FALCONSTOR SOFTWARE INC - Quarter Report: 2008 June (Form 10-Q)
UNITED STATES
SECURITIES AND EXCHANGE
COMMISSION
Washington, D.C.
20549
FORM 10-Q
(Mark
One)
xQUARTERLY REPORT PURSUANT TO SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the
quarterly period ended June 30,
2008
or
¨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
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FALCONSTOR
SOFTWARE, INC.
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|
(Exact
name of registrant as specified in its
charter)
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DELAWARE
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77-0216135
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(State
or other jurisdiction of incorporation or organization)
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(I.R.S.
Employer Identification No.)
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2
Huntington Quadrangle Melville, New York
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11747
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(Address
of principal executive offices)
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(Zip
Code)
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631-777-5188
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(Registrant’s
telephone number, including area code)
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(Former
name, former address and former fiscal year, if changed since last
report)
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Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes x No
¨
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company. See the definitions of “large accelerated filer,” “accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
(Check one):
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Large
accelerated filer ¨
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Accelerated
filer x
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Non-accelerated
filer ¨ (Do
not check if a smaller reporting company)
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Smaller
reporting company ¨
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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 July 31, 2008 was
51,696,955 and 47,794,255.
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM
10-Q
INDEX
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| Item 5 | Other Information |
37
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37
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PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial
Statements
FALCONSTOR
SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
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June
30, 2008
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December 31,
2007
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|||||||
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Assets
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(unaudited)
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|||||||
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Current
assets:
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||||||||
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Cash
and cash equivalents
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$ | 30,888,015 | $ | 32,219,349 | ||||
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Marketable
securities
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21,448,352 | 30,684,206 | ||||||
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Accounts receivable,
net of allowances of $8,469,362 and $8,780,880,
respectively
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22,306,050 | 26,141,636 | ||||||
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Prepaid
expenses and other current assets
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2,130,986 | 1,625,417 | ||||||
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Deferred
tax assets, net
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3,807,325 | 3,807,325 | ||||||
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Total
current assets
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80,580,728 | 94,477,933 | ||||||
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Property
and equipment, net of accumulated depreciation of $16,096,140 and
$13,861,313, respectively
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8,444,858 | 7,945,258 | ||||||
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Long-term
marketable securities
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1,389,146 | - | ||||||
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Deferred
tax assets, net
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6,037,536 | 5,969,778 | ||||||
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Other
assets, net
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3,114,340 | 2,831,878 | ||||||
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Goodwill
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3,512,796 | 3,512,796 | ||||||
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Other
intangible assets, net
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471,764 | 443,909 | ||||||
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Total
assets
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$ | 103,551,168 | $ | 115,181,552 | ||||
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Liabilities
and Stockholders' Equity
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||||||||
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Current
liabilities:
|
||||||||
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Accounts
payable
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$ | 1,207,355 | $ | 1,779,720 | ||||
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Accrued
expenses
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5,763,985 | 6,711,231 | ||||||
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Deferred
revenue, net
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15,421,883 | 14,142,145 | ||||||
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Total
current liabilities
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22,393,223 | 22,633,096 | ||||||
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Other
long-term liabilities
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249,542 | 251,094 | ||||||
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Deferred
revenue, net
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5,728,987 | 4,818,985 | ||||||
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Total
liabilities
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28,371,752 | 27,703,175 | ||||||
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Commitments
and contingencies
|
||||||||
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Stockholders'
equity:
|
||||||||
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Preferred
stock - $.001 par value, 2,000,000 shares authorized
|
- | - | ||||||
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Common
stock - $.001 par value, 100,000,000 shares authorized, 51,696,955 and
51,340,268 shares issued, respectively and 47,952,855 and 50,156,168
shares outstanding, respectively
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51,697 | 51,340 | ||||||
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Additional
paid-in capital
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129,204,439 | 122,294,782 | ||||||
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Accumulated
deficit
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(23,165,033 | ) | (25,292,001 | ) | ||||
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Common
stock held in treasury, at cost (3,744,100 and 1,184,100
shares,
respectively)
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(30,402,233 | ) | (9,053,824 | ) | ||||
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Accumulated
other comprehensive loss, net
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(509,454 | ) | (521,920 | ) | ||||
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Total
stockholders' equity
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75,179,416 | 87,478,377 | ||||||
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Total
liabilities and stockholders' equity
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$ | 103,551,168 | $ | 115,181,552 | ||||
See
accompanying notes to unaudited condensed consolidated financial
statements
FALCONSTOR SOFTWARE, INC. AND
SUBSIDIARIES
CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
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Three
Months Ended June 30,
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Six
Months Ended June 30,
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|||||||||||||||
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2008
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2007
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2008
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2007
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|||||||||||||
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Revenues:
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||||||||||||||||
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Software
license revenue
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$ | 15,018,364 | $ | 11,980,480 | $ | 30,337,283 | $ | 22,417,985 | ||||||||
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Maintenance
revenue
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5,521,881 | 4,535,780 | 10,636,128 | 8,869,319 | ||||||||||||
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Software
services and other revenue
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1,686,701 | 1,234,284 | 3,060,195 | 2,803,918 | ||||||||||||
| 22,226,946 | 17,750,544 | 44,033,606 | 34,091,222 | |||||||||||||
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Operating
expenses:
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||||||||||||||||
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Cost
of maintenance, software services and other revenue
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3,585,404 | 2,486,336 | 6,899,892 | 5,256,160 | ||||||||||||
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Software
development costs
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6,234,097 | 5,341,481 | 12,112,882 | 10,857,666 | ||||||||||||
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Selling
and marketing
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9,554,539 | 7,500,433 | 18,513,290 | 14,469,184 | ||||||||||||
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General
and administrative
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2,085,530 | 1,922,723 | 3,986,751 | 3,860,503 | ||||||||||||
| 21,459,570 | 17,250,973 | 41,512,815 | 34,443,513 | |||||||||||||
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Operating
income
(loss)
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767,376 | 499,571 | 2,520,791 | (352,291 | ) | |||||||||||
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Interest
and other income, net
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423,443 | 594,376 | 982,704 | 1,093,747 | ||||||||||||
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Income
before income taxes
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1,190,819 | 1,093,947 | 3,503,495 | 741,456 | ||||||||||||
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Provision
(benefit) for income taxes
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397,608 | (285,621 | ) | 1,376,527 | (83,537 | ) | ||||||||||
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Net
income
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$ | 793,211 | $ | 1,379,568 | $ | 2,126,968 | $ | 824,993 | ||||||||
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Basic
net income per share
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$ | 0.02 | $ | 0.03 | $ | 0.04 | $ | 0.02 | ||||||||
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Diluted
net income per
share
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$ | 0.02 | $ | 0.03 | $ | 0.04 | $ | 0.02 | ||||||||
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Weighted
average basic shares
outstanding
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48,066,451 | 49,378,812 | 48,828,229 | 48,988,778 | ||||||||||||
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Weighted
average diluted shares
outstanding
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50,249,824 | 53,007,181 | 50,970,034 | 50,802,963 | ||||||||||||
See
accompanying notes to unaudited condensed consolidated financial
statements.
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
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Six
Months Ended
June
30,
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||||||||
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2008
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2007
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|||||||
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Cash
flows from operating activities:
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||||||||
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Net
income
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$ | 2,126,968 | $ | 824,993 | ||||
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Adjustments
to reconcile net income to net cash provided by operating
activities:
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||||||||
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Depreciation
and amortization
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2,344,777 | 1,813,510 | ||||||
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Share-based
payment compensation
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4,774,985 | 4,087,651 | ||||||
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Non-cash
professional services expenses
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198,362 | 40,455 | ||||||
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Realized
gain on marketable securities
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(23,423 | ) | - | |||||
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Tax
benefit from stock option exercises
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(1,341,280 | ) | - | |||||
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Provision
for returns and doubtful accounts
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1,574,016 | 2,382,410 | ||||||
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Deferred
income taxes
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1,376,527 | - | ||||||
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Changes
in operating assets and liabilities:
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||||||||
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Accounts
receivable
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2,276,488 | 1,247,952 | ||||||
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Prepaid
expenses and other current assets
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(492,845 | ) | (798,235 | ) | ||||
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Other
assets
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(225,869 | ) | (16,823 | ) | ||||
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Accounts
payable
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(563,672 | ) | 246,209 | |||||
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Accrued
expenses
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(1,156,996 | ) | (1,278,200 | ) | ||||
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Deferred
revenue
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2,170,146 | 3,025,123 | ||||||
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Net
cash provided by operating activities
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13,038,184 | 11,575,045 | ||||||
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Cash
flows from investing activities:
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||||||||
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Sale
of marketable securities
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64,809,716 | 41,995,142 | ||||||
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Purchase
of marketable securities
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(57,323,528 | ) | (47,053,285 | ) | ||||
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Purchase
of property and equipment
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(2,565,521 | ) | (2,797,221 | ) | ||||
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Purchase
of software licenses
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- | (15,000 | ) | |||||
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Security
deposits
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(17,000 | ) | - | |||||
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Purchase
of intangible assets
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(160,328 | ) | (81,614 | ) | ||||
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Net
cash provided by (used in) investing activities
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4,743,339 | (7,951,978 | ) | |||||
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Cash
flows from financing activities:
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||||||||
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Payments
to acquire treasury stock
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(21,348,409 | ) | - | |||||
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Proceeds
from exercise of stock options
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779,720 | 6,574,614 | ||||||
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Tax
benefit from stock option exercises
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1,341,280 | - | ||||||
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Net
cash (used in) provided by financing activities
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(19,227,409 | ) | 6,574,614 | |||||
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Effect
of exchange rate changes on cash and cash equivalents
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114,552 | (77,046 | ) | |||||
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Net
(decrease) increase in cash and cash equivalents
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(1,331,334 | ) | 10,120,635 | |||||
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Cash
and cash equivalents, beginning of period
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32,219,349 | 16,105,009 | ||||||
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Cash
and cash equivalents, end of period
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$ | 30,888,015 | $ | 26,225,644 | ||||
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Cash
paid for income taxes
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$ | 1,303,253 | $ | 264,213 | ||||
The
Company did not pay any interest for the six months ended June 30, 2008 and
2007.
See
accompanying notes to unaudited condensed consolidated financial
statements
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
Notes
to Unaudited Condensed Consolidated Financial Statements
(1)
Summary of Significant Accounting Policies
(a)
The Company and Nature of Operations
FalconStor
Software, Inc., a Delaware Corporation (the "Company"), develops, manufactures
and sells network storage software solutions and provides the related
maintenance, implementation and engineering services.
(b)
Principles of Consolidation
The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
(c)
Use of Estimates
The
preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. The
Company’s more significant estimates include those related to revenue
recognition, accounts receivable allowances, deferred income taxes and
accounting for share-based compensation expense. Actual results could differ
from those estimates.
(d)
Unaudited Interim Financial Information
The
accompanying unaudited interim condensed consolidated financial statements have
been prepared, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission (“SEC”). Certain information and note
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States
of America have been condensed or omitted pursuant to such rules and
regulations relating to interim financial statements.
In the
opinion of management, the accompanying unaudited interim condensed consolidated
financial statements reflect all adjustments, consisting only of normal
recurring adjustments, necessary to present fairly the financial position of the
Company at June 30, 2008, and the results of its operations for the three and
six months ended June 30, 2008 and 2007. The results of operations of any
interim period are not necessarily indicative of the results of operations to be
expected for the full fiscal year.
(e)
Cash Equivalents and Marketable Securities
The
Company considers all highly liquid investments with maturities of three months
or less when purchased to be cash equivalents. As of June 30, 2008 and December
31, 2007, the Company’s cash equivalents consisted of money market funds and
commercial paper, and are recorded at fair value. At June 30, 2008, the fair
value of the Company’s cash equivalents, as defined under Financial Accounting
Standards Board “FASB” Statement of Financial Accounting Standards “SFAS”,
No. 157, Fair Value
Measurements, amounted to approximately
$18.8 million. As of June 30, 2008 and December 31, 2007, the Company’s
marketable securities consisted of corporate bonds, certificate of deposits,
auction rate securities and government securities, and are recorded at fair
value. As of June 30, 2008, the fair value of the Company’s current marketable
securities as defined under SFAS No. 157 was approximately $21.4 million. In
addition, at June 30, 2008, the Company had an additional $1.4 million of
long-term marketable securities that required a higher level of judgment to
determine the fair value, as defined under SFAS No. 157. As of December 31,
2007, the Company’s cash equivalents amounted to approximately $21.3 million,
and marketable securities amounted to approximately $30.7 million. All of the
Company’s marketable securities are classified as available-for-sale,
and accordingly, unrealized gains and losses on marketable securities, net
of tax are reflected as a component of accumulated other comprehensive loss in
stockholders’ equity.
As of
June 30, 2008, the Company had $1.5 million (at par value) of auction rate
securities included within its portfolio of marketable securities. These auction
rate notes are classified as available-for-sale, and accordingly, any unrealized
gains and losses are reflected as a component of accumulated other comprehensive
loss in stockholders’ equity, net of tax. During the six months ended June 30,
2008, the Company recorded approximately $113,000 of unrealized losses on these
auction rate notes. The Company determined the decline in market value below
cost to be temporary based upon the Company’s ability to retain the investment
over a period of time, which would be sufficient to allow for any recovery in
market value. Accordingly, based upon the Company’s intent and ability to retain
these investments over a period of time believed to be sufficient to recover the
value, it has classified the auction rate securities as long-term marketable
securities on its consolidated balance sheet as of June 30, 2008. See Note (7)
Fair Value
Measurements for
additional information.
