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Sonic Foundry (NASDAQ:SOFO)

Q2 2013 Earnings Call

April 25, 2013 4:30 pm ET

Executives

Tammy Jackson

Kenneth A. Minor - Chief Financial Officer, Chief Accounting Officer and Secretary

Gary R. Weis - Chief Executive Officer, Chief Technology Officer and Director

Tammy Jackson

Good afternoon, and welcome to Sonic Foundry's Earnings Presentation. I'm Tammy Jackson and will be moderating today's webcast. [Operator Instructions] We'll begin with the Safe Harbor statements and take Q&A directly after the prepared remarks.

In compliance with the SEC regulation regarding fair disclosure, we will be using SEC filings and public presentations, like the one you're viewing and participating in today, as the principal means of informing the Street and investors as to both our current and past results, as well as providing guidance on our projected operating results. Sonic Foundry will continue to meet with analysts, investors, the media and others on an intra-quarter basis but will not provide updates regarding quarter-to-date results, financial projections or any material nonpublic information during those meetings.

Sonic Foundry’s disclosure policy defines the period beginning on the 15th day of the third month of each fiscal quarter and ending on the day we publicly release the results of that quarter as a quiet period. During such quiet periods, we will not make any comments about our financial performance nor provide forward-looking guidance except in press release form. Finally, this conference will contain forward-looking statements about the products and services of Sonic Foundry within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements include statements about our products and services, our customer base, new partnerships, our future operating results and any statements we make about the company’s future, including responses to your questions. These types of statements address matters that are subject to many risks and uncertainties.

Actual results could differ materially from the forward-looking guidance we provide. Any forward-looking statements should be considered in context of the risk factors disclosed in our periodic Forms 10-Q, 10-K and other filings with the SEC. These filings can be accessed online at sec.gov and other websites or can be obtained from the company’s Investor Relations department. All of the information and disclosures we make today regarding our business, including any forward-looking guidance, are as of the date given, and we assume no obligation to update or change this information regardless of subsequent events. An archive of this presentation will be available at sonicfoundry.com for 30 days.

And now, Ken Minor will begin today's presentation.

Kenneth A. Minor

Thank you, Tammy. Good afternoon, everyone, and welcome to Sonic Foundry's second quarter financial presentation. I'll begin by going through a few of the quarter's highlights.

First of all, billings grew by 19% to $6.6 million over the prior year's $5.5 million. Many of our billings now represent recurring service and product fees and, therefore, deferred. So revenue grew 8% over the prior quarter -- prior year's quarter. The billings growth represents a leading indicator, however, of future revenues based on the deferral of those billings. Product revenue increased 13% year-over-year to $3.0 million, primarily as a result of an increase in product revenue from our partner, Mediasite KK, which supports higher education demand in Japan.

Product revenue does not reflect much of the impact from product licenses from My Mediasite. My Mediasite was released in late December and received strong customer demand but because that represents an annual license for those new software licenses, they're recurring licenses and they're initially deferred, and those will be recognized as revenue over the period that they cover.

In terms of the GAAP results. The GAAP net loss was $27,000 loss, which recognizes some pretty significant improvement over the prior year's $115,000 loss. But that's of course despite the investments that we've been making in those new initiatives that we talked about over the last year or so.

Our GAAP results were a $0.01 loss and that compares again favorably to the $0.03 loss that we recorded last year. We just also achieved non-GAAP income of $612,000, pretty significant improvement over the prior year's $60,000 loss. That's a $0.16 per share number on an EPS basis versus $0.02 loss last year. And again, that recognizes the significant amount of billings that are deferred from a balance sheet perspective but not recognized as revenues yet and will be, of course, coming up.

Gross margin of $4.7 million compares to $4.3 million last year. That's an improvement in the rate. Our rate increased to 73% this year versus 72% last year. Our cash balance was at $3.7 million at March 31, 2013, and the equity investment that we recorded in MS KK was $90,000 for the period.

In terms of the 6-month to date numbers, again, our billings are up sizably over the prior year and pretty consistently from Q1 to Q2. We had 20% increase year-over-year, now to $13.4 million we're in this year's period versus $11.2 million last year. In terms of the revenue rates, our revenue grew 7%, again, that's largely due to an increase in some units sold, as well as the mix of billings recognized as mix of billings that are deferred. And so that, obviously, that's the difference then between billings and revenues growth. The GAAP net loss spend, that was $166,000. That compares to $300,000 loss last year. And again, on a per share basis, that's $0.04 per share compared to $0.08 last year. And again, on a non-GAAP basis, pretty significant improvement. The non-GAAP numbers do represent a better indication of what cash flow is. And I think, as I mentioned before, is a leading indicator of revenue and profits to come. We did have non-GAAP income of $1.3 million or $0.33 per share. That's, again, compared to a loss last year. So the loss last year from a non-GAAP basis was $224,000 or $0.06 per share. And as I mentioned in the quarterly slide, that's due -- the main drivers, that's the deferred billings.

On a margin basis, our margins again were improved over the prior year, with $9.6 million in gross margins versus $8.8 million last year. The rate's 74% this year and 73% last year. Cash did decrease since September 30 of last year, about $800,000. We did expect it to decrease. The decrease is a little more than we expected due to some deferred collections from a couple of partners and those were delayed until April but those are now paid.

