UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended September 30, 2007
--------------------------------------------
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________________ to _____________________
COMMISSION FILE NUMBER 0-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0216135
(State of Incorporation) (I.R.S. Employer Identification No.)
2 Huntington Quadrangle
Melville, New York 11747
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: 631-777-5188
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes No
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition of
"accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange
Act.
Large Accelerated Filer Accelerated Filer X Non-Accelerated Filer
--- --- ---
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes No X
The number of shares of Common Stock issued and outstanding as of October
26, 2007 was 50,985,031 and 49,800,931.
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
Page
PART I. Financial Information 3
Item 1. Condensed Consolidated Financial Statements 3
Condensed Consolidated Balance Sheets at September 30, 2007 3
(unaudited) and December 31, 2006
Unaudited Condensed Consolidated Statements of Operations for the
three and nine months ended September 30, 2007 and 2006 4
Unaudited Condensed Consolidated Statements of Cash Flows for the
nine months ended September 30, 2007 and 2006 5
Notes to the Unaudited Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 18
Item 3. Qualitative and Quantitative Disclosures about Market Risk 27
Item 4. Controls and Procedures 27
PART II. Other Information 28
Item 1. Legal Proceedings 28
Item 1A. Risk Factors 28
Item 2. Unregistered Sales of Equities Proceeds and Use of Proceeds 30
Item 6. Exhibits 31
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
September 30, 2007 December 31, 2006
------------------ -----------------
ASSETS (unaudited)
Current assets:
Cash and cash equivalents ....................................................... $ 29,980,400 $ 15,605,329
Marketable securities ........................................................... 29,854,300 25,354,259
Accounts receivable, net of allowances of $7,768,896 and
$6,016,298, respectively ...................................................... 18,116,546 24,134,257
Prepaid expenses and other current assets ....................................... 1,625,876 1,244,937
Deferred tax asset, net ......................................................... 2,243,755 --
------------- -------------
Total current assets ..................................................... 81,820,877 66,338,782
Property and equipment, net of accumulated depreciation of
$12,850,270 and $10,221,780, respectively ....................................... 7,320,238 5,960,317
Goodwill ........................................................................... 3,512,796 3,512,796
Other intangible assets, net ....................................................... 431,549 407,316
Deferred tax asset, net ............................................................ 2,579,579 --
Other assets ....................................................................... 2,286,990 2,011,433
------------- -------------
Total assets ............................................................. $ 97,952,029 $ 78,230,644
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................................................ $ 839,058 $ 1,432,510
Accrued expenses ................................................................ 5,960,221 6,505,536
Deferred revenue ................................................................ 13,382,272 11,466,552
------------- -------------
Total current liabilities ................................................ 20,181,551 19,404,598
Other long-term liabilities ........................................................ 131,377 137,317
Deferred revenue ................................................................... 4,214,591 3,645,482
------------- -------------
Total liabilities ........................................................ 24,527,519 23,187,397
------------- -------------
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized ...... -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
50,977,331 and 49,085,539 shares issued, respectively and 49,793,231
and 48,220,339 shares outstanding, respectively ............................... 50,977 49,086
Additional paid-in capital ...................................................... 113,781,052 99,282,308
Accumulated deficit ............................................................. (30,948,578) (38,033,857)
Common stock held in treasury, at cost (1,184,100 and 865,200 shares at
September 30, 2007 and December 31, 2006, respectively) ....................... (9,053,824) (5,780,163)
Accumulated other comprehensive loss, net ....................................... (405,117) (474,127)
------------- -------------
Total stockholders' equity ............................................... 73,424,510 55,043,247
------------- -------------
Total liabilities and stockholders' equity ............................... $ 97,952,029 $ 78,230,644
============= =============
See accompanying notes to unaudited condensed consolidated financial statements.
3
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
------------------------------- --------------------------------
2007 2006 2007 2006
------------ ------------ ------------ ------------
Revenues:
Software license revenue ............................... $ 12,209,650 $ 8,685,667 $ 34,627,635 $ 23,088,377
Maintenance revenue .................................... 4,771,952 3,315,771 13,641,271 8,815,288
Software services and other revenue .................... 1,545,935 964,673 4,349,853 2,938,993
------------ ------------ ------------ ------------
18,527,537 12,966,111 52,618,759 34,842,658
------------ ------------ ------------ ------------
Operating expenses:
Amortization of purchased and capitalized
software .......................................... 33,869 81,334 83,691 334,389
Cost of maintenance, software services and
other revenue ..................................... 2,852,236 2,246,085 8,058,574 6,550,747
Software development costs .......................... 5,647,805 5,067,882 16,505,471 14,580,122
Selling and marketing ............................... 6,978,239 5,809,706 21,447,423 16,400,453
General and administrative .......................... 1,944,521 1,489,537 5,805,024 4,200,971
------------ ------------ ------------ ------------
17,456,670 14,694,544 51,900,183 42,066,682
------------ ------------ ------------ ------------
Operating income (loss) ......................... 1,070,867 (1,728,433) 718,576 (7,224,024)
------------ ------------ ------------ ------------
Interest and other income, net ......................... 682,132 514,415 1,775,879 1,185,075
------------ ------------ ------------ ------------
Income (loss) before income taxes ............... 1,752,999 (1,214,018) 2,494,455 (6,038,949)
Provision (benefit) for income taxes ................... (4,507,287) 44,353 (4,590,824) 161,103
------------ ------------ ------------ ------------
Net income (loss) ............................... $ 6,260,286 $ (1,258,371) $ 7,085,279 $ (6,200,052)
============ ============ ============ ============
Basic net income (loss) per share ...................... $ 0.13 $ (0.03) $ 0.14 $ (0.13)
============ ============ ============ ============
Diluted net income (loss) per share .................... $ 0.12 $ (0.03) $ 0.13 $ (0.13)
============ ============ ============ ============
Weighted average basic shares
outstanding ......................................... 49,686,430 47,990,558 49,223,884 48,014,662
============ ============ ============ ============
Weighted average diluted shares
outstanding ......................................... 53,482,577 47,990,558 52,744,600 48,014,662
============ ============ ============ ============
See accompanying notes to unaudited condensed consolidated financial statements.