(f)
Revenue Recognition
The
Company recognizes revenue from software licenses in accordance with Statement
of Position (“SOP”) 97-2, Software Revenue Recognition,
as amended by SOP 98-4 and SOP 98-9, and related interpretations to determine
the recognition of revenue. Accordingly, revenue for software licenses is
recognized when persuasive evidence of an arrangement exists, the fee is fixed
and determinable and the software is delivered and collection of the resulting
receivable is deemed probable. Software delivered to a customer on a
trial basis is not recognized as revenue until a permanent key code is delivered
to the customer. Reseller customers typically send the Company a purchase order
only when they have an end user identified. When a customer licenses software
together with the purchase of maintenance, the Company allocates a portion of
the fee to maintenance for its fair value. Software maintenance fees are
deferred and recognized as revenue ratably over the term of the contract. The
long-term portion of deferred revenue relates to maintenance contracts with
terms in excess of one year. The cost of providing technical support is included
in cost of maintenance, software service and other revenues. The Company
provides an allowance for software product returns as a reduction of revenue,
based upon historical experience and known or expected trends.
Revenues
associated with software implementation and software engineering services are
recognized as the services are completed. Costs of providing these
services are included in cost of maintenance, software services and other
revenue.
The
Company has entered into various distribution, licensing and joint promotion
agreements with OEMs and distributors, whereby the Company has provided to the
reseller a non-exclusive software license to install the Company’s software on
certain hardware or to resell the Company’s software in exchange for payments
based on the products distributed by the OEM or distributor. Nonrefundable
advances and engineering fees received by the Company from an OEM are recorded
as deferred revenue and recognized as revenue when related software engineering
services, if any, are complete and the software product master is delivered and
accepted.
The
Company has transactions in which it purchases hardware and
bundles this hardware with the Company’s software and sells the bundled
solution to its customer. Since the software is not essential for the
functionality of the equipment included in the Company’s bundled solutions, and
both the hardware and software have stand alone value to the customer, a portion
of the contractual fees is recognized as revenue when the software or hardware
is delivered based on the relative fair value(s) of the delivered
element(s).
For the
three months ended June 30, 2008, the Company had two customers that together
accounted for 33% of revenues, and one customer that accounted for 10% of the
accounts receivable balance at June 30, 2008. For the three months ended
June 30, 2007, the Company had two customers that together accounted for 40% of
revenues, and two customers that together accounted for 25% of the accounts
receivable balance at June 30, 2007.
(g)
Property and Equipment
Property
and equipment are recorded at cost. Depreciation is recognized using the
straight-line method over the estimated useful lives of the assets (3 to 7
years). Depreciation expense was $1,102,073 and $853,819 for the three months
ended June 30, 2008 and 2007, respectively. Depreciation expense was $2,134,566
and $1,654,928 for the six months ended June 30, 2008 and 2007,
respectively. Leasehold improvements are amortized on a straight-line basis over
the term of the respective leases or over their estimated useful lives,
whichever is shorter.
(h)
Goodwill and Other Intangible Assets
Goodwill
represents the excess of the purchase price over the estimated fair value of net
tangible and identifiable intangible assets acquired in business combinations.
Consistent with SFAS No. 142, Goodwill and Other Intangible
Assets, the Company has not amortized goodwill related to its
acquisitions, but instead tests the balance for impairment. The Company’s annual
impairment assessment is performed as of December 31st of each
year, and an assessment is made at other times if events or changes in
circumstances indicate that it is more likely than not that the asset is
impaired. Identifiable intangible assets are amortized over a three-year period
using the straight-line method and recorded as part of general and
administrative expenses. Amortization expense was $68,304 and $54,405
for the three months ended June 30, 2008 and 2007, respectively. Amortization
expense was $132,473 and $108,760 for the six months ended June 30, 2008 and
2007, respectively. The gross carrying amount and accumulated amortization of
other intangible assets as of June 30, 2008 and December 31, 2007 are as
follows:
|
June
30,
|
December
31,
|
|||||||
|
2008
|
2007
|
|||||||
|
Patents:
|
||||||||
|
Gross
carrying amount
|
$ | 1,449,822 | $ | 1,289,494 | ||||
|
Accumulated
amortization
|
(978,058 | ) | (845,585 | ) | ||||
|
Net
carrying amount
|
$ | 471,764 | $ | 443,909 | ||||
(i)
Software Development Costs and Purchased Technology
In
accordance with the provisions of SFAS No. 86, Accounting for the Costs of Software
to be Sold, Leased or Otherwise Marketed, costs associated with
the development of new software products and enhancements to existing software
products are expensed as incurred until technological feasibility of the product
has been established. Based on the Company’s product development process,
technological feasibility is established upon completion of a working model.
Amortization of software development costs is recorded at the greater of
straight line over three years or the ratio of current revenue of the related
products to total current and anticipated future revenue of these
products.
Purchased
software technology of $168,279 and $246,017 , net of accumulated amortization
of $5,209,152 and $5,131,414 , is included in other assets as of June 30, 2008
and December 31, 2007, respectively. Amortization expense was $38,869
and $24,286 for the three months ended June 30, 2008 and 2007, respectively and
$77,738 and $49,822 for the six months ended June 30, 2008 and 2007,
respectively. Amortization of purchased software technology is recorded at the
greater of the straight line basis over the products’ estimated remaining life
or the ratio of current period revenue of the related products to total current
and anticipated future revenue of these products.
(j)
Income Taxes
Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected to
be realized or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date. In determining the period in which related tax benefits are
realized for book purposes, excess share-based compensation deductions included
in net operating losses are realized after regular net operating losses are
exhausted. The Company recognizes interest and penalties accrued related to
unrecognized tax benefits as part of income tax expense in its condensed
consolidated statements of operations.
The
Company accounts for uncertain tax positions in accordance with FASB
Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, (“FIN 48”). FIN 48 is an interpretation of SFAS No. 109, Accounting for Income Taxes,
and addresses the determination of whether tax benefits claimed or expected to
be claimed on a tax return should be recorded in the financial
statements. Under FIN 48, the Company may recognize the tax benefit
from an uncertain tax position only if it meets the “more likely than not”
threshold that the position will be sustained on examination by the taxing
authority, based on the technical merits of the position.
The tax
benefits recognized in the financial statements from such a position should be
measured based on the largest benefit that has a greater than fifty percent
likelihood of being realized upon ultimate settlement. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties on income
taxes, accounting in interim periods, and also requires increased disclosures.
To date, no adjustments have been made to the recognized benefits from the
Company’s uncertain tax positions. See Note (6) Income Taxes for additional
information.
(k)
Long-Lived Assets
The
Company reviews its long-lived assets for impairment whenever events or changes
in circumstances indicate that the carrying amount of the asset may not be
recoverable. If the sum of the expected future cash flows, undiscounted and
without interest is less than the carrying amount of the asset, an impairment
loss is recognized as the amount by which the carrying amount of the asset
exceeds its fair value.
(l)
Share-Based Payments
The
Company accounts for stock-based awards under the provisions of SFAS No. 123(R),
Share-Based Payment,
which establishes the accounting for transactions in which an entity exchanges
its equity instruments for goods or services. Under the provisions of SFAS No.
123(R), share-based compensation expense is measured at the grant date, based on
the fair value of the award, and is recognized as an expense over the requisite
employee service period (generally the vesting period), net of estimated
forfeitures. The Company estimates the fair value of share-based payments using
the Black-Scholes option-pricing model. The estimation of stock-based awards
that will ultimately vest requires judgment, and to the extent actual results or
updated estimates differ from the Company’s current estimates, such amounts will
be recorded as a cumulative adjustment in the period estimates are revised. The
Company considers many factors when estimating expected forfeitures, including
types of awards, employee class and historical experience. Stock option
exercises and restricted stock awards are expected to be fulfilled with new
shares of common stock.
The
Company accounts for stock option grants and grants of restricted shares of
common stock to non-employees in accordance with SFAS No. 123, Accounting for Stock-Based
Compensation, and Emerging Issues Task Force (“EITF”) Issue
No. 96-18, Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services, which requires that the fair
value of these instruments be recognized as an expense over the period in which
the related services are rendered.
(m)
Financial Instruments
As of
June 30, 2008 and December 31, 2007, the fair value of the Company’s financial
instruments, including cash and cash equivalents, accounts receivable, accounts
payable and accrued expenses, approximates book value due to the short maturity
of these instruments.
(n)
Foreign Currency
Assets
and liabilities of foreign operations are translated at rates of exchange at the
end of the period, while results of operations are translated at average
exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders’ equity. Realized gains and losses
from foreign currency transactions are included in the condensed consolidated
statements of operations within interest and other income, net. Such
amounts have historically not been material.
(o)
Earnings Per Share (EPS)
Basic EPS
is computed based on the weighted average number of shares of common stock
outstanding. Diluted EPS is computed based on the weighted average number of
common shares outstanding increased by dilutive common stock equivalents. For
the three months ended June 30, 2008 and 2007, potentially dilutive vested and
unvested common stock equivalents included 9,175,754 and 6,228,219,
respectively, of stock option awards, restricted stock awards and restricted
stock unit awards outstanding. For the six months ended June 30, 2008 and 2007,
potentially dilutive vested and unvested common stock equivalents included
9,217,322 and 8,042,403, respectively, of stock option awards, restricted
stock awards and restricted stock unit 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 June 30, 2008
|
Three
Months Ended June 30, 2007
|
|||||||||||||||||||||||
|
Net
Income
|
Shares
|
Per
Share
|
Net
Income
|
Shares
|
Per
Share
|
|||||||||||||||||||
|
(Numerator)
|
(Denominator)
|
Amount
|
(Numerator)
|
(Denominator)
|
Amount
|
|||||||||||||||||||
|
Basic
EPS
|
$ | 793,211 | 48,066,451 | $ | 0.02 | $ | 1,379,568 | 49,378,812 | $ | 0.03 | ||||||||||||||
|
Effect
of dilutive securities:
|
||||||||||||||||||||||||
|
Stock
options and
|
||||||||||||||||||||||||
|
restricted
stock
|
2,183,373 | 3,628,369 | ||||||||||||||||||||||
|
Diluted
EPS
|
$ | 793,211 | 50,249,824 | $ | 0.02 | $ | 1,379,568 | 53,007,181 | $ | 0.03 | ||||||||||||||
|
Six
Months Ended June 30, 2008
|
Six
Months Ended June 30, 2007
|
|||||||||||||||||||||||
|
Net
Income
|
Shares
|
Per
Share
|
Net
Income
|
Shares
|
Per
Share
|
|||||||||||||||||||
|
(Numerator)
|
(Denominator)
|
Amount
|
(Numerator)
|
(Denominator)
|
Amount
|
|||||||||||||||||||
|
Basic
EPS
|
$ | 2,126,968 | 48,828,229 | $ | 0.04 | $ | 824,993 | 48,988,778 | $ | 0.02 | ||||||||||||||
|
Effect
of dilutive securities:
|
||||||||||||||||||||||||
|
Stock
options and
|
||||||||||||||||||||||||
|
restricted
stock
|
2,141,805 | 1,814,185 | ||||||||||||||||||||||
|
Diluted
EPS
|
$ | 2,126,968 | 50,970,034 | $ | 0.04 | $ | 824,993 | 50,802,963 | $ | 0.02 | ||||||||||||||
(p)
Comprehensive Income (Loss)
Comprehensive
income includes: (i) the Company’s net income, (ii) foreign currency translation
adjustments, (iii) unrealized (gains)/losses on marketable securities, net of
tax, and (iv) minimum pension liability adjustments, net of tax, pursuant to
SFAS No. 158, Employers’
Accounting for Defined Benefit Pension and Other Postretirement Plans, an
amendment of FASB Statements No. 87, 88, 106, and 132(R).
The
Company’s comprehensive income is as follows:
|
Three
Months Ended June 30,
|
Six
Months Ended June 30,
|
|||||||||||||||
|
2008
|
2007
|
2008
|
2007
|
|||||||||||||
|
Net
income
|
$ | 793,211 | $ | 1,379,568 | $ | 2,126,968 | $ | 824,993 | ||||||||
|
Other
comprehensive income (loss):
|
||||||||||||||||
|
Foreign
currency translation
|
||||||||||||||||
|
gain
(loss) adjustments
|
(142,933 | ) | (83,667 | ) | 162,062 | (124,879 |
)
|
|||||||||
|
Unrealized
gain (loss) on
|
||||||||||||||||
|
marketable
securities, net of tax
|
(92,042 | ) | (4,719 | ) | (154,509 | ) | 19,177 | |||||||||
|
Other
comprehensive income
|
836 | 2,569 | 4,913 | 2,569 | ||||||||||||
|
Other
comprehensive income (loss)
|
(234,139 | ) | (85,817 | ) | 12,466 | (103,133 |
)
|
|||||||||
|
Comprehensive
income
|
$ | 559,072 | $ | 1,293,751 | $ | 2,139,434 | $ | 721,860 | ||||||||
(q) Investments
As of
June 30, 2008 and December 31, 2007, the Company maintained certain cost-method
investments aggregating $1,116,457, respectively, which are included in “Other
assets” in the accompanying condensed consolidated balance sheets. During the
three and six months ended June 30, 2008 and 2007, the Company did not recognize
any impairment charges related to any of its cost-method
investments.
(r)
New Accounting Pronouncements
In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations. SFAS
No. 141(R) establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any noncontrolling interest in the acquiree
and the goodwill acquired. SFAS No. 141(R) also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. SFAS No. 141(R) is effective for fiscal years beginning
after December 15, 2008. The Company is currently evaluating the potential
impact, if any, of the adoption of SFAS No. 141(R) on its consolidated financial
statements.
In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51. SFAS No. 160 establishes accounting and reporting standards
for ownership interests in subsidiaries held by parties other than the parent,
the amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS No. 160 also establishes disclosure requirements that
clearly identify and distinguish between the interests of the parent and the
interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal
years beginning after December 15, 2008. The Company is currently evaluating the
potential impact, if any, of the adoption of SFAS No. 160 on its consolidated
financial statements.
