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Mike Niehuser is the founder of Beacon Rock Research, LLC which produces research for an institutional audience and focuses on precious, base and industrial metals, and substitutes, oil and gas, alternative energy, as well as communications and human resources. Mr. Niehuser was nominated to... More
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  • Sonic Foundry Solidifies Position in Lecture Capture 0 comments
    May 24, 2011 11:12 PM | about stocks: SOFO
    Sonic Foundry, Inc. (NasdaqCM: SOFO) appears to have moved beyond the economic downturn, to be aligned with major trends in communication, and has become increasingly well positioned to execute on its business plan. Management should be applauded for proactively responding ahead of the economic crisis in 2008. Sonic Foundry’s focus crystallized on the education segment, particularly with existing customers, and devoted itself to adapting its product and services in response to client feedback. This allowed for a reduction in sales and marketing expense, management successfully decreased operating expenses over about ten consecutive quarters while maintaining investment in product development, thereby effectively placing itself in excellent position today as a leader in lecture capture, hosting and archival.
    Sonic Foundry was awarded its third patent by the U.S. Patent and Trademark Office for its Mediasite product line. The patent, entitled “Rich Media Event Production System and Method Including the Capture, Indexing and Synchronizing of RGB-Based Graphic Content” aptly describes the value proposition of the Mediasite presentation recorder. Mediasite recorders accept and synchronize a wide variety of rich media (video, audio, graphics, etc.) data for transmission over the Internet, creating a positive viewing experience for a live audience or replay on demand. This provides both a low-cost recording opportunity with minimal distraction for the presenter, and exceptionally robust viewing opportunity, fully capitalizing on the flexibility and exponential communication opportunities of the Internet. In particular, the patent specifies the types of devices and methods used in capturing and synchronizing the rich media feed and for synchronizing images to enhance the ease of viewing.
    Sonic Foundry has completed developments beyond capture and viewing to providing a stable platform for institutional IT personnel. This includes both host and archival or managing burgeoning numbers of recorded lectures. They have also focused on aligning with major trends in technology combined with customer preferences and are working toward a major product to release later in 2011 to accommodate viewing rich media on mobile devices. Lecture capture for distribution over the Internet is becoming mainstream educational technology, with a premium paid for turnkey solutions with flexible capture and viewing, and strong hosting and content management.
    The Education Segment is a Growing Niche
    The education segment continues to be Sonic Foundry’s strongest market segment, with close to one thousand customers accounting for nearly two thirds of its billings. The buying patterns for this segment account for the strong financial performance in the second half of its fiscal year ending in September. While early in its history, Sonic Foundry was very successful in the sales penetration of some of the most recognized educational institutions. Product adoption predictably followed patterns of customer testing, adoption and institutionalization. The sales process for Mediasite appears to be maturing, as a greater number of institutions are aware of the permanence of on-line education, which is also being driven by student demand and expectations.
    We are also pleased that sales have moved beyond the elite institutions to state and community colleges, providing a cost effective and personalized education for professional retraining and development.  Over time, Sonic Foundry has enjoyed increasing deal size. They report “average” deals over $100,000 are up over 60% since 2009, with the average “large” deal size now over $250,000. While the sales experience appears somewhat predictable, timing of larger deals is sometimes difficult to predict as institutions incorporate Mediasite into remodeling or classroom construction. They continue to report success participating earlier in construction with architects and consultants. 
    Sonic Foundry continues to enjoy success in international sales, accounting for some of its largest deals to date. International billings account for about 30% of overall billing in 2Q11 compared to 20% in 2Q10. Understandably, business to Japan has been disrupted in 2011 and management remains cautiously optimistic about continuing prospects for the Middle East. It is interesting that they report a growing sales presence in India, one of the largest higher education markets in the world. They report a strong pipeline and growth building on expanding relationships.
    Management Team Aligned with Maturing Rich Media Segment
    The Rich Media segment appears to be maturing. The importance of rich media in the online education segment is now mainstream. There also appears to be converging customer driven trends for both technological advances and increasing audience demand for quality experiences for information on the Internet. In addition, with the efficiencies encouraged during the economic crisis, for both educational institutions and corporations, additional funds are available for merger and acquisitions as well as consolidation of companies representing important components (video conferencing, webcasting, broadcasting and content management) of an emerging solution set.