4
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Nine Months Ended
September 30,
2007 2006
------------ ------------
Cash flows from operating activities:
Net income (loss) ........................................................... $ 7,085,279 $ (6,200,052)
Adjustments to reconcile net income (loss) to net cash provided by
operating activities:
Depreciation and amortization ........................................... 2,831,657 2,723,834
Share-based payment compensation ........................................ 6,109,955 7,079,960
Non-cash professional services .......................................... 125,640 3,935
(Gain) loss on marketable securities .................................. (24,928) 28,855
Loss on foreign currency exchange ..................................... -- 41,670
Gain on sale of cost method investment ................................ -- (3,112)
Gain on sale of warrants .............................................. -- (38,378)
Tax benefit from stock option exercises ............................... -- (40,958)
Provision for returns and doubtful accounts ........................... 3,459,924 3,000,241
Deferred income tax benefit ........................................... (4,849,277) --
Changes in operating assets and liabilities:
Accounts receivable ..................................................... 2,565,015 (3,247,212)
Prepaid expenses and other current assets ............................... (368,093) (138,270)
Other assets ............................................................ (89,787) 341,424
Accounts payable ........................................................ (622,272) (29,396)
Accrued expenses ........................................................ (666,982) (64,303)
Deferred revenue ........................................................ 2,486,577 2,357,503
------------ ------------
Net cash provided by operating activities ............................. 18,042,708 5,815,741
------------ ------------
Cash flows from investing activities:
Sale of marketable securities ............................................... 66,846,390 51,109,599
Purchase of marketable securities ........................................... (71,228,841) (59,758,208)
Sale of cost method investment .............................................. -- 96,755
Purchase of cost method investment .......................................... (20,000) (198,764)
Sale of warrants ............................................................ -- 673,378
Purchase of warrants ........................................................ -- (635,000)
Purchase of property and equipment .......................................... (3,920,197) (2,562,621)
Purchase of software licenses ............................................... (185,000) (173,431)
Purchase of intangible assets ............................................... (191,188) (216,333)
Security deposits ........................................................... -- (2,062)
------------ ------------
Net cash used in investing activities ..................................... (8,698,836) (11,666,687)
------------ ------------
Cash flows from financing activities:
Proceeds from exercise of stock options ..................................... 8,265,041 1,730,437
Payments made to acquire treasury stock ..................................... (3,273,660) (2,147,234)
Tax benefit from stock option exercises ..................................... -- 40,958
------------ ------------
Net cash provided by (used in) financing activities ....................... 4,991,381 (375,839)
------------ ------------
Effect of exchange rate changes on cash and cash equivalents ................... 39,818 (5,600)
------------ ------------
Net increase (decrease) in cash and cash equivalents ........................... 14,375,071 (6,232,385)
Cash and cash equivalents, beginning of period ................................. 15,605,329 18,796,973
------------ ------------
Cash and cash equivalents, end of period ....................................... $ 29,980,400 $ 12,564,588
============ ============
Cash paid for income taxes ..................................................... $ 254,769 $ 37,946
============ ============
The Company did not pay any interest for the nine months ended September 30, 2007 and 2006.
See accompanying notes to unaudited condensed consolidated financial statements.
5
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(a) THE COMPANY AND NATURE OF OPERATIONS
FalconStor Software, Inc., a Delaware Corporation (the "Company"),
develops, manufactures and sells network storage 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 September 30, 2007, and the results of its operations for the
three and nine months ended September 30, 2007 and 2006. 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 a maturity of
three months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$17.6 million and $11.0 million at September 30, 2007 and December 31, 2006,
respectively. Marketable securities at September 30, 2007 and December 31, 2006
amounted to $29.9 million and $25.4 million, respectively, and consisted of
corporate bonds and government securities, which are classified as
available-for-sale, and accordingly, unrealized gains and losses on marketable
securities are reflected as a component of accumulated other comprehensive loss
in stockholders' equity.
(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
6
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 September 30, 2007, the Company had one customer
that accounted for 28% of revenues, and one customer that accounted for 16% of
the accounts receivable balance at September 30, 2007. For the three months
ended September 30, 2006, the Company had one customer that accounted for 27% of
revenues.
(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 $970,307 and $766,078 for the three months
ended September 30, 2007 and 2006, respectively. Depreciation expense was
$2,628,490 and $2,270,335 for the nine months ended September 30, 2007 and 2006,
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 FASB Statement of Financial Accounting
Standards ("SFAS") 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 $58,195 and $44,666 for
the three months ended September 30, 2007 and 2006, respectively. Amortization
expense was $166,955 and $135,314 for the nine months ended September 30, 2007
and 2006, respectively. The gross carrying amount and accumulated amortization
of other intangible assets as of September 30, 2007 and December 31, 2006 are as
follows:
7
September 30, December 31,
2007 2006
------------ ------------
Patents:
Gross carrying amount $ 1,214,281 $ 1,023,093
Accumulated amortization (782,732) (615,777)
----------- -----------
Net carrying amount $ 431,549 $ 407,316
=========== ===========
(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 $284,887 and $183,578, net of accumulated
amortization of $5,092,545 and $5,008,853 is included in other assets as of
September 30, 2007 and December 31, 2006, respectively. Amortization expense was
$33,869 and $81,334 for the three months ended September 30, 2007 and 2006,
respectively and $83,691 and $334,389 for the nine months ended September 30,
2007 and 2006, 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 consolidated statements of operations.
On January 1, 2007, the Company adopted Financial Accounting Standards
Board ("FASB") Interpretation No. 48, ACCOUNTING FOR UNCERTAINTY IN INCOME
TAXES, ("FIN 48"). FIN 48 is an interpretation of FASB Statement 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. The
adoption of FIN 48 did not result in any adjustment to the recognized benefits
from the Company's uncertain tax positions. See footnote No. (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.
8
(l) SHARE-BASED PAYMENTS
Effective January 1, 2006, the Company adopted 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) for awards expected to vest. The Company estimates the fair value of
share-based payments using the Black-Scholes option-pricing model. 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 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 require 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 September 30, 2007 and December 31, 2006, 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 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 and nine months ended September
30, 2006, all common stock equivalents were excluded from diluted net loss per
share for the periods. As of September 30, 2007 potentially dilutive vested and
unvested common stock equivalents included 9,901,651 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 September 30, 2007 Three Months Ended September 30, 2006
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- --------- ----------- ------------- ---------
Basic EPS (loss) $ 6,260,286 49,686,430 $ 0.13 $(1,258,371) 47,990,558 $ (0.03)
======== ========
Effect of dilutive securities:
Stock Options 3,796,147 --
----------- ---------- -------- ----------- ---------- --------
Diluted EPS (loss) $ 6,260,286 53,482,577 $ 0.12 $(1,258,371) 47,990,558 $ (0.03)
=========== ========== ======== =========== ========== ========
9
Nine Months Ended September 30, 2007 Nine Months Ended September 30, 2006
Net Income Shares Per Share Net Income Shares Per Share
(Numerator) (Denominator) Amount (Numerator) (Denominator) Amount
----------- ------------- --------- ----------- ------------- ---------
Basic EPS (loss) $ 7,085,279 49,223,884 $ 0.14 $(6,200,052) 48,014,662 $ (0.13)
======== ========
Effect of dilutive securities:
Stock Options 3,520,716 --
----------- ---------- -------- ----------- ---------- --------
Diluted EPS (loss) $ 7,085,279 52,744,600 $ 0.13 $(6,200,052) 48,014,662 $ (0.13)
=========== ========== ======== =========== ========== ========
(p) COMPREHENSIVE INCOME (LOSS)
The Company's comprehensive income (loss) is as follows:
Three Months Ended September 30, Nine Months Ended September 30,
2007 2006 2007 2006
----------- ----------- ----------- -----------
Net Income (loss) $ 6,260,286 $(1,258,371) $ 7,085,279 $(6,200,052)
----------- ----------- ----------- -----------
Other comprehensive income (loss):
Foreign currency translation
adjustments 121,980 (81,997) (2,899) 22,504
Unrealized gains on investments 73,488 44,092 92,665 25,212
Other comprehensive loss (23,325) -- (20,756) --
----------- ----------- ----------- -----------
Other comprehensive income (loss) 172,143 (37,905) 69,010 47,716
----------- ----------- ----------- -----------
Comprehensive income (loss) $ 6,432,429 $(1,296,276) $ 7,154,289 $(6,152,336)
=========== =========== =========== ===========
(q) NEW ACCOUNTING PRONOUNCEMENTS
In February 2007, the FASB issued SFAS No. 159, THE FAIR VALUE OPTION FOR
FINANCIAL ASSETS AND FINANCIAL LIABILITIES - INCLUDING AN AMENDMENT OF FASB
STATEMENT NO. 115. SFAS No. 159 permits entities to choose to measure eligible
items at fair value at specified election dates and to report unrealized gains
and losses on items for which the fair value option has been elected in earnings
at each subsequent reporting date. SFAS No. 159 is effective for fiscal years
beginning after November 15, 2007. The Company is currently evaluating the
impact of the provisions of SFAS No. 159 on its consolidated financial
statements.