We did also record equity income in the prior quarter from our Japanese affiliate in Q1, so the full year-to-date numbers now are $168,000 for the 6-month period.

In terms of the billings numbers, again, big increases. Product billings were up $521,000, that's 19%. Again, that's largely due to the recorders and the sale of our software licenses on an annual basis from My Mediasite. As I mentioned, My Mediasite was released December 17. And we now realize over $200,000 of new annual license fees from that new product. And so as I mentioned, that's a recurring fee. And so that fee will be due again next year. Service billings were up $520,000. That's an 18% increase year-over-year. And again, that's driven by events and support contracts growth.

In terms of the financial statements, I'm going through the summary for the first -- the second quarter, first. The year-over-year revenues were up 8%, as I mentioned. Product and other revenue increased $337,000. It's up 13%, $3.0 million in Q2 of 2013. That's compared to $2.7 million last year. Average selling price did decrease slightly, decreased from $9,400 in the prior year to $9,200. We did see a pretty significant change in the ratio of our racks to mobiles. And so we sold 3 racks for every mobile this period, and that compares to 1.3 racks for every mobile last year. And mobiles do carry a higher price point, so that does result of the ASP dropping some. We also had 1 single large refresh transaction at a slightly lower price point that had some impact on ASP. But as I mentioned, despite that, margins are up across the board.

In terms of the products, we did ship 302 units this period in Q2 of this year and that's compared to 249 last year. Again, a large part of that is due to some significant sales that our Japanese affiliate was fulfilling for Japanese demand in higher education.

Our gross margin, as I mentioned, improved from 72% last year to 73% this year. And we have seen some pretty good manufacturing improvement. Most of that manufacturing improvement that reflected the year-over-year change occurred late last year. And we do expect further improvements late this year and early into next year.

In terms of operating expenses, our operating expenses were up 9%. The total was $4.7 million, that compares to $4.3 million last year. Selling and marketing did increase $318,000. That's a 12% increase. That's primarily a result of higher salary, incentive comp and benefits, as well as higher depreciation, travel, sponsorship and trade show attendance cost. And these are all primarily related to the significant increase in billings over the periods, as well as cost that we're incurring to introduce new products and enter new markets.

In terms of G&A. G&A increased $184,000 to 28%. That's due primarily to increase of professional fees. We did have -- as well as a reversal of bad debt expense. As you may remember, Q2 of last year, we reversed a bad debt expense that we had recorded potentially in Q1 that created a negative bad debt expense in Q2 of last year, so it creates kind of an anomaly in the comparisons. So in other words, that piece doesn't represent an increase in bad debt expense. It just represents the lack of a big credit that we have last year.

In terms of product development costs, those costs decreased $94,000, and that's a 10% change, which results from $121,000 decrease in compensation and benefits. And we did increase our R&D headcount over last year in order to accelerate some of those new products and new feature releases that we have throughout the last few quarters. However, we did more than offset that by capitalizing $237,000 worth of software development costs. And so there were internal labor costs that we capitalized as a result of our development process, and we did extend the development cycle in order to allow for some pretty extensive design and testing of the recently released desktop capture applications. And that's due primarily to a bit of a change in how that's used. I mean, that desktop cap application is used primarily by presentation creators rather than administrators. And then -- so as a result, we're pretty focused on spending some extra dollars in making sure that the development cycle made for is possible. In addition to the internal labor, we capitalized approximately $221,000 of external costs. And again, that was related to some external design and testing costs. We do anticipate very limited capitalization in Q3, and we'll start amortizing these costs beginning in Q3 and we'll start doing that over 3 years. And I anticipate this likely won't recur often. And as I mentioned, this is a bit of a different event due to the fact of it's more of a consumer-based product.

The GAAP net loss of $27,000 or $0.01 a share compares to Q2 of 2013 (sic) [ 2012 ] $115,000 loss, which is a $0.03 loss per share. In terms of our non-GAAP results, we've adjusted GAAP results to account for noncash expenses, as well as the cash impact of billings that aren't recorded as revenues. And this gives you, I think, a better indication of what the cash from the business is generating. Our noncash depreciation and amortization increased to $283,000 in Q2 of this year, that compares to $219,000 last year. Our stock compensation cost decreased $164,000 this year. That's down from $183,000 last year. And billings exceeded revenues by $132,000, typically it's the other way around. Last year, revenues exceeded billings by $407,000. That's more typical, but because of the mix of our billings and the success of My Mediasite that we're seeing the reverse happen, so we're billing and collecting more than what we're recognizing as revenue right now.

And then finally, we also add back the noncash tax expense, that was $60,000 in Q2 of this year. So after you apply those, you end up with the $612,000 I mentioned versus the $60,000 loss from last year.

And again, for the full year, product revenue, this is a similar story, was up $564,000, that's an 11% increase year-over-year and that comes in at $5.9 million versus $5.4 million last year. In terms of the total units that we shipped, 572 units this year, that compares to 491 last year. And again, that was largely, certainly in Q2, from international demand. Gross margin, again, is improved by about a full point from 73% to 74%. And again, that's manufacturing improvements and efficiencies, as well as in -- for the full year, we had some improvements on the cost from our events business as well.