    In a dynamic, competitive environment, management remains key to maintain and develop shareholder value. It would appear that Sonic Foundry’s board has put in motion a number of changes to effect positive initiatives during ongoing industry consolidation. Rimas Buinevicius now serves as the Executive Chairman of the Board and Chief Strategy Officer. We see this focus to be particularly important in guiding the company through a changing environment and aligning with the right partners. Gary Weis now serves as the Chief Executive Officer (a director since 2004) with a strong background in sales and support of enterprise customers within the Internet networking and communications industry, previously with IBM, AT&T and Concert. The combination of these two positions optimizes strategic and operational execution. 
    It is also notable that Ray Hassell has been appointed Vice President International, key to the success of Sonic Foundry’s international sales effort. Also, Dharmesh Sampat, who joined Sonic Foundry as a Software Design Engineer in October 2001 as part of the acquisition of Mediasite technology from Carnegie Mellon University, has been appointed as Vice President of Engineering. We see these appointments as natural and important for Sonic Foundry to maintain and capitalize on its leadership position.
    Fiscal 2011 Second Quarter Financial Discussion:
    Sonic Foundry reported financial results for the second quarter of its 2011 fiscal year ending March 31, 2011. Sonic Foundry reported revenues of $5.5 million in 2Q11, well above our estimate of $4.7 million, and about 13% above revenues of $4.9 million in 2Q10. This was due to growth from services, increasingly important in its seasonally weaker quarter, of $2.8 million in 2Q11, up 20% over $2.4 million in 2Q10, and exceeding our estimate of $2.6 million. Most notable, event services and hosting, an increasingly important component of service revenues, were $1.2 million in 2Q11, up 45% over 2Q10. Revenues from product sales were $2.6 million in 2Q11, about 6% over $2.5 million in 2Q10, but below our estimate of $2.7 million. This demonstrates consistent annual quarter-over-quarter increases in revenues, the more rapid growth in service revenues, event services in particular, becoming increasingly more important in seasonally weaker quarters, and the impact of larger deals on forecasting product revenues. 
    Total billings were $5.1 million in 2Q11, up 8% from $4.8 million in 2Q10. Product billings were $2.7 million in 2Q11, up 6% from $2.5 million in 2Q10, and service billings (for support, hosting, training, and events) were $2.4 million in 2Q11, up 10% from $2.2 million in 2Q10. In the 2Q11 and 2Q10, 66% of billings were to preexisting customers. In 2Q11, billings to education customers totaled 56%, and 31% for corporate customers. While billings are not revenues, they are a helpful indicator of sales. As contracts are signed and billed, cash is collected, increasing both cash balances and unearned income, and billings become an important metric for understanding cash flow.
    Gross margin was about 70.0% in 2Q11, down from 74.9% in 2Q10. The lower gross profit reflected increased direct and outsourced event labor costs and lower markups. Interestingly, while there were fewer discounts awarded to a lesser number of high quantity large deals in 2Q11 compared to 2Q10, gross margins were also reduced by greater volumes of discounted units for customers whose recorders had reached the end of hardware warranty eligibility. Accordingly, average sale price of units increased to $10,200 per unit in 2Q11, up from $9,600 in 2Q10. Sonic Foundry shipped 227 units in 2Q11, down from 237 units in 2Q10. Sales of rack to mobile units remained unchanged at 1.5 units to one in 2Q11 compared to 2Q10. Overall, increasing revenues exceeded declines in gross margins, allowing Sonic Foundry to report an increase in gross income to $3.9 million in 2Q11, up 5% from $3.7 million in 2Q10. 
    Sonic Foundry has maintained excellent operating expense control during a period of growing sales and seasonality in the education segment. Operating expenses were $4.0 million in 2Q11, up 8% from $3.7 million in 2Q10. Selling and marketing expense was $2.4 million in 2Q11, or 44.2% of sales, slightly above $2.3 million in 2Q10, or 47.3% of sales, but below our estimate of $2.5 million for the quarter. This was due to higher incentive costs with billings as well as benefits and stock compensation. In addition, general and administrative expenses were $717,000 in 2Q11, up 21% over $594,000 in 2Q10 due to benefits and stock compensation, but also below our estimate of $750,000. Product development was $862,000 in 2Q11, slightly above $805,000 in 2Q10. Management noted that without changes in stock compensation, operating expense would have been flat over prior periods. 