In
February 2008, the FASB issued FASB Staff Position No. FAS 157-2,
Effective Date of FASB
Statement No. 157 (“FSP 157-2”), to partially defer SFAS
No. 157, Fair Value
Measurements. FSP 157-2 defers the effective date of SFAS No. 157
for nonfinancial assets and nonfinancial liabilities, except those that are
recognized or disclosed at fair value in the financial statements on a recurring
basis (at least annually), to fiscal years, and interim periods within those
fiscal years, beginning after November 15, 2008. The Company is currently
evaluating the potential impact, if any, SFAS No. 157 will have to nonfinancial
assets and liabilities (principally goodwill and intangible assets) to the
fiscal year beginning after November 15, 2008 on its consolidated financial
statements.
In
May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles. SFAS No. 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (the GAAP
hierarchy). SFAS No. 162 will become effective sixty days following the
Securities and Exchange Commission’s approval of the Public Company Accounting
Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles. The adoption of
the provisions of SFAS No. 162 is not anticipated to materially impact the
Company’s consolidated financial statements.
(s) Reclassifications
Certain
reclassifications have been made to prior periods’ unaudited condensed
consolidated financial statement presentations to conform to the current
periods’ presentation.
(2)
Share-Based Payment Arrangements
As of May
1, 2000, the Company adopted the FalconStor Software, Inc., 2000 Stock Option
Plan (the “2000 Plan”). The 2000 Plan is administered by the Board of Directors
and, as amended, provides for the grant of options to purchase up to 14,162,296
shares of Company common stock to employees, consultants and non-employee
directors. Options may be incentive (“ISO”) or non-qualified. ISOs granted must
have exercise prices at least equal to the fair value of the common stock on the
date of grant, and have terms not greater than ten years, except those to an
employee who owns stock with greater than 10% of the voting power of all classes
of stock of the Company, in which case they must have an option price at least
110% of the fair value of the stock, and expire no later than five years from
the date of grant. Non-qualified options granted must have exercise prices not
less than eighty percent of the fair value of the common stock on the date of
grant, and have terms not greater than ten years. All options granted under the
2000 Plan must be granted before May 1, 2010. As of June 30, 2008, 91,380 shares
were available for grant under the 2000 Plan.
On May
14, 2004, the Company adopted the FalconStor Software, Inc., 2004 Outside
Directors Stock Option Plan (the “2004 Plan”). The 2004 Plan is administered by
the Board of Directors and provides for the granting of options to non-employee
directors of the Company to purchase up to 300,000 shares of Company common
stock. Exercise prices of the options must be equal to the fair market value of
the common stock on the date of grant. Options granted have terms of ten years.
All options granted under the 2004 Plan must be granted within three years of
the adoption of the 2004 Plan. As of June 30, 2008, options to purchase 250,000
shares remain outstanding from the 2004 Plan and no additional options are
available for grant under the 2004 Plan.
On May
17, 2006, the Company adopted the FalconStor Software, Inc. 2006 Incentive Stock
Plan (the “2006 Plan”). The 2006 Plan was amended on May 8, 2007 and
May 8, 2008. The 2006 Plan is administered by the Board of Directors and
provides for the grant of incentive and nonqualified stock options, shares of
restricted stock, and restricted stock units to employees, officers, consultants
and advisors of the Company. The number of shares available for grant
or issuance under the 2006 Plan, as amended, is determined as
follows: If, on July 1st of any
calendar year in which the 2006 Plan is in effect, the number of shares of stock
as to which options restricted shares and restricted stock units may be granted
is less than five percent (5%) of the number of outstanding shares of stock,
then the number of shares of stock available for issuance under the 2006 Plan is
automatically increased so that the number equals five percent (5%) of the
shares of stock outstanding. In no event shall the number of shares of stock
subject to the 2006 Plan in the aggregate exceed twenty million shares, subject
to adjustment as provided in the 2006 Plan. On July 1, 2008, the total number of
outstanding shares of the Company’s common stock totaled 47,952,855. As of June
30, 2008, 29,356 shares were available for grant under the 2006 Plan. Pursuant
to the 2006 Plan, as amended, the total shares available for issuance under the
2006 Plan thus increased by 2,368,287 shares to 2,397,643 shares available for
issuance as of July 1, 2008. 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, shares of restricted stock,
and restricted stock units granted under the 2006 Plan must be granted within
ten years of the adoption of the 2006 Plan.
On May 8,
2007, the Company adopted the FalconStor Software, Inc. 2007 Outside Directors
Equity Compensation Plan (the “2007 Plan”). The 2007 Plan was amended on May 8,
2008. The 2007 Plan is administered by the Board of Directors and provides for
the issuance of up to 300,000 shares of Company common stock upon the vesting of
options or upon the grant of shares with such restrictions as determined by the
Board of Directors to the non-employee directors of the Company. Exercise prices
of the options must be equal to the fair market value of the common stock on the
date of grant. Options granted have terms of ten years. Shares of restricted
stock have the terms and conditions set by the Board of Directors and are
forfeitable until the terms of the grant have been satisfied. As of June 30,
2008, 185,000 shares were available for grant under the 2007 Plan.
The
following table summarizes stock option activity during the six months ended
June 30, 2008:
|
Weighted
|
||||||||||||||||
|
Weighted
|
Average
|
|||||||||||||||
|
Average
|
Remaining
|
Aggregate
|
||||||||||||||
|
Number
of
|
Exercise
|
Contractual
|
Intrinsic
|
|||||||||||||
|
Options
|
Price
|
Life (Years)
|
Value
|
|||||||||||||
|
Options
Outstanding at December 31, 2007
|
9,667,374 | $ | 6.79 | |||||||||||||
|
Granted
|
808,900 | $ | 8.44 | |||||||||||||
|
Exercised
|
- | - | ||||||||||||||
|
Canceled
|
(162,875 | ) | $ | 8.56 | ||||||||||||
|
Forfeited
|
(15,200 | ) | $ | 8.43 | ||||||||||||
|
Options
Outstanding at March 31, 2008
|
10,298,199 | $ | 6.88 | 6.27 | $ | 17,346,320 | ||||||||||
|
Granted
|
478,100 | $ | 8.35 | |||||||||||||
|
Exercised
|
(312,342 | ) | $ | 2.50 | ||||||||||||
|
Canceled
|
(58,560 | ) | $ | 10.48 | ||||||||||||
|
Forfeited
|
(825 | ) | $ | 7.58 | ||||||||||||
|
Options
Outstanding at June 30, 2008
|
10,404,572 | $ | 7.06 | 6.24 | $ | 12,966,177 | ||||||||||
|
Options
Exercisable at June 30, 2008
|
7,316,247 | $ | 5.88 | 5.02 | $ | 12,750,356 | ||||||||||
Stock
option exercises are fulfilled with new shares of common stock. The
total cash received from stock option exercises for the three months ended June
30, 2008 and 2007 was $779,720 and $2,446,812, respectively. The
total cash received from stock option exercises for the six months ended June
30, 2008 and 2007 was $779,720 and $6,574,614, respectively. The total intrinsic
value of stock options exercised during the three months ended June 30, 2008 and
2007 was $1,905,425 and $1,931,508 respectively. The total intrinsic
value of stock options exercised during the six months ended June 30, 2008 and
2007 was $1,905,425 and $8,240,820, respectively.
The
Company recognized share-based compensation expense for awards issued under the
Company’s equity plans in the following line items in the condensed consolidated
statements of operations:
|
Three
Months Ended
|
Three
Months Ended
|
|||||||
|
June
30,
|
June
30,
|
|||||||
|
2008
|
2007
|
|||||||
|
Cost
of maintenance, software services and other revenue
|
$ | 393,111 | $ | 224,454 | ||||
|
Software
development costs
|
907,994 | 756,294 | ||||||
|
Selling
and marketing
|
1,037,779 | 714,610 | ||||||
|
General
and administrative
|
294,817 | 242,663 | ||||||
| $ | 2,633,701 | $ | 1,938,021 | |||||
|
Six
Months Ended
|
Six
Months Ended
|
|||||||
|
June
30,
|
June
30,
|
|||||||
|
2008
|
2007
|
|||||||
|
Cost
of maintenance, software services and other revenue
|
$ | 673,709 | $ | 509,303 | ||||
|
Software
development costs
|
1,757,591 | 1,679,950 | ||||||
|
Selling
and marketing
|
2,032,729 | 1,433,527 | ||||||
|
General
and administrative
|
509,318 | 505,326 | ||||||
| $ | 4,973,347 | $ | 4,128,106 | |||||
The
Company began issuing restricted stock in 2006. During the three months ended
June 30, 2008, the Company began issuing restricted stock units. During 2006,
the Company granted 225,000 shares of restricted stock to certain officers and
employees at an average fair value per share at date of grant of $7.06 per
share. During 2007, the Company granted a total of 373,000 shares of restricted
stock at various times to certain outside directors, officers, employees and
non-employee consultants. The fair value of the restricted stock award grants
are being expensed at either the fair value per share at date of grant (outside
director, officers and employees) or at the fair value per share as of each
reporting period (non-employee consultants) which range from $9.87 to $15.30 per
share. During the three and six months ended June 30, 2008, the Company granted
a total of 78,500 and 460,500 shares of restricted stock, respectively, at
various times to certain officers, employees and non-employee consultants.
During the three months ended June 30, 2008, the Company granted 40,750
restricted stock units to employees. The fair value per share of the restricted
stock award grants are being expensed at either the fair value per share at date
of grant (outside director, officers and employees) or at the fair value per
share as of each reporting period (non-employee consultants) which range from
$7.08 to $9.29 per share.
As of
June 30, 2008, an aggregate of 1,099,250 shares of restricted stock/restricted
stock units had been issued, of which, 119,695 had vested and 25,000 had been
cancelled. As of June 30, 2007, an aggregate of 251,500 shares of restricted
stock had been issued, of which, none had vested or been cancelled.
The
following table summarizes restricted stock activity during the six months ended
June 30, 2008:
|
Number
of Restricted
|
||||
|
Stock
Awards / Units
|
||||
|
Non-Vested
at December 31, 2007
|
497,650 | |||
|
Granted
|
382,000 | |||
|
Vested
|
(12,600 | ) | ||
|
Canceled
|
- | |||
|
Non-Vested
at March 31, 2008
|
867,050 | |||
|
Granted
|
119,250 | |||
|
Vested
|
(31,745 | ) | ||
|
Canceled
|
- | |||
|
Non-Vested
at June 30, 2008
|
954,555 | |||
Options
granted to officers, employees and directors during fiscal 2008, 2007 and 2006
have exercise prices equal to the fair market value of the stock on the date of
grant, a contractual term of ten years, and a vesting period generally of three
years. Based on each respective group’s historical vesting experience
and expected trends, the estimated forfeiture rate for officers, employees and
directors, as adjusted, was 11%, 24% and 9%, respectively. All options granted
through December 31, 2005 had exercise prices equal to the fair market value of
the stock on the date of grant, a contractual term of ten years, a vesting
period of generally three years and an estimated forfeiture rate ranging from 5%
- 15%.
Options
granted to non-employee consultants have exercise prices equal to the fair
market value of the stock on the date of grant and a contractual term of ten
years. Restricted stock awards granted to non-employee consultants have a
contractual term equal to the lapse of restriction(s) of each specific award.
Vesting periods for both options granted and restricted stock awarded to
non-employee consultants range from one month to three years depending on the
respective service requirements.
The
Company estimates expected volatility based primarily on historical daily
volatility of the Company’s stock and other factors, if applicable. The
risk-free interest rate is based on the United States treasury yield curve in
effect at the time of grant. The expected option term is the number of years
that the Company estimates that options will be outstanding prior to exercise.
The expected term of the awards issued after December 31, 2007 was determined
based upon an estimate of the expected term of “plain vanilla”
options as prescribed in SEC Staff Accounting Bulletin (“SAB”) No. 110. The
expected term of the awards issued prior to January 1, 2008, was determined
using the “simplified method” prescribed in SAB No. 107.
As of
June 30, 2008, there was approximately $17,674,375, of total unrecognized
compensation cost related to the Company’s unvested options and restricted
shares granted under the Company’s stock plans.
(3) Segment
Reporting
The
Company is organized in a single operating segment for purposes of making
operating decisions and assessing performance. Revenues from the United States
to customers in the following geographical areas for the three and six months
ended June 30, 2008 and 2007, and the location of long-lived assets as of June
30, 2008 and December 31, 2007, are summarized as follows:
|
Three
Months Ended June 30,
|
Six
Months Ended June 30,
|
|||||||||||||||
|
2008
|
2007
|
2008
|
2007
|
|||||||||||||
|
United
States
|
$ | 13,204,111 | $ | 12,325,435 | $ | 28,085,853 | $ | 24,070,183 | ||||||||
|
Asia
|
3,241,326 | 2,174,322 | 5,915,773 | 4,060,086 | ||||||||||||
|
Other
international
|
5,781,509 | 3,250,787 | 10,031,980 | 5,960,953 | ||||||||||||
|
Total
revenues
|
$ | 22,226,946 | $ | 17,750,544 | $ | 44,033,606 | $ | 34,091,222 | ||||||||
|
June
30,
|
December
31,
|
|||||||
|
2008
|
2007
|
|||||||
|
Long-lived
assets:
|
||||||||
|
United
States
|
$ | 20,420,291 | $ | 18,483,889 | ||||
|
Asia
|
1,921,265 | 1,720,098 | ||||||
|
Other
international
|
628,884 | 499,632 | ||||||
|
Total
long-lived assets
|
$ | 22,970,440 | $ | 20,703,619 | ||||
(4)
Stock Repurchase Program
In October 2001, the Company’s Board of
Directors authorized the repurchase of up to two million shares of the Company’s
outstanding common stock. On February 6, 2008, the Company’s Board of Directors
increased the authorization to repurchase the Company’s outstanding common stock
from two million shares to five million shares in the aggregate. On July 22,
2008, the Company’s Board of Directors increased the authorization to repurchase
the Company’s outstanding common stock from five million shares to eight million
shares in the aggregate and as a result, as of July 22, 2008, the Company could
purchase up to 4,255,900 shares of its 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 months ended June 30,
2008, the Company repurchased 800,000 shares of its common stock in open market
purchases for a total cost of $6,871,532. During the six months ended June 30,
2008, the Company repurchased 2,560,000 shares of its common stock in open
market purchases for a total cost of $21,348,409. There were no stock
repurchases during the three and six months ended June 30, 2007. As of June 30,
2008, the Company had repurchased a total of 3,744,100 shares of its common
stock at an aggregate purchase price of $30,402,233, and had the authorization
to repurchase an additional 1,255,900 shares of its common stock before the July
22, 2008 increased authorization.
