our consolidated balance sheets. We regularly assess these risks and have established policies and business practices to manage the market risk of our marketable securities. We generally invest our excess cash in investment grade short- to intermediate-term fixed income securities and AAA-rated money market funds. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, and we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates. Due to the short-term nature of the majority of our investments, the already severely suppressed interest rates we currently earn, and the fact that over 60% of our total cash, cash equivalents and marketable securities are comprised of money market funds and cash, we do not believe we are subject to any material interest rate risks on our investment balances levels at June 30, 2013.
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. For the six months ended June 30, 2013 and 2012, approximately 60% and 58% of our sales were from outside North America. Not all of these transactions were made in foreign currencies. Our primary exposure is to fluctuations in exchange rates for the U.S. Dollar versus the Euro and Japanese Yen, and to a lesser extent the Canadian Dollar, the Korean Won, the New Taiwanese Dollar and the Australian dollar. Changes in exchange rates in the functional currency for each geographic area’s revenues are primarily offset by the related expenses associated with such revenues. However, changes in exchange rates of a particular currency could impact the re-measurement of such balances on our balance sheets.
If foreign currency exchange rates were to change adversely by 10% from the levels at June 30, 2013, the effect on our results before taxes from foreign currency fluctuations on our balance sheet would be approximately $1.2 million. The above analysis disregards the possibility that rates for different foreign currencies can move in opposite directions and that losses from one currency may be offset by gains from another currency.
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 control over financial reporting occurred during the quarter ended June 30, 2013, 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
See the discussion of the Company’s material litigation in Note (10) – Litigation to the unaudited condensed consolidated financial statements, which is incorporated by reference in the Item 1.
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, 2012 (the “2012 10-K”). The information below sets forth additional risk factors or risk factors that have had material changes since the 2012 10-K, and should be read in conjunction with Item 1A of the 2012 10-K.
We have had sixteen consecutive quarters of losses and there is no guarantee that we will return to profitability.
We have incurred losses in each of the last sixteen quarters. While we have taken steps to try reduce or eliminate the losses – such as reducing headcount and other expenses and trying to replace lost OEM sales with sales of FalconStor-branded products – there is no guarantee that we will be successful and return to profitability. As of June 30, 2013, we had approximately $21.9 million in cash, cash equivalents and marketable securities. If our losses continue we will deplete our available cash and we may not be able to continue to fund effective sales and marketing or research and development activities on which we are dependent.
If we are not able to cut spending and/or increase revenues and/or raise additional capital, we might run out of operating capital. Raising additional capital could result in the dilution of the percentage ownership of our current stockholders.
At the end of the second quarter of 2013, we had $21.9 million in cash and cash equivalents and marketable securities. At our current cash burn rate, the amount of cash and cash equivalents and marketable securities will only support our business through part of 2014. To avoid running out of cash, we are planning on reducing spending and we are attempting to increase our revenues. In addition, we signed a term sheet for an investment of up to $15 million from a new investor. We also entered into an agreement to sell of certain cost-based investments that are not part of our strategy going forward. If we are unsuccessful in any or all of these attempts to reduce spending, to increase revenues, to raise additional investment, or to sell off the cost-based investments, we could run out of operating capital. In addition, raising capital from new investors will likely result in the dilution of the percentage ownership of our current stockholders and depending on the terms could result in a decrease in the market price of our common stock.
We have terminated Wells Fargo Securities LLC’s engagement as our advisor with regard to potential strategic alternatives to enhance stockholder value.
We have terminated our retainer of the investment banking firm Wells Fargo Securities, LLC as our exclusive financial advisor to assist us in exploring and evaluating strategic alternatives to maximize stockholder value. This termination does not mean that we will not continue to explore additional strategic alternatives. However, there can be no guarantee that we will be able to identify or to enter into any strategic alternative to enhance stockholder value.
We continue to have turnover in our senior management.
On June 28, 2013, James P. McNiel voluntarily resigned his positions as President and Chief Executive Officer of the Company. Gary Quinn has been named President and Chief Executive Officer.
In addition to Mr. McNiel’s resignation, since September 29, 2010, we have accepted the resignations of our prior CEO; two CFO’s; our CTO; two VP’s of Sales for North America; our VP of Sales and General Manager for Europe, the Middle East and Africa; our VP of Sales and General Manager of Asia-Pacific; our VP of Global Support; and our VP of Marketing.
We have filled these positions with highly qualified individuals with extensive storage and software company experience. However, there can be no guarantee that the new senior management will be able to get up to speed and successfully manage the Company. In addition, with the exception of Gary Quinn, we have no employment agreements with any of our senior management and there can be no assurance that we will be able to retain any or all of the members of the senior management team.