    Increases in the components of operating expenses are typical with initiatives to increase revenues, maintain operations and a culture of product development in line with customer expectations. Consequently, with increasing revenues, total operating expense decreased as a percentage of revenues to 72.8% in 2Q11, down from 75.8% in 2Q10, providing evidence of operating leverage in one of its seasonally weaker quarters. Sonic Foundry reported an operating loss of $152,000 in 2Q11, slightly greater than an operating loss of $43,000 in 2Q10. Sonic Foundry reported a net loss of $272,000 in 2Q11, or ($0.07) per share, below our net income estimate of $0.02 per share, and below a net loss of $131,000 or ($0.04) per share in 2Q10. 
    Unearned revenues were $4.9 million at the end of 2Q11, down slightly from $5.2 million in 1Q11. Unearned income typically declines in the first half of its fiscal year and increases in the second half. Sonic Foundry reported cash balances of $4.2 million at the end of 2Q11, up from $3.9 million in the previous quarter. They note that cash provided from operations during 1H11 was $220,000 compared to cash used of $346,000 in 1H10. The reduction of both unearned revenues and accounts receivables, with an improving cash position, is not uncommon for Sonic Foundry in its weaker seasonal quarters. As of March 31, 2011, Sonic Foundry had no debt outstanding, and has not utilized its $1.8 million credit line available with Silicon Valley Bank in over a year. They appear to have more adequate capital and liquidity to meet required working capital needs. 
    Earlier Guidance and Our Model
    On its 1Q11 conference call, management offered a wide range of potential quarterly year-over-year sales growth of 10% to 40%. This was due to confidence of growing sales but accepting the impact of the size and timing of larger deals on quarterly performance. With significant sales penetration to existing customers, to both universities and community colleges, and rapidly increasing sales for services, particularly event services and hosting, variations in sales growth appeared likely due to deal size, but increasing revenues appear certain. After years of flat or declining operating expenses, management budgeted a 15% increase in operating expenses for sales and marketing and product development. They noted that with increasing revenues, even with a budgeted increase in operating expenses, they anticipated ongoing operating leverage in fiscal 2011. 
    On the 2Q11 conference call, management acknowledged the challenges in international sales, but more importantly, that their sales pipeline was 50% higher at the start of their third fiscal quarter than at any point in their history. They also noted that higher education institutions have come to terms with economic challenges and have opted to maintain investment in technology and infrastructure over personnel. In addition, they note clear signs of recovery, particularly in trade shows, demonstrated in growth of its services business. Consequently, the company expects to realize $2.2 million in sales from unearned income in its third fiscal quarter.
    Our model includes 10% to 20% growth, which is consistent with earlier guidance and historic growth rates. We have also anticipated some improvement in gross margins, in line with management comments and increases in service revenues. In addition, we also expect an overall increase in operating expenses. While our rate of increase may be less than earlier budgeted, some of the increase is dependent on higher sales activity. In either case, we believe our model is a reasonable base case forecast. Based on our model we anticipate earnings per share of $0.15 and $0.62 in fiscal 2011 and 2012, respectively. In addition, our model forecasts sales per share of $6.43 and $6.88 in fiscal 2011 and 2012, respectively.
    Sonic Foundry reported revenue growth in both products and services, with notable increases in its events services, in 2Q11, one of its seasonally weakest quarters. They report a strong sales pipeline, moving into its seasonally strongest quarters, and with control of operating expenses, are beginning to exhibit operating leverage. The company has focused management to align the business with market trends and optimize operations. They also anticipate new product introductions later in the year to accommodate changes in mobile devices. 
    Sonic Foundry has successfully navigated the economic downturn and has emerged as a clear leader in lecture capture as evidence by the quality and duration of its client base as well as the product and service offering. It is becoming clear that online education is now a necessary part of higher education and corporate communications, with premiums paid for quality turnkey solutions. Management noted increasing activity for mergers and acquisitions in the education segment at 4x to 8x sales. The activity is somewhat reminiscent at the time YouTube was acquired. A potential price of $25.00 per share, about 4x trailing sales per share, is about 40x our fiscal 2012 earnings forecast. Considering Sonic Foundry’s product leadership position, good management of operating expenses and share count, with strong balance sheet and building cash flow, our assessment appears reasonable.
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