(5)
Commitments and Contingencies
The Company has an operating lease
covering its corporate office facility that expires in February 2012. The
Company also has several operating leases related to offices in the United
States and foreign countries. The expiration dates for these leases range from
2008 through 2011. The following is a schedule of future minimum lease payments
for all operating leases as of June 30, 2008:
|
2008
|
$ | 1,233,311 | ||
|
2009
|
2,167,902 | |||
|
2010
|
1,867,745 | |||
|
2011
|
1,255,900 | |||
|
2012
|
209,230 | |||
| $ | 6,734,088 |
The
Company is subject to various legal proceedings and claims, asserted or
unasserted, which arise in the ordinary course of business. While the outcome of
any such matters cannot be predicted with certainty, such matters are not
expected to have a material adverse effect on the Company’s financial condition
or operating results.
On
December 31, 2007, the Company entered into an Employment Agreement (“Employment
Agreement”) with ReiJane Huai. Pursuant to the Employment Agreement, the Company
agreed to continue to employ Mr. Huai as President and Chief Executive Officer
of the Company effective January 1, 2008 through December 31, 2010, at annual
salaries of $310,000, $341,000 and $375,100 for calendar years 2008, 2009 and
2010, respectively. The Employment Agreement also provides for the payment of
annual bonuses to Mr. Huai, in the form of shares of the Company’s restricted
stock, based on the Company’s operating income (or “bonus targets” as defined in
the Employment Agreement) and for certain other contingent benefits set forth in
the Employment Agreement. Pursuant to the Employment Agreement, the 2008 annual
bonus of restricted stock due to Mr. Huai shall be issued within seventy-five
(75) days of the end of fiscal 2008, assuming the bonus targets are achieved.
The restricted stock is subject to a three-year vesting period commencing from
the date of grant. During the three and six months June 30, 2008, and in
accordance SFAS No. 123(R), the Company recognized approximately $116,000 and
$184,000, respectively, of share-based compensation expense, which was
classified as a liability award within the Company’s condensed consolidated
balance sheets, based upon the Company’s projected bonus award due to Mr. Huai
for 2008.
(6)
Income Taxes
The
Company’s provision for income taxes consists primarily of U.S. and foreign
taxes in amounts necessary to align the Company’s year-to-date tax provision
with the effective rate that the Company expects to achieve for the full year.
The Company’s 2008 annual effective tax rate is estimated to be approximately
39% (which includes U.S., state and local and foreign taxes) based upon the
Company’s anticipated earnings both in the U.S. and in its foreign
subsidiaries.
For the six months ended June 30, 2008,
the Company recorded a provision for income taxes of $1,376,527, which consisted
of U.S., state and local and foreign taxes and included a discrete item
associated with disqualifying dispositions of incentive stock options of
$47,621. During the six months ended June 30, 2007, the Company’s income tax
benefit was $83,537, which consisted primarily of U.S. federal alternative
minimum taxes and state minimum taxes that were expected to be incurred
primarily as a result of the then 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. In addition, the income tax benefit recorded during the six months ended
June 30, 2007 included discrete items for (i) $57,058 related to state income
taxes incurred in periods prior to 2007, (ii) $120,000 related to a change in
the Company’s estimate of amounts due in certain foreign jurisdictions for
periods prior to 2007, based upon the Company’s evaluation of information
obtained in 2007, and (iii) $341,361 of benefit associated with disqualifying
dispositions of incentive stock options.
The Company’s total unrecognized tax
benefits as of June 30, 2008 and December 31, 2007 were each approximately $4.4
million, which, if recognized, would affect the Company’s effective tax
rate. As of June 30, 2008, the Company had approximately $47,688 of
accrued interest and penalties.
(7)
Fair Value Measurements
The Company adopted the provisions of
SFAS No. 157, as amended by FSP FAS 157-1 and FSP FAS 157-2, on
January 1, 2008. Pursuant to the provisions of FSP FAS 157-2, the Company
will not apply the provisions of SFAS No. 157 until January 1, 2009
for nonfinancial assets and liabilities.
Fair Value
Hierarchy
SFAS No. 157 specifies a hierarchy
of valuation techniques based upon whether the inputs to those valuation
techniques reflect assumptions other market participants would use based upon
market data obtained from independent sources (observable inputs) or reflect the
Company’s own assumptions of market participant valuation (unobservable inputs).
In accordance with SFAS No. 157, these two types of inputs have created the
following fair value hierarchy:
|
|
·
|
Level 1 – Quoted prices
in active markets that are unadjusted and accessible at the measurement
date for identical, unrestricted assets or liabilities. The Level 1
category includes money market funds totaling $9.7 million, and government
treasuries totaling $9.5 million, which are included within cash and cash
equivalents and marketable securities in the condensed consolidated
balance sheets.
|
|
|
·
|
Level 2 – Quoted prices
for identical assets and liabilities in markets that are not active,
quoted prices for similar assets and liabilities in active markets or
financial instruments for which significant inputs are observable, either
directly or indirectly. The Level 2 category includes commercial paper
totaling $2.4 million, and government securities and corporate bonds
totaling $18.6 million, which are included within cash and cash
equivalents and marketable securities in the condensed consolidated
balance sheets.
|
|
|
·
|
Level
3 – Prices or valuations that require inputs that are both significant to
the fair value measurement and unobservable. The Level 3
category includes $1.4 million of auction rate securities, which are
included within long-term marketable securities in the condensed
consolidated balance sheets.
|
SFAS
No. 157 requires the use of observable market data if such data is
available without undue cost and effort.
Measurement
of Fair Value
The Company measures fair value as an
exit price using the procedures described below for all assets and liabilities
measured at fair value. When available, the Company uses unadjusted quoted
market prices to measure fair value and classifies such items within Level 1. If
quoted market prices are not available, fair value is based upon financial
models that use, where possible, current market-based or independently-sourced
market parameters such as interest rates and currency rates. Items valued
using financial generated models are classified according to the lowest level
input or value driver that is significant to the valuation. Thus, an item may be
classified in Level 3 even though there may be inputs that are readily
observable. If quoted market prices are not available, the valuation model used
generally depends on the specific asset or liability being valued. The
determination of fair value considers various factors including interest rate
yield curves and time value underlying the financial instruments.
As of June 30, 2008, the Company held
certain assets that are required to be measured at fair value on a recurring
basis. Included within the Company’s marketable securities portfolio are
investments in auction rate securities, which are classified as
available-for-sale securities and are reflected at fair value. However, due to
recent events in the U.S. credit markets, the auction events for these
securities held by the Company failed commencing in the first quarter of 2008,
and continued to fail through the second quarter of 2008. Therefore, the fair
values of these securities are estimated utilizing a discounted cash flow
analysis and other type of valuation model as of June 30, 2008. These
analyses consider, among other items, the collateral underlying the security,
the creditworthiness of the issuer, the timing of the expected future cash
flows, including the final maturity, and an assumption of when the next time the
security is expected to have a successful auction. These securities were also
compared, when possible, to other observable and relevant market data, which is
limited at this time.
As
of June 30, 2008, the Company recorded an unrealized loss of $113,350 to
accumulated other comprehensive loss as a result of the declines in the fair
value of auction rate securities. The auction rate securities at June 30, 2008,
totaled $1,500,000 (at par value), and are collateralized by student loan
portfolios, which are almost fully guaranteed by the United States government.
Because there is no assurance that auctions for these securities will be
successful in the near term as of June 30, 2008, $1,389,146 of the auction rates
securities are classified as long-term investments. Any future fluctuation in
the fair value related to these securities that the Company deems to be
temporary, including any recoveries of previous write-downs, would be recorded
to accumulated other comprehensive loss, net of tax. If at any time in the
future the Company determines that a valuation adjustment is
other-than-temporary, it will record a charge to earnings in the period of
determination.
Items
Measured at Fair Value on a Recurring Basis
The
following table presents the Company’s assets that are measured at fair value on
a recurring basis at June 30, 2008 consistent with the fair value hierarchy
provisions of SFAS No. 157:
|
Fair Value Measurements at Reporting Date
Using
|
||||||||||||||||
|
Quoted
Prices in
|
|
|||||||||||||||
|
Active
Markets for
|
Significant
other
|
Significant Unobservable |
||||||||||||||
|
Identical
Assets
|
Inputs
|
Inputs
|
||||||||||||||
|
(Level 1)
|
(Level 2)
|
(Level 3)
|
||||||||||||||
|
Cash
equivalents:
|
||||||||||||||||
|
Money
market funds
|
$ | 9,742,142 | $ | 9,742,142 | $ | - | $ | - | ||||||||
|
Commercial
paper
|
2,369,374 | - | 2,369,374 | - | ||||||||||||
|
Marketable
securities:
|
||||||||||||||||
|
Government
treasuries
|
9,547,628 | 9,547,628 | - | - | ||||||||||||
|
Corporate
bonds and government securities
|
18,592,747 | - | 18,592,747 | - | ||||||||||||
|
Auction
rate securities
|
1,389,146 | - | - | 1,389,146 | ||||||||||||
|
Total
assets measured at fair value
|
$ | 41,641,037 | $ | 19,289,770 | $ | 20,962,121 | $ | 1,389,146 | ||||||||
Based on
market conditions, the Company changed its valuation methodology for auction
rate securities to a discounted cash flow analysis and other type of valuation
model during the first quarter of 2008. Accordingly, these securities changed
from Level 1 to Level 3 within SFAS No. 157’s hierarchy since the
Company’s initial adoption of SFAS No. 157 on January 1, 2008. The
following table presents the Company’s assets measured at fair value on a
recurring basis using significant unobservable inputs (Level 3) as
defined in SFAS No. 157 at June 30, 2008:
|
Fair
Value Measurements Using Significant Unobservable Inputs
|
|||||
|
(Level 3)
|
|||||
|
Auction Rate Securities
|
|||||
|
Balance
at December 31, 2007
|
$ | - | |||
|
Transfers
to Level 3
|
1,502,496 | ||||
|
Total
unrealized losses in accumulated other
|
|||||
|
comprehensive
loss
|
(113,350 | ) | |||
|
Balance
at June 30, 2008
|
$ | 1,389,146 | |||
(8)
Subsequent Events
On July
1, 2008, the Company acquired certain assets of World Venture Limited (“World
Venture”), a network storage software business based in Hong Kong, at an
aggregate purchase price of $1.7 million before transaction and closing costs.
The Company will account for the acquisition under the purchase method of
accounting and will allocate the purchase price to the assets acquired based
upon their estimated fair value on the acquisition date. The impact of the World
Venture acquisition is not anticipated to be material to the Company’s
consolidated financial statements.
On July
1, 2008, pursuant to the FalconStor Software, Inc., 2006 Incentive Stock Plan,
as amended, the total shares available for issuance under the 2006 Plan
increased by 2,368,287 shares to 2,397,643 shares available for issuance as of
July 1, 2008 (see Note (2) Share-Based Payment
Arrangements for further details.)
On July 22, 2008, the Company’s Board
of Directors increased the authorization to repurchase the Company’s outstanding
common stock from five million shares to eight million shares in the
aggregate. The
repurchases may be made from time to time in open market transactions in such
amounts as determined at the discretion of the Company’s management. The terms
of the stock repurchases will be determined by management based on market
conditions (see Note (4) Stock
Repurchase Program.)
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
While we
continued to show revenue and operating income growth on both a year-over-year
and a quarter-over-quarter basis, revenues for the second quarter of 2008 failed
to meet our expectations. The shortfall resulted directly from lower
than projected revenues from one of our OEM customers as a result of their
product transition. In all other areas, we continue to experience
solid growth and although there can be no assurance, we expect revenues from
this OEM to rebound in the third and fourth quarters as their new product –
which continues to integrate our Virtual Tape Library software – is
introduced.
Despite
the lower than expected OEM revenue, revenues for the second quarter of 2008
increased 25% to $22.2 million compared with revenues of $17.8 million in the
second quarter of 2007. Even though revenue from one OEM fell short of our
expectations, revenues from all of our OEM partners combined still increased as
compared with both the second quarter of 2007 and the first quarter of 2008.
Revenues from our resellers increased 42% compared with the same period last
year and also increased compared with the first quarter of 2008. We
were pleased with the strong growth in revenues from our resellers.
EMC
Corporation accounted for 18% of our revenues in the quarter. We continue to
anticipate that EMC will account for 20% or more of our revenues for the full
year 2008. Sun Microsystems accounted for 15% of our revenues in the
second quarter of 2008 after not being a 10% customer in the first quarter. We
continue to anticipate that Sun will account for 10% or more of our revenues for
the full year 2008.
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 $0.8 million for the three months ended June 30, 2008. This
positive result includes $2.6 million of share-based compensation expense
related to SFAS No. 123(R). Cash flows from operations in the second quarter of
2008 were again positive. We continue to believe that our ability to fund our
own growth internally bodes well for our long-term success.
Deferred
revenue at June 30, 2008 increased 17%, compared with the balance at June 30,
2007. We consider the continued growth of our deferred revenue as an important
indicator of the success of our products. We believe that support and
maintenance renewals, which comprise the majority of our deferred revenue,
indicate satisfaction with our products and our support organization from our
end users.
Operating
expenses increased by $4.2 million, or 24%, compared with the second quarter of
2007. Operating expenses include $2.6 million in share-based compensation
expense for the second quarter of 2008, and $1.9 million in share-based
compensation expense for the second quarter of 2007. We are pleased that our
revenues, on both an absolute and a percentage basis, continue to grow at a
higher rate than our expenses, although we will continue to monitor expenses
carefully.
