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Jeffrey Walkenhorst, CFA
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Summary: Portfolio Manager at Copeland Capital, formerly a Senior Research Analyst at international think tank, Wall Street Research Analyst, and Private Investor. Experience consulting to investment funds, financial services firms, global organizations, and high net worth individuals/families.... More
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Copeland Capital Management LLC
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  • Google/On2 Provides Current M&A Comp for SOFO 0 comments
    Aug 11, 2009 10:25 PM | about stocks: SOFO, GOOG, ADBE, SNE, JAVA, ONT
    On 8/5/09, Google (NASDAQ:GOOG) and On2 Technologies (ONT) jointly announced that Google would acquire On2 in an all-stock transaction valuing ONT at $0.60 per share (compared to $0.38 the prior day, a 57% premium) for total consideration of $106.5 million (at time of deal). On2 is a developer of video compression technology used by customers such as Adobe (NASDAQ:ADBE), Skype, Nokia (NYSE:NOK), Infineon, Sun Microsystems (JAVA), Mediatek, Sony (NYSE:SNE), Brightcove, and Move Networks. Google management stated the following in the press release:
    • "Today video is an essential part of the web experience, and we believe high-quality video compression technology should be a part of the web platform," said Sundar Pichai, Vice President, Product Management, Google. "We are committed to innovation in video quality on the web, and we believe that On2's team and technology will help us further that goal."
    A MarketWatch article, "Video future at heart of Google's On2 acquisition", summarized the deal and highlighted the following:
    • "...the deal's price tag of $106.5 million in stock was barely enough to give Google watchers any pause. But the size of the deal isn't seen as nearly important as what On2's technology could add to Google's efforts to increase the amount and quality of the video it brings to consumers either via its YouTube video-sharing site, it's new mobile-device operating system, Android, or other ways to bring video over the Internet to consumers. What On2 does is make video-compression software, which, in its simplest terms, is used to reduce the amount of bandwidth needed to send video over the Internet and onto computers, cell phones and other devices. When the video is compressed, the quality improves after it is accessed and viewed."

    On 8/6/09, On2 announced financial results for the June quarter, posting revenue of $5.0 million (+53% Y/Y, + 24% Q/Q) and a GAAP net loss of ($224,000), or ($0.00) per share (including $420 thousand related to the proposed merger and $523 thousand in non-recurring items, partially offset by a $669 thousand one-time gain). The revenue growth was impressive, but management cautioned, "As our top-line patterns are likely to remain somewhat variable, there is no guarantee that positive earnings trends will continue into the next quarter". We include a historical snapshot of On2's quarterly income statement
    on
    our personal blog.

    Given Q/Q revenue variability for On2, we believe assessing trends on an annualized basis makes most sense. The company generated 2008 revenue of $16.3 million (+23% Y/Y) and trailing twelve month revenue through 6/30/09 was $17.6 million, implying a slight deceleration in Y/Y growth to approximately 18%. The company's TTM gross margin was a healthy 85% and TTM operating loss was approximately $9 million. At 6/30/09, On2's net cash position was $460 thousand, down $816 thousand from $1.28 million six months prior at 12/31/08. The company's deferred revenue balance declined to $1.5 million at 6/30/09 from $2.1 million at 12/31/08. Put simply, while revenue was/is growing and On2 was slashing expenses, the company's financial position was weakening. Google to the rescue!

    Google saw value in On2's installed customer base and patented video codec technology for efficiently bringing video to mass audiences online. Per the company's 2008 10-K, On2 had the following intellectual property:
    • On2 holds nine U.S. patents and has nine U.S. patent applications pending, and six international patent applications pending
    • On2 Finland had five U.S. patent applications pending, eight Finnish patents, one Finnish patent application pending, and six foreign (non-Finnish and non-U.S.) patent applications pending
    Accordingly, with a vision to employ the technology to expand/improve its own platforms, Google paid approximately six times On2's TTM revenue despite the latter's history of operating losses.

    This brings us to Sonic Foundry (NASDAQ:SOFO), our speculative, venture capital-like holding. While Sonic Foundry's Mediasite solution is different from On2's proprietary video technology, we see some similarities:
    • Strong market position with favorable long-term secular trends
    • Growing, installed, happy customer base
    • Patented, proprietary technology suitable for large enterprise deployments
    We previously outlined these points and more in our intitial post regarding the Mediasite franchise, all of which -- in our view -- suggest the business is worth multiples of current trading levels to an informed acquirer. We reported on 7/30/09 that Sonic is successfully surviving the economic malaise, targeting >20% revenue growth for fiscal 2009 (end September) and poised to generate positive free cash flow in fiscal 2010 (i.e. self-funding, no need for a "rescue").

    For all we know, Sonic Foundry may remain a stand-alone company indefinitely. However, for reference, let's consider the valuation implied by the Google/On2 transaction:
    • Sonic generated TTM cash billings of $19.7 million
    • Applying the same six times purchase multiple yields a valuation of $118.2 million, or $2.75 per share assuming 43 million fully diluted shares outstanding
    • Implied valuation is 4.4 times Sonic's current $27.1 million market capitalization (assuming 43 million shares)
    An M&A team at fill-in-the-blank large tech company might consider paying such a multiple with the goal of using the company's clout, branding, and distribution to grow the Mediasite franchise into a $50 to $100 million revenue business with 20% operating margins. In this scenario, the company would be paying 12 times operating income at the low-end.

    As an aside, there are some interesting Mediasite presentations on Sonic's blog from the recent Campus Technology conference, including one from a Google Business Development Manager.

    Disclosure: Long SOFO.
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