The operating expenses, similarly, were up 9%, comes to a total of $9.7 million for the 6-month period. That compares to $8.9 million last year. Selling and marketing increased $553,000 or 10%. Again, that's partly from higher salaries, comp and benefit costs, as well as higher depreciation and increased travel, sponsorships and trade show attendance. And as I said, for the second quarter results, that's a result of 20% increase in billings.

In terms of the G&A, again, similar results for the full year. Our G&A was up $174,000. That's a 12% increase. And again, it's largely professional cost that drove that up. I mean, for the full year, it's largely due to some year end annual accounting consulting fees, and part of that was a result of our investment in MS KK.

In terms of product development, product development increased $101,000. That's a 5% increase. And that's primarily a result of allocating some facility and fixed costs from G&A largely due to depreciation and higher facility cost. The headcount, as I mentioned, did increase in R&D year-over-year. And so had we not capitalized the software development costs associated with this development efforts, we would have seen wages increase as well but it almost exactly offset that amount. And again, that capitalized amounts $237,000.

And I mentioned the GAAP net loss for the full year, again, it's an improvement from $300,000 loss to $166,000. And just to kind of run you quick through the amortization -- or the reconciliation, rather, between GAAP and non-GAAP, we had noncash depreciation and amortization of $504,000 in this period. We have stock comp of $347,000. And again, our billings exceeded our revenues by $455,000 in this period, and that will -- a good chunk of that will be revenue then in the remainder of this fiscal year. Noncash deferred income taxes was $120,000 in both those periods. So again, we ended up with a $1.3 million of non-GAAP earnings versus a $200,000 loss last year.

And finally, in the balance sheet. Our current assets decreased slightly from $11.9 million to $11.3 million. And we did see some expected decreases in cash, as I mentioned, that was partially offset by some increases in prepaid expenses. The long-term assets, it's in the goodwill and other intangible line, do include the capitalized software development costs of $458,000. Current long-term liabilities also decreased slightly from $12.3 million to $12.2 million, it's almost flat. And again, our liabilities do include 2 significant noncash elements, and they increased. We had $6.1 million from unearned revenue which, again, is the billings over revenue phenomenon, and the $2.1 million deferred taxes. So together, 2/3 of our liabilities now are a result of noncash-related liabilities.

In terms of our debt, we do have the same debt facility which is Silicon Valley Bank that we talked about before. We have $1.3 million outstanding in the term loan. And we have the same $3 million revolving line of credit facility with the $3 million, our max. We did a $2.7 million available to borrow as of 3/31/2013. And we haven't borrowed that, there's no outstanding balance. And we do think that with the cash we've got in the bank and the debt availability we've got with Silicon Valley Bank, we've got more than adequate resources for the accomplishment of our business plans. So we don't have any plans to raise any equity financing at this point.

So at this point, I'm going to turn the presentation over to Gary, and then he's going to run us through a few of the business trends.

Gary R. Weis

Thanks, Ken, and good afternoon, everyone. As we usually do, we'll go through a couple of charts to show the performance of some of the basic metrics of the business.

The first chart deals with billings by the top 5 enterprise opportunities that we closed in the quarter. You can see the trend for the first and second quarter of this year is very similar to what it has been. There are no significant multiple large deals in this quarter. You see the profile on this chart. We are making progress on pursuing a number of our larger opportunities in a number of geographies now. None of those closed in the second quarter. So what you see here is that the billings and revenues that we're making is systemic in the normal run rate business. It isn't due to any particularly large deals.

I'll spend a few seconds on this chart. This is, again, the same chart we've used in the past to show the seasonal nature of the business. But I think I would emphasize, this quarter, what you see in the black bar on the left-hand chart that shows the non-GAAP net income for the first half of this year, the trend is significantly different than the first half of the last 3 years. And that the drivers of this are due to the fact that, as Ken pointed out in his presentation, a significant portion of our billings in these 2 quarters had been for products that are sold on an annual license basis. And because we recognize the billings for a full year, we can only prorate a portion of that into the quarter according to GAAP accounting. The non-GAAP number, however, is reflective of the total billings, the cash that we took in from customers. And again, this is a leading indicator of things to come. We see that mix in source of billings continuing. If you look at the right side part of the chart, you'll see that the revenue in billings numbers for the first half in total significantly larger than the previous first half of 2012. And so we don't see a change in the seasonal nature of the business, but growth is propelling larger numbers in the first half of the year.

I will make an observation that assuming that we maintain our growth going into the first half of 2014, it's very likely that we will be both GAAP and non-GAAP profitable for the first half of 2014.

For customer billings, as you can see, we still are realizing 86% of billings in the quarter from our existing customers. I'll comment a little bit on one of the things that's causing us to be able to better leverage the existing customer relations that we have. For the last year, we've been working on restructuring our sales force a bit to now have a significant portion of the sales force focused on being account executives with named accounts that they're selling to, which really focuses on our leveraging those relationships that we already have, and realizing more billing and revenue from those customers. We continue to have a regional or geographic-based selling model, but we now have 2 models that we are operating on as opposed to 1, and that allows us to more effectively capitalize on the existing relationships with customers that we have.