In September 2006, the FASB issued SFAS No. 157, FAIR VALUE Measurements,
to clarify the definition of fair value, establish a framework for measuring
fair value and expand the disclosures on fair value measurements. SFAS No. 157
defines fair value as the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at
the measurement date (an exit price). SFAS No. 157 also stipulates that, as a
market-based measurement, fair value should be determined based on the
assumptions that market participants would use in pricing the asset or
liability, and establishes a fair value hierarchy that distinguishes between (a)
market participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and (b) the
reporting entity's own assumptions about market participant assumptions
developed based on the best information available in the circumstances
(unobservable inputs). SFAS No. 157 becomes effective for the Company in its
fiscal year beginning January 1, 2008. The Company is currently evaluating the
impact of the provisions of SFAS No. 157 on its consolidated financial
statements.
10
(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.
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. 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. 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 "Calculation Date"), 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. 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 September 30, 2007,
1,914,256 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's stockholders approved the FalconStor
Software, Inc. 2007 Outside Directors Equity Compensation Plan (the "2007
Plan"). 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.
11
The following table summarizes stock option activity during the nine months
ended September 30, 2007:
Weighted
Weighted Average
Average Remaining Aggregate
Number of Exercise Contractual Intrinsic
Options Price Life (Years) Value
---------- --------- ------------ -----------
Outstanding at December 31, 2006 10,835,975 $ 5.62
Granted 64,000 $ 8.75
Exercised (998,353) $ 4.13
Canceled / Forfeited / Expired (97,467) $ 6.95
--------- ---------
Outstanding at March 31, 2007 9,804,155 $ 5.77 6.45 $45,595,769
--------- --------- ----------- -----------
Granted 330,000 $ 11.07
Exercised (396,918) $ 6.16
Canceled / Forfeited / Expired (132,149) $ 7.19
--------- ---------
Outstanding at June 30, 2007 9,605,088 $ 5.91 6.30 $44,607,190
--------- --------- ----------- -----------
Granted 452,500 $ 10.04
Exercised (430,521) $ 3.93
Canceled / Forfeited / Expired (197,916) $ 8.29
Options outstanding at September 30, 2007 9,429,151 $ 6.16 6.26 $55,536,438
========= ========= =========== ===========
Options exercisable at September 30, 2007 6,776,898 $ 5.35 5.33 $45,419,200
--------- --------- ----------- -----------
Stock option exercises are fulfilled with new shares of common stock. The
total cash received from stock option exercises for the three months ended
September 30, 2007 and 2006 was $1,690,427 and $630,165, respectively. The total
cash received from stock option exercises for the nine months ended September
30, 2007 and 2006 was $8,265,041 and $1,730,437, respectively. The total
intrinsic value of stock options exercised during the three months ended
September 30, 2007 and 2006 was $3,635,614 and $347,090, respectively. The total
intrinsic value of stock options exercised during the nine months ended
September 30, 2007 and 2006 was $11,876,434 and $1,970,327, respectively.
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:
12
Three Months Ended Three Months Ended
September 30, September 30,
2007 2006
---------- ----------
Cost of maintenance, software services and other revenue $283,860 $361,263
Software development costs 792,000 1,100,510
Selling and marketing 776,840 758,718
General and administrative 254,789 202,782
---------- ----------
$2,107,489 $2,423,273
========== ==========
Nine Months Ended Nine Months Ended
September 30, September 30,
2007 2006
---------- ----------
Cost of maintenance, software services and other revenue $793,162 $1,060,812
Software development costs 2,471,950 3,233,609
Selling and marketing 2,210,367 2,104,256
General and administrative 760,116 685,218
------- -------
$6,235,595 $7,083,895
========== ==========
In 2006, pursuant to the 2006 Plan, the Company granted options to purchase
25,000 shares of common stock to certain non-employee consultants (the "2006
consultants") in exchange for professional services. The fair value of the
option award was determined using the Black-Scholes method as of each balance
sheet date, and is being expensed over its respective period of services to be
provided. The 2006 consultants cumulative expense totaled $83,467 through
September 30, 2007, of which $27,559 and $65,553 were recognized during the
three and nine months ended September 30, 2007, respectively. During the three
and nine months ended September 30, 2006, the expensed recognized totaled
$3,935.
During the three months ended June 30, 2007, pursuant to the 2006 Plan, the
Company granted options to purchase 6,000 shares of common stock to certain
non-employee consultants (the "2007 consultants") in exchange for professional
services. During the three months ended September 30, 2007, pursuant to the 2006
Plan, the Company granted 11,000 shares of restricted stock to certain
non-employee consultants (the "2007 consultants") in exchange for professional
services. The fair value of the option award was determined using the
Black-Scholes method as of each balance sheet date, and is being expensed over
its respective period of service to be provided. The fair value of the
restricted stock award is being expensed at the fair value per share at date of
grant of $12.05 per share over its respective period of service to be provided.
The 2007 consultants cumulative expense totaled $60,087 through September 30,
2007, of which $57,625 and $60,087 were recognized during the three and nine
months ended September 30, 2007, respectively.
13
The following table summarizes restricted stock activity during the nine months
ended September 30, 2007:
Number of
Awards
--------
Non-Vested at December 31, 2006 225,000
Granted --
Vested --
Canceled / Forfeited --
--------
Non-Vested at March 31, 2007 225,000
--------
Granted 26,500
Vested --
Canceled / Forfeited --
--------
Non-Vested at June 30, 2007 251,500
--------
Granted 287,000
Vested (66,000)
Canceled / Forfeited --
--------
Non-Vested at September 30, 2007 472,500
========
In 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. In the second quarter of 2007, the Company granted 26,500
shares of restricted stock to certain Outside Directors and employees at a fair
value per share at date of grant of $11.10 per share. During the third quarter
of 2007, the Company granted 276,000 shares of restricted stock (excluding the
aforementioned 11,000 shares of restricted stock awarded to non-employee
consultants) to certain officers and employees at a fair value per share at date
of grant of $9.87 per share. As of September 30, 2007, an aggregate of 538,500
shares of restricted stock have been issued, of which, 66,000 have vested and
none have been forfeited. As of September 30, 2006, there were 200,000 shares of
restricted stock issued, of which, none had vested or been forfeited.
Options granted during both fiscal 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, a vesting period of three years and an estimated forfeiture rate
of 23%. The Company estimates expected volatility based primarily on historical
daily price changes of the Company's stock and other factors. The risk-free
interest rate is based on the United States treasury yield curve in effect at
the time of grant.
As of September 30, 2007 and 2006, there was approximately $12,352,206 and
$11,411,767, respectively, of total unrecognized compensation cost related to
the Company's unvested options and restricted shares granted under the Company's
stock plans, before cancellations and unrecognized compensation costs relating
to consultants awards.
In September 2003, the Company entered into a worldwide OEM agreement with
a major Technology Company (the "Technology Company"), and granted to the
Technology Company warrants to purchase 750,000 shares of the Company's common
stock with an exercise price of $6.18 per share. A portion of the warrants were
to vest annually subject to the Technology Company's achievement of pre-defined
and mutually agreed upon sales objectives over a three-year period beginning
June 1, 2004. As of June 1, 2007, none of the warrants had vested and the rights
to exercise the warrants have expired.