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 June 30, 2013, we had outstanding options to purchase 11,200,955 shares of our common stock, and we had an aggregate of 122,620 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 $4.25 per share. We also had 1,519,323 shares of our common stock reserved for issuance under our stock plans with respect to options (or restricted stock or restricted stock units) that have not been granted. In addition, if, on July 1st of any calendar year in which our 2006 Incentive Stock Plan, as amended (the “2006 Plan”), is in effect, the number of shares of stock to which options, restricted shares and restricted stock units 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. 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 restricted stock units and/or the grant and exercise of additional options and/or the grant and vesting of restricted stock and restricted stock units would dilute the then-existing stockholders’ percentage ownership of common stock, and any sales in the public market of the common stock issuable upon such exercise could adversely affect prevailing market prices for the common stock. Moreover, the terms upon which we would be able to obtain additional equity capital could be adversely affected because the holders of such securities can be expected to exercise or convert them at a time when we would, in all likelihood, be able to obtain any needed capital on terms more favorable than those provided by such securities.
Our stock price may be volatile.
The market price of our common stock has been volatile in the past and may be volatile in the future. For example, during the past twelve months ended June 30, 2013, the closing market price of our common stock as quoted on the NASDAQ Global Market fluctuated between $1.24 and $2.82. Subsequently to June 30, 2013, the closing market price of our common stock has been as low as $0.95. To the extent the market price of our common stock consistently closes below $1.00 per share, we may be subject to delisting from the NASDAQ Global Market. If our common stock is delisted from the NASDAQ Global Market, it could materially impact the liquidity of our stock or our ability to raise more capital. The market price of our common stock may be significantly affected by the following factors:
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actual or anticipated fluctuations in our operating results;
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the impact of the Deferred Prosecution Agreement and whether we comply with the Deferred Prosecution Agreement;
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the status of the class action and derivative lawsuits;
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failure to meet financial estimates;
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changes in market valuations of other technology companies, particularly those in the network storage software market;
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announcements by us or our competitors of significant technical innovations, acquisitions, strategic partnerships, strategic alternatives, joint ventures, licensing arrangements or capital commitments;
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loss of one or more key customers; and
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departures of key personnel.
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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.
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 5. Other Information
On August 8, 2013, the Company terminated its retainer of the investment banking firm Wells Fargo Securities, LLC as its exclusive financial advisor to assist the Company in exploring and evaluating strategic alternatives to maximize stockholder value.
On July 23, 2013, the Company’s Board of Directors appointed Gary Quinn the Company’s Chief Executive Officer and President. On July 23, 2013, the Company entered into an employment agreement with Mr. Quinn (the “Employment Agreement”). Pursuant to the Employment Agreement, Mr. Quinn is employed as the Company’s Chief Executive Officer and President for a term of two years. Mr. Quinn will receive an annual salary of $400,000 and standard Company benefits. On August 5, 2013, as called for by the Employment Agreement, Mr. Quinn was granted 500,000 shares of restricted Company common stock. The restrictions on 250,000 shares of the restricted stock lapse on each of the first two anniversaries of the date of the Employment Agreement.
On August 5, 2013, the Company reached an agreement in principle, and signed a term sheet, for an investment of between $7.5 million and $15.0 million from a private equity group. The investment will be in the form of redeemable convertible preferred stock. The purchase price of the redeemable convertible preferred stock will be the lesser of the volume weighted average price of the Company’s common stock for the twenty trading days immediately prior to the closing of the transaction and the closing price of the Company’s common tock on August 5, 2013, the date on which the term sheet for the transaction was signed.
On August 7, 2013, the Company signed an Equity Transfer Agreement, to sell its interest in Tianjin Zhongke Blue Whale Information Technologies Co., Ltd. (“Blue Whale”), a Chinese joint venture company, for $3.0 million. Closing of the sale is subject to the negotiation of definitive documents and certain other conditions, including the approval of the appropriate government entities in China.
On August 8, 2013, the Board of Directors voted to increase the number of Directors of the Company from five to six.
On August 8, 2013, Gary Quinn was elected a Director of the Company. Mr. Quinn is the Company’s President and Chief Executive Officer. Additional biographical information regarding Mr. Quinn may be found in the Form 8-K filed by the Company on July 24, 2013.
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31.1
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Certification of the Chief Executive Officer
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31.2
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Certification of the Chief Financial Officer
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32.1
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Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350)
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32.2
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Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350)
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99.1
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Agreement of Lease dated May 30, 2013 by and between Huntington Quadrangle 2, LLC, and FalconStor Software, Inc.
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101.1
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The following financial statements from FalconStor Software, Inc’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2013, formatted in XBRL (eXtensible Business Reporting Language):
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(i) unaudited Condensed Consolidated Balance Sheets – June 30, 2013 and December 31, 2012.
(ii) unaudited Condensed Consolidated Statement of Operations – Three and Six Months Ended June 30, 2013 and 2012.
(iii) unaudited Condensed Consolidated Statement of Comprehensive Loss – Three and Six Months Ended June 30, 2013 and 2012
(iv) unaudited Condensed Consolidated Statement of Cash Flows – Six Months Ended June 30, 2013 and 2012.
(v) Notes to unaudited Condensed Consolidated Financial Statements –June 30, 2013.
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.
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FALCONSTOR SOFTWARE, INC.
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(Registrant)
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/s/ Louis J. Petrucelly
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Louis J. Petrucelly
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Executive Vice President, Chief Financial Officer and Treasurer
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(principal financial and accounting officer)
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/s/ Gary Quinn
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Gary Quinn
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President & Chief Executive Officer
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August 9, 2013
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(principal executive officer)
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