Again, breakdown by sector, whether it's corporate, government, education, no particular surprises in these numbers. We had a strong quarter from the standpoint of corporate billings but nothing out of the ordinary. The same general kind of pattern that we have seen in the past 8 quarters.

And finally, in terms of the standard metrics of the business, international was strong in the quarter, and we think that based on our opportunities in outside of the United States, that will continue to be the trend in the third and fourth quarters as well.

I'll now shift to talk a little bit about customer and product trends. This slide, which I will not read through, is simply an indication of customer wins and major expansions in the quarter. You can see that there's some pretty impressive names such as Duke and Notre Dame in higher education. You can see that there's a mix of customers here in terms of non-higher education. And you also see the international flavor of our business in the logos that you see on this chart. We are seeing increased interest across the board in both our room-based lecture capture products and our new evolving My Mediasite desktop capture products, which I'll talk more about later in the presentation.

So again, we see very strong customer interest, very good penetration into new accounts and very good expansion in accounts where we have had a presence, but not as large as obviously the opportunity will allow us to obtain.

I'm going to take you through a bit of a history on the evolution of Mediasite. And for those of you that might have seen the shareholder meeting or attended the shareholder meeting, you'll recognize this sequence of charts which we used them at the shareholding meeting to help explain the nature of the evolution of our business.

In 2003 to 2008, that period between 2003 and 2008, the company was strongly focused on what we call room-based information capture. The reason we used the word information is that it is broader than lecture, but clearly in higher education, that translates to lecture capture. That room-based approach required us to have a very capable and intelligent appliance in each and every classroom, and we highly automated what was operated in that classroom so that the educational individuals presenting did not need to be familiar with the technology. They did not need to interact with the technology. They simply needed to show up, give their lecture, give their presentation. And when they were done, the system, the solution that we had sold to our customers, wrapped up what had been captured, publish it to our server and made it available to the various players that we would offer for customers to view the material that has been captured.

In 2012, we clearly saw some changes in the underlying technology. Prior to 2012, Windows Media had been a very standard way of formatting and presenting the video information. And as I'm sure all of you are aware, with Apple's debut of the iPad and the iPhone, new streaming technology and new encoding technologies such as H.264 and HTML5 became available. And we clearly realized that in order to give our customers the total value in our solution, we would need to support those protocols. So we began that evolution in 2011, delivered product in 2012 -- actually, we, I think, first delivered it in December of 2011, but 2012 was the year of implementation for our customers. And frankly, what we determined because of the sophistication and added capabilities in Mediasite 6.0, the customer had to do a lot to fully advantage themselves of that technology. So the year of 2012 was focused on us getting that technology out, using it as a base for future development and helping our customers most effectively use the technology.

In 2013, the focus has shifted. And it's very important that I emphasize that we are the market leader in room-based lecture capture. We're going to continue to be the market leader in room-based lecture capture. All of our customers really continue to deploy more recorders in more classrooms. However, in almost all of our customers, they also have a portion of their faculty who would like to participate in the classroom, meaning they would like to compose lecture material before they show up to the classroom, publish it to their students, before their students show up in the classroom, and then use the classroom time as a way to interact with their students, problem-solve, collaborate, do things that help cement the understanding of the material in the students' minds. And in order to do that, we need to offer complementary vehicles for the educators to capture and edit that information. That is what we call My Mediasite with both UGC and import capability, which I'm going to talk to a little bit more in a minute.

The other major thing that we're doing in the Mediasite 6.1 family is to introduce a concept called enterprise video platform. In the past, we've tended to call our server software EX server. It's a nice technical name, but in reality, it's not very descriptive of what we actually offer with that technology. What we do offer is capabilities, very broad and very deep capabilities for the customers to totally manage their enterprise video in their organizations, in their educational institutions, in their businesses. In many cases, we've seen customers that have a large library of video material that they want to share and re-purpose for different applications and so forth. What we're now capable of doing with the enterprise video platform is give the customer the ability to ingest that content, to transcode it into different formats and to really get a lot more value out of that content. Now that appeals to, obviously, education customers, but frankly, even more so for enterprise and business customers.

So 2013 and into 2014, we will position that technology, we will solve that technology, and we believe we will deliver a value set for the customer that isn't just focused on capture. It's focused on management, storage and searching. Now the other thing you see on this chart is something called voice search. And we have implemented a technology to allow us to take audio voice attached to a video, index it according to what we call a word list, which allows us to take a vocabulary that's appropriate for the setting, for the class, for the presentation, and allow that result of that indexing to be stored as metadata with the presentation. So the customer can now both search across all presentations in their library or within a presentation, find the voice term matching the search and go right to that presentation or go right to the time slot in that presentation. So as you can see, we're focused now on providing value other than just capture, and we think customers are buying that value, as Ken indicated with My Mediasite, and we think that, that will fuel a lot of our growth going forward in the future.

Now I've talked to a lot of these points already, but in reality, we are now enabling customers to capture and create and import content in a variety of ways. We certainly don't want to dictate our customers how they create and capture content. We offer them capabilities as part of Mediasite if they choose to use them. But because we now have a strong ability to ingest new content, we offer the customer full choice in terms of how they choose to get content into the Mediasite repository.