14
(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 and nine
months ended September 30, 2007 and 2006, and the location of long-lived assets
as of September 30, 2007 and December 31, 2006, are summarized as follows:
Three Months Ended September 30, Nine Months Ended September 30,
2007 2006 2007 2006
---- ---- ---- ----
United States $12,145,453 $ 8,263,470 $36,215,636 $23,162,241
Asia 3,074,235 2,157,413 7,134,321 5,657,281
Other international 3,307,849 2,545,228 9,268,802 6,023,136
----------- ----------- ----------- -----------
Total revenues $18,527,537 $12,966,111 $52,618,759 $34,842,658
=========== =========== =========== ===========
September 30, December 31,
2007 2006
----------- -----------
Long-lived assets:
United States $11,511,444 $10,113,633
Asia 1,678,264 1,498,534
Other international 361,865 279,695
----------- -----------
Total long-lived assets $13,551,573 $11,891,862
=========== ===========
(4) STOCK REPURCHASE PROGRAM
On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to 2,000,000 shares of the Company's outstanding
common stock. The repurchases may be made from time to time in open market
transactions in such amounts as determined at the discretion of the Company's
management. The terms of the stock repurchases will be determined by management
based on market conditions. During the three and nine months ended September 30,
2007, the Company purchased 318,900 shares of its common stock in open market
purchases for a total cost of $3,273,661. During the three and nine months ended
September 30, 2006, the Company purchased 65,600 and 315,600 shares of its
common stock in open market purchases for a total cost of $475,661 and
$2,147,234, respectively. As of September 30, 2007, the Company had repurchased
a total of 1,184,100 shares for $9,053,824.
15
(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 2007 through 2015. The following is a schedule
of future minimum lease payments for all operating leases as of September 30,
2007:
2007 ................................................ $ 542,343
2008 ................................................ 1,944,668
2009 ................................................ 1,870,649
2010 ................................................ 1,476,302
2011 ................................................ 1,374,974
Thereafter .......................................... 734,144
----------
$7,943,080
==========
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 September 27, 2007, the Company entered into a joint venture agreement
(the "Agreement") with the Institute of Computing Technology of the Chinese
Academy of Science and other independent third parties to establish a newly
formed company, Tianjin Zhongke Blue Whale Information Technologies Co., Ltd.
("Blue Whale"), that will research, produce and market enterprise-class storage,
archiving and compliance solutions domestically and internationally. Among other
requirements and responsibilities as outlined in the Agreement, the Company's
required capital contribution to Blue Whale will be approximately $850,000 or
10% of the total capital contribution. Such contribution is expected to be made
during the fourth quarter of 2007. The Company's investment in Blue Whale will
be accounted for under the cost method, in accordance with the Accounting
Principles Board Opinion No. 18, THE EQUITY METHOD OF ACCOUNTING FOR INVESTMENTS
IN COMMON STOCK.
(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. For the
three and nine months ended September 30, 2007, the provision includes a
discrete benefit of $4.5 million related to a partial reversal of the Company's
deferred income tax valuation allowance. Prior to the three months ended
September 30, 2007, the Company maintained a full valuation allowance against
its net deferred tax assets due to the Company's prior history of pre-tax losses
and uncertainty about the timing of and ability to generate taxable income in
the future and its assessment that the realization of the net deferred tax
assets did not meet the "more likely than not" criterion under SFAS No. 109. As
of September 30, 2007, based upon the Company's generation of cumulative taxable
income over the past three years and its expectations for taxable income in
future years, the Company determined that a portion of its deferred tax assets
were "more likely than not" realizable. Accordingly, as of September 30, 2007,
the Company partially reversed its deferred income tax valuation allowance. The
remaining deferred tax asset valuation allowance as of September 30, 2007 of
approximately $8.2 million relates to: (i) assets expected to be realized
through pre-tax income expected during the fourth quarter of 2007 of $2.4
million, (ii) capital loss carry forwards of $0.9 million, (iii) net operating
losses related to excess share-based compensation expense deductions of $3.6
million, (iv) foreign tax credits of $0.2 million, and (v) foreign net operating
losses of $1.1 million. The realization of the tax benefits from net operating
losses related to excess share-based compensation expense deductions will be
recorded as credits to additional-paid-in-capital when such benefits are
realized through reductions of income taxes payable.
For the three and nine months ended September 30, 2006, the Company's
provision for income taxes consisted of U.S. and foreign taxes in amounts
necessary to align its year-to-date tax provision with the effective tax rate
the Company expected to achieve for the full year. The provision included U.S.
federal alternative minimum taxes and state minimum taxes that were expected to
be incurred primarily as a result of the limitations on the Company's 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 and foreign
taxes.
16
As of December 31, 2006, the Company reported deferred tax assets and a
corresponding full valuation allowance, of $50.2 million. As of January 1, 2007,
the Company revised the recorded amounts of certain deferred tax assets (and
corresponding valuation allowance) to be $14.3 million, primarily due to the
limitations on the Company's ability to utilize certain deferred tax assets
relating to net operating losses acquired in the Company's 2001 reverse merger
transaction.
The Company's total unrecognized tax benefits as of September 30, 2007
were approximately $4.4 million, which, if recognized, would affect the
Company's effective tax rate. Total accrued interest and penalties through
September 30, 2007 were $35,468. During the three months ended September 30,
2007, there were no additional unrecognized tax benefits identified. The Company
does not expect that its unrecognized tax benefits will significantly change
within the next 12 months. The Company files a consolidated U.S. Income tax
return and tax returns in various state and local jurisdictions. The returns
filed in various state and local jurisdictions may be filed on a separate
company, combined or consolidated basis depending on the legal requirements of
the taxing jurisdiction. The Company's subsidiaries also file tax returns in
various foreign jurisdictions. In addition to the U.S., the Company's major
taxing jurisdictions include China, Japan, Taiwan, Korea, United Kingdom,
Germany and France. There have not been any past tax examinations nor are there
any current tax examinations in progress. Accordingly, as of January 1, 2007,
the Company remains subject to examination in all tax jurisdictions for all
periods since inception.
17
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 third quarter of 2007 reflected continued solid growth.
Both our revenues and our gross margins increased from the same period in the
prior year.
Revenues for the third quarter of 2007 increased 43% to $18.5 million
compared with revenues of $13.0 million in the third quarter of 2006. Revenues
from both our OEM partners and our resellers increased from the same period last
year.
Our revenues grew 4% from the previous quarter and were higher than our
revenues in every quarter in the Company's history, other than the fourth
quarter of 2006. We believe this shows continued momentum for our products and
services.
EMC Corporation accounted for 28% of our revenues in the quarter. We
anticipate that EMC will account for 20% or more of our revenues for the full
year 2007. Although Sun Microsystems was not a 10% customer in the third
quarter, our revenues from Sun Microsystems have continued to grow on a year
over year basis in both absolute and percentage terms.
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 $6.3 million for the three months ended September 30,
2007. This positive result includes $2.1 million of share-based compensation
expense related to SFAS No. 123(R) and an income tax benefit of $4.5 million.
Cash flows from operations in the third quarter of 2007 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 September 30, 2007 increased 47%, compared with the
balance at September 30, 2006. 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 $2.8 million, or 19%, compared with the
third quarter of 2006. Operating expenses include $2.1 million in share-based
compensation expense for the third quarter of 2007, and $2.4 million in
share-based compensation expense for the third quarter of 2006. 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 84% for the third quarter of 2007 from 82%
for the third quarter of 2006. Share-based compensation expense within cost of
maintenance, software services and other revenue was 2% of revenue in the third
quarter of 2007 and 3% in the third quarter of 2006.
18
At September 30, 2007 we had 402 employees compared with 344 at September
30, 2006. 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 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 SEPTEMBER 30, 2007 COMPARED
WITH THE THREE MONTHS ENDED SEPTEMBER 30, 2006.
Revenues for the three months ended September 30, 2007 increased 43% to
$18.5 million compared with $13.0 million for the three months ended September
30, 2006. Our operating expenses increased 19% from $14.7 million for the three
months ended September 30, 2006 to $17.5 million for the three months ended
September 30, 2007. Included in our operating expenses for the three months
ended September 30, 2007 and 2006 was $2.1 million and $2.4 million,
respectively, of share-based compensation expense in accordance with SFAS No.