Our gross
margins decreased to 84% for the second quarter of 2008 from 86% for the second
quarter of 2007. The major contributors to the decline in gross margins were
hardware expense and compensation expense.
The cost
of hardware resold with our software solutions was higher in the quarter,
relative to the price at which the hardware was resold, than in the same period
in 2007. Compensation expense increased due to higher headcount in our technical
support and post-sales support groups to support our continued growth.
Share-based compensation expense within cost of maintenance, software services
and other revenue was 2% of revenue in the second quarter of 2008 and 1% of
revenue in the second quarter of 2007.
For the
second quarter of 2008, we recorded income tax expense of $0.4 million compared
with a benefit of $0.3 million for the second quarter of 2007. Due to
the previous use of net operating loss carryforwards, 2008 will be the first
year in which our earnings will reflect the full impact of the federal, state,
local and foreign taxes to which we are subject. We are projecting that the
combined federal, state, local and foreign effective tax rate will be
approximately 39%.
At June
30, 2008, we had 462 employees compared with 394 employees at June 30, 2007. We
plan to continue adding research and development and sales and support
personnel, both in the United States and worldwide, as necessary. We also plan
to continue investing in infrastructure, including both equipment and
property.
We
continue to monitor our management structure to determine whether changes or
additional resources will help to continue or to accelerate the positive
momentum.
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 JUNE 30, 2008 COMPARED WITH THE THREE
MONTHS ENDED JUNE 30, 2007.
Revenues
for the three months ended June 30, 2008 increased 25% to $22.2 million compared
with $17.8 million for the three months ended June 30, 2007. Our operating
expenses increased 24% from $17.3 million for the three months ended June 30,
2007 to $21.5 million for the three months ended June 30, 2008. Included in our
operating expenses for the three months ended June 30, 2008 and 2007 was $2.6
million and $1.9 million, respectively, of share-based compensation expense in
accordance with SFAS No. 123(R). Net income for the three months ended June 30,
2008 was $0.8 million compared with a net income of $1.4 million for the three
months ended June 30, 2007. Included in our net income for the three months
ended June 30, 2008 and 2007, was an income tax expense of $0.4 million and an
income tax benefit of $0.3 million, respectively. The growth in revenues was due
to increases in all of our revenue sources: software license revenue,
maintenance revenues and software services and other revenues. The increase in
revenues was primarily driven by increases in (i) demand for our network storage
solution software, (ii) maintenance revenue from new and existing customers and
(iii) sales to our resellers, direct end-users and OEM partners. Revenue
contribution from our OEM partners increased in absolute dollars for the three
months ended June 30, 2008 as compared with the same period in 2007. Revenue
from resellers, distributors and direct end-users increased in both absolute
dollars and as a percentage of total revenue for the three months ended June 30,
2008 as compared with the same period in 2007. 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 462 employees as of June 30, 2008, as compared with 394
employees as of June 30, 2007. Finally, we continue to invest in our
infrastructure by increasing our capital expenditures particularly with
purchases of equipment for support of our existing and future product
offerings.
Revenues
|
Three
months ended June 30,
|
||||||||
|
2008
|
2007
|
|||||||
|
Revenues:
|
||||||||
|
Software
license revenue
|
$ | 15,018,364 | $ | 11,980,480 | ||||
|
Maintenance
revenue
|
5,521,881 | 4,535,780 | ||||||
|
Software
services and other revenue
|
1,686,701 | 1,234,284 | ||||||
|
Total
Revenues
|
$ | 22,226,946 | $ | 17,750,544 | ||||
|
Year-over-year
Percentage Growth
|
||||||||
|
Software
license revenue
|
25 | % | 37 | % | ||||
|
Maintenance
revenue
|
22 | % | 56 | % | ||||
|
Software
services and other revenue
|
37 | % | 19 | % | ||||
|
Total
percentage growth
|
25 | % | 40 | % | ||||
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 25% from $12.0 million for the three months ended June
30, 2007 to $15.0 million for the three months ended June 30, 2008. Software
license revenue represented 68% of our total revenues for the three months ended
June 30, 2008 and 67% of our total revenues for the same period in 2007. As a
result of broader market acceptance of our software applications, new product
offerings and increased demand for our products from our expanding base of
customers, we continue to experience increased sales from our OEM, reseller
partners and direct end-users, which were the primary drivers of the increase in
software license revenue. Overall, software license revenue increased from our
OEM partners, direct end-users and resellers. In particular, gross software
license revenues from our resellers increased 41% compared with the same period
last year and also increased compared with the first quarter of 2008. We expect
our software license revenue to continue to grow in future periods.
Maintenance
revenue
Maintenance
revenue is comprised of software maintenance and technical support services.
Revenues derived from maintenance and technical support contracts are deferred
and recognized ratably over the contractual maintenance term. Maintenance
revenues increased 22% from $4.5 million for the three months ended June 30,
2007 to $5.5 million for the three months ended June 30, 2008.
The major
factor behind the increase in maintenance revenue was an increase in the number
of maintenance and technical support contracts we sold. As we are in business
longer, and as we license more software to new customers and grow our installed
customer base, we expect the amount of maintenance and technical support
contracts we have to grow as well. We expect our maintenance revenue to continue
to increase primarily because (i) the majority of our new customers
purchase maintenance and support contracts, and (ii) the majority of our growing
existing customer base renewed their maintenance and support contracts after
their initial contracts expired.
Software
services and other revenue
Software
services and other revenues are comprised of professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. Professional services revenue is recognized in the period
that the related services are performed. Revenue from engineering services is
primarily related to customizing software product masters for some of our OEM
partners. Revenue from engineering services is recognized in the period in which
the services are completed. During the three months ended June 30, 2008 and June
30, 2007, we had transactions in which we purchased hardware and bundled this
hardware with our software and sold this bundled solution to our customer base.
A portion of the contractual fees is recognized as revenue when the hardware or
software is delivered to the customer based on the relative fair value of the
delivered element(s). Software services and other revenue increased 37% from
$1.2 million for the three months ended June 30, 2007 to $1.7 million for the
three months ended June 30, 2008.
The
increase in software services and other revenue was due to a increases in (i)
bundled hardware solutions we sold, which increased from $0.7 million for the
three months ended June 30, 2007 to $0.9 million for the same period in 2008,
and (ii) growth in our professional services sales, which increased from $0.5
million for the three months ended June 30, 2007 to $0.8 million for the same
period in 2008. This increase in professional services revenue was related to
the increase in our software license customers who elected to purchase
professional services and/or the number of professional services contracts that
were completed during the quarter. We expect professional services revenues to
vary from quarter to quarter based upon the number of customers who elect to
utilize our professional services upon purchasing our software licenses. The
bundled solutions revenue will vary from quarter to quarter based upon the
number of customers who wish to have us bundle hardware with our software for
one complete solution.
Cost
of Revenues
|
Three
months ended June 30,
|
||||||||
|
2008
|
2007
|
|||||||
|
Total
Revenues:
|
$ | 22,226,946 | $ | 17,750,544 | ||||
|
Cost
of maintenance, software services
|
||||||||
|
and
other revenue
|
$ | 3,585,404 | $ | 2,486,336 | ||||
|
Gross
Profit
|
$ | 18,641,542 | $ | 15,264,208 | ||||
|
Gross
Margin
|
84 | % | 86 | % | ||||
Cost
of maintenance, software services and other revenue
Cost of
maintenance, software services and other revenues consists primarily of
personnel and other costs associated with providing software implementations,
technical support under maintenance contracts, training, amortization of
purchased and capitalized software and share-based compensation expense
associated with SFAS No. 123(R). Cost of maintenance, software services and
other revenues also includes the cost of hardware purchased that was
resold. Cost of
maintenance, software services and other revenues for the three months ended
June 30, 2008 increased by 44% to $3.6 million compared with $2.5 million for
the same period in 2007. The increase in cost of maintenance, software services
and other revenue was primarily due to the increase in (i) personnel and related
costs, and (ii) the number of transactions in which we bundled purchased
hardware with our software and sold the bundled solution, resulting in increased
hardware costs for the three months ended June 30, 2008 as compared with the
same period in 2007. As a result of our increased sales from maintenance and
support contracts, we hired additional employees to provide technical support.
Our cost of maintenance, software services and other revenue will continue to
grow in absolute dollars as our revenues from these services also
increase.
Gross
profit increased $3.4 million from $15.3 million for the three months
ended June 30, 2007 to $18.6 million for the three months ended June 30, 2008.
Gross margins decreased from 86% for the three months ended June 30, 2007 to 84%
for the three months ended June 30, 2008. Even though our gross profit increased
due to our continued revenue growth, our gross margins decreased. Generally, our
gross margins may fluctuate based on several factors, including (i) revenue
growth levels, (ii) timing of changes in personnel headcount and related costs,
(iii) our mix of product offerings and services, and (iv) costs related to the
procurement of hardware for our bundled solutions.
Share-based
compensation expense included in the cost of maintenance, software services and
other revenue increased in absolute dollars to $0.4 million for the three months
ended June 30, 2008, from $0.2 million for the same period in 2007. Share-based
compensation expense was equal to 2% and 1% of revenue for the three months
ended June 30, 2008 and 2007, respectively.
Software
Development Costs
Software
development costs consist primarily of personnel costs for product development
personnel, share-based compensation expense associated with SFAS No. 123(R), and
other related costs associated with the development of new products,
enhancements to existing products, quality assurance and
testing. Software development costs increased 17% to $6.2 million for
the three months ended June 30, 2008 from $5.3 million in the same period in
2007. The major contributing factors to the increase in software development
costs were higher salary and personnel related costs as a result of increased
headcount to enhance and test our core network storage software product and the
development of new innovative features and options. Share-based compensation
expense included in software development costs increased in absolute dollars to
$0.9 million from $0.8 million for the three months ended June 30, 2008 and June
30, 2007, respectively. Share-based compensation expense included in software
development costs was equal to 4% of revenue for both the three months ended
June 30, 2008 and 2007, respectively. We intend to continue recruiting and
hiring product development personnel to support our software development
process.
Selling
and Marketing
Selling
and marketing expenses consist primarily of sales and marketing personnel and
related costs, share-based compensation expense associated with SFAS No. 123(R),
travel, public relations expense, marketing literature and promotions,
commissions, trade show expenses, and the costs associated with our foreign
sales offices. Selling and marketing expenses increased 27% to $9.6 million for
the three months ended June 30, 2008 from $7.5 million for the same period in
2007. The increase in selling and marketing expenses was primarily due to (i)
higher commissions paid as a result of our 25% increase in revenue, (ii) higher
salary and personnel related costs as a result of increased sales and marketing
headcount and (iii) higher advertising and marketing related expenses as a
result of our new product offerings/enhancements, new product branding and
related advertising and marketing of such initiatives. Share-based compensation
expense included in selling and marketing increased in absolute dollars to $1.0
million from $0.7 million for the three months ended June 30, 2008 and June 30,
2007, respectively. Share-based compensation expense included in selling and
marketing expenses was equal to 5% and 4% of revenue for the three months ended
June 30, 2008 and 2007, respectively. In addition, we continued to hire new
sales and sales support personnel and to expand our worldwide presence to
accommodate our anticipated revenue growth. We anticipate that as we continue to
grow sales, our sales and marketing expenses will continue to increase in
support of such sales growth.
General
and Administrative
General
and administrative expenses consist primarily of personnel costs of general and
administrative functions, share-based compensation expense associated with SFAS
No. 123(R), public company related costs, directors and officers insurance,
legal and professional fees, and other general corporate overhead
costs. General and administrative expenses increased 8% to $2.1
million for the three months ended June 30, 2008 from $1.9 million for the same
period in 2007. Increased compensation and personnel related costs as a result
of increased headcount to support our general and administrative needs was
offset by decreases in professional fees and various administrative expenses
during the three months ended June 30, 2008 as compared with the same period in
2007. Share-based compensation expense included in general and administrative
expenses increased in absolute dollars to $0.3 million from $0.2 million for the
three months ended June 30, 2008 and June 30, 2007, respectively. Share-based
compensation expense included in general and administrative expenses was equal
to 1% of revenue for both the three months ended June 30, 2008 and 2007,
respectively. Additionally, as our revenue and number of employees
increase, our overall general corporate overhead costs have generally increased
and are likely to continue to increase.
Interest
and Other Income
We invest
our cash primarily in money market funds, commercial paper, government
securities and corporate bonds. As of June 30, 2008, our cash, cash equivalents
and marketable securities totaled $53.7 million compared with $56.2 million as
of June 30, 2007. Interest and other income decreased to $0.4 million for the
three months ended June 30, 2008 compared with $0.6 million for the three months
ended June 30, 2007. The decrease in interest income was primarily related to
(i) a decrease in our cash, cash equivalents and marketable securities balances
as a result of our repurchase of 2,560,000 shares of our common stock at a
total cost of $21.3 million during 2008, and (ii) lower interest
rates on average cash balance invested during the three months ended June 30,
2008 as compared with the same period in 2007.
Income
Taxes
Our
provision for income taxes consists primarily of U.S. and foreign taxes in
amounts necessary to align our year-to-date tax provision with the effective
rate that we expect to achieve for the full year. For the three months ended
June 30, 2008, our provision for income taxes was $0.4 million, which consisted
of U.S., state and local and foreign taxes. For the three months ended June 30,
2007, we recorded an income tax benefit of $0.3 million, which consisted
primarily of U.S. federal alternative minimum taxes and state minimum taxes that
were expected to be incurred primarily as a result of the then 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. In addition, the income tax benefit recorded during the three
months ended June 30, 2007 included discrete items of $0.3 million of benefits
associated with disqualifying dispositions of incentive stock
options.