Once the presentations are stored in Mediasite, we then can deliver those presentations in a variety of player formats, certainly supporting all of the Apple technology with, say, HTML5, still supporting obviously the Windows Media technology, and interfacing to other solutions that are out there to allow the customer to control how that information is delivered outside Mediasite, such as Blackboard, such as Moodle, other educational technologies that allow the customer to integrate the video content with other course material.

Now the analysts out there, Forrester among one of them, where you can see this quote that I've displayed on the slide, has picked up a lot on how we're starting to evolve the capabilities that we offer to our customers. I won't read the quote, but the essence of it is that we're now focusing on being more multipurpose, we're focused on providing greater value. And again, to emphasize, we will continue to focus on providing the best capture experience as well, but customers don't have to use our capture experience. They can use other capture experiences and import that content into Mediasite.

Now what I would also like to do here is show you a real customer example. This is Sandia National Laboratories. Again, I won't read the quote. But the essence here is that Sandia really finds our video content management platform a really flexible way to help them realize their organization's mission in terms of managing information.

So let's talk a little bit about My Mediasite. The product debuted in December of last year. As Ken said, we've already booked a significant amount of billings against this product. It is part of the flip classroom capability. The user interface that you see here is what is now shipping with Mediasite 6.1.7, the most current release of Mediasite which was released this week, is a very practical, straightforward interface that's very intuitive. And it begins by allowing an educator or a corporate executive to decide what they want to do. Do they want to view an existing overview of how to use the product, do they want to record a presentation, do they want to manage the presentation that they've already recorded or do they want to alter the settings of the software. We then go through a step-by-step process of ensuring that after the user selects which format of recording that they want to do, screen caps plus audio, slide show plus audio or slide show plus video, we'll step the user through the configuration steps that are necessary to begin the recording. And I won't -- I don't have a slide capture here of the various steps, but this is just to illustrate the fact that this is very easy to use and it's a very modern user interface that's end user-oriented, not technical person-oriented. And then finally, when you're ready to go, you can preview the setting for what you're going to do and to actually begin the recording. The gentleman you see on the screen is our Vice President of Engineering, Dharmesh Sampat, who, obviously, played a big role in the development, and he happened to just be sitting in front of the camera when we composed this demo.

So you can see from what we're doing here is we're offering the customer a very easy-to-use capture mechanism. We've had strong feedback from our existing education customers that this does totally meet the desktop lecture capture requirement. It's instrumental for customers who are doing MOOCs, because in reality, the educator may very well want to compose the MOOC outside the classroom. So we think this capability will offer us a lot of potential revenue growth.

You've heard us talk a little bit before about multi-video streaming. And multi-video streaming is now taking shape in our development lab. Later this year, we will be announcing several variations of this product. This product does a wonderful job of capturing ultimately up to 4 concurrent videos and time-synchronizing those videos. It also continues to automatically generate thumbnail slides from one of those videos if the customer so chooses. So this screen shot again shows you a meeting room now that instead of just focusing on the educator, which would be kind of the lower right part, we also can, in this case, just for demonstration purposes, focus on the audience and capture what's going on in the audience in the upper right quadrant, and we also capture the document camera, that you see the educator using in the lower right-hand side. The document capture camera is captured at a full frame rate video, so it's very fluid and very easy to watch. Again, that capability, we think, again, enhances our room-based lecture capture presence.

Now why are we making that investment? We're making that investment to do multiple video, because our customers are telling us they want it, our customers are willing to buy it. The quote here from Duke shows you an indication of how this particular customer is choosing to use that technology. We think this will be very powerful. It will be very useful by a number of customers. And so, again, you'll see that ship this year, later in this year.

Our events business continues to be quite active. One of the things that we've focused on in the past several quarters is working with partners to capture larger events, because very simply, it's more attractive and more profitable for us to capture large events. This example, Ellucian, one of our partners that you see that we captured with ACTIVE, you see the statistics on the screen in terms of the size. With ACTIVE, we will also be capturing BlackBerry Live later this year. A quote from ACTIVE that you can, again, read for yourself, clearly, they value our current technology to do the capture, the streaming and the management, the on-demand playback of these events. We'll continue to expand this business. We'll continue to develop other partnerships as well.

The other thing that we're seeing from our customers is that they are dealing with this in multiple ways, multiple dimensions. So Hunter Douglas is an example, uses us to capture events, which is the event business. They use our hosting offering, which is where we will actually host the server for one of their divisions, and they also buy our product outright and install it and run it inside their company. So again, it's a way for us to leverage the total value we can bring to the customer. It's part of the relationship, selling and account management that we've transitioned our sales force for -- or our sales force to, and again, it's a way to leverage the value that we offer within these customers.

This is a quote from Scott Walker, who is going to be the keynote speaker at our UNLEASH event next week. And the point he makes in this quote is that the role of technology in buildings, as people construct buildings, where people either go to school, they learn or they work, is changing to offer a different capture experience other than simply focusing on the lecture at the front of the room. We're fully engaged in working with Scott and other consultants to figure out how we can continue to evolve our room-based capture technology to participate in that trend.