123(R). Net income for the three months ended September 30, 2007 was $6.3
million compared with a net loss of $1.3 million for the three months ended
September 30, 2006. Included in our net income for the three months ended
September 30, 2007 was an income tax benefit of $4.5 million associated with the
reversal of certain deferred tax asset valuation allowances as a result of our
continuing positive operating results and financial projections. Included in our
net loss for the three months ended September 30, 2006, was an income tax
provision of $44,000. The growth in revenues was due to significant increases in
our software license, maintenance revenues and software services and other
revenues. Revenue contribution from our OEM partners increased in both absolute
dollars and as a percentage of our total revenue for the quarter ended September
30, 2007 as compared with the same period in 2006. Revenue from resellers and
distributors also increased in absolute dollars for the three months ended
September 30, 2007 as compared with the same period in 2006. Expenses increased
in all aspects of our business to support our continued growth. As of September
30, 2007, in support of our continued growth and expansion both domestically and
internationally, we had 402 employees worldwide as compared with 344 employees
as of September 30, 2006. 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 lines.
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue is comprised of software licenses sold through our
OEMs, value-added resellers and distributors to end-users and, to a lesser
extent, directly to end-users. These revenues are recognized when, among other
requirements, we receive a customer purchase order or a royalty report
summarizing software licenses sold and the software and permanent key codes are
delivered to the customer. We sometimes receive nonrefundable royalty advances
and engineering fees from some of our OEM partners. These arrangements are
evidenced by a signed customer contract, and the revenue is recognized when the
software product master is delivered and accepted, and the engineering services,
if any, have been performed.
Software license revenue increased 41% from $8.7 million for the three
months ended September 30, 2006 to $12.2 million for the three months ended
September 30, 2007. Software license revenue represented 66% of our total
revenues for the three months ended September 30, 2007 and 67% for the three
months ended September 30, 2006. As a result of broader market acceptance of our
software applications and increased demand for our products from our expanding
base of customers, we continue to experience increased sales from both our OEM
and reseller partners, which were the primary drivers of the increase in
software license revenue. Software license revenue increased from both our OEM
partners and from our resellers. Revenue from our OEM partners increased as a
19
percentage of total revenue. We expect our software license revenue to continue
to grow in future periods.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenues are comprised of software
maintenance and technical support, professional services primarily related to
the implementation of our software, engineering services, and sales of computer
hardware. Revenue derived from maintenance and technical support contracts is
deferred and recognized ratably over the contractual maintenance term.
Professional services revenue is recognized in the period that the related
services are performed. Revenue from engineering services is primarily related
to customizing software product masters for some of our OEM partners. Revenue
from engineering services is recognized in the period the services are
completed. During the three months ended September 30, 2007 and 2006, 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). Maintenance, software services and other revenue increased 48% to
$6.3 million for the three months ended September 30, 2007 from $4.3 million for
the three months ended September 30, 2006.
The major factor behind the increase in maintenance, software services and
other revenue was an increase in the number of maintenance and technical support
contracts we sold. As we are in business longer, and as we license more software
to new customers and renew agreements with our installed customer base, we
expect these revenues will continue to increase. The majority of our new
customers purchase maintenance and support and most customers renew their
maintenance and support after their initial contracts expire. Maintenance
revenue increased $1.5 million from $3.3 million for the three months ended
September 30, 2006 to $4.8 million for the three months ended September 30,
2007. Software services and other revenue increased approximately $0.5 million
from $1.0 million for the three months ended September 30, 2006 to $1.5 million
for the three months ended September 30, 2007. We expect maintenance, software
services and other revenues to continue to increase.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
To remain successful in the network storage solutions market, we must
continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations we have purchased or licensed software for resale since 2001. As
of September 30, 2007, we had $0.3 million of purchased software licenses, net
of accumulated amortization of $5.1 million that are being amortized over three
years. For the three months ended September 30, 2007, we recorded $34,000 of
amortization related to these purchased software licenses. As of September 30,
2006, we had $0.2 million of purchased software licenses, net of accumulated
amortization of $5.0 million and recorded approximately $81,000 of amortization
for the three months ended September 30, 2006 related to these purchased
software licenses. We will continue to evaluate third party software licenses
and may make additional purchases from time to time, which would impact the
amount we record as amortization expense in future periods.
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, 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 September 30, 2007 increased by 24% to
$2.9 million compared with $2.2 million for the three months ended September 30,
2006. The increase in cost of maintenance, software services and other revenue
was primarily due to (i) the increased cost of hardware resulting from the
higher number of transactions in which we bundled this purchased hardware with
our software and sold the bundled solution during the three months ended
September 30, 2007 as compared with the same period in 2006, and (ii) the
increase in personnel and related costs for the three months ended September 30,
2007 as compared with the same period in 2006. As a result of our increased
sales from maintenance and support contracts, we hired additional employees to
20
provide technical support. Consequently, 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 for the three months ended September 30, 2007 was $15.6
million or 84% of revenue compared with $10.6 million or 82% of revenue for the
three months ended September 30, 2006. The increase in our gross margin was
primarily due to our continued revenue growth and focus on our cost structure.
Share-based compensation expense included in the cost of maintenance, software
services and other revenue decreased in absolute dollars to $0.3 million from
$0.4 million for the three months ended September 30, 2007 and 2006,
respectively. Share-based compensation expense was equal to 2% and 3% of revenue
for the three months ended September 30, 2007 and 2006, 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 11% to $5.6 million for the three months ended
September 30, 2007 from $5.1 million for the three months ended September 30,
2006. 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 as well
as to develop new innovative features and options during the three months ended
September 30, 2007 as compared with the same period in 2006. Share-based
compensation expense included in software development costs decreased in
absolute dollars to $0.8 million from $1.1 million for the three months ended
September 30, 2007 and 2006, respectively. Share-based compensation expense
included in software development costs was equal to 4% and 8% of revenue for the
three months ended September 30, 2007 and 2006, 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 20% to $7.0
million for the three months ended September 30, 2007 from $5.8 million for the
three months ended September 30, 2006. The increase in selling and marketing
expenses was primarily due to (i) higher commissions paid as a result of our 43%
increase in revenue, and (ii) higher salary and personnel related costs as a
result of increased sales and marketing headcount during the three months ended
September 30, 2007 as compared with the same period in 2006. Share-based
compensation expense included in selling and marketing remained consistent in
absolute dollars at $0.8 million for both the three months ended September 30,
2007 and 2006. Share-based compensation expense included in selling and
marketing expenses was equal to 4% and 6% of revenue for the three months ended
September 30, 2007 and 2006, 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 increased 31% to $1.9
million for the three months ended September 30, 2007 from $1.5 million for the
three months ended September 30, 2006. The increase in general and
administrative expenses was primarily due to (i) higher professional fees as a
result various tax related activities which commenced for fiscal year 2007, and
(ii) increased compensation and personnel related costs as a result of increased
headcount to support our general and administrative needs for the three months
ended September 30, 2007 as compared with the same period in 2006. Share-based
compensation expense included in general and administrative increased in
absolute dollars to $0.3 million from $0.2 million for the three months ended
September 30, 2007 and 2006, respectively. Share-based compensation expense
included in general and administrative expenses was equal to 1% and 2% of
21
revenue for the three months ended September 30, 2007 and 2006, respectively.
Additionally, as our revenue and number of employees increase, our legal and
professional fees and other general corporate overhead costs have increased and
are likely to continue to increase.