As of January 1, 2008, we had
approximately $5.1 million of federal net operating loss carryforwards available
to offset future taxable income and have utilized approximately $3.5 million
through June 30, 2008. These net operating loss carryforwards relate to excess
compensation deductions from exercises of stock options and the resulting
benefits will be credited to additional-paid-in-capital when realized. As of
June 30, 2008 and December 31, 2007, our deferred tax asset, net of a valuation
allowance was $9.8 million.
RESULTS
OF OPERATIONS – FOR THE SIX MONTHS ENDED JUNE 30, 2008 COMPARED WITH SIX MONTHS
ENDED JUNE 30, 2007.
Revenues
for the six months ended June 30, 2008 increased 29% to $44.0 million compared
with $34.1 million for the six months ended June 30, 2007. Our operating
expenses increased 21% from $34.4 million for the six months ended June 30, 2007
to $41.5 million for the six months ended June 30, 2008. Included in our
operating expenses for the six months ended June 30, 2008 and 2007 was $5.0
million and $4.1 million, respectively, of share-based compensation expense in
accordance with SFAS No. 123(R). Net income for the six months ended June 30,
2008 was $2.1 million compared with a net income of $0.8 million for the six
months ended June 30, 2007. Included in our net income for the six months ended
June 30, 2008 and 2007, was an income tax expense of $1.4 million and an income
tax benefit of $0.1 million, respectively. The growth in revenues was due to
significant growth in both our software license revenue and maintenance revenues
and moderate growth in our software services and other revenues. The increase in
revenues was primarily driven by increases in (i) demand for our network storage
solution software, (ii) maintenance revenue from new and existing customers and
(iii) sales to our resellers, direct end-users and OEM partners. Revenue
contribution from our OEM partners increased in absolute dollars for the six
months ended June 30, 2008 as compared with the same period in 2007. Revenue
from resellers, distributors and direct end-users increased in both absolute
dollars and as a percentage of total revenue for the six months ended June 30,
2008 as compared with the same period in 2007. Expenses increased in all aspects
of our business to support our continued growth, except for general and
administrative, for which expenses remained consistent. In support of our
continued growth and expansion both domestically and internationally, we
increased our worldwide headcount to 462 employees as of June 30, 2008, as
compared with 394 employees as of June 30, 2007. Finally, we continue to invest
in our infrastructure by increasing our capital expenditures particularly with
purchases of equipment for support of our existing and future product
offerings.
Revenues
|
Six
months ended June 30,
|
||||||||
|
2008
|
2007
|
|||||||
|
Revenues:
|
||||||||
|
Software
license revenue
|
$ | 30,337,283 | $ | 22,417,985 | ||||
|
Maintenance
revenue
|
10,636,128 | 8,869,319 | ||||||
|
Software
services and other revenue
|
3,060,195 | 2,803,918 | ||||||
|
Total
Revenues
|
$ | 44,033,606 | $ | 34,091,222 | ||||
|
Year-over-year
Percentage Growth
|
||||||||
|
Software
license revenue
|
35 | % | 56 | % | ||||
|
Maintenance
revenue
|
20 | % | 61 | % | ||||
|
Software
services and other revenue
|
9 | % | 42 | % | ||||
|
Total
percentage growth
|
29 | % | 56 | % | ||||
Software
license revenue
Software
license revenue increased 35% from $22.4 million for the six months ended June
30, 2007 to $30.3 million for the six months ended June 30, 2008. Software
license revenue represented 69% of our total revenues for the six months ended
June 30, 2008 and 66% of our total revenues for the same period in 2007. As a
result of broader market acceptance of our software applications, new product
offerings and increased demand for our products from our expanding base of
customers, we continue to experience increased sales from our OEM, reseller
partners and direct end-users, which were the primary drivers of the increase in
software license revenue. Overall, software license revenue increased from our
OEM partners, direct end-users and resellers. In particular, gross software
license revenues from our resellers increased 53% compared with the same period
last year. We expect our software license revenue to continue to grow in future
periods.
Maintenance
revenue
Maintenance
revenues increased 20% from $8.9 million for the six months ended June 30, 2007
to $10.6 million for the six months ended June 30, 2008. The major factor behind
the increase in maintenance revenue was an increase in the number of maintenance
and technical support contracts we sold. As we are in business longer, and as we
license more software to new customers and grow our installed customer base, we
expect the amount of maintenance and technical support contracts we have to grow
as well. We expect our maintenance revenue to continue to increase primarily
because (i) the majority of our new customers purchase maintenance
and support contracts, and (ii) the majority of our growing existing customer
base renewed their maintenance and support contracts after their initial
contracts expired.
Software
services and other revenue
During
the six months ended June 30, 2008 and June 30, 2007, we had transactions in
which we purchased hardware and bundled this hardware with our software and sold
this bundled solution to our customer base. A portion of the contractual fees is
recognized as revenue when the hardware or software is delivered to the customer
based on the relative fair value of the delivered element(s). Software services
and other revenue increased 9% from $2.8 million for the six months ended June
30, 2007 to $3.1 million for the six months ended June 30, 2008.
The
increase in software services and other revenue was primarily due to growth in
our professional services sales, which increased from $0.8 million for the six
months ended June 30, 2007 to $1.2 million for the same period in 2008. This
increase in professional services revenue was related to the increase in our
software license customers who elected to purchase professional services and/or
the number of professional services contracts that were completed during the
quarter. We expect professional services revenues to vary from quarter to
quarter based upon the number of customers who elect to utilize our professional
services upon purchasing our software licenses. The increase in our professional
services was offset by a decrease in bundled hardware solutions we sold, which
decreased from $2.0 million for the six months ended June 30, 2007 to $1.9
million for the same period in 2008. The bundled solutions revenue will vary
from quarter to quarter based upon the number of customers who wish to have us
bundle hardware with our software for one complete solution.
Cost
of Revenues
|
Six
months ended June 30,
|
||||||||
|
2008
|
2007
|
|||||||
|
Total
Revenues:
|
$ | 44,033,606 | $ | 34,091,222 | ||||
|
Cost
of maintenance, software services
|
||||||||
|
and
other revenue
|
$ | 6,899,892 | $ | 5,256,160 | ||||
|
Gross
Profit
|
$ | 37,133,714 | $ | 28,835,062 | ||||
|
Gross
Margin
|
84 | % | 85 | % | ||||
Cost
of maintenance, software services and other revenue
Cost of
maintenance, software services and other revenues for the six months ended June
30, 2008 increased by 31% to $6.9 million compared with $5.3 million for the
same period in 2007. The increase in cost of maintenance, software services and
other revenue was primarily due to the increase in (i) personnel and related
costs, and (ii) the increased hardware costs associated with the transactions in
which we bundled purchased hardware with our software and sold the bundled
solution, resulting in increased hardware costs for the six months ended June
30, 2008 as compared with the same period in 2007. As a result of our increased
sales from maintenance and support contracts, we hired additional employees to
provide technical support. Our cost of maintenance, software services and other
revenue will continue to grow in absolute dollars as our revenues from these
services also increase.
Gross
profit increased $8.3 million from $28.8 million for the six months
ended June 30, 2007 to $37.1 million for the six months ended June 30, 2008.
Gross margins decreased from 85% for the six months ended June 30, 2007 to 84%
for the six months ended June 30, 2008. Even though our gross profit increased
due to our continued revenue growth, our gross margins decreased. Generally, our
gross margins may fluctuate based on several factors, including (i) revenue
growth levels, (ii) timing of changes in personnel headcount and related costs,
(iii) our mix of product offerings and services, and (iv) costs related to the
procurement of hardware for our bundled solutions. Share-based compensation
expense included in the cost of maintenance, software services and other revenue
increased in absolute dollars to $0.7 million for the six months ended June 30,
2008, from $0.5 million for the same period in 2007. Share-based compensation
expense was equal to 2% and 1% of revenue for the six months ended June 30, 2008
and 2007, respectively.
Software
Development Costs
Software
development costs increased 12% to $12.1 million for the six months ended June
30, 2008 from $10.9 million in the same period in 2007. The major contributing
factors to the increase in software development costs were higher salary and
personnel related costs as a result of increased headcount to enhance and test
our core network storage software product and the development of new innovative
features and options. Share-based compensation expense included in software
development costs increased to $1.8 million from $1.7 million for the six months
ended June 30, 2008 and 2007, respectively. Share-based compensation expense
included in software development costs was equal to 4% and 5% of revenue for the
six months ended June 30, 2008 and 2007, respectively. We intend to continue
recruiting and hiring product development personnel to support our software
development process.
Selling
and Marketing
Selling
and marketing expenses increased 28% to $18.5 million for the six months ended
June 30, 2008 from $14.5 million for the same period in 2007. The increase in
selling and marketing expenses was primarily due to (i) higher commissions paid
as a result of our 29% increase in revenue, (ii) higher salary and personnel
related costs as a result of increased sales and marketing headcount and (iii)
higher advertising and marketing related expenses as a result of our new product
offerings/enhancements, new product branding and related advertising and
marketing of such initiatives. Share-based compensation expense included in
selling and marketing increased in absolute dollars to $2.0 million from $1.4
million for the six months ended June 30, 2008 and 2007, respectively.
Share-based compensation expense included in selling and marketing expenses was
equal to 5% and 4% of revenue for the six months ended June 30, 2008 and 2007,
respectively. In addition, we continued to hire new sales and sales support
personnel and to expand our worldwide presence to accommodate our anticipated
revenue growth. We anticipate that as we continue to grow sales, our sales and
marketing expenses will continue to increase in support of such sales
growth.
General
and Administrative
General
and administrative increased 3% to $4.0 million for the six months ended June
30, 2008 from $3.9 million for the same period in 2007. Increased compensation
and personnel related costs as a result of increased headcount to support our
general and administrative needs. These increases were offset by (i) decreases
in our professional fees during the six months ended June 30, 2008, as a result
of certain tax related activities which commenced and were completed during
fiscal year 2007 and (ii) decreases in various administrative expenses during
the six months ended June 30, 2008 as compared with the same period in 2007.
Share-based compensation expense included in general and administrative expenses
remained consistent in absolute dollars at $0.5 million for both the six months
ended June 30, 2008 and 2007. Share-based compensation expense included in
general and administrative expenses was equal to 1% of revenue for both the six
months ended June 30, 2008 and 2007. Additionally, as our revenue and
number of employees increase, our overall general corporate overhead costs have
generally increased and are likely to continue to increase.
Interest
and Other Income
We invest
our cash primarily in money market funds, commercial paper, government
securities and corporate bonds. As of June 30, 2008, our cash, cash equivalents
and marketable securities totaled $53.7 million compared with $56.2 million as
of June 30, 2007. Interest and other income decreased to $1.0 million for the
six months ended June 30, 2008 compared with $1.1 million for the six months
ended June 30, 2007. The decrease in interest income was primarily related to
(i) a decrease in cash, cash equivalents and marketable securities balances as a
result of our repurchase of 2,560,000 shares of our common stock at a total cost
of $21.3 million during 2008, and (ii) lower interest rates on average cash
balance invested during the six months ended June 30, 2008 as compared with the
same period in 2007.
Income
Taxes
Our
provision for income taxes consists primarily 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 six months ended June
30, 2008, our provision for income taxes was $1.4 million, which consisted of
U.S., state and local and foreign taxes. For the six months ended June 30, 2007,
we recorded an income tax benefit of $0.1 million, which consisted primarily of
U.S. federal alternative minimum taxes and state minimum taxes that were
expected to be incurred primarily as a result of the then 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. In addition, the income tax benefit recorded during the six
months ended June 30, 2007 included discrete items for (i) $57,058 related to
state income taxes incurred in periods prior to 2007, (ii) $120,000 related to a
change in our estimate of amounts due in certain foreign jurisdictions for
periods prior to 2007, based upon our evaluation of information obtained in
2007, and (iii) $0.3 million of benefit associated with disqualifying
dispositions of incentive stock options.
As of
January 1, 2008, we had approximately $5.1 million of federal net operating loss
carryforwards available to offset future taxable income and have utilized
approximately $3.5 million through June 30, 2008. These net operating loss
carryforwards relate to excess compensation deductions from exercises of stock
options and the resulting benefits will be credited to
additional-paid-in-capital when realized. As of June 30, 2008 and December 31,
2007, our deferred tax asset, net of a valuation allowance was $9.8
million.
Critical
Accounting Policies and Estimates
Our critical accounting policies and
estimates are those related to revenue recognition, accounts receivable
allowances, deferred income taxes and accounting for share-based compensation
expense.
Revenue Recognition. We
recognize revenue in accordance with the provisions of Statement of Position
97-2, Software Revenue
Recognition, as amended. Software license revenue is
recognized only when pervasive evidence of an arrangement exists and the fee is
fixed and determinable, among other criteria. An arrangement is
evidenced by a signed customer contract for nonrefundable royalty advances
received from OEMs or a customer purchase order or a royalty report summarizing
software licenses sold for each software license resold by an OEM, distributor
or solution provider to an end user. The software license fees are fixed and
determinable as our standard payment terms range from 30 to 90 days, depending
on regional billing practices, and we have not provided any of our customers
extended payment terms. When a customer licenses software together with the
purchase of maintenance, we allocate a portion of the fee to maintenance for its
fair value based on the contractual maintenance renewal rate.
Accounts Receivable. We review
accounts receivable to determine which ones are doubtful of
collection. In making the determination of the appropriate allowance
for uncollectible accounts and returns, we consider (i) historical return rates,
(ii) specific past due accounts, (iii) analysis of our accounts receivable
aging, (iv) customer payment terms, (v) historical collections, write-offs and
returns, (vi) changes in customer demand and relationships, and (vii)
concentrations of credit risk and customer creditworthiness. Historically, we
have experienced a somewhat consistent level of write-offs and returns as a
percentage of revenue due to our customer relationships, contract provisions and
credit assessments. Changes in the product return rates,
creditworthiness of customers, general economic conditions and other factors may
impact the level of future write-offs, revenues and our general and
administrative expenses.
Deferred Income Taxes.