And in closing, I'll talk just a little bit about UNLEASH. Our UNLEASH event continues to grow. As I said, it will be held next week here in Madison. It's a good measure for us of customer loyalty and customer participation. Customers come to this event from a wide number of countries and locations. They attend it not just to hear us talk about our products, because actually, very little of the content of these product -- contents of these sessions is us presenting. Rather, it's the customers collaborating on how to best use our products and exchanging best practices, so that customers actually pay for this event because of the value that they get out of it. So it's a very wonderful event that we host every year. Attendance is up this year, and you can see that more and more decision-makers are also attending the event.

And so with that, that gives you an update of where we are in the business, and I will turn it over to Tammy for any questions that you may have.

Question-and-Answer Session

Tammy Jackson

Thank you. First question, "What are your expectations for event services and hosting revenues for fiscal year '13?"

Gary R. Weis

We don't tend to externally breakdown our revenue forecast by those sublines of the business. We will continue to grow events, but we'll do it opportunistically for areas where it fits for us, both from a return perspective and from the standpoint of ability to service the business through partnerships. Hosting continues to grow. We're finding an increasing number of customers who want to avoid the complexity of installing the service solutions in their own enterprises and they rather have us do it for them. Ken, if you would have anything else to comment on?

Kenneth A. Minor

Well, the only thing I will add is, we are reiterating our guidance for fiscal '13, and I guess that's one thing we haven't mentioned. We started the fiscal year saying that we believe that our core business will generate 13% growth. And then we had opportunities, large opportunities, that can generate between 0 and an additional 8 points to that, and we feel like we're right on track. So we're keeping with all the original guidance we started off the fiscal year with.

Gary R. Weis

Yes, absolutely. And frankly, we see all of the components of our business productively contributing to meeting that guidance.

Tammy Jackson

Speaking of the large deals. Has there been any movement on your large international accounts?

Gary R. Weis

We would be happy to answer that in unison, and the answer is, yes. We have gotten our first order from one of those large accounts in the Middle East. It is, and I would emphasize, it is the first part of a much larger order. As we've emphasized in the past, the customer will buy the equipment when the facilities are constructed to use the equipment. One of the projects has gotten to the point where they're beginning to equip some of the rooms, and that's why we've seen the first order come in. We have 3 other large opportunities, in addition to that 1, which all have building occupancy schedules in 2014 and 2015. We're continuing to work those opportunities. We see no reason to report any change in our status or our confidence in winning those opportunities. But we do not set the timing, the customer does. And so our goal is to make sure that we have a happy customer, and that they're going to get the equipment installed in a timely fashion to meet their particular needs.

Kenneth A. Minor

What I'll add is that -- I'll stress that, that is a small piece of that first order. So it had very little to do with the billings growth year-over-year, and we achieved those big numbers without a big deal. So in other words -- and so that growth is really coming from the core business.

Tammy Jackson

You reported your gross margin improved year-over-year. Can you help us understand that the impact is all operational efficiencies? Or is there something else contributing?

Kenneth A. Minor

Yes. I mean, for the 6-month period, the biggest drivers are largely our manufacturers able to produce the products in a more efficient way. So in other words, they're producing the products at a better cost price, cost point for us. The other difference, and this didn't affect Q2 too much, but it did certainly affect Q1, was reduced consulting fees or third-party fees associated with our events business. If you remember, back a little over a year ago, we had some fairly significant third-party costs. A lot of that was pass-through billings that we're incurring for closed captioning. And very little of that exists at this point. So that the fees that go with our events business are substantially less than was a year ago. So I expect that, that will stay low. I expect that we'll see some other modest cost improvements. In the very tail end of this fiscal year, that will have a bigger impact on fiscal '14.

Gary R. Weis

And I guess I would add to what Ken said about the operational nature of the business, that a lot of times, we get questions about, "Do you feel price pressure from your customers to reduce the price of your products?" And the answer is unequivocally, no. That's one of the other factors that allow us to maintain our margins is we continue to price on a value basis for a solution. We don't sell the hardware separately. We don't sell the software separately. We sell the solution. And so I think the value that we're delivering to customers allows us to maintain our price point in the market.

Tammy Jackson

What was the approximate number of refresh units sold, the renewal rate for support service contracts, and how many My Mediasite implementations occurred in the quarter?

Kenneth A. Minor

Well, as I mentioned, in My Mediasite, we've done about $200,000 worth of licenses from My Mediasite. In terms of the total number of implementations, that's roughly in the 2-dozen range. In terms of -- I'm sorry, remind me of the other point. Was refresh units...

Tammy Jackson

[indiscernible]

Kenneth A. Minor

Yes, on the refresh units, it was similar to the prior year. And I don't have the exact number off the top of my head. But it was something like 113, 110, 115, right in that range. So fairly consistent with the prior period. In terms of the renewal rates, yes, I think our renewal rates were actually a little lower in Q2 than they were in Q1. But Q1 was, I think, a little bit anomalous because it included some amounts that didn't renew in Q4 of last year.

Gary R. Weis

Which was TETRA.

Kenneth A. Minor

Right, exactly.