INTEREST AND OTHER INCOME
We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
increased to $0.7 million for the three months ended September 30, 2007 compared
with $0.5 million for the three months ended September 30, 2006. This increase
is primarily due to increased cash balance as of September 30, 2007 as compared
with the same period in 2006, as well as increased interest rates, which
resulted in a higher average cash balance invested at greater interest rates.
INCOME TAXES
For the three months ended September 30, 2007, our provision for income
taxes consisted 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. Our income tax benefit was $4.5 million for the three months
ended September 30, 2007 as compared to an income tax expense of $44,000 for the
same period in 2006. The income tax benefit during the three months ended
September 30, 2007, includes a discrete benefit of $4.5 million related to a
partial reversal of our deferred income tax valuation allowance. Prior to the
three months ended September 30, 2007, we had recorded a valuation allowance to
fully reserve our net deferred tax assets based on our assessment that the
realization of the net deferred tax assets did not meet the "more likely than
not" criterion under SFAS No. 109. As of September 30, 2007, we determined that
based upon a number of factors, including our cumulative taxable income over the
past three fiscal years and expected profitability in future years, that certain
of our deferred tax assets were "more likely than not" realizable through future
earnings. Accordingly, as of September 30, 2007 we reversed a portion of our
deferred income tax valuation allowance.
For the three months ended September 30, 2006, our provision for income
taxes consisted of U.S. and foreign taxes in amounts necessary to align our
year-to-date tax provision with the effective tax rate that we expected to
achieve for the full year. The provision included U.S. federal alternative
minimum taxes and state minimum taxes that were expected to be incurred
primarily as a result of the 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 and foreign taxes.
RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED
WITH NINE MONTHS ENDED SEPTEMBER 30, 2006.
Revenues for the nine months ended September 30, 2007 increased 51% to
$52.6 million compared with $34.8 million for the nine months ended September
30, 2006. Our operating expenses increased 23% from $42.1 million for the nine
months ended September 30, 2006 to $51.9 million for the nine months ended
September 30, 2007. Included in our operating expenses for the nine months ended
September 30, 2007 and 2006 was $6.2 million and $7.1 million, respectively, of
share-based compensation expense related to stock-based compensation in
accordance with SFAS No. 123(R). Net income for the nine months ended September
30, 2007 was $7.1 million compared with a net loss of $6.2 million for the nine
months ended September 30, 2006. Included in our net income for the nine months
ended September 30, 2007 was a net income tax benefit of $4.6 million that
primarily consisted of a reversal of certain deferred tax asset valuation
allowances as a result of our continuing positive operating results and
financial projections. Included in our net loss for the nine months ended
September 30, 2006, was an income tax provision of $ 0.2 million. The growth in
revenues was due to significant increases in our software license, maintenance
revenues and software services and other revenues. Revenue contribution from our
OEM partners increased in absolute dollars and as a percentage of our total
revenue for the nine months ended September 30, 2007 as compared with the same
period in 2006. Revenue from resellers and distributors also increased in
absolute dollars for the nine months ended September 30, 2007 as compared with
the same period in 2006. Expenses increased in all aspects of our business to
support our continued growth. In support of our continued growth and expansion
both domestically and internationally, we increased our worldwide headcount to
402 employees as of September 30, 2007 as compared with 344 employees as of
September 30, 2006. 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 lines.
22
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue increased 50% from $23.1 million for the nine
months ended September 30, 2006 to $34.6 million for the nine months ended
September 30, 2007. Software license revenue represented 66% of our total
revenues for the nine months ended September 30, 2007 and 2006. As a result of
broader market acceptance of our software applications and increased demand for
our products from our expanding base of customers, we continue to experience
increased sales from both our OEM and reseller partners, which were the primary
drivers of the increase in software license revenue. Software license revenue
increased from both our OEM partners and from our resellers. Revenue from our
OEM partners increased as a percentage of total revenue. We expect our software
license revenue to continue to grow in future periods.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenue increased 53% to $18.0
million for the nine months ended September 30, 2007 from $11.8 million for the
nine months ended September 30, 2006. The major factor behind the increase in
maintenance, software services and other revenue was an increase in the number
of maintenance, technical support contracts and bundled hardware solutions we
sold. As we are in business longer, and as we license more software to new
customers and renew agreements with our installed customer base, we expect these
revenues will continue to increase. The majority of our new customers purchase
maintenance and support and most customers renew their maintenance and support
after their initial contracts expire. Maintenance revenue increased $4.8 million
from $8.8 million for the nine months ended September 30, 2006 to $13.6 million
for the nine months ended September 30, 2007. During the nine months ended
September 30, 2007 and 2006, we had transactions in which we purchased hardware
and bundled this hardware with our software and sold this bundled solution to
our customer base. Software services and other revenue increased approximately
$1.4 million from $2.9 million for the nine months ended September 30, 2006 to
$4.3 million for the nine months ended September 30, 2007. This increase is
primarily due to the increase in hardware we bundled with our software. We
expect maintenance, software services and other revenues to continue to
increase.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
As of September 30, 2007, we had $0.3 million of purchased software
licenses, net of accumulated amortization of $5.1 million that are being
amortized over three years. For the nine months ended September 30, 2007, we
recorded $0.1 million of amortization related to these purchased software
licenses. As of September 30, 2006, we had $0.2 million of purchased software
licenses, net of accumulated amortization of $5.0 million and recorded
approximately $0.3 million of amortization for the nine months ended September
30, 2006 related to these purchased software licenses.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues for the nine
months ended September 30, 2007 increased by 18% to $8.1 million compared with
$6.9 million for the nine months ended September 30, 2006. The increase in cost
of maintenance, software services and other revenue was primarily due to (i) the
increased cost of hardware as a result of the increased number of transactions
in which we bundled purchased hardware with our software and sold the bundled
solution, and (ii) the increase in personnel and related costs for the nine
months ended September 30, 2007 as compared with the same period in 2006. As a
result of our increased sales from maintenance and support contracts, we hired
additional employees to provide technical support. Consequently, 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 for the nine months ended September 30, 2007 was $44.5 million
or 85% of revenue compared with $28.0 million or 80% of revenue for the nine
months ended September 30, 2006. The increase in our gross margin was primarily
due to our continued revenue growth and focus on our cost structure. Share-based
compensation expense included in the cost of maintenance, software services and
other revenue decreased in absolute dollars to $0.8 million from $1.1 million
for the nine months ended September 30, 2007 and 2006, respectively. Share-based
compensation expense was equal to 2% and 3% of revenue for the nine months ended
September 30, 2007 and 2006, respectively.
23
SOFTWARE DEVELOPMENT COSTS
Software development costs increased 13% to $16.5 million for the nine
months ended September 30, 2007 from $14.6 million for the nine months ended
September 30, 2006. The major contributing factors to the increase in software
development costs were higher salary costs and personnel related costs as a
result of increased headcount to enhance and test our core network storage
software product, as well as to develop new innovative features and options
during the nine months ended September 30, 2007 as compared with the same period
in 2006. Share-based compensation expense included in software development costs
decreased in absolute dollars to $2.5 million from $3.2 million for the nine
months ended September 30, 2007 and 2006, respectively. Share-based compensation
expense included in software development costs was equal to 5% and 9% of revenue
for the nine months ended September 30, 2007 and 2006, respectively. We intend
to continue recruiting and hiring product development personnel to support our
software development process.