Consistent with the provisions of SFAS No. 109, we regularly estimate our
ability to recover deferred income taxes, and report such deferred tax assets at
the amount that is determined to be more-likely-than-not recoverable, and we
have to estimate our income taxes in each of the taxing jurisdictions in which
we operate. This process involves estimating our current tax expense together
with assessing any temporary differences resulting from the different treatment
of certain items, such as the timing for recognizing revenue and expenses for
tax and accounting purposes, as well as estimating foreign tax credits. These
differences may result in deferred tax assets and liabilities, which are
included in our consolidated balance sheet. We are required to assess the
likelihood that our deferred tax assets, which include net operating loss carry
forwards and temporary differences that are expected to be deductible in future
years, will be recoverable from future taxable income or other tax planning
strategies. If recovery is not likely, we have to provide a valuation allowance
based on our estimates of future taxable income in the various taxing
jurisdictions, and the amount of deferred taxes that are ultimately realizable.
The provision for current and deferred taxes involves evaluations and judgments
of uncertainties in the interpretation of complex tax regulations. This
evaluation considers several factors, including an estimate of the likelihood of
generating sufficient taxable income in future periods, the effect of temporary
differences, the expected reversal of deferred tax liabilities, past and
projected taxable income, and available tax planning strategies. As of June 30,
2008 and December 31, 2007, our deferred tax asset, net of a valuation
allowance, was $9.8 million.
Accounting for Share-Based
Payments. As discussed further in Note (2) Share-Based Payment
Arrangements, to our unaudited condensed consolidated financial
statements, we account for stock-based awards under SFAS No.
123(R).
We have
used and expect to continue to use the Black-Scholes option-pricing model to
compute the estimated fair value of share-based compensation expense. The
Black-Scholes option-pricing model includes assumptions regarding dividend
yields, expected volatility, expected option term and risk-free interest rates.
The assumptions used in computing the fair value of share-based compensation
expense reflect our best estimates, but involve uncertainties relating to market
and other conditions, many of which are outside of our control. We estimate
expected volatility based primarily on historical daily price changes of our
stock and other factors. The expected option term is the number of years that we
estimate that the stock options will be outstanding prior to exercise. The
estimated expected term of the stock awards issued after December 31, 2007 was
determined pursuant to SEC Staff Accounting Bulletin (“SAB”) No. 110. The
expected term of the awards issued prior to January 1, 2008, was determined
using the “simplified method” prescribed in SAB No. 107. Additionally, we
estimate forfeiture rates based primarily upon historical experiences, adjusted
when appropriate for known events or expected trends. We may adjust share-based
compensation expense on a quarterly basis for changes to our estimate of
expected equity award forfeitures based on our review of these events and
trends, and recognize the effect of adjusting the forfeiture rate for all
expense amortization after January 1, 2006 in the period in which we
revised the forfeiture estimate. If other assumptions or estimates had been
used, the share-based compensation expense that was recorded for the three and
six months ended June 30, 2008 and 2007 could have been materially different.
Furthermore, if different assumptions or estimates are used in future periods,
share-based compensation expense could be materially impacted in the
future.
Impact
of Recently Issued Accounting Pronouncements
In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations. SFAS
No. 141(R) establishes principles and requirements for how an acquirer
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, any noncontrolling interest in the acquiree
and the goodwill acquired. SFAS No. 141(R) also establishes disclosure
requirements to enable the evaluation of the nature and financial effects of the
business combination. SFAS No. 141(R) is effective for fiscal years beginning
after December 15, 2008. We are currently evaluating the potential impact,
if any, of the adoption of SFAS No. 141(R) on our consolidated financial
statements.
In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51. SFAS No. 160 establishes accounting and reporting standards
for ownership interests in subsidiaries held by parties other than the parent,
the amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS No. 160 also establishes disclosure requirements that
clearly identify and distinguish between the interests of the parent and the
interests of the noncontrolling owners. SFAS No. 160 is effective for fiscal
years beginning after December 15, 2008. We are currently evaluating the
potential impact, if any, of the adoption of SFAS No. 160 on our consolidated
financial statements.
In
February 2008, the FASB issued FASB Staff Position No. FAS 157-2,
Effective Date of FASB
Statement No. 157 (“FSP 157-2”), to partially defer SFAS
No. 157, Fair Value
Measurements. FSP 157-2 defers the effective date of SFAS No. 157
for nonfinancial assets and nonfinancial liabilities, except those that are
recognized or disclosed at fair value in the financial statements on a recurring
basis (at least annually), to fiscal years, and interim periods within those
fiscal years, beginning after November 15, 2008. We are currently
evaluating the potential impact, if any, SFAS No. 157 will have to nonfinancial
assets and liabilities to the fiscal year beginning after November 15, 2008 on
our consolidated financial statements.
In
May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted
Accounting Principles. SFAS No. 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements of nongovernmental entities that are
presented in conformity with generally accepted accounting principles (the GAAP
hierarchy). SFAS No. 162 will become effective sixty days following the
Securities and Exchange Commission’s approval of the Public Company Accounting
Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles. The adoption of
the provisions of SFAS No. 162 is not anticipated to materially impact our
consolidated financial statements.
LIQUIDITY
AND CAPITAL RESOURCES
|
Six
months ended June 30,
|
||||||||
|
2008
|
2007
|
|||||||
|
Cash
provided by (used in):
|
||||||||
|
Operating
activities
|
$ | 13,038,184 | $ | 11,575,045 | ||||
|
Investing
activities
|
4,743,339 | (7,951,978 | ) | |||||
|
Financing
activities
|
(19,227,409 | ) | 6,574,614 | |||||
|
Effect
of exchange rate changes
|
114,552 | (77,046 | ) | |||||
|
Net
(decrease) increase in cash and cash equivalents
|
$ | (1,331,334 | ) | $ | 10,120,635 | |||
Our
principal sources of liquidity are cash flows generated from operations and our
cash, cash equivalents, and marketable securities balances. Our cash and cash
equivalents and marketable securities balances as of June 30, 2008 totaled $53.7
million compared with $62.9 million as of December 31, 2007. Cash and cash
equivalents totaled $30.9 million and marketable securities totaled $22.8
million at June 30, 2008. As of December 31, 2007, we had $32.2 million in cash
and cash equivalents and $30.7 million in marketable securities.
During
the six months ended June 30, 2008, we continued making investments in our
infrastructure to support our current and long-term growth. We increased our
total number of employees as well as our investments in property and equipment
to support our growth. As we continue to grow, we will continue to make
investments in property and equipment and we will need to continue to increase
our headcount. In the past, we have also used cash to purchase software licenses
and to make acquisitions. We will continue to evaluate potential software
license purchases and acquisitions and if the right opportunity presents itself,
we may continue to use our cash for these purposes. On July 1, 2008, we
purchased certain assets of World Venture Limited for an aggregate purchase
price of $1.7 million before transaction and closing costs (see Note (8) Subsequent Events, to our
unaudited condensed consolidated financial statements.) However, as of the date
of this filing, with the exception of the aforementioned acquisition of World
Venture Limited, we have no other agreements, commitments or understandings with
respect to any such acquisitions.
We
currently do not have any debt and our only significant commitments are related
to our office leases.
In October 2001, our Board of Directors
authorized the repurchase of up to two million shares of our outstanding common
stock. On February 6, 2008, our Board of Directors increased the
authorization to repurchase our outstanding common stock from two million shares
to five million shares in the aggregate. On July 22, 2008, our Board of
Directors again increased the authorization to repurchase our outstanding common
stock from five million shares to eight million shares in the aggregate. During
the six months ended June 30, 2008, we repurchased 2,560,000 shares of our
common stock in open market purchases for a total cost of $21,348,409. There
were no stock repurchases during the six months ended June 30, 2007. As of June
30, 2008, we had repurchased a total of 3,744,100 shares of our common stock at
an aggregate purchase price of $30,402,233, and had the authorization to
repurchase an additional 1,255,900 shares of our common stock based upon our
judgment and market conditions before the July 22, 2008 increased
authorization.
Net cash
provided by operating activities totaled $13.0 million for the six months ended
June 30, 2008, compared with net cash provided by operating activities of $11.6
million for the same period in 2007. The increase in net cash provided by
operating activities during the six months ended June 30, 2008, as compared with
the same period in 2007, was primarily related to the growth in our net income
adjusted for: (i) the impact of non-cash charges, particularly relating to
stock-based compensation, depreciation and amortization and provision for
doubtful accounts; and (ii) adjustments for net changes in operating assets and
liabilities, particularly changes in our accounts receivable, deferred revenues,
and accrued expenses. These amounts were primarily offset by the adjustment for
the impact from the tax benefits recognized as a result of excess stock-based
compensation deductions and exercises of stock options. SFAS No. 123(R) requires
tax benefits relating to excess stock-based compensation deductions to be
presented as cash outflows from operating activities. We recognized tax benefits
related to stock-based compensation deductions of $1.3 million for the six
months ended June 30, 2008. There were no adjustments for the impact of non-cash
income tax benefits for the six months ended June 30, 2007.
Net cash
provided by investing activities was $4.7 million for the six months ended June
30, 2008, compared with net cash used in investing activities of $8.0 million
for the same period in 2007. Included in investing activities for both the six
months ended June 30, 2008 and 2007, are the sales and purchases of our
marketable securities. These represent the sales, maturities and reinvestment of
our marketable securities. The net cash provided by investing activities from
the net sales (purchases) of securities was $7.5 million for the six months
ended June 30, 2008 and ($5.1) million for the same period in 2007. These
amounts will fluctuate from period to period depending on the maturity dates of
our marketable securities. The cash used to purchase property and equipment was
$2.6 million and $2.8 million for the six months ended June 30, 2008 and 2007,
respectively. We continually evaluate opportunities to acquire software licenses
and we may continue to make similar investments if we find opportunities that
would benefit our business. We anticipate continued capital expenditures as we
continue to invest in our infrastructure to support our ongoing growth and
expansion both domestically and internationally.
Net cash
used in financing activities was $19.2 million for the six months ended June 30,
2008, compared with net cash provided by financing activities of $6.6 million
for the same period in 2007. Cash outflows from financing activities result from
the repurchase of our outstanding common stock. During the six months ended June
30, 2008, we repurchased 2,560,000 shares of our common at an aggregate purchase
price of $21.3 million. We did not repurchase any shares of our common stock
during the six months ended June 30, 2007. Cash inflows from financing
activities primarily results from the proceeds received from the exercise of
stock options. We received proceeds from the exercise of stock options of $0.8
million and $6.6 million for the six months ended June 30, 2008 and June 30,
2007, respectively. During the six months ended June 30, 2008, cash inflows from
financing activities was also impacted by the tax benefits recognized as a
result of excess stock-based compensation deductions and exercises of stock
options. SFAS No. 123(R) requires tax benefits relating to excess stock-based
compensation deductions be presented as cash inflows from financing activities.
We recognized tax benefits related to stock-based compensation deductions of
$1.3 million for the six months ended June 30, 2008. There were no tax benefits
related to stock-based compensation deductions recognized during the six months
ended June 30, 2007.
As
discussed in Note (7) Fair Value Measurements, to
our unaudited condensed consolidated financial statements, we adopted the
provisions of SFAS No. 157 effective January 1, 2008. We utilize
unobservable (Level 3) inputs in determining the fair value of auction
rate securities we hold totaling $1.5 million (at par value) at June 30,
2008.
As of
June 30, 2008, $1.5 million (at par value) of our investments was comprised
of auction rate securities. Liquidity for these auction rate securities is
typically provided by an auction process, which allows holders to sell their
notes, and resets the applicable interest rate at pre-determined intervals.
During the first quarter of 2008, we began experiencing failed auctions on
auction rate securities. An auction failure means that the parties wishing to
sell their securities could not be matched with an adequate volume of buyers. In
the event that there is a failed auction, the indenture governing the security
requires the issuer to pay interest at a contractually defined rate that is
generally above market rates for other types of similar short-term instruments.
The securities for which auctions have failed will continue to accrue interest
at the contractual rate and continue to reset the next auction date every 28 or
35 days until the auction succeeds, the issuer calls the securities, or
they mature. Because there is no assurance that auctions for these securities
will be successful in the near term and due to our ability and intent to hold
these securities to maturity, the auction rate securities were classified as
long-term investments in our unaudited condensed consolidated balance sheet at
June 30, 2008.
Our
auction rate securities are classified as available-for-sale securities and are
reflected at fair value. In prior periods during the auction process, which took
place every 28-35 days for most securities, quoted market prices were
readily available, which would qualify as Level 1 under SFAS No. 157.
However, due to events in credit markets during the first six months of 2008,
the auction events for most of these instruments failed, and, therefore, we have
determined the estimated fair values of these securities utilizing a discounted
cash flow analysis or other type of valuation model as of June 30, 2008. These
analyses consider, among other items, the collateral underlying the security,
the creditworthiness of the issuer, the timing of the expected future cash
flows, including the final maturity, associated with the securities, and an
assumption of when the next time the security is expected to have a successful
auction. These securities were also compared, when possible, to other observable
and relevant market data, which is limited at this time. Due to these events, we
reclassified these instruments as Level 3 during the first six months of
2008 and recorded a temporary unrealized decline in fair value in the aggregate
of approximately $113,000, with an offsetting entry to accumulated other
comprehensive loss, net of tax. We currently believe that this temporary decline
in fair value is primarily due to liquidity concerns, because the underlying
assets for the majority of securities are almost entirely backed by the
U.S. Government.
In
addition, our holdings of auction rate securities represented approximately 3%
of our cash equivalents, and marketable securities balance at June 30, 2008,
which we believe allows us sufficient time for the securities to return to full
value. Because we believe that the current decline in fair value is temporary
and based primarily on liquidity issues in the credit markets, any difference
between our estimate and an estimate that would be arrived at by another party
would have no impact on our earnings, since such difference would also be
recorded to accumulated other comprehensive loss. We will re-evaluate each of
these factors as market conditions change in subsequent periods.