Gary R. Weis

I think also that on the refreshes, as we sell more units on an annual basis, there's kind of a built-in schedule for when a customer will be highly motivated to do a refresh, and that's 4 years after they install the hardware. So as a result, and I've said this on calls in the past, refreshes are a very good part of our business because it represents a recommitment of the customer to the technology, and it enables collecting support fees going forward after the refresh.

Tammy Jackson

As you've gained experience with increased deal complexity, what changes have you made to attempt to reduce the closing cycle?

Gary R. Weis

I would say that the discipline we put into the sales process is really oriented toward maintaining the sales cycle and not having get lengthened because of the changes in procurement process at the various schools and businesses. It's really not so much business, it really is focused on higher education. So I just want to make sure everybody understands that we don't see a path to significantly lessen the time it takes to close a business, but rather we saw the trend develop in the fourth quarter last year, where as customers started to look at the possibility of using Mediasite as a campus-wide standard, that the review process and procurement process lengthened. One of the actions that we think will help with that is moving to an account executive relationship selling model for those larger customers.

Tammy Jackson

Is there a strategy for selling and marketing the enterprise video platform to the corporate customer?

Gary R. Weis

That's under development. I think that we have a number of opportunities to accomplish that. We're looking at ways in which we can speed up selling software licenses into the corporate business community. But it's a work in progress and something that I'm not prepared to talk about anymore in the call today.

Tammy Jackson

Given the low penetration of video capture across the education market, what will it take to accelerate the growth in new customers?

Gary R. Weis

Well, I will give you a very straightforward answer, and that is, we don't see a magic thing that's going to happen to accelerate that. There are a lot of natural forces that should lead higher education institutions to want to do more off campus distance-learning for which some form of capture technology, whether it's in-room or desktop or whatever, will be required. But education institutions are deliberate, and they are careful in how they make those changes. In some cases, they're strong influenced by faculty. And I don't want anyone to think that there's some kind of event that's going to happen that's going to cause a hockey stick of adaptation of video capture. We see steady growth, we see somewhat increasing growth. We are positioning ourselves to make sure we sell into that. But I don't want anyone to read into those comments that we think that there's some event that's going to suddenly accelerate the growth.

Tammy Jackson

Several questions have come-in about research and development. Please repeat why R&D costs were capitalized. And could you give us a better idea in terms of future plans to capitalize costs going forward?

Kenneth A. Minor

Sure. The My Mediasite site is an application that is going to be used more directly by end users. So presentation creators are going to be using that application. And so it's less likely that there will be an IT staff that's going to be managing that as an example. So a perfect example is there is going to be a professor in their office that's going to be using that application and it needs to be an application that is very intuitive, easy to use and requires no learning curve. So as a result, we spend some extra dollars from an outside perspective on the design of that to make sure that it have the kind of interface that people are used to seeing and more of a consumer application. I mean, I shouldn't say that this is a consumer application, but it needs to look -- it needs to be intuitive like a consumer application would be. Likewise, we want to make sure that we put some extra effort into development to make sure that we didn't have any issues with bugs, and this is not because we felt like it particularly needed it. We just want to make sure that there wasn't a situation where there's an end user that attempted to use it and had some situations that would cause him to stop using it. And we want to make sure that this is going to be very well received. So as a result, the development process was longer. We reached the point where the product reached technological feasibility in October, and we continue to do development on the inside, as well as incurring those outside costs.

I think it's different because we have not sold that kind of a product in the past. New products have always been geared more towards the administrator, IT savvy types of folks. And as a result, the products, the time cycle between technological feasibility and the time cycle that it reached the end user is very short. And as a result, that hadn't happened before. This wasn't a choice that we made. This is required by GAAP that you have to capitalize those costs, if there is a gap between technological feasibility to the time it's introduced to the market. So we did what we're required to do. I think we are not typically in the business where we do that kind of thing frequently. So I think it is going to be rare that this happens. I think there could certainly be other events that will cause it to happen again. But in the near term, we don't have any plans. And so while I said there will be some light capitalization in Q3, that's just the tail end of the effort as we got up to releasing 6.1.7.

Gary R. Weis

I guess, I would just follow up to emphasize what Ken said. This is -- you should not view this as a change in the way we're managing our R&D cost. The vast majority of our R&D cost is still focused on incremental improvement of the existing software that we have as part of our core product. Again, I'll emphasize that the reason this product is different is that you buy a license that enables individuals to use it within the company. There's a separate revenue stream for it, there's a separate test cycle for it, there's a separate development cycle for it. It's not part of the 6.1, 6.5, 6.7 development cycle to produce a general product. And so as Ken said, we're required for that kind of a business case to take the action that we took. But it is not, in any way, shape or form an indication is something that we plan to do more systemically in the business. We'll only repeat this if we have a similarly situated product development situation going into the future.

Tammy Jackson

How much headcount has been added to R&D in the last year, and is there a plan to add more?

Kenneth A. Minor

We don't expect much additional headcount, and we've been guiding towards that in our 10-Q. And I think if you look back, this is, I guess, about 6 quarters ago, but when we began the effort of growing headcount in R&D, I think the variance from 6 quarters ago to now is about 9. So about 9 additional engineering heads.