SELLING AND MARKETING
Selling and marketing expenses increased 31% to $21.4 million for the nine
months ended September 30, 2007 from $16.4 million for the nine months ended
September 30, 2006. The increase in selling and marketing expenses was primarily
due to (i) higher commissions paid as a result of our 51% increase in revenue
and (ii) higher salary and personnel related costs as a result of increased
sales and marketing headcount during the nine months ended September 30, 2007 as
compared with the same period in 2006. Share-based compensation expense included
in selling and marketing increased in absolute dollars to $2.2 million from $2.1
million for the nine months ended September 30, 2007 and 2006, respectively.
Share-based compensation expense included in selling and marketing expenses was
equal to 4% and 6% of revenue for the nine months ended September 30, 2007 and
2006, 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 increased 38% to $5.8 million for the
nine months ended September 30, 2007 from $4.2 million for the nine months ended
September 30, 2006. The increase in general and administrative expenses was
primarily due to (i) higher professional fees as a result of the implementation
of various tax related planning activities which commenced for fiscal year 2007,
and (ii) increased compensation and personnel related costs as a result of
increased headcount to support our general and administrative needs for the nine
months ended September 30, 2007 as compared with the same period in 2006.
Share-based compensation expense included in general and administrative
increased in absolute dollars to $0.8 million from $0.7 million for the nine
months ended September 30, 2007 and 2006, respectively. Share-based compensation
expense included in general and administrative expenses was equal to 1% and 2%
of revenue for the nine months ended September 30, 2007 and 2006, respectively.
Additionally, as our revenue and number of employees increase, our legal and
professional fees and other general corporate overhead costs have increased and
are likely to continue to increase.
INTEREST AND OTHER INCOME
We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
increased to $1.8 million for the nine months ended September 30, 2007 compared
with $1.2 million for the nine months ended September 30, 2006. This increase is
primarily due to increased cash balance during the nine months ended September
30, 2007 as compared with the same period in 2006, as well as increased interest
rates, which resulted in a higher average cash balance invested at greater
interest rates.
INCOME TAXES
For the nine months ended September 30, 2007, 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 nine months ended September 30, 2007 the provision
includes a discrete benefit of $4.5 million related to a partial reversal of our
deferred income tax valuation allowance. Prior to the three months ended
September 30, 2007, we maintained a full valuation allowance against our net
deferred tax assets due to our prior history of pre-tax losses and uncertainty
about the timing of and ability to generate taxable income in the future and its
assessment that the realization of the net deferred tax assets did not meet the
"more likely than not" criterion under SFAS No. 109. As of September 30, 2007,
24
based upon our generation of cumulative taxable income over the past three years
and our expectations for taxable income in future years, we determined that a
portion of our deferred tax assets were "more likely than not" realizable.
Accordingly, as of September 30, 2007, we partially reversed our deferred income
tax valuation allowance.
For the nine months ended September 30, 2006, our provision for income
taxes consisted of U.S. and foreign taxes in amounts necessary to align our
year-to-date tax provision with the effective tax rate that we expected to
achieve for the full year. The provision included U.S. federal alternative
minimum taxes and state minimum taxes that were expected to be incurred
primarily as a result of the 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 and foreign taxes.
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 are
doubtful of collection. In making the determination of the appropriate allowance
for uncollectible accounts and returns, we consider historical return rates,
specific past due accounts, analysis of our accounts receivable aging, customer
payment terms, historical collections, write-offs and returns, changes in
customer demand and relationships, concentrations of credit risk and customer
credit worthiness. Historically, we have experienced a somewhat consistent level
of write-offs and returns as a percentage of revenue due to our customer
relationships, contract provisions and credit assessments. Changes in the
product return rates, credit worthiness of customers, general economic
conditions and other factors may impact the level of future write-offs, revenues
and our general and administrative expenses.
DEFERRED INCOME TAXES. Consistent with the provisions of SFAS No. 109, we
regularly estimate our ability to recover deferred income taxes, and report such
assets at the amount that is determined to be more-likely-than-not recoverable.
This evaluation considers several factors, including an estimate of the
likelihood of generating sufficient taxable income in future periods over which
temporary differences reverse, the expected reversal of deferred tax
liabilities, past and projected taxable income, and available tax planning
strategies. During the three months ended September 30, 2007, based on positive
evidence from our earnings trends, we recognized a significant portion of our
deferred tax assets through a reduction in our deferred tax asset valuation
allowance. As of September 30, 2007, our deferred tax asset, net of a valuation
allowance was $4.8 million. Realization of these deferred tax assets is
dependent primarily upon our ability to generate sufficient future taxable
income. Among other things, if our operating results differ significantly from
our projections, our assessment about the realizability of our deferred tax
assets may change, resulting in a change to the net amount of our deferred tax
assets.
25
ACCOUNTING FOR SHARE-BASED PAYMENTS. As discussed further in "Notes to
Unaudited Condensed Consolidated Financial Statements - Note (2) SHARE-BASED
PAYMENTS," we adopted SFAS No. 123(R) on January 1, 2006 using the modified
prospective method.
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. Additionally, we estimate forfeiture rates based
primarily upon historical experiences, adjusted when appropriate for known
events or expected trends. If other assumptions or estimates had been used, the
share-based compensation expense that was recorded for the three and nine months
ended September 30, 2007 and 2006 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 February 2007, the FASB issued Statement of Financial Accounting
Standard ("SFAS") No. 159, THE FAIR VALUE OPTION FOR FINANCIAL ASSETS AND
FINANCIAL LIABILITIES - INCLUDING AN AMENDMENT OF FASB STATEMENT NO. 115. SFAS
No. 159 permits entities to choose to measure eligible items at fair value at
specified election dates and report unrealized gains and losses on items for
which the fair value option has been elected in earnings at each subsequent
reporting date. SFAS No. 159 is effective for fiscal years beginning after
November 15, 2007. We are currently evaluating the impact of the provisions of
SFAS No. 159 on our consolidated financial statements.
In September 2006, the FASB issued SFAS No. 157, FAIR VALUE Measurements,
to clarify the definition of fair value, establish a framework for measuring
fair value and expand the disclosures on fair value measurements. SFAS No. 157
defines fair value as the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at
the measurement date (an exit price). SFAS No. 157 also stipulates that, as a
market-based measurement, fair value should be determined based on the
assumptions that market participants would use in pricing the asset or
liability, and establishes a fair value hierarchy that distinguishes between (a)
market participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and (b) the
reporting entity's own assumptions about market participant assumptions
developed based on the best information available in the circumstances
(unobservable inputs). SFAS No. 157 becomes effective for the Company in its
fiscal year beginning January 1, 2008. We are currently evaluating the impact of
the provisions of SFAS No. 157 on our consolidated financial statements.
LIQUIDITY AND CAPITAL RESOURCES
Our total cash and cash equivalents and marketable securities balance as of
September 30, 2007 increased by $18.9 million compared with December 31, 2006.
Our cash and cash equivalents totaled $30.0 million and marketable securities
totaled $29.9 million at September 30, 2007. As of December 31, 2006, we had
approximately $15.6 million in cash and cash equivalents and $25.4 million in
marketable securities.
We continued to invest in our infrastructure to support our long-term
growth during the nine months ended September 30, 2007. We made investments in
property and equipment and we increased the number of employees during the first
nine months of 2007. As we continue to grow, we will continue to make
investments in property and equipment and will need to continue to increase our
headcount.
In October 2001, our Board of Directors authorized the repurchase of up to
2,000,000 shares of our outstanding common stock. During the three and nine
months ended September 30, 2007, we purchased 318,900 shares of our common stock
in open market purchases at an aggregate purchase price of $3.3 million. During
the three and nine months ended September 30, 2006, we purchased 65,600 and
315,600 shares at an aggregate purchase price of $0.5 million and $2.1 million,
respectively. As of September 30, 2007, we had purchased an aggregate of
1,184,100 shares of our common stock through various open market purchases at an
aggregate purchase price of $9.1 million or $7.65 per share. As of September 30,
26
2007, we have the ability to purchase an additional 815,900 shares of our common
stock based upon our judgment and market conditions.