We
currently do not have any debt and our only material cash commitments are
related to our office leases. We have an operating lease covering our corporate
office facility that expires in February 2012. We also have several operating
leases related to offices in the United States and foreign countries. The
expiration dates for these leases range from 2008 through 2011. Refer to Note
(5) Commitments and
Contingencies to our unaudited condensed consolidated financial
statements.
We
believe that our current balance of cash, cash equivalents and marketable
securities, and expected cash flows from operations, will be sufficient to meet
our cash requirements for at least the next twelve months.
Off-Balance
Sheet Arrangements
As of
June 30, 2008 and December 31, 2007, we had no off-balance sheet
arrangements.
Item 3. Qualitative and
Quantitative Disclosures About Market Risk
Interest Rate Risks. Our
return on our investments in cash, cash equivalents and marketable securities
which aggregated to $53.7 million as of June 30, 2008, is subject to interest
rate risks. We regularly assess these risks and have established policies and
business practices to manage the market risk of our marketable securities. If
interest rates were to change by 10% from the levels at June 30, 2008, the
effect on our financial results would be insignificant.
Foreign Currency Risk. We
have several offices outside the United States. Accordingly, we are subject to
exposure from adverse movements in foreign currency exchange rates. The effect
of foreign currency exchange rate fluctuations have not been material since our
inception. If foreign currency exchange rates were to change by 10% from the
levels at June 30, 2008, the effect on our other comprehensive income would be
insignificant. We do not use derivative financial instruments to limit our
foreign currency risk exposure.
Item
4. Controls and
Procedures
Under the supervision and with the
participation of our management, including our principal executive officer and
principal financial officer, we have evaluated the effectiveness of the design
and operation of our disclosure controls and procedures as of the end of the
period covered by this report, and, based on their evaluation, our principal
executive officer and principal financial officer have concluded that these
controls and procedures are effective. No changes in the Company's internal
controls over financial reporting occurred during the quarter ended June
30, 2008, that have materially affected, or are reasonably likely to
materially affect, the Company’s internal controls over financial
reporting.
Disclosure controls and procedures are
procedures that are designed to ensure that information required to be disclosed
by us in the reports that we file or submit under the Securities Exchange Act of
1934, as amended, is recorded, processed, summarized and reported, within the
time periods specified in the Securities and Exchange Commission's rules and
forms. Disclosure controls and procedures include, without limitation, controls
and procedures designed to ensure that information required to be disclosed by
us in the reports that we file under the Exchange Act is accumulated and
communicated to our management, including our principal executive officer
and principal financial officer, as appropriate to allow timely decisions
regarding required disclosure.
PART
II. OTHER
INFORMATION
Item
1. Legal Proceedings
We are
subject to various legal proceedings and claims, asserted or unasserted, which
arise in the ordinary course of business. While the outcome of any such matters
cannot be predicted with certainty, we believe that such matters will not have a
material adverse effect on our financial condition or operating
results.
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, 2007 (the “2007 10-K”). The information below sets
forth additional risk factors or risk factors that have had material changes
since the 2007 10-K, and should be read in conjunction with Item 1A of the 2007
10-K.
We
are dependent on certain key customers and a significant portion of our
receivables is concentrated with one customer.
We tend
to have one or more customers account for 10% or more of our revenues during
each fiscal quarter. For the quarter ended June 30, 2008, two
customers together accounted for 33% of our revenues. Both of these customers,
EMC Corporation, and Sun Microsystems, Inc., are OEM customers. While we believe
that we will continue to receive revenues from these customers, our agreements
with them do not have any minimum sales requirements and we cannot guarantee
continued revenue. If our contract with either one of these customers
terminates, or if the volume of sales from these customer significantly
declines, it would have a material adverse effect on our operating
results.
In
addition, as of June 30, 2008, one customer accounted for 10% of our outstanding
receivables. While we currently have no reason to doubt the collectibility of
these receivables, a business failure or reorganization by this customer could
harm our ability to collect this receivable and if we were unable to collect
this receivable, it would have a material adverse effect on our cash
flow.
Our
future quarterly results may fluctuate significantly, which could cause our
stock price to decline.
Our
previous results are not necessarily indicative of our future performance and
our future quarterly results may fluctuate significantly. Historically,
information technology spending has been highest in the fourth quarter of each
calendar year, and slowest in the first quarter. Our quarterly
results reflected this seasonality in first and second quarters of 2008, and we
anticipate that our quarterly results for the remainder of 2008 will show the
effects of seasonality as well.
Our
future performance will depend on many factors, including:
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|
·
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the
timing of securing software license contracts and the delivery of software
and related revenue recognition;
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·
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the
seasonality of information technology, including network storage
products, spending;
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|
·
|
the
average unit selling price of our
products;
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|
·
|
existing
or new competitors introducing better products at competitive prices
before we do;
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·
|
our
ability to manage successfully the complex and difficult process of
qualifying our products with our
customers;
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|
·
|
new
products or enhancements from us or our
competitors;
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|
|
·
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import
or export restrictions on our proprietary technology;
and
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·
|
personnel
changes.
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Many of
our expenses are relatively fixed and difficult to reduce or modify. As a
result, the fixed nature of our expenses will magnify any adverse effect of a
decrease in revenue on our operating results.
Foreign
currency fluctuations may impact our revenues.
Our licenses and services in Japan are
sold in Yen. We anticipate that sales of our licenses and services in Europe,
the Middle East and Africa, will at some point in 2008 begin to be made in
European Monetary Units (“Euros”).
Changes in economic or political
conditions globally and in any of the countries in which we operate could result
in exchange rate movements, new currency or exchange controls or other
restrictions being imposed on our operations.
Fluctuations
in the value of the U.S. dollar may adversely affect our results of operations.
Because our consolidated financial results are reported in U.S. dollars,
translation of sales or earnings generated in other currencies into U.S. dollars
can result in a significant increase or decrease in the reported amount of those
sales or earnings. Significant changes in the value of these foreign
currencies relative to the U.S. dollar could have a material adverse effect on
our financial condition or results of operations.
Fluctuations
in currencies relative to currencies in which our earnings are generated make it
more difficult to perform period-to-period comparisons of our reported results
of operations. For purposes of accounting, the assets and liabilities of our
foreign operations, where the local currency is the functional currency, are
translated using period-end exchange rates, and the revenues, expenses and cash
flows of our foreign operations are translated using average exchange rates
during each period.
In
addition to currency translation risks, we incur currency transaction risk
whenever we enter into either a purchase or a sales transaction using a currency
other than the local currency of the transacting entity. Given the volatility of
exchange rates, we cannot be assured we will be able to effectively manage our
currency transaction and/or translation risks. Volatility in currency exchange
rates may have a material effect on our financial condition or results of
operations. Currency exchange rate fluctuations have not, in the past, resulted
in a material impact on earnings. However, we may experience at times in the
future an impact on earnings as a result of foreign currency exchange rate
fluctuations.
Our
stock price may be volatile.
The
market price of our common stock has been volatile in the past and may be
volatile in the future. For example, during the trailing twelve
months ended June 30, 2008, the closing market price of our common stock as
quoted on the NASDAQ Global Market fluctuated between $6.85 and $15.30 per share
and subsequent to June 30, 2008, the closing market price has been as low as
$5.65 per share. The market price of our common stock may be significantly
affected by the following factors:
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·
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actual
or anticipated fluctuations in our operating
results;
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|
·
|
variance
in actual results as compared to financial
estimates;
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|
·
|
changes
in market valuations of other technology companies, particularly those in
the network storage software
market;
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·
|
announcements
by us or our competitors of significant technical innovations,
acquisitions, strategic partnerships, joint ventures or capital
commitments;
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·
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loss or
addition of one or more key OEM customers;
and
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·
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departures
of key personnel.
|
The stock
market has experienced extreme volatility that often has been unrelated to the
performance of particular companies. These market fluctuations may
cause our stock price to fall regardless of our performance.
We
have a significant number of outstanding options, the exercise of which would
dilute the then-existing stockholders’ percentage ownership of our common stock,
and a smaller number of restricted shares of stock, the vesting of which will
also dilute the then-existing stockholders’ percentage ownership of our common
stock.
As of
June 30, 2008, we had an aggregate of 10,404,572 outstanding options to purchase
our common stock and 954,555 outstanding restricted shares and restricted stock
units. If all of these outstanding options were exercised, and all of the
outstanding restricted stock and restricted stock units vested, the proceeds to
the Company would average $6.47 per share. We also had 305,736 shares of our
common stock reserved for issuance under our stock plans with respect to options
(or restricted stock or restricted stock units) that have not been granted
(excluding an additional 2,368,287 shares of common stock reserved for issuance
under the 2006 Plan as of July 1, 2008.) In addition, if, on July 1st of any
calendar year in which our 2006 Incentive Stock Plan (the “2006 Plan”) is in
effect, the number of shares of stock to which options , restricted shares and
restricted stock units may be granted is less than five percent (5%) of the
number of outstanding shares of stock, then the number of shares of stock
available for issuance under the 2006 Plan shall be increased so that the number
equals five percent (5%) of the shares of stock outstanding (as is currently the
situation). In no event shall the number of shares of stock subject to the 2006
Plan in the aggregate exceed twenty million shares, subject to adjustment as
provided in the 2006 Plan (see Note (2) Share-Based Payment
Arrangements to our unaudited condensed consolidated financial
statements). As a result of the amendment, on July 1, 2008, we now
have 2,674,023 shares of common stock reserved for issuance under our stock
plans.
The
exercise of all of the outstanding options and/or the vesting of all outstanding
restricted shares and restricted stock units and/or the grant and exercise of
additional options and/or the grant and vesting of restricted stock and
restricted stock units would dilute the then-existing stockholders’ percentage
ownership of common stock, and any sales in the public market of the common
stock issuable upon such exercise could adversely affect prevailing market
prices for the common stock. Moreover, the terms upon which we would
be able to obtain additional equity capital could be adversely affected because
the holders of such securities can be expected to exercise or convert them at a
time when we would, in all likelihood, be able to obtain any needed capital on
terms more favorable than those provided by such securities.
Unknown
Factors
Additional
risks and uncertainties of which we are unaware or which currently we deem
immaterial also may become important factors that affect us.
Item 2. Unregistered Sales of Equity Securities and
Use of Proceeds
Shares of
common stock repurchased during the quarter ended June 30, 2008:
|
Total
Number of
|
Maximum
Number
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|||||||||||||||
|
Shares
Purchased
|
of
Shares that May
|
|||||||||||||||
|
Total
Number of
|
Average
Price
|
as
Part of Publicly
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Yet
Be Purchased Under
|
|||||||||||||
|
Shares
Purchased
|
Paid
per Share
|
Announced
Plan
|
the
Plan at Month End
|
|||||||||||||
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April
2008
|
95,000 | $8.21 | 95,000 | 1,960,900 | ||||||||||||
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May
2008
|
705,000 | $8.64 | 705,000 | 1,255,900 | ||||||||||||
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Total
|
800,000 | $8.59 | 800,000 | 1,255,900 | ||||||||||||
On
February 6, 2008, the Company announced that its Board of Directors increased
its authorization to repurchase the Company’s outstanding common stock from two
million shares to five million shares in the aggregate. As of June 30, 2008, the
Company had repurchased 3,744,100 shares. The program has no expiration date. On
July 22, 2008, the Company’s Board of Directors increased the authorization to
repurchase the Company’s outstanding common stock from five million shares to
eight million shares in the aggregate and as a result, as of July 22, 2008, the
Company could purchase up to 4,255,900 shares of its common stock.
Item 4. Submission of Matters
to a Vote of Security Holders
The
Company held its annual meeting of stockholders on May 8, 2008. 46,588,521
shares of Common Stock, 93% of the outstanding shares, were represented in
person or by proxy.
Steven R.
Fischer was elected to serve as a director of the Company for a term expiring in
2011 with 46,429,253 shares voted in favor, 159,268 shares withheld and 0 broker
non-votes.
Alan W.
Kaufman was elected to serve as a director of the Company for a term expiring in
2011 with 46,270,740 shares voted in favor, 317,781 shares withheld and 0 broker
non-votes.
The terms
of office of Company directors ReiJane Huai, Lawrence S. Dolin, Steven L. Bock
and Patrick B. Carney did not expire prior to this annual meeting of
stockholders and each remains a director of the Company.
An
amendment to the FalconStor Software, Inc., 2006 Incentive Stock Plan was
approved with 26,503,320 shares voted in favor, 2,309,208 shares voted against,
59,672 shares abstained, and 17,716,321 broker non-votes.
An
amendment to the 2007 Outside Directors Equity Compensation Plan was approved
with 27,718,707 shares voted in favor, 1,090,090 shares voted against, 63,403
shares abstained, and 17,716,321 broker non-votes.
The
selection of KPMG LLP as the independent registered public accounting firm for
the Company was ratified with 46,065,530 shares voted in favor, 479,778 shares
voted against, 43,213 shares abstained and 0 broker non-votes.
Item
5. Other
Information
On July
24, 2008, we issued a
press release containing our Condensed
Consolidated Statement of Operations for the three and six months-ended June 30,
2008, and
we furnished the press release on
a Form 8-K. Subsequent to the filing of the Form 8-K, we
identified an error in the calculation of our non-cash share-based compensation
expense. The error was corrected in our 10-Q, which resulted in
additional operating expenses of $330,000, a decrease in our provision for
income taxes of $110,000 and a decrease in net income of
$220,000.
Item 6. Exhibits
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31.1
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Certification
of the Chief Executive Officer
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|
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31.2
|
Certification
of the Chief Financial Officer
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|
|
32.1
|
Certification
of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 (18 U.S.C. § 1350)
|
|
|
32.2
|
Certification
of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002 (18 U.S.C. § 1350)
|
|
|
99.1
|
FalconStor
Software, Inc., 2006 Incentive Stock Plan, as
amended
|
|
|
99.2
|
FalconStor
Software, Inc., 2007 Outside Directors Equity Compensation Plan, as
amended
|
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)
August
11, 2008
38