Gary R. Weis

Yes. And there's -- we think the level of resource that we're at now is adequate to execute our development plan for 2013 and 2014. And the only other additions that we would consider would be those that are operationally required to either do support or testing or something of that nature, which will be a very small number, if anything.

Tammy Jackson

Can you provide more color on the capitalization of external expenses in the amount of $221,000?

Kenneth A. Minor

Just to, I guess, essentially repeat what I said, we hired 2 firms to assist us in our own internal efforts with that same product. We hired a design firm that assists us with the user interface, and that occurred starting in January. We also hired a firm that assisted us in doing a great deal of testing on those products -- on that product, which began in October, and concluded in late February. So those costs are now done. I think there is a small amount that trickled into April, but the testing was completed as of February and the design was complete as of April.

Gary R. Weis

That is an important point, the testing aspect of this. Most of our testing for the core product deals with testing our service software and testing our recorder software, which runs in an environment that's very predictable. For a desktop capture, our application has to run across many, many different platforms. And we certainly weren't about to hire enough resource internally in the company to do that kind of testing across that broad target systems that would run the application. So we outsourced that. And again, that was a very effective way, in fact, to ensure that we did testing in that multi-platform environment.

Kenneth A. Minor

And one thing I should probably also say, this, as well, is new. So we have not incurred outsourced testing cost before, we've never incurred outsourced design cost before. And so this is not capitalizing some routine, regular outsourced cost that we've been incurring all the time. This is brand-new cost that we decided to invest in as a result of this new product and the focus that it has, with the revenue stream it has, and it's quite different.

Tammy Jackson

How does Mediasite compare with other video content management systems? And what new opportunities do you see in this market for Mediasite?

Gary R. Weis

First off, let me address the opportunities. We see a large opportunity in the corporate space where customers today may be ad hoc managing their video libraries with separate products, separate tools and people to basically take care of that management. Mediasite enterprise server, the video server capability, is certainly capable of providing all those functions on a homogeneous platform that's automated and easy for the customer to administer. So we think there are labor cost savings within companies. We think there are automation opportunities to transcode between formats. Probably the best example is some customers may have a large library of Adobe Flash-encoded content that they want to transform that to HTML5 or H.264, granted there's a whole number of tools out there to do that, but they're tools, they take people to run them and manage them and so forth. With our video server capability, with our video management capability, we do that in an all highly automated basis. So we think that's a big opportunity. And so the first part of the question, which was competition. So there's a number of folks who have started to do this. I don't think that -- Kaltura is probably one that comes to mind. Everybody has their kind of own slant on how to develop and prioritize features and capabilities. So I'm not going to try in this call today to go through a checklist of what the various folks do. But I think what we do is different than any of them. Because of our background and our heritage edX server, we focus a lot on things like security and protection of content and management of content. That's something we've done for years. We do it very well. So the adaptation for us to add the ingestion of content and transformation of content is relatively straightforward and still leverage all those things that we've developed in the past.

Tammy Jackson

We have time for just one more question. What innovations do you see on the horizon for this technology, such as note-taking, desktop sharing and expanded user interactions?

Gary R. Weis

We have a very long list of requirements for innovation that we've gotten from our customers. So one thing we will do is we will make sure, before we spend money on innovation, that there is a plan to be able to realize revenue from that innovation. So we're not big on speculative innovation. But to give you a few examples where we have gotten feedback from customers, note-taking is one thing where we've gotten feedback from our education customers. They think that's a value for their students, and improving student outcomes is a big deal. I'm not going to comment on when or for sure if we're going to do that, but that's certainly an area that we're looking at. Capturing content in a collaborative room-based situation is something that a lot of our educational customer partners have told us will be important as the classroom is flipped, doesn't take much to imagine that. You've had the educator compose a class with My Mediasite, and they've got the students together, and they're now doing problem solving and collaboration, and they like to capture what goes on for the benefit of students who are not in attendance or the benefit for review of students who have been in attendance. That's an interesting problem, and it does require innovation, because you no longer are just recording a camera that's pointed at the front of the room. So we are working on that capability. We have a list of other candidates that we are considering. But I don't have the time now to go into any of those. But suffice it to say that we have a long list, but we're going to be very picky about which ones we invest in, to have it tied to a business plan to sell whatever the innovation is.

Tammy Jackson

That's all the time we have for today's call.

Gary R. Weis

Well, thank you, Tammy, and thank you to all of the folks who attended this afternoon. I'll close by making what I think is very optimistic comment about, as Ken did earlier, about guidance. We're well on our track this year to achieving the guidance that we set. Remember, we said 13% billings increase for the core business, and the 18%, 19%, 20% you've seen in the first 2 quarters is the core business. It does not reflect any of the large Middle East opportunities. Those opportunities were outlooked from 0 to 8%. They are all still there. We're all very active in pursuing them. The timing, just like last year, is something we don't control, but we're very optimistic about the outcome over the next 2 years.

So again, we're -- Ken and I and the entire team are very optimistic about achieving the plans this year. We're very optimistic about 3 years from now getting to the point of having a business that's greater than $40 million in revenue with a 15% net income, pretax. And we're well on the way to the march to get there. So again, thanks for attending this afternoon, and we look forward to talking to you at the next meeting, about 3 months from now. Thank you.

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