Net cash provided by operating activities increased $12.2 million or 210%
to $18.0 million from $5.8 million for the nine months ended September 30, 2007
and 2006, respectively. The net cash provided by operating activities of $18.0
million was primarily derived from (i) our net income; (ii) adjustments for the
impact of non-cash charges, particularly relating to stock-based compensation,
depreciation and amortization and provision for doubtful accounts; and (iii)
adjustments for net changes in operating assets and liabilities, particularly
decreases in our accounts receivable and increase in our deferred revenues due
to increased revenues. These amounts were primarily offset by the adjustment for
the impact of our non-cash benefit relating to our income tax benefit. During
the nine months ended September 30, 2006, net cash provided from operating
activities was primarily derived from net loss adjusted for the impact of
non-cash charges and increases in both accounts receivables and deferred
revenues.
Net cash used in investing activities was $8.7 million and $11.7 million
for the nine months ended September 30, 2007 and 2006, respectively. Net cash
used in investing activities in each period was primarily due to (i) net
purchases of marketable securities; and (ii) purchases of property and
equipment, software licenses and intangible assets. 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 provided by (used in) financing activities was $5.0 million and
($0.4) million for the nine months ended September 30, 2007 and 2006,
respectively. Net cash provided by financing activities of $5.0 million was
derived from proceeds received from the exercise of stock options, offset by the
payments we made to acquire treasury stock. During the nine months ended
September 30, 2006, net cash used in financing activities was comprised of
payments made to acquire treasury stock, offset primarily by proceeds received
from the exercise of stock options.
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 2007 through 2015. Refer to
Note 5 of the notes 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 September 30, 2007 and 2006, 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 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 September 30, 2007, 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 September 30, 2007, the
effect on our other comprehensive income would be insignificant. We do not use
derivative financial instruments to limit our foreign currency risk exposure.
27
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 September 30, 2007, that have
materially affected, or are reasonably likely to materially affect, the
Company's internal controls over financial reporting.
Disclosure controls and procedures are procedures that are designed to ensure
that information required to be disclosed by us in the reports that we file or
submit under the Securities Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported, within the time periods specified in the
Securities and Exchange Commission's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by us in the reports that we
file under the Exchange Act is accumulated and communicated to our management,
including our principal executive officer and principal financial officer, as
appropriate to allow timely decisions regarding required disclosure.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
We are subject to various legal proceedings and claims, asserted or
unasserted, which arise in the ordinary course of business. While the outcome of
any such matters cannot be predicted with certainty, we believe that such
matters will not have a material adverse effect on our financial condition or
operating results.
ITEM 1A. RISK FACTORS
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, 2006 (the "2006 10-K"). The information below sets
forth additional risk factors or risk factors that have had material changes
since the 2006 10-K, and should be read in conjunction with Item 1A of the 2006
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 September 30, 2007,
one customer accounted for 28% of our revenues. While we believe that we will
continue to receive revenue 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.
In addition, as of September 30, 2007, one customer accounted for a total
of 16% of our outstanding receivables. While we currently have no reason to
doubt the collectibility of this receivable, a business failure or
reorganization by this customer 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.
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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 three quarters of 2007,
and we anticipate that our quarterly results for the remainder of 2007 will show
the effects of seasonality as well.
Our future performance will depend on many factors, including:
o the timing of securing software license contracts and the delivery of
software and related revenue recognition;
o the seasonality of information technology, including network storage products
spending;
o the average unit selling price of our products;
o existing or new competitors introducing better products at competitive prices
before we do;
o our ability to manage successfully the complex and difficult process of
qualifying our products with our customers;
o new products or enhancements from us or our competitors;
o import or export restrictions on our proprietary technology; and
o personnel changes.
Many of our expenses are relatively fixed and difficult to reduce or
modify. As a result, the fixed nature of our expenses will magnify any adverse
effect of a decrease in revenue on our operating results.
OUR STOCK PRICE MAY BE VOLATILE
The market price of our common stock has been volatile in the past and may
be volatile in the future. For example, during the trailing twelve months ended
September 30, 2007, the closing market price of our common stock as quoted on
the NASDAQ Global Market fluctuated between $7.25 and $12.50 per share and
subsequent to September 30, 2007, the closing market price has been as high as
$15.30 per share. The market price of our common stock may be significantly
affected by the following factors:
o actual or anticipated fluctuations in our operating results;
o variance in actual results as compared to financial estimates;
o changes in market valuations of other technology companies, particularly
those in the network storage software market;
o announcements by us or our competitors of significant technical innovations,
acquisitions, strategic partnerships, joint ventures or capital commitments;
o loss or addition of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
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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 September 30, 2007, we had an aggregate of 9,429,151 outstanding
options to purchase our common stock and 472,500 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 $5.87 per
share. We also had 2,532,836 shares of our common stock reserved for issuance
under our stock plans with respect to options (or restricted stock) that have
not been granted (see Note 2 to the 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.
THE MARKET FOR VIRTUAL STORAGE APPLIANCES FOR VMWARE VIRTUAL INFRASTRUCTURE IS
NEW AND UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF IT DOES NOT DEVELOP AS WE
EXPECT.
The adoption of virtual storage appliances for VMware Virtual
Infrastructures is important to our future success. The market for these virtual
storage appliances is still unproven, making it difficult to predict the
potential size or future growth rate. We are uncertain whether a viable market
for our products will develop or be sustainable. If this market fails to
develop, or develops more slowly than we expect, our business, financial
condition and results of operations would be adversely affected.
THE ABILITY TO CORRECTLY PREDICT OUR FUTURE EFFECTIVE TAX RATES COULD IMPACT OUR
ABILITY TO ACCURATELY FORECAST FUTURE EARNINGS.
We are subject to income taxes in both the United States and the various
foreign jurisdictions in which we operate. Judgment is required in determining
our provision for income taxes and there are many transactions and calculations
where the tax determination may be uncertain. Our future effective tax rates
could be affected by changes in our (i) earnings or losses; (ii) changes in the
valuation of our deferred tax assets; (iii) changes in tax laws; and (iv) other
factors. Our ability to correctly predict our future effective tax rates based
upon these possible changes could significantly impact our forecasted earnings.
UNKNOWN FACTORS
Additional risks and uncertainties of which we are unaware or which
currently we deem immaterial also may become important factors that affect us.
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ITEM 2. UNREGISTERED SALES OF EQUITIES PROCEEDS AND USE OF PROCEEDS
Shares of common stock repurchased during the quarter ended September 30, 2007:
Total Number of Maximum Number
Shares Purchased of Shares That May
Total Number of Average Price as Part of Publicly Yet be Purchased
Shares Purchased Paid Per Share Announced Plan Under the Plan
August 2007 233,000 $ 10.13 233,000 901,800
September 2007 85,900 $ 10.62 85,900 815,900
Total 318,900 $ 10.27 318,900 815,900
The Company's Board of Directors approved a program, effective October 24, 2001,
to repurchase up to two million shares of the Company's common stock. As of
September 30, 2007, the Company had repurchased 1,184,100 shares. The program
has no expiration date.
ITEM 6. EXHIBITS
31.1 Certification of the Chief Executive Officer
31.2 Certification of the Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss.
1350)
32.2 Certification of Chief Financial Officer pursuant to Section
906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. ss.
1350)
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FALCONSTOR SOFTWARE, INC.
/s/ James Weber
---------------------------------
James Weber
Chief Financial Officer, Vice President and Treasurer
(principal financial and accounting officer)
November 7, 2007
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